Macro-Economics For Policy Analysis

What is GDP

Gross Domestic Product(GDP) is a measure of the aggregate income of every person and corporation within a country’s borders. In other words, it is all value added in the input-output table.

What is an input-output matrix.

Matrix where rows are demand for an industry and columns are supply for an industry. All demands must equal supplies

How do you calculate gross output?

GO = cost of intermediate goods + value added

This can be reversed to find value added

What does value added represent?

Labor/salaries and profit(all value added is GDP)

Gross output vs GDP

Gross output represents all the supply/output of all finished goods at sales price. The GDP represents the value added, or the sales price minus the cost of intermediate inputs.

How do you calculate total demand?

Demand = value of intermediate inputs + value of final demand

What is final demand?

Final demand is the demand by end users of finished goods

What is the circular flow of income?

production of goods/services→employment→income generation→demand for goods/services→production of goods and services

Equation for Final Demand

FD(=GDP) = C + G + I + E - M

FD = Final Demand

C = Private Consumption Demand

G = Governmental Demand

I = Investment Demand(capital goods/machines)

E = Export Demand

M = Import Demands

What is the difference between nominal GDP and real GDP?

Nominal GDP(Y) is the product of the real GDP(y) and the price index(p)

Y = p x y

Theoretically, then, real GDP is adjusted for inflation using the price index.

In any case, nominal will be un-adjusted, and real will be adjusted for inflation.

How is unemployment calculated?

“Unemployed person” = someone aged at least 16 without work during some reference week and is available to start work within 2 weeks and is actively seeking work or has already found a job starting within 3 months.

U3(“unemployment rate”) = number of unemployed persons as a share of total active population(labor force is everyone between 16 and 65). The labor force includes people not seeking jobs, but the number of unemployed persons does not.

U6 on the other hand includes the people not seeking jobs plus the number of “unemployed persons” as a portion of labor force.

What is the definition of a recession?

Two quarters of back-to-back negative economic growth measured by real GDP

What is the difference between fiscal and monetary policy?

Fiscal policy is changing the variables in the GDP=FD=C +G +I+E-M equation via government action over public investment, taxes, etc. (expansionary fiscal policy vs fiscal austerity)

Monetary policy is a central bank(think the fed) attempts to influence inflation and GDP.

What can central banks do to change the inflation and GDP s situation?

Changing the interest rate:

• increasing interest rate reduces demand(especially investment I) and thus GDP should go down

• reduced interest rates mean more investment which means GDP will go up

• Problem: if central banks want to increase GDP, they cant go below zero

What is rolling over debt?

Rolling debt over is when government take out new loans to pay for the existing debt. As long as the economy grows, debt will not increase and the debt-to-gdp ratio will decline. Risky for high-debt countries, as countries need to source loans which often have high interest due to the governments existing debt.

In the neoclassical model, what is the general belief about employment?

The economy will tend toward full employment equilibrium

In the neoclassical model, what are the production factors?

Labor(L), Capital(K), and land/nature (N) have a price but are traded in markets. Capital is not just money, it is the means of production, or capital goods.

In the neoclassical model, what is “market clearance”?

If there is too much supply, price will go down until supply equals demand. Markets clear by pricing in neoclassical economics.

This is because consumers are supposed to be utility maximizers and firms are profit maximizers

Describe how the loanable funds market plays into the neoclassical model of macro-economics

Investment(I) in the means of production(K) is financed out of savings(S), which make up the “loanable funds” in the neoclassical model. Banks operate as intermediates between savers and investors because savings deposited in banks gives them the ability to loan to entrepreneurs to buy means of production(capital K). The loanable funds market will clear via the interest rate.

What is the view of money in the neoclassical model? Explain the classical dichotomy

Money is neutral.

Classical Dichotomy:

• changes in the quantity of money don’t originate in economy(exogenous), so they don’t effect relative prices in the economy.

What are the factor markets?

Labor market and capital goods market

What is the equilibrium real wage in neoclassical economics?

The wage at which the labor demand curve and the labor supply curve intersect in the labor market plot.

What is the “invisible hand” in neoclassical economics?

The market forces that clear the labor and capital markets, based on the assumption that both are perfectly competitive.

What ensures clearance of both factor markets in the neoclassical model?

The price mechanism

What is savings leakage in the neoclassical model and how is it mitigated?

Savings leakage is the amount of money that is saved and non reinvested, therefore leading to a decrease in the total economic output compared to the “full-employment” market output. It is mitigated by introducing a separate “market for loanable funds”

How is the bank conceptualized in the neoclassical model?

It is thought of as a market in itself, which clears with an ideal interest rate when loanable funds demand = loanable funds supply

What happens in a neoclassical loanable funds market when there is an excess of savings(supply of loanable funds)?

The banks want to make a profit off of these, so they try to sell them to firms. Firms, wanting to make a profit off of the investments, will drive the interest rate down and take loans, therefore increasing investment(demand for loanable funds) and decreasing the supply for loanable funds. This continues until the market reaches some equilibrium.

What is fiscal stimulus?

Fiscal stimulus is the same as an expansionary fiscal policy. It can be:

• Increase in public spending (g)

• increase in public investment (i)

• reduced income tax

What is the effect of fiscal stimulus in the neoclassical model?

Because government investment requires governments to borrow funds from banks, there will be a higher governmental demand for loanable funds. This will push the interest rate up, which will decrease private investment and increase saving, lowering consumption. This puts pressure on the economy.

How is equilibrium in the money market achieved in the neoclassical model?

Added monetarism to the model, as it does not account for money originally. In monetarism, the equilibrium is achieved by changing the price index. In other words, the money supply can only grow as a function of the price index.

What are the money growth rule and the monetary policy rule?

Money growth rule:

• M_hat^S = p_hat + y_hat

Monetary policy rule:

• Central banks should let the money supply grow in line with real GDP growth + 2%

What does the Keynesian model say about employment?

There is no market tendency toward full employment, and actually markets generally operate at less than full employment.

What is the role of aggregate demand in Keynesian economics?

Huge emphasis as the key driver of economic growth. Largely autonomous(or exogenous) of economic variables.

what drives investment by firms in Keynesian economics?

Subjective expectations of entrepreneurs about the future state of the economy(again largely autonomous or exogenous).

What determines investment strategies of firms in Keynesian economics?

A firm invests if they expect that in the near future there will be increased demand for their product. Strategy is always forward-looking, not backward-looking, and these expectations are inherently social, as they rely on experts and industry consensus.

What are “animal spirits” in investing(Keynesian economics)?

Business leaders have social motivations that often lead to self-fulfilling prophecies. If a firm or industry thinks a recession will occur, it will invest less, so the economy will go into a recession, so they will invest even less, etc.

Economy goes up in cycles of “optimism” and down in cycles of “depressed animal spirits”. This is called the business cycle.

What is the difference between business investment and consumption in Keynesian economics?

Consumption is stable, as households consume fixed proportions of disposable income, but business investment is very volatile.

What is the Keynesian attitude on banks and money?

They are NOT just intermediary institutions. They are money-creating institutions that issue loans without having to mobilize deposits, so they can create money from nothing to pre-finance investments. Money is therefore NOT neutral in Keynesian economics, as there is a monetary-production economy.

What is the Keynesian view on fiscal policy and monetary policy?

Can be used to keep real GDP close to full-employment levels, and there it does not crowd out private spending. It is much more effective than monetary policy because private investment is more influenced by profits than the cost of capital.

What is capital accumulation in Keynesian economics?

private investment that increases the economy’s productive capacity.

Describe the multiplier process in Keynesian economics

When a firm invests, say 100 billion, the demand will increase, and thus production will increase, and thus wages will increase. A fixed portion of the wage goes back into consumption, which increases the demand, starting the cycle over again, so the value added to the economy keeps increasing past the original 100 billion dollar investment.

What do ex-ante and ex-post mean? What is Keynes’ objection to their use in the neoclassical model

Ex-ante=”Before the fact”

• banks have to first mobilize existing savings

Ex-post = “After the fact”

• banks use the mobilized funding to invest

Keynes though of banks as institutions that can create money via credit instead of the ex-ante mobilization and ex-post investment of funds

How does the interest rate affect investment in Keynesian economics?

Not much, as investment is much more correlated to the animal spirits idea.

Describe the paradox of thrift

increased savings at a fixed portion of disposable income means that there will be less output(as the multiplier 1/σ decreases), therefore less income, therefore less savings.

Why doesn’t public investment crowd out private investment in the Keynesian model?

Banks dont have to raise the interest rate to attract more savings, as they can just create money and give the state a loan to finance a higher i_g. This is a critical aspect of Keynesian economics, that there is no savings-constraint since banks can create money.

How long do business cycles last in Keynesian economics?

7-9 years

What is a counter-cyclical fiscal policy?

Governmental policy that tries to dampen the effects of the business cycles by cutting spending during upswings and increasing spending during downturns/recessions. Government uses demand management to stabilize the economy.

What are the three key lessons of government budgeting in Keynesian economics?

1) Governmental budget deficit may be desirable in a downswing to help increase aggregate demand

2) Budget surplus may be desirable in an upswing to prevent economic over-heating.

3)

What is economic overheating?

GDP begins to approach the full employment levels, and there will be excess demands for raw material and energy, so their prices will rise, and inflation will rise.

In Keynesian economics, what happens to debt-to-gdp ratio when a government invests?

It goes down, as GDP increases more(due to multipliers) than debt does. The opposite is also true, that fiscal austerity increases the debt-to-gdp ratio.

What is the central bank’s relationship with money supply in Keynesian economics?

It influences, but does not control money supply. It’s influence is wielded via the interest rate,

Describe the liquidity trap in Keynesian economics

Families tend to prefer liquid money in times of economic uncertainty in order to keep all options open, but cash does not generate any returns, and saving increases the leakage out of the circular money cycle. This means that in times of recession, there is a positive feedback of savings/liquidity that puts pressure on the economy to keep receding. This is called pro-cyclical, as it increases the amplitude of the business cycle.

How do you get out of the liquidity trap in Keynesian economics?

Government must invest to get out of a recession by creating aggregate demand

What is the ex-post equality in Keynesian economics?

Equilibrium investment = savings(due to multipliers)

What were the causes of Italy’s financial decline after 1990? What did they do to try and solve it, and how did that work?

Major structural economic factors held down aggregate demand:

• low growth of real wages led to declining household income and declining domestic demand, increasing reliance on exports

• Declining public expenditures

• Poor export performance due to the strength of the euro

Italy tried to fix this via fiscal austerity, but it backfired as the debt-to-gdp ratio increased due to austerity.

What are the aspects of Keynesian economics missing in the IS-LM model?

1) It presents the real and monetary sectors as separate

2) it assumes money supply is exogenous(used as a lever in the economy by the central bank but not subject to economic forces) whereas Keynesian economics assumes money supply is endogenous(determined by demand for money)

3) Ignores uncertainty, which undermines the liquidity preference aspect of Keynesian economics

What are the IS and LM curves in the IS-LM model?

IS Curve: The curve of possible real GDPs y at which investment=savings

LM Curve: The curve of real GDP and interest rate that keep the supply of money equal to the demand for money

In the IS-LM model, how does a central bank control the money supply

To increase money supply, it buys government and private bonds. To decrease money supply, it sells these bonds.

How is money demand calculated in the IS-LM model?

M_d = L1 + L2

L1 is the transaction demand for money, or the demand of public/businesses for cash to pay for transactions

L2 is the speculative demand or money, or the demand that investors have for cash to hold onto and speculate

What is the Bond market?

Bonds are debts that are issued by governments and sold to financial investors. They will have periodic interest payments that are relatively low(~2.5%) and have a particular duration.

What is the correlation between interest rate and secondary bond market prices?

Negative correlation, so high interest rates = lowering secondary bond market prices, and vice versa

In the IS-LM model, what does increased government investment do?

Increased investment pushes the IS curve up, which then increases the interest rate and real GDP

In the IS-LM model, what does increasing the money supply do?

Pushes the LM curve to the right, lowering interest rates and increasing real GDP.

Describe the Monetarist version of the IS-LM model

In the monetarist formulation, money-market equilibrium determines nominal GDP, not real GDP. Partly this is because they assume there is no speculative demand for money. The problem is that this system is underdetermined, as you can’t say what will happen to real GDP and inflation if the money supply increases.

What is the money illusion in the monetarist IS-LM model?

The money illusion is the fact that as money supply increases, at first people do not recognize inflation and view their supply of money as the nominal supply of money.

In the monetarist IS-LM model, what is the view of long-term increases in the money supply?

Eventually consumers and firms realize that the increase of money will only cause inflation, so if the price levels rise in the same proportion as nominal GDP, real GDP will plateau. Increased investment, in this view, cannot promote sustained real GDP growth.

In the exogenous view of money, how is money created? What is the money multiplier model?

In exogenous view(neoclassical and IS-LM) money is created by national banks buying bonds from private banks, which then lend money to firms that will deposit that in other banks, which will then lend money to other firms, which will then deposit, etc. The money multiplier model is the model by which the amount of money in circulation gets multiplied when this loan→deposit→loan cycle continues, and is limited by the restrictions on cash reserves as a portion of loans.

How is money created in the endogenous model?

In the endogenous model(Keynesian) money is created by banks crediting firms with loans, which show up as assets first. This deposit-cash