Introduction to Macroeconomics

Gross Domestic Product (GDP)

The market value of all final goods & services produced within a country in a given period of time.

• Measures total income of everyone in the economy

• Measures total expenditure on the economy’s output of goods and services.

• Only includes final goods (excludes intermediate goods).

Firms V.S. Households

Firms buy/hire factors of production, use them to produce goods and services, then sell goods and services. While household own the factors of production, sell/rent them to firms for income, and buy and consume goods & services.

The four components of GDP (what are they)

Consumption, Investment, Government, Net Exports

• C: Total spending by households on goods and services.

• I: Total spending on goods that will be used in the future to produce more goods. I.e. Business capital, Residential capital, Inventory accumulations. (Does not include stocks/bonds)

• G: All spending on the goods and services purchased by the government (federal, state, and local levels)

• NX: Exports - imports

Formula for output

Y = C + I + G+ NX

Output = Consumption + Investment + Government + Net Exports

Real vs Nominal GDP

Real GDP: Values output using the prices of a base year (corrected for inflation).

Nominal GDP: Values output using current prices (not correct for inflation).

Remember —> Base year: Nominal GDP = GDP

GDP deflator

A measure of overall level of prices relative to inflation.

100 x Nominal GDP/ Real GDP

GDP per capita

The main indicator of the average person’s standard of living.

Consumer Price Index (CPI)

Measure of the overall level of prices & overall cost of goods and services bought by a typical consumer.

Contrasting GDP Deflator and CPI

Imported consumer goods —> Included in CPI but excluded from GDP deflator

Capital goods —> Excluded from CPI but included in GDP deflator

Growth rate equation

[(End Value/Beginning Value) ^ 1/n]

Productivity

Quantity of goods and services,

Productivity: Y/L (Real GDP/Quantity of Labor)

Determinants of Productivity:

• K: Physical capital, stock of equipment and structures used to produce goods and services

• H: Human capital, Knowledge and skills workers acquire through education, training, and experience

• N: Natural resources, inputs into production that nature provides.

Productivity function

Y = A F (L,K,H.N)

Output = technology * inputs (Labor x Physical x human x natural resources)

• A graph or equation showing the relation between output nd inputs

• F() is a function that shows how inputs are combined to produce output.

• A is the level of technology

• A multiplies the function F(), so improvements in technology (increases in A) allowed more output (Y) to be produced from any given combination of inputs.

Returns to scale

Constant return to scale: the inputs and outputs are increased by the same factor

Increasing return to scale: The outputs are increased more than the input factor

Decreasing return to scale: The inputs are increased more than the output factor

Diminishing Returns

Policies that raise savings and investment: fewer resources are used to make consumption goods

• More resources: to make capital goods

• K increases, rising productivity and living standards

• This faster growth is temporary, due to diminishing returns to capital: As K rises, the extra output from an additional unit of K falls.

The Catch up effect

The property whereby poor countries tend to grow more rapidly than rich ones. However, due to diminishing returns, their growth will slow as the nation becomes more developed.

Free Trade

Inward-oriented policies: tariffs, limits on investment from abroad (raising living standards by avoiding interactions with other countries)

Outward-oriented policies: Free trade to create growth via foreign investment.

Financial system

Group of institutions in the economy that help match the savings of one person with the investment of another

Financial institutions

Institutions through which savers can directly provide funds to borrowers

EX: financial markets & financial intermediaries (Banks)

Financial markets

Savers can directly provide funds to borrowers

The Bond Market: A bond is a certificate of indebtedness

The Stock market: A stock is a claim to partial ownership in a firm

Financial intermediaries

Institutions through which savers can indirectly provide funds to borrow (Banks)

Mutual Funds

Institutions that sell shares to the public and use the proceeds to buy portfolios of stocks and bonds

Elements of Financial Crises

• Large decline in some asset prices: (Housing crash)

• Insolvencies at financial institutions: (Banks and institutions failed when many homeowners stopped paying their mortgages)

• Decline in confidence in financial institutions: (Customers with uninsured deposits began pulling their funds out of financial institutions)

• Credit crunch: (Borrowers unable to get loans)

• Economic downturn (Failing financial institutions and a fall in vestment caused GDP to fall and unemployment to rise)

• Vicious circle: The downturn reduced profits and asset values, which worsened the crisis)

Accounting Identities

In closed economy: NX=0, therefore

Y= C + I + G ====  I= Y - C - G

National saving, S: Total income in the economy that remains after paying for consumption and government purchases

By definition: S = Y - C - G

Savings (S) = Investment (I) in a closed economy. 

• For T = taxes minus transfer payments

S= Y - C - G can be rewritten as: S= (Y - T -C) + (T - G) 

Private saving, Y - T - C: Come that households have left after paying for taxes and consumption

Public saving, T - G: Tax revenue that the government has left after paying for its spending

Budget surplus: T - G > 0: Excess of tax revenue over government spending = public saving (T-G)

Budget deficit: T-G < 0: Shortfall of tax revenue from government spending = -(public saving) = G - T

Saving v.s. investment

Private savings: Income remaining after households pay their taxes and pay for consumption. Ex: Starting a savings account

Investment: The purchase of new capital. Ex: Building a new 300,00 dollar house.

The Market for Loanable Funds

The Market for Loanable Funds

Loanable funds market: A supply-demand model of the financial system 

Helps us understand:

• How the financial system coordinates saving & investment. 

• How government policies and other factors affect saving, investment, and the interest rate. 

Assume: only one financial market

• All savers deposit their savings in this market. 

• All borrowers take out loans from this market. 

• There is one interest rate, which is both the return to saving and the cost of borrowing. 

The supply of loanable funds comes from saving: Households with extra income can loan it out and earn interest. 

Public savings:

• If positive, adds to national saving and the supply of loanable funds. 

• If negative, it reduces national saving and the supply of loanable funds. 

The demand for loanable funds comes from investment: Firms borrow the funds they need to pay for new equipment

Crowding out effect

private investment cannot compete with the government. In financial crises, the government will increase its borrowing and sending, leading to higher interest rates. This forces private investment to leave the market.

3 Functions of Money

1. Medium of exchange: Item that buyer gives to seller when they want to purchase goods and services

2. Unit of account: Yardstick people use to post prices and record debts

3. Store of value: Item that people can use to transfer purchasing power from the present to the future.

2 Kinds of Money

Commodity money: Takes the form of a commodity with intrinsic value Ex: Gold coins

Fiat money: Money without intrinsic value, used as money because of government decree, Ex: US dollar.

The Money Supply

Quantity of money available in the economy

Currency: Paper bills and coins in the hands of the public

Demand deposits: Balances in bank accounts that depositors can access on demand by writing a check

Money supply = money multiplier x bank reserves

Central Bank & Monetary policy

Central Bank: An institution that oversees the banking system and regulates the money supply

Monetary policy: Setting of the money supply by policymakers in the central bank

The central bank of the U.S. —> the FED

Bank Reserves

Banks keep a fraction of deposits as reserves and use the rest to make loans.

The Fed establishes reserve requirements: Regulations on the minimum amount of reserves that banks must hold against deposits:

The reserve ratio (R): Fraction of deposits that banks hold as reserves.

The Money Multiplier

1/R: Amount of money the banking system generates with each dollar of reserves

EX: R: 10%

Money multiplier 1/0.1 = 10, $100 of reserves creates 1000 of money.

Balance Sheet

Assets: Besides reserves and loans, banks also hold securities

Liabilities: Besides deposits, banks also obtain funds from issuing debt and equity.

Bank capital: The resources a bank obtains by issuing equity to its owners, Bank assets - Bank liabilities

Capital requirement

A government regulation that specifies a minimum amount of capital. Intended to ensure banks will be able to pay off depositors and debts.

Leverage

The use of borrowed funds to supplement existing funds for investment purposes.

Leverage ratio: Ratio of assets to bank capital

How can the Fed change the money supply?

By Changing bank reserves or changing the money multiplier

The federal funds rate

Interest rate at which banks make overnight loans to one another

Lender - has excess reserves

Borrower- needs reserves

Real v.s. Nominal

Real - quantities, relative prices

Nominal - measured in terms of money

The Aggregate-Demand (AD) Curve

The Ad curve shows the quantity of all goods and services demanded in the economy at any given price level.

What can shift the AD curve?

Any event that changes C, I, G, or NX, except a change in P, will shift the AD curve.

Aggregate Supply (AS) curve

Shows the total quantity of goods and services firms produce and sell at any given price level.

Long Run Aggregate Supply (LRAS)

A vertical line, because an increase of decrease in Price (P), will not affect the Natural Output (Yn).

The natural rate of output (Yn)

The amount of output the economy produces when unemployment is at its natural rate.

Why the LRAS curve might shift

Changes in L (quantity of Labor) or natural rate of unemployment, changes in K (physical capital) or H (human capital). changes in technology, changes in natural resources

Sticky Wage Theory

Nominal wages are sticky in the short run, they adjust sluggishly. This is due to labor contracts, social norms. Firms and workers set the nominal wage in advance based on Expected price (Pe).

If P > Pe:

1. Revenue is higher, but labor cost is not.

2. Production is more profitable, so firms increase output and employment

Sticky-Price Theory

Many prices are sticky in the short run, due to the costs of adjusting prices. Firms set sticky prices in advance based on expected Price.

Formula for Price

Y = Yn + a (P - PE)

Output = natural rate of output + unknown variable(Actual Price - Expected Price)

Why Short Run Aggregate Supply might Shift

Everything that shifts LRAS shifts SRAS as well + PE shifts SRAS if PE rises, and as a result Y falls.

Four steps to analyzing economic fluctuations

1. Determine whether the event shifts AD or AS

2. Determine whether curve shifts left or right

3. Use AD-AS diagram to see how the shift changes Y and P in the short run.

4. Use AD-AS diagram to see how economy moves from new SR equilibrium to new LR equilibrium.

The Wealth Effect

If the price level, P, declines:

• Increase in the real value of money

• Consumers are wealthier

• Increase in consumer spending, C

• Increase in quantity demanded of goods and services

The Interest-Rate Effect

Suppose the price level, P, declines:

• Buying goods and services requires fewer dollars

• Decrease in the interest rate

• Increase spending on investment goods, I

• Increase in quantity demanded of goods and services

The Exchange-Rate Effect (P and NX)

Suppose the U.S. price level, P, declines

• Decrease in the interest rate

• U.S. dollar depreciates

• Stimulates U.S. net exports, NX

• Increase in quantity demanded of goods and services.

Money Supply

Assumed fixed by central bank, does not depend on interest rate.

Money demand

Reflects how much wealth people want to hold in liquid form.

Contractionary Monetary policy

increased interest rate → decrease investment → Aggregate demand decreases.

Expansionary monetary policy

interest rate decrease → Investment increase → Aggregate demand increases. 

Expansionary fiscal policy

Government spending increases x taxes decreases → Government spending increases → Aggregate demand increases. 

Contractionary fiscal policy

Government spending decreases x taxes increases → Consumer spending decreases → Aggregate demand decreases

The Crowding-Out Effect

Results when expansionary fiscal policy raises the interest rate, thereby reduces investment spending, which reduces the net increase in aggregate demand. EX: Government puts 20 billion dollars into the economy, private investment cannot compete, therefore reducing aggregate demand.

Nominal variables v.s. Real variables

Nominal variables are measured in monetary units (nominal GDP- not adjusted for inflation) while real variables are measured in physical units. (real GDP- adjusted for inflation)

Real Wage

The price of labor relative to the price of output (W/P)

Velocity of money

The rate at which money changes hands

Notation: V = P x Y/ M

P x Y = nominal GDP = price level x real GDP

M = money supply

V= velocity

Principle of monetary neutrality

An increase in the rate of money growth raises the rate of inflation but does not affect any real variable

Labor Force Statistics

BLS divides population into 3 groups:

1. Employed: paid employees, self-employed, and unpaid workers in a family business

2. Unemployed: people not working who have looked for work during previous 4 weeks

3. Not in the labor force: everyone else

Unemployed rate & Labor-force participation

% of the labor force that is unemployed

u-rate = 100 x # of unemployed/ Labor force

% of the adult population that is in the labor force

labor-force participation rate = 100 x Labor force/ Adult Population