MT

Comprehensive Macro Notes: National Accounts, Price Level, Unemployment, Growth, Money, Exchange Rates, Policy, and EU

GDP and National Accounts (Lecture 2)

  • GDP definition
    • The market value of all final goods and services produced within a country in a given period of time
    • Excludes intermediate goods, used goods, and goods produced abroad by domestically owned factors of production
    • Purpose: compare economies across countries and over time; gauge business cycle health and size of the economy
  • Measurement approaches (circular flow framework)
    • Expenditure approach: sum expenditures on C, I, G, and NX
    • ext{GDP} = C + I + G + X - M
    • X = exports; M = imports; NX = X - M
    • Income approach: wages, interests, profits
    • Output (value-added) approach: sum value added at each stage of production
  • Limitations of GDP (production focus)
    • Informal economy not captured
    • Illegal activities
    • Domestic work often not included
  • Why measure GDP?
    • Enables comparisons over time and across countries
    • Indicates size and performance of the economy and health of the business cycle
    • Growth rate of real GDP as an indicator of economic health
  • Alternative measures to GDP
    • Gross National Product (GNP) / Gross National Income (GNI):
    • ext{GNI} = ext{GDP} + ext{income earned abroad by domestic residents} - ext{income earned domestically by foreigners}
    • Net National Product (NNP):
    • ext{NNP} = ext{GNP} - ext{depreciation of capital}
    • Gross National Income (GNI) includes income from abroad (e.g., remittances, profits from overseas investments)
    • Example: Ireland’s high GNI due to foreign investments and corporate headquarters
  • Purchasing Power Parity (PPP) GDP
    • Adjusts GDP for cost-of-living differences across countries
    • Example comparisons: China vs. U.S.; developing nations like India may have lower nominal GDP but higher GDP at PPP
  • GDP over time and per capita measures
    • Nominal GDP: measured in current prices
    • Real GDP: measured in constant prices (base year) to remove price level changes
    • Real GDP formula: ext{Real GDP} = rac{ ext{Nominal GDP}}{ ext{GDP deflator}}
    • Chain linking vs. fixed-base (constant prices) methods
    • GDP per capita: ext{GDP per capita} = rac{ ext{Total GDP}}{ ext{Population}} /year
    • GDP growth (total or per capita, real GDP)
  • Issues when comparing GDP across countries or times
    • Different population sizes -> GDP per capita differences
    • Different currencies -> GDP in USD vs domestic currency (exchange rate effects)
    • Different price levels -> PPP-adjusted comparisons
  • Health, development, and well-being measures
    • GDP does not capture well-being indicators like crime, leisure, environment, inequality, health, education, happiness
    • Human Development Index (HDI) as a broader measure
  • HDI (brief components)
    • Description: Combines GDP per capita with life expectancy and education indicators
    • Components:
    • Standard of living: GDP per capita (GNI per capita used in some formulations)
    • Health: Life expectancy at birth
    • Education: Mean years of schooling for adults 25+ and expected years of schooling for children entering school
    • Example: Countries with high GDP per capita may lag on HDI if health/education indicators are poorer (e.g., Saudi Arabia vs. Sweden)

The Price Level and Inflation (Lecture 5–7 overview)

  • Price level and cost of living
    • Price level: a snapshot of prices of goods/services at a specific period
    • Cost of living: resources needed to maintain standard of living
  • Inflation and deflation
    • Inflation: rise in the overall price level
    • Deflation: fall in the overall price level
  • Measuring the inflation rate
    • ext{Inflation rate} = 100 imes rac{Pt - P{t-1}}{P_{t-1}}
  • How to measure the price level (price index construction)
    • Steps:
    1. Fix the basket of goods/services
    2. Find prices in different times
    3. Compute basket cost in different times
    4. Choose a base year and compute the index
    5. Compute the inflation rate
  • Problems with price-level measures
    • Fixed weights vs chain-linked indices: substitution bias
    • New goods not reflected promptly
    • Quality changes over time
    • Relevance for individual consumers
    • See various price-level data and methods (ECB data links cited in class)
  • Different measures of the price level
    • Headline vs Core inflation: CPI-based; Core excludes volatile items (e.g., food/energy)
  • Correcting variables for inflation
    • Amount in year X in currency units: ext{Amount}{X} = ext{Amount}{T} imes rac{ ext{Price index}{X} }{ ext{Price index}{T} }
    • If X is base year, index = 1 (simplifies)
  • Real vs Nominal variables
    • Real GDP: ext{Real GDP} = rac{ ext{Nominal GDP}}{ ext{GDP deflator}}
    • Real vs Nominal interest rates: r = i - \pi \ (real\, interest\, rate)
    • Real wage: ext{Real wage} = rac{W}{P}
    • Real wage growth approximation: real wage growth ≈ nominal wage growth − inflation
  • PPP and exchange rates (recap)
    • Absolute PPP: exchange rate equals the ratio of price levels, e = P*/P
    • Relative PPP: exchange rate changes to offset differences in inflation across countries over time
    • Real exchange rate (conceptual): shows actual relative prices between countries

Unemployment and the Labour Market (Lecture 8–11 overview)

  • Who is unemployed?
    • General: person of working age, able and available for work at current wages, without a job
    • Specific: without a job, willing to start within two weeks and actively seeking or waiting to start a job
  • How unemployment is measured
    • Claimant count: number claiming unemployment benefits
    • Sensitive to eligibility rules
    • Labour force surveys: representative sample; sensitive to definitions/question wording
  • Labour market definitions
    • Employed: spent some of the previous week in a paid job
    • Economically inactive: not employed or unemployed due to education, retirement, etc.
    • Labour force: Employed + Unemployed
  • Labour market measurements
    • Unemployment rate: ext{Unemployment rate} = rac{ ext{unemployed}}{ ext{labour force}} imes 100
    • Labour force participation rate: rac{ ext{labour force}}{ ext{adult population}} imes 100
    • Employment rate: rac{ ext{employed}}{ ext{adult population}} imes 100
  • Problems with unemployment measurement
    • Discouraged workers
    • People employed who want to work more (underemployment)
    • Labor market programs influencing measured unemployment
  • Types and theory of unemployment
    • Natural rate of unemployment (NRU): actual unemployment tends to move around this rate in the absence of cyclical shocks
    • Frictional unemployment: job search in between jobs
    • Structural unemployment: caused by long-term changes in the economy (skills mismatch, geography, etc.)
    • Unemployment due to labour-market imperfections (minimum wage laws, unions, efficiency wages)
    • Cyclical unemployment: deviation from NRU due to business cycle fluctuations
  • Policy responses
    • Active measures: employment services, labour market programs
    • Passive measures: unemployment benefits
  • Impacts of unemployment
    • Individual: income loss, social consequences, potential hysteresis
    • Society: lost output, higher deficits, debt dynamics, regional impacts
  • Summary relationships
    • Measured unemployment ≈ NRU + cyclical unemployment
    • NRU = frictional + structural + unemployment due to labour-market imperfections
    • Policy analysis involves considering stabilization policies and long-run implications

Long-Run Growth and Sustainability (Lecture 4)

  • Growth sources
    • Productivity increases drive growth
    • Growth through investment in: physical capital, human capital, technological knowledge
    • Growth through natural resources and geography
    • Institutions matter: legal system, financial system, economic and political stability
  • The Solow model (growth theory)
    • More capital per worker raises growth temporarily; long-run growth is driven by technological progress (exogenous in the model)
  • Endogenous growth theory
    • How to generate technological progress: investment in R&D and human capital; incentives via monopoly rents and policy structure
  • Institutional theory
    • Environments that support investment in physical capital, education, and R&D: political stability, property rights, pro-investment culture
  • Sustainability of growth
    • Definition: capacity to produce today without compromising future generations' ability to meet their needs
    • Climate change and intertemporal choices: who bears the cost?
    • UN Sustainable Development Goals (SDGs)
  • Open economy factors
    • Openness to trade, geography, culture, and institutions influence long-run growth

Saving, Investment, and the Financial System (Lectures 5–6)

  • The financial system purpose
    • Matches savers and borrowers; channels money from savers to investors
    • Direct transfers (markets) vs. indirect transfers (financial intermediaries)
  • National saving in a closed economy
    • Identity: Y = C + I + G ext{ (closed economy, no NX)}
    • Savings: S = Y - C \; or\; S = I
    • In a closed economy: S = I
  • Public saving and budget balance
    • Government budget: T taxes, G spending
    • If T - G > 0
      ightarrow ext{budget surplus};
    • If T - G < 0
      ightarrow ext{budget deficit}
      ightarrow ext{increases government debt}
  • The loanable funds market
    • Supply of savings, demand for funds for investment
    • In a closed economy: S = I; in open economies, NCO links investment and savings across borders
  • The public sector and national savings in an open economy
    • National income: Y = C + I + G + NX
    • National saving: S = Y - C - G = I + NX
    • Since NX = NCO, we obtain: S = I + NCO
  • Private and public savings decomposition
    • Private saving: S_{private} = I + NCO + (G - T)
    • The role of budget deficits on the loanable funds market (crowding out) and long-run growth
  • The financial system and policy tools
    • Tax incentives for saving; tax credits for investment
    • Budget deficits influence the cost of borrowing and long-run growth outcomes
  • What the financial system does
    • Channel savings into investment; allocate risk; support long-run growth

Money, Central Banks, and Inflation (Lectures 6–7)

  • What is money?
    • A medium of exchange, unit of account, store of value
  • Kinds of money
    • Commodity money, fiat money (convertible and non-convertible), legal tender notions
  • Money stock definitions
    • Narrow money (M1): currency in circulation + overnight deposits
    • Intermediate money (M2)
    • Broad money (M3)
    • Note: Money stock measures used in the euro area and other economies vary; data sources cited in class
  • Central banks
    • Responsibilities: regulate money supply, control inflation, maintain financial stability
    • Duties: monetary policy, lender of last resort, clearing interbank payments, regulation of banks
  • Tools of monetary control
    • Overt open market operations (buying/selling government securities)
    • Policy interest rates (deposits and policy rates)
    • Reserve requirements
    • Unconventional policy: Quantitative easing/tightening (QE/ QT)
  • Risk in banks and macroprudential policy
    • Credit risk; liquidity risk; system-wide risk
    • Macroprudential tools: reserve requirements, equity capital, deposit insurance
  • Central bank digital currency (CBDC)
    • Rationale: public money vs private digital money; accessibility with reduced cash use
  • The quantity theory of money and the money-inflation link
    • Equation: M imes V = P imes Y
    • Velocity of money: V = rac{P imes Y}{M}
    • If velocity is constant and money supply grows faster than real output: inflation rises
    • Monetary neutrality: over the long run, changes in money do not affect real variables
  • Inflation: costs and taxes
    • Inflation tax: governments financing spending by printing money can reduce the real value of money
    • Deflations and hyperinflation risks

Open and Closed Economy Exchange, and the Balance of Payments (Lectures 7–8)

  • International transactions and the balance of payments
    • Net exports (NX) = Exports − Imports
    • Net capital outflow (NCO) = domestic saving invested abroad − foreign saving invested domestically
    • Identity: NX = NCO (under standard accounting frameworks)
    • The current account plus the financial account (and sometimes the capital account) sum to zero after including statistical adjustments
  • Core identity: Net Exports and Net Capital Outflow
    • If NX > 0 (trade surplus), then NCO > 0 (capital outflow)
    • If NX < 0 (trade deficit), then NCO < 0 (capital inflow)
  • The current account components
    • Trade balance on goods and services
    • Net primary income (payments on factors of production abroad)
    • Net secondary income (transfers from abroad)
  • The financial account and the capital account
    • Financial assets transactions with the rest of the world
    • Capital transfers and non-financial assets (land, resources) in the capital account
  • National saving in an open economy
    • National income identity: Y = C + I + G + NX
    • National saving: S = Y - C - G = I + NX
    • With NX = NCO: S = I + NCO
  • NIIP (Net International Investment Position)
    • The value of a country’s external assets minus its external liabilities

Exchange Rates: Nominal, Real, and PPP (Lectures 25–26, 50–52)

  • Nominal exchange rate
    • The rate at which one currency can be exchanged for another (e.g., SEK per EUR)
    • Determinants in the long run: price level differences (PPP), interest rate differentials, expectations, capital mobility
  • Real exchange rate
    • The rate at which goods/services from one country trade for goods/services of another
    • Determinants: nominal rate, price levels, and PPP relation
    • Absolute PPP: e = P*/P
    • Relative PPP: changes in exchange rate offset differences in inflation between countries
  • PPP concepts
    • Absolute PPP: same basket of goods costs the same in two countries when priced in a common currency
    • Relative PPP: the rate should adjust to offset inflation differentials over time
    • The long-run relation: changes in inflation differences influence exchange rate movements; not the only determinant in practice
  • Exchange rate regimes
    • Flexible (floating) vs fixed regimes
    • Crawling pegs, devaluations, revaluations
  • The monetary trilemma (impossibility theorem)
    • A country can choose any two of the following three: exchange-rate stability, monetary-policy autonomy, and free capital movement
  • Practical implications and crises
    • Exchange-rate crises can be triggered by macro imbalances and self-fulfilling expectations; central bank actions (rates, reserves) may be used to defend a currency

The AD/AS Model and Macroeconomic Policy (Lectures 11–13)

  • From short-run to long-run
    • Short-run: prices fixed; output determined by aggregate demand (Demand-determined)
    • Long-run: prices and wages flexible; output determined by long-run aggregate supply (LRAS) and potential output
  • Aggregate demand (AD) and aggregate supply (AS)
    • AD curve (downward sloping): relationship between price level and quantity of real GDP demanded
    • SRAS (upward/slightly upward sloped): prices are sticky; output deviates as price level deviates from expectations
    • LRAS: vertical; economy’s potential output determined by resources and technology
  • Shocks and policy in the AD/AS framework
    • Demand shocks shift AD; supply shocks shift SRAS
    • Stabilization policy: active stabilization (fiscal and monetary) vs automatic stabilizers
  • Long-run considerations
    • In the long run, output returns to potential; prices and wages adjust
  • Policy evaluation in the model
    • Trade-offs between output and inflation in the short run
    • The role of expectations (adaptive vs rational) in shaping short-run outcomes

The Phillips Curve and Inflation Targeting (Lecture 12)

  • The Phillips curve
    • Empirical negative relationship between unemployment and inflation
    • Short-run trade-off: policymakers face a choice between low inflation and low unemployment
    • Long-run view: the curve is vertical (inflation does not determine unemployment in the long run)
  • Expectations and the policy trade-off
    • Adaptive expectations vs rational expectations influence the short-run Phillips curve
    • Central bank credibility matters for inflation expectations
  • Inflation targeting and policy rules
    • Inflation targets (often around 2%) are used to anchor expectations
    • The Taylor rule as a guideline for setting interest rates
    • Nominal GDP targeting as an alternative
  • Inflation dynamics and stabilization
    • Costs of disinflation (sacrifice ratio)
    • The role of credible policy in reducing the inflation-unemployment trade-off over time
  • The “flat Phillips curve” question post-2007–08 crisis
    • Unemployment fell without a commensurate rise in inflation; possible explanations include part-time worker dynamics, lower NRU, and greater wage restraint

Supply-Side Policies and Growth (Lecture 13)

  • Supply-side policies vs demand management
    • Supply-side policies aim to expand production capacity and raise potential output without generating inflationary pressure
    • Market-oriented policies (freeing up markets, tax incentives) vs interventionist policies (investment in infrastructure, education, R&D)
  • Market-oriented policies
    • Lower taxes on labor and capital; increased incentives to work and invest (Laffer curve concept)
    • Greater wage flexibility; reduced government spending to avoid crowding out
    • Privatization and private-sector efficiency
  • Interventionist policies
    • Government investment in public goods (infrastructure, human capital, R&D)
    • Regional policies to counteract negative regional multipliers
  • Evaluation and limits
    • Empirical effectiveness is debated; context matters and spillovers can complicate attribution to supply-side policies alone
  • Supply-side policies as stabilizers
    • Long-run expansion of capacity can accompany stabilization goals without overburdening prices

The European Union and EMU (Lectures 16, 58–60)

  • What is a common currency area?
    • A geographic area where a single currency circulates as the medium of exchange
    • Also called a currency union or monetary union
  • Benefits of a common currency area
    • Easier trade (no currency exchange or exchange-rate risk)
    • Price transparency and reduced transaction costs
    • Economic stability via common monetary policy
  • Costs/risks
    • Loss of monetary-policy autonomy; cannot tailor policy to local conditions
    • Heterogeneous economies may be adversely affected by a shared policy stance
    • The exchange rate as automatic stabilizer is removed for member states
  • The EMU and Maastricht convergence criteria
    • Formation: Maastricht Treaty (1992); single euro introduced in 2002
    • Criteria emphasize fiscal discipline and macro stability; creation of the euro as the common currency
  • The four freedoms and the single market
    • Free movement of goods, services, labor, and capital
    • Harmonization of laws, competition policy, and a common external tariff
  • Optimum Currency Areas (OCA) criteria
    • Few asymmetric shocks; real wage flexibility; labor mobility; capital mobility; high trade integration
  • Fiscal policy in a currency union
    • Fiscal federalism with a common budget and transfers
    • If one country borrows, interest rates in the area may rise; risk of a spillover effect
    • The Stability and Growth Pact (SGP): deficits and debt rules (deficit ≤ 3% of GDP; debt ≤ 60% of GDP)
  • Challenges and future of the EMU
    • Populism and structural reforms concerns; credibility and competitiveness issues; debates on further integration

Exam Problem (Lecture 7: Money Growth, Inflation, and Exchange Rates)

  • Question: Between 2000 and 2020, Australia’s money stock grew on average 9% per year and real GDP grew 3% per year; New Zealand’s inflation averaged 2% per year.

    • a) Theoretically expected yearly inflation rate for Australia? Explain.

    • b) Theoretical expected yearly relative change in the AUD/NZD exchange rate? Does this imply a stronger or weaker AUD?

    • c) If calculations reflect actual outcomes, how has the real exchange rate between AUD and NZD been affected?

    • d) Do calculations align with actual inflation and exchange-rate movements?

    • Approach and answers (based on the quantity theory and PPP concepts from the course):

    • a) With


      • ext{Australia:} \piA \approx \Delta MA/MA - \Delta YA/Y_A = 9 ext{\%} - 3 ext{\%} = 6\%
      • New Zealand inflation is given as 2\% per year, so relative to NZ the inflation rate differential is 6\% (Australia) minus 0\% (NZ baseline) plus NZ’s actual inflation 2\%? Under the simple interpretation that NZ’s inflation is 2\%,Australia’s overall inflation would be approximately:
      • If we anchor to NZ inflation, πA ≈ πNZ + (ΔMA/MA - ΔYA/YA) = 2\% + 6\% = 8\%
      • Answer: about 8\% per year.

    • b) Relative exchange rate change under relative PPP:

      • The expected depreciation of AUD against NZD ≈ πA - πNZ ≈ 6\% per year
      • Therefore, AUD should weaken (depreciate) by about 6\% per year relative to NZD.

    • c) Real exchange rate impact (assuming PPP holds and other factors constant):

      • With a 6 percentage-point inflation disadvantage for Australia relative to New Zealand, the real exchange rate would also depreciate (AUD weaker in real terms) by roughly the same magnitude per year if other conditions hold.

    • d) Real-world alignment

      • In practice, inflation and exchange-rate dynamics depend on many factors (expectations, capital flows, policy credibility, risk premia, etc.). The simple margin 6–8% annual inflation and a 6% expected annual depreciation are stylized; actual outcomes can differ due to policy actions, risk, and other global shocks.

Key macroeconomic relationships and formulas (quick reference)

  • GDP identity (closed economy): Y = C + I + G \text{(for a closed economy)}
  • GDP in open economy: Y = C + I + G + NX
  • Saving and investment (closed economy): S = I
  • Saving, investment, and net capital outflow in open economy: S = I + NCO
  • Balance of payments identity: current account + financial account + capital account + net errors and omissions = 0 (roughly)
  • Money, velocity, and inflation (quantity theory): M V = P Y ; V = rac{P Y}{M}
  • Inflation and interest rates: r = i - \pi
  • Real variables vs nominal variables:
    • Real GDP = Nominal GDP / GDP deflator
    • Real wage = Nominal wage / Price level
  • PPP concepts:
    • Absolute PPP: e = \frac{P^*}{P}
    • Relative PPP: inflation differentials drive exchange-rate changes
  • Real exchange rate (typical form): E = e \times \frac{P}{P^*}
  • The Mundell–Fleming framework (brief idea): small open economy with perfect capital mobility; exchange-rate regime affects the transmission of fiscal/monetary policy to output
  • The Taylor rule (illustrative): i = \bar{i} + 0.5\,\pi + 0.5\, y (example form; notes mention policy rules guiding rate setting)
  • The natural rate of unemployment (NRU) and the Phillips curve framework: long-run vertical Phillips curve; short-run trade-offs influenced by expectations and policy credibility

Connections, implications, and broader themes

  • Linking growth, inflation, and exchange rates
    • Money growth and real growth influence the inflation rate; inflation differentials drive long-run exchange-rate changes via PPP
    • Over the long run, real variables are determined by real factors (technology, resources, institutions), while nominal variables respond to monetary policy and inflation dynamics
  • Policy design considerations
    • Stabilization policy vs structural reform: active demand management vs supply-side improvements
    • In a monetary union (EMU), fiscal policy coordination becomes crucial due to shared monetary policy and potential asymmetric shocks
    • The choice of exchange-rate regime interacts with fiscal and monetary policy effectiveness (e.g., fixed vs flexible regimes affect multipliers and stabilization outcomes)
  • Measurement and interpretation caveats
    • GDP captures production, not welfare; HDI provides broader well-being context
    • Price-level measures face substitution bias and quality/methodology challenges
    • Unemployment metrics may understate true labor-market slack (discouraged workers, underemployment)
  • Real-world relevance
    • The topics connect to current events (inflation dynamics, monetary policy normalization, open economy shocks, EU fiscal frameworks, and the sustainability transition)