Introduction to Macroeconomics

Introduction to Macroeconomics

Limited Resources/ Unlimited need = Economics

-Fiscal policy: Taxes

-Monetary policy: interest rates

Inflation/deflation: high inflation reduces purchasing power, while deflation can lead to economic stagnation

Macroeconomic approach: Central banks use monetary policy, adjusting interest rates or money supply, to control inflation. Raising interest rates slows inflation by curbing spending and borrowing. 

Economic growth

Trade deficits: Importing more than exporting → weakens a country’s currency and economic stability

Macroeconomic approach: Tariffs, trade agreements, or currency interventions to improve trade balances and support domestic industries

Income Inequality: leads to social unrest 

Macroeconomic approach:

Economic recessions: reduced production, higher unemployment, and lower consumer confidence

Macroeconomic approach: governments and central banks can implement stimulus packages, increasing public spending or reducing taxes

National Debt: High national debt limits a country’s ability to invest in public services and increase borrowing costs.

Macroeconomic approach: countries may use fiscal consolidation → cutting government spending or increasing taxes. 

Monetary stability and exchange rates: fluctuating exchange rates can affect trade and investment, leading to instability.

Macroeconomic Approach: Central banks may intervene. 

1. Determination of output: 

2. Unemployment

3. Interest Rates

4. Inflation

5. Monetary and fiscal policies

6. Policy Debates

Fiscal policy of lowering taxes

Increase public spending by introducing stimulus checks 

Temporary price ceiling on food and goods (No price gouging) 

Promote domestic goods by raising tariffs on imports

Lowering interest rates to allow citizens to take out loans

How is macroeconomic theory being used today? (Covid Pandemic) 

• Keynesian Economics: advocates for increased government spending during economic downturns. 

• Budget deficits and Debt: Governments faced decisions about balancing the immediate need for stimulus with concerns about long-term fiscal sustainability. 

• 2-monetary policy and central Bank actions: Central banks lowered interest rates.

• Quantitative Easing: buying government and corporate bonds to inject liquidity into the financial system to stabilize financial markets. 

• Inflation Expectations: the phillips curve was used to assess the relationship between employment and inflation. 

• Natural rate of unemployment: Policy interventions, such as wage subsidies and job retention schemes prevented long term scarring in labor markets. When unemployment is too low, inflation rises. 

• Universal Basic Income and Safety Nets: How could UBI affect labor market participation, productivity, and overall economic stability. 

• Supply and demand shocks: The invasion of Ukraine has disrupted global energy markets, especially oil and natural gas which is supplied from Russia.

• Cost-Push inflation: how higher energy prices lead to rising production costs, which is passed on to the consumers by companies in the form of goods and services. 

• Economic Sanctions: western countries have imposed economic sanctions on Russia, affecting trade, financial transactions, and the broader Russian economy. 

Macro 2.1 9/16/24

Macroeconomics (Big picture)

Gross Domestic Product (GDP): 

• Measures total income of everyone in the economy

• Also measures total expenditure on the economy’s output of goods and services

• Circular- Flow Diagram: shows GDP as spending, revenue, factor payments, and income. 

Firms:

Omits: The government, the financial system, and the foreign sector

Income = Expenditure (Every dollar a buyer spends is a dollar of income for the seller). 

(Insert diagram here)

GDP definition: the market value of all final goods & services produced within a country in a given period of time. 

Includes: All items produced in the economy and sold legally in markets

Excludes: Most Items produced and sold illicitly & items that are produced and consumed at home. 

Final goods: intended for the end user

Intermediate goods: used as components or ingredients in the production of other goods

-GDP only includes final goods – they already embody the value of the intermediate goods used in their production. 

GDP includes tangible goods (DVDs, beer, mountain bike) & intangible services (dry cleaning, concerts, cell phone service).  

GDP measures the value of production that occurs within a country’s borders, whether done by its own citizens or by foreigners located there. 

GDP is counted annually or quarterly (rare and inefficient). 

The four components of GDP

• Consumption

• Investment

• Government Purchases

• Net Exports

**Y= C + I + G + NX 

Consumption, C

• Total spending by households on goods and services

• For renters, C includes rent payments.

• For homeowners, C includes the imputed rental value of the house, but not the purchase price or mortgage payments.

• Not included in C: purchases of new housing. → considered an investment 

Investment, I 

• Total spending on goods that will be used in the future to produce more goods. 

• Business capital: business structures, equipment, and intellectual property products.

• Residential capital: landlord’s apartment building; a homeowner’s personal residence. 

• Inventory accumulations: goods produced but not yet sold.

• Investment does not mean the purchase of financial assets like stocks and bonds → it is a transfer of net capital. 

Government purchases (G)

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

Net exports, NX = exports- imports

• Exports: foreign spending on the economy’s goods and services.

• Imports: are the portions of C, I, and G that are spent on goods and services produced abroad

Real vs Nominal GDP

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

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

For the base year: Nominal GDP = Real GDP 

The nominal GDP is measured using the current prices

The real GDP is measured using constant prices from the base year. 

GDP deflator: A measure of the overall level of prices. 

= 100 X nominal GDP/ real GDP

• Measures the current level of prices relative to inflation. 

Real GDP per capita: the main indicator of the average person’s standard of living.

GDP is not a perfect measure of well being. 

Macro 2.2- CPI

Consumer price index:

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

How to calculate CPI:

• The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s shopping basket. 

• The BLS collects data on the prices of all the goods in the basket

• Use the prices to compute the prices

• Choose a base year and compute the CPI

• Compute the inflation rate

EXAMPLE: 

2014: 100 x (60/60) = 100 = 15% =     115-100/100 x 100% = 15

2015: 100 x (69/60) = 115 = 

Problems with CPI:

1. Substitution Bias:

• Over time, some prices rise faster than

• Consumers will substitute old goods with new goods that become relatively cheaper → CPI misses this substitution because it uses a fixed basket of goods

• As a result, CPI overstates increases in the cost of living.

2.  Unmeasured Quality changes

3. To overstate cost of living increase

• CPI probably still overstates inflation by about 0.5 percent per year.

• Important because Social Security payments and many contracts have COLAs tied to the CPI. 

Contrasting GDP Deflator and CPI

• Imported consumer goods → Included in CPI / Excluded from GDP deflator

• Capital goods → Excluded from CPI / Included in GDP deflator

Correcting variables for inflation

Minimum wage in 1963= 1.25

Minimum wage in 2013= 7.25

CPI in 1963= 30,9

CPI in 2013= 234.6

234.6/30.9= 7.59 x 1.25= $9.49 in 2013 dollars

1. 800

2. 30

D. yes

E. Taxes and government borrowing

Class 3.1

[(End Value/ Beginning Value) ^ 1/n] - 1= growth rate per year. 

Because of differences in growth rates…

• Ranking of countries by income changes substantially over time. 

• Poor countries are not doomed to poverty forever (Ex: Singapore)

Productivity

• Quantity of goods and services

• Produced from each unit of labor input

• Productivity = Y/L (output per worker), where

      Y= real GDP

      L= quantity of labor

Productivity is important because…

• Determinants living standards (When a nation’s workers are very productive, real GDP is large and income is high.)

Determinants of Productivity

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

• Physical capital per worker, K/L: Productivity is higher when the average worker has more capital (machines, equipment, etc.)

• An increase in K/L causes an increase in Y/L 

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

• Human capital per worker, H/L: Productivity is higher when the average worker has more human capital (education, skills, etc). 

• An increase in H/L causes an increase in Y/L.

• Natural resources, N

• Inputs into production that nature provides (land, rivers, and mineral deposits)

• Natural resources per worker, N/L

• An increase in N/L causes an increase in Y/L

• Technological knowledge: Society’s understanding of the best way (unfinished)

The production function Y = A F(L,K,H,N)

• A graph or equation showing the relation between output and 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”) allow more output (Y) to be produced from any given combination of inputs.

The production function has the property constant returns to scale;

• Changing all inputs by the same percentage causes output to change by that percentage.

• Doubling all inputs causes output to double:

2Y= A F (2L, 2K, 2H, 2N)

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

Saving & Investment: 

• To raise future productivity, invest more current resources in the production of capital, K. 

• Trade- off: since resources scarce, producing more capital requires producing fewer consumption goods

Diminishing Returns

Policies that raise saving 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. 

Ex: Post-War South Korea → devoted a similar share of GDP to investment as the USA, however South Korea grew 3x faster. 

Rich Countries: Driven by H/L (Constant innovation) 

Investment from abroad, investment in Education, Healthcare expenditure → increases productivity & capital. 

To foster economic growth, protect property rights, have stable court systems to curb corruption, and fraud. 

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. 

Research and Development:

• Technological progress: main reason why living standards rise over the long run. 

• Knowledge: Ideas can be shared freely, increasing the productivity of many.

• Policies to promote technological progress: Patent laws, Tax Incentives, Grants for basic research at universities. 

4.1- Financial Institutions

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

Matching savers with investors 

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 investment 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

The meaning of Saving and 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 300,000 dollar house. 

Investment is not the purchase of stocks and bonds due to transfer of ownership. 

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 

Markets, prices change to get back to equilibrium.

Investment incentives vs savings incentives.

Budget surplus → supply will change

Budget deficit → demand will change

Crowding out effect → private investment cannot compete with the government

Budget deficits reduce the economy’s growth rate and future standard of living. 

Wars and financial crises lead to high debt to GDP ratio. This changed in 2011 because the debt to GDP ratio has continued to increase even with high economic growth

Macro seminar

1. A. The lender is better off because since they agreed on a 5% interest rate, creating a nominal interest rate of 8%. However the real interest rate was 4%, therefore Boris is paying more because he was supposed to pay 3% but he paid 4%, and Lynn made 4% profit instead of 3%. 

B. The borrower is better off because he is only paying 1% real because the nominal stays the same, therefore the expected inflation was 5% but now is 7%, making Boris pay less and Lynn pay more. 

1. The graph will shift right. The equilibrium interest rate will increase to 12% while the quantity of loanable funds will increase to 500 billion. Yes, because interest rates will increase. 

2. Because you can get the most amount of money with the lowest interest rate possible

3. He is wrong because borrowing can help jumpstart the free market if the business becomes successful. 

4. The bond rate is more stable and less susceptible to crashes. 

5. A. investing in physical assets  b. Investment spending C. Investment spending D. Investment spending E. investing in financial assets. 

6. A well functioning financial system has an equilibrium between interest rates and quantity of loanable funds, therefore the interest rate is low enough for people to take out loans and make investments, and the quantity of loanable funds remains reasonably high. 

7. The change in inflation will make the equilibrium lower because there is less capital to spend. 

Private investment would decrease by 4 million because the interest rate increases by 2%, therefore the 200 billion increase in government spending leads to a 4

5.1- Money

The 3 Functions of Money

1. Medium of exchange: Item that buyers give to sellers 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. 

The 2 Kinds of Money

Commodity money: Takes the form of a commodity with intrinsic value. Ex: gold coins, cigarettes in POW camps.

Commodity-backed money

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 (non-bank) public

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

M1 = 3.2 trillion → Currency, demand deposits, traveler’s checks, and other checkable deposits. 

M2 = 12.7 trillion → M1 + savings deposits, small time deposits, money market mutual funds, and a few minor categories

Central Banks & Monetary Policy

Central bank: Institution that oversees the banking system and regulates the money supply. 

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

Federal Reserve (FED): The central bank of the U.S.

Bank Reserves

Fractional reserve banking system: Banks keep a fraction of deposits as reserves and use the rest to make loans. 

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

• Banks may hold more than this minimum

The reserve ratio, R: 

• Fraction of deposits that banks hold as reserves

• Total reserves as a percentage of total deposits. 

The fractional reserve banking system is in accounting terms, assets (90) + liabilities (100) = 190

Money multiplier = 1/R

• Amount of money the banking system generates with each dollar of reserves. 

$100 of reserves creates $1000

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

Also: bank assets minus 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

Leverage Amplifies Profits and Losses

Money supply = money multiplier x bank reserves

The fed can change the money supply by changing bank reserves or changing the money multiplier 

Open-market operations (OMOs): 

• THe purchase and sale of U.S. government bonds by the FED. 

To increase bank reserves and the money supply:

• THe Fed buys a government bond from a bank: Pays by depositing new reserves in that bank’s reserve account, with more reserves, the bank can make more loans, increasing the money supply. 

The Fed sets reserve requirements:

• Regulations on the minimum amount of reserves banks must hold against deposits. 

• Reducing reserve requirements would lower the reserve ratio and increase the money multiplier. 

Since 10/2008, the Fed has paid interest on reserves banks keep in accounts at the Fed. 

• Raising this interest rate would increase the reserve ratio and lower the money multiplier. 

The Fed does not control: 

• The amount of money that households choose to hold as deposits in banks. 

• The amount that bankers choose to lend. 

*Yet, the Fed can compensate for household and bank behavior to retain fairly precise control over the money supply. 

The Federal Funds rate:

Interest rate at which banks make overnight loans to one another

• Lender - has excess reserves

• Borrower - needs reserves

A change in federal funds rate

• Cause changes in other rates and have a big impact on the economy. For Example, raising or lowering federal fund rate has an affect on the interest of taking out a loan or a mortgage payment. 

Monetary Policy and the Fed Funds Rate: 

• To raise fed funds rate, the Fed sells government bonds (OMO). This removes reserves from the banking system, reduces supply of federal funds, causes r(f) to rise. 

(Higher interest rate → less quantity of bonds).

Macro Seminar:

1. M2 goes up 

2. M1 goes up

3. M2 goes down, M1 goes up. 

4. M1 goes up 

5. M2 goes up

A. Commodity money

B. Commodity money

C. Commodity-backed money

D. Fiat money

Q3.

1. The deposit changes the T-account of the local bank by adding 500 dollars to assets and liabilities. It increases the money supply. 

2. 450 dollars would go into the bank, 50 dollars would go into the reserves 

3. 1/0.1 * 450= $4500

4. 1/0.05 * 475= $9500

M1 = Cash + Checking 

           (0)   +   (500) =   500

 When you change the reserve ratio, you need to change the excess reserve as well (450 → 475) 

Q7:

When the federal reserves buys 50 million worth of treasury bills, its assets goes up 50 millions because they now own the treasury bills, however the liabilities also also increase 50 million. 

The T chart of the commercial bank will not change because They gained 50 million in reserves from the federal bank, but they lost 50 million treasury bills. Then you find the reserve ratio, which is 10%, and do the equation 1/R * 50 million, which is 500 million. So the commercial bank will add

6.1- Macronomics

Real GDP over the long run

• Grows about 3% per year on average

GDP in the short run

• Fluctuates around its trend

Recessions 

• Periods of falling real incomes and rising unemployment

Depressions

• Severe recessions (very rare)

When the actual GDP is growing faster than the potential GDP (Yp) → there will be inflation. 

The actual GDP is the demand side, the Yp is the supply side. 

When the actual GDP is growing slower than the potential GDP (Yp) → there will be a recession. 

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

Why AD curve is downsloping,

1. The Wealth Effect: An aggregate increase in the price level will lead to less purchasing power. A decrease will allow consumers to feel wealthier. 

2. The interest rate Effect: the interest rate Will go down because people spend less money on borrowing money, therefore there is more money to be borrowed, lowering the interest rate. → The US dollar will depreciate as a result.

3. The Exchange rate effect: When the price level, P, declines → the interest rate will go down, leading to the US dollar to depreciate. Since the US dollar’s exchange rate goes down, US exports will be cheaper and as a result more countries will buy US exports. Net exports increase, imports are too expensive. 

Why the AD curve might shift

Changes in C

• Stock market boom/crash

• Preferences re: consumption/saving tradeoff

• Tax hikes/cuts

Changes in I

• Firms buy new computers, equipment, factories

• Expectations, optimism/pessimism

• Interest rates

• Monetary Policy

• Investment Tax Credit or other tax incentives

Changes in G

• Federal spending

• State and Local spending

Changes in NX

• Booms/recessions in countries that buy our export

• Appreciation/depreciation result from international speculation in foreign exchange market. 

The aggregate-Supply (AS) Curves

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

• Was LRAS is vertical: not affected by price level in the long run, it is only affected by factors of production. 

• Why the LRAS curve might shift: any event that changes any of the determinants of Yn will shift LRAS, immigration increases L, causing Yn to rise. Finding Oil increases N, etc. 

• Over the long run, progress shifts LRAS to the right and growth in the money supply shifts AD to the right. 

• Result: ongoing inflation and growth in output.

3 reasons why aggregate supply (SRAS) is upward sloping

1. Sticky-wage theory: Wages do not change in the short term due to labor contracts. Firms and workers set the nominal wage in advance based on PE (price expected), the price level they expect to prevail. 

• If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output and employment. 

2. Sticky-price theory: If prices of goods go up, firms are slow to adapt the prices to account for inflation or increase in costs (in restaurants). Therefore, the firms that have not changed their prices have increased demand for their products

3. Misperceptions theory: Firms may confuse changes in P with changes in the relative price of the products they sell. 

• If P rises above PE: A firm see its price rise before realizing all prices are rising. 

• The firm may believe its relative price is rising, and may increase output and employment. 

What the 3 theories have in common: In all 3 theories, Y deviates from YN when P deviates from PE. 

1. P > PE → Y > YN (Positive)

2. P = PE → Y = YN (Zero) 

3. P < PE → Y < YN (Negative)

In the long run… 

• Sticky wages and prices become flexible

• Misperceptions are corrected

In the LR,

• PE = P

• AS curve is vertical. 

Everything that shifts LRAS shifts SRAS, too. 

Also, PE shifts SRAS: If PE rises, Workers & firms set higher wages. 

At each P, production is less profitable, Y falls, SRAS shifts left. 

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 the economy moves from new SR equilibrium to new LR equilibrium. 

In the short run, AD shifts from 1-2, it creates lower prices which incentivizes more production and thus increases the supply. 

When Aggregate Demand shifts to the left, cost of production decreases. This leads to P < PE and Y < YN. As a result of this, Aggregate supply will shift to the right because firms will want to increase output to make a profit. 

Exam: 

Section A: 10% multiple choice

Section B: answer ⅔ questions: 40%

Section C: answer ½ questions: 50%

7-1: Aggregate Demand

Theory of Liquidity Preference

The theory of liquidity preference

• A simple theory of the interest rate 

• R adjusts to balance supply and demand for money

• Nominal interest rate, real interest rate. 

Assumption: expected rate of inflation is constant

Money supply: Assumed fixed by central bank, does not depend on the interest rate. 

When return is low, convenience (cash) is preferred to putting money in investments with interest rates. 

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

• Assume Household wealth includes only two assets:

Money - Liquid but pays no interest

Bonds - pay interest but not as liquid

• A household’s “money demand” reflects its preference for liquidity. 

Variables that influence money demand:

Y (real output), r (nominal interest rate, and P (aggregate price level)

Suppose real income (Y) rises: 

• Households want to buy more goods and services, so they need more money. 

• To get this money, they attempt to sell some of their bonds. 

An increase in Y causes an increase in money, other things equal. 

How r is determined. 

MS curve is vertical: Changes in r do not affect MS, which is fixed by the Fed. 

MD curve is downward sloping: A fall in r increases money demand. 

Once the price level goes down, money demand will decrease and people will feel wealthy, therefore output increases because consumers feel as they can buy more. 

Treat money as a commodity, as demand for money decreases, interest rate would also go down. 

Higher interest rate → less investment

Monetary policy and the AD

The Fed: 

• Use monetary policy to shift the AD curve

• Policy instrument: the money supply (MS)

• Targets the interest rate: the federal funds rate.

Banks charge each other on short term loans. 

• Conducts open market operations to change MS.

Liquidity trap

If interest rates have already fallen to around zero

Monetary policy may no longer be effective, since nominal interest rate cannot be reduced further

Aggregate demand, production, and employment may be "trapped" at low levels

A central bank continues to have tools to expand the economy: 

• Forward guidance: raise inflation expectations by committing to keep interest rates low. 

• Quantitative easing: buy a larger variety of financial instruments (mortgages, corporate debt, and longer-term government bonds) (The Fed, 2008)

Fiscal Policy and the AD:

Fiscal policy: 

• Setting the level of government spending and taxation by government policymakers. 

Expansionary fiscal policy

• An increase in G and/or decrease in T, shifts AD right

Contractionary fiscal policy

• A decrease in G and/or increase in T, shifts AD left. 

Fiscal policy has two effects on AD… 

When Y > YN → There will be high inflation, therefore the government must institute a  Contractionary policy. 

When Y < YN → There will be a recession, therefore the government must institute an expansionary policy. 

1. The multiplier effect

Marginal Propensity to Consume = MPC

How big is the multiplier effect?

• Depends on how much consumers respond to increases in income. 

• Marginal propensity to consume, MPC = C/Y

• -Fraction of extra income that households consume rather than save. 

Example: 

If MPC = 0.8 and income rises 100$, C rises 80$

A formula for the multiplier. 

2. The Crowding-out effect

• Offset in aggregate demand

• REsults when expansionary fiscal policy raises the interest rate

• Thereby reduces investment spending

• Which reduced the net increase in aggregate demand

• So the size of the AD shift may be smaller than the initial fiscal expansion. 

Changes in Taxes

The multiplier effect is greater for government spending rather than a tax cut, because when G increases, all of it is put into the economy, however, when there is a tax cut, only some of it will be spent based on the Marginal Propensity to Consume (MPC).

Automatic stabilizers:

• Changes in fiscal policy that stimulate aggregate demand when the economy goes into recession. 

• Without policymakers having to take any deliberate action.

Examples: 

• The tax system: In recessions, taxes fall automatically, which stimulates aggregate demand. 

• Government spending: In recession, more people apply for public assistance (welfare, unemployment insurance)

• Government spending on these programs automatically rises

When congress cuts taxes→ consider short run effects on aggregate demand and employment, and the long-run effects on saving and growth.

When the Fed reduces the rate of money growth, must take into account not only the long run effects on inflation, but the short run effects on output and employment 

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

YN = YP

Include diagrams/ graphs 

1. Inflationary, lower government spending, higher taxes

2. Recessionary, higher government spending, lower taxes, less investment, shift aggregate demand 

3. Inflationary gap, the government would need to reduce its military spending (reduce G). 

4. Recessionary gap, 

9.1- The Value of Money

The Value of Money is nothing but purchasing power 

Purchasing Power/ 1 + Inflation Rate

P = price level (the CPI/ GDP deflator)

• P is the price of a basket of goods, measured in money. 

Money supply is determined by the Fed

Money demand is how much wealth people want to hold in liquid form. 

Depends on 

Quantity of money demanded

• Is negatively related on the demand for money

Higher level of P 

Suppose the Fed increases the money supply —> Then the value of money decreases

Nominal variables (without accounting for inflation)

• Are measured in monetary units.

Ex: nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour worked)

Real variables (including inflation)

• Are measured in physical units.

Ex: real GDP, real interest rate (measured in output), real wage (measured in output)

Real is accounts for the outputs, they need to be divided by the price level. 

Real Wage = W/P

Relative price: the price of one god relative to (divided by) another. 

Price of Pizza: $15

Price of Cds: $10

15/10 = 1.5 pizzas per cd. 

W: nominal wage = price of labor, e.g. $15 per hour

P = price level = price of goods and services, e.g. $5 unit of output

Real wage:  the price of labor relative to the price of output

15/5 = 3 units of output per hour. 

Velocity of money:

• The rate at which money changes hands

Notation: 

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

M = money supply

V = velocity

Velocity formula: 

V = P x Y/ M === M x V = P x Y

Velocity is fixed

When M is raised, the price level will go up 

If real GDP is constant, 

• Then inflation rate = money growth rate. 

If real GDP is growing, 

• Then inflation rate < money growth rate. 

The bottom line:

• Economic growth increases # of transactions. 

• Some money growth is needed for these extra transactions. 

• Excessive money growth causes inflation

Hyperinflation

• Inflation exceeding 50% per month. 

Prices rise when the government prints too much money. 

• Excessive growth in the money supply always causes hyperinflation.

Large government budget deficits

• Led to the creation of lare quantities of money and high inflation rates. 

The Inflation Tax

• Revenue the government raises by creating (printing) money

• Like a tax on everyone who holds money

Ex: when the government prints money, the price level rises & the dollars in your wallet are less valueable. 

• In the U.S., the inflation tax today accounts for less than 3%

The Fisher Effect

Principle of monetary neutrality

• An increase in the rate of money growth raises the rate of inflation but does not affect any real variable because Real Interest rate = Nominal Interest rate - Inflation Rate. 

Costs of Inflation

Resources are wasted when inflation encourages people to reduce their money holdings, increasing prices, firms shift the costs to the consumers. 

Shoeleather costs

• Resources wasted when inflation encourages people to reduce their money holdings

• Can be 

Misallocation of resources from relative-price variability:

-Firms don’t all raise prices at the same time, so relative prices can vary.

Tax distortions:

Inflation makes nominal income grow faster than real income. 

Taxes are based on nominal income, and some are not adjusted for inflation. 

So, inflation causes people to pay more taxes even when their real incomes don’t increase. 

2 to 3 percent is healthy inflation

Macro Seminar

Because when unemployment lowers, there are more workers therefore there is more demand in the market due to consumption being higher. As a result aggregate supply will shift left back to the equilibrium point because the workers will demand higher wages as the company is making more profits. Therefore prices will rise.

10.1- Macroeconomics

Labor Force Statistics

BLS divides population into 3 groups:

• Employed: paid employees, self-employed, and unpaid workers in a family

• Unemployment: people not working who have looked for work during previous 4 weeks

• Not in the labor force: everyone else

Labor Force = Employed + Unemployed 

Unemployment rate: % of the labor force that is unemployed

U-rate = 100 x # of unemployed/ Labor Force

Labor force participation rate: % of the adult population that is in the labor force

Labor-force participation rate = 100 x Labor force/ Adult population (people between 18-65)

Population → Adult population → Labor Force

(everyone)  (people between 18-65)    (% of adult population who CAN work) 

Unemployment rate:

• Not a perfect indicator of joblessness or the health of the labor market

It excludes discouraged workers

It does not distinguish between full-time and part-time work, or people working part time because full-time jobs are not available.

Some people misreport their work status

• Still a very useful barometer of the labor market & economy. 

• Most spells of unemployment are short

Cyclical Unemployment vs. the Natural Rate

Natural rate of unemployment

• Normal rate of unemployment around which the actual unemployment rate fluctuates. 

Cyclical unemployment

• - Deviation of unemployment from its natural rate

• Associated with business cycles. 

There needs to be a natural rate of unemployment because there is a need for frictional unemployment and structural unemployment

Frictional unemployment:

• Occurs when workers spend time searching for the jobs that best suit their skills and taste

• Short term for most workers

Structural unemployment:

• Occurs when there are fewer jobs than workers 

• Usually long term 

Frictional + Structural Unemployment = Natural Rate of Unemployment

The Phillips Curve

• Shows the short run tradeoff between inflation and unemployment 

• Tradeoff: High unemployment and low inflation

• Or low unemployment and high inflation

The long run Phillips curve

• Is vertical

• Unemployment rate tends towards its normal level (natural rate of unemployment)

• Unemployment does not depend on money growth and inflation in the long run. 

If the Fed increases the money supply slowly…

• Inflation rate is low

• Unemployment – Natural rate

If the Fed increases the money supply quickly… 

• Inflation rate is high 

• Unemployment – natural rate. 

The long-run Phillips curve

• Expression of the classical idea of monetary neutrality 

Increase in money supply

• Aggregate-demand curve- shifts right

• Price level increases

• Output is at natural level

• Inflation rate increases

• Unemployment- natural rate

Meaning of “Natural” 

• Unemployment rate toward which the economy gravitates in the long run 

• Not necessarily socially desirable

• Not constant over time

Labor market policies

• Affect the natural rate of unemployment

• Shift the Phillips curve

Policy Change - reduce the natural rate of unemployment 

• Long-run Phillips curve shifts left

• Long-run aggregate-supply curve shifts right

• For any given rate of money growth and inflation: lower unemployment, higher output

Reconciling Theory and Evidence

Expected inflation: Determines the position of short-run aggregate-supply curve

Short run: 

• The Fed can take

• Expected inflation and short- run aggregate-supply curve

• As already determined. 

Short run:

• Money supply changes

• Aggregate-demand curve shifts along a given short-run aggregate supply curve

• Unexpected fluctuations in 

• Output and prices

• Unemployment and inflation

• Downward-sloping Phillips curve

Long run: 

• People- expect whatever inflation rate the Fed chooses to produce

• Nominal wages - adjust to keep pace with inflation

• Long-run aggregate supply curve is vertical

Long run:

• Money supply changes

Shifts in Phillips Curve

Supply Shock

• Event that directly alters firms firms’ costs and prices

• Shifts economy’s aggregate-supply curve

• Shifts the phillips curve 

Increase in oil prices

-Short-run Phillips curve shifts right

If temporary- revert back

If permanent- needs government intervention

The Cost of Reducing Inflation

• Disinflation: Reduction in the rate of inflation

• Deflation: Reduction in the price level

Contractionary monetary policy

• Aggregate demand - contracts

• Higher unemployment

• Lower Inflation

Sacrifice ratio

• Number of percentage points of annual output lost in the process of reducing inflation by 1 percentage point. 

Seminar:

1. Unemployment will decrease

2. Unemployment will decrease

3. Unemployment will decrease

4. Unemployment will increase, because the government will have greater control over number of workers, the union would not be able to protect their jobs