Macro - Review

GDP = C + I + G + NX

MV = P Q (= $GDP)

Circular Flow

GDP: Real and Nominal• Gross Domestic Product (GDP): the market

value of all final goods and services produced within a country during a year.

GDP = C + I + G + Ex – Im

= C + I + G + NX• Real GDP adjusts for inflation

Nominal GDP = $GDP = P x Q $ GDP = GDP Deflator x Real GDP

Real GDP = Q = $GDP/P = Nominal GDP divided by

(deflated by) the GDP Price Deflator

Price Indexes (Base Year = 100)• Consumer Price Index (CPI)

– cost over time of a typical bundle of goods and services purchased by households.

CPI = Cost of Typical Market Basket Now

divided by

Cost of the Same Basket in Base Year

Inflation Rate = {Change in CPI} ÷ {Initial CPI}

• GDP Price Deflator (GDP Price Index)– measures average prices over time of all

goods and services included in GDP.

Unemployment

Rate ofUnemployment

= number unemployednumber in the Labor Force

Unemployment rate: % of labor force not working.

• Unemployed persons: not working and looking• Labor force: Employed + unemployed

noninstitutionalized persons 16+ years of age• Underemployed workers are treated as employed• Discouraged workers are not in the labor force• “Natural” or normal rate of unemployment (NAIRU)

Seasonal UnemploymentFrictional Unemployment: searching for jobsStructural Unemployment: Imperfect match between employee skills and requirements of available jobs.

• Cyclical Unemployment : Results from business cycle

Interest Rates: Nominal and Real

• Nominal Interest Rate (i): the interest rate observed in the market.

• Real Interest Rate (r): the nominal rate adjusted for inflation ().Real Interest Rate = Nominal Interest Rate

– Inflation Rate

r = i - • Low real interest rates spur business

investment spending (the I in C + I + G + NX)

Aggregate Demand (AD): the economy-wide demand for goods and services.

• Aggregate demand curve relates aggregate expenditure for goods and services to the price level

• The aggregate demand curve slopes downward owing to price-level effects:–Wealth Effect (Real Wealth/Real Balances) – Interest Rate Effect– International Trade Effect (Substitution)

Shifting Aggregate Demand Curve

Factors that Affect AD Shifts in AD

• Consumption– Income– Wealth– Interest Rates– Expectations/Confidence– Demographics– Taxes

• Investment– Interest Rates– Technology– Cost of Capital Goods– Capacity Utilization– Expectations/Confidence

AD = C + I + G + NX

Government Spending Net Exports

– Domestic & Foreign Income

– Domestic & Foreign Prices

– Exchange Rates– Government Policy

Aggregate Supply• Aggregate Supply (AS): the quantity of real GDP

produced at different price levels.Short-run Aggregate Supply SRAS slopes upward

– a higher price level (holding production costs and capital constant in short-run) higher profit margins

firms want to produce more.

Long Run Aggregate Supply LRAS is vertical: higher prices cannot elicit more output in the long-run.

• Resource costs are NOT fixed in the long-run.– As prices rises, workers demand and get higher

wages

Profits don’t rise with price in long-runAS is set by production possibilities in the long-run

Aggregate Supply: Short – Run & Long – Run

Aggregate Demand and

Supply Equilibrium:

Short-run and long-run

responses to increase

in aggregate demand

Aggregate Expenditures = AE = GDP

Y = AE = C + I + G + NX• Disposable income = Yd = Y-T = after tax

income.

Yd = Y - T = C + SConsumption is related to disposable income

(Y-T).

C = Ca +cYd

where c = Marginal Propensity to Consume = mpcCa = Autonomous consumption

Additional income not consumed is savedmpc + mps =1

Aggregate Expenditures = AE = GDP

In a closed economy, saving either finances private investment (I) or the government’s deficit (G – T)

S = I + (G – T) at equilibrium

Investment can be crowded out by the deficit

I = S – (G-T)• Leakages from the spending stream (S + T)

= Injections to the spending stream (I + G)• S + T = I + G

Shifts in the Consumption Function Expected Future Income

– An increase in expected future income will cause current consumption to rise and your saving to fall.

Wealth– An increase in wealth raises current consumption and

lowers current saving. Expected Real Interest Rate

Higher real return incentive to save more … but– Higher return to saving less needs to be put aside to

achieve the same desired future savings.– Net effect: increased real interest rates reduce

consumption and increase saving. Demographics Taxes – Ricardian Equivalence: Anticipation of Future

Taxes

Demand-Side Equilibrium and the MultiplierAt equilibrium: Y = C + I + G + NX = AE

Increase in Y = Spending Multiplier x {Increase in Autonomous Spending}

Multiplier = 1/(mps + mpi)

From Aggregate Expenditure toAggregate Demand:As price level rises, real money balances decrease and consumption function shifts owing to i) wealth effectii) interest rate effectiii) international competition

Demand-Side Policy: Greater

Spending Means Higher Prices

Real GDP

Pri

ce

Le

ve

l

(c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.)

AD1

AD

Y?

Fiscal Policy: Some Definitions• Fiscal policy: government spending and taxing

– Demand-side policies– Supply-side policies:

• Discretionary Fiscal Policy: aimed at achieving a policy goal.

• Automatic Stabilizer: fiscal policy that changes automatically and countercyclically as income changes.– Progressive taxes– Unemployment insurance– Welfare payments / other transfer payments

Functions of Money

• Medium of exchange

• Unit of account–Standard of Deferred Payment

• Store of value

Multiple Creation of Bank Deposits M1Fractional Reserve Banking System: R = .1

Deposit expansion multiplier = 1/R(when banks lend all excess reserves and public redeposits proceeds of loans into the banking system no leakages)

The Fed’s Policy Tools

1) Reserve Requirements

2) Discount rate

“primary credit rate”

3) Open market operations• Manage the public’s expectations

Inflation Targeting?

Fed Policy LinkagesTools – Intermediate Targets – Goals

Equation of Exchange: relates quantity of money to nominal GDP

– M = money supply (some aggregate)– V = velocity of money (of the aggregate)– P = price level– Q = real GDP– PQ = nominal GDP

MV = PQ(Note: V = PQ/M)

Money Demand– Transactions demand– Precautionary demand– Speculative demand … fear decline in the value of other assets, so

hold money as a safeguard.

How Money Supply Changes Affect GDP

Aggregate Demand and Supply Phillips Curve

Expectations and the Phillips Curve

• Starting at (1): 5% unemployment and 3% inflation. People believe inflation will continue at 3% Curve I.

• Then Fed hypes inflation to 6% unemployment falls to 3% (Point 2 on Curve I).

• Expectations adjust to 6% inflation Wage demands up Economy moves to point (3) Unemployment returns to 5%.

• If expectations adjust instantly, e.g., anticipating Fed’s policy, economy moves directly from (1) to (3).

Expectations Formation • Adaptive Expectations: expectations of the future

based on history• The public acts on its expectations The present depends on the past

• Rational Expectations: expectation based on all available relevant information. – The public understands how the economy

works.– The public knows the structure and linkages

between variables in the economy.– The public anticipates policy actions and their

consequence– The public acts now on its expectations

The present depends on the future

New Classical Economics:Rational Expectations Policy Ineffectiveness{Expansionary policy movement from 1 to 3}

Macroeconomic ViewpointsLaissez - Faire

ClassicalMonetaristNew Classical

Activist/InterventionistKeynesianNew Keynesian

The Modern Keynesian Model:

Sticky Prices Demand

Management Policies Can Stabilize an

Unstable Economy

Long and Variable Policy Lags

– 1. Recognition Lag: policymakers need time to realize that there is a problem.

– 2. Reaction Lag: they need time to formulate an appropriate policy response.

– 3. Effect Lag: policy takes time to implement and work through the economy.

• Countercyclical policies can become procyclical policies, worsening fluctuations

Determinants of Growth• Size and quality of the labor force• Capital• Land/Natural Resources … are not a necessary

condition for economic growth … they can be acquired through trade.

• Technology