Introduction to Macroeconomics

Chapter 20: Measuring a Nation’s well-being

1. Micro vs. macro

• Microeconomics looks at individual decision making and household decisions in the market

• Macroeconomics lumps households together and lumps firms together and looks at them as an aggregate

• Income of all households and firms combined

• Macroeconomics is interested in the overall prices to see if they go up or down (their fluctuations)

• Unemployment on an aggregate level

• Why does average unemployment fluctuates between countries?

• Interest rates

• Borrows in a market and money exchange rates

1. Measuring a Nations well being

• What are models?

• Models are simplifications of the world (the simpler the better)

• Models are used to understand things

• Models are compiled through assumptions to leave stuff out and make things simpler

• Assumptions by nature are always wrong

• Circular flow diagram

• Circular flow

• Circular flow diagram is a flowchart of the economy that shows the input and output of households and firms

• Real flows: goods, services and factors of production

• Households own factors of production

• Payment flows: flows that represent financial payments

• Each flow is equally large, closed and equal in output value

• Production ≡ expenditures ≡ income

1. Gross Domestic Product (GDP)

• Measures all the output produced in the economy

• GDP: is the market value of all final goods and services that are produced within a country in a given period of time

• Market value: use the market value and price of each output at its market price and add up the outputs

• Use market prices

• Some services produced are not captured by GDP, even if they produce value (ex. Informal work like repairing own bike)

• Production of informal work is not included in GDP

• Final goods: final goods produced but not consumed by households

• Leave out intermediary goods (input goods)

• Only count output final goods consumed by customers to avoid double counting

• Only measure the “end of the chain”

• Goods and services: goods and services are equally valuable in the count of GDP

• Produced: produced in a country in a period of time

• Products from a different period of time are not included in the current GDP

• Used or second-hand goods are not included in the current GDP

• However, the service provided in the selling of a used (second-hand) good, is included in the current GDP

• Within a country: geographical criteria to identify where the good is done and where the service happened

• Who does the labor to produce the good is irrelevant

• Gross Domestic Product- where the production happened

• Regardless of nationality of owners of factors of production

• Where are the factors of production located when it’s produced?

• Gross National Products- output produced by factors of production owned by nationals, regardless of where is was produced

• Given period of time

• Time frame to compute GDP

• Flow variable (GDP) measured quarterly or yearly in a physical representation

• Stock variable: quantity at a certain amount of time

• GDP is used to measure the market value of all financial goods and services produced within a country in a given amount of time

• GDP measures wellbeing of the economy

• Measures total income

• Measures total expenditures of the population

• Limitations of GDP

• Well-being is subjective (different for everybody

• Higher income does not always mean higher well-being

• Illegal activities do not add to GDP even if they generate value

• Four components of GDP (expenditure)

• Consumption: spending on goods and services

• Investment: spending on new equipment and structures + own households

• Government spending: spending of goods and services by the government (local, regional and central)

• Net Exports: difference between value of goods and services exported and value of goods and services imported

1. Measuring GDP

• Nominal GDP: nominal GDP uses current prices to value the economy’s production of goods and services

• Real GDP: real GDP uses constant-base year prices to value the economy’s production of goods and services

• GDP deflator: the GDP deflator measures the level of prices in an economy (the difference between real and nominal prices)

1. Nominal GDP

• Nominal: when we can compute GDP, we use values and prices of the current/ same year

• GDP at current prices (prices of the same year)

• Calculate Nominal GDP pg. 424

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1. Real GDP

• In real GDP values are evaluated by prices of base year

• Calculate Real GDO pg. 424

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1. GDP deflator

• GDP deflator is calculated by dividing the nominal GDP / real GDP x 100

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1. Price level

How many times nominal GDP is higher than in base year	=	How many times real GDP is higher than in base year	x	How many times prices are higher than in base year

$600 / 200		=	$350/ $250	x	How many times prices are higher than in base year

How many times prices are higher than in base year	=	$600/ $200 $350/ $200	≈	1.71

• The factor by which the price level increases

Price level increase rate = Nominal GDP / Real GDP

• The ratio measure by which prices have increased relative to the base year, hence is a measure of the price level

• Price level is usually expressed as an index (P) that has no units and a value of 100 in the base year

1. Nominal vs. Real GDP

	Nominal GDP	Real GDP
Components	C, I, G, NX	C, I, G, NX
Prices used	Market Prices	Constant Prices

• Real GDP is a better measure of well-being because it measures the evolution of value and price

1. Three ways to compute GDP

2. Production approach

• The production approach solves the issue of double counting and its based in a value chain

• Statisticians do not use the final goods in the production approach because adding all costs is not a good way of calculating GDP because some of the inputs can be counted more than once, hence allowing for double counting

• Instead is best to use the value added

• Valued added: for every chain, you take the market price of the output of that firm and subtract the market cost (price) of the intermediate consumption (purchases) of that firm that aren’t factor inputs.

Value added = (Market price of output) – (Market price of non-factor inputs)

• Problems of double counting

• Solution 1: only use final goods and services

• Solution 2: compute for every producer – value added

1. Income approach

• GDP is the sum of all value added

• Where does the added value end up?

• Income from labor (wages)

• Income from capital (profits)

• Income from land (rent)

• The total added value ≡ income

• GDP estimates from the income approach tend to be lower than the GDP estimates from the value added approach

1. Expenditure Approach

• Expenditures on financial goods and services

• Consumption (C): most of the consumption expenditure and purchases of households (not firms)

• Investment (I): mostly purchases of machines and tools by firms

• Purchases of structure and changes in inventories

• Government purchases (G): purchases of goods and services by the government

• Wages are taken as market value of services provided by the government

• Salaries of government workers

• Spending on public works

• Does not include transfer payments as the government does not require the people to give something in return

• Net Exports: (Exports – Imports)

• Imports do not subtract from GDP

• We subtract because we wrongly overstated factors of GDP

• Doesn’t increase or decrease GDP

• If you want to pay more out than in = trade deficit, but in terms of goods, more goods are in than out = trade surplus

1. GDP as a measure of well-being

• In a graph:

• X axis: GDP per person

• Y axis: things other than GDP (ex. Health)

• As the income per capita increases, health also increases

• GDP is a useful measure of well-being but is not a perfect measure

• GDP does not take into account

• Leisure

• Non-market activities

• The environment

• Income distribution

Chapter 21: Measuring the cost of living

1. Objectives

• Cost of living: knowing how much money people need to maintain living standards in terms of goods and services they can afford to buy

• Calculated by Consumer Price Index (CPI)

1. Basket: goods and services bought by a consumer (for a year)

2. Check good by good the price of those goods (done monthly since prices can change)

3. CPI monitors the cost of living

• No unit because it’s an index

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1. Inflation monitors the change of CPI

1. Consumer Price Index (CPI)

• GDP deflator may not be the best to measure the cost of living

• CPI is the measure of the price of goods and services consumed by a typical household or consumer

1. Procedure to measure CPI

2. Survey consumers to determine a fix basket of good

• Keep track of the things consumed

• Statisticians compute on average what is bought

Per Year	4 salads	2 burgers

1. Find the prices of each good or service in each year

• Usually students are sent out to find the prices of the goods in different places (monthly)

2016	$1/ salad	$2/ burger
2017	$2/ salad	$3/ burger

1. Compute the price of the basket of goods in each year

2016	($1/ salad * 4 salads) + ($2/ burger * 2 burgers)	= $8
2017	($2/ salad * 4 salads) + ($3/ burger * 2 burgers)	= $14

1. Chose a base year and complete the index

• Index has no unites and in base year = 100

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CPI (2016) base year	$8 / $8 x 100	= 100
CPI (2017)	$14 / $8 x 100	= 175

1. Use the CPI to compute the inflation rate

• Once you have the index you can compute the rate of inflation

π (year t)	175 - 100 x 100 % 100	= 75%

1. Problems in measuring the cost of living (with CPI)

• Ignores changes in prices and affects changes in quantity demanded

• Salads relative to burgers became more expensive, you will buy more burgers than salads

• Substitution bias: quantity doesn’t change

P salads		Q salads
P burgers		Q burgers

• New goods

• If we have a fixed basket of goods, it means it ignores new goods hence it ignores the fact that some goods may disappear

• The basket must be regularly adjusted

• Unmeasured quality change

• CPI doesn’t capture quality change that is not reflected in the description of the goods

• It’s not representative for all customers

• Index measures what happens on average in the basket, the basket represents what happens to the goods in the basket but not necessarily those that are relevant to your cost of living

1. Difference between GDP deflator and CPI

• GDP deflator and CPI won’t give the same result

	GDP deflator	CPI
Which goods and services	All produced	Basket bought
Where do goods and services come from	Domestically	It doesn’t matter
Imports	Not included	Included
Who buys the goods and services	It doesn’t matter	Consumers
Needs to adjust goods and services	It’s done automatically	Basket must be updated
Calculus	Nominal GDP * 100 Real GDP .	Price of basket (year t) * 100 Price of basket (base year) .

1. Correcting economic variables for the effects of inflation

• We can compare money values from the past with money values from the future

1. Comparing money figures from different times

Amount in today’s currency =	CPI today x CPI base year	Amount in base year currency

1. Indexation

• Indexing: the correction of money amount for effects of inflation by law or contract

• The effect of inflation on amount are adjusted

	January 2017	January 2018
CPI	104	106

• Index went up by 2 points

• Indexed rent:

Indexed rent =	$506 / month x (106 / 104)	≈ $510 / month

1. Real and Nominal Interest rate

• Nominal interest rate: the interest rate as usually reported without a correction for the effects of inflation

• Real interest rate: the interest rate corrected for the effects of inflation

Real interest rate t	= Nominal interest rate t -	Inflation t

Chapter 22: Production and Growth

1. The rule of 70 (Principle of compounding)

• The rule of 70 is used to interpret percentage growth rate

Percentage growth rate
1% per year	doubling time ≈ 70 years
2% per year	doubling time ≈ 35 years
3% per year	doubling time ≈ 14 years

• Rule of 70 because you divide 70 (doubling time) by the percentage growth rate

Doubling time ≈	70 % Percentage growth rate per year

• The higher the percent at which income grows, the faster it doubles

1. Growth Theory

• Over a period of time the economy can experience strong periods of growth rate and also other times when growth is slower, this established trend is usually expressed as a growth rate in percentage terms

• Some key determinants of economic growth are:

• Rate of human and physical capital

• Population growth

• Other factors that can influence economic growth

• Level of macroeconomic stability

• Type of trade policy in the country

1. Productivity

2. Why is productivity so important?

• Productivity refers to the quantity of goods and services that a worker (or any factor of production) can produced in a specified time period

• The key role of productivity is determining living standards is as true for nations as it is for an individual

• A nation can enjoy a high standard of living if it can produce a large quantity of goods and services

• To understand large differences in living standards across countries over time, we focus on production of goods and services

1. How productivity is determined

• The determinants of productivity can be identified as: physical capital (K), human capital (H), natural resources (N) and technological knowledge (A)

• Physical capital: the stock of equipment and structures that are used to produce goods and services

• An important feature of capital is that it’s a “produced” factor of production

• Capital is a factor of production use to produce all kinds of goods and services, including more capital

• Human capital: the economist’s term for the knowledge and skills that workers acquire through education, training and experience

• It includes the skills accumulated in early childhood until on-the-job training for adults in the labor force

• Similarities to physical capital:

• Raises a nation’s ability to produce goods and services

• Human capital is also a produced factor of production

• Producing human capital requires inputs in the form of teachers, lectures and student time (producing the human capital that will be used in the future)

• Natural resources: the inputs into production of goods and services that are provided by nature, such as land, rivers and mineral deposits

• Natural resources can take two forms:

• Renewable: forests (can be restocked)

• Nonrenewable: oil (limited in supply)

• Differences in natural resources are responsible for some differences in standards of living however, they are not necessary for an economy to be highly productive in producing goods and services

• Technological knowledge: society’s understanding of the best ways to produce goods and services

• Technological knowledge takes many forms which are important for the production of goods and services

• Common knowledge: after it starts to be used by one person, everyone becomes aware of it

• Proprietary: it is only known by the company that discovers it

• Patent system: gives temporary right to be exclusive to the manufacturer

• There is an important difference between technological knowledge and human capital:

• Technological knowledge refers to society’s understanding about how the world works, and human capital refers to the resources expended transmitting this understanding to the labor force

• Technical progress means that the quality of physical and human capital is improved

1. The production function

• Production function: output = f (factors of production)

Y =	A x	f ( L,	K,	H,	N )
Real GDP =	Technology	f ( Labor,	Physical capital,	Human capital,	Natural capital)

• Assumption 1

• Production function has constant returns to scale

• If you double inputs, outputs also double

• if we scale all factors of production by z, outputs are also scale up by z

• zy = A x f ( zL, zK, zH, zN )

• z = 1/ L

Y = L .	A x f	( L . L	K L	H L	N ) L .

Y = L .	A x f	( K . L	H L	N ) L .

• Y / L = output per person, labor productivity

• K / L = how much capital per worker

• H / L = how much human capital per worker

• N / L = how much natural resources per worker

Labor productivity =	( Technology ) x	f (factor of production per worker)

• Assumption 2

• Production has diminishing marginal product

• Curve becomes flatter as it increases, therefore, the additional unit impact is greater in the lower part of the curve

• The diminishing marginal product implies that poor countries can catch up to rich countries since they grow faster and rich grow slower

1. Causes of growth

• Steady-state equilibrium will be dependent on an economy’s characteristics like:

• Its population

• The level of physical and human capital

• The savings rate and depreciation rate

• The proportion of the labor force in work

• The level of technology

1. Changes in the savings rate

• An increase in the savings rate can increase investment and the capital-output ratio

• Savings finance investment = savings + investment

I (investment) ≡ S (savings) + Net inflow of savings

• Savings can increase when people spend less and save more

• Saving rate (s) ^ s I K / L Y / L

• Increase in savings rate leads to more savings that can be used to finance more investments which leads to an increase in capital per worker leading to an increase in productivity

• But: diminishing returns, at one point the economy will run out of “steam” and will stop increasing (the increase is temporarily)

1. An increase in population

• If population grows at the same rate as income, then GDP remains constant

• A rising population however, doesn’t mean that the labor force is increasing

• An aging population could mean that the labor force is shrinking

• If the labor force is increasing, in order for the capital-output ratio to remain constant, investment must provide more capital

• If investment doesn’t keep pace with the rise of population, people will become poorer

• This explains why many less developed countries experience continued high levels of poverty because their population rises but investment fails to keep up

• Another way in which a county can influence population growth is to invoke the use of incentives

• Having a child has opportunity costs, and when opportunity costs rises, people will choose to have smaller families

1. Dilution of capital stock

• High population growth reduces GDP per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly

• When population growth is rapid, each worker is equipped with less capital, this smaller quantity of capital per worker leads to lower productivity and lower GDP per worker

• The rapid population growth makes it harder to provide workers with the tools and skills needed to achieve high levels of productivity

1. Promoting technological progress

• The world population growth has been the engine of technological progress and economic prosperity

• If there is more people, there is a greater probability that some of those people will come up with new ideas that lead to technological progress

• Michael Kremer- “Population growth and technological change”

1. An increase in technology

• The aggregate production function shows that even if capital and labor remain constant, an increase in technology will income because both capital and labor become more productive

• Better technology leads to better productivity

• Not only does technology mean that the effects of diminishing marginal product can be offset, but it leads to proportional increases in productive capacity

1. Endogenous growth theory

• Technology is exogeneous in that the level of technology is not affected by either capital accumulation or changes in the population

• Technology can be viewed as a public good which is non-rival

• To investigate why improvements in technology occur endogenous growth theory

• Endogenous growth theory: a theory that the rate of economic growth in the long-run is determined by the rate of growth in total factor productivity and this total factor is dependent on the rate at which technology progresses

• Investment into R&D is an important element of the exponential changes in technology

• Creative destruction: new technologies replace old ones

• Endogenous growth refers to the result of choices made by people, the economic choices of people and the result of those choices

1. Economic growth and public policy

2. The importance of savings and investment

• For society to invest more in capital, it must consume less and save more of its current income

• Sacrifice consumption of goods and services in the present to enjoy a higher consumption in the future

• Countries that devote large share of GDP to investment (like China), also have stronger average growth rate

• High investment leads to more rapid economic growth

1. Diminishing returns and the Catch-up effect

• An increase in the savings rate leads to a higher growth but only for a while due to diminishing returns

• In the long run, higher savings rate leads to a higher level of productivity and income, but not higher growth

• It is easier for a country to grow fast if it starts relatively poor

• Catch-up effect: the property whereby countries that start off poor tend to grow more rapidly than countries that start-up rich

1. Investment from abroad

• Investment abroad takes many forms:

• Foreign direct investment: a capital investment that is owned by a foreign entity

• Foreign portfolio investment: an investment that is financed with foreign money but operated by domestic residents

• GDP is the income earned within a country by both residents and non-residents, and GNP is the income earned by residents of a country both at home and abroad

• Investments from abroad increase the economy’s stock of capital and it’s a way poor countries benefit from technologies developed in rich countries

1. Education

• One way in which government policy can enhance the standard of living is to provide good schools and to encourage population to take advantage of it

• Education (investment in human capital) it's an investment in long-run economic success

• Education has positive externalities

• An educated person might generate new ideas about how to improve productivity

• A problem poor countries might face is “brain drain” which is the emigration of many of the most highly educated people into rich countries

1. Health and nutrition

• Healthier workers are more productive, investments can increase living standards

1. Political stability and good governance

• It’s important for the price system to work that there is an economy-wide respect for property rights

• Economic prosperity depends on a good honest governance as well as political stability and; political stability provides to respect of property rights

1. Free trade

• International trade can improve the economic wellbeing of a country

• Trade is to a degree a type of technology

• When a country imports and exports, the country benefits in the same way as it had invented a new technology (the imported product)

• A country that eliminates trade barriers will experience a similar economic growth that would occur after a major technological advance

1. Research and development

• Ways the government encourages research and development

• Science research laboratories owned and funded by the government

• System of research grants to promising researchers

• Patent systems

1. Population growth

• A large population means there is a chance for a larger labor force for production and more people to consume the goods and services produced

Chapter 23: Unemployment

1. Learning objectives

• Explain key concepts of unemployment

• Calculate the working population, unemployment rate and participation rate

• Difference between frictional and structural unemployment

1. Identifying unemployment

2. What is unemployment

• An unemployed person is not simply “someone who does not have a job” but more accurately, “someone who does not have a job but is available for work”.

• Willing to work at going wage rates

• The number of unemployed in an economy is the number of people of working age who are able and available for work at current wage rates and who don’t have a job

1. How is unemployment measured

2. The claimant count

• Claimant count: counting the number of people who, on any given day, are claiming unemployment benefit payment from the government

• Number of unemployment benefit claimants is a measure of the total labor force and expressing the count as a proportion of the labor force is a measure of the unemployment rate

• Drawbacks

• It is subject to changes in the rules the government applies for eligibility of such benefits

1. Labor force surveys

• Labor force surveys: asking people questions through surveys if they are unemployed based on the accepted definition of unemployment

• Each person surveyed must be placed in one of the following:

Employed	Unemployed	Economically inactive
Someone who spent some of the previous week working at a paid job	Someone who is without a job and who is willing to start work within the next two weeks and either has been looking for a job within the past 4 weeks or is waiting to start a job	People who are not in employment or unemployed due to reasons such as being in full-time education or careers and raising families

• Labor force: the total number of workers, including both the employed and the unemployed

• Unemployment rate: the percentage of the labor force that is unemployed

Unemployment rate	Employment rate
Number of unemployed x 100 % Labor force .	Number of employed x 100 % Labor force .

• Labor force participation rate (economic activity rate): the percentage of the adult population that is in the labor force

Labor force participation rate =	Labor force x 100 % Adult population .

1. The Causes of unemployment

• The equilibrium wage rate is that which brings together the number of workers willing and able to work at the wage rate with the demand for labor at that wage rate

1. Frictional unemployment

• Frictional unemployment: the unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills

• Voluntary unemployment: where people choose to remain unemployed rather than take jobs which are available

• Involuntary unemployment: where people want to work at going market wage rates but cannot find employment

• People can choose to remain unemployed due to the unemployment benefits

• If unemployment benefits increase, the search effort to find a job decreases hence frictional unemployment increases

• Government can help reduce frictional unemployment by

• Facilitate job search by having job search offices

• Provide training to the unemployed

1. Structural unemployment

• Structural unemployment: unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one

• Reasons for structural unemployment

• Occupation and geographic immobility workers are immovable between regions

• Occupational immobility: where workers are unable to easily move from one occupation to another

• Geographic immobility: where people are unable to take work because of difficulties associated with moving to different regions

• Technological change

• Structural change in the economy: structural changes affect the make-up of economies

• Collective bargaining

1. Labor market imperfections

• Imperfections: wages being above market equilibrium

• Minimum wage laws: a price floor applied to the labor market

• It forces the wage to remain above the level that balances supply and demand, it rises the quantity of labor supplied and reduces the quantity of labor demanded

• Unions and collective bargaining

• Unions: worker associations that bargains with employees over wages, benefits and working conditions, act as a cartel to exercise market power

• Collective bargaining: the process by which unions and firms agree on terms of employment

• When unions rise the wage above equilibrium level, it rises quantity of labor supplied and reduces the quantity of labor demanded, resulting in unemployment

• Are unions good or bad?

• Bad because they are a type of cartel

• Good because they are a necessary antidote to the market power of the firms and are key for helping firms respond efficiently to workers

• There is no real correct answer

• Efficiency wages: above equilibrium wages paid by firms in order to increase worker productivity

• Paying high wages might be profitable because they might rise efficiency of workers

• Types of efficiency wage theory

• Worker health: better paid workers, eat better hence they are healthier and more productive

• Worker turnover: the more the firm pays the worker, the less likely to leave

• Worker effort: the better the workers are paid the better their performance is

• Worker quality: by paying a high wage, the firm attracts a better pool of workers

1. The natural rate of unemployment

• Happens when an economy is growing, unemployment decreases but never zero

• When economy increases, unemployment decreases

• When economy decreases, unemployment increases

• Natural rate of unemployment (NRU):the normal rate of unemployment around which unemployment rate fluctuates

NRU =	Rate at which people lose jobs x 100 % Rate at which people find jobs + rate at which people lose jobs .

Natural rate of unemployment =	Frictional unemployment rate - structural unemployment rate

• NRU is the sum of frictional and structural unemployment

• Cyclical unemployment:the deviation of unemployment from its natural state

• Can be negative as it can be below average

Cyclical unemployment =	Unemployment rate - natural rate of unemployment

1. How long are the unemployed without work?

• Most spells of unemployment are short-term, and most unemployment observed at any given time is long-term

• Most people who become unemployed will soon find jobs, yet most of the economy’s unemployment problem is attributable to the relatively few workers who are jobless for a long period of time

1. Job search

• Job search: the process by which workers find appropriate jobs given their taste and skills

• One reason why economies always experience some unemployment

1. Why some frictional unemployment is inevitable?

• Frictional unemployment is inevitable simply because the economy is always changing

• Sectoral shifts

• Workers find that their jobs are a bad match for their tastes and skills, hence they leave

1. Public policy and job search

• The faster the information spreads about job openings, the faster the economy can match workers and firms

• If policy can reduce the time it takes unemployed workers to find new jobs, it can reduce the unemployment rate

1. Unemployment insurance

• Unemployment insurance: a government program that partially protects workers’ incomes when they become unemployed

• Government policy that increases the amount of frictional unemployment without intending to do so

• Benefits are paid to unemployed whose skills were no longer needed

• Reduces the hardships of unemployment but increases the amount of unemployment

• Unemployment benefits cause people to devote less effort to job search

1. Marx and reserve army of the unemployed

• Karl Marx believed that unemployment was a necessary condition for capitalism to survive

• Marx referred to the unemployed as the “reverse industrial army of labor”

• Having a reserve army of the unemployed is a fundamental reminder to workers that they too could join it if they pushed their power too far

• The existence of a reserve army of the unemployed is of value in exploiting growth in economic activity

• Helps capitalists in providing them new workers to help cope with increasing output demands

1. The cost of unemployment

• Unemployment imposes costs in the individual and their family but there is also a wider cost of unemployment which affects the government and the whole economy

1. The costs of unemployment to the individual

• Loss of earnings: no paychecks or income just unemployment benefits

• Stress, self-esteem and health problems

• Drug and alcohol abuse and crime

• Family breakdown

• De-skilling: skills start eroding and becoming useless or forgotten

1. The costs of unemployment to society and the economy

• The opportunity cost of unemployment

• Represents a loss of output (what the individual would have produced)

• Decreases revenues

• The tax and benefits effect

• Tax revenues decrease, and unemployment benefits increase

1. The reverse multiplier effect

• Cycle effect: keeps affecting people down the chain as a cause of unemployment

• Unemployed spend less firms sell less people from firm might lose their job

Chapter 24: Saving, investment, and the financial system

1. Learning objectives

• Identify the purpose of a financial system and be able to identify and distinguish different financial markets acting in an economy

• Bond market

• Stock market

• Key terminology of a financial system

• Understand the functioning of the financial markets

• Market for loanable funds

• Relationship between financial markets and the effect of economic policy

• National accounts: savings vs. investments

1. Financial institutions in the economy

• Financial system: the group of institutions in the economy that help to match one person’s saving with another person’s investment

• The financial system moves the economy’s scarce resources from savers to borrowers

• Savers supply their money to the financial system with the hope to get it back with interest later

• Borrowers demand money from the financial system knowing they will have to pay it back with interest later

• All of the financial institutions serve the same goal- directing the resources of savers into the hands of borrowers

1. Financial markets

• Financial markets: financial institutions through which savers can directly provide funds to borrowers

1. The Bond Market

• Bond:a certificate of indebtedness

• IOU (I Owe You)

• A bond must include:

• The principal: amount borrowed + interest

• Date of maturity: the time at which the loan will be repaid

• Issuer of the bond

• Coupon: the rate of interest that will be paid periodically

• Important characteristics of bonds:

• Bond’s term: the length of time until the bond matures

• Long-term bonds are riskier than short-term because of the long wait

• Credit risk: the probability that the borrower will fail to some of the interest or principal

• Borrowers can default on their loans

• When high probability is best to have a higher interest rate

• Tradable security

• Bonds can be traded in a secondary market

• Yield (coupon yield): return on a bond

Yield =	Coupon Price of bond	x 100 %

• There is an inverse relationship between price and yield

• As bond price rise, yield falls and vice versa

• Bond prices are affected by existing bonds in the market

• Market interest rate increases, price of bond decreases

• Market interest rate decreases, price of bond increases

1. The Stock Market

• Stock (share):a claim to partial ownership and future profits of a firm

• Equity finance: sale of stock to raise money

• Debt finance: sale of bonds

• Compared to bonds, stocks offer the holder a higher risk and potentially higher return

• The share has tradable security

• Share price reflects expectations about future profits of the firm

• Traded in a stock exchange market

• Stock index: measure of the average prices of a group of shares

1. Financial intermediaries

• Financial intermediaries:financial institutions through which savers can indirectly provide funds to borrowers

• Intermediary- role in standing between savers and borrowers

1. Banks

• Banks take in savings and deposits and use them to make loans for borrowers

• Financial intermediaries with which people are most familiar with

• Facilitate purchases of goods and services by allowing the use of debit cards

1. Investment or mutual fund

• Investment (mutual) fund:an institution that sells shares to the public and uses the proceeds to buy a portfolio of stocks and bonds

• If the value of the portfolio rises, the shareholder benefits; if the value falls, the shareholder suffers a lost

• Allows savers to better diversify (face less risk)

• Charge a fee

1. Other financial instruments

• Collateralized Debt Obligations (CDO’s): pools of asset-backed securities which are dependent on the value of the asset that backs them up and the stream of income that flows from these assets.

• Problems when people defaulted on their payments

• Credit Default Swaps (CDS): a means by which a bondholder can insure against the risk of default

• CDS are means of insuring against the risk involved of for example in the risk of payers defaulting on the payment of their mortgage debt

• Dark pools: an electronic network which puts buyers of shares in touch with sellers

1. Saving and investment in the national income accounts

2. Some important identities

• GDP= total income in the economy and the total expenditure on the economy’s output of goods and services

• Since we assume we are in a closed economy there in no international trade, imports or exports hence NX = 0

Y ≡ C + I + G

I ≡ Y - C - G

• National saving (S):the total income in the economy that remains after paying for consumption and government purchases

S ≡ S ≡ S ≡	Private saving + public saving ( Y - T - G ) + ( T - G ) . Y - C - G

• Private saving: the income that households have left after paying for taxes and consumption

• Public savings: the tax revenue that the government has left after paying for its spending

• Budget surplus:where government tax revenue is greater than spending because it receives more money than it spends

• T - G > 0

• Budget deficit:where government tax revenue is less than spending and the government has to borrow to finance spending

• T - G < 0

• Government deficit: a situation where government spends more than it generates in tax revenue over a period

• Government (national) debt: the accumulation of the total debt owned by a government

1. The meaning of saving and investment

• Investment refers to the purchase of new capital, such as equipment or buildings

• Although the accounting identity S = I shows that savings and investment are equal for the economy as a whole, this doesn’t have to be true for everyone

1. The market for loanable funds

• Market of loanable funds: the market in which those who want to save supply funds, and those who want to borrow to invest demand funds

• Loanable funds refers to all income that people have chosen to save or lend out

• One interest rate which is the return for saving and cost of borrowing

1. Supply and demand for loanable funds

• Consists of the supply of and demand for loanable funds and the price in this market is the interest rate

• The supply of loanable funds comes from people who have an extra income they want to save and lend out (national savings)

• The demand for loanable funds comes from households and firms who wish to borrow to make investments (investments)

• The interest rate (r) represents the price for a loanable fund and the amount received on savings

• If r increases quantity supplied of loanable funds increases

• If r increases quantity demanded of loanable funds decreases

• Shifts in the demand and supply can bring changes to the interest rate

• Because inflation erodes the value of money over time, real interest rates reflect more accurately the real return to savings and cost of borrowing

1. Policy 1: Saving incentives

• Saving incentives such as tax incentives shift of supply of loanable funds to the right (increase in supply of loanable funds)

• Real interest rate (r) decreases

• The shift in the supply curve (s) moves the market equilibrium along the demand curve ( savings (s) and investment (I) increase)

• Interest elasticity of demand and supply: the responsiveness of the demand and supply of loanable funds to changes in the interest rate

1. Policy 2: Investment incentives

• Investment incentives such as an investment tax credit shifts the demand for loanable funds to the right (increase in demand for loanable funds)

• Real interest rate (r) increases

• Since firms would have an incentive to increase investment, the market equilibrium moves along the supply curve ( savings (s) and investment(I) increase)

1. Policy 3: Government Budget deficits and surpluses

• A government increase in spending (G) can lead to a budget deficit or a decrease in spending can lead to a budget surplus. A budget deficit for example decreases the supply of loanable funds (shift to left) (public saving becomes negative)

• Real interest rate (r) increases

• The market equilibrium then moves along the demand curve to the left (savings (s) and investment (I) decrease)

• Crowding out: the fall (decrease) in investment that results from government borrowing

Chapter 25: The basic tools of Finance

1. Present value: Measuring the time value of money

• Money today is more valuable than the same amount of money in the future

• Present value: the amount of money today, that would be needed to produce, using prevailing interest rates, a given future amount of money

• What sum of money would you need to put into an interest-bearing account at a particular interest rate to generate the future sum

• Future value: the amount of money in the future that an amount of money today will yield, given prevailing interest rates

• Compare $200 in 10 years with the future value of $100 today

• Put $100 in a savings account with interest rate of 5% (0.05)

Value after 1 year =	$100 x ( 1 + r )	= $105.00
Value after 2 years =	$100 x ( 1 + r ) ^2	= $110.75
……	……	……
Value after 10 years =	$100 x ( 1 + r ) ^10	≈ $163.00

Future value = present value x ( 1 + r ) ^ N

Present value =	Future value ( 1 + r ) ^ N

1. What determines the price of a share

• Value of share = present value of future profits

• Financial analysts try to predict future profits using all available relevant information

• If share price < value of share

• People buy shares

• Share price increases until it = the value of the share

• Efficient market hypothesis- share price incorporates all available information

• Speculative bubbles cause irrational markets

1. Managing risk

• Risk: the probability of something happening resulting in a loss or damage

• Risk adverse: exhibiting a dislike for uncertainty

• Reduce risk by diversification, insurance and the risk-return trade-off

• Diversification: the reduction of risk achieved by replacing a single risk which a large number of smaller unrelated risks

• Idiosyncratic risk: risk that affects only a single economic factor

• Aggregate risk: risk that affects all economic actors at once

1. Asset valuation

• Learning the price of the asset is easy what is difficult is determining the value

• Fundamental analysis: the study of a company’s accounting statements and future prospects to determine its value

Chapter 27: The monetary System

1. Learning objectives

• Learn the meaning of money and understand that there are other things aside bank notes and coins that are money

• Discuss the difference between the alternate functions of money and what characteristics make money useful by each one of the functions

• Distinguish between commodity money and fiat money

• Compare the role of a central bank and a commercial bank

• Tell differences between European Central Bank, Euro System and European System of central bank

• Discuss how commercial banks affect the money supply and how a central bank controls the money supply

1. The meaning of money

• Money: the set of assets in an economy that people regularly use to buy goods and services from other people

• Money includes only those few types of wealth that are regularly accepted by sellers in exchange of goods and services

1. The Functions of Money

• Money has three functions in the economy: it’s a medium of exchange, a unit of account and a store of value

• These functions together distinguish money from other assets in the economy like stocks and bonds

• Medium of exchange: an item that buyers give to sellers when they want to purchase goods and services

• This transfer of money allows for a transaction to take place

• Unit of account: the yardstick people use to post prices and record debts

• Way to measure and record economic value and transactions

• Store of value: an item that people can use to transfer purchasing power from the present to the future

• Wealth: the total of all stores of value, including both money and non-monetary assets

1. Liquidity

• Liquidity:the ease with which an asset can be converted into the economy’s medium of exchange

• Money is the most liquid asset as it’s the economy’s medium of exchange

• Bonds and stocks are relatively liquid

• Money may be the most liquid asset but it’s not perfect as a store of value as when prices rise, the value of money fall

1. The Kinds of Money

• Commodity money: money that takes the form of a commodity with intrinsic value

• Intrinsic value: the item would have value even if it were not used as money

• Gold standard: a system in which currency is based in the value of gold and the currency can be converted to gold

• Fiat money: money without intrinsic value that is used as money because of government decree (ex. currencies)

1. Money in the economy

• Money stock (M): the quantity of money circulating in the economy

• A stock (not a flow) that is measured at a point in time

• Entire stocks of currency and other liquid instruments

• Currency:the paper banknotes and coins in the hands of the public

• Most accepted medium of exchange in modern economy

• Currency = banknotes and coins held by public

Money stock (M) =	Currency + demand deposits

• Currency is not the only asset used to buy goods and services

• Debit cards- means of transferring money between accounts

• Credit cards- means of deferring payments

• Demand deposits:balances in bank accounts that depositors can access on demand by using a debit card

• Measures of money stock:

M1 Narrow monetary aggregate	M2 Intermediate monetary aggregate	M3 Broad monetary aggregate
Currency + overnight deposits	M1 + short-term deposits (maturity shorter than 2 years)	M2 + long-term deposits (maturity longer than 2 years)
More liquid		Less liquid

• Money stock for an advanced economy includes not just currency but also deposits in banks and other financial institutions that can be readily accessed and used to buy goods and services

1. The role of Central Banks

• Central Bank: an institution designed to regulate the quantity of money in the economy

• Money supply: the quantity of money available in the economy

1. Functions of Central Banks

• Two main functions:

• Macroeconomic stability: maintenance of stable growth and prices and the avoidance of excessive and damaging swings in economic activity

• Central bank has the power to increase or decrease the amount of currency in the economy

• Maintenance of stability in the financial system

• Use relationship with the rest of the banking system to supply liquidity, the cash needed to ensure transactions in the financial system are honored

• Monetary policy:the set of actions taken by the central bank in order to affect the money supply

• Open market operations: the purchase and sale of non-monetary assets from and to the banking sector by the central bank

• Increase the money supply through creating currency by buying bonds in the bond market extra currency now belongs to bond seller

• Decrease money supply by selling bonds from their portfolio the currency received leads to reduction in bank accounts decreasing money supply

• Central bank is important because the changes they make in the money supply can profoundly affect economy and inflation

• Guardian of inflation stability

• Lender of last resort- provides the funds necessary to ensure that banks can continue to operate

• Monitor, supervise and regulate the banking system

1. Financial institutions

• Financial institutions: company engaged in a business of dealing with monetary transactions such as deposits and loans

Central Banks	Commercial Banks	Other
Central banks are responsible for the control of the money stock through monetary policy	Commercial banks deal with the day-to-day business of the banking sector (deposits, savings account, loans	Investment banks , insurance and investment companies
Serve commercial banks	Serve individuals and businesses	Serve individuals and businesses

1. The European Central Bank and the Eurosystem

• European Central Bank (ECB):the overall central bank of the 19 countries comprising the European Monetary Union

• Frankfurt, Germany (1998)

• Same currency and a common monetary policy

• Main objective- maintain price stability a and implement a monetary policy that helps keep it, also keep inflation below 2%

• Eurosystem: the system made up of the ECB plus the national central banks of each of the 19 countries comprising the European Monetary Union

• Executive board of the ECB

• President, vice president and four other people of high standing in bank policy

• Responsible for deciding and executing the monetary policy

• Policy is designed by the Governing council (Executive board + governors of the 19 central banks)

• Monetary policy strategy of “in the pursuit of price stability, it aims to maintain inflation rates below, but close to 2 per cent over the medium term”

1. The bank and the money supply

• Banks earn interests on assets and have to pay interests on liabilities

• Spread: the difference between the average interest banks earn on assets and the average interest rate paid on liabilities

1. A bank’s balance sheet

Assets	Liabilities
Reserves of cash Securities hold Loans What it owns What others owe to it	Demand deposits Savings deposits Borrowings Equity capital What it owes to others

1. Constraints on bank lending

• If the CB increases lending rates to the banking system, banks have to increase the interest rate on lending to maintain spreads leading to reduction of demand for loans (vice versa)

• If lending is increasing and money growth is rising fast risk in accelerating inflation rate

• Increase lending rate which is designed to slow down the rate of money growth

• To attract new loans, banks may have to offer lower rates than competitors which affects the profitability of their operations

• Credit risk: the risk that a bank faces in default of loans

1. Macroprudential policy

• Systematic risk: the risk of failure across the whole of the financial sector

• The risk is increased due to the interconnectedness and interdependence of the financial system (problems cascade down to others and can lead to economic shutdown

• Macroprudential policy: policies designed to limit the risks across the financial sector by focusing on improving “prudential” standards of operation that enhance stability and reduce risk

• Liquidity risk: the risk that a bank might not be able to fund demand for withdrawals

• The failure of one bank can lead to the problem cascading down

1. Reserve ratio and the money multiplier

• Reserve ratio (RR):portion of reservable liabilities that commercial banks hold onto, rather than lend out or invest

• Aka cash reserve ratio

Reserve ratio =	Reserves deposits	x 100%

• The Central Bank informs commercial banks of the required reserve ratio (RRR) that is compulsory keeping when making loans

• Required Reserve Ratio (RRR):portion of the reservable liabilities that commercial banks must hold rather than lend out or invest

• The goal is to provide loans to make profits by creating money

• Money multiplier:measures an estimate of the maximum amount of money that the banks can create given the required reserves

Money multiplier =	1 Reserve ratio

• $100 deposit, bank keeps a 10% reserve ratio and lends out the rest

M =	$100 + $90 + $81 + …
M =	$100 + $100 x ( 1 – reserve ratio ) + $100 x ( 1 – reserve ratio )^2 + ( … )
M =	$100 [ 1 + ( 1 – reserve ratio ) + ( 1 – reserve ratio ) ^ 2 + ( … ) ]
M =	$100 [ 1 + ( x ) + ( x^2 ) + ( … )

1 + x + x^2 + x^3 + … = Geometric series .	1 1 - x	If I x I < 1
M = $100 x	1 1 - x	If I x I < 1
M = $100 x	1 Reserve ratio	= 1 = $100 x 10 = $1000 0.10 .

With $100 of additional reserves, the banking system creates at most $1000 of additional money

1. The Central Bank’s tools of monetary control

• Three main tools to maintain economic stability: open market operations, the refinancing rate and reserve requirements

1. Open Market Operations

• An open market purchase of bonds by Central Banks effectively increase broad money and to decrease broad money , it can sell bonds from its portfolio

• Outright open market operations: the outright sale or purchase of non-monetary assets to or from the banking sector by the central bank without a corresponding agreement to reverse the transaction at a later date

• Open market transactions: when central banks buy or sell bonds from banks

1. Th Refinancing rate

• Refinancing rate:interest rate at which the central bank is willing to lend to commercial banks on a short-term basis

• Interest rate that the central bank charges on the loans

• Aka reposition rate (UK), discount rate, policy rate, refi rate

• Useless right now as the rate is equal to zero, meaning that no more cutting is possible

• Interbank market: very active market in which banks lend money to each other

• Repurchasing agreement: the sale of a non-monetary asset together with an agreement to repurchase it at a set price at a specified future date

• Money market: the market in which commercial banks lend money to one another on a short-term basis

1. Quantitative Easing

• The process of quantitative easing involves the central bank buying assets from private sector institutions financed by the creation of broad money

• Reserve requirements: portion of the reservable liabilities that commercial banks must hold rather than lend out or invest

1. Problems when controlling Money supply

• Suppose: ECB buys a $100 bond from the public (public receives $100) (rr = 10%)

• Problem 1: public deposits only part of the $100 ( ex. $50)

• banks can only lend $45

• money supply increases only a little

• Problem 2: public deposits all $100

• But banks chooses to lend less than $90 (ex. $45) because the bank doesn’t have anyone reliable who wants a loan (available borrowers are risky)

• Credit crunch

• Money supply increases a little

1. Unconventional tools of monetary policy

• European Central Bank buys assets other than government bonds

• Quantitative Easing (QE) – buying other assets other than government bonds

• European Central Bank (ECB) charges negative interest rate on reserved deposited by banks

1. Main tools to maintain stability

Open market operations	Refinancing rate	Quantitative easing
Expansionary (loose) monetary policy
Buying bonds Increase money supply and decrease interest rate	Decreasing refinancing rate Decreases interest rate and increases money supply	Buying bonds from private institutions decrease interest rate & increase money supply
Contractionary (tight) monetary policy
Selling bonds decreases money supply and increases interest rates	Increasing refinancing rate increases interest rate and decreases money supply
	Unconventional monetary policy- scarcely used 1930s great depression

Chapter 28: Money Growth and Inflation:

1. Learning Objectives

• Identify the changes in the price levels that lead to inflation and/ or deflation

• Identify the negative relationship between the price level and the value of money

• Analyze the market of money to determine the equilibrium and the determinants of the demand and supply of money

• Quantify the effect of a change in the ECB monetary policy

• Summarize the classical dichotomy and discuss the effects of monetary changes in nominal and real variables

• Use the velocity of money equation to understand the changes in price level and discuss the criticisms in the theory

• Fisher effect

• Summarize the costs of inflation, specially the inflation-induced tax

1. What is Inflation

• Inflation (π): an increase in the overall level of prices in the economy

• Price level (P): a snapshot of the prices of goods and services in an economy at a particular period of time

• Deflation: a fall in the price level over a period occurring when the inflation rate is less than 0 per cent

• If inflation is higher than desired, the supply of money will be tighter; but if inflation is lower than desired, they will increase the supply of money

1. Classical Theory of Inflation

• Classicaltheory of inflation sought to explain price rises by the increase in supply of gold and silver

1. The Level of Prices and the Value of Money

• The price level can be a measure of the value of money

• An increase in the price level (P) means a lower value of money because each unit of money now buys a smaller quantity of goods and services (money value falls)

• Purchasing power of $1: how many baskets of goods you can buy with $1

Purchasing power of $1 (1 / P) =	1 P (basket of goods)

• If price level (P) increases purchasing power (1 / P) decreases

• They have a negative relation

Price level	Inflation
Snapshot of the weighted average value of a basket of goods and services in one period	(Positive) change in the price level between two periods, a negative change is called deflation

When analyzing 3 or more periods, we can see the change in speed at which prices are changing (inflating)		Month 1	Month 2	Month 3
Acceleration	3	3.5	3.7
Deceleration	3	3.65	3.45
Stabilization	3.45	3.45	3.45

• Inflation: price levels increase and value of money decrease. Deflation: price level decreases and value of money increases

• Given your financial wealth, how much of that wealth would you want to hold as money

• As little as possible because it generates no interest (depends on the interest rate)

• If there is no interest rate, you would be indifferent (want to hold it as money)

• As interest rate increases, the desire for less money increases

1. Money Supply, Money Demand and Monetary Equilibrium

• Market of money = market of liquid cash

• Supply of money (Ms): depends on the required reserve ratio (RRR) and is controlled by the ECB

• X axis

• Demand for money (Md): how much wealth people want to have in liquid form (cash)

• A higher price level increases the quantity of money demanded

• Y axis

• Monetary equilibrium: the overall level of prices adjusts to the level at which the demand for money equals the quantity of money supplied

• The equilibrium of money supply and demand determines the value of money and the price level

• At equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the central bank

Demand slope: negative	Supply slope: inelastic
An increase in value of money implies a decrease in the quantity of money demanded	Vertical because of the assumption that the central bank can fix the money supply

• Money demand (Md) is determined by the purchasing power of $1 (1/P)

• If 1/P decreases P increases

• More money needed for average transaction

• If Md increases, it’s a movement along the Md curve

• If the price level is above equilibrium, people will want to hold (Md) to pay for goods and services but since the (Ms) is fixed it results in an excess demand for money at this price level

• Price level must fall to balance supply and demand

• If the price level is below equilibrium people will want to hold (Md1) but the (Ms) is fixed,

• Price level must rise to balance supply and demand

1. The Effects of Monetary Injection

• Suppose the central bank doubles the supply of money through purchases of government bonds from the public in open market operations

• Monetary injection shifts the supply curve to the right and equilibrium moves from point A to point B as a result the value of money (1/P) decreases and the price level increases

• When an increase in the money supply makes euros more plentiful, the result is an increase in the price level that makes each euro less valuable

• P and 1/P adjust and bring supply and demand back to balance

• If the central bank lets the money supply grow, it causes inflation but if it lets the money supply decrease, it causes deflation

• Hyperinflation: prices increase really fast

• Quantity theory of money:a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines inflation rate

• Explanation of how price level is determined and why it might change over time

1. A Brief Look at the Adjustment Process

• The immediate effect of a monetary injection is to create a n excess supply of money, before injection (economy was in equilibrium) after injection (the supply of money is greater than the demand at the price level and people have more euros in their pocket than they need to buy goods and services

• People try to get rid of this by:

• Buy goods and services or bonds with the excess holdings of money

• Use the excess of money to make loans to others

• Injection of money increases the demand for goods and services however the economy’s ability to supply goods and services hasn’t changed as none of the factors has been altered

• This causes the prices of goods and services to increase , the new price level increases the quantity of money demanded (people use more money in each transaction) this causes the economy to reach a new equilibrium

1. The Classical Dichotomy and Monetary Neutrality

• Nominal variables: variables measured in monetary units

• Nominal GDP, nominal prices, nominal interest rates

• Real variables:variables measured in physical units

• Relative prices, real wages, real GDP, real interest rate

• Classical dichotomy: the theoretical reparation of nominal and real variables

• Monetary changes (changes in supply) are irrelevant for real variables in the long-run

1. Relative Prices

• Relative prices: price expressed in terms of how much of one good has to be given up in purchasing another

• Not expressed in terms of money

• For example: Price good 1 = $2/ good 1 and price of good 2 = $1/ good 2

Relative price of Good 1 =	$2 / good 1 $1 / good 2

Relative price for Good 1 =	$2 / good 1 $1 / good 2	X	Good 2 / $1 Good 2 / $1

Relative price of Good 1 =	$2 Good 1 $1 Good 2

1. Real wages

• Real wage:the money wage adjusted for inflation, measured by the ratio of the wage rate to price (W / P)

• If the wage rate and price change, then the real wage gives a more accurate reflection of how the consumer has been affected

• Measures the rate at which economy exchanges goods and services for each unit of labor

• Real interest rates measure the rate at which the economy exchanges goods and services produced today for goods and services produced in the future

1. Monetary neutrality

• Monetary neutrality:the proposition that changes in the money supply do not affect real variables

• Applies more in the long-run and not in the short-run

1. Velocity and Quantity Equation

• Velocity of money:the rate at which money exchanges hands as it moves around the economy

• Velocity only takes into account the rate at which money exchanges hands for final goods and doesn’t take into account second hand goods

Velocity of money (V) =	P x Y M	V = velocity of money P = price level (GDP deflator) Y = real GDP (Q of output) M = quantity of money

Velocity (V) =	Nominal GDP Quantity of money

• If we reorder the equation, we can get the quantity equation

• Quantity equation:the equation ( M x V = P x Y ), which relates the quantity of money, the velocity of money, and the currency value of the economy’s output of goods and services

• Aka equation of exchange

• The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other 3 variables

• P must increase

• Y must increase

• V must fall

• Assumption 1: V is constant in the long run (V bar) and Y is also constant as none of the factors of production is affected (Y bar)

• Assumption 2: (M) supply of money does not influence Y (Y bar)

M x V (bar) = P x Y (bar)

• If money supply (M) increases, then price levels (P) must also increase to keep balance

• Quantity theory of money: money growth causes inflation

• To regulate/ bring down inflation, the supply on money must also be brought down

1. The Inflation Tax

• Inflation tax: the revenue the government raises by creating money

• When the government prints money, price level rises and the value of money falls

• It acts like a tax on everyone who holds money

• It’s a progressive tax since the richer you are, the more money you are likely to hold hence the more inflation tax will affect you

• Hyperinflation: a period of extreme and accelerating increase in the price level

• Government has high spending, limited borrow ability, bad tax revenue which as a result makes them print money to pay for their spending

• Ends with financial reforms like: cutting down government spending

• Inflation forces people to hold more money than they usually do hence they lose purchasing power and the government gains purchasing power

1. The Fisher Effect

• Fisher effect:the one-for-one adjustment of the nominal interest rate to the inflation rate

i (t) =	r(t)	+	π (t)
Nominal interest rate =	Real interest rate	+	Inflation rate

• Real interest rate is determined by supply and demand for loanable funds; inflation rate is determined by the growth in money supply

• When the ECB increases the money supply, the result is both a higher inflation rate and a higher interest rate

1. The Costs of Inflation

• Inflation in itself does not reduce peoples real purchasing power, it reduces the purchasing power of $1, it doesn’t mean the purchasing power of people go down since wages can increase

1. A Fall in Purchasing power? The Inflation Fallacy

• Inflation fallacy: it reduces peoples purchasing power but not the real one

• When prices rise, buyers of goods and services pay more for what they buy and sellers for those goods get more for what they sell

• The reason behind the inflation fallacy lies in monetary neutrality

1. Shoeleather Costs

• Shoeleather: the resources wasted when inflation encourages people to reduce their money holding

• When inflation is high you are punished for holding wealth as money but holding it as bonds or savings accounts protect your money thanks to the Fisher effect

1. Menu Costs

• Menu costs: the costs of changing prices

• Include the costs of deciding new prices, adjusting internal systems to coordinate the changes in prices, the costs of printing new price lists and the price of sending this new lists and catalogues to customers

• Inflation increases the menu costs that firms must bear, high inflation makes firm costs rise rapidly, such does hyperinflation

1. Relative Price Variability and the Misallocation of Resources

• Price variability matters because market economies rely on relative prices to allocate scarce resources

• Consumers decide what to buy by comparing the quality and prices of goods and services

• When inflation distorts relative prices, consumer decisions are distorted, and markets are less able to allocate resources to their best use

1. Inflation-Induced Tax Distortions

• Inflation discourages savings through:

• the tax treatment of capital gains- the profits made by selling an asset for more than its purchase price

• the tax treatment of interest income- treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation

	Economy A	Economy B
Inflation	0%	8%
Real interest rate	4%	4%
i = r + π	4%	12%
Minus: tax = 0.25 x i	-1%	-3%
i after tax	3%	9%
r after tax	3%	1%

• Saving is less attractive on an economy with high inflation, high inflation in the long run is bad for growth

1. Confusion and Inconvenience

• Because inflation causes money at different times to have different real values, computing a firm’s profit is more complicated in an economy with inflation

• Inflation makes investors less able to sort out successful and unsuccessful firms which impedes financial markets in their role of allocating the economy’s savings to alternative types of investment

• People are fooled into not making optimum decisions since prices are changing constantly

1. A Special Cost of Unexpected Inflation: Arbitrary Redistribution of Wealth

• Unexpected inflation is important because to consider together with another fact: inflation is especially volatile and uncertain when the average rate of inflation is high

• Unexpected inflation: redistributes wealth from creditors to debtors (creditors lose, and debtors gain)

• P = $1/ can of soda

• Debtor borrows today $10 for 1 year

Real value of debt =	$10 $1 / can of soda	= 10 cans of soda

• Debtor pays back $10 1 year later

Π = 0% real value of debt = 10 cans of soda
Π = 100% real value of debt = 5 cans of soda

• Governments have an additional money they want banks to issue more money and create inflation because it redistributes wealth

• If the government is a debtor, unexpected inflation benefits the government and makes creditors worse off

• That’s why governments with a lot of debt are tempted to increase inflation

• If inflation is expected, instead of expressing the contract in nominal terms, you express it in real terms

Chapter 29: Open-economy: Basic concepts

1. Learning objectives

• Recognize the key macroeconomics variables that describe an open economy and why

• Exports, imports, trade balance, net exports, exchange rates

• Describe the two ways open economies interact

• Buying and selling goods and services

• Buying and selling capital assets

• Understand the flow of goods and capital and how their two flows are related

• Synthesize the possible scenarios, in terms of trade, that an open economy can face

• Trade deficit

• Balance trade

• Trade surplus

• Understand the relationship between saving, investment and international flows

• Asses the impact of different currencies in trade

• Understand the difference between nominal and real exchange rates and how both evolve over time

• Understand the PPP theory of exchange rates

1. The international flows of goods and services

• Open Economy: flow of goods across borders

• Cross border flows of:

• Goods and services (imports and exports)

• Savings

• People (migration)

• An open economy interacts with other economies in two ways: it buys and sells goods and services in world product markets, and it buys and sells capital assets in world financial markets

Close economy model	Open economy model
Advantages: - Makes easier the study of unemployment, interest rate and inflation Disadvantages: -Very limited model for our economics nowadays	Advantages: -Better model to understand advanced economies Disadvantages: -the study of unemployment, interest rates and inflation become complicated
International trade and International markets

1. The flow of goods and services: Exports, Imports and Net Exports

• Exports: domestically produced goods and services that are sold abroad

• Imports: foreign produced goods and services that are purchased by the domestic economy

• Net exports(NX): the value of its exports (X) minus the value of its imports (M)

• Trade balance:the value of a nation’s exports minus the value of its income; also called net exports

• Trade surplus:an excess of exports over imports

• Net exports are positive; the country sells more goods and services abroad than it buys from other countries

• Trade deficit:an excess of imports over exports

• Net exports are negative; the country sells fewer goods and services abroad than it buys from other countries

• Balanced trade:a situation in which exports equal imports; net exports equal zero

• Factors that influence a countries exports, imports and net exports:

• The tastes of consumers for domestic and foreign goods

• The prices of goods at home and abroad

• Exchange rates at which people can use home currency to buy foreign currencies

• The income of consumers abroad and at home

• The costs of transporting goods from country to country

• The policies of the government towards international trade

1. The flow of financial resources: Net capital outflow

• Savers residing in Belgium buys a new American government bond

• Domestic resident buys foreign asset

• Outflow of savings from Belgium

• Savers residing in US buys a Belgian government bond

• Inflow of savings into Belgium

• Net Outflow of Savings

• (Outflow of savings) – (Inflow of savings)

• = Net Capital Outflow or Net Foreign Investment

• Net capital outflow (NCO):the purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners

NCO =	Purchase of foreign assets by domestic residents – purchase of domestic assets by foreigners

• Savers compare domestic and foreign assets (NCO increases) if:

• If foreign interests go down, people buy domestic bonds

• If domestic interests go down, people buy foreign bonds

• If domestic risk goes up, people buy foreign bonds

• If foreign risk goes up, people buy domestic bonds

(Foreign) Direct Investment (FDI)	(Foreign) Portfolio Investment	Other investments

• Factors affecting net capital outflow:

• Real interest paid (both on domestic and foreign assets)

• Risk perception (economic and political) for holding assets abroad

• Government policies that affect foreign ownerships of foreign assets

1. The equality of net exports and net capital outflow

• Both net exports and net capital outflow measure a type of imbalance in the goods and financial markets

• NX measure an imbalance in between a country’s exports and imports in the goods market

• NCO measures an imbalance between the amount of foreign assets bought by domestic residents and the amount of domestic assets bought by foreigners

• Every transaction affecting one side of equilibrium must affect (exactly in the same amount) the other side of the equation

1. Saving and Investment, and their relationship to the international flows

S ≡ ( Y – T – C ) + ( T – G )
S ≡ ( Y – C – G )
Y ≡ ( C + I + G + NX )
Y – C – G = I + NX
S ≡ I + NCO
Savings = domestic investment + Net capital outflow

1. Internal flows of goods and capital

• Trade Surplus- value of exports exceed values of imports (NX > 0)

• Income must be greater than domestic spending, but if income is more than spending, then savings must investment

• Because the country is saving more than its investing, it most be spending some of its savings abroad NCO > 0

• Trade Deficit- value of exports is less than value of imports (NX < 0)

• Income must be less than domestic spending , if income is less than spending, then saving must be less than investment

• NCO < 0 negative

• Trade Balance

• Exports equal imports NX = 0

• Income equals domestic spending and saving equals investment NCO = 0

1. The prices for international transactions: Real and Nominal exchange rates

2. Nominal exchange rates

• Nominal exchange rate:the rate at which a person can trade the currency of one country for the currency of another

• Determined by interaction of demand and supply of the exchange on foreign exchange markets

Real exchange rate = e =	Unit of foreign currency Unit of domestic currency

• To convert foreign into home currency = foreign currency x home currency rate

• To convert home into foreign currency = home currency / foreign currency rate

• Appreciation and Depreciation of Currencies

• Appreciation: an increase in the value of a currency as measured by the amount of foreign currency it can buy

• Currency strengthens

• Depreciation: a decrease in the value of currency as measure by the amount of foreign currency it can buy

• Currency weakens

• A depreciation in a currency = import prices expensive, export prices cheaper

• An appreciation in a currency = import prices cheaper, exports expensive

• Exchange rate Indexes

• To study changes in exchange rates, people use indices that measure the average change in many exchange rates

• Exchange rate index: turns many exchange rates into a single measure of the international value of the currency

1. Real exchange rates

• Real exchanges rate:the rate at which the goods and services of one country trade for the goods and services of another

Real exchange rates = E =	(Nominal exchange rate x Domestic price) Foreign price
Real exchange rates = E =	Number of foreign baskets Domestic basket
P = domestic price P* = foreign price e = nominal exchange rate	e x P P*

• Real exchange rate depends on the nominal exchange rate and on the prices of goods in the two countries measured in local currency

• Key in determining how much a country imports and exports

• Real exchange rate measures the prices of the basket of goods and services available domestically relative to a basket of goods and services available abroad

1. Real vs Nominal exchange rates & Appreciation vs Depreciation

Nominal Exchange Rate (e) (NER)	Real Exchange Rate (E) (RER)
Number of units of domestic currency that are needed to purchase a unit of a given foreign currency	Rate at which domestic goods and services can be traded for foreign goods and services in the exchange market

Appreciation of Euro relative to dollar	Depreciation of euro relative to dollar
- Before appreciation: 1 euro = $0.80 and $1 = 1.25 euros -After depreciation 1 euro = $0.90 and $1 = 1.11 euros Value of euro increases, and value of dollar decreases -Depreciation of dollar relative to euro	- Before appreciation: 1 euro = $0.80 and $1 = 1.25 euros -After depreciation 1 euro = $0.70 and $1 = 1.42 euros Value of euro decreases, and value of dollar increases -Appreciation of dollar relative to euro

1. A first theory of exchange rate determination: Purchasing power parity (PPP)

• Purchasing power parity (PPP): a theory of exchange rates whereby a unit of any given currency should be able to buy the same quantity of goods in all countries

• Simplest theory of exchange rates

• Describes the forces that determine the exchange rates in the long-run

1. The basic logic of Purchasing Power Parity (PPP)

• Arbitrage: process of taking advantage of differences in prices in different markets

• Buying where is cheap and selling where the prices are higher (expensive)

• Law of one price: law that asserts that all goods must sell for the same price in all locations, otherwise there would be opportunities for profit left unexploited

Law of one price = e x P = P*

• Currency must have the same purchasing power in all countries

• Parity means equality, and purchasing power refers to the value of money

• PPP states that a unit of all currencies must have the same real value in every country

1. Implications of Purchasing Power Parity (PPP)

• PPP theory tells us that the nominal exchange rate between the currencies of tow countries depends on the price levels in those countries

1 P	=	1 x e P*
Purchasing power of 1 euro		Purchasing power of 1 euro converted into foreign currency
We rearrange the equation
1 = e x P . P*
To see the implications of the nominal exchange rate, solve for e
e = P* . P

• Nominal exchange rate equals the ratio of the foreign price level to the domestic price level

• According to the PPP theory, the nominal exchange rate between the currencies of two countries must reflect the different price levels in those countries

• Nominal exchange rates change when price levels change

1. Limitations of Purchasing Power Parity (PPP)

• Limitations:

• The basket will contain no tradable goods and services (mostly services), hence the law of one price won’t apply to those baskets

• Its best to use baskets without non-tradeable goods

• Trade barriers such (such as tariffs)

• Goods in the basket may be imperfect substitutes

• Only works when studying long-term trends

• Consumers are not identical

• As real exchange rates drifts from the level predicted by PPP, people have greater incentive to move goods across national borders

Chapter 30: The open economy: a macro-economic model

1. Learning objectives

• Build a model to explain an open economy’s trade balance and exchange rate

• Use the model to analyze the effects of government budget deficits

• Use the model to analyze the macroeconomics effects of trade policies

• Use the model to analyze political instability and capital flight

1. Supply and Demand for loanable funds and for foreign currency exchange

• The market of loanable funds coordinates the economy’s savings, investment and flow of loanable funds abroad (NCO)

• The market of foreign currency exchange coordinate people who want to exchange a domestic currency for the currency of other countries

1. Market demand review

1. The market for loanable funds

• Market for loanable funds: market where all savers go to deposit their savings and all borrowers go to get their loans

• Only one interest rate which is both the return to saving and the cost to borrowing

• Loanable fund: money that households decide to save

S =	I	+	NCO
Saving =	Domestic Investment	+	Net Capital Outflow

• The two sides of this identity represent the two sides of the market of loanable funds

• The supply of loanable funds comes from national savings (S)

• The demand for loanable funds comes from domestic investment (I) and net capital outflow (NCO)

• Since NCO can be either positive or negative it can add or subtract to the demand

• The quantity of loanable funds supplied, and the quantity of loanable funds demanded depend on the real interest rate

• A higher real interest rate encourages people to save and therefore raises the quantity of loanable funds supplied

• A higher interest rate also makes borrowing to finance capital projects costlier therefore it discourages investment and reduces the quantity of loanable funds demanded

• The demand for loanable funds comes from those who want loanable funds to buy domestic capital goods but also from those who want loanable funds to buy foreign assets

• At the equilibrium interest rate, the amount that people want to save exactly balances the amount that people want to borrow for the purpose of buying domestic capital and foreign assets

• The interest rate adjusts to bring the supply and demand for loanable funds into balance

• If interest rate is below equilibrium shortage of loanable funds push interest rate upward

• If interest rate is above equilibrium surplus of loanable funds drive interest rate downward

1. The market for foreign currency exchange

• Foreign exchange market: market where one currency is traded for another

• Foreign currency: the assets circulating in the financial flows

NCO	=	NX
Net Capital Outflow	=	Net exports

• This identity states that the imbalance between the purchases and the sales of capital assets abroad (NCO) equals the imbalance between imports and exports of goods and services

• Open economy treats the two sides of this identity as representing the two sides of the market for foreign currency exchange

• Net capital outflow represents the quantity of domestic currency supplied for the purpose of buying foreign assets

• Net exports represent the quantity of domestic currency demanded for the purpose of buying net exports of goods and services

• The real exchange rate is the relative price of domestic and foreign goods and, therefore it’s a key determinant for net exports

• A higher real exchange rate makes domestic goods more expensive and reduces the quantity of domestic currency demanded to buy those goods

• The real exchange rate is determined by the supply and demand for foreign currency exchange

• The supply of domestic currency to be exchanged into foreign currency comes from (NCO)

• Because NCO does not depend on the real exchange rate, the supply is vertical

• The demand of domestic currency comes from (NX)

• Because a lower exchange rate stimulate NX the demand curve is downward sloping

• At equilibrium real exchange rate , the number of domestic currency people supply to buy foreign assets exactly balances the number of domestic currency people demand to buy net exports

• The real exchange rate adjusts to balance the supply and demand for domestic currency just as the price of any good adjusts to balance the demand sand supply for that good

• If the real exchange rate were below equilibrium quantity supplied of domestic currency s would be less than the quantity demanded the shortage of domestic currency would push the value of home currency upwards

• If the real exchange rate were above equilibrium quantity supplied of domestic currency would exceed the quantity demanded the surplus of domestic currency would drive the value of home currency downward

1. Equilibrium in the open economy

2. Net capital outflow: The link between the two markets

• In the market of loanable funds, supply comes from national savings, demand comes from domestic investment and net capital outflow , and the real interest rate balances supply and demand

• In the market for foreign currency exchange, supply comes from net capital outflow, demand comes from net exports and the real exchange rate balances supply and demand

• NCO is the variable that links this two markets

• In the market of loanable funds NCO is part of demand

• In the market for foreign currency exchange NCO is the source of supply

• The key determinant for NCO is the real interest rate

• There is a negative relationship between the interest rate and NCO

• Because a higher domestic real interest makes domestic assets more attractive, it reduces net capital outflow

• NCO can be negative, if it is, the economy is experiencing a net capital inflow

1. Simultaneous equilibrium in two markets

• Market for loanable funds

• National savings is the source of supply of loanable funds

• Domestic investment and NCO are the source of demand for loanable funds

• The equilibrium real interest rate brings the quantity of loanable funds supplied and demanded into balance

• Net capital outflow

• Shows how interest rate from the market for loanable funds determined NCO

• A higher interest rate at home makes domestic assets more attractive which reduces NCO (slopes downward)

• Market for foreign currency exchange

• Because foreign assets must be purchased with foreign currency, the quantity of NCO (from the NCO graph curve) determines the supply of domestic currency to be exchanged into foreign currencies

• Since the real exchange rate doesn’t affect NCO, supply is vertical

• The demand for domestic currency comes from net exports, since a depreciation of the real exchange rate increases net exports, the demand curve for foreign currency slopes downwards

• The equilibrium real exchange rate brings into balance the quantity of home currency supplied and the quantity demanded in the market of foreign currency exchange

• The two markets determine two relative prices:

• The real interest rate (determined in NCO graph) is the price of goods and services in the present relative to goods and services in the future

• The real exchange rate (determined by foreign currency market) is the price of domestic goods and services relative to foreign goods and services

• These two prices adjust the balance supply and demand in both markets determine (S), (I), (NCO) and (NX)

1. How policies and events affect an open economy

2. Government budget deficits

• A budget deficit represents negative public savings it reduces national savings

• A government budget deficit therefore reduces the supply of loanable funds, drives up the interest rate and crowds out investment

• Because savings are reduced, the supply curve for loanable funds shifts to the left

• The shift in in the supply curve for loanable funds leads to a rise in interest rate to balance the demand

• Faced with a higher interest rate, borrowers in the market for loanable funds choose to borrow less (investment goes down)

• Movement from point A to point B along the demand curve for loanable funds

• The reduced supply of loanable funds has an effect on the NCO graph curve

• The increase in the interest rate reduces NCO

• Because savings kept at home now earn a higher interest of return, investing abroad is less attractive, and domestic residents buy less foreign assets

• Higher interest rates also attract foreign investors who want to earn the higher return on the domestic (foreign to them) assets

• When budget deficit increase interest rates, both domestic and foreign behavior cause domestic NCO to fall

• The market for foreign currency exchange shows how budget deficits have an effect

• Because NCO is reduced, people need less foreign currency to buy foreign assets, this leads to a left shift in the supply curve of domestic currency

• The reduced supply of domestic currency causes the real exchange rate to appreciate

• The domestic currency becomes more valuable compared to foreign currencies

• This makes domestic goods more expensive compared to foreign goods

• Since people both at home and abroad switch their purchases away from the more expensive domestic goods, exports from home country fall and imports increase

• Home country NX fall

• In an open economy, government budget deficits rise real interest rate, crowd out domestic investment, cause the currency to appreciate and push the trade balance towards deficit

• Budget deficit and trade deficit are so closely related in both theory and practice, that when they are large, they are often referred to as “twin deficits”

1. Trade policy

• Policy: a government policy that directly influences the quantity of goods and services that a country imports and exports

• Suppose: An EU car industry, concerned about completion from Japanese car makers, convinces the EU to impose a quota on the number of cars that can be imported from Japan into the EU

• The initial impact of the import the import restriction is on imports

• Since NX = Exports – Imports the policy also affects net exports

• Because NX are the source of demand for

• As the quota restricts the number of Japanese cars sold in the EU, it reduces imports at a given real exchange rate

• Net exports ( X – M ) will rise for any real exchange rate

• Because foreigners need euros to buy EU net exports, there is an increase demand for euros in the market for foreign currency exchange

• This increase in the demand for euros shifts the demand in the market for foreign currency exchange to the right

• The market for foreign currency exchange shows that the increase in the demand for euros causes the real exchange rate to appreciate (increase)

• Since nothing has happened in the market for loanable funds, there is no change in the real interest rate

• Since there is no change in the real interest rate, there is no change in net capital outflow (NCO graph)

• Since there is no change in NCO, there can be no change in net exports, even though the import quota has reduced import

• The reason why NX can stay the same even if imports fall is explained by the change in the real exchange rate

• When the euro appreciates in the market for foreign currency exchange, EU goods become more expensive relative to foreign goods

• The appreciation encourages imports and discourages exports, both changes offset the direct increase in NX due to the import quota

• Import quota reduces both imports and exports but NX remains unchanged

• Trade policies do not affect trade balance, policies that directly influence exports or imports do not alter NX

• Net exports = Net capital outflow = national savings – domestic investment

• Trade policies do not affect trade balance because they have no effect on (S) or (I)

• Real exchange rate adjusts to keep trade balance the same

• Even if trade policies don’t affect trade balance, they affect some firms

1. Capital flight

• Capital fight: a large and sudden reduction in the demand for assets located in a county

• Suppose: a country experiences a considerable outflow of funds (ex. Nigeria)

• If investors around the world decide they want to sell their assets in Nigeria and use the proceeds to buy assets in other countries, this increases Nigerian NCO which affects both markets in the model (loanable funds & foreign currency exchange)

• It affects the NCO curve and this in turn affects influences the supply of the Nigerian currency in the markets for foreign currency exchange

• Since the demand for loanable funds comes from both domestic investment (I) and NCO, capital flight affects the demand curve in the market for loanable funds

• When NCO increases , there is a greater demand for loanable funds to finance these purchases of capital assets abroad

• The market for loanable funds shows the demand curve for loanable funds shifts to the right

• Since NCO is higher for any interest rate, the NCO curve shifts to the right (in the NCO graph)

• To see the effects of capital flight we compare the old and new equilibrium

• The market for loanable funds shows that the increased demand for loanable funds causes the interest rate in Nigeria to increase

• The NCO curve (graph) shows the Nigerian NCO increases

• The market for foreign currency exchange shows that the increase in NCO increases the supply of Nigerian currency in this market

• This increase in supply causes Nigerian currency to depreciate (value decrease)

• Capital flight from Nigeria increases Nigerian interest rates and decreases the value of Nigerian currency in the market for foreign currency exchange

• This price changes that result from capital flight influence some key macroeconomics quantities

• The depreciation of the currency makes exports cheaper and imports expensive which pushes trade balance towards surplus

• The increase in the interest rate reduces domestic investment which slows economic growth

• Although capital flight has the largest impact in the country from which capital is fleeing, it also affects other countries

• Capital flight can be caused by a lack of confidence in an economy or by political instability, but it can also manifest itself in funds leaving a country illegally

1. Policies affecting open market equilibrium

Policies affecting open market equilibrium	Events
Government deficits (fiscal policy)	Import quota (trade policy)	Capital flight
Affects negatively the supply curve of market of loanable funds (national savings)	Affects negatively the demand curve of the market for foreign currency exchange (net exports)	Simultaneously: [a] Affects positively the demand curve of market for loanable funds (NCO component); [b] affects positively the NCO; [c] Affects positively the supply curve of domestic currency
Transmission: negative movement along NCO curve	Transmission: no change NCO curve
Result: Twin deficits Budget deficit Decrease in (S) increase in (real interest rate) decrease in NCO currency appreciation trade deficit	Result: No net effect NX Import quota Decrease in imports (M) increase in NX increase in demand for EUR currency appreciation decrease in exports (X)	Result: balance surplus (NX) capital flight increase NCO Increase in demand foreign funds increase in real interest rate (RIR) Increase in supply of domestic currency decrease in real exchange rate (RER) increase in exports balance surplus (NX)

Chapter 31: Short-run economic fluctuations (Business Cycles)

1. Fluctuations in the short run

• Business cycle:periods of expansion and slowdown (fluctuation) in the economic growth

• Looks at how different economic variables change as economic growth changed

• Recessions: a period of declining real incomes and rising unemployment, it occurs after two successive quarters of negative economic growth

• Periods when GDP drops

• Depression:a severe recession

• Business cycles can be analyzed through looking at periods of economic growth and identifying peaks and troughs in activity where each represents a turning point

• Peak: a point where related economic variables begin to decline together

• Trough: the point where related economic variables begin to rise

• Lagged indicators: variables that may not change at the same time as other variables

• The term “cycle” is misleading as it implies that expansions and contractions are part of a regular pattern but that’s not true

• There is no specific pattern to the periods between peaks and troughs nor to the length of the upswing and downturn in economies

• In theory, there is no reason why business cycles occur at all

• If factor resources are being employed fully, investment is sufficient to cover depreciation and labor productivity is stable then the economy could continue to grow

• Shocks to the economy through changes in consumption and government spending can cause full employment output to be disrupted (demand side explanation to short-run fluctuations)

• Other explanations include changes to productivity levels through changes in technology or the ability of workers to seek increases in real wages

• Monetary policy has a central role in short-run fluctuations

• Does money affect real GDP? Does it affect unemployment? Is it neutral?

	Short-run	Long run
M GDP, unemployment Expected prices / price level	Yes No	No Yes

• Key facts about economic fluctuations:

• Economic fluctuations = business cycles

• 1. Economic fluctuations are irregular and unpredictable

• 2. Most macroeconomic variables fluctuate together

• Typically, during recessions investment spending goes down

• 3. As output falls, unemployment rises

1. Trend Growth rates

• Time-series data: observations on a variable over a period and which are ordered over time

• Central to the analysis of business cycles is GDP over time

• The trend line shows how over time, the GDP has risen; it also shows how actual GDP fluctuates around the trend

• The debate of what causes short-term fluctuations also focuses attention on policy response and welfare needs

• Assumes that economy is deviating from its equilibrium

• Some economists believe that the economy may not be deviating from its equilibrium but instead moves form one equilibrium point to another

1. Data concepts

• When economic activity is accelerating, and the rate of growth is rising each year this represents a period of expansion

• Depending on the rate real output is accelerating, it may be referred to as boom

• When GDP growth is positive, the economy is growing (accelerating); if its negative, the economy is shrinking (decelerating)

• Contraction: when real output is lower than the previous time period

• Amplitude: the difference between peak and trough and trend of output

1. Trends

• Trend: the underlying long-term movement in a data series

• Trends can be upwards over time, downwards or constant

• Trends can demonstrate patterns over a period which be described as:

• Stationary data: time-series data that has a constant mean value over time

• Nonstationary data: time-series data where the mean value can either rise or fall over time

• Disagreements between economist such as the paths of business cycles and the policy options that might be applied is derived in large part from different interpretations of the reliability and validity of different statistical methods

• Deterministic trends: trends that are constant, positive or negative, independent of time for the series being analyzed

• Stochastic trends: where trend variables change by some random amount in each time period

• What causes GDP to deviate must be a transitory phenomenon deviation is temporary and can be influenced

1. Procyclical and Countercyclical movements in Macroeconomic data

• When economic activity slows, unemployment rises, and inflation decelerates

• Comovements: the movement of pairs of variables

• Typically, GDP is a variable and will be compared against another economic variable like inflation

• Procyclical: a variable that is above trend when GDP is above trend

• Countercyclical: a variable that is below trend when GDP is above trend

1. Variables as indicators

• Cyclical indicators (CLI): variables to try to identify potential turning points in economic activity

• Characteristics of cyclical indicators (they can be):

• Leading indicator: an indicator that can be used to foretell future changes in economic activity

• Lagging indicator: an indicator whose changes occur after changes in economic activity have occurred

• Coincident indicator: an indicator whose changes occur at the same time as changes in economic activity

1. Cause of Changes in the Business cycle

• We know that economy is made up of households and firms, so we can expect that their behavior has a role to play in how economic activity changes

1. Household spending decisions

• Households make decisions about how much labor to supply based on changes in real wages

• Labor supplied depends on the real wage rate the rate of growth of wages in relation to prices affects consumers purchasing power

• Households make consumption decisions on everyday goods and services also on “big-ticket” items

• Purchasing of this items may be cyclical

• Households will make decisions based on changes in interest rates, house prices and taxation

• Increase in interest rates may encourage savings and reduce consumption

• Changes in house prices affect people’s wealth which leads to changes in spending

• Changes in tax rates affect people in different ways but have a considerable effect

1. Firms’ decision-making

• Firms make decisions about production levels based on what they think they can sell

• If demand is strong they increase output, may take more workers and buy more raw materials to satisfy demand

• Firms also make decisions about how many workers to hire based on real wage rate and productivity levels

• If real wage rate falls then firms can afford to hire more workers

• If productivity levels rise, then cost can be lowers and firms can be more competitive

• Firms will also monitor stock levels

• If stocks build up, then maybe sales are slowing down (vice versa)

1. External forces

• Movements in exchange rates affect the competitiveness of domestic and foreign firms through changes in imports and export prices

• Must also take into account unexpected events like war and terrorism

1. Government policy

• Since governments have control over considerable amount of economic activity, they make decisions about tax rates, and have to try to consider the incentive effects of such changes

• Decisions about major infrastructure investments

• Changes in interest rates will affect both households and firms

1. Confidence and expectations

• Household and firms make decisions not only based on current needs, but also future ones

• Our expectations of the future shape our decisions, and confidence of firms and households to make decisions

Chapter 33: Aggregate demand and aggregate supply

1. Learning objectives

• Understand three key facts about short-run fluctuations

• Irregular and unpredictable, Macro variables fluctuate together and Okun’s Law

• Clarify the difference between the model of market demand and supply and the market model of aggregate demand and aggregate supply

• Realize how the economy differs between the short-run and the long-run

• In the short-term, no monetary neutrality

• Explain the difference between the slopes of AD, SRAS and LRAS

• Realize what changes induce shifts in AD, SRAS and LRAS

• Use the model of AD and AS to explain economic fluctuations

1. Three key facts about economic fluctuations

2. Fact 1: Economic fluctuations are irregular and unpredictable

• When real GDP grows rapidly:

• During these periods of economic expansion, profits and customers grow

• When real GDP falls:

• Firms experience declining sales and decreasing profits

• Fluctuations are irregular and hard to predict

1. Fact 2: Most macroeconomic quantities fluctuate together

• Most macroeconomic variables that measure some type of income, spending or production, fluctuate closely together

• When real GDP falls in a recession, so do personal income, consumer spending, investment spending, etc.

• Although many macroeconomic variables fluctuate together, they fluctuate by different amounts

• In particular, investment spending varies greatly over the business cycle

1. Fact 3: As output falls, unemployment rises

• When real GDP declines, the rate of unemployment rises

• The negative relationship between unemployment and real GDP is Okun´s law

• Okun´s law: a “law” which is based on observations that in order to keep the unemployment rate steady, real GDP needs to grow at or close to its potential

• If unemployment rate is to be reduced, real GDP must grow above its potential

• To reduce unemployment rate by 1% in a year, real GDP must rise by around 2% more than potential GDP over the year

• Unemployment is referred to as a “laggard indicator” there is a time-lag between any downturn in economic activity and a rise in unemployment (vice versa)

1. Economic fluctuations

Irregular and unpredictable	Macro variables fluctuate together	Okun’s Law
-changes in business conditions	-GDP, personal income, profits, consumer spending, investment spending -Fluctuate together but not by the same amount	-Changes in output are negatively strongly correlated with changes in the use of labor force Decrease in GDP increase in unemployment -When GDP recovers, unemployment does not recover immediately

1. Explaining short-run economic fluctuations

2. How the short-run differs from the long-run

• Long run: theories to explain what determines most important macroeconomic variables in the long-run

• Two main ideas: classical dichotomy and monetary neutrality

• Classical dichotomy: the separation of variables into real variables and nominal variables

• According to the classical macroeconomic theory, changes in monetary supply affect nominal variables but not real variables

• As a result of this monetary neutrality, we can examine the determinants of real variables

• Do this assumptions of classical macroeconomic theory apply to the world we live in?

• The classical theory describes the world in the long-run but not in the short-run

• When studying year-to-tear (short-run) changes in the economy, the assumptions of monetary neutrality are no longer appropriate

• In the short-run, real and nominal variables are highly intertwined

• Changes in the money supply can temporarily push output away from its long-run trend

• To understand the economy in the short-run, we must abandon classical dichotomy and the neutrality of money

1. Short vs. Long run

Neutrality of money no longer an assumption	Prices are no longer at equilibrium level
-Real and nominal variables are very intertwined -Changes in the money supply (M) affect real GDP	-Price level is different than the prices expected

1. The basic model of economic fluctuations

• Focuses on two variables:

• The first variable is the economy’s output of goods and services, as measured by real GDP

• Real variable, horizontal axis

• The second variable is the overall price level, an average of prices of all goods and services in an economy measured by the CPI or GDP deflator

• Nominal variable, vertical axis

• By focusing in these two variables we highlight the breakdown of the classical dichotomy

• Model of aggregate demand and aggregate supply:the model that many economists use to explain short-run fluctuations in economic activity around its long-run trend

• Aggregate demand curve: a curve that shows the quantity of goods and services that household, firms and the government want to buy at each price level

• Aggregate supply curve:a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

• Microeconomic substitution effect from one market to another is not possible when analyzing the economy as a whole

• The quantity in our model measures the total quantity produced in all of the economy’s markets

1. The Aggregate demand curve

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

• AD curve is downwards sloping due to the inverse relationship between price level and national income

• A fall in the economy’s overall level of prices, tends to rise the quantity of goods and services demanded

• If price of goods and services goes down AD goes up

• Negative slope: decrease in price level increase in output

• Aggregate demand for domestic goods and services

Y =	C + 60%	I + 20%	G + 20%	NX

1. Why the AD slopes downwards

• A fall in the price level increases the quantity of goods and services demanded, there are 3 reasons for this negative relationship

• As price levels fall, real wealth rises, interest rates fall, and the exchange rate depreciates

• These effects stimulate spending on consumption, investment and net exports

• Increased spending on these components of output means larger quantity of goods and services demanded

1. The price level and consumption: The wealth effect

• The nominal value of money (but as cash and in bank account) is fixed but its real value isn’t

• When prices fall, money becomes more valuable because it can be used to buy more goods and services

• A decrease in price level makes consumers wealthier which encourages them to spend more

• The increase in consumer spending means a larger quantity of G&S demanded

Real value Of Money	M = $1000 P1 = $25 / basket P2 = $10 / basket
M P	=	$1000 $25 / basket	= 40 baskets
M P	=	$1000 $10 / basket	= 100 baskets

1. The price level and investment: The interest rate effect

• When price level falls households try to reduce their holdings of money by lending some of it out this increases the supply of real money balances

• As households try to convert some of their money into interest-bearing assets, they drive down interest rates

• Lower interest rates encourage borrowing by firms that want to invest in new factories and equipment and households who want to invest in new housing

• A lower price level reduces the interest rate which encourages greater spending on investment goods which increases the quantity of goods and services demanded

• Price level decreases demand for cash demand of bonds increases interest rates decrease investment increases

• Less cash needed, people buy bonds which drives down interest rate which then encourages investment

1. The price level and Net exports: The exchange rate effect

• Since lower price levels decrease the interest rate, investors will seek higher return by investing abroad

• Suppose: interest rate on EU bonds falls, and investment fund might sell EU government bods to buy US bonds

• As the investment fund tries to convert its euros to dollars, it increases the supply of EUR in the market for foreign currency exchange

• The increase supply of EUR causes it to depreciate relative to other currencies

• Since EUR buy less units of foreign currencies, foreign goods become more expensive but domestic goods become cheaper to foreigners

• This change in the real exchange rate increases EU net exports (more exports than imports)

• The fall in the EU price level interest rates fall real value of EUR falls depreciation of EUR increases NX increases the quantity of goods and services demanded in EU economy

• Price level decreases interest rates decrease NCO increase exchange rate decreases NX increases

• Investors look for better interest rate abroad, which causes an excess of EUR in the international market which causes the EUR to depreciate, which increases NX

1. Overview on the reasons:

• Consumers are wealthier, which stimulates demand for consumption of goods

• Interest rates fall, which stimulates the demand for investment goods

• Exchange rate depreciates, which stimulates demand for net exports

AD: P decreases aggregate demand for domestic output increases

1. Why the AD curve might shift

• The downwards slope of AD, curve shows that a fall in the price level¸ increases the quantity of goods and services demanded

• Many other factors can affect the quantity of goods and services demanded at a given price level and when one of this factors changes, the AD curve shifts

• C + G + I + NX (any increases) shift right

• C + G + I + NX (any decreases) shift

1. Shifts arising from Consumption

• Suppose people become concerned about saving, hence they save more which will result in a decrease in consumption

• Since the quantity of goods demanded at any price level is lower, the AD shifts left (vice versa)

• Any event that changes how much people want to consume, at a given price level will shift the AD curve (ex. Taxation, economy boom)

1. Shifts arising from Investment

• Any event that changes how much firms want to invest at a given price level sifts the AD curve

• Tax policy can influence AD thorough investment:

• Investment tax credit increases the quantity of investment goods that a firm demands shifts AD right

• Money supply can influence investment and AD:

• An increases in money supply lowers the interest rate which makes borrowing less costly which stimulates investment spending AD curve shift right

1. Shifts arising from Government purchases

• Most direct way through which policy makers shift AD

• Decrease in G spending means a shift of Ad to the left (vice versa)

1. Shifts arising from Net exports

• An event that changes net exports for a given price level shifts the AD curve

• NX sometimes changes because of movements in the exchange rate

• Appreciation decreases NX shift left

• Depreciation increase NX shift right

1. Expansionary fiscal policy and loose monetary policy:

• Expansionary fiscal policy:

• Government spending increases, or Taxes decrease increase in consumption and investment

• Loose monetary policy:

• Money supply increases decrease real interest rate increase investment

1. The Aggregate supply curve

• The AS curve tells us the total quantity of goods and services that firms produce and sell at any given price level

• The AS curve shows a relationship that depends on the time horizon being examined

• In the long-run: the AS curve is vertical

• In the shirt-run: the AS curve is upwards sloping

1. Why the AS is vertical in the long-run

• In the long-run, the production of goods and services depends on its supplies of labor, capital and natural resources, and on the available technology used to turn this factors of production into goods and services

• Since the price level doesn’t affect these long-run determinants of real GDP, the long-run AS curve is vertical

• In the long-run the economy’s L, K, N, and A determine the total quantity of goods and services supplied, this quantity is the same regardless of what the price level is

• The LRAS is consistent with the idea that real variables do not depend on nominal variables because it implies that the quantity of output (real) does not depend on the price level (nominal)

• The reason why the supply curve of specific goods and services can be upward sloping is because their supply depends on relative prices- the prices of those goods and services compared to other prices in the economy

1. Why the LRAS curve might shift

• The LRAS shows the quantity of goods and services predicted by the classical macroeconomic theory

• Natural rate of output (Y^N):the output level in an economy when all existing factors of production (land, labor, capital and technology resources) are fully utilized and where unemployment is at its natural rate

• Any change in the economy that alters the natural rate of output shifts the LRAS

1. Shifts arising from Labor

• If there is a greater number of workers quantity of goods and services supplied increase LRAS curve shifts right (vice versa)

• LRAS also depends on natural rate of unemployment, any change in the natural rate of unemployment shifts the LRAS curve

• Natural rate of unemployment increases smaller quantity produced LRAS shifts left (vice versa)

1. Shifts arising from Capital

• An increase in the economy’s capital stock increases productivity increases the quantity of goods and services supplied LRAS curve shifts right (vice versa)

• Regardless if we refer to physical capital or human capital

1. Shifts arising from Natural resources

• An economy’s production depend on its natural resources, an increase or new discovery of one of the natural resources shifts LRAS right and a change that reduces a natural resource LRAS shift left

• A change in the availability of the resources can also shift the AS curve

1. Shifts arising from Technological knowledge

• The most important reason why the economy produces more than in previous generations is technological knowledge

1. Overview in the shifts of LRAS

• Any policy or event that raised real GDP increases G&S supplied LRAS shift right

• Any policy or event that lowered real GDP lowers G&S supplied LRAS shift left

1. A new way to depict long-run growth and Inflation

• Using AD and LRAS we can now describe the economy’s long-run trend

• The two most important forces that govern in the long-run and cause the curves to shift are:

• Technology: technological progress enhances the economy’s ability to produce goods and services shifts LRAS to the right

• Money supply: an increase in the money supply over time shifts AD to the right

• The result of this is trend growth in output and continuing inflation

1. Why the AS curve slopes upward in the short-run

• In the short-run, an increase in the overall level of prices in the economy tends to rise the quantity of goods and services supplied (vice versa)

• The positive relationship between price level and the quantity of output supplied can be due to: sticky wages, sticky prices or misperceptions

• Over time wages, prices and perceptions adjust, so this positive relation is temporary

• They are similar in the theme that the quantity of output supplied, deviates from its long-run or “natural” level when the price level deviates from the price level people expected to prevail

• Price level rises above expected leveloutput rises above natural rate (vice versa)

1. The sticky wage theory

• SRAS slopes upward because nominal wages are slow to adjust (“sticky”) in the short-run

• The slow adjustment of nominal wages is due to long-term contracts between workers and firms that fix nominal wages for a period

• May also be attributed to social norms and notions of fairness that influence wage setting and change only slowly over time

• If price level (P) falls nominal wages will remain stuck at (W) real wage (W/P) rises above the level the firm planned to pay

• Since wages are a big part of production costs, a higher real wage means real costs have increased

• As a result, the firm hires less people and production of G&S decreases

• Because wages do not adjust immediately to price levels, a decrease in price level production and employment decrease decrease in quantity supplied (AS) of G&S

1. The sticky price theory

• Emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions

• The slow adjustment is in part due because of the menu cost to adjust prices

• Suppose: a frim announces its prices in advanced based on the economic conditions will prevail

• If the economy experiences a contraction in the money supply price levels decrease some firms may lag behind because they don’t want to incur additional menu costs

• Because these lagging firms have prices that are too high sales will decrease will cause the firm to cut back on production and employment

• Since all prices don’t adjust instantly, an unexpected fall in price level leaves some firms with higher-than-desired prices which depress sales and induce firms to reduce the quantity of G&S produced

1. The misperceptions theory

• Changes in overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output

• Due to these short-run misperceptions, suppliers respond to changes in price level which leads to upward sloping AS

• Price level falls below what is expected

• When suppliers see the prices of their product fall, they may mistakenly believe their relative prices have fallen

• Suppliers may think that temporarily the reward to produce the same quantity of output is low hence they reduce the quantity of output supplied

• A lower price level causes misperceptions about relative prices which induce suppliers to respond to the lower price level by decreasing the quantity of G&S supplied

1. Overview on the reasons

• Each of the three theories of SRAS talks about temporary problems, which will not persist forever since people will eventually adjust their expectations, nominal wages adjust, prices become unstuck and misperceptions are corrected

AS: Price levels (P) decrease aggregate supply decrease

1. Why the SRAS curve might shift

• The SRAS curve tells us the quantity of goods and services supplied in the short-run for any given level of prices

• SRAS similar to the LRAS but made upward sloping due to: sticky wages, sticky prices, and misperceptions

• Shifts in LRAS arise from changes in L, K, N or A

• This same variables shift the SRAS curve

• Expected price levels are a new variable that affect the position of the SRAS curve

• Wages, prices and perceptions are set on the basis of expectations of the price level, when expectations change SRAS curve shifts

• When workers and firms expect price levels to be high they are likely to negotiate nominal wages

• High wages increase a firms costs which leads to a reduction in quantity of G&S supplied

• When expected price level rises wages are higher costs increase quantity supplied of G&S decrease SRAS shift left (vice versa)

• An increase in the expected price level reduces the quantity of goods and services supplied and shifts the SRAS curve to the right

• A decrease in the expected price level rises the quantity of goods and services supplied and shifts the SRAS curve to the right

• These shifts play a key role in reconciling the economy’s behavior in the short-run with its behavior in the long-run

• In the short-run, expectations are fixed, and economy is at intersection with AD and SRAS curves

• In the long-run, expectations adjust, and SRAS curve shifts economy will eventually find itself at intersection with AD and LRAS

1. Two Causes of economic fluctuations

2. The effects of a shift in AD

• Suppose: wave of pessimism in the economy, because of this, many economic agents lose confidence in the future and alter their plans

• The long-run equilibrium of the economy is found where AD curve crosses LRAS curve (point A)

• When the economy reaches this long-run equilibrium, wages, prices and perceptions will have adjusted so that the SRAS curve crosses that point as well

• Households cut back their spending and delay mayor purchases, and firms put off buying new equipment

• This reduces AD for G&S, por any price level households and firms want to buy a smaller quantity AD shifts to the left

• In the short run, economy moves along the initial SRAS from point A to point B which causes output (Y) to fall and the price level (p) falls as well

• The falling level of output shows that the economy is in recession

• Firms then respond to lower sales and productivity by reducing employment

• Pessimism about the future leads to falling incomes and rising unemployment

• As a cause of pessimism, AD shifts left the economy moves from point A to point B output falls and price levels fall

• Over time, as wages, prices and perceptions adjust SRAS shifts right economy reaches point C where the new AD crosses the LRAS curve price level falls again (P3) and output returns to its natural rate

• The short-run problem of recession can be solved by increasing AD by either:

• Increase in government spending or an increase in money supply increase the G&S demanded at any price shift AD curve to the right

• This would offset the initial shift in AD (bring back to AD1) and return economy back to point A

• Even without this action, the recession will remedy itself over a period of time

• Expectations will adjust to new reality and price levels will fall SRAS curve will shift right (AS2) economy reaches point C where AD2 crosses LRAS output back to normal

• In the long run, the shift in AD is reflected in the price level and not level of output

• The long-run effect of a shift is a nominal change (price level) but not real change (output is the same)

• In the short run, shifts in AD cause fluctuations in the economy’s output of goods and services

• In the long-run, shifts in AD affect the overall price level but do not affect output

1. The effects of a shift in AS

• Suppose: some firms experience an increase in their costs of production

• For any given price level, firms want now to supply a smaller quantity of goods and services SRAS curve shifts to the left (SRAS2)

• When some event increases a firms’ costs SRAS curve shifts left (SRAS2) economy moves along AD from point A to point B results in stagflation (output falls and price level rises)

• Stagflation: a period of falling output and rising prices

• Stagnation (falling output) and inflation (rising prices)

• Stagflation provides no easy choices to policy makers, the only possibility is to do nothing

• Outputs of goods and services remain depressed for a while (Y2) but eventually the recession will remedy itself as expectations (prices, wages and perceptions) adjust to raise production costs

• Over time, as the SRAS shifts back (SRAS1) price level falls and quantity of output approaches its natural rate (YN) in the long run: economy returns to point A where AD crosses LRAS curve

• Policy makers might attempt to offset some of the effects of the shift in SRAS by shifting the AD curve

• AD curve shifts to the right (AD2) exactly enough to prevent the SRAS shift from affecting output economy moves directly form point A to point B output remains at natural rate and price level rises (P3)

• Policy makers “accommodate” the shift in SRAS because they allow the increase in costs to permanently affect price levels (Keynes approach)

• Faced with a shift in SRAS (SRAS2) policymakers try to shift AD to the right economy moves from point A to point B

• Prevents supply shift from reducing output in the short-run, but price level permanently rises (P3)

• Shifts in SRAS can cause stagflation- a combination of recession (falling output) and inflation (rising prices)

• Policy makers who can influence AD cannot offset both of these effects simultaneously

1. New Keynesian economics

• Keynesian economics developed in response to depression and were the main economic policy across the developed world in the post-war era

• New Keynesian economics Sought to explain how price and age stickiness had its foundations in the microeconomic analysis of labor markets and price setting by firms

• Placed an emphasis on providing sound microeconomic principles to underpin Keynesian macroeconomics

1. Features of new Keynesian economics

• Argues that short-run fluctuations in economic output violate the classical dichotomy

• Changes in nominal variables (money supply) have an influence on real variables (output and unemployment) in the short

• Argue that an understanding of the imperfections in the economy are necessary to understand the changes in economic activity

• That firms operate under imperfect competition, consumers and firms are subject to imperfect information

• New Keynesian economists remind us that the complexities of the economy deserve a better look at what economists are actually agreeing and disagreeing and why

Chapter 32: Keynesian economics and the Multiplier effect

1. Neo classical orthodoxy into Keynesian economics

• Neo-classical orthodoxy had held the market cleared without government involvement in both the short and the long-run

• The Great Depression saw millions of people lose their jobs and unemployment remaining high

• John Keynes – book: “The General theory of Unemployment and Money”

• Attempted to explain the short-run economic fluctuations in general and also the Great Depression in particular

• Macroeconomics as a separate path of economics researched the experiences of the Great Depression

• Recessions and depressions can occur because of inadequate AD for goods and services

• “The long-run is a misleading guide to current affairs”

• Aimed at policymakers and economists

• Keynes advocated policies to increase AD including government spending and public works

• Necessity of short-run interventions in the economy, the focus on monetary and supply policy as the main ways of controlling the economy in most countries

1. The multiplier effect

• Planned expenditure is dependent on the levels of C, I, G, NX

• Actual expenditure/ output will be denoted (Y) and the economy will be at equilibrium when planned expenditure is equal to actual expenditure (E = Y)

• The positive slope of the expenditure function implies that planned spending rises as income rises

• What determines the slope of the expenditure function has important policy implication as it can have repercussions

• Multiplier effect: the additional shifts in AD that result when expansionary fiscal policy increases income and thereby increases consumer spending

1. A formula for the spending multiplier

• You can derive a formula for the size of the multiplier effect that arises from consumer spending

• Marginal propensity to consume (MPC):the fraction of extra income that a household consumes rather than saves

• Marginal propensity to save (MPS): the fraction of extra income that a household saves rather than spends

• Suppose:

• MPC = 0.75

• Changes in government purchases = $10 billion

• Teachers earn $10 billion more of which they consume:

$10 billion x 0.75 = $7.5 billion = First change in consumption

• Shareholders and workers of the firms that produce these goods earn $7.5 billion more of which they consume:

$7.5billion x 0.75 = $5.6 billion = Second change in consumption

• By how much does aggregate demand increase?

	∆ G	$10 billion
+	∆ G1	$10 billion x MPC
+	∆ G2	$10 billion x MPC2
+	∆ G3	$10 billion x MPC3
+	…….	………….
	∆ Y	∆ G x ( 1 + MPC + MPC2 + MPC3 + … )

• Geometric series:

1 + x + x2 + x3 + …. =	1 1 - x

∆ Y =	∆ G x ( 1 + MPC + MPC2 + MPC3 + … )
∆ Y =	∆ G x	1 1 - MPC
∆ Y =	$10 billion x	1 1 – 0.75
∆ Y =	$10 billion x 4 .
∆ Y =	$40 billion .

• 1 – MPC = MPS

Chapter 34: The influence of monetary and fiscal policy on aggregate demand

1. How Monetary policy influences aggregate demand

• AD curve shows the total quantity of goods and services demanded in the economy for any price level and slopes down for 3 reasons:

• The wealth effect: a lower price level rises the real value of households’ money holdings, and higher real wealth stimulates consumer spending (least important)

• The interest rate effect: a lower price level lowers the interest rate as people try to lend out their excess of money holdings, and the lower interest rate stimulates investment spending (most important)

• The exchange rate effect: when a lower price level lowers the interest rate, investors move some of their funds overseas and cause the domestic currency to dereplicate relative to foreign currencies , this depreciation makes domestic goods cheaper compared to foreign goods, stimulating on NX

• Interest rate effect is the most important because it impacts immediately upon the whole economy, affecting consumers, homebuyers and firms across the board

• Theory of liquidity preference: Keynes’ theory that the interest rate adjusts to bring money supply and money demand into balance

• Theory on how interest rate is determined

1. The theory of Liquidity preference

• We try to explain both nominal and real interest rates

• When nominal interest rate rises or falls, the real interest rate that people expect to earn rises or falls as well

1. Money supply

• Money demand is controlled by the Central Bank and can alter the money supply through the purchase and sale of government bonds

• The quantity of money supplied in the economy is fixed at whatever level the bank decides hence, it does not depend on other economic variables (regardless of the interest rate)

1. Money Demand

• The liquidity of money explains demand for it: people choose to hold money instead of other assets that offer higher rates of return because money can be used to buy goods and services

Money demand (Md) = L ( i, P x Y )

Md = Liquidity preference ( nominal interest rate x nominal GDP )

• Nominal interest rate = opportunity cost of money

• If the interest rate goes up, its more expensive to hold money

• Interest rate increases money demand decreases (movement along the curve)

• If nominal GDP increases money demand increases (shift of the curve)

1. Equilibrium in the money market

• According to the theory of liquidity preference, the interest rate adjusts to bring money supply and money demand into balance

• If the interest is above equilibrium, the quantity of money people want to hold is less than what the ECB created surplus of money (vice versa)

1. The downwards slope of aggregate demand curve

• Money market and the slope of aggregate demand:

• An increase in price level shifts money demand curve right money demand increases increase in mode demand causes interest rates to increase

• Since interest rate is the cost of borrowing, the increase in the interest rate reduces the quantity of goods and services demanded

• This negative relationship between the price level and quantity demanded is represented with a downward sloping AD curve (panel b)

• This analysis of the interest rate effect can be summarized in three steps:

• A higher price level rises money demand

• Higher money demand leads to higher interest rate

• A higher interest rate reduces the quantity of goods and services demanded

• Same logic works vice versa

1. Changes in money supply

• One important factor that shifts AD curve is monetary policy

• Suppose: the central bank increases the money supply

• An increase in the money supply shift money supply to the right

• Since the money demand curve hasn’t changed interest rate falls to balance money supply and demand

• Money supply must fall to induce people to hold the additional money that the central bank has created

• The interest rate influences the quantity of goods and services demanded

• The lower interest rate reduces the costs of borrowing and the return of saving the quantity of goods and services demanded at a given price level increases

• The monetary injection rises the quantity of goods and services demanded at every price level the entire AD curve shifts right

• An increase in monetary supply shifts MS to the right reduces the equilibrium interest rate since the interest rate is the cost of borrowing, the fall in the interest rate increases the quantity of goods and services demanded at a given price level shifting AD to the right

• Vice versa

1. How Fiscal policy influences aggregate demand

• Fiscal policy refers to governments choices regarding the overall level of government purchases or taxes

1. Changes in government purchases

• The multiplier effect means that AD will shift by a larger amount than the increase in government spending

• The crowding out effect suggests that the shift in AD will be smaller than the initial injection

• Increase in government purchases stimulates the AD for goods and services, it also causes the interest rate to rise and the higher interest rate reduces investment spending and chokes off AD

• The reduction in AD results when a fiscal expansion increases the interest rate is called the crowding-out effect

• When the government increases the purchases of goods and services, the resulting increase in income increases the demand money MD shifts to the right this causes the equilibrium interest to rise

• The initial impact of the increase in government purchases shifts AD curve from AD1 to AD2 , but since the interest rate is the cost of borrowing, the increase in the interest rate tends to reduce the quantity of goods and services demanded (mainly investment goods) this crowding-out of investment partially offsets the impact of fiscal expansion on AD AD curve shifts to AD3

• For example: when the government increases its purchases by $10 billion

• The AD of goods and services could rise more or less than $10 billion depending on whether the multiplier effect or crowding-out effect is larger

1. Changes in taxes

• When the government cuts personal income taxes increases households take-home pay households will have extra income but will also spend some on consumption (multiplier effect)

• Since it increases consumer spending, the tax cut shifts AD to the right (vice versa)

• Higher income leads to money demand which increases interest rates which makes borrowing costlier reduces spending (crowding-out effect)

1. Using policy to Stabilize the economy

• Automatic stabilizers: changes in fiscal policy that stimulate AD when the economy goes into a recession, without policy makers having to take any deliberate action

• Balanced budget: where the total sum of money received by a government in tax revenue and interest is equal to the amount it spends, including on any debt interest owning