Macroeconomics Notes

Macroeconomics Chapter 2

Gross Domestic Product (GDP)

The measure of the aggregate output in the national income accounts is GDP: gross domestic product. This is defined as:

• The value of goods and services produced in an economy during a given period
• The sum of the value added of an economy during a given period
• The sum of incomes in an economy during a given period

The nominal GDP is the sum of the quantities of final goods multiplied by their current price; the real GDP is the sum of the quantities of final goods multiplied by their constant price.

Economic Growth and Employment

Periods of positive growth are called expansions, while periods of negative growth are called recessions.

The employment (N) is the number of people in working age who has a job. The unemployment (U) is the number of people in working age who's looking for a job. The labor force is the sum of both: L = N + U.

The unemployment rate is given by: u = U/L. Economists care about unemployment because:

• It directly affects the welfare of the unemployed
• It’s a signal that the economy may not be using all of its resources

A fair rate of unemployment is 4%.

Inflation

Inflation is a sustained increase in the price level, while deflation is a sustained decrease in the price level. Inflation can be computed by:

• The GDP deflator (Pt) which measures the average price of output: Pt = nominal GDP/real GDP
• The consumer price index (CPI) which measures the cost of living

Economists care about inflation because during periods of inflation, prices and wages don’t rise proportionately, leading to distortion.

Chapter 3

GDP Components

GDP = C + I + G + X – IM (open economy) or GDP = C + I + G (closed economy)

Consumption

CONSUMPTION C = C₀ + C₁ × (Y – T) is an endogenous variable and represents goods and services purchased by consumers.

C₀ = what people consume. It is the intercept of the consumption function.

C₁ = propensity to consume.

The consumption function C(Y_d) is a behavioral equation because it captures the consumers’ behavior. It could also be written as C = c₀ + c₁Y_d where Y_d is called disposable income (income that remains after paying taxes and receiving transfers from the government) and is given by: Y_d = Y - T.

Investment

INVESTMENT I = I is an exogenous variable, taken as given. It is the sum of non-residential investments and residential investments. It depends on:

• Level of sales (+) The higher the production, the higher the investment
• Interest rate (−) The higher the interest rate, the lower the investment

Government Spending

GOVERNMENT SPENDING (G) is an exogenous variable. Together with T, it describes fiscal policy.

Trade Balance

EXPORTS (X) are the purchases of foreign goods and services by consumers.

IMPORTS (IM) are the purchases of national goods by consumers.

X = IM Trade balance

X > IM Trade surplus

X < IM Trade deficit

Total Demand for Goods

The total demand for goods is written as:

• Z = C + I + G + X – IM in an OPEN ECONOMY
• Z = C + I + G in a CLOSED ECONOMY

In a closed economy, the equilibrium of the GOODS MARKET requires two equilibrium conditions:

1. First is that: Y = Z. The production Y must be equal to the demand Z. From that we get:
   [ ]1 – c₁T[c₀+I +G]
   Y = 1–c₁[ ]1 is the multiplier and is always positive because 0 < x < 1
   [ ]1–c₁[c₀ + I + G – c₁T] is that part of demand that doesn’t depend on output, so it’s called autonomous spending
2. Second is that: I = S + (T – G). This condition is called the IS relation: what firms want to invest must be equal to what people want to save. From that we get:
   [ ]1Y = [c₀ + I + G – c₁T] the same result as before 1–c₁

Saving

SAVING (S) is the sum of private and public savings:

• Private saving: S = Y – T – C
• Public saving: S = T – G

T = G Balanced budget

T > G S > 0 public saving is positive Budget surplus

T < G S < 0 public saving is negative Budget deficit

The paradox of saving is that the more people try to save, the more the output declines with unchanged saving!

Chapter 4

Types of Money and Bonds

There are two types of money:

• Currency
• Checkable deposits

Then there are the bonds that cannot be used for transactions. The proportion of money/bonds that should be held depends on:

• Your level of transaction
• The interest rate on bonds

Demand for Money

The demand for money M_d = $YL(i). The higher the nominal income ($Y), the higher the demand for money. The lower the interest rate (i), the higher the demand for money.

In FINANCIAL MARKET the equilibrium condition requires that money supply be equal to money demand: M = $YL(i) and this is called LM relation.

Determination of the Interest Rate

Must be such that the money supply is equal to the money demand. An increase in nominal income ($Y) leads to an increase in the demand curve M_d (shifting to the right) that corresponds to an increase in i. An increase in the supply of money leads to a decrease in the interest rate.

The open market operations are the method Central Banks use to change the money supply in modern economies:

• If CB buys bonds, increase in money supply M_s EXPANSIONARY POLICY
• If CB sells bonds, decrease in money supply M_s CONTRACTIONARY POLICY

The higher the price of the bond, the lower the interest rate: once the CB has bought the bonds (increasing M_s), also the demand of bonds (M_d) increases and consequently their selling price and the result is that the interest rate (i) goes down. So i is determined by the equality of M_s and M_d.

T-bills

T-bills are bonds issued by the US government that are repaid in 1 year or less.

Summary

The interest rate is determined by the equilibrium between M_d and M_s.

• By changing the M_s, the CB can affect the interest rate.
• The CB changes the M_s through open-market operations, which are sales or purchases of bonds for money.
• Open-market operations in which CB increases the M_s by buying bonds lead to an increase in the price of bonds and a decrease in the interest rate.
• Open-market operations in which CB decreases the M_s by selling bonds lead to a decrease in the price of bonds and an increase in the interest rate.

Financial Intermediaries

Financial intermediaries are institutions which receive funds from people and firms and then use these funds to buy bonds or stock or to make loans to other people. Banks keep as reserve part of the funds they receive in three ways:

• Every day some depositors withdraw cash from the bank and others deposit cash to the bank.
• Every day some depositors of the bank write checks to depositors of other banks and, in the same way, depositors of other banks write checks to depositors of the bank.
• Banks are subjected to reserve requirements: the actual reserve ratio in USA is about 10%.

Banking Operations

A bank run is a situation where banks run out of reserves. To avoid it, the US government introduced:

• The federal deposit insurance
• The narrow banking

When people can hold both currency and checkable deposits, they have to decide how much of it they want to hold. Currency demand CU_d = c M_d. Checkable deposits demand D_d = (1 – c) M_d. The larger the amount of checkable deposits, the larger the amount of reserves that the banks must hold. The relation between reserves (R) and deposit (D) is: R = ΘD.

The demand for reserves by banks is given by: R_d = Θ (1 – c) M_d.

The demand for CB money is equal to the sum of currency and reserves: H_d = CU_d + R_d. In equilibrium, the supply for CB money (H) is equal to the demand for CB money (H_d): H = H_d. In equilibrium, the supply for bank reserves is equal to the demand for bank reserves: H – CU_d = R_d.

The overall M_s is equal to the CB money (H) times the money multiplier: ¹⁄_{(c + (1 – c)Θ)}.

Chapter 5

IS Relation

The IS relation is expressed as: Y = Z. Taking into account the investment relation, the equilibrium condition becomes: Y = C(Y – T) + I(Y,i) + G.

Production and Interest Rate

PRODUCTION: the more the production, the more the machineries.

INTEREST RATE: the higher the interest rate, the lower the investment.

An increase in OUTPUT Y leads to an increase in the DEMAND Z and a decrease in the interest rate (i).

An increase in INTEREST RATE i leads to a decrease in DEMAND Z (and also in income/output Y, production, and then in investment I).

IS Curve

The downward-sloping IS CURVE describes the relation between interest rate (i) and output (Y): an increase in i implies a decrease in Y. The factors which shift the IS curve are G, T, and CONSUMER CONFIDENCE.

• LEFT SHIFT: Any factor that decreases Y (↑T; ↓G; ↓C. CONFIDENCE)
• RIGHT SHIFT: Any factor that increases Y (↓T; ↑G; ↑C. CONFIDENCE)

An increase in taxes shifts the IS curve to the left. The IS curve DOES NOT shift when there is a reduction in the interest rate.

LM Relation

The LM relation is expressed as: M = $YL(i). It becomes: ^M⁄_P = YL(i).

An increase in income Y leads to an increase in the demand for money M_d. Given the supply of money M_s, the increase in the demand leads to an increase in the equilibrium interest rate i.

In the financial market, an increase in income Y leads to an increase in interest rate i, and that’s why the LM curve is upward sloping. An increase in money M/P causes the LM curve to shift down. So, in the financial market, an increase in the level of income, corresponding to an increase in the demand for money, leads to an increase in the interest rate.

Equilibrium

Equilibrium in the goods market states that an increase in the interest rate corresponds to a decrease in output; equilibrium in the financial market states that an increase in the interest rate corresponds to an increase in output. So there’s only one point (A) at which both goods and financial markets are in equilibrium.

Shifts of IS and LM Curves

The shifts of IS, LM, AD, and AS curves depend on various factors:

• An increase in taxes shifts the IS curve to the left.
• A decrease in taxes shifts the IS curve to the right.