Macroeconomics Notes

SUMMARY

The interest rate is determined by the equilibrium between Md and Ms

 By changing the Ms the CB can affect the interest rate

 The CB changes the Ms through Open-market operations, which are sales or purchases of

 bonds for money

Open-market operations in which CB increases the Ms by buying bonds lead to an increace

 in the price of bonds and to a decrease in the interest rate

Open-market operations in which CB decreses the Ms by selling bonds lead to a decrease

 in the price of bond and to an increase in the interest rate

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 fund that receive in 3 ways:

1. Every day some depositors withdraw cash from the bank and others deposit cash to the

bank

2. 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

3. Banks are subjected to reserve requirements: the actual reserve ratio in USA is about 10%

CB Balance Sheet

ASSETS LIABILITIES

Bonds CB money = reserves + currency

Bank Balance Sheet

ASSETS LIABILITIES

Reseves, loans, bonds Checkable deposits

An increase in interest rate (i) implies a lower demand of CB money because the demand for

currency and checkable deposits by people goes down (they rather hold bonds)

A bank run is a bank that run of of reserves, in order to avoid it the US governments introduced:

a) The federal deposit insurance

b) The narrow banking

When people can hold both currency and checkable deposit they have to decide how much of it

they want to hold.

Currency demand CUd = c Md

Checkable deposits demand Dd = (1 – c) Md

The larger the amount of checkable deposits, the larger the amout 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: Rd = Θ (1 – c) Md

The demand for CB money is equal to the sum of currency and reserves: Hd = CUd + Rd

In equilibrium the supply for CB money (H) is equal to the demand for CB money (Hd): H = Hd

In equilibrium the supply for bank reserves is equal to the demand for bank reserves: H – CUd =

Rd [ ]

1 H

The overall Ms is equal to the CB money (H) times the money multiplier: c 1 – c

( )

+Θ

High-powered money is the termi used to refect the fact that the Ms depends on H or monetary

base.

CHAPTER 5

IS relation: Y = Z



Taking into account the investment relation, the equilibrium condition becomes:

Y = C(Y – T) + I(Y,i) + G

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)

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 shifts 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 DO NOT shift when there is a reduction in interest

rate LM relation: M = $YL(i)

 M

It becomes: = YL(i)

P

An increase in income Y leads to an increase in the demand for money Md. Given the supply of

money Ms, 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 in the goods market states that at an increase in

interest rate corresponds a decrease in output; equilibrium in

the financial market states that at an increase in the interest rate

corresponds an increase in output. So there’s only one point (A)

at which both goods and financial markets are in equilibrium.

SHIFTS of IS of LM of AD of AS Movement Movement Trade Domestic

in output Y in interest balance demand

rate i

↑ in taxes Left / Down Down

T

↓ in taxes Right / Up Up

T

↑ in g. Right / Right Up Up Trade Up

spending deficit (appreciatio

G n of E)

↓ in g. Left / Left Down Down

spending

G

↑ in money / Down Right Up Down

M

↓ in money / up Left Down Up

M

↑reserve Up

deposit

ratio (q)

Monetary Up

contraction

Monetary Down Right

expansion

Fiscal Right

expansion

Fiscal Left down

contraction

A fiscal contraction (consolidation) is a reduction of the budget deficit by increasing taxes T or

reducing the government sending G.

A fiscal expansion is an increase of the deficit by reducing taxes T or increasing government

spending G.

Fiscal contraction > investments I

Fiscal expansion < investments I

A monetary contraction is a decrease in the money supply Ms

A monetary expansion is an increase in the money supply Ms

The combination of the monetary policy (LM) and the fiscal policy (IS) is known as the policy mix.

CHAPTER 6

Non institutional civilian population # of people potentially available for civilian

employment

Civilian labor force # of working people or people looking for a job

Out of labor force # of people who doesn’t work, neither is looking for a

job

Participation rate Civilian labor force : non institutional civilian population

Unemployment rate Unemployed : civilian labor force

The wage determination could:

1. Come from collective bargaining

2. Be set by employers

So the aggregate nominal wage: W = Pe F(u;z) is affected by:

a) Expected price level Pe: set taking into account how many goods and services the

employee can afford

b) Unemployment rate (u): the higher the rate, the lower the power of collective bargaining so

the employees are forced to accept the wage offered to them

c) Catchall variable (z): benefit coming from the job (i.e. unemployment insurance)

The price determination belongs to the fact that prices set by firm strictly depend on the nature of

the production function (i.e. on the costs they face!): Y = N means that output Y is considered

proportional to the size of employment, because in order to produce one more unit of a good is

necessary one more worker. So: P = (1 + µ)W where µ is the mark-up of price over the cost and is

equal to 0 in perfectly competitive markets.

WAGE-SETTING RELATION: W/P = F(u;z)

Real wage decreases when unemployment increases

PRICE-SETTING RELATION: W/P = 1/(1 +µ)

Real wage implied by price setting doesn’t depend on

unemployment

Real wage decreases when µ increases

Price increases when µ increases

The equilibrium condition in the LABOR MARKET requires that the real wage chosen in wage-

1

setting is equal to the real wage implied by price-setting: F(un;z) = 1+ µ

The equilibrium unemployment rate (Un) is called the natural

rate of unemployment.

An increase of unemployment benefits (z):

Leads to an increase of real wage W/P

 Shifts the WS curve up

 Leads to an increase in the natural rate of

 unemployment

A higher Un is needed to bring the real wage back to what firms

are willing to pay.

An increase in mark-up µ:

Leads to a decrease in real wage W/P

 Shifts PS down

 Leads to a decrease in the natural rate of

 unemployment

A higher un is needed to make workers accept a lower wage.

The natural level of employment I given by: Nn = L(1 – un) where:

un is the natural rate of unemployment

L is the labor force

It represents the level of employment when unemployment is equal to un.

The natural level of output is given by: Yn = Nn = L(1 –un)

It represents the level of production when employment is equal to Nn.

SUMMARY

The real wage W/P chosen in wage-setting is a decreasing function of unemployment rate

 The real wage implied by price-setting is constant

 Equilibrium in the labor market requires that the real wage chosen in wage-setting is equal

 to the real wage implied in price-setting determining the equilibrium unemployment rate

(Un)

This equilibrium is called natural rate of unemployment

 Associated whit the natural level of unemployment there are also a natural level of

 employment and a natural level of output

CHAPTER 7

The Aggregate Supply relation (AS – AD model) captures the effect of output on the price

 level. It’s derived from the behavior of wages and prices.

It’s derived from wage and price determinations, so we get:

P = Pe(1 + µ) F(u;z) The price level depends on the expected price

level Pe and on the unemployment rate un. We

assume that µ and z are constant.

Then we express the unemployment rate in terms of output:

YL

( )

1 –

u =

In this way we get: Y The price level depends on the expected price

, z)

(1−

P = Pe(1 + µ) F L level Pe and on the level of output. We assume

µ, z and L are constant.

The AS model has 2 important properties:

1. An increase in output leads to an increase in price level. Because

1.1. ↑ output leads to an ↑employment

1.2. ↑employment leads to ↓unemployment

1.3. ↓unemployment leas to ↑nominal wage(W)

1.4. ↑nominal wage leads to ↑firm’s costs that leads to ↑price level

2. An increase in the expected price level leads to an increase in the actual price level

2.1. ↑expected price level leads to ↑nominal wage (W)

2.2. ↑nominal wage leads to ↑price The AS

curve is

upward

sloping.

It pass

through point

A where Y =

Yn and P =

Pe.

This property has 2 implications:

When Y > Yn, P > Pe

When Y < Yn, P < Pe An increase in Pe shifts the AS curve up

The Aggregate Demand relation (AD –AS model) captures the effect of output on the

 price level.

It’s derived from the equilibrium conditions in goods and financial markets, so we get:

MP

( )

,G , T

Y = Y

↑P leads to ↓W/P

↓W/P leads to ↑i

↑i leads to ↓demand

↓demand leads to ↓Y

Any variable shifting IS and LM curve also shift the AD

curve.

↓ in money shifts AD to the left

↑in G shifts to