Diploma pre-sessional
Macroeconomics
Laura Sochat
29/09-01/10
Based on EC108 lecture notes
Laura Sochat

EC201 classes every Thursday at 17.00 in S0.13.

Email: Laura.Sochat@warwick.ac.uk

Office hours (S0.86):

Monday: 15.00-16.00

Thursday: 11.00-12.00

Check my webpage regularly, as I will announce changes on there, if any.
Gross Domestic Product

Market value of all final goods and services produced within an economy in a
given period of time.


How do you compute GDP?


Can either be seen as total income, or total expenditure. Why must those be equal?
Suppose economy produces three goods- X, Y, and Z.
𝐺𝐺𝐺 = (𝑃𝑥 × 𝑄𝑥 ) + (𝑃𝑦 × 𝑄𝑦 ) + (𝑃𝑧 × 𝑄𝑧 )
Treatment of inventories, used good and intermediate goods and services.

Class exercise: using value added to compute GDP

Weat = 1£

Flour = 3£

Bread = 6£
GDP (continued)



Nominal vs. Real GDP

Nominal GDP: Value at current prices. If prices increase-> Nominal GDP increases. If
quantity increase-> Nominal GDP increases

Real GDP: Value at a ‘base-year’ prices. Value of real GDP changes only when quantity
changes.
What is included in GDP

Y = I + C + G + NX

I is investment, C is consumption, G is Government Spending, and NX is net exports
(Exports-Imports)
What is the difference between GNP and GDP?
Cost of living – Consumer Price Index

Measures the level of prices.

Computed by collecting the price of thousands of goods and services.


Suppose a typical consumer consumes 8 units of good X and 5 units of good Y
each month.


Different weights attributed to different goods and services depending on their
relative importance in the basket of the typical consumer.
How would you computer the CPI?
Look back.. To what could we compare the CPI to?
GDP deflator vs. CPI
GDP deflator
CPI
Includes all goods and services (incl.
goods bought by firms and
government)
Measures the prices of goods and
services in the basket of a typical
consumer
Imported goods are not part of GDP,
and therefore not included in the
GDP deflator measure.
Goods produced elsewhere but
consumed domestically are included
in the CPI measure
The basket of goods and services
changes every year.
CPI looks at a fixed basket of goods
and services over the years.
Population

Employed


Unemployed


Not employed but looking for a job
Labour force


Working in a paid job
Available labour to produce goods and services (includes both employed and unemployed
persons)
Not in the labour force

Not employed, and not looking for a job
The unemployment rate represents the percentage of the labour force that is
unemployed.
𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢
𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈𝑈 𝑟𝑟𝑟𝑟 =
× 100
𝑙𝑙𝑙𝑙𝑙𝑙 𝑓𝑓𝑓𝑓𝑓
The labour force participation rate represents the fraction of the adult population
which participates in the labour force.
𝑙𝑙𝑙𝑙𝑙𝑙 𝑓𝑓𝑓𝑓𝑓
𝑙𝑙𝑙𝑙𝑙𝑙 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑟𝑟𝑟𝑟 =
× 100
𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
Very quickly: A Closed Economy, market
clearing model.
Supply side
Factors of production and the
production function

Factors of production are the ‘tools’ used to produce goods and services in the
economy



Labour, 𝐿 = 𝐿�
�
Capital, 𝐾 = 𝐾
Output produced using a given amount of capital and labour represents the
available technology – This is represented through the production function:
𝑌 = 𝐹 𝐾, 𝐿
Where F is usually assumed to have constant returns to scale. What does this mean?
Demand for the factors of production

How is the demand for the factors of production determined?

A firm will demand each factor of production up until the point where its cost= its
benefit
Cost = Wages and rent paid to the factors of production
Benefits = extra output from an using extra unit of that factor of production
(marginal product)

Diminishing marginal returns

As a factor input is increased, its marginal product falls. Why is that?
Demand side
Aggregate demand

Consumption : Consumer’s demand for goods and services


𝐶 =𝐶 𝑌−𝑇
As disposable income increases, consumption increases.
Investment : Demand for investment goods
𝐼 = 𝐼 (𝑟)

As r increases, Investment decreases. Why?


r represents the cost of borrowing, it is the opportunity cost of using own funds.
Government Spending : Government demand for goods and services

We assume government spending to be exogenous
𝒀=𝑪 𝒀−𝑻 +𝑰 𝒓 +𝑮
Equilibrium



Aggregate demand- 𝑌 = 𝐶 𝑌 − 𝑇 + 𝐼 𝑟 + 𝐺
Aggregate supply- 𝑌 = 𝐹 𝐾, 𝐿
Equilibrium where Demand = Supply
𝐶 𝑌 − 𝑇 + 𝐼 𝑟 + 𝐺 = 𝐹 𝐾, 𝐿
Y, T, G, K and L are given in this model. The real interest rate adjusts to equate
demand and supply. We can therefore rewrite this equation such as:
� , 𝐿�)
𝐶 𝑌� − 𝑇� + 𝐼 𝑟 + 𝐺̅ = 𝐹(𝐾
Money and Inflation
The functions of money

Store of value


Unit of account


It is a way to transfer purchasing power from the present to the future.
Prices, debt, are quoted and recorded in term of money.
Medium of exchange

We use money to buy goods and services
Quantity of money: Control and
measures

Symbol
Assets included
M1
Checkable deposits +
currency in circulation
M2
M1 + retail money market
mutual fund balances, saving
deposits, small time deposits
Controlled through monetary policy

In many countries today, monetary policy is delegated to independent central
banks.

Open market operations, discount rate, reserve requirements.

Money multiplier (multiplied effect of monetary base on money supply).
Quantity Equation

How is the quantity of money related to income and prices?
𝑀×𝑉 =𝑃×𝑌

Y represents output, proxy for transactions (T) - the higher the output, the higher the
number of transactions will be.

P represents the price of one unit of output.

PY is therefore the dollar value of output (nominal GDP, remember earlier).

V is the income velocity of money, that is the number of times the average pound bill
changes hands in a given time period.

M represents the quantity of money.
Quantity Theory of Money

Assuming constant and exogenous velocity, we can look at the effect of a
change in the money supply

𝑀 × 𝑉� = 𝑃 × 𝑌


A change in the money supply implies a proportional change in nominal GDP.
How is the overall price level determined?

Nominal GDP is determined by the money supply (see above), and

Y is determined by the factors of production (and the production function)

Therefore?
Inflation


Start by rewriting the quantity theory of money in terms of growth rates:
∆𝑉
=0
𝑉
∆𝑃
=𝜋
𝑃
∆𝑀 ∆𝑉 ∆𝑃 ∆𝑌
+
=
+
𝑀
𝑉
𝑃
𝑌
We can therefore rewrite the quantity theory of money such as:
∆𝑀 ∆𝑌
−
=𝜋
𝑌
𝑀
What can you conclude?
Inflation and interest rates

Denote the nominal interest rate i, the real interest rate r, and inflation, as
before, π.
𝑟 =𝑖−𝜋
This is the fisher equation.

We saw that the real interest rate adjusts for equilibrium (S=I)

An increase in the money supply leads to an increase in inflation

An increase in the inflation rate causes a one-to-one increase in the nominal interest rateThis is the fisher effect.
The role of expectations- Two real
interest rates
When making investment decisions, people do not know what inflation will be in
the future. They therefore make their decision using their expectations of
inflation:

𝑟 = 𝑖 − 𝜋𝑒
Money demand depends on Y, but also on i


The nominal interest rate is the opportunity cost of holding money.
Given 𝑟, 𝜋 𝑒 and Y, a change in M leads to a change in P of the same
percentage.

What happens if inflation expectations change? Look at a money demand equation
𝑀 𝑑
= 𝐿(𝑖, 𝑌)
𝑃
Building the IS-LM model
Keynesian cross and the IS curve

Income is determined by the spending plan of households

If people want to spend

Firms can sell more

The more firms sell, the more they produce


The more workers they hire
Planned expenditure versus Actual expenditure

Why would they differ?

Firms may sell more or less than what they have produced

Unplanned inventory investment
For simplicity, assume that G, T and I are given and constant:
𝑃𝑃 = 𝐶 𝑌 − 𝑇� + 𝐼 ̅ + 𝐺̅
Planned expenditure as a function of
Income
The Keynesian Cross
Equilibrium in the Keynesian cross

Suppose you start at point 𝑌𝐴

Actual expenditure > Planned expenditure. Firms are producing more than they are
selling

Workers get laid off



Production decreases until Y is back at its equilibrium level.
Multiplier effects:

What would be the effect of an increase in G?

Of an increase in T?
Now let’s look at what happens to income when the interest rate changes…
The IS curve
The theory of liquidity preference

Denote
𝑀 𝑠
to
𝑃
be the supply of real money balances and is assumed to be
exogenous, and therefore does not depend on the interest rate.

As we saw before, this is not true for the demand for money, more
particularly,
𝑀 𝑑
= 𝐿(𝑟, 𝑌)
𝑃


The interest rate adjusts to ensure equilibrium in the market for the most liquid
asset- Money.
Now let’s look at what happens to the interest rate when income increases…
Market for real money balances and the
LM curve
Short run Equilibrium