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Course Summary

Elementary Macroeconomics Notes
Salpy Kanimian
Chapter 20 – Introduction to macroeconomics
Some Definitions
• Microeconomics: Examines the functioning of individual industries and the behavior of
individual decision-making units—firms and households.
• Macroeconomics: Deals with the economy as a whole. Macroeconomics focuses on the
determinants of total national income, deals with aggregates such as aggregate consumption and investment, and looks at the overall level of prices instead of individual prices.
Fiscal policy, gov. intervention, Keynesian theory, 1929, 2008, . . .
• Aggregate Behavior: the behavior of all households and firms together.
• Sticky Prices: prices that do not always adjust rapidly to maintain equality between supply
and demand.
• Concerns of Macroeconomics: output growth, unemployment and inflation/deflation.
• Aggregate Output: main measure of the quality of an economy; the total value of goods
and services produced in a time period.
• Business Cycle: cycle of short term ups and downs in the economy.
• Recession: a period during which aggregate output declines.
• Depression: a long and deep recession.
• Contraction/Recession/Slump: period from peak to trough in the business cycle.
• Expansion/Boom: period from trough to peak in the business cycle.
• Inflation: increase in the overall price level.
• Hyperinflation: a rapid inflation
• Deflation: decrease in the overall price level.
• Great Depression: The period of severe economic contraction and high unemployment that
began in 1929 and continued throughout the 1930s.
Three Markets Arena
To see the big picture of the macroeconomy, we divide the participants in the economy into four
broad groups (sectors):
• Households sector
• Firms (businesses sector)
• The government (public sector)
Elementary Macroeconomics Notes
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• The rest of the world (foreign sector)
Households and firms make up the private sector, the government is the public sector, and the rest
of the world is the foreign sector.
circular flow: A diagram showing the flows in and out of the sectors in the economy.
Goods and service market:
Demand: households, government, firms.
Supply: firms.
Labor market: Demand: firms, government.
Supply: households.
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Financial market:
Demand: firms as investment, government by issuing bonds, and households for purchases.
Supply: households supply funds to earn in dividends on stocks and interest on bonds.
More Definitions
• Treasury bonds/bills: promissory notes issued by the government when it borrows money.
• Corporate bonds/notes: promissory notes issued by firms when they borrow money.
• Dividend: profit given by firms to shareholders.
• Shares of stock: Financial instruments that give the holder rights to shares of ownership
and profits from firms.
The Role of The Government in The Macroeconomy
• Fiscal Policy: government policies concerning taxes and spending
• Monetary Policy: tools used by central banks to control short term interest rate.
• Fine-tuning: government’s role in regulating inflation and unemployment.
• Stagflation: situation of both high inflation and high unemployment.
• Transfer Payments: cash payments made by the government to people who do not supply
goods, services or labor in exchange for these payments (social security, welfare, ...).
Chapter 21 – Measuring National Output and National Income
Some Definitions
• Gross Domestic Product (GDP): It is the total market value of a country’s output. It is
the market value of all final goods and services produced within a given period of time by
factors of production located within a country.
• Final Goods and Services: goods and services produced for final use.
• Intermediate Goods: goods to be used for further processing by another firm.
• Value Added: the difference between the value of goods when the leave a stage of production and the cost of the goods when they entered that stage.
• Gross National Product (GNP): It is the total market value of all final goods and services
produced within a given time period by factors of production owned by a country’s citizens,
regardless of location.
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Calculating GDP
Calculating the GDP (Expenditure = Income)
Exclusions from the GDP:
• Used goods in ownership and no production of goods or services
• Paper transactions
• Production abroad
• Informal/Illegal economy
Expenditure Approach
GDP = C + I + G + (EX–IM )
• C = Personal Consumption Expenditures Durable Goods Non-durable Goods Services
• I = Gross Private Domestic Investment Residential Non-residential Inventory Change
• G = Government Consumption and Gross Investment Federal State Local
Gross and Net Investment
• Depreciation (D): the amount by which an asset’s value falls with time.
• Gross Investment (GI): total value of all newly produced capital goods.
Net Investment = Gross Investment - Depreciation =⇒ N I = GI–D
Income Approach
National Income
• Compensation of employees (wages, salaries, social payments)
• Proprietor’s income (sole ownership and partnership companies)
• Corporate profits
• Rental income
• Net interest (paid by businesses)
• Indirect taxes minus subsidies
• Net business transfer payments
• Surplus of government enterprises (profits or losses of government owned companies)
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Gross Domestic Product (GDP)
+ Receipts of factor income from the rest of the world
– Payments of factor income to the rest of the world
= Gross National Product (GNP)
– Depreciation
= Net National Product (NNP)
– Statistical Discrepancy
= National Income (NI)
+ Statistical Discrepancy
= Net National Product (NNP)
+ Depreciation
= Gross National Product (GNP)
– Receipts of factor income from the rest of the world
+ Payments of factor income to the rest of the world
= Gross Domestic Product (GDP)
More Definitions
• Disposable personal income or after-tax income: Personal income minus personal income
taxes. The amount that households have to spend or save.
• Personal saving: The amount of disposable income that is left after total personal spending
in a given period.
• Personal saving rate: The percentage of disposable personal income that is saved.
If the personal saving rate is low, households are spending a large amount relative to their incomes; if it is high, households are spending cautiously.
Real vs Nominal GDP
nominal GDP: Gross domestic product measured in current dollars.
base year: The year chosen for the weights in a fixed-weight procedure.
GDP deflator
The GDP deflator is one measure of the overall price level.
Limitations of GDP
• Informal Economy not included in GDP, and may constitute a big part of the economy.
• GDP is a measure of wealth not of social welfare, even though the two are correlated.
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Chapter 22 – Unemployment, Inflation and Long-Run Growth
Some Definitions
• Employed: Any person 16 years old or older (1) who works for pay, either for someone
else or in his or her own business for 1 or more hours per week, (2) who works without
pay for 15 or more hours per week in a family enterprise, or (3) who has a job but has been
temporarily absent with or without pay.
• Unemployed: A person 16 years old or older who is not working, is available for work, and
has made specific efforts to find work during the previous 4 weeks.
• Not in the Labor Force: A person who is not looking for work because he or she does not
want a job or has given up looking.
• Discouraged worker effect: The decline in the measured unemployment rate that results
when people who want to work but cannot find jobs grow discouraged and stop looking,
thus dropping out of the ranks of the unemployed and the labor force.
Causes of Unemployment
• Frictional unemployment: The portion of unemployment that is due to the normal turnover
in the labor market; used to denote short-run job/skill-matching problems.
• Structural unemployment: The portion of unemployment that is due to changes in the
structure of the economy that result in a significant loss of jobs in certain industries.
• Cyclical unemployment: Unemployment that is above frictional plus structural unemployment. It can be unemployment due to recessions, or seasonal unemployment that occurs
when employment is dependent on seasonal activities.
Natural rate of unemployment: The unemployment rate that occurs as a normal part of the functioning of the economy. Sometimes taken as the sum of frictional unemployment rate and structural unemployment rate.
LaborF orce = Employed + U nemployed
U nemploymentRate =
U nemployed
U nemployed
LaborF orce
U nemployed + Employed
P opulation = LaborF orce + P eoplenotintheLaborF orce
LaborF orceP articipationRate =
LaborF orce
P opulation
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Some Definitions
• Consumer price index (CPI): A fixed-weight price index computed each month by the
Bureau of Labor Statistics using a bundle that is meant to represent the “market basket”
purchased monthly by the typical urban consumer.
• Producer price indexes (PPIs), are indexes of prices that producers receive for products at
all stages in the production process, not just the final stage. One advantage of some of
the PPIs is that they detect price increases early in the production process. Because their
movements sometimes foreshadow future changes in consumer prices, they are considered
to be leading indicators of future consumer prices.
• The inflation rate is the change in the CPI from one year to another.
Inflation May Change the Distribution of Income
The effects of anticipated inflation on the distribution of income are likely to be fairly small, since
people and institutions will adjust to the anticipated inflation.
Unanticipated inflation may have large effects, depending, among other things, on the amount of
indexing to inflation.
real interest rate: The difference between the interest rate on a loan and the inflation rate.
Actual inflation that is higher (lower) than anticipated benefits debtors (creditors).
Real interest rate = interest rate - expected inflation
Long-Run Growth
Some Definitions
• Output growth: The growth rate of the output of the entire economy.
• Per-capita output growth The growth rate of output per person in the economy.
• Productivity growth The growth rate of output per worker.
Chapter 23 – Aggregate Expenditure and Equilibrium Output
Some Definitions
• Aggregate output: The total quantity of goods and services produced (or supplied) in an
economy in a given period.
• Aggregate income: The total income received by all factors of production in a given period.
• Aggregate Output (income) (Y): A combined term used to remind you of the exact equality
between aggregate output and aggregate income. Aggregate output = aggregate income =
Elementary Macroeconomics Notes
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Consumption Function
C = a + bY
a = autonomous consumption (wealth, consumer confidence ...)
b = Marginal propensity to consume (M P C) =
In practice, the decisions of households about how much to consume in a given period are also
affected by:
• Their wealth
• The interest rate
• Their expectations of the future
Saving and Investment
Aggregate saving (S): The part of aggregate income that is not consumed.
S =Y −C
Marginal propensity to save (MPS): That fraction of a change in income that is saved.
MP C + MP S = 1
Planned investment (I): Those additions to capital stock and inventory that are planned by firms.
Actual investment: The actual amount of investment that takes place; it includes items such as
unplanned changes in inventory.
Actual Investment = Planned Investment + Unplanned Change in Inventory
Unplanned change in inventory: Y – (C + I)
Equilibrium occurs when there is no tendency for change. In the macroeconomic goods market,
equilibrium occurs when planned aggregate expenditure is equal to aggregate output.
Planned aggregate expenditure (AE): The total amount the economy plans to spend in a given
period, equal to consumption plus planned investment: AE = C + I
At equilibrium:
(a + I)
Unplanned inventory change = 0 =⇒ actual investment = planned investment
Y = AE = C + I = a + bY + I =
Y = C + S =⇒ C + S = C + I =⇒ S = I
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At disequilibrium, the economy changes in a way to converge to equilibrium. If planned expenditure exceeds aggregate output, there will be unplanned inventory reductions. Firms will then
increase production (output), thus increasing income until it reaches equilibrium value. The same
process happens in reverse when aggregate output exceeds planned expenditure and firms have
to reduce their inventory, thus producing less and generating less income.
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The Multiplier
Multiplier: The ratio of the change in the equilibrium level of output to a change in some exogenous variable.
Exogenous variable: A variable that is assumed not to depend on the state of the economy—that
is, it does not change when the economy changes.
Assuming Planned Investment (I) is exogenous, its multiplier is:
1 − MP C
Paradox of Thrift
When people decide to save more in a recession, the recession becomes worse, and only government intervention could solve the problem of a recession.
When households become concerned about the future and decide to save more, the corresponding
decrease in consumption leads to a drop in spending and income.
Households end up consuming less, but they have not saved any more, because income declined,
and the recession becomes worse.
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Chapter 24 – The Government and Fiscal Policy
Some Definitions
• Monetary Policy: The behavior of the Federal Reserve concerning the nation’s money
• Discretionary Fiscal Policy: Changes in taxes or spending that are the result of deliberate
changes in government policy.
• Net taxes (T): Taxes paid by firms and households to the government minus transfer payments made to households by the government.
Disposable Income:
Yd = Y –T = C + S
AE = C + I + G
Y =C +S+T
C = a + b(Y –T )
Budget deficit = G − T
With Government only
Government Spending Multiplier:
Tax Multiplier: −M
= 1−b
1−M P C
Government spending multiplier > Tax multiplier, so an increase in government spending is a
more effective fiscal policy than a tax cut. This can be shown mathematically by comparing the
multipliers or by deriving them again with the geometric series method.
The Balanced Budget Multiplier is the ratio of change in the equilibrium level of output to a
change in government spending where the change in government spending is balanced by a
change in taxes so as not to create any deficit. The balanced budget multiplier is equal to 1:
the change in Y resulting from the change in G and the equal change in T are exactly the same
size as the initial change in G or T.
With Endogenous taxes
Taxes: T = T0 + tY
Government Spending Multiplier:
Tax Multiplier: 1−b+bt
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With Imports and Exports
Exports: X = X0
Imports: M = M0 + mY
Government Spending Multiplier:
Tax Multiplier: 1−b+bt+m
End of Midterm Material
Elementary Macroeconomics Notes
Salpy Kanimian
Chapter 25 - The Money Supply and the Federal Reserve
Some Definitions
• Money is a means of payment, or a medium of exchange, a store of value, and a unit of
account. Paper money became legal tender and widely used in all countries because of its
• Barter: The direct exchange of goods and services for other goods and services.
• Medium of exchange, or means of payment: What sellers generally accept and what buyers
generally use to pay for goods and services.
• Store of value: An asset that can be used to transport purchasing power from one time
period to another.
• Liquidity property of money: The property of money that makes it a good medium of
exchange as well as a store of value is that it is portable and readily accepted and thus
easily exchanged for goods.
• Unit of account: A standard unit that provides a consistent way of quoting prices.
• Commodity monies: Items used as money that also have intrinsic value in some other use
(cigarettes in prison or dolphin teeth in the Solomon Islands).
• Fiat, or token money: Items designated as money that are intrinsically worthless (paper
• Legal tender: Money that a government has required to be accepted in settlement of debts.
• Currency debasement: The decrease in the value of money that occurs when its supply is
increased rapidly.
Money is then used to buy things (a means of payment), to hold wealth (a store of value)
and to quote prices (a unit of account).
• There are many kinds of money: M1, transaction money = currency held outside banks +
demand deposits + traveler’s checks + other checkable deposits.
M2, broad money = M1 + savings accounts + money market accounts + other near monies
like close substitutes for transaction money such as savings accounts and money market
Banks are financial intermediaries, meaning that they act as a link between those who have money
to lend and those who want to borrow money, thereby creating money through loans. If a bank is
used to store some lenders’ money, which is later used to be loaned out to borrowers, the bank is
at risk of a run. A run on a bank occurs when many of those who have claims on a bank (deposits)
present them at the same time. This is why the central bank in each country (the Federal Reserve
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Bank in the United States) acts to regulate the banking system, preventing runs and bankruptcy,
by imposing a required reserve ratio.
Reserves: The deposits that a bank has at the Federal Reserve Bank plus its cash on hand.
Required Reserve Ratio: The percentage of its total deposits that a bank must keep as reserves at
the Federal Reserve (as opposed to giving them out as loans).
T-Account for a Bank:
Assets = Liabilities + N etW orth
Reserves + Loans = Deposits + N etW orth
The Fed
• Central banks are sometimes known as “bankers’ banks.”
• The Fed’s crucial role is to control the money supply.
• The Fed also performs several important functions for banks, such as clearing interbank
payments and assisting banks that are in difficult financial positions.
• The Fed is also responsible for managing exchange rates and the nation’s foreign exchange
• The Fed also facilitates the transfer of funds among banks and is responsible for many of
the regulations governing banking practices and standards.
• lender of last resort One of the functions of the Fed: It provides funds to troubled banks
that cannot find any other sources of funds.
Creation of Money
Deposits made to a bank stack up as reserves. However, the bank is only required to keep a
certain percentage of those reserves (as set by the required reserve ratio) at the bank. The rest
can be loaned out to borrowers. This way, the bank can loan out excess reserves. When the
excess reserves are zero, the bank is said to be loaned up. However, loans made by a bank have
a multiplier effect. When a bank gives out a loan, it is assumed that the money loaned out will
be deposited back into the banking system by the borrower, or paid to someone who will deposit
them himself (be it at the same or another bank). This increases the bank’s deposits, increasing its
reserves, and excess reserves, allowing it to give out even more loans. This is how banks create
ExcessReserves = ActualReserves–RequiredReserves
M oneyM ultiplier =
• Interest is the fee that borrowers pay to lenders for the use of their funds. Firms and governments borrow funds by issuing bonds, and they pay interest to the lenders that purchase
the bonds. Households also borrow, either directly from banks and finance companies or
by taking out mortgages.
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• Bonds are more complicated loans. Bonds have several properties. First, they are issued
with a face value, typically in denominations of $1,000. Second, they come with a maturity
date, which is the date the borrower agrees to pay the lender the face value of the bond.
Third, there is a fixed payment of a specified amount that is paid to the bondholder each
year (coupon). This payment is known as a coupon. However, the bonds are not always
sold at face value, and their price is determined by the market. The coupon does not change
in value, and can be used to calculate the interest rate, which would be equal to interest
payment / price of bond. Markets directly determine bond prices, and indirectly determine
interest rates.
Demand for money
The demand for money is how much of its financial assets a household wants to hold in the
form of money (liquid), that does not yield any interest, versus how much money it wants
to hold in interest-bearing securities like bonds. We assume that checking accounts do not
return interest, or at least the interest they return is lower than that of bonds. The same
principles apply to both households and firms.
Money Demand Curve
The money demand curve represents the inverse relationship between interest rates and
demand for money. The higher the interest rate, the lower the demand for money is.
The demand for money is in
nominal terms. It is affected by the nominal income, represented by P.Y, where P is the
aggregate price level, and Y is the real output and income. P.Y is then the nominal output
and income. When P increases or when Y increases, the money demand curve shifts to the
right, and when P or Y decrease, the money demand curve shifts to the left.
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Changing the equilibrium interest rate
Changes in the money supply (through monetary policies, tight or easy) can bring about
changes in the equilibrium interest rate.
If the money supply increases (easy monetary policy), the money supply vertical curve
shifts to the right, the supply of bonds is decreasing, which drives the price of bonds up.
The new equilibrium price of the bonds corresponds to a lower equilibrium interest rate.
If the money supply decreases (tight monetary policy), the money supply vertical curve
shifts to the left, the supply of bonds is increasing, which drives the price of bonds down.
The new equilibrium price of the bonds corresponds to a lower equilibrium interest rate.
Controlling the Money Supply
The Federal Reserve can increase or decrease the money supply by using three methods.
• Required Reserve Ratio
The Fed decreases the rrr to increase the money supply:
A decrease in the rrr leads to an increase (or creation if at zero) in excess reserves, which
allow banks to give out more loans. Differently put, a decrease in the rrr increases the
money multiplier, thereby increasing the money supply.
The Fed increases the rrr to decrease the money supply:
An increase in the rrr will cause a decrease (or a shortage if at zero) in excess reserves,
which forces bank to recall some of their loans, or more generally to limit future loans,
which decreases the money supply (and the multiplier effect). This method is not widely
used by the Fed, because of the delay in its effect. However it is a powerful tool if there
are no excess reserves held by the banking system.
• The Discount Rate
Being the lender of last resort, the Fed provides funds to troubled banks that cannot find
any other source of funds, for a fee, called the discount rate. If the discount rate is higher
than the borrowing rate of the private market, the Fed can be said to be exerting moral
suasion on banks, pressuring them to discourage them to borrow heavily from the central
The Fed decreases the discount rate to increase the money supply, and increases the discount rate to decrease the money supply: The more a bank can borrow from the Fed, the
higher its reserves, and the higher its capacity to make loans. More loans means a creation
of money, and an increase in money supply, and vice versa.
• Open Market Operations
Open market operations are the purchase and sale by the Fed of government securities in
open market, which is a tool used to expand or contract the amount of reserves in the system and thus the money supply.
The Fed can buy government securities (IOUs) from the Treasury Department, which handles tax collection (T) and payment of government expenses (G). When there is a deficit (G
– T), the government finances the debt by issuing bills, bonds and notes that pay interest.
The Fed being a quasi-independent institution can buy these government securities.
When the Fed sells some of its securities to the public, the deposits and reserves of the
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banking system decrease (because the public pay for the securities with checks drawn on
their banks). The required reserve ratio is unchanged however, so a decrease in reserves
will cause banks to recall their loans or reduce the number of new loans. The money supply
will then decrease.
When the Fed buys government securities from the public, the deposits increase (because
the Fed pays the public), so the reserves increase, which creates excess reserves that can
be loaned out to borrowers, increasing the money supply. When the Fed buys government
securities from the public, the deposits increase (because the Fed pays the public), so the
reserves increase, which creates excess reserves that can be loaned out to borrowers, increasing the money supply.
An open market purchase of securities by the Fed results in an increase in reserves
and an increase in the supply of money by an amount equal to the money multiplier
times the change in reserves.
An open market sale of securities by the Fed results in a decrease in reserves and a
decrease in the supply of money by an amount equal to the money multiplier times
the change in reserves.
Money Supply
Supply and Demand in the Money Market
Equilibrium exists in the money market when the supply of money is equal to the demand for
money and thus when the supply of bonds is equal to the demand for bonds.
At r0 the price of bonds would be bid up (and thus the interest rate down).
At r1 the price of bonds would be bid down (and thus the interest rate up).
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Chapter 26 – The Determination of Aggregate Output, the
Price Level, and the Interest Rate
Aggregate Supply
• Aggregate supply: The total supply of all goods and services in an economy.
• Aggregate supply (AS) curve: A graph that shows the relationship between the aggregate
quantity of output supplied by all firms in an economy and the overall price level.
The Short-Run Aggregate Supply Curve:
• Slope: If all prices, including wages, are increasing at the same rate, then there would be no
output response. As prices rise, firms get more for their products and pay proportionately
more for workers. The AS curve would be vertical. However, wages are sticky, and do
not move at the same time as other prices. When wages lag prices, firms can respond to
the increase of the demand by raising prices and increasing output, because there is no
change in the marginal costs of the firm, which results in a positive-sloping AS curve, in an
imperfectly competitive economy. In a perfectly competitive economy, the output prices
are determined in the market, and firms decide how much to produce accordingly. When
demand increases, there will be an increase in output prices (due to the demand increase)
and to an increase in output, resulting also in a positive slope.
• Shape: When the economy is using all its capital and all the labor that wants to work at
the market wage, the aggregate output is at level Y*. An increase in demand (for goods
or labor) can only be met in an increase in prices, because the output cannot be further
increased. Wages and prices are not sticky at this level, and this results in a vertical shape.
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When the levels of output are low, firms are likely to have excess capacity in terms of
equipment and workforce, so an increase in demand can increase output with little increase
in prices, because there is no extra cost due to the excess. This results in a relatively flat
Supply Shock
A change in costs that shifts the short-run aggregate supply (AS) curve. An increase in wage rates
or energy prices decreases aggregate supply, shifting the AS curve to the left, whereas an decease
in wage rates or energy prices increases aggregate supply, shifting the AS curve to the right.
Planned Aggregate Expenditure and the Interest Rate
AE = C + I + G
As the interest rate rises (falls), I falls, thus total planned spending falls (rises) as well.
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IS curve
Relationship between aggregate output and the interest rate in the goods market.
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Behavior of The Fed
Output (Y) and inflation (P) are two main inputs into the Fed’s interest rate decision.
Fed rule Equation that shows how the Fed’s interest rate decision depends on the state of the
r = αY + βP + γZ
where Z includes economic factors (other than Y and P) that lie outside our model and are likely
to vary from period to period in ways that are hard to predict.
Aggregate Demand Curve
• The AD curve is not a market demand curve, and it is not the sum of all market demand
curves in the economy.
• Because many prices rise together when the overall price level rises, we cannot use the
ceteris-paribus assumption to draw the AD curve.
• AD falls when P increases because the higher P leads the Fed to raise r (to prevent inflation
probably by decrease MS), which decreases I and thus Y.
• The higher interest rate causes aggregate output to fall. AD curve slopes down because the
Fed raises the interest rate (r) when P increases and because I depends negatively on r. real
wealth effect on consumption also contributes to a downward-sloping AD curve.
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• real wealth effect: The change in consumption brought about by a change in real wealth
that results from a change in the price level.
Equilibrium between Aggregate Demand and Supply
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The Long Run Aggregate Supply Curve
Y0 represents the potential GDP, which is the level of aggregate output that can be sustained in
the long run without inflation. It is the physical limit where all plants are operating around the
clock, many workers are on overtime and there is no cyclical unemployment. Output can be
pushed above Y0, like in the vertical part of the short-run AS curve to the right of Y0, but it will
cause an upward pressure on wages. Wage rates will then rise shifting the short-run AS curve to
the left, driving the output back to Y0. When the short-run equilibrium occurs to the left of Y0,
there is a disagreement as to what will happen: some believe that output will rise to meet Y0,
others believe that wages will fall, shifting the AS curve to the right, causing the price level to
fall the level of aggregate output to rise back to Y0.
Potential GDP
• The vertical portion of the short-run AS curve exists because there are physical limits to
the amount that an economy can produce in any given time period.
• potential output, or potential GDP: The level of aggregate output that can be sustained in
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the long run without inflation.
Short-Run Equilibrium below Potential Output
Economists have different opinions on how to determine whether an economy is operating at or
above potential output.
Those who believe the AS curve is vertical in the long run believe that output will tend to rise
when wages fall with high unemployment.
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Chapter 27: Policy Effects and Cost Shocks in the AS/AD
• Whatever the motivations for particular macroeconomic policies, decisions made in the
political process about taxes and spending have important macroeconomic consequences.
• The AS/AD model developed in the last chapter allows us to explore these consequences.
Fiscal Policy Effects
• The level of net taxes (T) (i.e., taxes minus transfer payments) is an important fiscal policy
variable, along with government spending (G).
• Earlier, we learned that the tax multiplier is smaller in absolute value than is the government
spending multiplier.
• This chapter shows that both a decrease in net taxes and an increase in government spending
increase output (Y). Both result in a shift of the AD curve to the right.
Flat Portion
The economy is producing on the nearly flat part of the AS curve when most firms are producing
well below capacity. When this is the case, firms will respond to an increase in demand by
increasing output much more than they increase prices. When the economy is producing on the
steep part of the AS curve, firms are close to capacity and will respond to an increase in demand
by increasing prices much more than they increase output.
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Vertical Portion
The first thing that happens when G increases is an unanticipated decline in firms’ inventories.
Because firms are very close to capacity output when the economy is on the steep part of the
AS curve, they cannot increase their output very much. The result is a substantial increase in the
price level, which increases the demand for money, which (with a fixed money supply) leads to an
increase in the interest rate, decreasing planned investment. There is nearly complete crowding
out of investment. If firms are producing at capacity, prices and interest rates will continue to rise
until the increase in G is completely matched by a decrease in planned investment and there is
complete crowding out.
• If the shift in the AD curve is caused by a decrease in net taxes, it is consumption, not
government spending, that causes the crowding out of investment.
• When the economy is on the flat part of the AS curve, there is very little crowding out of
planned investment. Output expands to meet the increased demand.
• Because the price level increases very little, the Fed does not raise the interest rate much,
and so there is little change in planned investment.
Fiscal Policy Effects in the Long Run
• If wages adjust fully to match higher prices, then the long-run AS curve is vertical, and so
fiscal policy will have no effect on output.
• The key question is how fast wages adjust to changes in prices: comparison and contrast
(two opposite views)
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New classical economists believe that wage rate changes do not lag behind price changes,
thus a vertical AS curve even in the short run.
The simple “Keynesian” view is a kink in the AS curve at capacity output.
Monetary Policy Effects
The Fed’s Response to the Z Factors
• An increase in Z, such as an increase in consumer confidence, shifts the AD curve to the
left due to a tightening of monetary policy could also lead to crowding out.
• Monetary policy in the form of changes in Z has the same issues as does fiscal policy in
the form of changes in G and T.
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Chapter 28 - The Labor Market in the Macroeconomy
The Classical View of the Labor Market
Classical economists assumed that the labor market always cleared, meaning that the wage rate
adjusts to equate the quantity demanded with the quantity supplied, thereby implying that unemployment does not exist.
The labor demand curve is a graph that illustrates the amount of labor that firms want to employ at each given wage rate, in accordance with the desired level of output. The labor supply
curve is a graph that illustrates the amount of labor that households want to supply at each given
wage rate. The intersection of the two curves sets the equilibrium wage rates (that clear the market) at a specified employment rate.
The classical idea that wages adjust to clear the labor market is consistent with the view that
wages respond quickly to price changes.
In the absence of sticky wages, the AS curve will be vertical.
In this case, monetary and fiscal policy will have no effect on real output.
In this view, there is no unemployment problem to be solved!
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The unemployment rate and the classical view
Some classical economists believe that the unemployment rate does not really reflect if the labor
market is working poorly. The fact that some people want to work at a wage higher than the
current wage and will continue to look for a job that pays this (and fail) does not mean that the
labor market.
Explaining the existence of unemployment
Unemployment exists because wage rates do not completely adjust when the demand for labor
falls. Wage rates do not fall as far as needed, so there will be more people who wish to work at
the current wage rates than there are jobs for those people, and that is unemployment.
• Sticky Wages
Sticky wages refers to the downward rigidity of wages as an explanation for the existence
of unemployment. Wages do not fall when demand decreases, and this prevents the market
from being cleared. Some explanations to sticky wages are stated in what follows:
– Social, or implicit, contracts are unspoken agreements between workers and firms that
firms will not cut wages. Firms usually abide by this contract because wage cuts hurt
worker morale and reduce productivity, so cutting wages could turn out to be more
costly than not.
– relative-wage explanation of unemployment: An explanation for sticky wages (and
therefore unemployment): If workers are concerned about their wages relative to
other workers in other firms and industries, they may be unwilling to accept a wage
cut unless they know that all other workers are receiving similar cuts.
– Some other explicit contracts explain why wages are sticky. They are employment
contracts that stipulate workers’ wages, usually for a period of 1 to 3 years. This
guarantees that wages will not change due to economic fluctuations: in case of a
slowdown, wages will not fall, but some workers will be laid off. Firms sign these
contracts between wage negotiations are time costly and can reduce productivity, so a
period of 1 to 3 years will minimize negotiations costs and costs of locking workers.
– Cost-of-living adjustments (COLAs) are contract provisions that tie the wages to
changes in the cost of living. The greater the inflation rate, the more the wages are
raised. However, the increase in wages is usually smaller than the change in prices.
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• Efficiency Wage Theory: The efficiency wage theory states that the productivity of workers
increases with the wage rate. With this in mind, firms may have an incentive to pay wages
above the market-clearing rate. This will result in people who want to work at the wage
paid by firms but cannot find employment. The efficiency wage theory only works if the
wages offered by firms are above the market wage.
• Imperfect Information: Firms have imperfect information, or incomplete information. They
might set wages that simply do not clear the labor market, because they don’t know what
the exact market-clearing wage is. Even if firms try to adjust wages later on to the correct
market-clearing level, unemployment will persist because the labor market is complex and
constantly changing, so the market-clearing wages will take time to be determined after
they have been disturbed from equilibrium.
• Minimum wage: Minimum wage laws are laws that set a floor for wage rates – that is,
a minimum hourly rate for any kind of labor. If some groups of workers (low-skilled,
teenagers, immigrants) have a market- clearing wage that is lower than minimum wage
lows, they won’t be able to find jobs because no firm will hire them and pay them wages
that are lower than the output value they can produce.
The short-run relationship between the unemployment rate and inflation
When an event causes the aggregate demand to increase, firms experience an unanticipated decline in inventories. They respond by increasing output (Y) and hiring workers, the unemploy36
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ment rate falls. If the economy is not close to capacity, there will be little increase in the price
level. If, however, aggregate demand continues to row, the ability of the economy to increase
output will eventually reach its limit. As aggregate demand shifts farther and farther to the right
along the AS curve, the price level increases more and more and output begins to reach its limit.
At the point at which the AS curve becomes vertical, output cannot rise any farther. If output
cannot grow, the unemployment rate cannot be pushed any lower. There is a negative relationship between the unemployment rate and the price level. As the unemployment rate declines in
response to the economy’s moving closer and closer to capacity output, the overall price level
rises more and more.
The inflation rate, which is the percentage change in the price level, has a more important relationship with the unemployment rate. It is called the Phillips Curve.
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Aggregate Supply and Aggregate Demand Analysis and the Phillips
• The Philips Curve is smooth and stable if only the AD curve is shifting. If AD is shifting
to the right, and AS is not moving, the plot of the relationship between P and Y will be
upward sloping, so the relationship between the unemployment rate and the inflation rate
will be downward sloping.
• The Philips Curve is also smooth and stable if only the AS curve is shifting. If AS is
shifting to the left, and AD is not moving, the plot of the relationship between P and Y will
be downward sloping, so the relationship between the unemployment rate and the inflation
rate will be upward sloping.
• The Philips Curve is not smooth nor stable if both the AS and the AD curve are shifting, because there will be no systematic relationship between P and Y, so no systematic
relationship between unemployment and inflation rate.
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Price of imports: When the price of imports varies, such as the prices of energy and oil which
is imported, it causes a cost shock, and a shift of the AS curve. When the AS curve shifts at the
same time as the AD curve, it destabilizes the Philips curve that loses its shape.
Expectations and the Phillips Curve
Expectations also destabilize the Philips curve. Prices depend on expectations, because when
inflation is expected to be high, firms will increase the prices of their products, and also increase wage rates which in turn increase prices even more. If the rate of inflation depends on
expectations, the Phillips Curve will shift as expectations change. For example, if inflationary
expectations increase, the result will be an increase in the rate of inflation even though the unemployment rate may not have changed. In this case, the Phillips Curve will shift to the right.
If inflationary expectations decrease, the Phillips Curve will shift to the left—there will be less
inflation at any given level of the unemployment rate.
Inflation and Aggregate Demand
Inflation is affected by more than just aggregate demand. If, say, inflation is also affected by cost
variables like the price of imports, there will be no stable relationship between just inflation and
aggregate demand unless the cost variables are not changing. Similarly, if the unemployment rate
is taken to be a measure of aggregate demand, where inflation depends on both the unemployment
rate and cost variables, there will be no stable Phillips Curve unless the cost variables are not
changing. Therefore, the unemployment rate can have an important effect on inflation even
though this will not be evident from a plot of inflation against the unemployment rate—that is,
from the Phillips Curve.
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The Long-Run Aggregate Supply Curve, Potential Output, and the
Natural Rate of Unemployment
Those who believe that the AS curve is vertical in the long run also believe that the Phillips Curve
is vertical in the long run at the natural rate of unemployment. The natural rate is generally the
sum of the frictional and structural rates. If the Phillips Curve is vertical in the long run, then
there is a limit to how low government policy can push the unemployment rate without setting
off inflation.
The Nonaccelerating Inflation Rate of Unemployment (NAIRU)
In the long run, with a long-run vertical Phillips Curve, the actual unemployment rate moves to
U* because of the natural workings of the economy.
NAIRU: The nonaccelerating inflation rate of unemployment.
If the actual unemployment rate is below (above) the NAIRU, the change in the inflation rate will
be positive (negative).
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Chapter 32 – Alternative views in macroeconomics
Keynesian economics
In a broad sense, Keynesian economics is the foundation of modern macroeconomics. In a narrower sense, Keynesian refers to economists who advocate active government intervention in the
The monetarist analysis of the economy places a great deal of emphasis on the velocity of money,
which is defined as the number of times a dollar bill changes hands, on average, during the course
of a year. The velocity of money is the ratio of nominal GDP to the stock of money, defined by
the equation
P xY
V =
M xV = P xY
The quantity theory of money assumes that velocity is constant (or virtually constant). This
implies that changes in the supply of money will lead to equal percentage changes in nominal
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The quantity theory of money equation is
M xV̄ = P xY
The equation says that demand for money does not depend on the interest rate.
Most economists believe that sustained inflation is a purely monetary phenomenon. Inflation
cannot continue indefinitely unless the Fed “accommodates” it by expanding the money supply.
Most monetarists blame most of the instability in the economy on the federal government and are
skeptical of the government’s ability to manage the macroeconomy. They argue that the money
supply should grow at a rate equal to the average growth of real output (income) (Y)—the Fed
should expand the money supply to accommodate real growth but not inflation.
Supply-side economics
Supply-side economics focuses on incentives to stimulate supply. Supply-side economists believe that if we lower taxes, workers will work harder and save more and firms will invest more
and produce more. At their most extreme, supply-siders argue that incentive effects are likely to
be so great that a major cut in taxes will actually increase tax revenues.
The Laffer curve shows the relationship between tax rates and tax revenues. Supply-side economists
use it to argue that it is possible to generate higher revenues by cutting tax rates. This does not
appear to have been the case during the Reagan administration, however, where lower tax rates
decreased tax revenues significantly and contributed to the large increase in the federal debt during the 1980s.
New classical macroeconomics
New classical macroeconomics uses the assumption of rational expectations. The rational expectations hypothesis assumes that people know the “true model” that generates economic variables.
For example, rational expectations assumes that people know how inflation is determined in the
economy and use this model to forecast future inflation rates.
The Lucas supply function assumes that real output (Y) depends on the actual price level minus
the expected price level, or the price surprise. This function combined with the assumption that
expectations are rational implies that anticipated policy changes have no effect on real output.
Real business cycle theory is an attempt to explain business cycle fluctuations under the assumptions of complete price and wage flexibility and rational expectations. It emphasizes shocks to
technology and other shocks New Keynesian economics relaxes the assumption of complete price
and wage flexibility. There is usually a role for government policy in these models.
Testing alternative macroeconomic models
Economists disagree about which macroeconomic model is best for several reasons: (1) Macroeconomic models differ in ways that are hard to standardize; (2) when testing the rational- expectations assumption, we are never sure that whatever model is taken to be the true model is the
true one; and (3) the amount of data available is fairly small.