TOPIC 1: MEASURING A NATION’S
INCOME
WHAT IS MACROECONOMICS?

Macroeconomics is the study of the economy as a
whole, addresses many topical issues:






Why some countries are rich while many other are poor?
What policies might help poor countries grow out of
poverty?
Why does the cost of living keep rising?
Why are millions of people unemployed, even when the
economy is booming?
What causes recessions? Can the government do anything
to combat recessions?
Why does the country have such a huge trade deficit?
What is the government budget deficit? How does it affect
the economy?
WHAT IS MACROECONOMICS?

Macroeconomics deals with major issues of
Current output and long run economic growth
 Inflation
 Unemployment
 The effect of globalization upon the domestic
economy

GROSS DOMESTIC PRODUCT
Gross domestic product (GDP) is a measure of the
total output of an economy.
 GDP is the total market value of all final goods and
services produced within a country in a given period
of time.

GROSS DOMESTIC PRODUCT

“GDP is the Market Value . . .”


“. . . Of All. . .”


Includes all items produced in the economy and
legally sold in markets
“. . . Final . . .”


Output is valued at market prices.
It records only the value of final goods, not
intermediate goods.
“. . . Goods and Services . . .”

It includes both tangible goods (food, clothing, cars)
and intangible services (haircuts, art performing,
doctor visits).
GROSS DOMESTIC PRODUCT

“. . . Produced . . .”


“ . . . Within a Country . . .”


It includes goods and services currently produced,
not transactions involving goods produced in the
past.
It measures the value of production within the
geographic confines of a country.
“. . . In a Given Period of Time.”

It measures the value of production that takes place
within a specific interval of time, usually a year or a
quarter.
WHAT IS NOT COUNTED IN GDP?
Items that are produced and consumed at home
and that never enter the marketplace.
 Items produced and sold illicitly, such as illegal
drugs.
 Nonproduction transactions


Financial transactions




Public transfer payments
Private transfer payments
Stock market transactions
Secondhand sales
HOW TO MEASURE GDP?

There are 3 methods to measure GDP
Output method
 Expenditure method
 Income method

MEASUREMENT OF GDP BY OUTPUT METHOD

GDP is measured as sum of market value of all final
goods and services produced within a country in a
given period of time.
The value of the final goods already includes the value of
the intermediate goods, so including intermediate goods in
GDP would be double-counting.
 Use value added method to exclude intermediate goods.
 Value added is the market value of a firm’s output minus
the value of the intermediate goods the firm used to
produce that output.


GDP = value of final goods produced
= sum of value added at all stages of production
VALUE ADDED METHOD
Stage of
Sales Value of
Production
Materials or Product
Value Added
Firm A, Sheep ranch
$150
$150
Firm B, wool processor
$200
$50
Firm C, suit manufacturer
$270
$70
Firm D, retail clothier
$350
$80
Total value added
GDP = $350
$350
MEASUREMENT OF GDP BY EXPENDITURE
METHOD
GDP is measured as the total expenditure on
domestically produced final goods and services.
 GDP = C + I + G + NX

C: Household consumption
 I: Gross private domestic investment
 G: Government spending
 NX: Net exports

THE COMPONENTS OF GDP

Household consumption expenditures (C) is total
spending by households for goods and services,
with the exception of purchases of new housing.
Durable consumer goods: last a long time
ex: cars, home appliances …
 Nondurable consumer goods: last a short time
ex: food, clothing …
 Consumer expenditures for services: work done for
consumers
ex: dry cleaning, entertainment, air travel …

THE COMPONENTS OF GDP

Gross private domestic investment (I) is spending on
goods bought for future use including:
Purchases of machinery, equipment and tools by
business enterprises;
 Constructions such as commercial and residential
structures;
 Changes in business inventories.

THE COMPONENTS OF GDP

Government spending (G) is government
consumption and investment.
Government consumption: Expenditures for goods
and services that government consumes in providing
public services.
 Government investment: Expenditures for social
capital which have long lifetimes.
Note: Government transfer payments are excluded from
government spending because they are not made in
exchange for currently produced goods or services.


THE COMPONENTS OF GDP

Net exports (NX) is the difference between exports
and imports
Exports (X): are domestically produced goods and
services that are sold abroad.
 Imports (M): are foreign produced goods and
services that are consumed domestically.

NX = X – M
THE COMPONENTS OF GDP IN VIETNAM, 2016
SOURCE: WORLD BANK
MEASUREMENT OF GDP BY INCOME METHOD

GDP is measured as the total income earned by
domestically located factors of production.

GDP = Compensation of employees + Rents + Interests
+ Proprietors’ income + Corporate profits + Indirect
business taxes + Depreciation – Receipts of factor
income from overseas + Payments of factor income to
foreigners
REAL VERSUS NOMINAL GDP
 Nominal
GDP values the current production of
goods and services at current prices.
 Real GDP values the current production of
goods and services at constant prices.

Changes in nominal GDP can be due to
changes in prices
 changes in quantities of output produced


Changes in real GDP can only be due to changes
in quantities, because real GDP is constructed
using constant base-year prices.
EXAMPLE: REAL VERSUS NOMINAL GDP
Good
2010
2016
2017
Quantity
Price
Quantity
Price
Quantity
Price
Hotdog
250
$2
300
$3
400
$4
Hamburger
500
$5
600
$6
650
$6
GDP DEFLATOR
The GDP deflator is defined as the ratio of nominal
GDP to real GDP times 100.
 The GDP deflator tells us what portion of the rise in
nominal GDP that is attributable to a rise in prices
rather than a rise in the quantities produced.
 The GDP deflator reflects what’s happening to the
overall level of prices in the economy. It measures
the price of output relative to its price in the base
year.

NOMINAL GDP, REAL GDP AND GDP DEFLATOR
IN VIETNAM, 2016
SOURCE: WORLD BANK
Nominal GDP in 2016 (at 2016 price):
VND 4,502.7 trillion
 Real GDP in 2016 (at 2010 price):
VND 3,054.4 trillion
 The GDP deflator in 2016 is 147.

REAL GDP IN VIETNAM (TRILLION VND IN 2010 PRICE)
SOURCE: WORLD BANK
SHORTCOMINGS OF GDP
Nonmarket activities
 Leisure
 Improved product quality
 The underground economy
 GDP and the environment
 Composition and distribution of output
 Noneconomic sources of well-being

GDP, GNP AND GNI



Gross National Product (GDP) measures the value of
output produced in a country.
Gross National Product (GNP) measures the value of
output produced by the domestic residents’ owned
economic resources regardless of where they are
domiciled.
GNP = GDP + Net foreign factor incomes
= GDP + (Receipts of factor income from overseas
– Payments of factor income to foreigners)
Gross National Income (GNI) measures the total income
earned by a nation’s residents.
GNI = Compensation of employees + Rents + Interests +
Proprietors’ Income + Corporate Profits
TOPIC 2. INFLATION
INFLATION

Inflation exists when there is a sustained increase in the
economy’s general price level.



The economy’s general price level refers to the overall price of
all goods and services in the economy.
The inflation rate is the percentage change in the general
price level from the previous period.

If the inflation rate is positive: price level increases → inflation.

If the inflation rate is negative: price level decreases →
deflation.

If the inflation rate is zero: stale prices.
Disinflation occurs when the inflation rate decreases.
THE CONSUMER PRICE INDEX
The consumer price index (CPI) is used as a
measurement for the general price level.
 CPI is a measure of the overall cost of a basket of
goods and services bought by a typical household.

It is used to monitor changes in the cost of living over
time.
 When the CPI rises, the typical family has to spend
more dollars to maintain the same standard of living.

HOW THE CONSUMER PRICE INDEX IS
CALCULATED?
1. Fix the basket

Identifies a market basket of goods and services that
the typical household buys.
2. Compute the basket’s cost in base year.

Find the price of each of the goods and services in the
basket in base year and calculate the cost of the
basket.
3. Compute the basket’s cost in year t.

Find the price of each of the goods and services in the
basket in year t and calculate the cost of the basket in
that year.
HOW THE CONSUMER PRICE INDEX IS
CALCULATED?
4. Compute the index

Compute the index by dividing the cost of the basket
in year t by the cost of the basket in the base year
and multiplying by 100.
5. Compute the inflation rate

The inflation rate is the percentage change in the
consumer price index from the preceding period.
EXAMPLE: CALCULATING THE CONSUMER PRICE INDEX
AND THE INFLATION RATE
Basket of goods: 4 hotdogs and 2 hamburgers
 Prices of goods:
Year
Price of hotdogs
Price of hamburgers
2010
$1
$2
2016
$2
$3
2017
$3
$4

EXAMPLE: CALCULATING THE CONSUMER PRICE
INDEX AND THE INFLATION RATE
Base year is 2010.
 Basket of goods in 2010 costs $1,200.
 The same basket in 2017 costs $1,236.
 CPI = ($1,236/$1,200)  100 = 103.
 Prices increased 3% between 2010 and 2017.

PROBLEMS IN MEASURING THE COST OF
LIVING

The CPI is an accurate measure of the selected
goods that make up the typical bundle, but it is not
a perfect measure of the cost of living.
Substitution bias
 Introduction of new goods
 Unmeasured quality changes

PROBLEMS IN MEASURING THE COST OF
LIVING

Substitution bias
The basket does not change to reflect consumer
reaction to changes in relative prices.
 Consumers substitute toward goods that have
become relatively less expensive.
→ The CPI overstates the true cost of living by not
considering consumer substitution.

PROBLEMS IN MEASURING THE COST OF
LIVING

Introduction of new goods
The basket does not reflect the change in purchasing
power brought on by the introduction of new
products.
 New products result in greater variety, which in turn
makes each dollar more valuable.
 Consumers need fewer dollars to maintain any given
standard of living.
→ The CPI overstates the true cost of living.

PROBLEMS IN MEASURING THE COST OF
LIVING

Unmeasured quality changes
If the quality of a good rises from one year to the
next, the value of a dollar rises, even if the price of
the good stays the same → The CPI overstates the
true cost of living.
 If the quality of a good falls from one year to the next,
the value of a dollar falls, even if the price of the good
stays the same → The CPI understates the true cost
of living.

THE GDP DEFLATOR VERSUS THE
CONSUMER PRICE INDEX
Both consumer price index and GDP deflator can
be used to measure the general price level.
 There are two differences between the indexes that
can cause them to diverge.

THE GDP DEFLATOR VERSUS THE
CONSUMER PRICE INDEX
 The
GDP deflator reflects the prices of all
goods and services produced domestically,
whereas...
 …the consumer price index reflects the prices
of all goods and services bought by consumers.
THE GDP DEFLATOR VERSUS THE
CONSUMER PRICE INDEX
 The
GDP deflator compares the price of
currently produced goods and services to the
price of the same goods and services in the
base year, where as …
 … the consumer price index compares the
price of a fixed basket of goods and services to
the price of the basket in the base year.
TWO MEASURES OF INFLATION IN VIETNAM
SOURCE: ASIAN DEVELOPMENT BANK
CORRECTING ECONOMIC VARIABLES FOR THE
EFFECTS OF INFLATION
Price indexes are used to correct for the effects of
inflation when comparing dollar figures from different
times.
 Do the following to convert dollar values from year t
into today’s dollars:

Amount in
today’s
dollars
=
Amount in
year t’s dollars
Price level today
Price level in year t
THE MOST POPULAR MOVIES OF ALL TIMES,
INFLATION ADJUSTED
REAL AND NOMINAL INTEREST RATES
Interest represents a payment in the future for a
transfer of money in the past.
 The nominal interest rate is the interest rate usually
reported and not corrected for inflation.



It is the interest rate that a bank pays.
The real interest rate is the interest rate that is
corrected for the effects of inflation.
REAL AND NOMINAL INTEREST RATES IN VIETNAM
SOURCE: ASIAN DEVELOPMENT BANK
THE COSTS OF INFLATION
Shoeleather costs
 Menu costs
 Relative price variability
 Tax distortions
 Confusion and inconvenience
 Arbitrary redistribution of wealth

SHOELEATHER COSTS





Shoeleather costs are the resources wasted when inflation
encourages people to reduce their money holdings.
Inflation reduces the real value of money, so people have
an incentive to minimize their cash holdings.
Less cash requires more frequent trips to the bank to
withdraw money from interest-bearing accounts.
The actual cost of reducing your money holdings is the
time and convenience you must sacrifice to keep less
money on hand.
Also, extra trips to the bank take time away from
productive activities.
MENU COSTS
Menu costs are the costs of adjusting prices.
 During inflationary times, it is necessary to update
price lists and other posted prices.
 This is a resource-consuming process that takes
away from other productive activities.

RELATIVE-PRICE VARIABILITY AND THE
MISALLOCATION OF RESOURCES
Inflation distorts relative prices.
 Consumer decisions are distorted, and markets are
less able to allocate resources to their best use.

INFLATION-INDUCED TAX DISTORTION
The income tax treats the nominal interest earned
on savings as income, even though part of the
nominal interest rate merely compensates for
inflation.
 The after-tax real interest rate falls, making saving
less attractive.

CONFUSION AND INCONVENIENCE
Inflation erodes the real value of money. It causes
dollars at different times to have different real
values.
 Therefore, with rising prices, it is more difficult to
compare real revenues, costs, and profits over
time.

A SPECIAL COST OF UNEXPECTED INFLATION:
ARBITRARY REDISTRIBUTION OF WEALTH
Unexpected inflation redistributes wealth among the
population in a way that has nothing to do with
either merit or need.
 These redistributions occur because many loans in
the economy are specified in terms of the monetary
unit of account.

TOPIC 3: UNEMPLOYMENT
IDENTIFYING UNEMPLOYMENT

Categories of unemployment

The problem of unemployment is usually divided into
two categories, the long run problem and the short
run problem.
Long run problem: the natural rate of unemployment
 Short run problem: the cyclical rate of unemployment

HOW IS UNEMPLOYMENT MEASURED?

Natural rate of unemployment


The natural rate of unemployment is the
unemployment rate that exists when the economy is
at full employment output.
Cyclical unemployment
Cyclical unemployment refers to the year-to-year
fluctuations in unemployment around its natural rate.
 It is associated with short-term ups and downs of the
business cycle.

BUSINESS CYCLE
Business cycle refers to the ups and downs in the
level of economic activity. It shows how real output
fluctuates around its growth trend.
 A business cycle has four phases

Peak: the real output is at nearly maximum level, high
income, low unemployment, the price level is likely to
rise.
 Recession: a period of decline in total output, income,
employment and trade.
 Trough: the real output is at the lowest level, low
income, high unemployment.
 Recovery: a period of rising in total output, income,
employment and trade.

UNEMPLOYMENT RATE IN THE U.S. SINCE
1960
Percent of
Labor Force
10
Unemployment rate
8
6
Natural rate of
unemployment
4
2
0
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
HOW IS UNEMPLOYMENT MEASURED?
Unemployment is measured by the Bureau of Labor
Statistics.
 The total population is divided into 2 groups:

Children: people less than 16 years of ages
 Adult population: people at 16 years of ages and
over.



Not in labor force: adults who are potential workers but
are not employed nor seeking work.
Labor force: adults who are able and willing to work.
HOW IS UNEMPLOYMENT MEASURED?

Labor force
The labor force is the total number of workers,
including both the employed and the unemployed.
 Labor force = Employed + Unemployed

Employed: people who have paid jobs (employees and
self-employed workers).
 Unemployed: people who have no jobs but actively
seeking for job (new entrants, re-entrants, lost job, quit
job, laid off).

HOW IS UNEMPLOYMENT MEASURED?

The labor force participation rate is the percentage
of the adult population that is in the labor force.


Labor force participation rate =
(Labor force / Adult population) × 100%
The unemployment rate is the percentage of the
labor force that is unemployed.

Unemployment rate =
(Unemployed / Labor force) × 100%
LABOR FORCE PARTICIPATION RATES FOR MEN AND
WOMEN IN THE U.S. SINCE 1950
Labor force
participation rate
100
80
Men
60
40
Women
20
0
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
LABOR FORCE PARTICIPATION RATE AND UNEMPLOYMENT
RATE IN VIETNAM
SOURCE: WORLD BANK
LABOR STRUCTURE BY ECONOMIC SECTOR IN
VIETNAM, 2015
SOURCE: GSO
PROBLEMS IN MEASURING UNEMPLOYMENT

It is difficult to distinguish between a person who is
unemployed and a person who is not in the labor
force.
Discouraged workers: people who would like to work
but have given up looking for jobs after an
unsuccessful search, don’t show up in unemployment
statistics.
 Other people may claim to be unemployed in order to
receive financial assistance, even though they aren’t
looking for work.

ECONOMIC COSTS OF UNEMPLOYMENT
Individual cost
 Society cost
 Unequal burden







Occupation: low-skilled workers and high-skilled
workers
Age: teenagers and adults
Race and ethnicity
Gender: men and women
Education: less educated and more educated workers
Duration
FRICTIONAL UNEMPLOYMENT

Frictional unemployment refers to the unemployment
that results from the time that it takes to match workers
with jobs.


In other words, it takes time for workers to search for the
jobs that are best suit their tastes and skills.
Workers are “between jobs”
Some workers quit their current jobs to find better ones.
 Some workers have been fired and are seeking reemployment.
 Some workers are temporarily laid of because of changes in
seasonal demand.
 Workers first enter the labor force and searching for their first
jobs.



Frictional unemployment consists of search unemployment
and wait unemployment.
Frictional unemployment is inevitable but desirable.
JOB SEARCH
Job search is the process by which workers find
appropriate jobs given their tastes and skills.
 It results from the fact that it takes time for qualified
individuals to be matched with appropriate jobs.
 Unemployment is caused by the time spent
searching for the “right” job.

WHY SOME FRICTIONAL UNEMPLOYMENT IS
INEVITABLE?
Search unemployment is inevitable because the
economy is always changing.
 Changes in the composition of demand among
industries or regions are called sectoral shifts.
 It takes time for workers to search for and find jobs
in new sectors.

PUBLIC POLICY AND JOB SEARCH
Government programs can affect the time it takes
unemployed workers to find new jobs.
 These programs include the following:

Government-run employment agencies
 Public training programs
 Unemployment insurance

PUBLIC POLICY AND JOB SEARCH
Government-run employment agencies give out
information about job vacancies in order to match
workers and jobs more quickly.
 Public training programs aim to ease the transition
of workers from declining to growing industries and
to help disadvantaged groups escape poverty.

PUBLIC POLICY AND JOB SEARCH
Unemployment insurance is a government program
that partially protects workers’ incomes when they
become unemployed.
 Offers workers partial protection against job losses.
 Offers partial payment of former wages for a limited
time to those who are laid off.

PUBLIC POLICY AND JOB SEARCH

Unemployment insurance
increases the amount of search unemployment.
 reduces the search efforts of the unemployed.
 may improve the chances of workers being matched
with the right jobs.

STRUCTURAL UNEMPLOYMENT
Structural unemployment is the unemployment that
results because the number of jobs available in
some labor markets is insufficient to provide a job
for everyone who wants one.
 It occurs when the quantity of labor supplied
exceeds the quantity demanded.
 Why is there structural unemployment?

Minimum wage laws
 Unions
 Efficiency wages

MINIMUM WAGE LAWS

When the minimum wage is set above the level that
balances supply and demand, it creates
unemployment.
FIGURE 5. UNEMPLOYMENT FROM A WAGE ABOVE THE
EQUILIBRIUM LEVEL
Wage
Labor
supply
Surplus of labor =
Unemployment
Minimum
wage
WE
Labor
demand
0
LD
LE
LS
Quantity of
Labor
UNION AND COLLECTIVE BARGAINING
A union is a worker association that bargains with
employers over wages, benefits and working
conditions.
 A union is a type of cartel attempting to exert its
market power.
 The process by which unions and firms agree on
the terms of employment is called collective
bargaining.

UNION AND COLLECTIVE BARGAINING
A strike will be organized if the union and the firm
cannot reach an agreement.
 A strike occurs when the union organizes a
withdrawal of labor from the firm.
 A strike makes some workers better off and other
workers worse off.
 Workers in unions (insiders) reap the benefits of
collective bargaining, while workers not in the union
(outsiders) bear some of the costs.

THE THEORY OF EFFICIENCY WAGES
Efficiency wages are above equilibrium wages paid
by firms in order to increase worker productivity.
 The theory of efficiency wages states that firms
operate more efficiently if wages are above the
equilibrium level.

THE THEORY OF EFFICIENCY WAGES

A firm may prefer higher than equilibrium wages for
the following reasons:
Worker health: Better paid workers eat a better diet
and thus are more productive.
 Worker turnover: A higher paid worker is less likely to
look for another job.
 Worker quality: Higher wages attract a better pool of
workers to apply for jobs.
 Worker effort: Higher wages motivate workers to put
forward their best effort.

TOPIC 4. PRODUCTION AND GROWTH
PRODUCTION AND GROWTH
A country’s standard of living is measured by real
GDP per person.
 Within a country there are large changes in the
standard of living over time.
 Among countries, there are significant variation in
living standards.

ECONOMIC GROWTH IN SOME COUNTRIES
THE GROWTH RATE OF REAL GDP, POPULATION AND REAL
GDP PER CAPITA IN VIETNAM, 1986-2016
SOURCE: WORLD BANK
PRODUCTIVITY: ITS ROLE AND DETERMINANTS
A country’s standard of living depends on its ability
to produce goods and service or the productivity of
its workers.
 Productivity refers to the amount of goods and
services that a worker can produce from each hour
of work.
 Productivity plays a key role in determining living
standards for all nations in the world.

PRODUCTIVITY: ITS ROLE AND DETERMINANTS
To understand the large differences in living standards
across countries, we must focus on the production of
goods and services.
 The inputs used to produce goods and services are
called the factors of production.
 The factors of production directly determine productivity.
 The factors of production

Physical capital
 Human capital
 Natural resources
 Technological knowledge

PRODUCTIVITY: ITS ROLE AND DETERMINANTS




Physical capital: is the stock of equipment and
structures that are used to produce goods and
services such as tools, equipment, machinery,
factories, buildings, roads …
Human capital: is the knowledge and skills that
workers acquire through education, training, and
experience.
Natural resources: inputs used in production that are
provided by nature, such as land, rivers, and mineral
deposits.
Technological knowledge: society’s understanding of
the best ways to produce goods and services.
THE PRODUCTION FUNCTION

Economists often use an aggregate production
function to describe the relationship between the
quantity of inputs used in production and the
quantity of output from production.
THE PRODUCTION FUNCTION

Y = A F(L, K, H, N)







Y = quantity of output
A = available production technology
L = quantity of labor
K = quantity of physical capital
H = quantity of human capital
N = quantity of natural resources
F( ) is a function that shows how the inputs are
combined.
THE PRODUCTION FUNCTION

Production function with constant returns to scale
Y/ L = A F(1, K/ L, H/ L, N/ L)
Where:
Y/L = output per worker
K/L = physical capital per worker
H/L = human capital per worker
N/L = natural resources per worker
ECONOMIC GROWTH AND PUBLIC POLICY

Government policies that raise productivity and
living standards






Encourage saving and investment.
Encourage investment from abroad
Encourage education and training.
Establish secure property rights and maintain political
stability.
Promote free trade.
Promote research and development.
FOREIGN INVESTMENT
Governments can increase capital accumulation
and long term economic growth by encouraging
investment from foreign sources.
 Investment from abroad takes several forms:

Foreign Direct Investment: capital investment owned
and operated by a foreign entity.
 Foreign Portfolio Investment: investments financed
with foreign money but operated by domestic
residents.

EDUCATION
For a country’s long run growth, education is at
least as important as investment in physical capital.
 An educated person might generate new ideas
about how best to produce goods and services,
which in turn, might enter society’s pool of
knowledge and provide an external benefit to
others.
 One problem facing some poor countries is the
brain drain - the emigration of many of the most
highly educated workers to rich countries.

PROPERTY RIGHTS AND POLITICAL STABILITY

Property rights refer to the ability of people to
exercise authority over the resources they own.
An economy-wide respect for property rights is an
important prerequisite for the price system to work.
 It is necessary for investors to feel that their
investments are secure.

FREE TRADE
Trade is, in some ways, a type of technology.
 A country that eliminates trade restrictions will
experience the same kind of economic growth that
would occur after a major technological advance.

RESEARCH AND DEVELOPMENT

The advance of technological knowledge has led to
higher standards of living.
Most technological advance comes from private
research by firms and individual inventors.
 Government can encourage the development of new
technologies through research grants, tax breaks,
and the patent system.

POPULATION GROWTH
Economists and other social scientists have long
debated how population growth affects a society.
 Population growth interacts with other factors of
production:

Stretching natural resources
 Diluting the capital stock
 Promoting technological progress

TOPIC 5: SAVING, INVESTMENT AND
THE FINANCIAL SYSTEM
THE MEANING OF SAVING AND INVESTMENT
TO ECONOMIC GROWTH
Stock of physical capital determines economic
growth.
 Investment increases the stock of physical capital.
 Saving provides the sources of funds for
investment.

Savers are those people whose incomes exceed their
consumption.
 Borrowers are firms that borrow money to make their
investment.

SAVING, INVESTMENT, AND THE FINANCIAL
SYSTEM
The financial system consists of the group of
institutions in the economy that help to match one
person’s saving with another person’s investment. It
moves the economy’s scarce resources from
savers to borrowers.
 Financial institutions can be grouped into two
different categories:

Financial markets
 Financial intermediaries

FINANCIAL INSTITUTIONS

Financial markets are the institutions through which
savers can directly provide funds to borrowers.



Stock market
Bond market
Financial intermediaries are financial institutions
through which savers can indirectly provide funds to
borrowers.


Banks
Mutual Funds
FINANCIAL MARKETS

The Bond Market


A bond is a certificate of indebtedness that specifies
obligations of the borrower to the holder of the bond.
Characteristics of a Bond
Term: The length of time until the bond matures.
 Credit Risk: The probability that the borrower will fail to pay
some of the interest or principal.
 Tax Treatment: The way in which the tax laws treat the interest
on the bond.
 Municipal bonds are federal tax exempt.

FINANCIAL MARKETS

The Stock Market
Stock represents a claim to partial ownership in a firm
and is therefore, a claim to the profits that the firm
makes.
 The sale of stock to raise money is called equity
financing.


Compared to bonds, stocks offer both higher risk and
potentially higher returns.
FINANCIAL MARKETS

The Stock Market

Most newspaper stock tables provide the following
information:




Price (of a share)
Volume (number of shares sold)
Dividend (profits paid to stockholders)
Price-earnings ratio
FINANCIAL INTERMEDIARIES

Banks
A bank is a financial intermediary that takes deposits
from people who want to save and use the deposits
to make loans to people who want to borrow.
 It pays depositors interest on their deposits and
charges borrowers higher interest on their loans.

FINANCIAL INTERMEDIARIES

Mutual Funds
A mutual fund is an institution that sells shares to the
public and uses the proceeds to buy a portfolio, of
various types of stocks, bonds, or both.
 Mutual funds allow people with small amounts of
money to easily diversify.

SAVING AND INVESTMENT IN THE NATIONAL
INCOME ACCOUNT




For an open economy:
Y = C + I + G + NX
For a closed economy: the economy does not engage in
international trade:
Y=C+I+G
National saving is equal to:
S=Y–C–G
S = (Y – T – C) + (T – G)
For the economy as a whole, saving must be equal to
investment.
S=I
SAVING AND INVESTMENT

National saving


Private saving



National saving is the total income in the economy that
remains after paying for consumption and government
purchases.
Private saving is the amount of income that households have
left after paying their taxes and paying for their consumption.
Private saving = (Y – T – C)
Public saving


Public saving is the amount of tax revenue that the
government has left after paying for its spending.
Public saving = (T – G)
SAVING AND INVESTMENT

Government budget
If T > G, the government runs a budget surplus
because it receives more money than it spends.
 The surplus of T - G represents public saving.
 If T < G, the government runs a budget deficit
because it spends more money than it receives in tax
revenue.
 If T = G, the government runs a balanced budget.

THE MARKET FOR LOANABLE FUNDS
Financial markets coordinate the economy’s saving and
investment in the market for loanable funds.
 The market for loanable funds is the market in which
those who want to save supply funds and those who
want to borrow to invest demand funds.

SUPPLY AND DEMAND FOR LOANABLE FUNDS
Loanable funds refers to all income that people
have chosen to save and lend out, rather than use
for their own consumption.
 The supply of loanable funds comes from people
who have extra income they want to save and lend
out.
 The demand for loanable funds comes from
households and firms that wish to borrow to make
investments.

SUPPLY AND DEMAND FOR LOANABLE FUNDS

Interest rate
the price of the loan
 the amount that borrowers pay for loans and the
amount that lenders receive on their saving

Financial markets work much like other markets in
the economy.
 The equilibrium of the supply and demand for
loanable funds determines the real interest rate.

THE MARKET FOR LOANABLE FUNDS
Interest
Rate
S
Equilibrium
Interest
rate
I
0
Equilibrium
quantity of lf
Quantity of Loanable
Funds
HOW POLICIES AFFECT THE LOANABLE
FUNDS MARKET
Taxes and saving
 Taxes and investment
 Government budget deficits and surpluses

POLICY 1: SAVING INCENTIVES
Taxes on interest income substantially reduce the
future payoff from current saving and, as a result,
reduce the incentive to save.
 A tax decrease increases the incentive for
households to save at any given interest rate.

The supply of loanable funds curve shifts right.
 The equilibrium interest rate decreases.
 The quantity demanded for loanable funds increases.

AN INCREASE IN THE SUPPLY OF LOANABLE FUNDS
Interest
Rate
S1
S2
1. Tax incentives for
saving increase the
supply of loanable
funds . . .
5%
4%
2. . . . which
reduces the
equilibrium
interest rate . . .
I
0
$1,200
$1,600
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
POLICY 2: INVESTMENT INCENTIVES
An investment tax credit increases the incentive to
borrow.
 Increases the demand for loanable funds.
 Shifts the demand curve to the right.
 Results in a higher interest rate and a greater
quantity saved.

INVESTMENT INCENTIVES INCREASE THE DEMAND FOR
LOANABLE FUNDS
Interest
Rate
S
1. An investment
tax credit
increases the
demand for
loanable fund s . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
0
I2
I1
$1,200
$1,400
3. . . . and raises the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
POLICY 3: GOVERNMENT BUDGET DEFICITS
AND SURPLUSES
When the government spends more than it receives
in tax revenues, the short fall is called the budget
deficit.
 Government budget deficit reduces national saving
which in turns reduces the supply of loanable funds
available to finance investment by households and
firms.
 This fall in investment is referred to as crowding
out.


The deficit borrowing crowds out private borrowers
who are trying to finance investments.
POLICY 3: GOVERNMENT BUDGET DEFICITS
AND SURPLUSES
A budget deficit decreases the supply of loanable
funds.
 Shifts the supply curve to the left.
 Increases the equilibrium interest rate.
 Reduces the equilibrium quantity of loanable funds.

THE EFFECT OF A GOVERNMENT BUDGET DEFICIT
Interest
Rate
S2
S1
1. A budget deficit
decreases the
supply of loanable
funds . . .
6%
5%
2. . . . which
raises the
equilibrium
interest rate . . .
I
0
$800
$1,200
3. . . . and reduces the equilibrium
quantity of loanable funds.
Loanable Funds
(in billions of dollars)
POLICY 3: GOVERNMENT BUDGET DEFICITS
AND SURPLUSES
A budget deficit decreases the supply of loanable
funds, raises the interest rate, and dicourages
investment.
 A budget surplus increases the supply of loanable
funds, reduces the interest rate, and stimulates
investment.

TOPIC 6: THE MONETARY SYSTEM
MONEY: DEFINITION
Money is the stock
of assets that can be
readily used to make
transactions.
THE FUNCTIONS OF MONEY

Money is an asset that performs the 3 basic
functions:
Medium of exchange: It is readily acceptable as
payment, is usable for buying and selling goods and
services.
 Unit of account: monetary units are used as yardstick
for measuring the relative worth of a wide variety of
goods, services and resources.
 Store of value: It enables people to transfer
purchasing power from the present to the future.

THE KINDS OF MONEY

Commodity money takes the form of a commodity
with intrinsic value.


Examples: gold, silver, precious mental.
Fiat money is used as money because of
government decree.
It does not have intrinsic value.
 Examples: coins and notes.

SUPPLY OF MONEY
The money supply is the quantity of money
available in the economy.
 Monetary base Mo: currency (notes and coins)
issued by the Central Bank.
 Money supply M1 = Currency circulated in public +
Demand deposits
 Money supply M2 = Money supply M1 + Saving
deposits + Small time deposits + Money market
mutual funds

MONEY SUPPLY MEASURES IN VIETNAM (IN BILLION
VND), 2016
SOURCE: ASIAN DEVELOPMENT BANK
8
THE BANKING SYSTEM

The banking system has 2 layers: the Central Bank
and commercial banks.
The Central Bank is designed to oversee the banking
system and regulates the quantity of money in the
economy.
 Commercial banks are financial intermediaries that
perform two basic functions: accept deposits of
money and make loans.

THE BALANCE SHEET OF A COMMERCIAL BANK

The balance sheet of a commercial bank is a
statement of assets and liabilities that summarizes
the financial position of the bank at a certain time.
Assets: things that the bank owns or owed by others.
 Liabilities: things that the bank owes or owned by
others.


The balance sheet must balance
Assets = Liabilities
THE BALANCE SHEET OF A COMMERCIAL BANK
Reserves are the cash that the banks keep.
 The required reserve ratio is the minimum fraction
of deposits that banks are required to keep as
reserves.
 In a fractional-reserve banking system, banks hold
a fraction of the money deposited as reserves and
lend out the rest.

THE BALANCE SHEET OF A COMMERCIAL BANK
Actual reserves (AR): amount of cash that the bank
actually keeps.
 Required reserves (RR): amount of cash that the
bank is required to keep.
 Excess reserves (ER): amount of cash that the
bank keeps beyond its required level.
ER = AR - RR
 Whenever the bank has excess reserves, it can
make a loan of up to its excess reserves.
Loan = ER

THE BALANCE SHEET OF A COMMERCIAL BANK

This T-Account shows a
bank that…
accepts deposits,
 keeps a portion
as reserves,
 and lends out
the rest.


It assumes a
reserve ratio
of 10%.
First National Bank
Assets
Reserves
$10.00
Liabilities
Deposits
$100.00
Loans
$90.00
Total Assets
$100.00
Total Liabilities
$100.00
HOW BANKS CREATE MONEY?

Banks create money by making loans.
When a person deposits money into a bank, the bank
has excess reserve and can make a loan of up to its
excess reserve.
 When the bank makes a loan, the money supply
increases by the amount of the loan.
 When the bank loans money, that money may be
deposited into another bank → Another bank has
excess reserve and can make a loan.
 This process keeps going: creates more deposits and
more reserves to be lent out.


How much money that the banking system can
create from an initial deposit?
THE BANKING SYSTEM: MULTIPLE-DEPOSIT
EXPANSION

The banking system’s lending potential
The reserve ratio for all commercial banks is 20%.
 Initially all banks are meeting this 20% reserve
requirement exactly. No excess reserves exist.
 Suppose a person deposits $100 in Bank A.

BALANCE SHEET: BANK A

Entry 1: Customer deposits $100
Assets
Reserves

Liabilities
$100
Checkable deposits
$100
Entry 2: A loan is made
Assets
Liabilities
Reserves
$20
Loan
$80
Checkable deposits
$100
BALANCE SHEET: BANK B
Entry 1: Acquires the deposits of $80
Assets
Liabilities
Reserves
$80
Checkable deposits

Entry 2: A loan is made
Assets
Reserves
$16
Loan
$64
$80

Liabilities
Checkable deposits
$80
BALANCE SHEET: BANK C
Entry 1: Acquires the deposits of $64
Assets
Liabilities
Reserves
$64 Checkable deposits

Entry 2: A loan is made
Assets
Reserves
$12.8
Loan
$51.2
$64

Liabilities
Checkable deposits
$115.2
EXPANSION OF THE MONEY SUPPLY BY
THE COMMERCIAL BANKING SYSTEM
Bank
Bank A
Bank B
Bank C
Bank D
Bank E
Bank F
Bank G
…..
Acquire reserves
and deposits
$100
80
64
51.2
40.96
32.77
26.21
Required
reserves
$20
16
12.8
10.24
8.19
6.55
5.24
Total amount of money created
Excess
reserve
Loans
$80
64
51.2
40.96
32.77
26.21
20.97
$80
64
51.2
40.96
32.77
26.21
20.97
$400
THE MONEY MULTIPLIER
The money multiplier is the amount of money the
banking system generates with each dollar of
reserves.
 The money multiplier is the reciprocal of the
required reserve ratio:
Money multiplier = 1/ Required reserve ratio

HOW BANKS CREATE MONEY?
Initial deposit: D0
 Required reserve ratio: r
 Initial excess reserve = (1- r) × D0
 Total loans that the banking system can make =
Initial excess reserve × Money multiplier =
(1- r) × D0 × (1/r)
 Total money created by banks = Total loans that
the banking system can make

HOW BANKS CREATE MONEY?
Total loans created
= Initial excess × Money
by the banking system
reserves
multiplier


If the required reserve ratio of 50%, $100 in cash
deposited would allow the banking system to create
maximum loans of
Total loans = 50 x (1/0.5) = $100
If the required reserve ratio of 5%, $100 in cash
deposited would allow the banking system to create
maximum loans of
Total loans = 95 x (1/0.05) = $1900
THE CENTRAL BANK

The roles of the Central Bank
Issue currency
 Acts as a banker to banks




Hold reserves of commercial banks
Clearing checks among banks
Lender of the last resort
Acts a banker to government
 Supervise and regulate banks
 Control the money supply

THE CENTRAL BANK’S TOOLS OF MONETARY
CONTROL

The Central Bank has three monetary instruments
Open market operations Nghiep vu thi truong mo
 Changing the reserve requirement
 Changing the discount rate

THE CENTRAL BANK’S TOOLS OF MONETARY
CONTROL

Open market operations

The Central Bank conducts open market operations
when it buys government bonds from or sells
government bonds to the public.


When the Central Bank sells government bonds, the
money supply decreases.
When the Central Bank buys government bonds, the
money supply increases.
THE CENTRAL BANK’S TOOLS OF MONETARY
CONTROL

Changing the reserve requirements

The required reserve ratio is the minimum fraction of
deposits that banks are required to keep as reserves.


When the Central Bank lowers the required reserve
ratio, money supply increases.
When the Central Bank raises the required reserve ratio,
money supply decreases.
THE CENTRAL BANK’S TOOLS OF MONETARY
CONTROL

Changing the discount rate

The discount rate is the interest rate the Central Bank
charges banks for loans.


When the Central Bank lowers the discount rate, money
supply increases.
When the Central Bank raises the discount rate, money
supply decreases.
PROBLEMS IN CONTROLLING THE MONEY
SUPPLY
The Central Bank’s control of the money supply is
not precise.
 The Central Bank must wrestle with two problems
that arise due to fractional-reserve banking.

The Central Bank does not control the amount of
money that households choose to hold as deposits in
banks.
 The Central Bank does not control the amount of
money that bankers choose to lend.

TOPIC 7: AGGREGATE DEMAND AND
AGGREGATE SUPPLY
THREE KEY FACTS ABOUT ECONOMIC
FLUCTUATIONS
 Fluctuations
in the economy are often called the
business cycle.



Economic fluctuations are irregular and
unpredictable.
Most macroeconomic variables fluctuate together.
As output falls, unemployment rises.
SHORT RUN ECONOMIC FLUCTUATIONS
(a) Real GDP
Billions of
2000 Dollars
$10,000
9,000
8,000
7,000
Real GDP
6,000
5,000
4,000
3,000
2,000
1965
1970
1975
1980
1985
1990
1995
2000
2005
SHORT RUN ECONOMIC FLUCTUATIONS
(b) Investment Spending
Billions of
2000 Dollars
$1,500
1,000
Investment
Spending
500
0
1965
1970
1975
1980
1985
1990
1995
2000
2005
SHORT RUN ECONOMIC FLUCTUATIONS
(c) Unemployment Rate
Percent of
Labor Force
12%
10
Unemployment
Rate
8
6
4
2
1965
1970
1975
1980
1985
1990
1995
2000
2005
THE MODEL OF AGGREGATE DEMAND AND
AGGREGATE SUPPLY
Economist use the model of aggregate demand and
aggregate supply to explain short run fluctuations in
economic activity around its long run trend.
 Two variables are used to develop a model to
analyze the short run fluctuations.

The economy’s output of goods and services
measured by real GDP.
 The average level of prices measured by the CPI or
the GDP deflator.

THE MODEL OF AGGREGATE DEMAND AND
AGGREGATE SUPPLY
The aggregate demand curve shows the total
output of goods and services that all sectors of the
economy want to buy at each price level.
 The aggregate supply curve shows the total output
of goods and services that firms choose to produce
and sell at each price level.

THE AGGREGATE DEMAND CURVE

The four components of GDP contribute to the
aggregate demand for goods and services.
AD = C + I + G + NX
THE AGGREGATE DEMAND CURVE
Price
Level
P
P2
1. A decrease
in the price
level . . .
0
Aggregate
demand
Y
Y2
2. . . . increases the quantity of
goods and services demanded.
Quantity of
Output
WHY THE AGGREGATE DEMAND CURVE IS
DOWNWARD SLOPING?

The wealth effect

The price level and consumption
A lower price level raises the real value of money and
makes consumers wealthier, which encourages them to
spend more.
 This increase in consumer spending means a larger
quantity of goods and services demanded.

WHY THE AGGREGATE DEMAND CURVE IS
DOWNWARD SLOPING?

The interest rate effect

The price level and investment
A lower price level reduces the interest rate and makes
borrowing less expensive, which encourages greater
spending on investment goods.
 This increase in investment spending means a larger
quantity of goods and services demanded.

WHY THE AGGREGATE DEMAND CURVE IS
DOWNWARD SLOPING?

The exchange rate effect

The price level and net exports
A lower price level causes the domestic goods become
relatively cheaper compared to foreign goods which stimulates
the net exports.
 The increase in net export spending means a larger quantity of
goods and services demanded.

WHY THE AGGREGATE DEMAND CURVE
MIGHT SHIFT?

Shifts in aggregate demand curve might arise from
changes in:
Consumption
 Investment
 Government purchases
 Net exports

THE AGGREGATE SUPPLY CURVE
In the long run, the aggregate supply curve is
vertical because the price level does not affect long
run determinants of real GDP.
 In the short run, the aggregate supply curve is
upward sloping.

THE LONG RUN AGGREGATE SUPPLY
CURVE


In the long run, an economy’s production of goods and
services depends on its supplies of labor, capital, and
natural resources and on the available technology used
to turn these factors of production into goods and
services.
The long run aggregate supply curve is vertical at the
natural rate of output, which is the production of goods
and services that an economy achieves in the long run
when unemployment is at its normal rate.

This level of production is also referred to as potential
output or full employment output.
THE LONG RUN AGGREGATE SUPPLY CURVE
Price
Level
Long-run
aggregate
supply
P
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level . . .
0
Natural rate
of output
Quantity of
Output
WHY THE LONG RUN AGGREGATE SUPPLY
CURVE MIGHT SHIFT?
Any change in the economy that alters the natural
rate of output shifts the long run aggregate supply
curve.
 Shifts might arise from changes in:

Labor
 Capital
 Natural resources
 Technological knowledge

THE SHORT RUN AGGREGATE SUPPLY
CURVE
In the short run, an increase in the overall level of
prices in the economy tends to raise the quantity of
goods and services supplied.
 A decrease in the level of prices tends to reduce the
quantity of goods and services supplied.
 As a result, the short run aggregate supply curve is
upward sloping.

THE SHORT RUN AGGREGATE SUPPLY CURVE
Price
Level
Short-run
aggregate
supply
P
P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.
1. A decrease
in the price
level . . .
0
Y2
Y
Quantity of
Output
WHY THE AGGREGATE SUPPLY CURVE
SLOPES UPWARD IN THE SHORT RUN?

The Sticky Wage Theory
Nominal wages are slow to adjust to changing
economic conditions, or are “sticky” in the short run
 Nominal wages do not adjust immediately to a fall in
the price level. A lower price level makes employment
and production less profitable.
 This induces firms to reduce the quantity of goods
and services supplied.

WHY THE AGGREGATE SUPPLY CURVE
SLOPES UPWARD IN THE SHORT RUN?

The theory suggests that output deviates in the
short run from the natural rate when the actual price
level deviates from the price level that people had
expected to prevail.
Quantity
of output
supplied
=
Natural
rate of
output
+
a
Actual
price level
Expected
price level
WHY THE SHORT RUN AGGREGATE SUPPLY
CURVE MIGHT SHIFT?

Shifts might arise from changes in:






Labor
Capital
Natural resources
Technology
Expected price level
Per unit cost of production
WHY THE AGGREGATE SUPPLY CURVE MIGHT
SHIFT?
An increase in the expected price level reduces the
quantity of goods and services supplied and shifts
the short run aggregate supply curve to the left.
 A decrease in the expected price level raises the
quantity of goods and services supplied and shifts
the short run aggregate supply curve to the right.

THE LONG RUN EQUILIBRIUM
Price
Level
Long-run
aggregate
supply
Short-run
aggregate
supply
A
Equilibrium
price
Aggregate
demand
0
Natural rate
of output
Quantity of
Output
TWO CAUSES OF ECONOMIC FLUCTUATIONS

Shifts in aggregate demand
In the short run, shifts in aggregate demand cause
fluctuations in the economy’s output of goods and
services.
 In the long run, shifts in aggregate demand affect the
overall price level but do not affect output.
 Policymakers who influence aggregate demand can
potentially mitigate the severity of economic
fluctuations.

A CONTRACTION IN AGGREGATE DEMAND
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
TWO CAUSES OF ECONOMIC FLUCTUATIONS

Shifts in aggregate supply

Consider an adverse shift in aggregate supply





A decrease in one of the determinants of aggregate supply
shifts the curve to the left.
Output falls below the natural rate of employment.
Unemployment rises.
The price level rises.
Adverse shifts in aggregate supply cause stagflation - a
period of recession and inflation.
AN ADVERSE SHIFT IN AGGREGATE SUPPLY
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
Y2
2. . . . causes output to fall . . .
Y
Quantity of
Output
TOPIC 8: THE INFLUENCE OF MONETARY
AND FISCAL POLICY ON AGGREGATE
DEMAND
THE THEORY OF LIQUIDITY PREFERENCE
Keynes developed the theory of liquidity preference
in order to explain what factors determine the
economy’s interest rate.
 According to the theory, the interest rate adjusts to
balance the supply and demand for money.
 Liquidity preference theory attempts to explain both
nominal and real rates by holding constant the rate
of inflation.

THE THEORY OF LIQUIDITY PREFERENCE

Money Supply

The money supply is controlled by the Central Bank
through



Open market operations
Changing the reserve requirements
Changing the discount rate
Because it is fixed by the Central Bank, the quantity of
money supplied does not depend on the interest rate.
 The fixed money supply is represented by a vertical
supply curve.

THE THEORY OF LIQUIDITY PREFERENCE

Money Demand






Money demand is determined by several factors.
According to the theory of liquidity preference, one of
the most important factors is the interest rate.
People choose to hold money instead of other
interest earning assets because money can be used
to buy goods and services.
The opportunity cost of holding money is the interest
that could be earned on interest earning assets.
An increase in the interest rate raises the opportunity
cost of holding money.
As a result, the quantity of money demanded is
reduced.
THE THEORY OF LIQUIDITY PREFERENCE

Equilibrium in the money market

According to the theory of liquidity preference:
The interest rate adjusts to balance the supply and
demand for money.
 There is one interest rate, called the equilibrium interest
rate, at which the quantity of money demanded equals
the quantity of money supplied.

THE DOWNWARD SLOPE OF THE AGGREGATE
DEMAND CURVE





The price level is one determinant of the demand for
money.
A higher price level increases the quantity of money
demanded for any given interest rate.
Higher money demand leads to a higher interest rate.
The quantity of goods and services demanded falls.
The end result of this analysis is a negative relationship
between the price level and the quantity of goods and
services demanded.
THE MONEY MARKET AND THE SLOPE OF THE
AGGREGATE DEMAND CURVE
(a) The Money Market
Interest
Rate
(b) The Aggregate Demand Curve
Price
Level
Money
supply
2. . . . increases the
demand for money . . .
P2
r2
Money demand at
price level P2 , MD2
r
3. . . .
which
increases
the
equilibrium 0
interest
rate . . .
Money demand at
price level P , MD
Quantity fixed
by the Fed
Quantity
of Money
1. An
P
increase
in the
price
level . . . 0
Aggregate
demand
Y2
Y
Quantity
of Output
4. . . . which in turn reduces the quantity
of goods and services demanded.
CHANGES IN THE MONEY SUPPLY
The Central Bank can shift the aggregate demand
curve when it changes monetary policy.
 An increase in the money supply shifts the money
supply curve to the right.
 Without a change in the money demand curve, the
interest rate falls.
 Falling interest rates increase the quantity of goods
and services demanded at each price level.
 The aggregate demand curve shifts to the right.

A MONETARY INJECTION
(b) The Aggregate Demand Curve
(a) The Money Market
Interest
Rate
r
2. . . . the
equilibrium
interest rate
falls . . .
Money
supply,
MS
Price
Level
MS2
1. When the Fed
increases the
money supply . . .
P
r2
AD2
Money demand
at price level P
0
Quantity
of Money
Aggregate
demand, AD
0
Y
Y
Quantity
of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.
MONETARY POLICY

Monetary policy is conducted when the government
controls the money supply.
Expansionary monetary policy: Money supply
increases.
 Contractionary monetary policy: Money supply
decreases.

HOW MONETARY POLICY INFLUENCES
AGGREGATE DEMAND
When the government conducts expansionary
monetary policy, money supply increases which
lowers the interest rate and increases investment at
any given price level → aggregate demand
increases and the AD curve shifts to the right.
 When the government conducts contractionary
monetary policy, money supply decreases which
increases the interest rate and reduces investment
at any given price level → aggregate demand
decreases and the AD curve shifts to the left.

HOW FISCAL POLICY INFLUENCES
AGGREGATE DEMAND

Fiscal policy is conducted when the government
changes government spending and/or taxes.
Expansionary fiscal policy: Increase government
spending and/or lower taxes.
 Contractionary fiscal policy: Decrease government
spending and/or higher taxes.

CHANGES IN GOVERNMENT PURCHASES
When the government alters its own purchases of
goods or services, it shifts the aggregate demand
curve directly.
 There are two macroeconomic effects from the
change in government purchases:

The multiplier effect
 The crowding out effect

THE MULTIPLIER EFFECT

Government purchases are said to have a multiplier
effect on aggregate demand.


Each dollar spent by the government can raise the
aggregate demand for goods and services by more
than a dollar.
The multiplier effect refers to the additional shifts in
aggregate demand that result when expansionary
fiscal policy increases income and thereby
increases consumer spending.
THE MULTIPLIER EFFECT

The formula for the multiplier is



If the MPC = 0.75, then the multiplier will be
Multiplier = 1/(1 – 0.75) = 4


Multiplier = 1/(1 – MPC)
The marginal propensity to consume (MPC) is the
fraction of extra income that a household consumes
rather than saves.
In this case, a $20 billion increase in government
spending generates $80 billion of increased demand for
goods and services.
A larger MPC means a larger multiplier in an
economy.
THE CROWDING OUT EFFECT





Fiscal policy may not affect the economy as strongly as
predicted by the multiplier.
An increase in government purchases causes the
interest rate to rise.
A higher interest rate reduces investment spending and
thus aggregate demand.
This reduction in demand that results when a fiscal
expansion raises the interest rate is called the crowding
out effect.
The crowding out effect tends to dampen the effects of
fiscal policy on aggregate demand.
CHANGES IN TAXES
When the government cuts personal income taxes,
it increases households’ take-home pay.
 Households save some of this additional income.
 Households also spend some of it on consumer
goods.
 Increased household spending shifts the aggregate
demand curve to the right.

CHANGES IN TAXES
The size of the shift in aggregate demand resulting
from a tax change is affected by the multiplier and
crowding out effects.
 It is also determined by the households’ perceptions
about the permanency of the tax change.

AUTOMATIC STABILIZERS
Automatic stabilizers are changes in fiscal policy
that stimulate aggregate demand when the
economy goes into a recession without
policymakers having to take any deliberate action.
 Automatic stabilizers include the tax system and
some forms of government spending.

USING POLICY TO STABILIZE THE ECONOMY

Economic stabilization has been an explicit goal of U.S.
policy since the Employment Act of 1946, which states
that:


“it is the continuing policy and responsibility of the federal
government to…promote full employment and production.”
The Employment Act has two implications:
The government should avoid being the cause of economic
fluctuations.
 The government should respond to changes in the private
economy in order to stabilize aggregate demand.

THE CASE AGAINST ACTIVE STABILIZATION
POLICY
Some economists argue that monetary and fiscal
policy destabilizes the economy.
 Monetary and fiscal policy affect the economy with
a substantial lag.
 They suggest the economy should be left to deal
with the short run fluctuations on its own.

TOPIC 9: OPEN ECONOMY
MACROECONOMICS: BASIC
CONCEPTS
OPEN ECONOMY MACROECONOMICS: BASIC
CONCEPTS

Open and closed economies

A closed economy is one that does not interact with
other economies in the world.


There are no exports, no imports, and no capital flows.
An open economy is one that interacts freely with
other economies around the world.
THE INTERNATIONAL FLOW OF GOODS AND
CAPITAL

An open economy interacts with other countries in
two ways.
It buys and sells goods and services in world product
markets.
 It buys and sells capital assets in world financial
markets.

The flow of goods: Net exports
 The flow of financial resources: Net capital outflow

THE FLOW OF GOODS: EXPORTS, IMPORTS,
NET EXPORTS
Exports are goods and services that are produced
domestically and sold abroad.
 Imports are goods and services that are produced
abroad and sold domestically.
 Net exports (NX) are the value of a nation’s exports
minus the value of its imports.
 Net exports are also called the trade balance.

THE FLOW OF GOODS: EXPORTS, IMPORTS,
NET EXPORTS

A trade deficit is a situation in which net exports
(NX) are negative.


A trade surplus is a situation in which net exports
(NX) are positive.


Imports > Exports
Exports > Imports
Balanced trade refers to when net exports (NX) are
zero.

Exports = Imports
THE FLOW OF GOODS: EXPORTS, IMPORTS,
NET EXPORTS

Factors that affect net exports






The tastes of consumers for domestic and foreign
goods.
The prices of goods at home and abroad.
The exchange rates at which people can use
domestic currency to buy foreign currencies.
The incomes of consumers at home and abroad.
The costs of transporting goods from country to
country.
The policies of the government toward international
trade.
THE INTERNATIONALIZATION OF THE U.S.
ECONOMY
Percent
of GDP
15
Imports
10
Exports
5
0
1950 1955
1960 1965 1970 1975 1980 1985 1990 1995 2000
2005
THE FLOW OF FINANCIAL RESOURCES: NET
CAPITAL OUTFLOW

Net capital outflow refers to the purchase of foreign
assets by domestic residents minus the purchase of
domestic assets by foreigners.
When a U.S. resident buys stock in Telmex, the
Mexican phone company, the purchase raises U.S.
net capital outflow.
 When a Japanese residents buys a bond issued by
the U.S. government, the purchase reduces the U.S.
net capital outflow.

THE FLOW OF FINANCIAL RESOURCES: NET
CAPITAL OUTFLOW

Variables that influence net capital outflow
The real interest rates being paid on foreign assets.
 The real interest rates being paid on domestic assets.
 The perceived economic and political risks of holding
assets abroad.
 The government policies that affect foreign ownership
of domestic assets.

THE EQUALITY OF NET EXPORTS AND NET
CAPITAL OUTFLOW

For an economy as a whole, NX and NCO must
balance each other so that:
NCO = NX
SAVING, INVESTMENT, AND THEIR
RELATIONSHIP TO THE INTERNATIONAL FLOWS
Total output
 National saving


Since
then
Y = C + I + G + NX
S=Y–C–G
S = I + NX
NCO = NX
S = I + NCO
National saving = Domestic
investment
+ Net capital
outflow
INTERNATIONAL FLOWS OF GOODS AND CAPITAL:
SUMMARY
NATIONAL SAVING, DOMESTIC INVESTMENT, AND
NET FOREIGN INVESTMENT
(a) National Saving and Domestic Investment (as a percentage of GDP)
Percent
of GDP
20
Domestic investment
18
16
14
National saving
12
10
1960
1965
1970
1975
1980
1985
1990
1995
200 0
2005
NATIONAL SAVING, DOMESTIC INVESTMENT, AND
NET FOREIGN INVESTMENT
(b) Net Capital Outflow (as a percentage of GDP)
Percent
of GDP
2
Net capital
outflow
1
0
1
2
3
4
5
6
1960
1965
1970
1975
1980
1985
1990
1995
2000
2005
THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL
AND NOMINAL EXCHANGE RATES
International transactions are influenced by
international prices.
 The two most important international prices are the
nominal exchange rate and the real exchange rate.

NOMINAL EXCHANGE RATES

The nominal exchange rate is the rate at which a
person can trade the currency of one country for
the currency of another.
NOMINAL EXCHANGE RATES

The nominal exchange rate is expressed in two
ways:
In units of foreign currency per one unit of domestic
currency.
 In units of domestic currency per one unit of the
foreign currency.

NOMINAL EXCHANGE RATES
Appreciation refers to an increase in the value of a
currency as measured by the amount of foreign
currency it can buy.
 Depreciation refers to a decrease in the value of a
currency as measured by the amount of foreign
currency it can buy.

If a dollar buys more foreign currency, there is an
appreciation of the dollar.
 If a dollar buys less foreign currency there is a
depreciation of the dollar.

REAL EXCHANGE RATES

The real exchange rate is the rate at which a
person can trade the goods and services of one
country for the goods and services of another.
REAL EXCHANGE RATES

The real exchange rate depends on the nominal
exchange rate and the prices of goods in the two
countries measured in local currencies.
Real exchange rate =

Nominal exchange rate × Domestic price
Foreign price
The real exchange rate is a key determinant of how
much a country exports and imports.
REAL EXCHANGE RATES

A depreciation (fall) in the real exchange rate
Domestic goods have become cheaper relative to
foreign goods.
 This encourages consumers both at home and
abroad to buy more domestic goods and less foreign
goods.
 As a result, exports rise and imports fall which cause
net exports to rise.


Conversely, an appreciation (rise) in the real
exchange rate causes net exports to fall.
A FIRST THEORY OF EXCHANGE RATE DETERMINATION:
PURCHASING POWER PARITY
The purchasing power parity theory is the simplest
and most widely accepted theory explaining the
variation of currency exchange rates.
 Purchasing power parity is 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.

THE BASIC LOGIC OF PURCHASING POWER
PARITY
The theory of purchasing power parity is based on
a principle called the law of one price.
 According to the law of one price, a good must sell
for the same price in all locations.
 If the law of one price were not true, unexploited
profit opportunities would exist.
 The process of taking advantage of differences in
prices in different markets is called arbitrage.
 If arbitrage occurs, eventually prices that differed in
two markets would necessarily converge.

IMPLICATIONS OF PURCHASING POWER
PARITY

When the central bank prints large quantities of money,
the money loses value both in terms of the goods and
services it can buy and in terms of the amount of other
currencies it can buy.
MONEY, PRICES, AND THE NOMINAL EXCHANGE RATE DURING THE GERMAN
HYPERINFLATION
Indexes
(Jan. 1921 = 100)
1,000,000,000,000,000
Money supply
10,000,000,000
Price level
100,000
1
Exchange rate
.00001
.0000000001
1921
1922
1923
1924
1925
LIMITATIONS OF PURCHASING POWER PARITY
Many goods are not easily traded or shipped from
one country to another.
 Tradable goods are not always perfect substitutes
when they are produced in different countries.

TOPIC 10: A MACROECONOMIC
THEORY OF THE OPEN ECONOMY
A MACROECONOMICS THEORY OF THE OPEN
ECONOMY
 Key
macroeconomic variables in an open
economy
Net exports
 Net foreign investment
 Real interest rates
 Real exchange rates

A MACROECONOMICS THEORY OF THE OPEN
ECONOMY
 Basic
assumptions of a macroeconomic model
of an open economy
Considers a large open economy.
 Takes the economy’s GDP as given.
 Takes the economy’s price level as given.

THE MARKET FOR LOANABLE FUNDS
The market for loanable funds
S = I + NCO
 At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of investment and net capital outflows.
 The supply of loanable funds comes from national
saving (S).
 The demand for loanable funds comes from
domestic investment (I) and net capital outflows
(NCO).

THE MARKET FOR LOANABLE FUNDS
The supply and demand for loanable funds depend
on the real interest rate.
 A higher real interest rate encourages people to
save and raises the quantity of loanable funds
supplied.
 The interest rate adjusts to bring the supply and
demand for loanable funds into balance.
 At the equilibrium interest rate, the amount that
people want to save exactly balances the desired
quantities of domestic investment and net foreign
investment.

THE MARKET FOR LOANABLE FUNDS
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
Quantity of
Loanable Funds
THE MARKET FOR FOREIGN CURRENCY
EXCHANGE
The two sides of the foreign currency exchange
market are represented by NCO and NX.
 NCO represents the imbalance between the
purchases and sales of capital assets.
 NX represents the imbalance between exports and
imports of goods and services.

THE MARKET FOR FOREIGN-CURRENCY
EXCHANGE
The demand curve is downward sloping because a
higher exchange rate makes domestic goods more
expensive.
 The supply curve is vertical because the quantity of
dollars supplied for net capital outflow is unrelated
to the real exchange rate.
 The price that balances the supply and demand for
foreign currency exchange is the real exchange
rate.

THE MARKET FOR FOREIGN CURRENCY EXCHANGE
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
THE MARKET FOR FOREIGN CURRENCY
EXCHANGE
The real exchange rate adjusts to balance the
supply and demand for dollars.
 At the equilibrium real exchange rate, the demand
for dollars to buy net exports exactly balances the
supply of dollars to be exchanged into foreign
currency to buy assets abroad.

EQUILIBRIUM IN THE OPEN ECONOMY
In the market for loanable funds, supply comes from
national saving and demand comes from domestic
investment and net capital outflow.
 In the market for foreign currency exchange, supply
comes from net capital outflow and demand comes
from net exports.

EQUILIBRIUM IN THE OPEN ECONOMY

Net capital outflow links the loanable funds market
and the foreign currency exchange market.

The key determinant of net capital outflow is the real
interest rate.
HOW NET CAPITAL OUTFLOW DEPENDS ON THE
INTEREST RATE
Real
Interest
Rate
Net capital outflow
is negative.
0
Net capital outflow
is positive.
Net Capital
Outflow
SIMULTANEOUS EQUILIBRIUM IN TWO
MARKETS
Prices in the loanable funds market and the foreign
currency exchange market adjust simultaneously to
balance supply and demand in these two markets.
 As they do, they determine the macroeconomic
variables of national saving, domestic investment,
net foreign investment, and net exports.

THE REAL EQUILIBRIUM IN AN OPEN ECONOMY
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
Demand
Net capital
outflow, NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
Supply
E
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
HOW POLICIES AND EVENTS AFFECT AN
OPEN ECONOMY

The magnitude and variation in important
macroeconomic variables depend on the following:
Government budget deficits
 Trade policies
 Political and economic stability

GOVERNMENT BUDGET DEFICITS

In an open economy, government budget deficits






Reduce the supply of loanable funds,
Drive up the interest rate,
Crowd out domestic investment,
Cause net capital outflow to fall,
Increase the real exchange rate,
Reduce the net exports.
THE EFFECTS OF GOVERNMENT BUDGET DEFICIT
(a) The Market for Loanable Funds
Real
Interest
Rate
r2
S
1. A budget deficit reduces
(b) Net Capital Outflow
the supply of loanable funds . . .
Real
Interest
Rate
S
B
r2
A
r
2. . . . which
increases
the real
interest
rate . . .
r
3. . . . which in
turn reduces
net capital
outflow.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
E1
5. . . . which
causes the
real exchange
rate to
appreciate.
S
S
4. The decrease
in net capital
outflow reduces
the supply of dollars
to be exchanged
into foreign
currency . . .
Demand
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
TRADE POLICY
A trade policy is a government policy that directly
influences the quantity of goods and services that a
country imports or exports.
 Tariff: A tax on an imported good.
 Import quota: A limit on the quantity of a good
produced abroad and sold domestically.

EFFECT OF AN IMPORT QUOTA

The impose of import quota leads to
An increase in net exports,
 A rise in the real exchange rate,
 Domestic goods become relatively more expensive that
encourages imports and discourages exports,
 The fall in net exports offsets the initial increase in it that
leads net exports unchanged.

THE EFFECTS OF AN IMPORT QUOTA
(a) The Market for Loanable Funds
Real
Interest
Rate
(b) Net Capital Outflow
Real
Interest
Rate
Supply
r
r
3. Net exports,
however, remain
the same.
Demand
NCO
Quantity of
Loanable Funds
Net Capital
Outflow
Real
Exchange
Rate
E2
2. . . . and
causes the
real exchange
rate to
appreciate.
Supply
1. An import
quota increases
the demand for
dollars . . .
E
D
D
Quantity of
Dollars
(c) The Market for Foreign-Currency Exchange
POLITICAL INSTABILITY AND CAPITAL FLIGHT
Capital flight is a large and sudden reduction in the
demand for assets located in a country.
 Capital flight has its largest impact on the country
from which the capital is fleeing, but it also affects
other countries.
 If investors become concerned about the safety of
their investments, capital can quickly leave an
economy.
 Interest rates increase and the domestic currency
depreciates.

THE EFFECTS OF CAPITAL FLIGHT
(a) The Market for Loanable Funds in Mexico
Real
Interest
Rate
(b) Mexican Net Capital Outflow
Real
Interest
Rate
Supply
r2
r2
r1
r1
3. . . . which
increases
the interest
rate.
1. An increase
in net capital
outflow. . .
D2
D1
NCO1
Quantity of
2. . . . increases the demand
Loanable Funds
for loanable funds . . .
NCO2
Net Capital
Outflow
Real
Exchange
Rate
E
5. . . . which
causes the
peso to
depreciate.
S
S2
4. At the same
time, the increase
in net capital
outflow
increases the
supply of pesos . . .
E
Demand
Quantity of
Pesos
(c) The Market for Foreign-Currency Exchange