The Macroeconomic Environment
Presentation 1
Topics: Introduction, Real Vs. Nominal,
The Production Function
18:34 30/01/2024
The Macroeconomic Environment, IDC
1
What Macroeconomics Study?

Rich Vs. Poor countries

Causes of Inflation

Recessions, depressions

The influence of Government Policies
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The Macroeconomic Environment, IDC
2
The State of The Economy Affects Everyone

Business people

College graduates

Senior citizens

Macroeconomics is central for world politics:



Euro zone
China’s fixed exchange rate towards the US dollar.
US large trade deficit
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The Macroeconomic Environment, IDC
3
The work of Macroeconomists

Data:





Income
Prices
Unemployment
Many more other variables
All from different time periods and different countries.
Purpose: to formulate general theories to explain
this data
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The Macroeconomic Environment, IDC
4
Macroeconomics

Young and imperfect science.

Predicting Economic Future = Predicting next
month’s temperature

Yet the existing knowledge is useful


For explaining economic events
For formulating economic policy.
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The Macroeconomic Environment, IDC
5
Topics of this course

The GDP/GNP and its growth

The Aggregate Demand:





The Private Consumption
Investment
Government Consumption
Export
Import
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The Macroeconomic Environment, IDC
6
Topics of this course - continue







The money market
The Aggregate Supply
The Products Market.
Issues of the open economy.
Fiscal Policy
Monetary policy, expectation and inflation
Long Term vs. Short Term considerations
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The Macroeconomic Environment, IDC
7
Measuring the Value of Economic Activity: Gross
Domestic Product

GDP
The Market Value of all final goods and services
produced within an economy in a given period of
time.
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The Macroeconomic Environment, IDC
8
Basic Concepts – National Accounting



Added Value – The Value Added by the
business unit.
Example – Shoe maker took leather, and the
strings and created a shoe. The value of the
show minus the value of the inputs is the
added value.
The Product of the Business Sector – The
total added value of all the business units
including the government companies.
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The Macroeconomic Environment, IDC
9
Real GDP Versus Nominal GDP

Assume an economy produces only two goods: apples and oranges.

GDP=(Price of Apples X Quantity of Apples) + (Price of Oranges X
Quantity of Oranges).

Nominal GDP: the value of goods and services measured in current
prices.
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The Macroeconomic Environment, IDC
10
Real GDP Versus Nominal GDP- Cont’d

Real GDP: the value of goods and services measured by a
constant set of prices.

Real GDP2009 = (Price 2009 of Apples X Quantity 2009 of
Apples) + (Price 2009 of Oranges X Quantity 2009 of Oranges).

Real GDP2010 = (Price 2009 of Apples X Quantity 2010 of Apples)
+ (Price 2009 of Oranges X Quantity2010 of Oranges).
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The Macroeconomic Environment, IDC
11
Computing Changes in Data over time


percentage change.
We want to know what was the percentage change in the value of
nominal GDP between time t to time t+1.
100 *
 GDPt 1 
 GDPt 1  GDPt 
GDPt 1

 100  100 * 
 1  100 * 
GDPt
GDPt
 GDPt



When we compare data over time we are interested in the “real”
changes of the variables. This are the changes which are not
attributed to changes in prices.
12
18:34 30/01/2024
The Macroeconomic Environment, IDC
Understanding Data- Real and Nominal Values

Example:


In year 2008 the worker earned 1000 shekels per week
In year 2009 the worker earned 1200 shekels per week

How much did the worker’s wage changed between the years
2008-2009?

How much has the purchasing power grown?

Assume: prices increased by 4% from 2008 to 2009.
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The Macroeconomic Environment, IDC
13
Price level (P) and inflation rate
t
Price level is a relative concept:
Price level at the end of December 2008 is determined as a base:
so the price level of year 2008 is P=1.
If during 2009 there is a price increase of 4% so we say the
Inflation rate during 2009 was  = 4%.
At the end of 2009 the price level is P=1.04. Therefore the
connection between the price level and the inflation rate is:
Pt 1  Pt (1   t )
14
18:34 30/01/2024
The Macroeconomic Environment, IDC
Real and Nominal Interest Rate

At January 1st, 2008 one took a loan of 1000 NIS.

At December 31st, 2008 a sum of 1100 shekels was
returned, including interest.

What is the interest rate on the loan?

Assume: during the period price increased by 4%.
18:34 30/01/2024
The Macroeconomic Environment, IDC
15
GDP Per Capita Current Prices $US
2013
120000
100000
80000
60000
40000
20000
0
Source: International Monetary Fund, World
Economic
Outlook Database, October 2014
18:34 30/01/2024
Source: IMF
The Macroeconomic Environment, IDC
16
Data


http://www.imf.org/external/datamapper/index
.php
This link shows world maps of


GDP Per Capita
GDP Growth
Source:
IMF Data
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The Macroeconomic Environment, IDC
17
Expansion
Recession
Depression
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The Macroeconomic Environment, IDC
18
18:34 30/01/2024
The Macroeconomic Environment, IDC
19
Basic Concepts
Expansion: periods in which the production and employment
increase.
Recession: periods of economic downturn in which the
employment and the production decrease.
Business cycle: the change in the short run between
recession and expansion.
Depression: long and deep recession.
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The Macroeconomic Environment, IDC
20
Inflation Percentage Change 2013
12
10
8
6
4
2
0
-2
Source: International Monetary Fund, World
Economic Outlook Database, October 2014
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The Macroeconomic Environment, IDC
21
Basic Concepts in the Labor Market
8,462,000
Total Population
5,775,100
Population that is
not in the working age
(Youngsters, retired)
Population in the
Working Age (15-64)
Do Not Participate
in the Labor Force
5.4%
210,000
Participate in the
)64.5%) 3,901,000
Labor Force
Unemployed
Employed.
3,691,000
Employment Rate =The Rate of those employed out of the
total population in the Working age
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22 30/01/2024
The Macroeconomic Environment, IDC
22
Basic Concepts – Labor Market
Rate of participation in the labor force – labor force
(number of employed + number of job seekers)/amount of
population in the working age.
Unemployment rate – the amount of unemployed out of the
number of employed + number of job seekers (not including
people in the working age who are not looking for jobs).
Deflation: periods of decrease in prices
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The Macroeconomic Environment, IDC
23
Basic Concepts – The Labor Market
Total Labor Force
=Participation in the Labor Force
Population in the working age
Unemployed
=
Total Labor Force
)u(Unemployment Rate
Employed
Employment Rate
Population in the working age
Natural Unemployment Rate- Unemployment that Stems from Frictional and
Structural Unemployment – Impossible to narrow down in the short run.
18:34
24 30/01/2024
The Macroeconomic Environment, IDC
24
Source: International Monetary Fund, World
18:34
30/01/2024
Economic
Outlook Database, October 2014
27.3
26.1
16.6
13.0
12.2
10.3
8.4
8.0
7.6
7.4
7.1
7.1
7.0
7.0
6.9
6.4
6.3
5.9
5.7
5.4
5.3
4.9
4.3
4.1
4.0
4.0
3.5
3.2
3.1
10.3
16.2
UNEMPLOYMENT 2013
The Macroeconomic Environment, IDC
25
Employment Rate – Population Age 25-64
Percent
Group
2010
2015
Jews, non ultra
orthodox
79
80.5
Ultra Orthodox
32.9
40.9
Arab
66.8
71.7
Jews, non ultra
Women orthodoxs
Ultra Orthodox
Arab
70.3
50.5
19.9
75.5
65.1
29.4
Men
18:34
The‫המאקרו‬
Macroeconomic
26 30/01/2024
‫ מושגי יסוד במאקרו כלכלה‬- ‫כלכלית‬
‫ הסביבה‬- Environment,
‫ד"ר יצחק אורון‬IDC
26
The Macroeconomic Environment
Topics: Monetary Policy and Short Run Equilibrium
1
Determining the Interest Rate
r
3
2
IS
675 800
Y
The IS-MP model
The IS curve itself does not tell us what either the interest rate
or output is.
We know that the economy should be on the curve, but we
don’t know where.
To pin down where, we need a second relationhip between
interest rate and output.
3
Monetary Policy
Monetary policy is conducted by the central bank.
The goal of the central bank (CB):
Price stability
Full employment
4
Monetary Policy (non-conventional)
Rebuild the financial
markets
Purchasing
Giving
Financial Assets. Liquidity
5
Monetary
Expansion
(Interest Rate
Almost Zero)
Policy
Goal
Commitment Purchasing
To continue Bonds.
The policy
‫ מדיניות כספית ושיווי משקל בזמן הקצר במשק סגור‬- ‫ הסביבה המאקרו כלכלית‬- ‫ד"ר יצחק אורון‬
Policy
Tools
Inflation and Inflation Target
Inflation
Target
(range) is
in light
blue.
Inflation in
CPI is in
organge
"‫"דה מרקר‬
28.10.14
6
Jul- 9
Jan- 3
9
Jul- 94
Jan- 4
9
Jul- 95
Jan- 5
96
Jul- 9
Jan- 6
9
Jul- 97
Jan- 7
98
Jul- 9
Jan- 8
9
Jul- 99
Jan- 9
0
Jul- 00
Jan- 0
0
Jul- 01
Jan- 1
0
Jul- 02
Jan- 2
03
Jul- 0
Jan- 3
0
Jul- 04
Jan- 4
05
Jul- 0
Jan- 5
0
Jul- 06
Jan- 6
0
Jul- 07
Jan- 7
0
Jul- 08
Jan- 8
0
Jul- 09
Jan- 9
1
Jul- 10
Jan- 0
1
Jul- 11
Jan- 1
12
Jul- 1
Jan- 2
1
Jul- 13
Jan- 3
1
Jul- 14
Jan- 4
1
Jul- 15
Jan- 5
16
Inflation and Inflation Target in Israel
16
14
12
10
8
6
4
2
0
-2
-4
7
‫‪Expectations of Inflation‬‬
‫‪1994-2015‬‬
‫‪14‬‬
‫‪12‬‬
‫‪10‬‬
‫‪8‬‬
‫‪6‬‬
‫‪4‬‬
‫‪2‬‬
‫‪0‬‬
‫‪-2‬‬
‫ול‪93-‬‬
‫י‬
‫נו‪94-‬‬
‫יול‪94-‬‬
‫י‬
‫נו‪95-‬‬
‫י‬
‫ול‪95-‬‬
‫י‬
‫נו‪96-‬‬
‫יול‪96-‬‬
‫י‬
‫נו‪97-‬‬
‫יול‪97-‬‬
‫י‬
‫נו‪98-‬‬
‫יול‪98-‬‬
‫י‬
‫נו‪99-‬‬
‫י‬
‫ול‪99-‬‬
‫י‬
‫נו‪00-‬‬
‫י‬
‫ול‪00-‬‬
‫י‬
‫נו‪01-‬‬
‫יול‪01-‬‬
‫י‬
‫נו‪02-‬‬
‫יול‪02-‬‬
‫י‬
‫נו‪03-‬‬
‫יול‪03-‬‬
‫י‬
‫נו‪04-‬‬
‫יול‪04-‬‬
‫י‬
‫נו‪05-‬‬
‫י‬
‫ול‪05-‬‬
‫י‬
‫נו‪06-‬‬
‫יול‪06-‬‬
‫י‬
‫נו‪07-‬‬
‫יול‪07-‬‬
‫י‬
‫נו‪08-‬‬
‫יול‪08-‬‬
‫י‬
‫נו‪09-‬‬
‫יול‪09-‬‬
‫י‬
‫נו‪10-‬‬
‫י‬
‫ול‪10-‬‬
‫י‬
‫נו‪11-‬‬
‫יול‪11-‬‬
‫י‬
‫נו‪12-‬‬
‫יול‪12-‬‬
‫י‬
‫נו‪13-‬‬
‫יול‪13-‬‬
‫י‬
‫נו‪14-‬‬
‫י‬
‫ול‪14-‬‬
‫י‬
‫נו‪15-‬‬
‫יול‪15-‬‬
‫י‬
‫נו‪16-‬‬
‫י‬
‫ד"ר יצחק אורון ‪ -‬הסביבה המאקרו כלכלית ‪ -‬מדיניות כספית ושיווי משקל בזמן הקצר במשק סגור‬
‫‪8‬‬
Monetary Policy
The main instrument: short term nominal interest rate.
The Bank of Israel determines the interest rate once a month
and Publicizes its consideration on its website.
9
‫‪The Interest Rate of the Bank of Israel‬‬
‫‪1993-2015‬‬
‫‪18‬‬
‫‪16‬‬
‫‪14‬‬
‫‪12‬‬
‫‪10‬‬
‫‪8‬‬
‫‪6‬‬
‫‪4‬‬
‫‪2‬‬
‫‪0‬‬
‫יול‪93-‬‬
‫ינו‪94-‬‬
‫יול‪94-‬‬
‫ינו‪95-‬‬
‫יול‪95-‬‬
‫ינו‪96-‬‬
‫יול‪96-‬‬
‫ינו‪97-‬‬
‫יול‪97-‬‬
‫ינו‪98-‬‬
‫יול‪98-‬‬
‫ינו‪99-‬‬
‫יול‪99-‬‬
‫ינו‪00-‬‬
‫יול‪00-‬‬
‫ינו‪01-‬‬
‫יול‪01-‬‬
‫ינו‪02-‬‬
‫יול‪02-‬‬
‫ינו‪03-‬‬
‫יול‪03-‬‬
‫ינו‪04-‬‬
‫יול‪04-‬‬
‫ינו‪05-‬‬
‫יול‪05-‬‬
‫ינו‪06-‬‬
‫יול‪06-‬‬
‫ינו‪07-‬‬
‫יול‪07-‬‬
‫ינו‪08-‬‬
‫יול‪08-‬‬
‫ינו‪09-‬‬
‫יול‪09-‬‬
‫ינו‪10-‬‬
‫יול‪10-‬‬
‫ינו‪11-‬‬
‫יול‪11-‬‬
‫ינו‪12-‬‬
‫יול‪12-‬‬
‫ינו‪13-‬‬
‫יול‪13-‬‬
‫ינו‪14-‬‬
‫יול‪14-‬‬
‫ינו‪15-‬‬
‫יול‪15-‬‬
‫ינו‪16-‬‬
‫‪10‬‬
‫‪Return on Short Term Loan and on One Year Bond‬‬
‫‪1993-2014‬‬
‫‪18‬‬
‫‪16‬‬
‫‪14‬‬
‫‪12‬‬
‫‪10‬‬
‫‪8‬‬
‫‪6‬‬
‫‪4‬‬
‫‪2‬‬
‫‪0‬‬
‫‪-2‬‬
‫ול‪93-‬‬
‫י‬
‫נו‪94-‬‬
‫יול‪94-‬‬
‫י‬
‫נו‪95-‬‬
‫י‬
‫ול‪95-‬‬
‫י‬
‫נו‪96-‬‬
‫יול‪96-‬‬
‫י‬
‫נו‪97-‬‬
‫יול‪97-‬‬
‫י‬
‫נו‪98-‬‬
‫יול‪98-‬‬
‫י‬
‫נו‪99-‬‬
‫י‬
‫ול‪99-‬‬
‫י‬
‫נו‪00-‬‬
‫יול‪00-‬‬
‫י‬
‫נו‪01-‬‬
‫יול‪01-‬‬
‫י‬
‫נו‪02-‬‬
‫יול‪02-‬‬
‫י‬
‫נו‪03-‬‬
‫י‬
‫ול‪03-‬‬
‫י‬
‫נו‪04-‬‬
‫י‬
‫ול‪04-‬‬
‫י‬
‫נו‪05-‬‬
‫יול‪05-‬‬
‫י‬
‫נו‪06-‬‬
‫יול‪06-‬‬
‫י‬
‫נו‪07-‬‬
‫יול‪07-‬‬
‫י‬
‫נו‪08-‬‬
‫יול‪08-‬‬
‫י‬
‫נו‪09-‬‬
‫י‬
‫ול‪09-‬‬
‫י‬
‫נו‪10-‬‬
‫יול‪10-‬‬
‫י‬
‫נו‪11-‬‬
‫יול‪11-‬‬
‫י‬
‫נו‪12-‬‬
‫יול‪12-‬‬
‫י‬
‫נו‪13-‬‬
‫י‬
‫ול‪13-‬‬
‫י‬
‫נו‪14-‬‬
‫יול‪14-‬‬
‫י‬
‫נו‪15-‬‬
‫יול‪15-‬‬
‫י‬
‫נו‪16-‬‬
‫י‬
‫מק"מ‬
‫אג"ח צמוד לשנה‬
‫‪11‬‬
‫‪The Bank of Israel interest rate‬‬
‫‪and The Inflation Expectations‬‬
‫‪1993-2015‬‬
‫‪18‬‬
‫ול‪93-‬‬
‫י‬
‫נו‪94-‬‬
‫יול‪94-‬‬
‫י‬
‫נו‪95-‬‬
‫י‬
‫ול‪95-‬‬
‫י‬
‫נו‪96-‬‬
‫י‬
‫ול‪96-‬‬
‫י‬
‫נו‪97-‬‬
‫יול‪97-‬‬
‫י‬
‫נו‪98-‬‬
‫יול‪98-‬‬
‫י‬
‫נו‪99-‬‬
‫יול‪99-‬‬
‫י‬
‫נו‪00-‬‬
‫יול‪00-‬‬
‫י‬
‫נו‪01-‬‬
‫יול‪01-‬‬
‫י‬
‫נו‪02-‬‬
‫י‬
‫ול‪02-‬‬
‫י‬
‫נו‪03-‬‬
‫יול‪03-‬‬
‫י‬
‫נו‪04-‬‬
‫יול‪04-‬‬
‫י‬
‫נו‪05-‬‬
‫יול‪05-‬‬
‫י‬
‫נו‪06-‬‬
‫יול‪06-‬‬
‫י‬
‫נו‪07-‬‬
‫י‬
‫ול‪07-‬‬
‫י‬
‫נו‪08-‬‬
‫י‬
‫ול‪08-‬‬
‫י‬
‫נו‪09-‬‬
‫יול‪09-‬‬
‫י‬
‫נו‪10-‬‬
‫יול‪10-‬‬
‫י‬
‫נו‪11-‬‬
‫יול‪11-‬‬
‫י‬
‫נו‪12-‬‬
‫יול‪12-‬‬
‫י‬
‫נו‪13-‬‬
‫י‬
‫ול‪13-‬‬
‫י‬
‫נו‪14-‬‬
‫י‬
‫ול‪14-‬‬
‫י‬
‫נו‪15-‬‬
‫יול‪15-‬‬
‫י‬
‫נו‪16-‬‬
‫י‬
‫ריבית ב"י‬
‫ציפיות לאינפלציה‬
‫‪16‬‬
‫‪Interest Rate‬‬
‫‪14‬‬
‫‪12‬‬
‫‪10‬‬
‫‪8‬‬
‫‪6‬‬
‫‪4‬‬
‫‪12‬‬
‫‪0‬‬
‫‪Inflation‬‬
‫‪Expectations‬‬
‫‪2‬‬
‫‪-2‬‬
‫‪The Bank of Israel interest rate‬‬
‫‪and The Inflation Expectations‬‬
‫‪1993-2015‬‬
‫‪18‬‬
‫‪15‬‬
‫ול‪93-‬‬
‫י‬
‫נו‪94-‬‬
‫יול‪94-‬‬
‫י‬
‫נו‪95-‬‬
‫י‬
‫ול‪95-‬‬
‫י‬
‫נו‪96-‬‬
‫י‬
‫ול‪96-‬‬
‫י‬
‫נו‪97-‬‬
‫יול‪97-‬‬
‫י‬
‫נו‪98-‬‬
‫יול‪98-‬‬
‫י‬
‫נו‪99-‬‬
‫יול‪99-‬‬
‫י‬
‫נו‪00-‬‬
‫יול‪00-‬‬
‫י‬
‫נו‪01-‬‬
‫יול‪01-‬‬
‫י‬
‫נו‪02-‬‬
‫י‬
‫ול‪02-‬‬
‫י‬
‫נו‪03-‬‬
‫יול‪03-‬‬
‫י‬
‫נו‪04-‬‬
‫יול‪04-‬‬
‫י‬
‫נו‪05-‬‬
‫יול‪05-‬‬
‫י‬
‫נו‪06-‬‬
‫יול‪06-‬‬
‫י‬
‫נו‪07-‬‬
‫י‬
‫ול‪07-‬‬
‫י‬
‫נו‪08-‬‬
‫י‬
‫ול‪08-‬‬
‫י‬
‫נו‪09-‬‬
‫יול‪09-‬‬
‫י‬
‫נו‪10-‬‬
‫יול‪10-‬‬
‫י‬
‫נו‪11-‬‬
‫יול‪11-‬‬
‫י‬
‫נו‪12-‬‬
‫יול‪12-‬‬
‫י‬
‫נו‪13-‬‬
‫י‬
‫ול‪13-‬‬
‫י‬
‫נו‪14-‬‬
‫י‬
‫ול‪14-‬‬
‫י‬
‫נו‪15-‬‬
‫יול‪15-‬‬
‫י‬
‫נו‪16-‬‬
‫י‬
‫ריבית ב"י‬
‫אינפלציה‬
‫‪12‬‬
‫‪Interest Rate‬‬
‫‪9‬‬
‫‪6‬‬
‫‪Inflation‬‬
‫‪Expectations‬‬
‫ד"ר יצחק אורון ‪ -‬הסביבה המאקרו כלכלית ‪ -‬מדיניות כספית ושיווי משקל בזמן הקצר במשק סגור‬
‫‪13‬‬
‫‪3‬‬
‫‪0‬‬
‫‪-3‬‬
The Growth Rate of the GDP in OECD and
the International Trade
14
‫‪Policy Tools Bank of Israel‬‬
‫ד"ר יצחק אורון ‪ -‬הסביבה המאקרו כלכלית ‪ -‬מדיניות כספית ושיווי משקל בזמן הקצר במשק סגור‬
‫‪15‬‬
Monetary Policy : Definitions
i - nominal interest rate
r - real interest rate
 e  Expected Inflation
 T  Inflation target
r T  Real Interest rate target
GDP gap 
16
Y full  Y
Y full
r  i  e
Monetary Policy : The Taylor Rule
• The central bank chooses the
nominal interest rate (i)
r  i 
e
• The real interest rate (r) is defined as
the nominal interest rate minus the
expected inflation rate.
17
Monetary Policy : Taylor Rule
i   T  rT  (1   )( e   T )   (GDP gap)
By determine i the Central Bank determines r:
r  i  e
r  i   e   T   e  r T  (1   )( e   T )   (GDP gap)
r   T (1  (1   ))   e ((1   )  1)  r T   (GDP gap)
r   T ( )   e ( )  r T   (GDP gap)
r  r T   ( e   T )   (GDP gap)
18
‫‪The Interest Rate of the Bank of Israel‬‬
‫‪The Interest According to Taylor’s Rule‬‬
‫‪1993-2004‬‬
‫‪25‬‬
‫‪20‬‬
‫‪15‬‬
‫‪10‬‬
‫‪5‬‬
‫‪0‬‬
‫‪-5‬‬
‫י‬
‫נו‪05-‬‬
‫י‬
‫ול‪03-‬‬
‫י‬
‫נו‪04-‬‬
‫י‬
‫ול‪04-‬‬
‫י‬
‫נו‪03-‬‬
‫ול‪02-‬‬
‫י‬
‫י‬
‫נו‪02-‬‬
‫ול‪01-‬‬
‫י‬
‫י‬
‫נו‪01-‬‬
‫ול‪00-‬‬
‫י‬
‫י‬
‫נו‪00-‬‬
‫ול‪99-‬‬
‫י‬
‫י‬
‫נו‪99-‬‬
‫ול‪98-‬‬
‫י‬
‫י‬
‫נו‪98-‬‬
‫ול‪97-‬‬
‫י‬
‫י‬
‫נו‪97-‬‬
‫ול‪96-‬‬
‫י‬
‫י‬
‫נו‪96-‬‬
‫ול‪94-‬‬
‫י‬
‫נו‪95-‬‬
‫י‬
‫ול‪95-‬‬
‫י‬
‫י‬
‫נו‪94-‬‬
‫ול‪93-‬‬
‫י‬
‫‪T. Strict‬‬
‫‪Taylor‬‬
‫ריבית ב"י‬
‫‪19‬‬
Monetary Policy: The Taylor Rule and MP curve
r  r   (   )   (
T
e
T
Y full  Y
Y full
)
Notice: The interest rate is a function of Y!!!!
All the other elements in the equations are constants!!! They are not
determined by the market but elsewhere.
r ,  ,  , Y full
T
21
e
T
Monetary Policy: The Taylor Rule and MP curve
r  r T   ( e   T )   (GDP gap)
 e  r 
Y full  Y
Y 
 r 
full
Y
When GDP gap ↑→ r ↓ (it is
preceded by a minus sign).
When GDP gap↓→ r ↑
When Y↑→ GDP gap↓→ r ↑
We can draw a curve that presents the real interest rate the CB
Determines for a given known expected inflation. It is called the
Monetary Policy: MP=r(Y).
22
Monetary Policy: The Taylor Rule and MP curve
r  r T   ( e   T )   (GDP gap)
All else equal – the central bank prefers output to be higher.
Thus when output declines, they reduce interest rate in order to increase the
demand for goods and thereby stem the fall in output.
But the central bank cannot just keep cutting the interest rate and raising the
demand for good further and further, since if Y increases more than Yfull,
prices may rise. Since the CB wants to keep inflation from becoming too high,
they raise the interest rate when output rise.
It is these twin concerns about output and inflation that causes the central
bank to make the real interest rate an increasing function of output.
23
The Taylor Rule and the MP Curve: An Example
r  r T   ( e   T )   (GDP gap)
Example:
rT  3
  0 .5
 2
e 4
T 3
YF  1,000
24
YF  Y
GDP GAP 
YF
The Taylor Rule and the MP Curve: An Example
MP : r  r T   ( e   T )   (GDP gap )
1,000  Y
MP : r  3  0.5(4  3)  2
1,000
2Y
2Y
MP : r  3.5  2 
 1.5 
1,000
1,000
r
MP
1.5
25
Y
Monetary Policy: The MP Curve
r
MP1
MP shifts
because of
an increase in
expected
Inflation or
due to a
the change
level of the
target values.
26
MP0
A movement on MP due
To a change in GDP
Y
Growth of GDP (quarter vs. the same quarter in the
previous year.
The Interest rate of the Central Bank (quarterly
average)
2006 ‫ אוגוסט‬,‫סקירה כלכלית ופיננסית – בנק הפועלים‬
27
IS-MP
A Short Term Equilibrium in the Goods Market
r
MP0
r0
IS
28
Y0
Y
IS-MP
An Increase in the Government Expenditure
r
MP0
r1
r0
29
IS1
IS0
Y0
Y1
Y
IS-MP
An Increase in the Expected Inflation
r
MP1
MP0
r1
r0
IS0
30
Y1
Y0
Y
Types of Monetary Policy
An expanding monetary policy:
shifts the MP curve downwards (to the right) – the interest rate will be lower for
any given expected inflation and GDP.
A contracting monetary policy
Shifts the MP curve upward (to the left) – the interest rate will be higher for any
given expected inflation and GDP.
31
A Tax Increase and an Expanding Monetary Policy to
Maintain the level of employment .
r
MP0
MP1
r0
r1
IS0
IS1
Y0
32
Y
The Macroeconomic Environment
Presentation #7: The Open Economy
1
1
The Open Economy
Introducing consideration that leads to
import and export activity.
 For this activity – we need foreign
currency.
 Foreign currency is a good – it is bought
and sold in world markets.
 Our central bank is not allowed to print
foreign currency.

2
Daily Exchange Rate –NIS vs. Dollar
USA
3
Foreign Currency Market
Supply of Foreign Currency
Exports of goods abroad
Gifts from abroad
Investment from abroad
Loans from abroad
Demand for forigen currency
Imports from abroad
Gifts to foreign countries
Investment abroad
Loans to citizens abroad
e
S
Nominal
Exchange Rate
D
foreign currency quantity
4
4
Foreign Currency Market
Supply of Foreign Currency
How will a change in P will
affect Supply of foreign
currency?
How will a change in P$ will
affect Supply of foreign currency
Demand for foreign currency
How will a change in P will affect
Demand for foreign currency?
How will a change in P $ will affect
Demand for foreign currency?
e
S
Nominal
Exchange Rate
D
foreign currency quantity
5
5
Foreign Currency Market –
How the nominal and real exchange rate interact
e  P$
P
S
e  P$
P 2
e  P$
P 0
e  P$
P 1
D
Foreign currency quantity
P  excess demand for foreign currency  e 
$
P  excess supply for foeign currency  e 
6
6
The Open Economy – Exchange Rate
Nominal Exchange rate (denoted e)–
The price of foreign currency in local currency units.
i.e. e=3.7 shekels for $1, means that the nominal exchange rate is 3.7
shekels to dollar.
The decision of whether to import or export a product i is based
on comparison of two prices:
$
Compare
e Pi$ and Pi
e  Pi$
Pi
e  Pi$
Pi
1
and compute
i 
this product will be imported.
1
this product will be exported.
e  Pi
Pi
why? The price in NIS of
the foreign good is lower
than the price of the local
good.
why? producers get higher
income from selling the
product abroad then
locally.
7
The Open Economy – Exchange Rate
We can talk about the total imports and total exports. We will
use the price level in each country to determine:
Compare
$
e  Plevel
and
Plevel
Denote: real exchange rate ε

$
e  Plevel
Plevel
8
8
The Open Economy – Exchange Rate
real exchange rate

$
e  Plevel
Plevel
When the real exchange rate increase it means that the goods from
the US become more expensive than goods from Israel.
This means that imports from the US will decrease, but exports to
the US will increase.*
9
9
The effect of an increase in national
income
We assume that since when Y↑→C↑ → IM↑
When income increases the demand for foreign currency increases.
e  P$
P
S
D0
D1
An increase in
the national
income leads to
an increase in
the nominal and
real exchange
rate.
Foreign currency quantity
10
10
The Interest Rate and the Foreign Exchange Market
In the global economy foreign currency flow between countries
for purposes such as loans, deposits and investments.
Definition: CF (capital flow) –
Net flow of capital (foreign currency) into our economy
CF depends on the differences between the local and the foreign
interest rate (r* ( . We will take r* as given.
r
CF(r-r1*)
CF(r-r0*)
r1*>r0*
CF (r  r* )
11
CF
11
Foreign Currency Market with CF
e P
P
$
S
e  P$
P
CF(r-r*)
e  P$
P
S0
S1
CF
Quantity of foreign currency
Quantity of foreign currency
Quantity of foreign currency
12
12
Currency Market with Cash Flow
e  P$
P
S0
S1
CF
D
Quantity of foreign currency
CF = IM - EX
13
13
The Net Capital Flow to the market
CF = IM(Y) - EX
The difference between the value of imports
and the value of exports equals capital inflows.
Capital flow depends on the interest rate.
When the central bank increases the interest rate,
the net capital flow increases and the import surplus
increases.
r  CF (r  r*)  ( IM  EX ) 
14
14
A Different Presentation of the Market
For Foreign Currency
e  P$
P
CF
IM-Ex=0
IM=Ex
IM-EX
CF
15
15
The Effect of an Increase in the Local
e P
Interest Rate
$
S1
P
e1  P $
P $
e2  P
P
S2
The supply of
Foreign currency
with CF.
CF
D
Quantity of currency
e * P$
r  CF (r  r*)  Supply of foreign currency 

P
16
16
The Aggregate Demand in the
Open Market
E = C + I + G + EX- IM
CF(r-r*) = IM - EX
E – total expenditure = AD
C - consumption
I – Investment
G – government spending
Ex - export
Im - Import
CF - net capital inflow
E = C + I + G - CF(r-r*)
An equilibrium in the market for goods:
E = Y  C + I + G – CF(r-r*) = Y
17
17
The IS Curve in the Open Economy
We build the IS curve in an open economy
in the very same way that we built it in the closed economy.
In the closed economy:
r  C, I  E 
In an open economy:
E = C + I + G - CF(r-r*)
r  C, I , CF  E 
E
E = C + I(r0) + G - CF(r0-r*)
E = C + I(r1) + G - CF(r1-r*)
18
r1>r0
Y
18
Short Run Equilibrium
r
r
IS
CF (r-r*)
r0
MP
Y0
Y
e  P$
P
CF
CF
IM-EX
19
19
The Effect of Expanding Fiscal Policy
r IS
0
r
IS1
CF
r1
r0
MP
Y
Y0 Y1
e  P$
P
CF
Fiscal policy: change in G or T.
Expanding fiscal policy:
Means that G increase, T
decrease, or G-T increase.
IM-EX
20
20
The Effect of an Decrease in the Expected Inflation Rate
r
r
IS
CF
r0
r1 MP0
MP1
Y
Y0
Y1
CF
e  P$
P
CF1
CF0
IM-EX
21
21
The Effect of Contracting Monetary Policy
r
IS
r
CF
MP1
r1
r1
r0
r0
MP
Y1 Y0
Y
e P
P
$
CF0
CF1
CF
Monetary policy: change in r
according to the Taylor rule. It
means a shift in the MP curve.
22
Contracting monetary policy: a
monetary policy that leads to a rise
in r.
IM-EX
CF0 CF1
22
The Influence of an Increase in r*
r
IS
r
CF1
IS1
CF
r1
r0
MP
Y0 Y1
23
Notice: here the change
starts from the CF diagram.
An increase in r* leads to
decrease in capital flow and
hence decrease in the supply
of foreign currency. IT also
means a shift of the IS curve
because CF decreased. The
real exchange rates increase
and hence IM-EX decrease.
Y
e  P$
P
CF
IM-EX
23
Data about the Global Economy and
The Background of the 2008 crisis
The Macroeconomic Environment
Dr. Yael Hadasss
The Share in the GDP and in the Population
2014
Country
Population (1000)
Percentage of World
Population
Percentage of World
GDP
China
1,355,692,576
18.9
14.3
India
1,236,344,631
17.2
5.6
Brazil
202,656,788
2.8
2.9
Russia
142,470,272
2.0
3.4
The European Union
511,434,812
7.1
14.3
United States
318,892,103
4.4
19.1
Japan
127,103,388
1.8
4.6
The whole World
7,174,611,584
The Share in the GDP and in the Population 2014
Share of GDP
Share of world's population
19.1
18.9
17.2
14.3
14.3
7.1
5.6
4.6
4.4
1.8
UNITED STATES
THE EUROPEAN
UNION
JAPAN
CHINA
INDIA
The Price of an Oil Barrel (Brent)
4
Commodity Prices (Bloomberg)
5
Monetary Policy

The main objectives of the Bank: Financial Stability, Economic
Stability. Maintaining price stability. Lender of Last Resort.

Response of the central banks to the crisis – reduce the
interest rates around the world.
Interest Rates in US (blue) and in the Euro Zone (red)
7
Private Consumption in US
Rate of Change in the Private Consumption
(quarter by quarter)
8
Global Risks
The Crisis’s Outcomes




The crisis started as a financial crisis
The central banks reduced interest rates.
The government took expanding fiscal policies measures.
As a result the deficits and debts of the countries increased.
The Debts of various countries
(Percentage of the GDP)
Japan
11
USA
France UK
GermanyIsrael
Brazil
India
China Russia
Euro-Dollar Exchange Rate
(The price of Euro in $US)
12
Inflation in the Euro Zone
13
The US data
GDP
(left axis)
14
Unemployment Rate
(Right axis)
The Israeli Economy
The Israeli Economy
16
2014
2013
2012
8,216
8,059
7,907
Population (thousands)
1.03%
1.9%
1.8%
Population Growth Rate
1,087
1,049
992
Nominal GDP (billion NIS)
0.8%
1.3%
1.1%
GDP Per Capita Growth Rate
5.9%
6.2%
6.9%
Unemployment Rate
-0.2%
1.8%
1.6%
Inflation Rate
0.6%
1.4%
2.3%
2.6%
3.1%
3.7%
Yearly average of the Bank of
Israel Interest Rate
Fiscal Deficit relative to the
GDP
Israel GDP growth
GDP and GDP of the business sector’s growth rate in Israel
12
GDP
10
GDP -Business
Sector
8
6
3.3
4
1.2
2
0
-2
-4
18
18
Government Deficit and Government
Debts (percent of GDP)
Government Debt
(left axis)
Government Deficit
(right axis)
Inflation and Inflation Target in Israel
Local Uses of the GDP
1950-2014
)Percent of GDP)
160
140
Y
C+G+I
C+G
C
120
100
80
60
40
20
0
2014
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
1956
1954
1952
1950
21
Import and Export
1950-2014
)Percent of GDP)
Prices of Housing in Israel
Housing Price Index
(nominal)
Housing Price Index
(real)
The Macroeconomic Environment
Topic: Investment
1
1/30/2024
The Macroeconomic Environment
1
The Theory of Investment

Investment goods – aimed at providing higher
standard of living at a later date.

Investment is the component of the GDP that
links the present and the future.
1/30/2024
The Macroeconomic Environment
2
Investment
The investment is the most volatile macroeconomic
component.
The Investment = The products that were produced
today, were not sold and remained for use in the
business sector for the future.
In crisis – the investment falls dramatically, and
explains that majority of the fall in the aggregate
demand. At booms it is the opposite.
1/30/2024
3
The Macroeconomic Environment
3
Investment
There are 3 types of investment spending:
•Business fixed investment – equipment and
structures used in production.
•Residential investment.
•Inventory investment
4
1/30/2024
The Macroeconomic Environment
4
Investment in business fixed assets -NPV
Rn  Cn
Ri  Ci
R1  C1 R2  C2
NPV  ( R0  C0 ) 

   

2
n
1 r
(1  r )
(1  r )
(1  r )i
NPV = Investment.
NPV↑→ Investment ↑
NPV↓→ Investment ↓
 r↓→ NPV↑
Technology improves → Investment ↑
5
The Macroeconomic Environment
1/30/2024
Explaining Investment in inventory : the Accelerator
We assume that when the amount of investment in inventory depends
on the growth of the GDP.
Investment in inventory is positively depended on the product.
This is called the accelerator influence.
Yt  Yt 1
I  
Yt 1
This size is depends on the product this year. The last year’s product
Is given.
6
The Macroeconomic Environment
1/30/2024
Investment : Summary
The investment:
Grows when y grows: positive relation to the national product
False when r increase: negative relation to the interest rate.
The investment is influenced mainly by the interest rate and
therefore we assume that the major economic factor that influence
the investment is the interest rate.
1/30/2024
The Macroeconomic Environment
7
Graphical Presentation
I
I(Y;r1<r0)
I(Y;r0)
Y
8
The Macroeconomic Environment
1/30/2024
Data about Investment
* Investment is the most volatile component of
the GDP.
* In crisis times the investment is very small and
explains the most decline in aggregate demand.
* When a market is recovering from crisis the
opposite is true.
1/30/2024
The Macroeconomic Environment
9
Investment
10
1/30/2024
The Macroeconomic Environment
10
1/30/2024
The Macroeconomic Environment
11
Total Gross Investment in Israel
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The Macroeconomic Environment
12
Total Gross Investment in Israel
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The Macroeconomic Environment
13
The Government’s Consumption
The Macroeconomic Environment
Government Budget
Spending
G – Government’s
consumption
Ig – Government’s
investment
Income
Taxes
Bonds (loans = finance
the deficit)
The Government’s Budget Deficit
Definitions:
Government Savings: Net Taxes-G= Sg
If Sg<0 budget deficit.
If Sg >0 a budget surplus.
A yearly government deficit of 3% of GDP is considered stable.
Government accumulated debt of no more than 60% of GDP is
considered stable.
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3
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4
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5
Government’s Debt as a Percentage
of GDP, (year average)
Source: www.cbs.gov.il
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6
Why A High Government’s Deficit is bad for the economy?
When the budget deficit is high the government
is willing to pay more for loans (Government
bonds).
This raises interest rates and decrease
investment and output.
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7
Policy
Fiscal Policy – Affects the Goods Market. Operated
by the Government who changes the spending on
goods or taxes collected.
No change in the interest rate and in the quantity of
money.
Expanding Fiscal Policy – Increase in Spending or
Decrease in Taxes
Contracting Fiscal Policy: Decrease in Spending or
Increase in Taxes.
8
‫ הצריכה הציבורית‬- ‫ הסביבה המאקרו כלכלית וכלכלת ישראל‬- ‫ד"ר יצחק אורון‬
Policy
Monetary Policy – Operated by the Central Bank.
Main tool is changing the interest rate.
Following recent crises the central bank used other
tools as well.
9
‫ הצריכה הציבורית‬- ‫ הסביבה המאקרו כלכלית וכלכלת ישראל‬- ‫ד"ר יצחק אורון‬
Problems driven by deficits

If the government wishes to finance the additional deficit
through loans it must offer a higher interest rate on its bonds.
This leads to lower investment and in the open economy has
an adverse affect on the capital flows as we will study in the
future.
The Effect of Taxes on the Private Consumption

Reminder from the Keynsian Theory –

AD = C+G+I (AD is aggregate demand).

C=C0+mpc*(Y-Tnet)

Disposable income:
Yd= Y-Tnet

Government Financing and Private Consumption
Assume: ΔG↑.
Finance through tax:
ΔG = ΔT
The Aggregate Demand will increase by:
AD  G  mpc * T  G 1  mpc
1  mpcG
AD
 Y 

 G
1  mpc
1  mpc
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12
Financing Through Loans

2. Finance through loans:
G  B

G
AD  G  Y 
1  mpc
The difference in financing government spending will
result in a different effect on the Aggregate Demand and
output.
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13
Ricardian Equivalence
David Ricardo (1772-1823). Robert Barro
reintroduced the idea in 1974.
Borrowing will lead to increased taxation in the
future hence the public will behave as if the
government financed the budget deficit with
taxes..
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14
Deficit and Business Cycle
When Y↑ → Tax ↑ →Public debt will decrease.
When Y↓ → Tax ↓ →Public debt will increase.
anti-cyclic measure – in downturns the government
should increase deficit in order to prevent the loss of
output.
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15
The Macroeconomic Environment
Topics: Equilibrium in the Goods Market – The IS curve
1
The Goods Market and the IS curve
The IS curve plots the relationship between the interest rate and
the level of income that arises in the market for goods and
services.
Keynes: The Aggregate Demand – AD or E
In a closed economy: E=C+G+I
Consumption depends on disposable income C=C(Y-T).
Assume: I,G,T are not functions of Y.
E=C(Y-T)+G+I
In Equilibrium Y=E → Y= C(Y-T)+G+I
2
The Aggregate Expenditure - E
Data
C  100  0.8(Y  T )
I  100  25r
G  50
T  50
r2
Finding E and calculating the Equilibrium
Demand=Supply
In Equilibrium
3
C  100  0.8(Y  50)  60  0.8Y
I  100  25  2  50
G  50
E  160  0.8Y
E Y
160  0.8Y  Y  Y  800
Denote : Y0  800
The Aggregate Expenditure – E - AD
E0 (Y ; r  2)  160  0.8Y
E0(Y,r0)
E
160
0.8
450
800
4
Y
The Effect of an Increase in the Interest Rate
Data
C  100  0.8(Y  T )
I  100  25r
G  50
T  50
r 3
Finding E and calculating the Equilibrium
C  100  0.8(Y  50)  60  0.8Y
I  100  25  3  25
G  50
E  135  0.8Y
Demand=Supply
E  Y  Y  675
In Equilibrium
Denote : Y1  675
5
The Effect of an Increase in the Interest Rates
E0(Y,r0=2)
E
E1(Y,r1=3)
180
135
675
6
800
Y
IS Curve
When r↑ →Y↓
E0(Y,r0)
E
E1(Y,r1)
r0  2  r1  3
675 800
The IS curve: all the
points of equilibrium of r
and Y from the above
graph (the market of
goods and services).
r
3
2
IS
675 800
7
Y
Y
Building IS Curve
C  100  0.8(Y  T )
I  100  25r
G  50
T  50
r ?
The Aggregate Expenditure is: E  (100  0.8(Y  50))  (100  25r )  50
 210  0.8Y  25r
Data:
In Equilibrium
8
E Y 
210  0.8Y  25r  Y 
210  25r  0.2Y
210 25

r Y
0.2 0.2
IS : Y  1050  125r
Changes of the IS Curve and Changes on
the IS Curve
A change in interest rate will lead to a move along the curve.
Changes in the components of E (AD) will lead to a move of the IS curve:
Changes that increase E will lead to a shift upward of the IS curve:
G , I , C Y  T  
Changes that decreases E will lead to a shift downward of the IS curve:
G , I , T  C Y  T  
Expanding
Fiscal Policy
r
IS0
Contracting
Fiscal Policy
Y
Other Changes that Shifts IS
Changes in the Private Consumption
When there is an improvement in the “mood” of consumers or
Increased wealth, and consumption increases for any given
interest rate, IS shifts to the right.
Changes in the Investment
When investors become optimistic (Animal Spirit) – investment
will increase for any given interest rate. As a result the national
product increases for a given interest rate. IS shifts right.
11
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11
Exercise in Aggregate
Demand – Fiscal Policy
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1
Aggregate Demand in the closed
economy = C+G+I
Review
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C= C0 + mpc * (Y-T)
I = I0 – a*r
2
Understanding
Changes in Y
driven by
changes in AD
 Understanding the Multiplier
C  100  0.8(Y  T )

I  100  25r

G  50
  AD  100  0.8(Y  50)  50  100  25 * 2

T  50


r2

AD  160  0.8Y  Y  160  0.8Y  0.2Y  160  Y  800
AD  G  100
AD  260  0.8Y  Y  260  0.8Y  0.2Y  260  Y  1300
G  100  Y  1300  800  500
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3
Round
Understanding
Changes in Y
driven by
changes in ADThe Multiplier
Effect
Change in AD
Change in Y
1
∆𝐺
∆𝑌 = ∆𝐺
2
∆𝐶2 =mpc*∆𝐺
∆𝑌2 =mpc*∆𝐺
3
∆𝐶3 =mpc2 ∗ ∆𝐺
∆𝑌3 =mpc2 ∗ ∆𝐺
4
∆𝐶4 =mpc3 ∗ ∆𝐺
∆𝑌4 =mpc3 ∗ ∆𝐺
5
∆𝐶5 =mpc4 ∗ ∆𝐺
∆𝑌5 =mpc4 ∗ ∆𝐺
..
…
…
7
𝑇𝑜𝑡𝑎𝑙 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝐷
= ∆𝐺 +
σ𝑛𝑖=1 ∆𝐶𝑖 =100 ∗ (0.8 +
0.82+0.83 +0.84…)
𝑇𝑜𝑡𝑎𝑙 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌 =
∗ (1 + mpc2+mpc3
+mpc4…)
σ𝑛𝑖=1 ∆𝑌𝑖 =∆𝐺
1
1−𝑚𝑝𝑐
 ∆𝑌 = (1 + MPC + MPC2+MPC3+…….)* ∆𝐺 = ∆𝐺*
 Notice that in equilibrium AD=Y so the sum of the changes G and C equals the
sum of changes in Y.
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4
Understanding
Changes in Y
driven by
changes in ADThe Multiplier
EffectNumerical
Example
Round
Change in AD
Change in Y
1
100
∆𝑌 = 100
2
∆𝐶2 =0.8*100=80
∆𝑌2 =0.8*100=80
3
∆𝐶3 =0.82 ∗ 100 =64
∆𝑌3 =0.82 ∗ 100 = 64
4
∆𝐶4 =0.83 ∗ 100=51.2
∆𝑌4 =0.83 ∗ 100=51.2
5
∆𝐶5 =0.84 ∗ 100 = 40.96
∆𝑌5 =0.84 ∗ 100=40.96
..
…
…
7
𝑇𝑜𝑡𝑎𝑙 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝐴𝐷 =
100 + σ𝑛𝑖=1 ∆𝐶𝑖 =100 ∗
(0.8 + 0.82+0.83 +0.84…)

𝑇𝑜𝑡𝑎𝑙 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑌 =
(1 + 0.8+0.82+0.83
+0.84…)
σ𝑛𝑖=1 ∆𝑌𝑖 =100 ∗
1
=500
1−0.8
 ∆𝑌 = (1 + 0.8 + 0.82+0.83+…….)* 100 = 100*
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5
Summary of
the Effect of
Fiscal Policy
Tools on the
output
 A Change in Government Consumption Under Different
Financing Assumptions:
 Increased Government spending, Financed by a Loan
 ∆𝐺 = ∆𝐵 → ∆𝐴𝐷 = ∆𝐺 → ∆𝑌 =
1
1−𝑚𝑝𝑐
∗ ∆𝐺
 Increased Government spending, Financed by Tax
 ∆𝐺 = ∆𝑇 → ∆𝐴𝐷 = ∆𝐺 − 𝑚𝑝𝑐 ∗ ∆𝑇 → ∆𝑌 =
1−𝑚𝑝𝑐
1−𝑚𝑝𝑐
∗ ∆𝐺= ∆𝐺
 A Change in Taxation
 ∆𝑇 → ∆𝐴𝐷 =−𝑚𝑝𝑐 ∗ ∆𝐺 → ∆𝑌 =
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−𝑚𝑝𝑐
1−𝑚𝑝𝑐
∗ ∆𝑇
6
The Case of
John F.
Kennedy 1961
 Reducing Taxes in 1964 (personal and corporate taxes)
 Result –
 Economic Boom –
Year
Growth in Real GDP
1963
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Unemployment
5.7%
1964
5.3 %
5.2%
1965
6.0 %
4.5%
7
The Case of
George W.
Bush 2000
 Reducing Income Taxes – 2001, 2003
 Result –
 Economic Boom –
Year
Growth in Real GDP
2003
2004
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Unemployment
6.3%
4.4%
5.4%
8
In 2009 – Obama offered a stimulus package that would cost the
government $800 billion (5% of annual GDP) that consisted of:
The Case of
Barack Obama
1/30/2024
 (1) Tax cuts
 (2) Transfer payments
 (3) increase in Government purchase of goods and services.
 Year
Result –
Growth in Real GDP
Unemployment
 2009
Economic Boom –
-3%
9.3%
2010
3%
9.6%
2011
2%
8.9%
2012
3%
8.1%
9
Bonds
Bond
Face Value $1000
Coupon Rate 5%
Time to Maturity 5 years
𝑃𝑣 = −1000 +
50
50
+
1+𝑟
1+𝑟
2+
50
1+𝑟
3+
50
1+𝑟
4+
1000 + 50
1+𝑟 5
Bond
Face Value $1000
Coupon Rate 5%
What will be the
price of the
bond if r=0.05?
𝑃𝑣 = −1000 +
Time to Maturity 5 years
50
50
+
1 + 0.05
1 + 0.05
2+
50
1 + 0.05
3+
50
1 + 0.05
4+
1000 + 50
1 + 0.05 5
Bond
Face Value $1000
Coupon Rate 5%
What will be the
price of the
bond if r=0.08?
𝑃𝑣 = −1000 +
Time to Maturity 5 years
50
50
+
1 + 0.08
1 + 0.08
2+
50
1 + 0.08
3+
50
1 + 0.08
4+
1000 + 50
1 + 0.08 5
Bond
Face Value $1000
Interest Rate 5%
What will be the
price of the
bond if r=0.03?
𝑃𝑣 = −1000 +
Time to Maturity 5 years
50
50
+
1 + 0.03
1 + 0.03
2+
50
1 + 0.03
3+
50
1 + 0.03
4+
1000 + 50
1 + 0.03 5
Long Term Considerations
The Macroeconomic Environment
Incorporating Inflation into our
model

We now want to extend the analysis to incorporate
inflation.

The behavior of inflation stems from how firms
respond to the demand for their goods and services.

This behavior therefore goes under the heading of
aggregate supply.

Together, aggregate demand and aggregate supply
determine not only output and inflation at a point in
time, but how they change over time.
The Behavior of Inflation
Definitions


Inflation rate:
Pt  Pt 1
t 
Pt
Y full (also called natural rate of output)
is the level of output that prevails when
prices are completely flexible; it is the
level of output that is produced when the
unemployment rate is at its natural rate.
Natural Rate of Unemployment
The Behavior of Inflation
Assumptions:

At a point in time, the rate of inflation is given.

Y>Yfull → inflation ↑.

When output is above full employment, firms must run extra shifts
and have difficulty finding and retaining workers. As a result, they
raise their prices by more than before

Y<Yfull → inflation ↓

When output is below full employment firms have idle capacity
and little trouble finding new workers and retaining their current
ones. As a result, they raise their prices by less than they were
raising them before.

Y=Yfull → inflation is constant.
This behavior is consistent with the
data


US Data:
During the boom of the 1960s, when unemployment fell
below 4 percent, inflation rose from around 1 percent to
over 4 percent.

During the severe recession of 1981–1982, for example,
when unemployment rose to almost 11 percent and output
was far below its natural rate (Yfull), inflation fell from close
to 10 percent to under 4 percent.

Laurence Ball identified 65 episodes in 19 industrialized
countries in which inflation fell substantially. He found that in
a large majority of the episodes, output was below its natural
rate. That is, periods of below-normal output are associated
with falling inflation
Two important considerations

inflation at a point in time is given. If, for example, the
government uses fiscal policy to increase aggregate demand,
the immediate effect of the policy is to raise output with no
change in inflation. Only later does the above-normal output
cause inflation to rise (Long term).

Second, our assumption concerns the behavior of inflation,
not prices. Below-normal output does not cause most firms
to actually reduce their prices. For example, inflation
remained positive – that is, the price level continued to rise –
during the 1981–1982 recession. Instead, below-normal
output causes firms to raise their prices by less than
before. Although inflation remained positive in the 1981–
1982 recession, it fell substantially from what it had been
before the recession.

Why Inflation is bad?
It appears to lower investment of all kinds
by creating uncertainty.
 It reduces confidence in future
government policies.
 It divert some of the economy’s
productive capacity into such activities as
forecasting inflation and trying to offset its
effects.
 It magnifies the microeconomic
distortions created by the tax system.

Adding a new diagram to our model
We wish to graph inflation and output
together.
 We assume that inflation does not change
with output at a given point in time, only
as a long term response.


IA
Y
IA- inflation adjustment line.
We will also call it the aggregate
supply curve.
Translating the Aggregate Demand to Inflation-Output Diagram
MP1
r
MP2
MP3
IS
r1
r2
r3

1
Y1 Y2
Y3
Y
AD
2
3
10
Y1 Y2
Y3
Y
The AD-IA model

At a given point in time, there is an
equilibrium in which output and inflation are
determined.
IA
AD
Y
*
Y
The AD-IA model
Inflation adjustment process: Suppose Y*>Yf, .
In the background, the increases in inflation are
causing the central bank to raise the real interest
rate for a given level of output, and these changes in
monetary policy are causing output to fall. These
shifts of the MP curve in response to changes in
inflation in the IS-MP diagram correspond to
movements along the AD curve in the AD-IA diagram


LongTerm

IA
*
IA
Long term
Shortterm
AD
Y
full
Y
*
Y
Adjustment to the Long Run. Starting from Y>Yfull
r
IS
r
CF
MPt+1
r1
r0
MPt

YF Yt
CF Y e  P $
CF
P
AD
 t 1
t
..
NIM
IM-EX
YF Yt
13
The AD-IA model
Inflation adjustment process: Suppose
Y*<Yf, in the background, the decreases in
inflation are causing the central bank to reduce
the real interest rate for a given level of
output, and these changes in monetary policy
are causing output to rise

IA

LongTerm

*
Shortterm
IA
Long term
AD
Y
*
Y
full
Y
Adjustment to the Long Run. Starting from Y<Yfull
r
IS
r
MPt
MPt+1
CF
r0
r1

Yt
AD
t
 t 1
YF
..
Y
CF
e  P$
P
NIM
IM-EX
15
Yt YF
Changes to the Aggregate Demand Side of the Economy: G↑
Assume that
we start from
Yfull. The G
increases.
What happens?
MP1
MP0
r
r3
r2
IS1
r1
IS0

ELR1
16
Y1
Y
1
0
Denote: ELR
Long Term
Equilibrium
Yfull
IA1
IA0
ELR0
AD0 AD1
Yfull
Y1
Increase in G. Starting from Y=Yfull
IS
r
MPt+1
IS
r
CF
r1
r0
MPt

YF Yt
CF Y e  P $
CF
P
 t 1
t
..
ELR1
ELR0
NIM
AD0 AD1
YF Yt
17
IM-EX
Changes to the Aggregate Demand Side of the Economy: G↑
starting from Y=Yf
Summary of results
Y ↑↓ at the end stays the same
C ↑↓ at the end stays the same (assuming that G was not financed by T).
r ↑→ I ↓, CF↑,
And of course
18


Contracting Monetary Policy –
Short Run and Long Effects
r
r
IS
CF
MP1
r**
r0
MP0

Y1
AD1
 ***

YF
CF Y e  P $
AD0
ESR1
CF
P
..
ELR1
IA0
NIM
IA1
IM-EX
Y1 YF
19
r  r T   ( e   T )   (
YF  Y
)
YF
Inflation Shocks

Immediate one-time change in inflation in the current
period.

A negative inflation shock lifts IA immediately.

A positive inflation shock lowers IA immediately.

The shock is an event that causes producers to change
the prices immediately in a different pace then before.

Reasons:

An oil prices shock like in the 1970s.

New taxes on the business sector.

Opening the market for foreign competition – cheap
imports or expensive exports.
Negative Inflation Shock – Short Run and Long Run Effects
r
r
IS0
MP**
CF
r*
r0
MP0

Y1 YF
CF Y e  P $
CF
P

*
**
ESR1
..
NIM
ELR1 AD0
IM-EX
Y1 YF
21
Supply Shocks
Supply Shock is a change in Yfull (or a
change in the natural rate of
unemployment).
 Why it happens:
 Immigration or change in the size of the
labor force.
 Productivity shock – the same factor of
production can produce more due to a
change in technology.

Supply Shocks –
Short Run and Long Effects
r
r
IS
CF
MP1
r0
r1
MP0

YF0 YF1
CF Y e  P $
AD0


ESR1
*
**
P
.
IA0
ELR1
IA1
IA1
23
CF
e1  P1
P1
$
e0  P0
P0
NIM
$
IM-EX
YF0 YF1 r  r T   ( e   T )   (YF  Y )
YF
The Macroeconomic Environment
Presentation 8
Topic: The Solow Growth Model
1
18:41 30/01/2024
Year
1980
1990
2000
2010
0.01
10,000
11,046
12,202
13,478
0.02
10,000
12,190
14,859
18,114
Annual Growth Rate
0.03
0.04
10,000
10,000
13,439
14,802
18,061
21,911
24,273
32,434
0.07
10,000
19,672
38,697
76,123
0.08
10,000
21,589
46,610
100,627
Assume: in 1980 GDP per capita is $10,000.
This is a simulation what happens over decades with different
growth rates.
2
18:41 30/01/2024
Real GDP per person in 1870
4,000
3,500
3,000
Real GDP per person in 1870
2,500
2,000
1,500
1,000
500
0
Australia
United
Kingdom
United
States
France
Germany
Canada
Sweden
Japan
Figures are in U.S. dollars at 1990 prices, adjusted for differences in the purchasing power of the various national currencies. Source: Angus Maddison,
3 Forces in Capitalist Development A long run comparative view, New York: Oxford University Press. 1991, Table 1.1.
18:41
30/01/2024
Dynamic
Data of
2005 is from BLS
www.bls.gov.il rescaled to 1990 prices. All this is quoted at Abel Andrew B, Ben S. Bernanke and Dean Croushore, Macroeconomics, Pearson Education,
2008.
GDP Per Capita Growth
Country
Japan
Sweden
Canada
Germany
France
United States
United Kingdom
Australia
4
Real GDP per person in
1870
737
1,664
1,695
1,821
1,876
2,445
3,191
3,645
Annual
Growth
Rate (%)
2.5
1.9
2
1.8
1.8
1.9
1.4
1.4
18:41 30/01/2024
Real GDP Per person in 2005
35,000
Real GDP Per person in 2005
30,000
25,000
20,000
15,000
10,000
5,000
0
United
States
Canada
Australia
Sweden
United
Kingdom
France
Japan
Germany
Figures are in U.S. dollars at 1990 prices, adjusted for differences in the purchasing power of the various national currencies. Source: Angus Maddison,
5 Forces in Capitalist Development A long run comparative view, New York: Oxford University Press. 1991, Table 1.1.
18:41
30/01/2024
Dynamic
Data of
2005 is from BLS
www.bls.gov.il rescaled to 1990 prices. All this is quoted at Abel Andrew B, Ben S. Bernanke and Dean Croushore, Macroeconomics, Pearson Education,
2008.
General Production Function
•
•
•
Each product is manufactured by inputs.
We are looking for a way to produce the maximum product out of
given amount of inputs.
The Production Function: the relation between the amount of the
inputs and outputs.
Y  F ( K , L)
•
•
•
6
K-capital, L- labor
Connection between technology and the production function.
Technology changes alter the production function.
The Macroeconomic Environment,
Dr. Yael Hadass, IDC 2015
18:41 30/01/2024
The Cobb Douglas Production
Y  A  K   L1
α is the share of income that the capital owners receive. 0 < 𝛼 < 1.
If you want to read more about this function is it in Mankiw’s textbook 8th edition
p.56-59.
K= capital, L=Labor, Y=GDP
We can write the production function in values per worker.
Denote:
Y
K

y
L
,k 
 y  Ak
L
Y  A  K   L1

1
Y
K  L
 A    
L
 L  L
7

Y
K
  A 
L
L
The Macroeconomic Environment,
Dr. Yael Hadass, IDC 2015
18:41 30/01/2024
Explanation to those who want to know why we can divide
the Cobb Douglas Production Function by L
• Many production functions have the property of
constant returns to scale (CRS).
• An increase of an equal percentage in all factors of
production causes an increase in output of the same
percentage.
zY  F ( zK , zL )
8
• For any positive number z.
• The Cobb Douglas function displays Constant
Returns to scale hence it allows us to divide the two
inputs and the outputs by L.
The Cobb Douglas Production in graph
form
Output
Per
Worker
Capital per Worker
9
The Macroeconomic Environment,
Dr. Yael Hadass, IDC 2015
18:41 30/01/2024
Solow Model
All the variables are per worker
Output per worker $
Output per worker, f(k)
y  Ak 
y1
y0
Capital per worker k
10
k0
k1
The connection between output and savings
y  ci
c  (1 - s)y  y - sy
y  c  sy
 sy  i
y  f(k)  i  sf(k)
11
18:41 30/01/2024
Solow Model
all the values below are per person
Output
per worker $,
Investment per worker $
Output per worker, f(k)
y1
y0
c
Investment per
worker, sf(k)
y
i
Capital per worker k
12
k0
18:41 30/01/2024
k1
Solow Model
Steady State Level of Capital
Output per worker,$
Investment per worker $
The value of depreciation $
k  i   * k  sf (k )  k
Depreciation, δk
δ(k2)
sf(k2)
sf(k1)
δ(k1)
k  0
worker, sf(k)
k  0
Decrease
in k
Increase
in k
13
Investment per
k1
18:41 30/01/2024
k*
k2
Capital per worker k
Finding the Steady State
k  i  k
k  sf (k )  k
Denote k * as the k in which k  0.
k  0  sf (k * )  k *
The condition in which k  0 :
*
14
k
s

*
f (k ) 
1515
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Equilibrium in the Solow Model
Output per worker,$
Investment per worker $
The value of capital per worker’s depreciation $
f(k)
y1
y*
*k
y0
s*f(k)< *k
s*f(k)
s*f(k)> *k
k0
1616
k*
k1 Capital per worker k
18:41 30/01/2024
The Effect of a Decrease in the
Depreciation Rate
Output per worker,$
Investment per worker $
Break even investment, $
y2
f(k)
1*k
y1
1> 2→y2>y1
2*k
s*f(k)
k1
k2
Capital per person k
1717
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The Influence of Technological Improvement
Economic Growth=The growth of output per worker
f2(k)
Output per worker,$
Investment per worker $
Break even investment, $
y2
f1(k)
f0(k)
y1
y0
*k
s*f(k)
k0
1818
k1
k2
Capital per worker k
18:41 30/01/2024
Solow Model With Population
Growth
η is population growth
η =0.02 → the population grows at a rate of 2% per year
k  i  k   * k
k  i  (   ) * k
19
k  sf (k )  (   ) * k
The Steady State with Population Growth
k  0
sf (k )  (   ) * k
k
s

f (k ) (   )
Solow Model
Steady State Level of Capital
Population Growth is η>0
Output per worker,$
Investment per worker $
Break Even Investment, $
(δ+η)k
Investment per
worker, sf(k)
Capital per worker k
20
20
k1
k*
k2
18:41 30/01/2024
The Macroeconomic Environment, Dr. Yael HadassIDC 2013
Equilibrium in the Solow Model
Output per worker,$With Population Growth
Investment per worker $
Break even investment, $
f(k)
y1
y*
(+η)*k
y0
s*f(k)< (+η)* k
s*f(k)> (+η)* k
k0
2121
s*f(k)
k*
kCapital
per worker k
1
18:41 30/01/2024
The Effects of Changes in the Savings
Rate
Output per worker,$
Investment per worker $
The value of capital per worker’s depreciation $
f(k)
y*2
y*1
s2 > s1
y1 < y2
(+)*k
s2*f(k)
s1*f(k)
k*1
2222
k*2 Capital per worker k
18:41 30/01/2024
23
18:41 30/01/2024
The Influence of Technological Improvement
Economic Growth=The growth of output per worker
f2(k)
Output per worker,$
Investment per worker $
Break even investment, $
y2
y1
f1(k)
f0(k)
y0
(+)*k
s*f(k)
k0
2424
k1
k2
Capital per worker k
18:41 30/01/2024
The Effect of a Decrease in the
Depreciation Rate
Output per worker,$
Investment per worker $
Break even investment, $
y2
f(k)
(1 +)*k
y1
1> 2→y2>y1
(2+ )*k
s*f(k)
k1
k2
Capital per person k
2525
18:41 30/01/2024