Macro - Review
GDP = C + I + G + NX
MV = P Q (= $GDP)
Circular
Flow
GDP: Real and Nominal
• Gross Domestic Product (GDP): the market
value of all final goods and services
produced within a country during a year.
GDP = C + I + G + Ex – Im
= C + I + G + NX
• Real GDP adjusts for inflation
Nominal GDP = $GDP = P x Q
$ GDP = GDP Deflator x Real GDP
Real GDP = Q = $GDP/P
= Nominal GDP divided by
(deflated by) the GDP Price Deflator
Price Indexes (Base Year = 100)
• Consumer Price Index (CPI)
– cost over time of a typical bundle of goods
and services purchased by households.
CPI = Cost of Typical Market Basket Now
divided by
Cost of the Same Basket in Base Year
Inflation Rate = {Change in CPI} ÷ {Initial CPI}
• GDP Price Deflator (GDP Price Index)
– measures average prices over time of all
goods and services included in GDP.
Unemployment
Unemployment rate: % of labor force not working.
number unemployed
Rate of
= number in the Labor Force
Unemployment
• Unemployed persons: not working and looking
• Labor force: Employed + unemployed
noninstitutionalized persons 16+ years of age
• Underemployed workers are treated as employed
• Discouraged workers are not in the labor force
• “Natural” or normal rate of unemployment (NAIRU)
Seasonal Unemployment
Frictional Unemployment: searching for jobs
Structural Unemployment: Imperfect match between
employee skills and requirements of available jobs.
• Cyclical Unemployment : Results from business cycle
Interest Rates: Nominal and Real
• Nominal Interest Rate (i): the interest
rate observed in the market.
• Real Interest Rate (r): the nominal rate
adjusted for inflation ().
Real Interest Rate = Nominal Interest Rate
– Inflation Rate
r=i-
• Low real interest rates spur business
investment spending (the I in C + I + G + NX)
Aggregate Demand (AD): the economywide demand for goods and services.
• Aggregate demand curve relates aggregate
expenditure for goods and services to the
price level
• The aggregate demand curve slopes
downward owing to price-level effects:
– Wealth Effect (Real Wealth/Real Balances)
– Interest Rate Effect
– International Trade Effect (Substitution)
Shifting Aggregate Demand Curve
Factors that Affect AD  Shifts in AD
AD = C + I + G + NX
• Consumption
– Income
– Wealth
– Interest Rates
– Expectations/Confidence
– Demographics
– Taxes
• Investment
– Interest Rates
– Technology
– Cost of Capital Goods
– Capacity Utilization
– Expectations/Confidence


Government Spending
Net Exports
– Domestic & Foreign
Income
– Domestic & Foreign
Prices
– Exchange Rates
– Government Policy
Aggregate Supply
• Aggregate Supply (AS): the quantity of real GDP
produced at different price levels.
Short-run Aggregate Supply SRAS slopes upward
– a higher price level (holding production costs and
capital constant in short-run)  higher profit margins
firms want to produce more.
Long Run Aggregate Supply LRAS is vertical: higher
prices cannot elicit more output in the long-run.
• Resource costs are NOT fixed in the long-run.
– As prices rises, workers demand and get higher
wages
Profits don’t rise with price in long-run
AS is set by production possibilities in the long-run
Aggregate Supply:
Short – Run & Long – Run
Aggregate
Demand and
Supply
Equilibrium:
Short-run
and long-run
responses
to increase
in aggregate
demand
Aggregate Expenditures = AE = GDP
Y = AE = C + I + G + NX
• Disposable income = Yd = Y-T = after tax
income.
Yd = Y - T = C + S
Consumption is related to disposable income
(Y-T).
C = Ca +cYd
where c = Marginal Propensity to Consume = mpc
Ca = Autonomous consumption
 Additional income not consumed is saved
mpc + mps =1
Aggregate Expenditures = AE = GDP
In a closed economy, saving either finances
private investment (I) or the government’s
deficit (G – T)
S = I + (G – T) at equilibrium
Investment can be crowded out by the deficit
I = S – (G-T)
• Leakages from the spending stream (S + T)
= Injections to the spending stream (I + G)
• S+T=I+G
Shifts in the Consumption Function

Expected Future Income
–

Wealth
–

–

An increase in wealth raises current consumption and
lowers current saving.
Expected Real Interest Rate


An increase in expected future income will cause
current consumption to rise and your saving to fall.
Higher real return  incentive to save more … but
Higher return to saving  less needs to be put aside to
achieve the same desired future savings.
– Net effect: increased real interest rates reduce
consumption and increase saving.
Demographics
Taxes – Ricardian Equivalence: Anticipation of Future
Taxes
Demand-Side Equilibrium and the Multiplier
At equilibrium: Y = C + I + G + NX = AE
Increase in Y = Spending Multiplier x {Increase in
Autonomous Spending}
Multiplier = 1/(mps + mpi)
From Aggregate
Expenditure to
Aggregate
Demand:
As price level rises,
real money balances
decrease and
consumption function
shifts owing to
i) wealth effect
ii) interest rate effect
iii) international
competition
Demand-Side
Policy: Greater
Spending Means
Higher Prices
Price Level
(c) Aggregate Demand and Supply in
the classical range of AS curve. (Prices
rise without significant improvements
in output and employment.)
AD1
AD
Y?
Real GDP
Fiscal Policy: Some Definitions
• Fiscal policy: government spending and taxing
– Demand-side policies
– Supply-side policies:
• Discretionary Fiscal Policy: aimed at
achieving a policy goal.
• Automatic Stabilizer: fiscal policy that
changes automatically and
countercyclically as income changes.
– Progressive taxes
– Unemployment insurance
– Welfare payments / other transfer payments
Functions of Money
•
Medium of exchange
•
Unit of account
–Standard of Deferred Payment
•
Store of value
Multiple Creation of Bank Deposits  M1
Fractional Reserve Banking System: R = .1
Deposit expansion multiplier = 1/R
(when banks lend all excess reserves and public redeposits
proceeds of loans into the banking system  no leakages)
The Fed’s Policy Tools
1) Reserve Requirements
2) Discount rate
“primary credit rate”
3) Open market operations
• Manage the public’s expectations
Inflation Targeting?
Fed Policy Linkages
Tools – Intermediate Targets – Goals
Equation of Exchange: relates
quantity of money to nominal GDP
–
–
–
–
–
M = money supply (some aggregate)
V = velocity of money (of the aggregate)
P = price level
Q = real GDP
PQ = nominal GDP
MV = PQ
(Note: V = PQ/M)
Money Demand
– Transactions demand
– Precautionary demand
– Speculative demand
… fear decline in the value of other assets, so
hold money as a safeguard.
How Money Supply Changes Affect GDP
Aggregate Demand and Supply
 Phillips Curve
Expectations
and the Phillips Curve
• Starting at (1): 5%
unemployment and 3%
inflation. People believe
inflation will continue at 3%
 Curve I.
• Then Fed hypes inflation to
6%  unemployment falls to
3% (Point 2 on Curve I).
• Expectations adjust to 6%
inflation  Wage demands
up  Economy moves to
point (3) Unemployment
returns to 5%.
• If expectations adjust
instantly, e.g., anticipating
Fed’s policy, economy moves
directly from (1) to (3).
Expectations Formation
• Adaptive Expectations: expectations of the future
based on history
• The public acts on its expectations
The present depends on the past
• Rational Expectations: expectation based on all
available relevant information.
– The public understands how the economy
works.
– The public knows the structure and linkages
between variables in the economy.
– The public anticipates policy actions and their
consequence
– The public acts now on its expectations
The present depends on the future
New Classical Economics:
Rational Expectations  Policy Ineffectiveness
{Expansionary policy  movement from 1 to 3}
Macroeconomic Viewpoints
Laissez - Faire
Classical
Monetarist
New Classical
Activist/Interventionist
Keynesian
New Keynesian
The Modern
Keynesian Model:
Sticky Prices
 Demand
Management Policies
Can Stabilize an
Unstable Economy
Long and Variable Policy Lags
– 1. Recognition Lag: policymakers need time
to realize that there is a problem.
– 2. Reaction Lag: they need time to formulate
an appropriate policy response.
– 3. Effect Lag: policy takes time to implement
and work through the economy.
• Countercyclical policies can become
procyclical policies, worsening fluctuations
Determinants of Growth
• Size and quality of the labor force
• Capital
• Land/Natural Resources … are not a necessary
condition for economic growth … they can
be acquired through trade.
• Technology