Welcome to Day 12
Principles of
Macroeconomics
1. MEASURING TOTAL OUTPUT
Learning Objectives
1. Define gross domestic product and its
four major spending components and
illustrate the various flows using the
circular flow model.
2. Distinguish between measuring GDP as
the sum of the values of final goods and
services and as the sum of values added
at each stage of production.
3. Distinguish between gross domestic
product and gross national product.
1.1 The Components of GDP
GDP =
consumption (C) + private investment (I) + government purchases
(G) + net exports (Xn)
Or
GDP =
C + I + G + Xn
•
•
A flow variable is a variable that is
measured over a specific period of time.
A stock variable is a variable that is
independent of time.
1.1 The Components of GDP
•
Personal consumption is a flow variable that
measures the value of goods and services
purchased by households during a time period.
Personal consumption
Consumer goods
and services
Households
Firms
Factors of
production (labor,
capital, and natural
resources)
Factor incomes (wages, interest, profit, and rent)
1.1 The Components of GDP
•
Gross private domestic investment is the
value of all goods produced during a period for
use in the production of other goods and
services.
Personal consumption
Private investment
Households
Firms
Factor incomes
1.1 The Components of GDP
•
•
Government purchases are the sum of purchases of
goods and services from firms by government agencies
plus the total value of output produced by government
agencies themselves during a time period.
Transfer payments are payments that do not require the
recipient to produce a good or service in order to receive
them.
1.1 The Components of GDP
Personal consumption
Private investment
Firms
Households
Government
purchases
Government
agencies
Factor incomes
1.1 The Components of GDP
•
•
•
•
•
Exports are the sales of a country’s goods and
services to buyers in the rest of the world during
a particular time period.
Imports are purchases of foreign-produces
goods and services by a country’s residents
during a period.
Net Exports are exports minus imports.
Exports (X) – imports (M) = net exports (Xn)
A trade deficit occurs when there are negative
net exports.
A trade surplus occurs when there are positive
net exports.
1.1 The Components of GDP
Private investment
Personal consumption
Firms
Government
purchases
Government
agencies
Households
Net
Exports
Factor incomes
Rest of the world
1.1 The Components of GDP
3. GDP AND ECONOMIC WELLBEING
Learning Objectives
1. Discuss and give examples of
measurement and conceptual problems
in using real GDP as a measure of
economic performance and of economic
well-being.
2. Explain the use of per capita real GNP or
GDP to compare economic performance
across countries and discuss its
limitations.
3.2 Conceptual Problems with
Real GDP
A second set of limitation or real GDP
stems from problems inherent in the
indicator itself.
– Household Production
– Underground and Illegal Production
– Leisure
– The GDP Accounts Ignore “Bads” (e.g.
crime spending, negative externalities,
environmental pollution)
• More GDP cannot necessarily be equated
with more human happiness.
•
3.3 International Comparisons
of Real GDP and GNP
•
•
Per capita real GNP or GDP is a
country’s real GNP or GDP divided by its
population.
Comparing one country’s output to
another presents additional challenges.
That said, when the data suggest huge
disparities in levels of GNP per capita, for
example, we observe real differences in
living standards.
Welcome to Day 13
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
Output or Real GDP
•
Potential output is the level of output
an economy can achieve when labor is
employed at its natural level.
– the natural level of real GDP
Welcome to Day 14
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
1. AGGREGATE DEMAND
Learning Objectives
1. Define potential output, also called the natural level of
GDP.
2. Define aggregate demand, represent it using a
hypothetical aggregate demand curve, and identify and
explain the three effects that cause this curve to slope
downward.
3. Distinguish between a change in the aggregate quantity
of goods and services demanded and a change in
aggregate demand.
4. Use examples to explain how each component of
aggregate demand can be a possible aggregate demand
shifter.
5. Explain what a multiplier is and tell how to calculate it.
1.1 The Slope of the Aggregate
Demand Curve
•
•
•
•
•
•
Aggregate demand is the relationship between the total
quantity of goods and services demanded (from all the four
sources of demand) and the price level, all other determinants
of spending unchanged.
The aggregate demand curve is a graphical representation
of aggregate demand.
The wealth effect is the tendency for a change in the price
level to affect real wealth and thus alter consumption.
The interest rate effect is the tendency for a change in the
price level to affect the interest rate and thus to affect the
quantity of investment demanded.
The international trade effect is the tendency for a change
in the price level to affect net exports.
The change in the aggregate quantity of goods and
services demanded refers to a movement along an
aggregate demand curve.
Aggregate Demand
1.2 Changes in Aggregate
Demand
•
A Change in aggregate demand is a
change in the aggregate quantity of
goods and services demanded at
every price level. This can be caused
by changes in…
– Consumption,
– Investment,
– Government purchases,
– Net exports.
1.2 Changes in Aggregate
Demand
The Multiplier
•
The multiplier is the ratio of the change in the
quantity of real GDP demanded at each price
level to the initial change in one or more
components of aggregate demand that
produced it.
EQUATION 1.1
Multiplier = Δ (real GDP demanded at each price level)
initial Δ (component of AD)
EQUATION 1.2
Δ (real GDP demanded at each price level) = Multiplier
× initial Δ (component of AD)
The Multiplier
Effect of initial increase in
net exports without
multiplier effect
AD1
AD2
The Multiplier
Effect of initial decrease in
net exports without
multiplier effect
AD2
AD1
2. AGGREGATE DEMAND AND AGGREGATE
SUPPLY: THE LONG RUN AND THE SHORT RUN
Learning Objectives
1. Distinguish between the short run and the long run, as these
terms are used in macroeconomics.
2. Draw a hypothetical long-run aggregate supply curve and
explain what it shows about the natural levels of employment
and output at various price levels, given changes in aggregate
demand.
3. Draw a hypothetical short-run aggregate supply curve,
explain why it slopes upward, and explain why it may shift;
that is, distinguish between a change in the aggregate
quantity of goods and services supplied and a change in
short-run aggregate supply.
4. Discuss various explanations for wage and price stickiness.
5. Explain and illustrate what is meant by equilibrium in the
short run and relate the equilibrium to potential output.
2. AGGREGATE DEMAND AND AGGREGATE
SUPPLY: THE LONG RUN AND THE SHORT RUN
•
•
•
The short run in macroeconomic analysis,
is a period in which wages and some other
prices are sticky and do not respond to
changes in economic conditions.
A sticky price is a price that is slow to
adjust to its equilibrium level, creating
sustained periods of shortage or surplus.
The long run in macroeconomic analysis, is
a period in which wages and prices are
flexible.
2.1 The Long Run
•
The long run aggregate supply (LRAS) curve is
a graphical representation that relates the level of
output produced by firms to the price level in the
long run.
Long-Run Equilibrium
Why is the long-run aggregate
supply curve (LRAS) straight up and
down?
Let’s believe that the more
profitable something is, the more
of it will be made. How do rising
prices affect profits?
Price of car
$20,000
Cost of making car
Labor $8,000
Steel $8,000
Glass $4,000
Total Cost of Making Car = $20,000
Profit is $0.
Now double the sales price and all the
costs.
Price of car
$40,000
Cost of making car
Labor $16,000
Steel $16,000
Glass $8,000
Total Cost of Making Car = $40,000
Profit is $0.
How many more cars are being made
at double the sales price?
Price of car
$22,000
Cost of making car
Labor $8,000
Steel $8,000
Glass $4,000
Total Cost of Making Car = $20,000
Profit is $2,000.
Now double the sales price and all the
costs.
Price of car
$44,000
Cost of making car
Labor $16,000
Steel $16,000
Glass $8,000
Total Cost of Making Car = $40,000
Profit is $4,000.
Is it actually more profitable to make
cars now?
Welcome to Day 15
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
1) Take out a piece of paper.
2) Write your name, the day and
time of the class.
3) Write Econ 2 Quiz 5
Fill in the blanks for the following
equation. Use only the domestic parts
of GDP You may use the common one
letter abbreviations.
1) GDP = ___ + ___ + ___
2) Write out what one of the
abbreviations stands for.
2.2 The Short Run
•
•
•
The short run aggregate supply (SRAS)
curve is a graphical representation of the
relationship between production and the price
level in the short run.
A change in the aggregate quantity of
goods and services supplied is characterized
by movement along the short-run aggregate
supply curve.
A change in short-run aggregate supply is
characterized by a change in the aggregate
quantity of goods and services supplied at
every price level in the short-run.
Price of car
$20,000
Cost of making car
Labor $8,000
Steel $8,000
Glass $4,000
Total Cost of Making Car = $20,000
Profit is $0.
Now double the sales price and all the
costs.
Price of car
$40,000
Cost of making car
Labor $8,000
Steel $16,000
Glass $8,000
Total Cost of Making Car = $32,000
Profit is $8,000.
How many more cars are being made
at double the sales price?
Deriving the Short-Run
Aggregate Supply Curve
Things that raise the cost of
production shift the SRAS curve
left. Things that lower the of
production shift the SRAS curve
right. For example, changes in:
1) Resource prices
2) Wages
3) Cost of employer paid health
insurance
Changes in Short-Run Aggregate
Supply
Shift caused by
increase in
price of natural
resources.
SRAS3 SRAS1 SRAS2
Shift caused by
decrease in
price of natural
resources.
Short-Run Equilibrium
SRAS2 SRAS1
P2
Shift caused by increase in
health insurance premium
paid by firms
P1
AD1
Y2
Y1
Short-Run Equilibrium
SRAS1
Shift caused by
increase in
government
purchases.
P2
P1
AD1
Y1
Y2
AD2
3. RECESSIONARY AND INFLATIONARY GAPS
AND LONG-RUN MACROECONOMIC
EQUILIBRIUM
Learning Objectives
1. Explain and illustrate graphically
recessionary and inflationary gaps and
relate these gaps to what is happening in
the labor market.
2. Identify the various policy choices available
when an economy experiences an
inflationary or recessionary gap and discuss
some of the pros and cons that make these
choices controversial.
3.1 Recessionary and Inflationary
Gaps
•
A recessionary gap is the gap between the level of real GDP
and potential output, when real GDP is less than potential.
3.1 Recessionary and Inflationary
Gaps
•
An inflationary gap is the gap between the level of real GDP
and potential output, when real GDP is greater than potential.
What determines exactly where Yp is?
When unemployment is high, wages
fall in the long-run.
When unemployment is low, wages
rise in the long-run.
When unemployment is at the natural
rate of unemployment, wages stay the
same in the long-run.
Yp is the amount of real GDP
produced when unemployment is
at the natural level.
It is the amount of stuff we make
when unemployment is such that
wages do not change even in the
long-run.
When output is low, unemployment is
high and wages fall. SRAS curve shifts
right until output rises to Yp.
When output is high, unemployment is
low and wages rise. SRAS curve shifts
left until output rises to Yp.
Welcome to Day 16
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
Welcome to Day 17
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
1) Take out a piece of paper.
2) Write your name, the day and
time of the class.
3) Write Econ 2 Quiz 6
In a normal one good supply and
demand curve, the supply curve
slopes up, showing that the
businesses will produce more of the
good at a higher price. Explain why
the macro long-run aggregate supply
curve does not slope up, but is
straight up and down, showing that
businesses do not produce more of
the good at higher prices.
3.2 Restoring Long-Run
Macroeconomic Equilibrium
LRAS
SRAS2
SRAS1
Shift in long run as
nominal wages rise.
P3
Shift caused by increase in
government purchases.
P2
P1
AD1
YP
Y2
AD2
Inflationary gap
3.2 Restoring Long-Run
Macroeconomic Equilibrium
Shift in long run as
nominal wages fall.
LRAS
SRAS2
SRAS1
Shift caused by
increase in
insurance premiums
paid by firms..
P2
P1
AD1
Recessionary gap
Y2
YP
1. WHAT IS MONEY?
Learning Objectives
1. Define money and discuss its three basic
functions.
2. Distinguish between commodity money
and fiat money, giving examples of each.
3. Define what is meant by the money
supply and tell what is included in the
Federal Reserve System’s two definitions
of it (M1 and M2).
1.1 The Functions of Money
•
Money is anything that serves as a
medium of exchange.
− A medium of exchange is anything
that is widely accepted as a means of
payment.
• To Barter an individual exchanges
goods directly for other goods.
− A unit of account is a consistent
means of measuring the value of things.
− A store of value is an item that holds
value over time.
1.2 Types of Money
•
•
•
•
•
Commodity money is money that has value apart
from its use as money.
– E.g. Mackerel in federal prisons, gold, and silver
Fiat money is money that some authority, generally
a government, has ordered to be accepted as a
medium of exchange.
– E.g. paper money and coins in the U.S. “this note
is legal tender for all debts public and private”
Currency is paper money and coins.
Checkable deposits are balances in checking
accounts.
A check is a written order to a bank to transfer
ownership of a checkable deposit.
1.3 Measuring Money
•
•
•
•
Money supply refers to the total quantity
of money in the economy at any one time.
Liquidity is the ease with which an asset
can be converted into currency.
M1 is the narrowest of the Fed’s money
supply definitions that includes currency in
circulation, checkable deposits, and
traveler’s checks.
M2 is a broader measure of the money
supply than M1 that includes M1 and other
deposits.
The two M’s: January 2012
Measured in
billions
Welcome to Day 18
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
2. THE BANKING SYSTEMS AND
MONEY CREATION
Learning Objectives
1. Explain what banks are, what their
balance sheets look like, and what is
meant by a fractional reserve banking
system.
2. Describe the process of money creation
(destruction), using the concept of the
deposit multiplier.
3. Describe how and why banks are
regulated and insured.
2.1 Banks and Other Financial
Intermediaries
•
•
A financial intermediary is an institution
that amasses funds from one group and
makes them available to another.
A bank is a financial intermediary that
accepts deposits, makes loans, and offers
checking accounts.
2.2 Bank Finance and a
Fractional reserve System
•
•
•
•
•
•
A balance sheet is a financial statement
showing assets, liabilities, and net worth.
Assets are anything of value.
Liabilities are obligations to other parties.
Net worth refers to assets less liabilities.
Reserves are bank assets held as cash in
vaults and in deposits with the Federal
Reserve.
A fractional reserve banking system is a
system in which banks hold reserves whose
value is less than the sum of claims
outstanding on those reserves.
The Consolidated Balance Sheet for U.S.
Commercial Banks, January 2012
Assets
Reserves
Liabilities and Net Worth
$1,592.9 Checkable deposits
$8,517.9
Other assets
1,316.2 Borrowings
1,588.1
Loans
7,042.0 Other liabilities
1,049.4
Securities
2,546.1
Total assets
$12,497.2 Total Liabilities
Net worth
$11,155.4
$1,341.8
2.3 Money Creation
•
•
•
•
Required reserves are the quantity of
reserves banks are required to hold.
The required reserve ratio is the ratio of
reserves to checkable deposits a bank
must maintain.
Excess reserves are reserves in excess of
the required level.
A bank is said to be loaned up when its
excess reserves equal zero.
A Balance Sheet for ACME Bank
ACME Bank
Assets
Liabilities
Reserves
$1,000
Loans
$9,000
Deposits
$10,000
A Balance Sheet for ACME Bank
A Balance Sheet for ACME Bank
2.4 The Deposit Multiplier
•
A deposit multiplier is the ratio of the
maximum possible change in checkable
deposits (ΔD) to the change in reserves
(ΔR).
EQUATION 2.1
EQUATION 2.5
D $10,000
md 

 10
R $1,000
1
D

 md
rrr R
Welcome to Day 19
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
1) Take out a piece of paper.
2) Write your name, the day and
time of the class.
3) Write Econ 2 Quiz 7
Using the AD curve and the long run
aggregate supply curve only, show the
effect of an increase in AD in the long
run. Mark starting price and quantity
P1 and Q1, and ending price and
quantity P2 and Q2. Next to the
diagram, write what is happening to
price and quantity (rises, falls, stays
the same).
2.4 The Deposit Multiplier
•
A deposit multiplier is the ratio of the
maximum possible change in checkable
deposits (ΔD) to the change in reserves
(ΔR).
EQUATION 2.1
EQUATION 2.5
D $10,000
md 

 10
R $1,000
1
D

 md
rrr R
3. THE FEDERAL RESERVE
SYSTEM
Learning Objectives
1. Explain the primary functions of central banks.
2. Describe how the Federal Reserve System is
structured and governed.
3. Identify and explain the tools of monetary policy.
4. Describe how the Fed creates and destroys money
when it buys and sells federal government bonds.
•
A central bank is a bank that acts as a banker to the
central government, acts as a banker to banks, acts
as a regulator of banks, conducts monetary policy,
and supports the stability of the financial system.
3.1 Structure of the Fed
3.2 Powers of the Fed
• Fed sets the reserve requirements.
What happens to the money supply if the Fed
lowers the reserve requirement?
What if they raise the reserve requirement?
3.2 Powers of the Fed
• Fed sets the reserve requirements.
What happens to the money supply if the Fed
lowers the reserve requirement?
- Money supply goes up.
What if they raise the reserve requirement?
- Money supply goes down.
3.2 Powers of the Fed
• The discount window and other credit
facilities
– The discount rate is the interest rate
changed by the Fed when it lends reserves
to banks.
– The federal funds market is a market in
which banks lend reserves to one another.
– A federal funds rate is the interest rate
charged when one bank lends reserves to
another.
What happens to the money supply if
the Fed raises the discount rate?
What if they lower the discount rate?
What happens to the money supply if
the Fed raises the discount rate?
- Lowers the money supply.
What if they lower the discount rate?
- Raises the money supply.
3.2 Powers of the Fed
• Open market operations
–A bond is a promise by the issuer
of the bond to pay the owner of
the bond a payment or a series of
payments on a specific date or
dates.
–Open market operations are the
buying and selling of federal
government bonds by the Fed.
Open market operations are the Fed buying
and selling government bonds to banks.
When the Fed buys bonds from banks with
newly created money, the banks have more
reserves to loan out.
-Money supply goes up.
When the Fed sells bonds to banks, the banks
have less reserves to loan out.
- Money supply goes down.
Welcome to Day 20
Principles of
Macroeconomics
Quiz today?
Magic 8 ball says ….
1) Take out a piece of paper.
2) Write your name, the day and
time of the class.
3) Write Econ 2 Quiz 8
1. Which of the following is
money as defined by M2?
A) Currency inside bank vaults.
B) Credit cards.
C) Gold.
D) None of the above.
1. THE BOND AND FOREIGN
EXCHANGE MARKETS
Financial markets are markets in which
funds accumulated by one group are made
available to another group.
– Savers supply funds to financial markets
and borrowers demand funds.
1.1 The Bond Market
•
•
•
•
Bond prices and interest rates.
The face value of a bond is the amount
the issuer of a bond will have to pay on the
maturity date.
The maturity date is the date when a
bond matures, or comes due.
The interest rate is the payment made for
the use of money, expressed as a
percentage of the amount borrowed.
1.1 The Bond Market
EQUATION 1.1
•
Face value - bond price
100  interest rate
Bond price
At a price of $950, the interest rate is
5.3%
$1,000 - $950
$950
100  5.3%
1.1 The Credit Market
It is generally considered that a
decrease in the interest rate,
ceteris paribus, will increase AD, as
people will borrow more money to
buy things.
You can hold your money as cash
for convenience of spending
OR
You can put it in the bank to earn
interest.
The higher the interest rate, the
less cash you want to hold.
2.1 The Demand for Money
2.1 The Demand for Money
An increase in real GDP, for example, causes demand to
increase. At the same interest rate the quantity of money
demanded increases from M to M’.
• Other
determinants of
the demand for
money
– Real GDP
– The Price Level
– Expectations
– Preferences
2.2 The Supply of Money
•
Supply curve of money is the curve that
shows the relationship between the quantity of
money supplied and the market interest rate
all other determinants of supply unchanged.
M
2.3 Equilibrium in the Market for
Money
•
•
Money market is the interaction among
institutions through which money is supplied
to individuals, firms, and other institutions
that demand money.
Money market equilibrium is the interest
rate at which the quantity of money
demanded is equal to the quantity of money
supplied.
2.3 Equilibrium in the Market for
Money
The Fed creates new money.
1) Banks have excess reserves.
2) Interest rates fall.
3) Loans increase which increases
spending (AD).
4) People hold onto more cash,
and put less in the bank.