Introduction to Economics

Macroeconomics
Course Outline
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Supplementary Texts
 Mankiw, N. Gregory, Macroeconomics, Fourth Edition, Worth Publishers, 2000
 McCandless Jr., George T. with Neil Wallace, Introduction to Dynamic Macroeconomic
Theory: An Overlapping Generations Approach, Harvard University Press, 1991 (ISBN:
0-674-46111-8)

 Romer, David, Advanced Macroeconomics, McGraw-Hill, 1998

 Barro, R and X Sala-i-Martin, Economic Growth, MaGraw-Hill, 1997
 Azariadis, C, Intertemporal Macroeconomics, Blackwell, 1993 (ISBN: 1-55786-366-0)
 Blanchard, O. and S. Fischer, Lectures on Macroeconomics, MIT Press, 1989
 Sargent, T., Dynamic Macroeconomic Theory, Harvard University Press, 1987

 Chiang, A. C., Elements of Dynamic Optimization, McGraw-Hill, 1992 (ISBN: 0-07-

112568-X)
 Intriligator, M. D., Mathematical Optimization and Economic Theory, Prentice Hall,
1971
 Kamien, M. I. and N. L. Schwartz, Dynamic Optimization: The Calculus of Variations
and Optimal Control in Economics and Management, 2nd Edition, Elsevier, 1991

Further reading materials will be introduced during the course if needed.

*****************************************************
Session 1: Introduction: Aims of macroeconomics

Session 2: Some Concepts in Macroeconomics (National Income, Unemployment,

Inflation)

Session 3: IS=LM Analysis I (a basic model)

Session 4: IS=LM Analysis II (government policies evaluation)

Session 5: Economic Growth

1
 Introduction to Economics
Macroeconomics1
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Session 1
(The way of thinking and some important terms)
1. Introduction
What is macroeconomics?
 the study of the economy as a whole
Example: Income, growth rate, inflation, unemployment rate
 to attempt to formulate general theories that help to explain the data
-> why? -> economists cannot conduct controlled experiments, and have to
use the data that history gives them.
 Particularly important data:
Real GDP: the total income of everyone in the economy
Inflation Rate: how quickly prices are rising
Unemployment Rate: the fraction of the labour force that is out of work

How do economists formulate theories?

 by using models
 Models always have two kinds of variables:
Endogenous variables: variables that a model tries to explain
Exogenous variables: variables that a model takes as given
 the purpose of a model is to show how the exogenous variables affect the
endogenous variables

Key Point 1: when building your own model up

1. Make sure what you want to explain (what is your target?)
2. Then choose the variables/your targets (Endogenous variables) you want to explain
3. Choose some important elements (Exogenous variables) which affect your targets (Note: do
not put too many exogenous variables!! You should make your own model as simple as you can.
A messy model is not fancy at all!!)

1
Examples and figures used in the lecturenotes have been obtained from Mankiw (2000)
‘Macroeconomics, 4th Edition’.

2
Example 1: the market of paracetamol
(when you talk about a market, there are always demand and supply in the market)

important 3 elements when you talk about a market:

Demand: specify the behaviour of buyers -> demand function
Supply: specify the behaviour of sellers -> supply function
Equilibrium: what is (are) determined when demand = supply ->price and quantity (normally)

What you want to explain -> how the price and quantity of paracetamol in the market are
affected (changed)
What are endogenous variables? -> the price of paracetamol and the quantity of paracetamol in
equilibrium
What are exogenous variables?--which depend upon what you want to consider—Income of
buyers, the cost of production of paracetamol, and the price of substitutes (complements):
Two goods are substitutes if both can satisfy the same need of the consumer; they are complements if they are consumed jointly in order to satisfy
some particular need.

Demand function: Q d = D( p, I )
Supply function: Q s = S ( p , c, p s )
Market clearing condition: Qd = Qs
(the condition under which the market is in equilibrium)
where Q, p, I , c, p s denote the quantity of paracetamol, the price of paracetamol, income of
buyers, the cost of production of paracetamol, and the price of a substitute, respectively.

Figures

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2. The Data of Macroeconomics
~ To qualify the performance of the economy
~ To learn how to measure economic performance

GDP (Gross Domestic Product)

the nation’s total income and the total expenditure on its output of goods and services
 to measure the value of economic activity
 to summarise in a single number the pound value of new economic activity in a
given period of time
Key Point 2: On GDP
Goods or services produced by NOT CURRENT economic activity are NOT included in the
current GDP.

 to be interpreted as the total income of everyone in the economy as well as the total
expenditure on the economy’s output of goods and services

Some Rules for computing GDP

 To compute the total value of (new) different goods and services in a given period of
time, market prices are used.
Example 2: three goods, A, B, and C in the economy in year 2000
unit price quantity produced
good A £2.00 10
good B £1.00 5
good C £3.00 20

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 GDP=£2.00*10+£1.00*5+£3.00*20=£85.00

 The sale of used goods is not included as part of GDP. The transfer of an asset is not
included in GDP (not an addition to the economy’s income).
Example 3: The current sale of a Pokemon card (£1.50) is added to GDP.
However, when a collector sells a rare Pokemon card to another collector for £20.00, this
is not included in GDP.

 The treatment of inventories

Example 4: A bread making company hired new workers to produce 5000 kg
more new bread in year 2000 and the result of this new production was as follows:

Total 5000kg
(1) Sold 3000kg
(2) kept in the freezer for sale 1500kg
later
(3) spoiled 500kg

Which one ((1), (2), (3)) is included in GDP of year 2000?

Suppose that (2) was sold in year 2001. Does this contribute to GDP of year 2001?

 The Treatment of Intermediate Goods (The Value Added)

Example 5: A Tomato producing farmer produced £1,000,000 tomato in year
2000. Furthermore, a tomato-sauce producing company bought £50,000 tomato from this farmer
and then produced £10,000,000 tomato sauce in year 2000. The rest of tomato (£1,000,000-
£50,000=£950,000) was consumed in year 2000.
How can we compute GDP of year 2000?

Key Point 3: GDP includes only the value of final goods and services. AND, the sum of all value
added must equal the value of all final goods and services.

 Housing Services (Imputed Value)

 Economic Activity in the Underground Market

Real GDP versus Nominal GDP

Example 6: The quantity of each good is the same as in Example 2, but the prices have
been changed (as double much) in year 2001 as follows:

three goods, A, B, and C in the economy in year 2001

unit price quantity produced
good A £4.00 10
good B £2.00 5
good C £6.00 20
According to the formula given above, the GDP of year 2001 is:
GDP=£4.00*10+£2.00*5+£6.00*20=£170.00,

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which implies that the GDP of year 2001 would be as double much as that of year 2000, although
the amount of goods are services, which can be consumed physically in year 2001, is exactly the
same as in year 2000.
 The value of GDP is influenced by the change in prices.

Nominal GDP: measured at current prices

Real GDP: measured using a constant set of prices (Base-year prices)

 which shows what would have happened to expenditure on output if quantities had
changed but prices had not.

No min al Deflator
GDP Deflator: GDP Deflator =
Re al GDP

The Components of Expenditure (GDP)

GDP is divided into four broad categories such that:

Y = C + I + G + NX ,
where Y , C , I , G , NX denote GDP, consumption, investment, government purchases, and net
exports, respectively.
Consumption, C: the goods and services bought by households
=nondurable goods + durable goods + services
Investment, I: the goods bought for future use
=business fixed investment + residential fixed investment
+ inventory investment
Government purchases, G: the goods and services bought by central and local
governments (Note: transfer payments such as social security are not included, since
transfer payments only reallocate existing income, and thus are not part of GDP)
Net Exports, NX: the values of goods and services exported - the value of goods and
services imported

Some Other Measures of Income

Gross National Product (GNP)

GNP = GDP + Factor Payments from Abroad - Factor Payments to Abroad

Key Point 4: GDP measures the total income produced domestically, and GNP measures the total
income earned by nationals.

Example 7: A British resident owns a flat in Tokyo. How is the rental income he/she earns in
Tokyo treated?
Included in the GDP of Japan, since it is earned in Japan, but not in the GNP of
Japan. Included in the GNP of the UK, but not in the GDP of the UK.

Net National Product (NNP)

NNP = GNP - Depreciation,
where depreciation is called the consumption of fixed capital.

CPI (Consumer Price Index)

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To measure the cost of living
An increase in the overall level of prices is called inflation, and how can the overall level of prices
(namely, inflation) be measured?
 The CPI turns the prices of many goods and services into a single index measuring
the overall level of prices.
 The price of a basket of goods and services purchased by a typical consumer is used
for computing the CPI (Not all goods are included)
 Why a typical consumer?

Example 8: A typical consumer buys the following items every month:

Quantity bought current price base-year price

Item A 10 £1.50 £1.00
Item B 5 £3.00 £2.50

[1 0 * current price of Item A + 5* current price of Item B]

CPI =
(10 * base - year price of Item A + 5* base - year price of Item B)
1 0 * £1..5 0 + 5 * £3.0 0
=
1 0 * £10. 0 + 5 * £2.5 0

The Difference between the CPI and the GDP Deflator

 1. The GDP deflator measures the prices of all goods and services, but the CPI
meausures the prices of only the goods and services bought by consumers.
 2. The GDP deflator includes only goods and services produced domestically, and
thus does not include any imported goods or services. However, the CPI includes
goods imported if they are bought.
Example 9: A Toyota car produced in Japan and imported to the UK. What is the
difference in the effect of a price change between CPI and GDP Deflator?
 The CPI uses a fixed basket, but the GDP deflator allows the basket to change.
Example 10: Foot and Mouth Decease attacked the UK cattle rancher, and the
product of beef fell nearly to zero, thus resulting in an incredible increase in the price of
UK beef. How is this increase taken into account in CPI and GDP deflator?

The Unemployment Rate

To measure joblessness
 Why is the unemployment rate so important?
 Because an economy’s workers are its chief resource, keeping workers employed is a
paramount concern of economic policymakers.
 The unemployment rate measures the percentage of those wanting to work who do not have
jobs.
 An adult population (16 yrs and over) is divided into 3 categories; employed, unemployed and
not in the labour force (Note: a person who wants a job but has given up looking for is
counted as not being in the labour force, thus not counted as unemployed)
 Labour force = Number of Employed + Number of Unemployed
 Unemployment Rate = (Number of Unemployed / Labour Force)*100
 Labour-Force Participation Rate = (Labour Force / Adult Population)*100

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 Okun’s Law: The (negative) relationship between unemployment and GDP

What have we learned?

 how to measure economic performance
What will we learn next?
 how to explain economic performance

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 Introduction to Economics
Macroeconomics
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Session 2
(The economy in the long run)

3. GDP in Detail (How is GDP determined?)

As we have learned, GDP measures both a nation’s total output of goods and services and its
total income (expenditure).

Questions answered here:

1. How much do the firms in the economy produce?
2. Who gets the income from production?
3. Who buys the output of the economy?
4. What equilibrates the demand for and supply of goods and services?

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Q1: What Determines the Total Production of Goods and Services?
 Production function of the economy (taken as given) determines the total
production level of the economy. The production function is assumed such that:
Y = F (K , L),
where K and L denote capital and labour, respectively, both of which are called
the factors of production.

Assumptions on the production function

1. the economy’s factors are constant, namely
L = L, K = K
2. the factors (capital and labour) are fully utilised (no unemployment, and no capital lies idle)
3. a constant returns to scale property
zY = F (zK , zL)
From the first and the second assumptions, the total level of GDP is determined such that:
Y = F (K , L ) = F ( K , L ) = Y ,
which implies that the total level of GDP is constant. (But note that it is assumed that all factors
are fully utilised (no unemployment here!).)

Key Point 5: GDP is determined by the economy’s production function, which is assumed to be
taken as given.

Q2: How is National Income Distributed to the Factors of Production?

(Note that the total output of an economy equals its total income.)
 Factor prices determine the distribution of income!!
 Where and how?
 Where -> in the factor market
 How -> demand for the factor = supply of the factor

Factors
Labour, L Capital, K
Economic agent to demand for The firm The firm
Economic agent to supply of The worker (the Household) The savers (the Households)

Due to the first assumption, the supply curve is vertical such that

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As seen in the above figure, the equilibrium quantity of each factor is always the supply level.
How about the equilibrium price of each factor?
 The demand curve determines the price.
 How can we obtain the demand curve by the firm?
 The profit maximisation behaviour of the firm
Assumption on the market
It is assumed that the market is competitive.
 What does “competitive” in economics mean?
 Each economic agent in the market is too small so that they have no power to change
the price in the market, thus they take all prices as given.

How can we describe the optimisation behaviour of the firm?

Assumption on the behaviour of the firm

It is assumed that the firm maximises its profit, namely that the firm decides the amount of
factors they use for its production in order to maximise its profit.
 What is profit in economics?
 Profit is defined in economics as
Profit = Total Revenue – Total Cost, which is in this case:
Pr ofit = pY - wL - rK ,
where p, w, r denote the price of goods and services the firm produces, the wage rate
per hour, and the rental rate of capital, respectively.

The Firm’s Demand for Factors

<Terminology>
The Marginal Product of Labour (MPL): MPL is the extra amount of output the firm gets
from one extra unit of labour, holding the amount of capital fixed, which can be written as
MPL = F (K , L + 1) - F (K , L)

The Marginal Product of Capital (MPC): MPC is the extra amount of output the firm gets
from one extra unit of capital, holding the amount of labour fixed, which can be written as
MPC = F (K + 1, L) - F (K , L)

Real Wage (W/P: wage rate W divided by price P): The payment to labour measured in units of
output rather than in pounds.

Real Rental Price of Capital (R/P: rental price R divided by price P): The payment to capital
measured in units of output rather than in pounds.

A Further Assumption on the Production Function

It is assumed that the production function has a property of diminishing marginal product.
 What is the property of diminishing marginal product?
 Holding the amount of capital (labour) fixed, the marginal product of labour (capital)
decreases as the amount of labour (capital) increases.

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Example 11: Suppose that the firm is hiring one more unit of labour to produce more output. Is
this decision profitable? From an increase in one unit of labour, the following will occur:

An increase in the total revenue p  MPL

An increase in the total cost w
An increase in profit p  MPL  w
which implies that if the extra revenue ( p  MPL ) exceeds the wage rate w, an extra unit of
labour increases profit. Thus, the firm continues to hire labour until the next unit would no
longer be profitable: Until MPL falls to the point where the extra revenue equals the wage, the
firm continues to fire labour, thus the firm’s demand for labour id determined by
p  MPL  w
In other words, the firm demands for labour according to the above equation (in order to satisfy
the above equation). By the way, what is the above relationship between the (real) price of labour
and the quantity of labour the firm wants to hire?
Yes, it is the demand function of the firm for labour!!!

Key Point 6: The firm demands for labour according to the relationship such that
MPL = real wage rate

Since the production function is assumed to have a diminishing marginal product, the demand
function curves downward as

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How is the case of an increase in one unit of capital?
 Answer is the same, thus

Key Point 7: The firm demands for labour according to the relationship such that
MPC = real rental price

The Division of GDP (The Answer to Q2)

According to the firm’s optimisation behaviour, the real wage paid to each worker (household)
equals the MPL and the real rental price paid to each owner of capital (household) equals the
MPK. Thus, the total real wages paid to labour are MPL  L , and the total real return paid to
capital owners is MPK  K . This implies that the total income paid in the form of wage and
rent in the economy is MPL  L  MPK  K .

What is the relationship between GDP and the total income paid?
 According to assumption 3. on the production function (a constant returns to scale
property), the production function also has a property such that:
F  K , L   MPK  K    MPL  K  ,
which implies that GDP is fully paid out to households in the form of wage and rent.

Key Point 8: Total output (GDP) is divided between the payments to capital and the payments to
labour, depending on their marginal productivities. Since their productivities are given by the
production function, which is also assumed to be taken as given, the payments, or the
distribution of income are determined by the factor prices.

Q3: What Determines the Demand for Goods and Services?

As we learned, GDP (total expenditure) is divided into Consumption (C), Investment (I),
Government Purchases (G), and Net Export (NX). The next step is to explore how these four
components are determined.

From simplicity, a closed economy is assumed from now on

 A closed economy means that there is no trade with foreign country, thus, Net
Export is always zero.

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  Under the above assumption, GDP is expressed by
Y CI G
Consumption, C
It is assumed that consumption depends on disposable income.
 Disposable income is defined as:
Disposable income  Y  T ,
where Y, T denote income (GDP) and tax paid minus transfers from the government,
respectively
 It is assumed that the higher is disposable income, the greater is consumption,
and the consumption function is given by
C  C Y  T 

Investment, I
Assumption on Investment
 The amount of investment depends on the (real) interest rate
 Why?
 I = I (r ) , Investment goes up (down) as the interest goes down (up), namely,
investment is a decreasing function of the (real) interest rate.

Government Purchases, G (and T)

Assumption on G and T
Just for simplicity, it is assumed that both G and T are constant, so
G = G,
T=T

Q4. What Brings the Supply and Demand for Goods and Services into Equilibrium?
 The interest rate has the crucial role of equilibrating supply and demand
 How?
 There are 2 ways to obtain the answer.
(A) Equilibrium in the Market for Goods and Services
(Supply and Demand for the Economy’s Output (GDP))
Step 1: By the definition of GDP, we can get
Y = C + I + G, (1)
which implies that GDP is divided into four categories (the above equation is an identity!! In
other words, the above equation is the definition of GDP, thus it always holds).
Step 2: By the assumption on consumption, we get
C = C(Y - T ), (2)
which implies that consumption is determined (demand for consumption) , depending on
disposable income.
Step 3: By the assumption on investment, we get
I = I (r ), (3)
which implies that investment is determined (demand for investment), depending on the real
interest rate.
Step 4: By the assumption on G and T, we get
G = G,
(4)
T = T,
which implies that the government budget is fixed (demand for the government purchases).
Step 5: Note that (2), (3), and (4) are demand functions of 3 components, so

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 C(Y - T ) + I (r ) + G (5)
is the total demand function in the economy.
Step 6: What determined the supply function of the economy?
 By the assumption on factors in the economy, we get
K = K,
L = L,
which implies that two factors are fixed, and it is also assumed that the factors are fully
utilised.
 Through the economy’s production function, we get the supply function of the
economy such that
Y = F (K , L ), (6)
which determined the total supply level of this economy.
Step 7: As we have got demand ((5)) and supply ((6)), what we need to do is to obtain an
equilibrium. Yes, in equilibrium, we get
Y = C(Y - T ) + I (r ) + G . (7)
Step 8: How is the above equation guaranteed (How does the left hand side (supply) equal the
right hand side (demand))? Since Y , T , G are all fixed, the real interest rate has to change in
order to equilibrate the left hand side and the right hand side.
 The real interest rate has the crucial role!!!

Key Point 9: In the market of output of goods and services, we get
Demand function equation (5)
Supply function equation (6)
the equilibrium condition equation (7)
endogenous variable r
exogenous variables Y (K , L ), G , T

(B) Equilibrium in the Financial Markets

(Supply and Demand for Loanable Funds)
 Note that the interest rate is the cost of borrowing and the return to lending in
financial markets
Step 1: By an identity (1), we get
Y - C - G = I,
which can also be written as
(Y - T - C ) + (T - G ) = I ,
where the first term and the second term in the left hand side are called private saving ( S p ) and
public saving ( S G ) respectively.
Step 2: Note that the left hand side is the supply of loanable funds by the private sector (private
saving) and by the public sector (public saving). The right hand side is the demand function for
loanable funds by the firm.
Step 3: Demand and supply are:
Y -T -C+T -G
Supply of loanable funds:
= (Y - T - C(Y - T )) + (T - G ) = S p + S G

Demand for loanable funds: I (r )

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and in equilibrium in loanable funds markets, we get
S p + S G = I (r ), (8)
where the real interest rate also has crucial role for equilibrating supply and demand in loanable
funds markets.

Key Point 10: When (7) holds, (8) always holds, and the real interest rate to satisfy (7) is the same
as the real interest rate to satisfy (8). If the output market is in equilibrium, then the loanable
funds market is also in equilibrium.

Now, we know how to examine the effects of fiscal policy on the economy.
 How can we examine the effect of fiscal policy within this framework?
 an expansion (a cut) of social security (transfers from the government to households),
or of subsidies
 an expansion of government purchases such as public investment
 an effect of a decrease (an increase) in taxes
 an effect of immigration
Example 12: A effect of an increase in public investment to stimulate an economy
Suppose that the government decides to increase public investment (or a decision to
make another huge dome somewhere)
Now, what we want to examine is to evaluate the effect of building a new dome on the UK
economy.
 What is an exogenous variable?
 What is an endogenous variable?
 What is the equilibrium condition?
Study the effect both in the output market and in the loanable funds market.

Example 13: A effect of an expansion of subsidies on the economy.

Study the effect both in the output market and in the loanable funds market.

Exercises (on page 71 in Macroeconomics by Makiw)

1., 4., and 6.

4. Unemployment
Questions answered here
1. What determines the natural rate of unemployment?
2. Why is always there some unemployment?

Q1. What determines the natural rate of unemployment?

 the natural rate of unemployment is the average rate of unemployment around which
the economy fluctuates.

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A Simple Model to describe the rate of unemployment
L: the labour force
E: the number of employed
U: the number of unemployed workers
L = E +U (9)
s: the rate of job separation, the fraction of employed individuals who lose their job each month
f: the rate of job finding, the fraction of unemployed indidivuals who find a job each month

If the labour market is stable, or in a steady state – the unemployment rate is neither rising nor
falling – then the number of people finding jobs must equal the number of people losing jobs,
which yields:
fU = sE (10)
(9) and (10) yield

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 fU = s( L - U ),
which also yields
U s
= ,
L s+ f
where the left hand side denotes the steady state rate of unemployment

Example14: Suppose that 1 percent of the employed lose their jobs each month (s=0.01). This
means that on average jobs last 100 months, or about 8 years. Suppose further that about 20
percent of the unemployed find a job each month (f=0.20), so that spells of unemployment last 5
months on average. Then the steady state rate of unemployment is given such that:
U 0.0 1
= = 0.0 4 7 6,
L 0.0 1 + 0.2 0
.which means that the steady state rate of unemployment in this example is about 5 %.

Key Point 11: Any policy aimed at lowering the natural rate of unemployment must either reduce
the rate of job separation or increase the rate of job finding. Similarly, any policy that affects the
rate of job separation or job finding also changes the natural rate of unemployment.

The above model can succeed in explaining how the rate of unemployment is affected, but it
cannot explain the reason why there is unemployment in the first place!!

Q2: Why is there unemployment?

<Reason 1>: Frictional Unemployment
 The worker is not identical, and all workers are equally well suited for all jobs.
Furthermore, the worker and the employer do not have perfect information on the
place of well-suited workers/jobs.
 Because different jobs require different skills and pay different wages, unemployed
workers may not accept the first job offer they receive.
 Unemployed workers need time to search for suitable jobs.
 This kind of unemployed workers is called frictional unemployed workers.
 There is always frictional unemployment.

<Reason 2>: Wage Rigidity

 what does the existence of unemployment mean?
 Supply and demand for labour in the labour market is not equal!!
 Unemployment means the excess supply of labour in the labour market.
 Why?
 The wage rate should decrease to clear the labour market when there is
unemployment, if the labour market functions as it is assumed in economics.
 As long as the wage rate moves smoothly, there should not be any unemployment in
the labour market.
 The wage rate is sticky (not smooth) : the failure of wages to adjust until labour
supply equals labour demand.
 The uemployment resulting from wage rigidity is called wait unemployment.
 Why is there wage rigidity? (Why does the wage rate decrease when there is
unemployment?)
1. Minimum-wage laws
2. Unions power

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 3. The firm itself sets the wage rate at a relatively higher level than the market
clearing level (an equilibrium level). This idea is called efficiency-wage theory.
The efficiency-wage theory says:
3-1. Better-paid workers are healthier, thus more productive
3-2. The more a firm pays its workers, the greater their incentive to
say with the firm, thus resulting in decreasing the time spent hiring and training
new workers for the firm.
3-3. If a firm reduces its wage the best employee may quit, thus
resulting in a decrease in the average quality of a firm’s work force.
3-4. The higher the wage, the greater the cost to the worker of
getting fired, thus resulting in an increase in productivity.

Exercises (on page 153 in Macroeconomics by Makiw)

5.

5. Money and Inflation

Questions answers here
1. What is money?
2. What causes inflation?
3. What determines demand for money?
4. What is determined in the market of money?

Q1. What is money?

 Money is the stock of assets that can be readily used to make transactions.
 The functions of money
1. As a store of value
2. As a unit of account
3. As a medium of exchange
 How is the quantity of money (this is called money supply) controlled, and by whom?
 By the central bank
 money supply is controlled through open-market operations
 When the central bank wants to increase (decrease) money supply, it buys (sells)
government bonds in the bond market in exchange for money in hand.
 How is the quantity of money measured?

19
The most commonly used measures for studying the effects of money on the economy are M1
and M2.
<Terminology>
Currency: the sum of outstanding paper money and coins
Demand Deposits; the funds people hold in their checking account

Q2: What causes inflation?

The Quantity Theory of Money
to examine how the quantity of money affects the economy.
Step 1: Think about the relationship between transactions and money in a given period.

T: the total number of transactions in one year. T is also interpreted as the number of times in a
year that goods or services are exchanged for money.
P: the price of a typical transaction, or the number of pounds exchanged.
M: the quantity of money
V: the transactions velocity of money, which measures the rate at which money circulates in the
economy. V is the number of times a pound bill changes hands in a year.
Step 2: what is the product, P x T?
P x T = the number of pounds exchanged in a year
which is the total transactions measured in money (pounds).
Step 3: This must always be equal to
M x V= the quantity of money circulated through all the transactions,
thus, we always have the following identity:
M x V= P x T,
which is called the quantity equation.

Example15: Suppose that 100 packages of paracetamol are sold in a year at 86p per package.
Then T equals 100 per year, and P equals £0.86 per package. The total number of pounds
exchanged is

20
 P x T = 100 x £0.86 = £86 per year
Suppose further that the quantity of money in this economy is £10.00. Then we can compute
velocity as
V = PT/M = (£86 per year)/( £10.00)=8.6 times per year,
which means that each pound must change hands 8.6 times a year for £86.00 of transactions per
year to take place with £10.00 of money in this economy.

Key Point 12: The quantity equation is an identity: The definitions of the four variables make it true.
This implies that one of the variables changes, one or more of the others must also change to
maintain the identity.

Now, substitute T, transactions, with Y, output in a year. Then we can interpret the quantity
equation as
Y: the total output, namely GDP
P: the price of one unit of output, or the GDP deflator,
V: income velocity of money, since Y is also total income
so PY can be interpreted as nominal GDP, and we can get
M x V = P x Y, (11)
which is also an identity. (11) is most commonly used to explain inflation.
Assumption on Velocity
It is assumed that the velocity is constant.

Then, (11) becomes a useful theory of the effects of money, called the Quantity Theory of
Money, since, under the above assumption,
MV = PY , (12)
which implies that the quantity of money determines the pound value of the economy’s output
(nominal GDP).
Under all the assumptions
 1. The (real) output level, Y, is determined by the economy’s production function,
thus, the money supply determines the nominal level of GDP, PY.
 2. Since the money supply determines nominal GDP, the money supply also
determines the GDP deflator (real GDP is determined by the production function).
 (12) is also written as:
% change in M + % change in V = % change in P + % change in Y
 A % change in V is zero by assumption. A % change in Y depends on growth in the
factors of production and on technology, all of which are assumed to be taken as
given so far. A % change in M is controlled by the central bank, which is the rate of
money supply. A % change in P is the rate of inflation.
 Thus, the growth in the money supply fully determines the rate of inflation.

Key Point 13: The Quantity Theory of Money states that the central bank, which controls the
money supply, has ultimate control over the rate of inflation. If the central bank keeps the money
supply stable, the price level will be stable. If the central bank increases the money supply rapidly,
the price level will rise rapidly (inflation will occur).

Q3.: What determines demand for money?

 Any relationship between demand for money and income?
 Our intuition: The more income they have, the more money they hold.
 Real money balances are important for considering demand for money.
 What are real money balances?

21
  Real money balances are defined by M/P, the quantity of money in terms of the
quantity of goods and services it can buy.
 Real money balances measure the purchasing power of the stock of money.
Example 16:: Suppose that an economy produces only paracetamol. If the quantity of
money in this economy is £10.00, and the price of a package of paracetamol is £0.50,
then real money balances in this economy are 20 packages of paracetamol. That is, at a
current price, the stock of money in this economy is able to buy 20 packages of
paracetamol.
 Demand for real money balances depend on real income, Y (real GDP) such that:
( )
d

P = L1 (Y ),
M
where demand for real money balances (the left hand side) increases (decreases) as
real income increases (decreases).
 Demand for real money balances also depend on the nominal interest rate, i.
 Why? & What is the nominal interest rate?
 Nominal interest rate: the interest rate that the bank pays
 Real interest rate: the interest rate that increases your purchasing power
 There is the relationship among the nominal interest rate, i, the real interest rate, r,
and the rate of inflation,  , such that:
r = i -
 The nominal interest rate is the opportunity cost of holding money. The nominal rate
is what you give up by holding money rather than bonds.
 If the opportunity cost of holding money increases, then demand for real money
balances will decrease, thus,
( )
d

P = L2 (i ),
M
where demand for real money balances (the left hand side) increases as the
nominal interest decreases (increases).
 Demand for the real money balances is simply written as:
( )
d

P = L1 (Y ) + L2 (i ) = L(i , Y )
M

Q4: What is determined in the market of money?

( )
d
Demand for the real money balances: M P = L1 (Y ) + L2 (i ) = L(i , Y )

Supply (by the central bank) of the real money balances: M P

( ) ( )
d
the equilibrium condition: M P = M P = L(i , Y )

22
23
 Introduction to Economics
Macroeconomics
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Session 3
(The economy in the short run)

6. Economic Fluctuations in the Short Run

What is the difference between “the short run” and “the long run”?
 In the long run, prices are flexible and can respond to changes in supply or demand.
In the short run, many prices are “sticky” at some predetermined level.
Key Point 14: In the long run (the analysis so far), the amount of output depends on the
economy’s ability to supply goods and services, which in turn depends on the supplies of capital
and labour and on the available production technology. However, in the short run, output also
depends on the demand for goods and services. Demand is influenced by public policy, which
implies that output is also influenced by public policy in the short run (not in the long run).
 How?
 How can we obtain the aggregate demand curve?
 From
MV  PY ,

24
Now, we can talk about demand and supply in the market of goods and services. Since we now
know the aggregate demand for goods and services, what we have to think about is the supply of
goods and services. (Note that when we say “demand” and “supply” we always focus on the
relationship between “price” and “quantity ”)
 How can we obtain “aggregate supply”?
 It differs depending on the assumption “in the long run” or “the short run”.
 In the long run, the quantity of supply is fixed. In the short run, the price is fixed
(“sticky”).
Example 17: The effect of a decrease in the money supply.
In the long run

In the short run

What happens in the transition from the short run to the long run?
 When the economy is in its long run equilibrium, the short run aggregate supply curve
must cross this point as well, as shown in the following figure:

25
 Example 17: The effect of a decrease in the money supply.

Step 1: In the short run, output and employment fall below their natural levels, which means that
the economy is in a recession.
Step 2: Over time, in response to the low demand, wages and prices fall. The gradual reduction in
the price level moves the economy downward along the aggregate demand curve in the transition.
Step 3: In the long run, output and employment are back to their natural levels, but prices are lower
than before.

Key Point 15: A shift in aggregate demand caused by a demand shock such as a change in the
money supply affects output in the short run, but this effect dissipates over time as firms adjust
their prices in the long run.

Monetary Policy to Stabilise the Economy

Example 18: An expansion of availability of credit cards

 How can the expansion be incorporated into our analysis?

26
 d
 M
   L1  Y   kY
 P
 The expansion can be interpreted as a decrease in k. This implies with the market
clearing condition in the money market that
V  1k
thus, an expansion of availability of credit cards can be interpreted as an increase in
velocity. This implies an outward shift of the aggregate demand curve as:

Example 19: A new environmental protection law/ An increase in union aggressiveness.

 These effects can be interpreted as supply shocks, which can be expressed by an
upward shift of the aggregate supply curve as:

27
7. IS - LM Model
 The leading interpretation of Keynes’s theory.
 The goal of this model is to show what determined national income for any given price
level
 So, it is assumed that the price is fixed = the analysis in the short run.
 the goods and services market -> IS curve
 the real money balances market -> IM curve

7-1. The Market for goods and services: IS Curve

What is the IS curve?
 A set of pairs of the price and income which are obtained when the goods and
services market is in equilibrium.
 From the definition of an identity, we always get
GDP  Y  C  I  G ,
where I includes an expected inventories. Y is actual expenditure.
 Planed expenditure, E, is defined by
E  C  I  G  CY  T   I  G ,
where C , T , I , G denote planned consumption, planned tax revenue, planned
investment, and planned government purchases, respectively, and Y denotes actual
expenditure (=income).

If planned expenditure is equal to actual expenditure, the goods and services market is in
equilibrium as follows:

28
Example 20: The effect of fiscal policy (an expansion of government purchases / a tax cut / an
increase in social security benefits etc. )
It has been assumed that planned investment is fixed. However, as we learned, it is more realistic
to assume that planned investment depends on the interest rate such that:
I  I r ,
where planned investment decreases (increases) as the interest rate increases (decreases).
Under this assumption, we can get the downward IS curve as follows:

Example 21: The effect of fiscal policy reconsidered (How fiscal policy shifts the IS curve?)

29
Key Point 16: The IS curve shows the combinations of the interest rate and the level of income
that are consistent with equilibrium in the market for goods and services. The IS curve is drawn
for a given fiscal policy. Changes in fiscal policy that raise the demand for goods and services
shift the IS curve to the right. Changes in fiscal policy that reduce the demand for goods and
services shift the IS curve to the left.

7-2. The Market for real money balances: LM Curve

 In the short run, the price is sticky, so
PP
 Under the assumption that the money supply is controlled by a central bank and that
it is fixed, we get
   
s s
M  M
P P  fixed
 Demand for real money balances is
 
P  Lr , Y   L1  Y   L2  r  ,
d
M

30
 where it is simply assumed that the rate of inflation is zero (why?). As we learned, L2
decreases (increases) as the interest rate increases (decreases). <- why?
 With all the assumptions, we get

Example 22: The effect of changes in money supply on the LM curve

Key Point 17: The LM curve shows the combinations of the interest rate and the level of income
that are consistent with equilibrium in the market for real money balances. The LM curve is
drawn for a given supply of real money balances. Decreases in the supply of money shift the LM
curve upward. Increases in the supply of money shift the LM curve downward.

7-3. The Short Run Equilibrium

 On the IS curve:
Y  C Y  T   I  r   G
 On the LM curve:
M  Lr , Y 
P
 Endogenous variables: Y, r

31
  Exogenous variables: T, G, M, P
 The equilibrium of the economy is the point at which the IS curve and the LM curve
cross. This point gives the interest rate r and the level of income Y that satisfy
conditions for equilibrium in both the goods market and money market as shown

Key Point 18: At the intersection, actual expenditure equals planned expenditure (equilibrium in
the goods and services market), and the demand for real money balances equals the supply
(equilibrium in the money market).

32
 Introduction to Economics
Macroeconomics
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Session 4
(Policy Evaluation)

8. IS - LM Analysis II (Policy Evaluation)

Changes in Government Purchases (Taxes)
Example 23: The effect of an increase in government purchases.
 An increase in government purchases results in an increase in the economy’s planned
expenditure.
 The increase in planned expenditure stimulates the production of goods and services
 Total income Y rises.
 The rise in total income increases the quantity of money demanded at every interest
rate.
 Since the supply of money is not changed, higher money demand causes the
equilibrium interest rate r to rise.
 The increase in the interest rate results in firms cutting back on their investment
plans.
 This fall in investment partially offsets the expansionary effect of the increase in the
government purchases.

Changes in the Money Supply

33
Example 24: The effect of an increase in the money supply
 An increase in the money supply M leads to an increase in real money balances.
 People have more money than they want to hold at the prevailing interest rate.
 They start depositing this extra money in banks or use it to buy bonds.
 The interest rate then falls until people are willing to hold all the extra money that the
Bank of England created.
 A lower interest rate stimulates planned investment, which increases planned
expenditure. This increase in planned expenditure results in an increase in income Y.

The Interaction between Monetary Policy and Fiscal Policy

Example 25: Suppose that the Parliament decided to increase an income tax rate. What happens
if
 (1) any other policy is not followed.
 (2) the policy to maintain the interest rate at the current level is introduced.
 (3) the policy to maintain income at the current level is introduced

In case (1)
What happens in the amount of disposable income when an income tax rate increases?
What happens in the economy?

In case (2)
What happens in investment by keeping the interest rate at the current level?
What happens in the economy (income) by the policy followed?

In case (3)
What happens in the money market?
What happens in the good and services market?

34
Aggregate Demand Curve from the IS – LM model
We derived the aggregate demand curve from the quantity theory of money such that
MV  PY
by assuming M and V are both constant. Now we obtain the aggregate demand curve from the
IS – LM model.
 What happens in the IS – LM model when the price level changes?
 For any given money supply, a higher price level reduces the supply of real money
balances.
 A lower supply of real money balances shifts the LM curve upward, which raises the
equilibrium interest rate and lowers the equilibrium level of income.

35
36
 Introduction to Economics
Macroeconomics
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Session 5
(Economic Growth)

9. Economic Growth
There are three elements to make an economy grow:
 (1) Investment in Capital
 (2) An expansion of an Population
 (3) Technological Progress

9-(1). Investment in Capital

Production Function
It is assumed that the production function has a property of constant returns to scale such that:

zY  F  zK , zL ,

which also implies that

y  f k , (12)

where y and k denote Y/L and K/L, respectively.

The Demand for Goods and the Consumption Function

The demand for output is assumed to be only consumption and investment (the government
sector and international trade are ignored by assumption) such that:

y  ci (13)

and it is also assumed that people save a fraction s of their income and consume a fraction (1-s)
such that

c  1  s  y (14)

(12) and (13) yield

37
 y  1  s  y  i

and thus we get

i  sy (15)

Substituting (12) into (15) yields

i  sf k , (16)

which shows the relationship between the existing stock of capital k and the accumulation of new
capital i.

Capital is assumed to depreciate at rate  , so a change in capital stock is written as

k  i   k (17)

(17) can be simplified by substituting (16) such that:

k  sf k   k (18)

When k  0, the capital stock k and output f(k) are steady over time (rather than growing or
shrinking), since the capital stock will not change due to the reason that the two forces
(investment and depreciation) just balance. The capital stock when k  0, denoted k* is called
the steady state level of capital.

38
9-(2) Population Growth
An assumption on a population
The population and the labour force now grow at a constant rate n. Then (18) is modified such
that:

k  sf k     n k

The effect of a change in a population is explored as follows:

39
 Introduction to Economics
Macroeconomics
Instructor
Professor Ryuta Ray Kato
Email: raykato@meiji.ac.jp

Summary and Exercises

<Summary>
In Session 1 (Introduction)
 Macroeconomics is the study of the economy as a whole
 When modelling, you have to choose the variables/your targets (Endogenous variables)
you want to explain, and then choose some important elements (Exogenous variables)
which affect your targets.
 GDP is the nation’s total income and the total expenditure on its output of goods and
services, which summarises in a single number the pound value of new economic activity
in a given period of time

In Session 2 (in the Long-run)

 The total production (expenditure) of goods and services is determined by the production
function of the economy.
 In the long-run, the amount of two factors, labour and capital is assumed to be fixed.
Thus, the total production is also assumed to be fixed in the long-run.
 Under the assumption of constant returns to scale, GDP is completely divided into
labour and capital such that:
Y  F K , L   MPC  K  MPL  L,
where MPC and MPL denote the marginal product of capital and the marginal product of
labour, respectively.
 In the market of output of goods and services, we get

Demand function equation (5)

Supply function equation (6)
the equilibrium condition equation (7)
endogenous variable r
exogenous variables Y (K , L ), G , T

where (5), (6) and (7) are

C(Y - T ) + I (r ) + G (5)
Y = F (K , L ), (6)
Y = C(Y - T ) + I (r ) + G . (7)
 When the goods and services market is in equilibrium, the financial market is also in
equilibrium.

40
  According to the Quantity Theory of Money, the central bank has ultimate control over
the rate of inflation.
 The demand for money depends on income and the nominal interest rate such that:
 
M
P
d
 Li, Y 

In Session 3 (The Short-run)

 The price is sticky in the short-run, but the price is flexible in the long-run. In the short-
run, the price cannot move smoothly to adjust the market.
 There are two markets considered in the IS – LM model: The market for goods and
services and the market for real money balances
 IS Curve: the pairs of income and the nominal interest rate which are obtained when the
market for goods and services is in equilibrium
 LM Curve: the pairs of income and the nominal interest rate which are obtained when
the market for real money balances is in equilibrium

In Session 4 (Policy Evaluation)

 The effects of fiscal policy are studied by the shifts of the IS curve.
 The effects of monetary policy are studied by the shifts of the LM curve.
 The IS curve shifts to the right by an increase in G (government purchases), or a decrease
in T (net tax). The IS curve shifts to the left by a decrease in G, or an increase in T.
 An increase in the money supply shifts the LM curve downward. A decrease in the
money supply shifts the LM curve upward.

In Session 5 (Economic Growth)

 An economy grows by
 investment in capital
 an expansion of an population
 technological progress
 The more saving, the more does the total output grow.
 The more population, the more does the total output grow. However, income per worker
decreases in a steady state.

<Exercises>

Exercise 1:
Suppose that there is no foreign account. Suppose also that the following functions are given:

C  A  cY  T ,
I  B  ar ,
L  0.1Y  10r  100
M
 100
P
where
C: private consumption,
I: private investment
Y: income (GDP)
T: tax

41
G: government expenditure
r: interest rate
M: nominal money supply
P: price level
L: money demand
c, a, B: parameters

Then answer the following questions within the IS-LM model.

1. Obtain the total demand in the goods market

2. Obtain the IS curve
3. Show the relationship between (Y,r) on the IS curve (Hint: Differentiate the IS curve to show
the relationship)
4. Obtain the LM curve
5. Obtain the equilibrium interest rate in both the goods market and the money market.
6. Obtain the equilibrium income (GDP) in the both markets.
7. Suppose that the government introduced a new plan of 10 million yen public investment.
Then how much can GDP be expected to increase? Answer this question under the
assumption of a  10, c  0.8 . (Show your calculation process as well)
8. How much should the government decrease the amount of tax in order to increase the
equilibrium GDP? Answer this question under the assumption of a  10, c  0.9 . (Show
your calculation process as well)

Exercise 2:
Suppose that there is not the foreign account. Suppose also that the following functions are
given:

C  A    Y  T ,
I  B  r ,
L  Y  r  100
M
 100
P
where
C: private consumption,
I: private investment
Y: income (GDP)
T: tax
G: government expenditure
r: interest rate
M: nominal money supply
P: price level
L: money demand
A, B,  ,  ,  ,  : parameters

Then answer the following questions within the IS-LM model.

1. Obtain the IS curve, and then derive the condition for the IS curve to have a negative slope.
2. Obtain the LM curve, and then derive the condition for the LM curve to have a positive
slope.

42
3. Suppose that the government introduced a new plan to increase public investment by
dG  0 . Then how much can GDP be expected to increase in a new equilibrium?
4. Suppose that the government introduced a new plan to increase public investment by
dG  0 followed by the same amount of an increase in tax. Thus, under this policy, we
have dG  dT . What happens to the equilibrium interest rate under this policy?

Exercise 3:
Suppose that there is not the foreign account. Suppose also that the following functions are
given:
C  F Y  T ,
I  I r ,
L  L1 Y   L2 r 
M
B
P
where
C: private consumption, or F, the function of Y-T, and dF d Y  T   0
I: private investment, or the function of the interest rate, r, and dI dr  0
Y: income (GDP)
T: tax
G: government expenditure
r: interest rate
M: nominal money supply
P: price level
L: money demand, and dL1 dY  0, dL2 dr  0
B : parameter, and positive

Then answer the following questions within the IS-LM model.

1. Obtain the IS curve, and then derive the condition for the IS curve to have a negative slope.
2. Obtain the LM curve, and then derive the condition for the LM curve to have a positive
slope.
3. Suppose that the government increased the tax revenue by dT  0 . Then how much can
the equilibrium GDP be expected to decrease in a new equilibrium?
4. Suppose that the government wants GDP to increase by 1 million Japanese yen ( dY  1
million Japanese yen) in a new equilibrium. Then how much does the government have to
increase public investment ( dG ) in order to achieve the increase in GDP? Furthermore, if
the government has to reduce the tax revenue ( dT ) to achieve the same result in stead of
changing G, then how much does the government have to reduce it? Answer in both cases.

43