Professional Documents
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Handbook For Final PE
Handbook For Final PE
Revision on Principle of
Macroeconomics
BY ISB ACADEMIC TEAM
Under no circumstances should one copy this document without author’s permission.
Chapter 23: Measuring a Nation’s Income 2
Chapter 23:
- GDP measures two things at once: total income and total expenditure
2. “... of All…” :
+ excluding illegal drugs, items produced and consumed at home, never get
into market. (E.g.: Karen cleans her own house instead of hiring people to
clean her house => The value Karen spent cleaning her house is not
included in GDP)
+ For people who rent their houses, the rent is included in GDP.
+ For people who own their houses, estimated rental value is included in
GDP. (assume that if the owners use their house for rent)
3. “... Final…” :
Chapter 23: Measuring a Nation’s Income 4
+ Intermediate goods are goods purchased to produce other goods for sale.
For example:
4. “... Goods and Services…”: tangible goods (food, clothing, car) and
intangible services (haircuts, housecleaning, doctor visits).
For example: Ford produced a $500 car in 2018 but did not sale it until 2019.
For example:
The Government reports the GDP for a quarter “at an annual rate” (the amount
of income and expenditure during the quarter multiplied by 4) with seasonal
adjustment.
GNP = GDP + income nationals earn abroad - income foreigner earn here
For example:
GDP = C + I + G + NX
With: C is Consumption;
I is Investment;
G is Government Purchases;
1. Consumption:
For example: My purchases a Pizza for $15 and pays rent for $200.
2. Investment:
For example: Apple produces $1000 of computers and adds all into inventory.
Chapter 23: Measuring a Nation’s Income 7
3. Government Purchases:
4. Net Exports:
1. A Numerical Example:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
GDP Deflator = x100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃
Chapter 23: Measuring a Nation’s Income 9
- GDP doesn’t measure what make life worthwhile, but it measures the
ability to achieve it.
- GDP excludes value of activity take place out of the market, quality of
environment, distribution of income among the economy.
EXERCISE
2. To compute GDP we
average.
a. Production generates income so that income and production are the same
but the value of the cars sold in 2004 will not cause 2004 GDP to
increase.
b. The value of increased inventory will not affect GDP in 2003, but will be
and the value of the cars sold in 2004 will increase 2004 GDP.
b. These numbers are adjusted to make them measure at annual rates, but no
c. These numbers are at quarterly rates that have been seasonally adjusted.
d. These numbers are at quarterly rates and have not been seasonally
adjusted.
6. Flour is
$400, depreciation of $300, export of $500 and import of $600. Then GDP
will equal?
A. $6400
B. $7000
C. $8900
D. $9500
10. A firm produces consumer goods and adds some to inventory in the
third quarter of 2018. In the fourth quarter the firm sells the goods at a
actions, what component(s) of 2019 real GDP change in the fourth quarter?
GDP?
B. Not included in GDP because they are not payments for currently
D. Not included in GDP because taxes will have to be raised to pay for them.
14. What components of US GDP (if any) would each of the following
transactions affect?
15. Which of the following statements about nominal GDP and real GDP
is most accurate?
GDP.
GDP.
c. Real GDP and nominal GDP are equally good measures of economic
well-being.
16. Suppose GDP consists of wheat and rice. In 2002, 20 bushels of wheat
are sold at $4 per bushel, and 10 bushels of rice are sold at $2 per bushel. If
Chapter 23: Measuring a Nation’s Income 16
the price of wheat was $2 per bushel and the price of rice was $1 per bushel
a. $100, real 2002 GDP is $50, and the GDP deflator is 50.
b. $50, real 2002 GDP is $100, and the GDP deflator is 200.
c. $100, real 2002 GDP is $50, and the GDP deflator is 200.
d. $40, real 2002 GDP is $100, and the GDP deflator is 50.
an increase in production.
increase in production.
budget.
18. Suppose that the country of Wakanda produces only eggs and ham.
The table below shows price of each goods throughout the years. Supposed
that consumers always buy 100 units of eggs and 50 units of ham.
percent
percent
percent
percent
billion in 2016 and reported a GDP deflator of 125 in 2017 and a deflator of
GDP is the market value of all final goods and services produced .... → used
3. a. Production generates income so that income and production are the same
but the value of the cars sold in 2004 will not cause 2004 GDP to increase.
so the 2003 GDP will increase. 25 cars that are sold in 2004 were produced in
good to sell, whereas a final good is a good that is consumed by a consumer for
(Explain: GNP is the income of all people of that nationality. For example, US
GNP includes income of all American, even abroad. So GNP is GDP including
USA’s GNP. But since he works only in Canada, he will not contribute to the
USA’s GDP
9. A. $6400
inventory means the investment decreases. And when the firm sells the goods at
imported good which leads to the decrease in net export. However, U.S
consumption increases because U.S citizen bought the dress, so the increase in
consumption off set the decrease in net export, which leaves the U.S GDP
unchanged. The owner of the fashion shop in France is American, so U.S GNP
increases.)
investment regardless of where they were made. Stocks and bonds are not
included in the investment, they are included in the saving. The estimated rental
13. B. Not included in GDP because they are not payments for currently
14.
a. Consumption
b. Investment
Chapter 23: Measuring a Nation’s Income 21
d. Consumption
e. Government Purchases
and Import)
g. Investment
15. b. Real GDP is a better gauge of economic well-being than is nominal GDP.
(Explain: Real GDP answers a hypothetical question: What would be the value
of the goods and services produced this year if we valued these goods and
services at the prices that prevailed in some specific year in the past? By
evaluating current production using prices that are fixed at past levels, real GDP
shows how the economy’s overall production of goods and services changes
over time)
16. c. $100, real 2002 GDP is $50, and the GDP deflator is 200
Chapter 23: Measuring a Nation’s Income 22
wheat
2001 $2 1 $1 1
2002 $4 20 $2 10
17. a. increase in nominal GDP that is due to an increase in prices rather than
18. d. Inflation rate in 2017 is -10 percent, inflation rate in 2018 is -5.56
percent
Chapter 23: Measuring a Nation’s Income 23
Compute the Real GDP, we got 2016 Real GDP = 62.5, 2017 Real GDP = 80
Since Real GDP and GDP Deflator both increase from 2016 to 2017, Price level
Chapter 24:
CPI: a measure of the overall cost of the goods and services bought by a
typical consumers.
The CPI increases => consumers need to pay more to maintain the same
living standard.
Formula:
Price of a basket is calculated as the total price of all the goods in the basket.
1. Substitution bias:
increases more rapidly than price of B. Consumers will be more likely to buy
less A and more B. CPI ignores this change in quantity bought because the
basket is fixed.
Consumers have greater set of choice from which to choose => Less
dollars are needed to maintain the same level of well-being => Each dollar
becomes more valuable. Because CPI has fixed basket, it does not reflect to
● All 3 problems with CPI above overstate the CPI (and in turn Inflation
Rate)
Chapter 24: Measuring the Cost of Living 26
a. What is included?
The first difference is that the GDP deflator reflects the prices of all
goods and services produced domestically, whereas the consumer price index
reflects the prices of all goods and services bought by typical consumers.
Imported goods ✗ ✓
Capital goods ✓ ✗
Imported goods are not included in the GDP because when people buy
imported goods, the increase in Consumption offsets the decrease in Net Export.
CPI, on the other hand, will include Imported goods if it is typically bought by
consumers.
Chapter 24: Measuring the Cost of Living 27
does not include Capital goods because it is not typically bought by consumers.
GDP because it is produced domestically but not in the CPI because a typical
b. Differences:
Fixed prices from base year Fixed basket from base year
bought by consumers)
Formula:
E.g.: Determine how much does an amount of 2018 $500 worth in 2019,
today. Given that the CPI in 2018 is 169, CPI in 2019 is 225.
= $500 × 225
169
= $665.68
2/ Indexation:
Formula:
* Real interest: how fast your purchasing power increases, corrected for
inflation
* Nominal interest: how fast your money increases, not corrected for
inflation
- Housing
- Transport
EXERCISE
a. Suppose that the USA import cameras from Canada. An increase in the
price of imported cameras is captured by the USA’s CPI but not by the
c. The "base year" in a price index is the benchmark year against which
d. If the CPI rises at 5 percent per year, then every individual in the
e. The largest category of goods and services in the CPI is food and non-
alcoholic beverages.
02/ An inflation rate calculated using the CPI shows the rate of change of
a. all prices.
03/ Which one of these is a problem arisen from the measurement of CPI?
a. When price of good A rises faster and price of good B, people will buy
b. When a new good enters the market, it is not counted in the CPI
04/ The following table shows the prices and the quantities consumed in the
country known as the University States. Suppose the base year is 2003. This
is the year the typical consumption basket was determined so the quantities
consumed during 2003 are the only quantities needed to calculate the CPI
in every year.
Pencils
f. What type of bias do you observe in the CPI and corresponding inflation
05/ Suppose that you lend your flatmate $100 for one year at a nominal
interest rate of 9%
a. How many dollars of interest will your flatmate pay you at the end of the
year?
b. Suppose at the time you both agreed to the terms of the loan, you both
expected the inflation rate to be 5 per cent during the year of the loan.
What do you both expect the real interest rate to be on the loan?
c. In the case described above, actual inflation turned out to be higher than
expected. Which of the two of you had the unexpected gain or loss? Your
d. What would the real interest rate on the loan have been if the actual
f. Suppose that after 1 year, you have already paid back your loan and
interest. A few days later he complained that your $109 can buy 4% less
06/ Andrew is offered a job in Des Moines where the CPI is 80 and a job in
New York where the CPI is 125. Andrew’s job offer in Des Moines is for
$42,000. How much does the New York job need to pay in order to make
07/ If your wage rises from €500 per week to €625 per week while the CPI
rises from 112 to 121, how should you feel about your standards of living? .
should the salary of a typical accountant now in order to have the same
purchasing power as before? Given that the CPI in 2019 is 148 and the CPI
in 1999 is 80.
A. True. Explain: Camera is a good typical consumers buy, so it’s in the basket
and an increase in price leads to an increase in CPI. On the other hand, the
C. True.
Chapter 24: Measuring the Cost of Living 35
D. False
(Explain: When the CPI rise by 5% per year, every individual in the country
5%
need increase in their income for their standard of living to
𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 1
remain constant)
E. False. (Solutions: Housing and Transportation (see p.508, PE text book for
further details))
2. D
Explain: Because the CPI calculated the price of the goods in the basket, so
4.
A. (Answer: 100)
B. (Answer: 145.45)
C. (Answer: 250)
D. (Answer: 45,45%)
E. (Answer: 71.88%)
Chapter 24: Measuring the Cost of Living 36
F. (Answer: Substitution bias since the price of pen rises faster than the price of
other two goods, people will buy more books and pencils and less pens)
5.
E. (Answer: You will receive more in terms of money, but in terms of purchasing
F. ( Answer: Inflation=13%)
6. (Answer: Applying the formula of Inflation, we can see that the Price level in
Inflation = 8.03%
So Wage rises more than the price level => Increased standards of living)
Chapter 25:
I/ Determinant of Productivity:
a/ Physical Capital (Capital): the stock of equipment and structures that are
E.g.: To produce a table, the workers needs equipment like saws, drills, etc. So
b/ Human Capital: the knowledge and skills that workers acquire through
E.g.: skills accumulated throughout the life of a worker are called Human Capital.
c/ Natural Resources: the inputs into the production of goods and services that
E.g.: To build a hydropower plant, people need a fast-current river. So the river
is Natural Resource.
Chapter 25: Production and Growth 38
*Note:
distinct.
society’s textbooks, whereas human capital is the amount of time that the
EXERCISE
technological knowledge.
technique.
technological knowledge.
(iii) The builder use saw, hammer,... to build a house. Saw, hammer,.. are
Physical Capital.
(iv) The jeweler uses ruby ore to make a ruby ring. The ruby ore is
Physical Capital
a. (i), (ii)
b. (i), (iii)
c. (ii), (iv)
d. (iii), (iv)
human capital is the amount of time that the population has devoted to
read them.
knowledge.
2. b. (i), (iii)
(Explain:
society’s textbooks, whereas human capital is the amount of time that the
(iii) is correct. Saw, hammer,... are tools used to build a house, so they are
Physical Capital.
(Explain:
on Technological Knowledge and Human Capital but all four factors including
Knowledge)
Chapter 26: Saving, Investment, and the Financial System 42
Chapter 26:
Saving, Investment, and the Financial System
I/ Bond:
- IOU (I owe you); certificate of indebtedness
E.g.: A buys a bond from B. B will pay A periodically according to
interest rate until the bond matures. When the bond matures, B will repay A the
amount of money A had provided initially.
Terminology:
- Date when the full amount will be paid: date of maturity
- Amount borrowed initially: principal
- Length of time until bond matures: term
- Bond that never matures: perpetuity
- Probability the borrower will fail to repay: credit risk
Chapter 26: Saving, Investment, and the Financial System 43
II/ Stock:
A claim to partial ownership of a firm
- Sales of stock: equity finance
- Stock pays depend on profit of the firm
- Stock: higher risk but also higher return potential
- Stock price reflect profitability
- Bond holders’ payment is included in company’s expense.
Optimistic about company’s future → Demand for stock increases →
Price of stock increases
Pessimistic about company’s future → Demand for stock decreases →
Price of stock decreases
● Formula:
+ Earnings = Retained Earnings + Dividend
+ Dividend (per share) = Dividend yield * Stock price per share
+ Price-Earning Ratio = Stock Price per share / Earnings per share
III/ Bank:
Take deposit from who want to save, use deposit to lend to people, charge
borrower higher interest rate on their loans.
Banks are:
- Medium of exchange
- Store of value (like stocks and bonds)
Saving = Investment
For an individual, the equation above might not hold. But as a closed
economy,Saving always equals Investment.
S = I = (Y - T - C) + (T - G)
S: national saving
(Y - T - C): private saving
● Note: Private saving must always be Y - T - C, NOT Y - C - T
(T - G): public saving
T>G: budget surplus
T<G: budget deficit
a/ Saving incentive:
Reduce tax on interest income => Savers now will get more interest than
before => Save more => Supply curve shift right.
b/ Investment incentive:
Chapter 26: Saving, Investment, and the Financial System 47
EXERCISE
1. Which of the following statements is most likely to be correct?
is about to enter a boom period because people will be able to buy stock
is about to enter a recession because low stock prices may mean that
about the business cycle because stock prices can fall for many reasons.
is
a. 45.
b. 50
c. 15
d. 25
equal 2,000. What are private saving, public saving, and national saving?
4. The country of Hykania does not trade with any other country. Its
GDP is $20 billion. Its government purchases $3 billion worth of goods and
a. $4 billion
b. $3 billion
c. $2 billion
5. The Eye of Horus incense company has $10 million in cash which it
has accumulated from retained earnings. It was planning to use the money
to build a new factory. Recently, the rate of interest has increased. The
a. not influence the decision to build the factory because The Eye of Horus
b. not influence the decision to build the factory because its stockholders are
c. make it more likely that The Eye of Horus will build the factory because
d. make it less likely that The Eye of Horus will build the factory because
a. the supply for loanable funds shifts right and the demand shifts left.
b. the supply for loanable funds shifts left and the demand shifts right.
c. neither curve shifts, but the quantity of loanable funds supplied increases
equilibrium.
d. neither curve shifts, but the quantity of loanable funds supplied decreases
equilibrium.
7. Suppose that the government were to replace the income tax with a
8. In the last few years the U.S. government has gone from a surplus to
1st, 2020. What is the principal and the term of the bond, respectively? Is
c. The principal cannot be determined without the Interest Rate, 1 year, Low
Interest Rate
a. Stock
b. Bond
c. Bank Deposits
a. $.25, 5
Chapter 26: Saving, Investment, and the Financial System 52
b. $.25, 6.7
c. $1.25, 5
d. $1.25, 6.7
13. Other things the same, as the maturity of a bond becomes longer, the
14. All else equal, when people become more optimistic about a
c. demand for the stock and the price will both rise.
d. demand for the stock and the price will both fall.
15. Henry buys a bond issued by Ralston Purina, which uses the funds to
economy is about to enter a recession because low stock prices may mean
So low stock price suggests that people are expecting low corporate profit.)
2. d. 25
= 2% * 50 = $1
Earning + Dividend )
4. c. $2 billion
Negative Tax
Private Saving = Y - T -C
= $4 billion
→ C = $15 billion
5. d. make it less likely that The Eye of Horus will build the factory because
(Explain: The opportunity cost of building a new factory with $10 million is
giving to the bank and earn Interest. When Interest Rate increased, the Interest
increases and the quantity demanded decreases as the interest rate rises to
equilibrium.
less and Savers will supply more. As a result, the market eventually gets back to
its equilibrium.)
(Explain: Consumption tax encourages Savings, the Supply curve for the
The Supply curve of the market for loanable fund is determined by National
Saving, which is the sum of Private Saving and Public Saving. When the
decreases → Supply for loanable fund decreases → The Supply curve shift to
the left)
(Explain: The principal is the amount borrowed. The term is the length of time
until the bond matures. The bond will be more likely to have a Low Interest
11. c. $1.25, 5
Price-Earning Ratio = 25 / 5 = 5)
provides fund. When Microsoft sells a bond to the public, the money flow from
the public to Microsoft, so they are borrowing money from the public.)
(Explain: Long-term bond is more riskier than short-term bond so it has higher
interest rate)
14. c. demand for the stock and the price will both rise
Chapter 26: Saving, Investment, and the Financial System 57
Chapter 28:
Unemployment
I- Identifying Unemployment:
- 3 groups of population:
Unemployed: people who are not working, have looked for work during
the previous 4 weeks. Waiting to be recalled from having been laid off.
Not in the labor force: everyone else who does not fit into the first 2
categories. Including full-time students, retirees, and homemakers.
=> Labor force: the total number of workers, including the employed
and unemployed.
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Unemployment rate= × 100%
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
Labor-force participation rate= × 100%
𝐴𝑑𝑢𝑙𝑡 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
However, the u-rate is still a very useful barometer of the labor market &
economy.
+ Frictional unemployment:
- Occurs when workers spend time searching for the jobs that best
suit their skills and tastes
+ Structural unemployment
- Usually longer-term
3. Unemployment Insurance:
The minimum wage may exceed the equilibrium wage => Surplus of
workers => Unemployment for workers with least skills.
Chapter 28: Unemployment 62
- When unions raise the wage above equilibrium => surplus of labor =>
unemployment results.
=>
Chapter 28: Unemployment 63
- Worker Health:
- Worker Turnover:
- Worker Quality:
- Worker Effort:
+ Above-equilibrium wage makes workers more eager to keep their
jobs => have more incentive to work, not to shirk.
EXERCISE
b. Brett, who has become discouraged looking for a job and has quit
x 100.
4. In 2000 in the United Kingdom, the adult population was about 46.5
million, the labor force participation rate was 63.5 percent, and the
unemployment rate was 5.8 percent. What was the number of people
5. The BLS recently reported that there were 48.6 million people over age
25 who had at least a bachelor’s degree. Of this number, 38.0 million were
in the labor force and 36.9 million were employed. What was the labor-
force participation rate and the unemployment rate for this group?
where they are unlikely to be hired. If these individuals were counted as out
would be higher.
would be lower.
would be lower.
9. Tom is looking for work after school, but everywhere he fills out an
application he is told that so have lots of others. Simon has a law degree.
Several firms have made him offers, but he thinks he might be able to find
unemployed.
unemployed.
Chapter 28: Unemployment 68
Unemployment increases.
c. A typical unemployed worker near the end of the time in which she
d. Liz pays the workers for her plumbing and heating company more
than the equilibrium wage because she believes it will make them
work harder.
Chapter 28: Unemployment 70
Figure 1
13. Refer to Figure 1. If the minimum wage is $5, the number of people
unemployed is
15. Unions
manufactures CD drives on an assembly line. Her staff has told her that the
output the firm produces, given the number of workers employed, indicates
b. pay all workers below the equilibrium wage rate to make up for the
c. make sure that workers are getting paid exactly the equilibrium
wage rate
Chapter 28: Unemployment 72
d. reduce production
a. is a constant.
unemployment?
available jobs.
rate
(Explain:
A is correct. Derrick is included in the labor force because he has a job, he just
B is wrong. Brett would like to work but has given up finding a job. So Brett is
(Explain:
Since 63.5% of the population join the labor force, Labor Force = 63.5% x 46.5
(Explain:
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
Labor Force participation rate = × 100% =
𝐴𝑑𝑢𝑙𝑡 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛
38 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
× 100% = 78%
48.6 𝑚𝑖𝑙𝑙𝑖𝑜𝑛
𝑈𝑚𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
Unemployed Rate = × 100% =
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
lower.
(Explain:
When people are counted as out of the Labor Force instead of Unemployed.
Chapter 28: Unemployment 76
Labor-Force participation Rate would be lower because there are now less
Unemployment Rate would be lower because there are now less unemployed
people)
(Explain: Structural unemployment means that there are not enough position for
the demand for job. This is cause by Wages kept above Equilibrium, causing a
suitable jobs. This could be caused by: Job Search, Sectoral Shift,
Unemployment Insurance.)
(Explain: Tom has to compete with each others for one position, which
indicates that there are not enough positions for all the workers finding jobs =>
Simon is currently finding a position which fits his skills the most => Simon is
frictionally unemployed.)
Computer companies => They are frictionally unemployed until they have
11. c. A typical unemployed worker near the end of the time in which she can
(Explain:
B is wrong. When the government lift off minimum wages law, Structural
12.b. Fred decides to close his Thai restaurant because he cannot afford to pay
(Explain:
force.
to Minimum wages.)
Chapter 28: Unemployment 79
(Explain: The minimum wages of $5 is currently less than the equilibrium wage
of $6. So the price floor has no effect on the market of labor. So market is still
When the minimum wages fall to $5, it has no effect on the market because it is
lower than the equilibrium wages => Market goes back to the equilibrium =>
(Explain:
A is wrong. Unions use collective bargaining to ask for higher wages =>
Causing Unemployment
C is wrong. Unions use collective bargaining to ask for higher wages =>
Reduce quantity of labor of a firm. So the firm now has less labor and has to
D is correct. When workers are fired from unions, they move to a non-
16.a. pay all workers more than the equilibrium wage rate.
(Explain: Some workers are not working at their full potential. According to
Efficiency Wage theory, the CEO should increase salaries to encourage the
productivity of workers.)
- Always fluctuates
19. a. The Internet provides more readily available information about available
jobs.
(Explain:
discouraged worker, which is now counted as out of the labor force. So Labor-
decreases.)
21.A
Chapter 29
Money: the set of assets in an economy that people use to buy goods and
3 functions of money:
+ Medium of exchange: an item that buyers give to sellers when they want
+ Unit of account: the yardstick people use to measure prices and record
debts.
+ Store of value: an item that people can use to transfer purchasing power
2 kinds of money:
government decree.
+ Currency: the paper bills and coins in the hands of the public.
central bank.
Chapter 29: The Monetary System 86
For example:
Assets Liabilities
Loans $90
➢ Before First National Bank makes any loans, the money supply is the
$100 of deposits.
➢ When the bank lends out some of the deposit, the borrowers hold $90 in
currency.
𝒓𝒆𝒔𝒆𝒓𝒗𝒆
+ Reserve ratio (R) = : the fraction of deposits that banks hold
𝒅𝒆𝒑𝒐𝒔𝒊𝒕𝒔
For example: $100 is deposited into the fractional-reserve banking system with
the reserve ratio of 5%. How much money does the banking system generate?
SOL:
𝛥𝐷𝑒𝑝𝑜𝑠𝑖𝑡 $100
𝛥𝑀𝑜𝑛𝑒𝑦=𝛥𝐷𝑒𝑝𝑜𝑠𝑖𝑡 × 𝑀𝑜𝑛𝑒𝑦 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟= = = $2000.
𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑟𝑎𝑡𝑖𝑜 5%
Assets Liabilities
Reserves Deposits
Loans Debt
purpose of investment
𝑎𝑠𝑠𝑒𝑡𝑠
+ Leverage ratio =
𝑐𝑎𝑝𝑖𝑡𝑎𝑙
E.g.: Leverage ratio = 20 => For every dollar the owner contributed, the bank
has $20 of assets, $19 are financed with borrowed money by taking in deposits
or issuing debt.
- Banks borrow from discount window and are charged with discount
rate.
+ When discount rate ↗ =>Banks will borrow less => Money Supply ↘
+ Discount rate ↘ => Banks will borrow more => Money Supply ↗
a. Reserve requirement:
- The regulation that set the minimum amount of reserves that banks must
hold.
b. Interest on reserve:
Chapter 29: The Monetary System 90
- The Fed will pay banks interest depends on the amount of reserves they
hold.
the bank.
+ Sell bonds => Federal Fund Rate ↗ => Reserve ↘ => Money Supply ↗
+ Buy bonds => Federal Fund Rate ↘ => Reserve ↗ => Money Supply ↘
EXERCISE
1/ If you deposit $100 into a demand deposit at a bank, this action by itself
Chapter 29: The Monetary System 91
b. decreases.
c. increases.
Assets Liabilities
Loans: $125,000
5/ If a bank uses $80 of reserves to make a new loan when the reserve ratio
is 25 percent,
c. the money supply will eventually increase by more than $20 but less
than $80.
Chapter 29: The Monetary System 93
Assuming that people hold only deposits and no currency, and that banks
a. 29 percent.
b. 22.5 percent.
c. 16 percent.
a. $5,000.
b. $1,000.
c. $500.
d. $0.
increases.
Chapter 29: The Monetary System 94
decreases.
increases.
increases.
9/If the reserve ratio is 20 percent, and banks do not hold excess reserves,
when the Fed sells $40 million of bonds to the public, bank reserves
$200 million.
$800 million.
$200 million.
$800 million.
10/The banking system has $10 million in reserves, the reserve requirement
is 20 percent, and there are no excess reserves. The public holds $10 million
Other things the same, this action will cause the money supply to
c. fall by $5 million.
11. The Fed can increase the price level by conducting open market
12. At one time, the country of Gia Lai had no banks, but had currency of
currency into the banking system. If banks do not hold excess reserves,
a. $10 million
b. $12 million
Chapter 29: The Monetary System 96
c. $25 million
d. $30 million
(ii) There are 2 types of money: Fiat Money and Commodity Money
C. All is correct
D. None is correct
Table 2:
Asset Liabilities
Security: $400
A. $150
B. $1500
C. $400
respectively:
Chapter 29: The Monetary System 98
2. C (Explain: When the bank loan out money, the depositors still have demand
deposits, but now the borrowers hold more currency, so money supply
increases. In other words, as a bank creates the asset of money, it also creates a
corresponding liability for those who borrowed the created money, but the
3. D (Explain:
A is correct. The reserve ratio is 5%, so the Reserves must equal 5% of the new
B is correct. The depositor deposits $500, so, initially, the bank reserves will
increase by $500
Chapter 29: The Monetary System 99
C is correct. The reserve ratio is 5%, so the bank can do whatever it wants with
the remaining 95%, it can lend out or put it in Excess Reserves. In this case, the
4. B
(Explain: When someone deposits $50,000 into the bank, the bank now have
Reserve is $20,000 => Excess Reserves now equals $5,000. The bank now have
remaining. Since the bank doesn’t lend out more loan, the $50,000 will be
5.D (Explain: When the bank uses $80 to make new loan. The money supply
will initially increase by $80. Eventually, the money supply will increase by
$320. When the bank lend out money and create more money supply, the level
7.D (Explain: When you deposit $500 of currency into demand deposit, money
supply will not change. And since the reserve ratio of the bank is 100%, it does
8.B (Explain:
1
The Money Multiplier = , so when Reserve Ratio increases,
𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜
9.C (Explain: The Fed is currently performing Open market Sales, which will
Initially, the bank reserves fall by $40 million due to the sales of bonds
1
The Money Multiplier = =5
𝑅𝑒𝑠𝑒𝑟𝑣𝑒 𝑅𝑎𝑡𝑖𝑜
million)
10.B (Explain:
Chapter 29: The Monetary System 101
As the reserve ratio have increased from 20% to 25%, the money supply falls.
As the reserve ratio increased from 20% to 25%, the reserves increased $2.5M.
So the bank has $2.5 million less to lend out, which decrease money supply by
$10M)
11.D (Explain:
When the Fed perform open market purchase, the Fed is buying bonds from the
banks, the money will go to the bank, thus the bank now has more money to
Discount rate is used when the Fed lends money to bank. When discount rate
decreases, the bank will be encouraged to borrow money from the Fed, so
When the Reserve Requirement Ratio decreases, the amount the bank needs to
reserve is smaller, the amount the bank can lend out is larger => Money supply
increases)
When people deposits $5M in the bank, the bank creates $25M of money supply
14. B(Explain:
(i): Wrong. Fiat Money doesn’t have intrinsic value, but Commodity Money has
(v), (vi): Correct. Money can be in the hand of public (Currency) or in balances
16.C (Explain:
𝑅𝑒𝑞𝑢𝑖𝑟𝑒𝑑 𝑅𝑒𝑠𝑒𝑟𝑣𝑒
Requirement Reserve = x 100%)
𝐷𝑒𝑝𝑜𝑠𝑖𝑡
Chapter 30: Money Growth and Inflation 103
Chapter 30
- The Price Level (P) measured by CPI or GDP Deflator is the number of
- The Value of Money (1/P): the quantity of goods and services that can be
- Money demand reflects how much wealth people want to hold in liquid
form.
+ The interest rate that a person could earn by using the money to
inflation rate.
Monetary Injection: Create excess Supply of Money -> increase Demand for
goods and services -> Increase in the Price -> Increase in the quantity of money
variables.
+ Real: physical unit, relative Price, real wage, real interest rate,
production, employment.
MxV=PxY
With
V: Velocity of Money
Y: real GDP
Fisher effect: Money Supply increase -> Nominal interest rate increases,
P increase -> pay more -> receive more -> inflation does not itself reduce
2. Shoeleather Costs:
3. Menu Costs:
- High inflation -> change P -> waste money in printing new menu.
Inflation causes relative price to vary more than they otherwise would ->
misallocation.
- Tax treatment on capital gain: increase size of capital gain -> increase tax
burden
Wealth:
EXERCISE
3. When the money market is drawn with the value of money on the
4. When the money market is drawn with the value of money on the
6. When the money market is drawn with the value of money on the
vertical axis, if the price level is higher the equilibrium price level, there is
Figure 1
Chapter 30: Money Growth and Inflation 113
7. Refer to Figure 1.
a. classical variable.
b. dichotomous variable.
c. nominal variable.
d. real variable.
will
a. increase employment.
c. increase production.
a. (P x Y)/M.
b. (P x M)/Y.
c. (Y x M)/P.
d. (Y x M)/V.
Chapter 30: Money Growth and Inflation 115
13. Last year Tealandia produced 50,000 bags of green tea, which sold at 4
a. 20
b. 5
c. 1/20
d. 1/5
14. The money supply in Freedonia is $200 billion. Nominal GDP is $800
billion and real GDP is $400 billion. Assuming that velocity is stable, if real
GDP grows by 10 percent this year, and if the money supply does not
15. Velocity in the country of Shem is always stable. In 2002, the money
supply was $200 billion and the GDP price deflator was four times as high
as it was in the base year. In 2003, the money supply increased to $240
billion, the price level increased by 15 percent, and nominal GDP equaled
$1,200 billion. By how much did real GDP increase between 2002 and
2003?
a. 20 percent
b. 4.35 percent
c. 2.17 percent
expenditures.
17. Greta puts money in a savings account at her bank earning 4.5 percent.
One year later she takes her money out and notes that while her money was
a. 4.5 percent more money with which she can purchase 7 percent
more goods.
b. 4.5 percent more money with which she can purchase 2 percent
more goods.
c. 7 percent more money with which she can purchase 7 percent more
goods.
fewer goods.
a. the nominal interest rate would be greater than the real interest rate.
b. the real interest rate would be greater than the nominal interest rate.
Chapter 30: Money Growth and Inflation 118
c. the real interest rate would equal the nominal interest rate.
inflation.
high.
20. You put money in an account and earn a real interest rate of 4 percent.
a. 1.2 percent
b. 2.8 percent
Chapter 30: Money Growth and Inflation 119
c. 4.8 percent
a. creditors receive a lower real interest rate than they had anticipated.
b. creditors pay a lower real interest rate than they had anticipated.
c. debtors receive a higher real interest rate than they had anticipated.
d. debtors pay a higher real interest rate than they had anticipated.
100%
Chapter 30: Money Growth and Inflation 120
that year (or the percentage in price level of all goods included in GDP in that
year))
(Explain: In order for Price Level to increase, the equilibrium point A must
curve must shift left or Money Supply curve must shift right
axis (axes) will only cause movement along the curve. Other variables will
E.g.: In Question 4, Price Level and Value of Money are variables shown
in the vertical axes, so a change in Price Level and Value of Money will only
1
(Explain: When the Price level (P) decreases, the Value of Money ( ) increases.
𝑃
When the Value of Money increases, people need less money to perform the
We can also put the situation in a graph, when the Value of Money
increases, the equilibrium point A must move upward => Quantity of Money
Demanded is lower.
(Explain: When the Price Level is larger than the equilibrium Price Level, there
(Explain:
When MS1 shifts to MS2, the equilibrium shifts from point A to point D,
𝑃𝑟𝑖𝑐𝑒 𝑔𝑜𝑜𝑑 𝐴
Relative Price of Good A compared to good B =
𝑃𝑟𝑖𝑐𝑒 𝑔𝑜𝑜𝑑 𝐵
physical units)
variable.
Price level and nominal wage are nominal variables because they are
When money supply increases, Money Supply curve shifts to the right,
decrease of the value of each dollars. In order for the nominal wage to have the
(Explain: M . V = P . Y
13. ANSWER: a. 20
Money Supply (M) and Velocity of Money (V) does not change after the
=> P1 . Y1 = P2 . Q2
⇔ P1 . Y1 = P1 . ( 1 - a) . Y1 . ( 1 + b)
⇔ 1 = ( 1- a) . (1+b)
⇔ 1 = (1-a) . (1 + 10%)
⇔ a = 9.09%)
(Explain:
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃 60
Real GDP = => Y2 =
𝐺𝐷𝑃 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 23
Since V is constant
Chapter 30: Money Growth and Inflation 127
V1 = V2
⇔ Y1 = 2.5
tax (Inflation Tax) because Inflation erodes the value of the money in your
wallet.
17. ANSWER: b. 4.5 percent more money with which she can purchase 2
(Explain:
She earns 4.5% interest, which means after a year, she will have 4.5%
more money.
She will have 4.5% more money but only have 2% more purchasing
18. ANSWER: b. the real interest rate would be greater than the nominal
interest rate.
=> In order for Deflation to occur, Real Interest must be greater than
Nominal Interest)
inflation is high.
of Resources
value of the money in your wallet => People will keep more money in the bank,
withdraw less money, and make more trips to the bank. Shoe-leather Cost refers
to the time and resources used to make more trips to the bank.
Compute the new Nominal Interest rate affected by tax, then compute the
21. ANSWER: a. creditors receive a lower real interest rate than they had
anticipated.
(Explain: When the loans are made, creditors and debtors set up Nominal
When Inflation Rate is more than expected, debtors now have to pay back
creditors less real value than before (because Inflation erodes value of money
=> Creditors receive a lower real interest rate than they had anticipated.)
Chapter 31: Open-Economy Macroeconomics: Basic Concepts 130
Chapter 31
● E = I: balanced trade
by foreigners
investment.
the investment.
NCO = NX
Explain:
When America exports (NX increases), other countries will pay America
foreign currency instead of USD. With foreign currency, America will buy
International Flows:
NCO increases)
Nominal exchange rate: the rate at which a person can trade the currency of
E.g.: Exchange rate = 80 yen/ dollar => 1 dollar can be exchanged for 80 yen
Real exchange rate: the rate at which a person can trade the goods and services
Rule of variables:
E.g.:
Real exchange rate is the key determinant of how much to export and import
Real exchange rate ↘ => US goods are cheaper relative to other countries’
Real exchange rate ↗ => US goods are more expensive relative to other
be able to buy the same quantity of goods in all countries (same real value in all
countries).
Based on law of one price: If an identical good has lower price in place
A than place B. People will buy goods from A and sell them in B for profit
Chapter 31: Open-Economy Macroeconomics: Basic Concepts 136
(arbitrage). Eventually, this will drive up demand in place A and supply in place
B => Increase price in place A and decrease price and place B until prices on
equals 1:
the currencies of 2 countries must reflect the price level of that 2 countries.
Money printed ↗ => money value ↘ in terms of goods and services and
These two reasons stop Arbitrage from functioning effectively, thus the
EXERCISE
1. Oceania buys $100 of wine from Escudia and Escudia buys $40 of
wool from Oceania. What are the net exports of Oceania and Escudia
in that order?
2. In 2001, Denmark had net exports of $8.3 billion and sold $52.4
balanced trade.
Chapter 31: Open-Economy Macroeconomics: Basic Concepts 138
deficit
surplus
surplus
deficit
0.
counts as
5. Bolivia buys railroad engines from a U.S. firm and pays for them
a. increases both U.S. net exports and U.S. net capital outflow.
b. decreases both U.S. net exports and U.S. net capital outflow.
c. increases U.S. net exports and does not affect U.S. net capital
outflow.
B. (ii), (v)
8. A country has $100 million of net exports and $170 million of saving.
10. Suppose the real exchange rate is 1/2 gallon of Canadian gasoline per
gallon of U.S. gasoline, a gallon of U.S. gasoline costs $1.50 U.S., and
exchange rate?
11. A U.S. firm buys sardines from Morocco and pays for them with U.S.
decreases.
increases.
14. The exchange rate is about 153 Kazakhstan tenge per dollar.
if
c. the price level in the United States rose or the price level in
Kasakhstan fell.
d. the price level in the United States fell or the price level in
Kasakhstan rose.
15. Suppose that the real exchange rate between the United States and
will increase the real exchange rate (that is increase the number of
b. Nick, a U.S. citizen, decides that his trip to Nepal would be too
18. When a country's central bank increases the money supply, its
19. How much of US dollar can be exchanged from 50.000 VND. Given that
A. $2.17
B. $0.46
D. $3
Chapter 31: Open-Economy Macroeconomics: Basic Concepts 146
20. Exchange rate is 23.000 VND / Dollar. Suppose that a bottle of Heinz
A. 1
B. 2
C. 3
Vietnam is missing
(Explain: Oceania imports $100 and exports $40 => Oceania’s Net Export = -
$60
Escudia imports $40 and exports $100 => Escudia’s Net Export = $60)
trade surplus
Chapter 31: Open-Economy Macroeconomics: Basic Concepts 147
Since Net Export = $8.3 billion > 0, the government is running budget surplus)
3. Answer: D. Trade balance is Net Export, balanced trade is when Net Export
= 0.
26-2b p.556 for more details). When Larry opens a bookstore, he is actively
5. ANSWER: a. increases both U.S. net exports and U.S. net capital outflow.
increases. When the US receives the money from Bolivia, the US will use the
money to buy Bolivian assets because they were paid in Bolivian currency.
stores in other countries. So (i), (iii), and (iv) are Foreign Direct Investment.
stocks and bonds issued by foreign companies. So (ii) and (v) are Foreign
Portfolio Investment.)
9. ANSWER: a. both positive net exports and positive net capital outflow.
That country will use foreign currency to buy foreign assets. As a result,
decreases. Since the US paid Morocco with US dollar, Morocco can use that
12. ANSWER: a. Both domestic investment and net capital outflow increase.
Export.
Without any exact numbers given, the situation where Saving must increase is
when both Investment and Net Capital Outflow (also Net Export) increase.)
Y = C + I + G + NX
14. ANSWER: d. the price level in the United States fell or the price level in
Kasakhstan rose.
𝐾𝑎𝑧𝑎𝑘ℎ𝑠𝑡𝑎𝑛 𝑡𝑒𝑛𝑔𝑒
(Explain: Exchange rate =
𝐷𝑜𝑙𝑙𝑎𝑟
So, in order for Exchange rate to rise, Price level in the US must fall or price
a. When a dollar can buy more shillings, Nominal Exchange rate increases
increases)
16. ANSWER: a. John, a French citizen, decides that US pork has become too
buy more foreign currency. As a result, foreigners who want to buy US goods
(Explain: Purchasing power parities states that an amount of currency has the
Recall that Real exchange rate is the rate at which one good can be traded with
another. Since you can buy the same amount of good everywhere with the same
18. ANSWER: b. price level rises and its currency depreciates relative to other
(Explain: When the central bank increases money supply, Inflation rate will rise
and the value of the currency will decrease. An amount of currency now can
buy less foreign currency than before, so we say that the currency depreciates
𝑉𝑁𝐷 50.000
(Explain: Exchange Rate = 23.000 VND/ Dollar = =
𝐷𝑜𝑙𝑙𝑎𝑟 𝐷𝑜𝑙𝑙𝑎𝑟
Dollar = $2.17)
20. Ans: A. 1
currency can buy the same amount of goods anywhere (Real Exchange Rate =
1). Since $3 can be used to buy 1 bottle of ketchup in the US, $3 can also be
Chapter 32:
A Macroeconomic Theory of the Open Economy
S = I + NCO
S = I + NCO is that for every dollar a nation saves ( S increases), it can either
use it finance purchase of domestic capital ( I increases ) or foreign capital
(NCO increases).
NCO > 0: Net outflow of capital. Purchase of capital overseas add to the
Demand for Loanable Fund
NCO < 0: Net inflow of capital. Purchase of capital coming from abroad reduce
the Demand for Loanable Fund.
Savings, Investment, and NCO are all influenced by Real Interest rate. People
rely on Real Interest Rate to decide to amount to save and to decide whether to
choose domestic or foreign assets.
Chapter 32: A Macroeconomic Theory of the Open Economy 154
NX = NCO
Why NX = NCO?
Suppose when Net Export > 0, America is exporting more than importing. With
the foreign currency on hands, America will buy foreign assets ( NCO > 0) and
vice versa.
Net Export is affected by Real Exchange Rate ( When Real Exchange Rate
increases => The dollars appreciate => Goods in the US are more expensive =>
Less Export and more Import =>Net Export decreases and vice versa). But
NCO is unaffected by Real Exchange Rate, so Supply of dollars in the market of
foreign-currency exchange is vertical.
From the link, we can figure out how 2 markets are connected to each other:
Chapter 32: A Macroeconomic Theory of the Open Economy 157
*How to draw:
Step 1: Determine the equilibrium in the market for loanable fund
Step 2: Determine the NCO through the equilibrium in the market for loanable
fund
Step 3: Determine the Supply of dollars in the market of foreign-currency
exchange through the amount of NCO
2. Trade Policy:
Chapter 32: A Macroeconomic Theory of the Open Economy 159
● In Mexico:
- Foreign purchase of domestic assets ↓ → NCO ↑ → NCO curve shift
right:
Chapter 32: A Macroeconomic Theory of the Open Economy 161
EXERCISE
Chapter 32: A Macroeconomic Theory of the Open Economy 162
a. S = I
b. S = NCO
c. S = I + NCO
d. S + I = NCO
2. Jack and Jill are co-owners of the U.S. firm Wells Petroleum. Jack
borrows money to build an oil well in Texas. Jill borrows money to build
a. Both Jack and Jill’s purchase of capital count as demand for loanable
b. Neither Jack nor Jill’s purchase of capital count as demand for loanable
a. the supply of dollars equals the demand for dollars in the foreign-
a. U.S. goods more expensive relative to foreign goods and reduces the
b. U.S. goods more expensive relative to foreign goods and reduces the
c. foreign goods more expensive relative to U.S. goods and reduces the
d. foreign goods more expensive relative to U.S. goods and reduces the
to
a. g.
b. h.
c. i.
7. Refer to the figure above. Starting from r1 and E3, an increase in the
a. r0 and E4.
b. r0 and E2.
c. r2 and E4.
d. r2 and E2.
a. increase, U.S. imports increase, and U.S. net exports are unchanged.
d. decrease, U.S. imports decrease, and U.S. net exports are unchanged.
9. Which of the following is the correct way to show the effects of a new
import quota?
a. shift the demand for loanable funds right, the supply of dollars for
b. shift the demand for loanable funds right, and the supply of dollars for
a. left, which would make the real exchange rate of the Kenyan schilling
appreciate.
b. left, which would make the real exchange rate of the Kenyan schilling
depreciate.
c. right, which would make the real exchange rate of the Kenyan schilling
appreciate.
Chapter 32: A Macroeconomic Theory of the Open Economy 167
d. right, which would make the real exchange rate of the Kenyan schilling
depreciate.
11. In 2002 it looked like the Argentinean government might default on its
to appreciate.
to depreciate.
currency to appreciate.
currency to depreciate.
vertical because:
buying assets abroad and NCO is not affected by Real Exchange Rate
Chapter 32: A Macroeconomic Theory of the Open Economy 168
buying assets abroad and NCO is not affected by Real Exchange Rate
buying assets abroad and NCO is not affected by Real Interest Rate
buying assets abroad and NCO is not affected by Real Interest Rate
13. Supposed that Cambodia is experiencing Capital Flight. What will the
1. ANSWER: c. S = I + NCO
2. ANSWER: a. Both Jack and Jill’s purchase of capital count as demand for
EXPLAIN: Jack borrows money to build an oil well in Texas, so his purchase
(EXPLAIN: Real exchange is the rate at which one good is traded for another.
Coffee. Which means that 2 units of Trung Nguyên coffee can be traded for 1
4. ANSWER: a. the supply of dollars equals the demand for dollars in the
When Real Exchange Rate increases, US goods are now more expensive
relative to other goods, so now domestic buyers will buy more foreign goods,
foreign buyers will buy less US goods => Export decreases, Import increases =>
6. ANSWER: c. i.
Chapter 32: A Macroeconomic Theory of the Open Economy 171
(EXPLAIN: An increase in budget surplus shifts the supply curve in the market
of loanable fund to the right. Since this does not shift the curve in market for
foreign-currency exchange, the market move along the same curve => g to i)
A leftward shift in supply curve in market for loanable fund increases the
A leftward shift in supply curve in market for loanable fund increases the
real exchange rate from point g to f, but do not shift the curve.)
8. ANSWER: d. decrease, U.S. imports decrease, and U.S. net exports are
unchanged.
(EXPLAIN: Import decreases (1) => Increases Net Export => Shifts Demand
increases (2)
From (1), (2) => We conclude that Import and Export decreases, but Net
(EXPLAIN: An import quota is the same with tariff, they shifts the Demand
10. ANSWER: d. right, which would make the real exchange rate of the
(EXPLAIN: Capital Flight means a large and sudden reduction in demand for
assets in a country.
assets decreases => Net Capital Outflow increases => Shifts the Demand curve
Capital flight also shifts Net Capital Outflow curve to the right, causing
11. ANSWER: b. raised Argentinean interest rates and caused the Argentinean
currency to depreciate.
12. Ans: A. The amount of NCO represents the quantity of dollars supplied for
buying assets abroad and NCO is not affected by Real Exchange Rate
13. Ans: A. Vietnamese Real interest rate decreases, Real exchange rate
increases
will have to bear effects which are opposite to what the Capital Flight country
are bearing.)
Chapter 33: Aggregate Demand and Aggregate Supply 175
Chapter 33:
has trouble.
impossible to predict.
and so on.
When firms choose to produce a smaller quantity of goods and services, they
describes the world in the long run but not in the short run.
Y = C + I + G + NX
* Assume G fixed
→ Demand rises
Price level falls → Real value rises → Household do not need to hold much
Price level falls → Interest rate falls → Investors seek higher return by
Exchange rate falls → Dollars depreciate → Net Export rises → Demand for
+ Pessimism, Interest rate rises, Money supply falls: Firm cut back
services that firms choose to produce and sell at each price level.
Nominal variables like Price Level cannot affect real variables like
Unemployment rate.
Chapter 33: Aggregate Demand and Aggregate Supply 181
available technology
Determinant of Productivity.
Eventually, technological process and money supply will rise over time:
- Sticky-Wage Theory:
When Inflation rate is lower than expected Inflation rate, real wage is
now larger than expected, production is now less profitable, so firms will
- Sticky-Price Theory:
Firms announce their price according to the expected inflation rate in the
future.
When Inflation rate is lower than Expected Inflation rate, some firms will
adjust their price immediately, some will not because they don’t want to
incur cost of changing menus. These firms will have higher price than
others which will decrease their sales and decrease their production.
Vice versa.
- Misperceptions Theory:
When price level falls, price of the sellers will fall too. When their prices
fall, they may mistakenly think that their relative price has fallen, so they
Vice versa.
Chapter 33: Aggregate Demand and Aggregate Supply 185
*We can express the upward slope of the Short-run Aggregate Supply
Same effects with all that shift Long-Run Aggregate-Supply Curve: Amount of
Knowledge
Chapter 33: Aggregate Demand and Aggregate Supply 186
E.g.: When Expected price level rises, Nominal wage for workers is now higher
=> Costs of production is now higher => Production decreases at any given
Suppose that the stock market crashes. In the short-run, this will shifts the
Aggregate Demand curve to the left, decreasing equilibrium price level and
In the long-run, with the lower price level, people will start to adjust their
expected price level. They will decrease their expected price level, shifting the
Short-run Aggregate Supply to the right, Natural level of output is back to its
*Note: Policymakers can shifts Aggregate Demand curve to ease the effect of a
particular event.
Chapter 33: Aggregate Demand and Aggregate Supply 188
If left alone, the economy will adjust itself like above, Natural level of
output is unaffected in the long-run, but not the Price level. If the policymakers
intervent, they will try to shift Aggregate Demand curve so that both Natural
production. In the short-run, such event will reduce production and shift Short-
run Aggregate Supply curve to the left, decreasing Natural level of Output and
increasing Price level (Stagflation: decreasing output and increasing price level)
In the long-run, people will adjust their expected price level. When
workers increase their expected price level and ask to raise their nominal wage,
Short-run Aggregate Supply curve will shift further to the left, firms’ costs will
But, eventually, the loop will slow down due to the limited bargaining
power of workers when unemployment rate is high. Nominal wage will rise,
firm’s costs will be reduced, and the economy shifts back to its initial
equilibrium.
Chapter 33: Aggregate Demand and Aggregate Supply 189
Demand curve.
Chapter 33: Aggregate Demand and Aggregate Supply 190
EXERCISE
1. Business cycles
relationship between
States
a. less money, so they lend less, and the interest rate rises, so firms
increase investment.
b. less money, so they lend more, and the interest rate falls, so firms
decrease investment.
c. more money, so they lend more, and the interest rate falls, so firms
increase investment.
d. more money, so they lend less, and the interest rate rises, so firms
decrease investment.
goods.
United States.
States.
Chapter 33: Aggregate Demand and Aggregate Supply 195
11. The long-run aggregate supply curve would shift right if immigration
from abroad
wage.
wage.
12. The long-run aggregate supply curve would shift right if the
government were to
b. an increase in real GDP but does not change the price level.
c. an increase in the price level but does not change real GDP.
a. increases less than expected so that firms believe the relative price
b. increases less than expected so that firms believe the relative price
c. increases more than expected so that firms believe the relative price
d. increases more than expected so that firms believe the relative price
supply curve if workers and firms expected prices to rise by 2 percent but
16. The sticky price theory of the short-run aggregate supply curve says
supply to the
b. right, and an increase in the actual price level does not shift short-
d. left, and an increase in the actual price level does not shift short-
19. Which of the following would cause prices to rise and real GDP to
Figure 1
economy moves
21. Policymakers who control monetary and fiscal policy and want to
offset the effects on output of a leftward shift in aggregate supply could use
policy to shift
a. real GDP will rise and the price level might rise, fall, or stay the
same. In the long-run, real GDP will rise and the price level might
b. the price level will fall, and real GDP might rise, fall, or stay the
same. In the long-run, real GDP and the price level will be
unaffected.
c. the price level will rise, and real GDP might rise, fall, or stay the
same. In the long run, real GDP will rise and the price level will
fall.
d. the price level will fall, and real GDP might rise, fall, or stay the
same. In the long run, real GDP will rise and the price level will
fall.
together.
the relationship between real GDP (quantity of output) and GDP deflator (Price
level))
households, firms, government, and customers abroad want to buy at each level.
however, are assets, so their purchase are not included in Aggregate Demand)
4. ANSWER: c. falls while foreign exchange rates and interest rate rise.
(Explanation:
Chapter 33: Aggregate Demand and Aggregate Supply 204
According the the Wealth effect, Interest-rate effect, and Exchange rate
effect, increase in price level will lead to lower value of money, higher interest
When the price level falls, interest rate decreases. Households will
increase foreign bonds purchases because they have a higher interest rate. To
buy foreign bonds, people will try to convert more dollars into foreign currency.
increases.)
6. ANSWER: d. more money, so they lend less, and the interest rate rises, so
decreases => Consumers will feel poorer. They tend to hold more money and
lend out less. Interest rate will rises, making borrowing money from the bank
(Explanation: A stock market crash makes people feel poorer, so they will
spend less at any given price level => Decrease Consumption => Aggregate
capital goods.
(Explanation:
shifts left.
people will be less likely to consume => Consumption decreases => Aggregate
the US will be more expensive, so US people will buy more foreign goods and
foreigners will buy less US goods => Export decreases, Import increases => Net
When other countries experience recessions, they will buy fewer goods in
the US => Export decreases => Net Export decreases => Aggregate Demand
shifts left)
When the government lifts off minimum wage law, there would be less
(Explanation:
Chapter 33: Aggregate Demand and Aggregate Supply 207
Supply of labor decreases => Long-run Aggregate Supply curve shifts left
generous => Supply of labor decreases => Long-run Aggregate Supply curve
shifts left
Consumption => Aggregate Demand curve shifts left, not Long-run Aggregate
Supply curve.)
13. ANSWER: c. an increase in the price level but does not change real GDP.
(Explanation: An increase in money supply will increase the price level. But in
the long-run, price level does not affect the determinants of real GDP => So real
14. ANSWER: c. increases more than expected so that firms believe the
(Explanation: When price level increases more than expected and the suppliers
see that their price of products rises. They believe that their relative price has
(Explanation: When price level rises more than expected, real wages decreases.
As a result, firms’ managers actually pay less for workers because the contracts
on wages was determined based on expected price level and cannot be changed
now. Production is now more profitable and they will hire more workers.)
16. ANSWER: d. higher than desired prices which depresses their sales.
slowly or does not adjust because of menu cost. As a result, some firms will
have price higher than desired => Their sales will decrease)
18. ANSWER: d. left, and an increase in the actual price level does not shift
When the expected price level increases, quantity of output supplied will
The increase in actual price level does not shift Short-run Aggregate
Supply curve.)
In order for the price level to rise and real GDP to fall in the short-run, the
equilibrium point A must move up and to the left. We can see that it can only be
price level cause the quantity of output supplied (Real GDP) to decrease =>
curve to the right, increasing both Price level and quantity of output.
reduces the price level. When the price level decreases, in the long run, people
will re-adjust their expectation of the price level. As the expected price level
(Explanation: Policymakers will always want the economy to shift back to its
Short-run Aggregate Supply curve shifts to the left. Policymakers will use
monetary and fiscal policies to shifting the Aggregate Demand curve to the right
than before, so Short-run Aggregate Supply curve will shift to the left,
23. ANSWER: d. the price level will fall, and real GDP might rise, fall, or stay
the same. In the long run, real GDP will rise and the price level will fall.
(Explanation:
In the short-run:
+ Stock market declined causes the Aggregate Demand curve to shift to the
Supply curve to the right from SRAS1 to SRAS2, moving the equilibrium
point from B to C.
=> In the short-run, Price level will decrease, but Real GDP will be ambiguous.
Real GDP can decrease, increase, or stay the same depending on the magnitude
of the shift in Short-run Aggregate Supply curve and Aggregate Demand curve.
From the short-run, we can see that Price level decreases. In the long-run,
people will start adjusting their expected price level. As expected price level
Chapter 34:
Demand
● Money supply: assume fixed by the central bank, does not depend on
interest rate.
- The Fed can influence the money supply using a variety of other
tools
● Money demand reflects how much wealth people want to hold in liquid
form.
- Recall that any asset’s liquidity refers to the ease with which that
(3) A higher interest rate reduces the quantity of goods and services
demanded.
To sum up:
- The news often report that the FED targets the interest rate. More
precisely, the federal funds rate, which banks charge each other on short-
term loans
- To change the interest rate and shift the AD curve, the FED conduct open
market operation.
1. Fiscal policy: the setting of the level of govt spending and taxation by govt
policymakers.
(taxation)
CHAPTER 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand 221
+ shifts AD right
(taxation)
+ shifts AD left
For example: If the govt buys $20b of planes from Boeing, Boeing’s
and owners (as profits or stock dividends). These people are also consumers
and will spend a portion of the extra income. This extra consumption causes
=> A bigger MPC means changes in Y cause bigger changes in C, which in turn
expansionary fiscal policy raises the interest rate and thereby reduces
investment spending.
- The fiscal expansion raises the demand for money => Income increases
- Interest rate increases => reduces the quantity of goods and services demanded
aggregate demand.
CHAPTER 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand 224
⇒ Sum up: When the government increases its purchases, the aggregate
demand for goods and services could rise by more or less depending on the
● Changes in tax
shifts right.
effects.
-> A permanent tax cut causes a bigger increase in C—and a bigger shift in
and employment.
● Other factors:
workers, consumers.
● When GDP falls below its natural rate => use expansionary
● When GDP rises above its natural rate, use contractionary policy
respond to changes in r.
❖ Due to these long lags, critics of active policy argue that such policies
3. Automatic stabilizers
● Govt spending:
unemployment insurance).
CHAPTER 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand 228
EXERCISE
decrease in the price level and so help to explain the slope of the
new hotels.
c. Janet feels wealthier because of the price drop and so she decides
a. short run and supposes that the price level adjusts to bring money
b. short run and supposes that the interest rate adjusts to bring money
c. long run and supposes that the price level adjusts to bring money
d. long run and supposes that the interest rate adjusts to bring money
holding money is
d. the difference between the inflation rate and the interest rate on
bonds.
more of it.
less of it.
more of it.
less of it.
Figure 1
c. If the interest rate is 4 percent, the demand for goods will rise when
d. If the interest rate is 4 percent, the demand for goods will rise and
money supply will drop when the money market is in its new
equilibrium.
changes in
c. trade policy.
10. The government buys a bridge. The owner of the company that
builds the bridge pays her workers. The workers increase their
spending. Firms that the workers buy goods from increase their
a. 5/3.
b. 5/2.
c. 5.
d. 15.
billion to the right. In order to stabilize the price level at its original
out effect is always half of the multiplier effect, and if the MPC equals
a. $4 billion.
b. $25 billion.
c. $50 billion.
d. $100 billion.
14. If households view a tax cut as being temporary, the tax cut
it as permanent.
CHAPTER 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand 235
c. has the same affect as when households view the cut as permanent.
it as permanent.
Figure 2
employment would be
c. an increase in taxes
(Explain:
rely on 3 effects: Wealth effect, Interest rate effect, and Exchange rate effect.
A is wrong. When interest rate falls, borrowing is now cheaper than before,
which encourages people to borrow more to invest more in capital goods =>
Interest-rate effect.
B is wrong. When exchange rate falls, one French currency can buy more US
currency => Goods in the US is cheaper => French restaurants buy more US
C is wrong. When the price level drops, the value of each dollars increases =>
Nominal Wages are fixed, workers now have earn more real value of money.
Thus, firms must lay off some workers. However, this does not represent 1 of 3
2. ANSWER: b. short run and supposes that the interest rate adjusts to bring
(Explain: Instead of holding money, you can use that amount of money to buy
interest-bearing bond and earn interest every period. So we say that the
(Explain: When the interest rate increases, you will actually get more interest if
you buy bonds instead of holding money. So, as interest rate increases, the
opportunity cost of holding money increases, people will choose to hold less
money)
5. ANSWER: c. If the interest rate is 4 percent, the demand for goods will rise
(Explain: Treat money market like any other market we have learned
previously.
CHAPTER 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand 238
The correct answer is C. When interest rate is 4%, shortage occurs. So, the
market will eventually get back to its initial equilibrium. As Demand for Money
rise, Demand for goods also rises. Supply of money does not change even when
Shortage (or Surplus) presents because Money Supply is fixed by the the Fed)
(Explain: When Price level increases, people will demand for more money in
the Money Market => Shift Money Demand curve in the Money Market right,
(Explain: If the Fed conducts open-market sales => Money Supply shifts lefts.
It raises interest rate and decreases demand for goods and services at any given
(Explain: When the stock market crashes => Aggregate Demand shifts left. The
Fed can offset the effect by controlling Money Supply to shift back Aggregate
1
(Explain: Multiplier = )
1 − 𝑀𝑃𝐶
services => Money Demand in the Money Market increases => Interest rate
increases => Investment spending decreases => Aggregate Demand shifts left.)
Aggregate Demand curve shifted by $100 billions => In order to come back to
the equilibrium, Aggregate Demand curve must shift back $50 billions.
+ Multiplier Effect:
+ Crowding-out effect:
Crowding-out effect = 2A
⇔ A = $25 billions
CHAPTER 34: The Influence of Monetary and Fiscal Policy on Aggregate Demand 241
=> Government must cut its spending by $25 billions in order to get the price
view it as permanent.
(Explain: When the tax cut is temporary, households will view the extra income
from the tax cut as a small addition to their financial resources. Contrary to
temporary tax cut, permanent tax cut will induce households into viewing this
extra income as a large addition to their financial resources. So, temporary tax
cut has smaller effect on Aggregate Demand than permanent tax cut)
(Explain: Currently the economy is having AD2, which is lower than the long-
Employment. To regain full employment, AD2 must shift back to the long-run
C is wrong. An increase in taxes will depress demand for goods and services =>
Shift AD left)
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 242
Chapter 35:
- Phillips curve: a curve that shows the short-run trade-off between inflation and
unemployment
- It illustrates a negative association between the inflation rate and the unemployment
rate.
- Since fiscal and monetary policy affect agg demand, the PC appeared to offer
● Anything in between.
- The Phillips curve shows the combinations of inflation and unemployment that arise
in the short run as shifts in the aggregate-demand curve move the economy along the
- The greater the expansion of the money supply, the faster AD will shift to the right,
But this higher inflation will not produce lower unemployment in the long run,
unemployment always goes to its natural rate whether inflation is high or low.
In the long run, faster money growth only causes faster inflation.
- Long-Run Phillips Curve: vertical, price level and inflation do not affect
inflation: expected inflation - a measure of how much people expect the price
level to change.
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 =
- Short run: Fed can reduce u-rate below the natural u-rate by making inflation
- Long run: Expectations catch up to reality, u-rate goes back to natural u-rate
- The vertical long-run aggregate-supply curve and the vertical long-run Phillips
curve both imply that monetary policy influences nominal variables (the price level
and the inflation rate) not real variables (output and unemployment).
Example:
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 246
- Initially,
+ PC shifts upward,
- Expansionary policy moves the economy up along the short-run Phillips curve,
expected inflation rises → short-run Phillips curve shifts right and vice versa.
- Supply shock: an event that directly alters firms’ costs and prices, shifting the
Example: large increase in oil prices → raises the cost of producing gasoline →
As panel (a) shows, this reduction in supply is represented by the leftward shift in
the aggregate-supply curve from AS1 to AS2. Output falls from Y1 to Y2, and
the price level rises from P1 to P2. A combination of lower output and higher
(inflation)
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 248
(a reduction in the price level). Disinflation is like slowing down, whereas Deflation is
- To reduce inflation, Fed must slow the rate of money growth, which reduces
aggregate demand.
- In the long run, at point C: unemployment is back at its natural rate, but with
lower inflation.
- Sacrifice Ratio: the number of percentage points of annual output lost in the
For example: Typical estimate of the sacrifice ratio: 5. Which means: to reduce
- Rational Expectation: the theory that people optimally use all the information
the future.
unemployment rate gets back to its natural rate quicklier and vice versa.
- Low sacrifice ratio: shorter labor contracts, Central Bank is credible and vice
versa.
reducing inflation. Then expected inflation falls, the short-run Phillips Curve shifts
downward quicklier.
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 251
Result: Disinflations can cause less unemployment than the traditional sacrifice ratio
EXERCISE
3. If the short-run Phillips curve were stable, which of the following would
be unusual?
a. an increase in inflation and an increase in output
b. a decrease in inflation and an increase in unemployment
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 252
4. Suppose that a central bank increases the money supply. In the short-run,
according to the Phillips curve, this should make
a. prices, output, and employment rise.
b. prices and output rise, employment fall.
c. prices rise and output and employment fall.
d. prices fall, output, and employment rise.
Figure 1
6. Refer to Figure 1. If the economy starts at c and 1, then in the short run,
an increase in taxes moves the economy to
a. b and 2.
b. d and 3.
c. e and 2.
d. None of the above is correct.
7. In the long run, if the Fed increases the rate at which it increases the
money supply,
a. inflation will be higher.
b. unemployment will be lower.
c. real GDP will be higher.
d. All of the above are correct.
a. both the long-run Phillips curve and the long-run aggregate supply
curve would shift right.
b. both the long-run Phillips curve and the long-run aggregate supply
curve would shift left.
c. the long-run Phillips curve would shift right, and the long-run
aggregate supply curve would shift left.
d. the long-run Phillips curve would shift left, and the long-run
aggregate supply curve would shift right.
9. The position of the long-run Phillips curve and the long-run aggregate
supply curve both depend on
a. the natural rate of unemployment and monetary growth.
b. the natural rate of unemployment, but not monetary growth.
c. monetary growth, but not the natural rate of unemployment.
d. neither monetary growth nor the natural rate of unemployment.
Figure 2
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 255
11. Refer to Figure 2. The economy would move from c and 3 to b and 2
a. in the short run if money supply growth increased unexpectedly.
b. in the short run if money supply growth decreased unexpectedly.
c. in the long run if money supply growth increases.
d. in the long run if money supply growth decreases.
12. The analysis of Friedman and Phelps can be summarized in the following
equation where a is positive number:
a. Unemployment Rate = Natural Rate of Unemployment – a(Actual
Inflation – Expected Inflation).
b. Unemployment Rate = Natural Rate of Unemployment – a(Expected
Inflation – Actual Inflation).
c. Unemployment Rate = Expected Rate of Inflation – a(Actual
Inflation – Expected Inflation).
d. Unemployment Rate = Actual Rate of Inflation – a(Actual
Unemployment – Expected Unemployment).
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 256
13. In recent years, inflation expectations have fallen. This has shifted the
short-run Phillips curve
a. left, meaning that at any given inflation rate unemployment will be
lower in the short run than before.
b. right, meaning that at any given inflation rate unemployment will be
lower in the short run than before.
c. right, meaning that at any given inflation rate unemployment will be
higher in the short run than before.
d. left, meaning that at any given inflation rate unemployment will be
higher in the short run than before.
14. Suppose a war disrupts the supply of oil to the country. We would expect
the
a. short-run aggregate supply curve, short-run Phillips curve to shift
left.
b. short-run aggregate supply curve, short-run Phillips curve to shift
right.
c. short-run aggregate supply curve to shift left, and the short-run
Phillips curve to shift right.
d. short-run aggregate supply curve to shift left, the short-run Phillips
curve to shift right
15. Suppose an economy with high inflation decides to decrease the money
supply growth rate.
a. Initially unemployment rises. Eventually the short-run Phillips curve
shifts right.
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 257
16. If a central bank reduced inflation by 3 percentage points and that made
output fall by 3 percentage points each year for 3 years and the
unemployment rate rises from 3 percent to 9 percent for three years, the
sacrifice ratio is
a. 1.
b. 2.
c. 3.
d. None of the above is correct.
1. ANSWER: b. inflation depends primarily upon the money supply growth rate.
(Explain:
B is correct. When government prints more money, the value of each dollars
C is wrong. The trade-off between inflation rate and unemployment rate is only
in the short-run)
2. ANSWER: b. in the long run, prices will be higher and unemployment will be
unchanged.
(Explain:
When the Aggregate Demand curve shifts from point A to point B, unemployment rate
(Explain: When the central bank increases the money supply, people will demand for
more money in the money market. Thus shifting the Aggregate Demand curve to the
right, increasing the price level and Quantity of output. In the short-run Phillips curve,
5. ANSWER: c. Louis makes smaller increases in the prices at his health food store.
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 260
(Explain: When government policy moves the economy up along a short-run Phillips
curve, Inflation rate will rise and Unemployment rate will decrease.
A is a wrong answer. When the central bank raises money supply, Inflation rate
will increase.
B is a wrong answer. Unemployment rate decreases => People will get more job
offer.
6. ANSWER: b. d and 3.
(Explain: The first model in the right is the model of Aggregate Demand and Supply.
When the government increases taxes, Aggregate Demand curve shift to the left => The
Chapter 35: The Short-Run Trade-off between Inflation and Unemployment 261
economy moves to point d, thus decreasing price level and inflation rate =>
Unemployment rate increases => The economy moves to point 3 in the short-run
Phillips curve)
(Explain: In the long-run, increase in money supply only affects nominal variables. So
it will not affect Unemployment rate, real GDP. However, an increase in money supply
8. ANSWER: c. the long-run Phillips curve would shift right, and the long-run
more common, firms will have to fire workers with less skills, thus natural rate of
unemployment will increase, long-run Phillips curve will shift right. When
unemployment increases, there will be less workers joining in production process =>
(Explain: The determinant of the long-run Phillips curve is the natural rate of
Unemployment rate is low, higher quantity of products will be made, Aggregate Supply
Monetary growth, on the other hand, is not the determinant of long-run Phillips
curve. Change in money supply will not affect Inflation Rate in the long-run.
Supply curve.)
10. ANSWER: c. d and 4 in the short run, e and 5 in the long run.
(Explain: From the equilibrium point c, a right-ward shift of Aggregate Demand will
move the equilibrium to point d in the short-run, short-run Phillips curve moves to
point 4.
In the long-run, people will adjust the expected inflation rate. This shifts the
Aggregate Supply curve to the left, moving the equilibrium from point to e. As
expected inflation rate increases, Short-run Phillips curve shifts to the right, resulting a
11. ANSWER: b. in the short run if money supply growth decreased unexpectedly.
(Explain: In order for the equilibrium point moves from c to b, and from point 3 to 2,
Aggregate Demand curve must shift to the left. A decrease in money supply would shift
13. ANSWER: a. left, meaning that at any given inflation rate unemployment will be
(Explain: When expected inflation drops, short-run Phillips curve will shift to the left.
14. ANSWER: d. short-run aggregate supply curve to shift left, the short-run Phillips
(Explain: Supply shock cause the Aggregate Supply curve to shift to the left, resulting
in lower quantity of output and higher price level =>Short-run Phillips curve shifts
right.)
15. ANSWER: b. Initially unemployment rises. Eventually the short-run Phillips curve
shifts left.
(Explain: When an economy decide to decrease money supply, Inflation rate will be
lower => Unemployment rate will be higher. In the long-run, people will adjust their
expected inflation rate. When expected inflation rate is lower, Short-run Phillips curve
shifts left)
16. ANSWER: c. 3.
Reference