Week1: Introductory Macroeconomics

Microeconomics Macroeconomics
Study of how households and firms make Economy wide phenomena work as a whole
decisions

Principles of economic as a whole:

*Country’s standard of living depends on its availability to produce g&s
 Depends on equipment used, personality, skills, technology
*Price rises (Inflation) as government prints too much money
 Value of money fall when excessive amount of money printed
*Society faces short run trade-off between inflation and unemployment
GDP measures
 Total income of everyone and expenditure on economy output of g&s
 Income must equal to expenditure for an economy as a whole
 Because every dollar buyer spent is every dollar earned by seller

GDP (Gross Domestic Product)

 the total market value of all final g&s produced within a country in a given period
GNP(Gross National Product)
 Market value of g&s produced by permanent residents of a nation within given time

#GDP focuses on where production occurs whereas GNP focuses on who produces it

Y = C + I + G + NX
Consumption: spending of households on g&s
Investment: spending on capital equipment, inventory, new houses
Government purchases: spending on g&s by government exclude transfer payment
Net exports: export(foreign spending on country’s g&s) - imports (C+I+G purchased
from abroad)
Nominal GDP: values output using current price, not adjusted for inflation
Real GDP: values output using prices of base year, adjusted for inflation
Real GDP per capita: indicator of the average’s person’s standard of living
GDP deflator
 ratio of nominal GDP to real GDP X100
 tells rise in nominal GDP is attributable to rise in price rather than rise in quantity
Things not included in GDP:
 value of leisure (activity that takes place outside of market)
 value of clean environment
#large GDP allows country to have better schools, environment, sanitary
Circular flow diagram:
o depiction of macroeconomy
o Factor of production (input like labor, land, capital, natural resources)
o Factor payments (payment to factor of production, wages and rent)
 Week2: Measuring the Cost of Living
Consumer price index:
 Measure of overall price level
 Measure of the cost of g&s bought by typical consumer
Calculating CPI:
o Fix the basket: surveys consumers to determine what’s in the typical basket
o Find the prices: collects data on the prices of all goods in basket
o Compute basket cost: use the prices to compute total cost of the basket
o (Cost current year/cost base year)x100
o Inflation rate=[(CPI current year-CPI last year)/CPI last year]x 100
Problems of CPI:
Substitution Bias:
 consumer substitute towards goods that relatively cheaper, mitigating the effects of
price rises
 CPI keep using the fixed basket, hence overstate increases in cost of living
Introduction of new goods:
 New goods increase the varieties, consumers find products that more closely meets
their needs
 CPI using the fixed basket of g&s, thus overstate the increases in cost of living
Unmeasured quality change:
 Improvement in quality of g&s increase value of each dollar
 Since quality is hard to measure, CPI overstates an increase in cost of living

CPI GDP Deflator

Include imported goods Exclude imported goods
Exclude Capital goods Include Capital goods if produced domestically
Uses fixed basket Uses basket of current produced g&s

Comparing dollar figures from different times:

(Price level today/ price level in year T)x dollar amount in year T
Nominal interest rate:
 Not corrected for inflation
 Rate of growth in dollar value of deposit/debt
Real interest rate:
 Corrected for inflation
 Rate of growth in purchasing power pf deposit/debt

Real interest rate=Nominal rate-inflation rate

Productivity is the key determinant of a country’s living standard
 Y(real GDP) / L(quantity of labour)
 An economy income is economy’s output
Determinants of productivity
 Physical capital, stock of equipment be used to produce g&s
 Physical capital per worker, capital of average worker (K/L increases, Y/L increases)
Human capital
 Knowledge and skills of labour through training, experience, education
 Average worker has more human capital (H/L increases, Y/L increases)
Natural resources
o Inputs into production provided by nature (land, water)
o Increases in N/L increase Y/L, keeping other things equal
Technological knowledge
 Society understanding of best way to produce g&s

A= F(L,K,H,N)
 Week3: Unemployment

Labor force= num.Employed + num.Unemployed

Employed
 Work during reference week for pay, profit and gain
 Work less than 30 hours a week but willing and able to accept additional hours of
work were considered underemployed.
Unemployed
 Individuals did not search for employment or not qualified for work
 Individuals who were waiting for the response of job
Not in labor force:
 All individual not in employed and unemployed

Limitation of unemployment rate:

o Excludes Discouraged workers (no seeking for work) means the person is no in th
labour force, causing unemployment rate to fall
o Unemployment fails to show the things are worse, such as a person turns from a full
time job to part-time job-not distinguish full time and part time work
o People could misreport their work status
o Not a perfect indicatr of joblessness of the labor market
Overstated
 labour force includes people on unemployment benefits are not looking for work
Understated
 working part-time but they might prefer full time
 discouraged workers who want to work but given up of looking for job
Natural unemployment
 normal unemployment rate which actual unemployment rate fluctuates
Cyclical unemployment
 deviation of unemployment from its natural rate
 associated with business cycle
Frictional unemployment
 occurs when workers spend time searching for job best suit their skills/taste
 short term
Structural unemployment
 occurs when fewer jobs than workers
 due to above equilibrium wage (minimum wage law, union)
 long term

Public policy and job search:

 provide information about job vacancies to speed up matching of workers with jobs
 public training programmes aim to equip workers in declining industries with skill
needed in growing industries

Minimum wage:
 may exceed equilibrium wage for skilled workers, causing structural unemployment
Union:
 exert their market power to negotiate for higher wage and more benefit
Efficiency wages:
 company voluntarily pay above equilibrium wage to boost worker productivity
 better worker health and more productivity
 more incentive to stay, less turnover
 attracts better quality workers
 prevent shirk
 Week4: Money and inflation
Money solve the problem:
 trade of barter (exchange g&s with one another)
 require double coincidence of wants
 waste time of searching others to trade with

Functions of money:
Medium of exchange between buyers and sellers
 Unit of account people use to post price and record debt
 Store of value, be used to transfer purchasing power from the present to future

2Types of Money
Commodity money:
 Takes form of commodity with intrinsic value (Gold coin)
Fiat money:
 Money without intrinsic value (U.S dollar)
 Used as money because of government decree

Intrinsic value:
 Item would have value even if it does not used as money
Gold standard:
 Paper money that convertible into gold on demand

The money supply:

 Quantity of money in the economy
Currency:
 Paper bills and coins in publics’ hand (non-bnk)
Demand deposit:
 Balances in bank account
 Can be accessed on demand by writing check

Central bank:
 Institution oversees bank system and regulates money supply
Monetary policy
 Setting of money supply by policymakers in central bank

Financial system:
 Central banks
 Banks
 Financial intermediaries
Central bank:
 Oversee the banking system
 Carry out monetary policy
 Regulate money quantity in the economy
Banks:
 Can influence the quantity of demand deposit and money supply in the economy

Bank reserves
 In fractional reserve banking system, bank keep fraction of deposit as reserve and
use the rest to make loans
 Central bank established reserve requirements, regulations on minimum amount
must hold by bank against deposits


 Fractional reserve banking system creates money, not wealth

Money multiplier: amount of money the banking system generates with each dollar reserves

Central banks’ 3 tools of Monetary Control:

 OMO: buy bonds to increase money supply, sell bonds to decrease money supply
 Reserve requirement: affect how much money bank can loan out to create money
supply, reduce reserve requirement to increase money supply, raises reserve
requirement to decrease money supply
 Discount rate: central bank reduces discount rate to encourage banks borrow more
reserves from Central Bank, banks can then make more loan to create more money
supply (central bank only use this method during crisis as central bank is a “lender of
last resort”)

Inflation: increases in the overall prices

Deflation: decreases in the overall prices
Hyperinflation: Extraordinarily high rate inflation
#inflation drives up prices and drives down value of money

Quantity theory of money:

 Quantity of money available in economy (money value) determines the price level
 Growth rate in money quantity determines inflation rate

Money Demand:
 Refer how much wealth people want to hold liquid form (money)
 Quantity demand of money Positively relate to Price level & Negatively relate to
Value of money, considering other things equal
 Other things include interest rate, ATM available, credit cards
Money Supply-Demand diagram:
 Supply curve is always vertical (determined by Fed)
 Fed set the Money supply at fixed value despite Price level

#In long run, money supply and money demand bring into new equilibrium by overall level
of prices

Effects of Monetary injection:

 Economy is in an equilibrium
 Fed doubles money supply
 Money supply curve shifts right
 Value of money decrease, price level increases
#At initial Price level, increasing money supply cause excess supply of money. People use
the money to buy extra g&s or loaning to others, resulting higher demand of goods. Since
supply of goods does not increase, price must increase
Nominal variables: measured in monetary units, does not account for inflation
Real variables: all measured in physical units, adjusted for inflation
Real wage: the price of labour relate to the price of output:
Nominal wage/price level of g&s=

Classical dichotomy:Theoretical separation of nominal/real variable

 Monetary development affects nominal variable, not real variable
 If central bank double money supplies, all nominal variable (price) increase, while
real variable (real wage) remains the same
Monetary neutrality: changes in money supply does not affect real variables
 Labour price relative to Price level unchanged
 Labour supplied/demand unchanged
 Total employment labour unchanged
 Total output is remaining unchanged
Velocity of money: rate at which money change hands

Hyperinflation: inflation exceeding 50%, often caused by excessive money supply

Inflation tax:

 When tax revenue inadequate, govt print money to pay for its spending
 inflation tax, inflation caused by inflation is like a tax on everyone who holds money

Fisher effect:

 money supply growth determines inflation rate

 real interest rate determined by savings/investment in loanable fund market
 in long run, money is neutral, money supply affect inflation rate, not real interest
rate
 nominal rate adjust one-for-one with inflation rate changes
 inflation rate applies to all people holdings of money, not wealth
 increase in inflation rate cause the same increase in nominal rate, so real interest
rate (wealth) remain unchanged
 Week5: Inflation and Unemployment

#In long run, inflation and unemployment are unrelated

Inflation rate depends:

 money supply
Unemployment (natural rate) depends:
 minimum wage
 market power of union
 efficiency wage
 process of job search
#Yet, Inflation and unemployment are closed watched indicators of economy

Misery index
 Inflation + Unemployment
 Gauge the health of economy

Philip curve:
 Explain short run trade-off between inflation & unemployment
 Nominal wage growth (inflation) correlates negatively with unemployment

Policymakers (Monetary and fiscal policy)

 To influence aggregate demand
 Trade-off:
 A: high unemployment & low inflation & low aggregate demand
 B: low unemployment & high inflation & high aggregate demand
 Sloping downwards as the two factors are in negative relationship
Long-run Philip curve:
 Vertical
 Natural rate of unemployment (tends towards its normal level)
 Unemployment not affected by money growth and inflation
 Fed increases money supply quickly/slowly only affect inflation rate in long run
 Trade off was temporarily
 Aggregate demand curve shifts right, cause rise in price level but natural output level

Expected inflation: measure of how much people expect price level to change

Short-run Philip curve:

In short run:
 Central bank can reduce unemployment rate below natural unemployment rate by making
inflation higher than unexpected.
In long run:
 Expectation catch-up to reality, unemployment rate goes back to natural unemployment
rate whether inflation rate is high/low

Natural rate hypothesis:

 Unemployment rate eventually return to its natural rate, regardless of inflation rate
Supply shock:
 Event that directly alters firms’ costs and prices
 Shift economy AS curve and Philip curve

Eg. Increase in oil price:

 AS curve shift left, cause lower output & employment, but higher price level
 Short-run Philip curve shift right, higher inflation & lower unemployment
 If temporary, revert back; If long term, requires government intervention

The Cost of reducing Inflation:

o Central Bank slow the rate of money growth, which reduces aggregate demand
o Short run: output falls, unemployment rises
o Long run: output and unemployment back to natural rate

Contractionary Monetary Policy

 Lower aggregate demand, higher unemployment but lower inflation
 Overtime, Philip curve shift left, natural unemployment and lower inflation

 Disinflation requires enduring a period of high unemployment & low output

 Sacrifice ratio: %point of annual output lost to %point reduction in inflation
Rational expectations and Costless Disinflation
 Smaller sacrifice ratio
 Fed convinces everyone it is committed to reduce inflation, expected inflation falls, SRPC
shift downward

Rational expectation:
 Costless disinflation
 Favorable supply shock
 Raised interest rate to contract aggregate demand

Financial crisis:
 Large decline in aggregate demand
 Steep increase in unemployment
 Reduced rate of inflation

Summary:
 The Philip curve explains the short run trade-off between inflation and unemployment
 In long run there is no trade-off, money growth determines inflation rate while
unemployment equal its natural rate
 Supply shock and changes in expected inflation shift short-run Philip curve, making trade-off
more/less favourable
 Central bank can reduce inflation by contracting money supply, which increase
unemployment. In long run, expectations adjust unemployment return to its natural rate
 Credible commitment can lower cost of disinflation by inducing rapid adjustment of
expectations