Macroeconomics

Chapter 23: Measuring a nation’s income

Gross Domestic Product
 The market value of all final goods and services produced in a country during a given
period.
 Total expenditure on final goods and services produced in a country.
 Total revenue is obtained by the production factors located in a country.
o Spending = income (Every rupee spent by a buyer means an income for a seller)

Value added
Value added to a company is the value of its production less the value of intermediate goods the
company uses in that production process.
GDP = Value of final goods produced
= Sum of value added at every stage of production

Other Indicators
 Gross National Income = Total income of the country’s residents.
 Net National Income = GNP – losses from depreciation.
 National Income = Total income of the country’s residents from the production of goods &
services.
 Personal Income = Income received by households & Businesses exclude corporate.
 Personal Income Available = Personal income - tax
= Income remains to households and businesses after fulfilling their
obligation to the state.

GDP Components
1. Consumption: - Value of goods and services purchased by household except for
purchase of a new house. Durable & Non-durable goods and services;
2. Investment: - Spending on capital equipment, inventories & structure including new
housing. Spending on new capital.
3. Government purchase: - Expenditure of central, regional, and local government
4. Net exports: - Exports – Imports
GDP = C + I + G + NX

Real vs Nominal GDP

Nominal GDP
Production of goods and services valued at current prices.
Real GDP
Production of goods and services valued at prices of a base year.

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Change Reason
Nominal: - Price changes, change in quantity produced
Real: - Change in quantity produced.

GDP Deflator = 100 x Nominal GDP

Real GDP
Inflation Rate = 100 x GDP Deflator2 - GDP Deflator1
GDP Deflator1

GDP & Economic welfare

Drawbacks: - It does not measure Life expectancy, Health of children, Quality education,
Entertainment value, Value of a clean environment, Beauty of poetry, Courage & wisdom, and
Distribution of Income.

Appendix: Percentage variance

Percentage variance in (XxY) = % variance in X + % variance in Y
Percentage variance in (X/Y) = % variance in X - % variance in Y

International Differences
Rich-country – Higher GDP per person
#Better
 Life expectancy
 Literacy
 Internet Usage
Poor country – Lower GDP per person
#Worse
 Life expectancy
 Literacy
 Internet Usage
Low GDP per person: -
 More infants with low birth weight
 Higher rate of infant mortality
 Higher rate of maternal mortality
 Higher rate of child malnutrition
 Less common access to safe drinking water
 Fewer school-age children are actually in school
 Fewer teachers per student
 Fewer television
 Fewer telephones
 Fewer paved roads
 Fewer households with electricity

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Chapter 24: Measuring the cost of living
PPI Producer Price Index

WPI Wholesaler Price Index

CPI Consumer Price Index

Baskets

1. Food
2. Fuel
3. Manufacturing Items

The Consumer Price Index

 Measure consumer cost of living.

 It shows the cost of a basket of goods and services related to the cost of the same basket in the
base year.
 It is used to measure the level of prices in an economy.
 Percentage change in CPI measures the Inflation rate.

How is it calculated?

1. Fix the basket

a. MOSPI surveys consumers to determine what’s the typical consumer’s “Shopping
basket”.
2. Find the Prices
a. MOSPI collects data on the prices of all goods in the basket.
3. Compute the basket’s cost
a. Use the prices to calculate the total cost of the basket.
b. Prices variable quantity constant.
4. Choose a base year and compute the index
CPI = 100 x the Cost of the basket in the current year

Cost of the basket in the base year

Inflation Rate = 100 x CPI this year – CPI last year

CPI last year

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Drawbacks

1. Introduction to new goods

a. Introduction of new goods increases the variety and allows the customer to find a
product more closely meets their needs.
b. In effect, the dollar became more valuable
c. CPI misses this effect because of the fixed basket.
d. Thus, CPI overstates increases in the cost of living.
2. Change in quality
a. Improvement in the quality of goods in the basket increases the value of each dollar.
b. BLS tries to account for quality change but it misses some, as quality is hard to measure.
c. Thus, CPI overstates increases in the cost of living.
3. Substitution bias
a. Over time some prices rise faster than others.
b. Consumer substitute towards the good that is relatively cheaper.
c. CPI misses this substitution because of the fixed basket.
d. Thus, CPI overstates increases in the cost of living.

CPI Vs GDP Deflator

1. Imported consumer goods

a. Include in CPI
b. Exclude from GDP Deflator
2. Capital goods
a. Exclude from CPI
b. Include in GDP Deflator (Produced domestically)
3. The Basket
a. Fixed basket in CPI
b. GDP Deflator uses a basket of currently produced goods

Correcting variables for inflation

Amount in today’s dollar = Amount in year t dollars x Price level today

The price level in year t

Indexation (Real Interest Rate)

Real Interest Rate = Nominal Interest Rate - Inflation

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Chapter 25: Production and growth
Production = T, HK, PK, NR
Productivity
Quality of goods and services produced from each unit of Labour
Output per worker Y/L
Y= Real GDP L= Quantity of labor
Importance
 Key determination of living standard.
 Higher productivity is the key determinant of a higher living standard.
 Economy’s income in economy’s output.
Determination
 Physical capital per worker
 Stock of equipment per worker.
 Used to produce goods and services.
 Human capital per worker
 Knowledge and skills through education, training, and experience.
 Inputs in form of teachers, libraries, and student time.
 Natural resources per worker
 Inputs in products and services.
 provided by nature.
 Renewable and non-renewable.
 Technological knowledge
 Understanding the best ways to produce goods and services.
The production functions
Relation between quantity input and quantity output.
Y=A F (L, K, H, N)
Y= Output A= Available technology L= Labour
K= Physical capital H= Human capital N= Natural Resources
Production function with the constant return.
xY=A F (xL, xK, xH, xN)
Are Natural resources a limit to growth?
For
 Limited non-renewable resources.
 Stop economic growth.
 Force living standards to fall.
Against
 Technological progress
 Improved use of natural resources
 Recycling
 New materials
Prices of Natural Resources
Scarcity is reflected in market prices.
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Prices - Substantial fluctuation in the short run.
- Stable or falling in the long run
Ability to conserve
Increasing more than their supplies.
Government can do many things to raise productivity and living standards.
 Encourage savings and investment.
 Diminishing returns and the catchup effect.
 Encourage investment from abroad.
 Encourage education and training.
 Health and nutrition.
 Property rights and political stability.
 Free trade.
 Promote research and development.
 Population growth.
Investment from abroad
Another way for a country to invest in new capital.
1. Foreign direct investment (FDI)
Capital investment is owned and operated by a foreign entity.
2. Foreign portfolio investment (FPI)
Capital investment is owned by the foreign entity but operated by the domestic resident.
Benefits
 Increase the economy’s stock of capital
 Higher productivity and higher wages
 Good for developing countries that cannot generate enough savings to fund investments
themselves.
World Bank
 Encourage the flow of capital to poor countries.
 Funds from the world’s advanced countries.
 Make loans to less developed countries (Road, sewer systems, schools, etc)
 Advice about how the funds might best be used.
World bank and the International monetary fund
Setup after World War II
 Economic distress leads to political turmoil, international tensions, and military conflicts.
 Every country has an interest in promoting economic prosperity around the world.
Education
 Investment in human capital.
 The gap between the wages of educated and uneducated workers.
 Opportunity cost: wages forgone.
 Conveys positive externalities.
 Public education – large subsidies to human capital investment.
 Problems for the poor country: Brain drain
Healthier worker
 More productivity

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Human Capital
 Education
 Expenditure that leads to a healthier population.

Wages
 Reflect a worker’s productivity.

The right investment in the health of the population

 Increase productivity
 Raise living standards

Historic trends: Long-run economic growth

 Improve health – from better nutrition
 Taller workers – higher wages – better productivity

Vicious circle in poor countries

 Poor countries are poor.
Because their population is not healthy.
 The population is not healthy
Because they’re poor and can’t afford better healthcare and nutrition.

Virtuous circle
 Policies lead to more rapid economic growth
Naturally improve health outcomes, which in turn further promotes economic growth.

Property rights
Pre-requisite for the price system to work.
 Protect
The ability of people to exercise authority over the resources they own.
 Courts enforce property rights.
Promote political stability.
 Lack
Major problem
Contracts are hard to enforce
Fraud goes unpunished
Less investment, including from abroad, and the economy functions less efficiently (Lower
living standards)
Economic stability, efficiency, and health growth
 Require law enforcement
 Effective courts
 Stable constitution
 Honest government officials

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Corruption
 Impedes the coordinating power of the market.
 Discourage domestic savings.
 Discourage investment from abroad.
Free trade
 Inward oriented policies
Avoid interaction with the rest of the world.
Infant industry argument. (Tariffs, other trade restrictions)
Generally failed to create growth
 Outward oriented policies
Integrated into the world economy
International trade in goods and services
Economic growth
Often succeeded
 Amount of trade determined by
Government policy
Geography (Easier to trade for countries with natural seaports)
Technological progress
The main reason why living standards rise over the long run.
Knowledge – public good
 The government encourages research and development.
 Farming methods
 Aerospace research (Air force: NASA)
 Research grants
o National science foundation
o National institute of health
 Tax breaks
 Patent system
Large population
 More workers to produce goods and services
The larger total output of goods and services
 More consumer
Effects
1. Stretching natural resources (Malthus)
a. Strain society’s ability to provide for itself.
b. Mankind is doomed to forever live in poverty.
2. Diluting the capital stock
a. High population growth
b. Spread the capital stock more thinly
c. Lower productivity and living standards
3. Promoting technological progress (Michael Kremer)
a. World population growth
i. Engine for technological progress and economic prosperity.
ii. More people = More scientist, inventors, engineers = More frequent discoveries.

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Chapter 26: Saving, Investment, and Financial System
Closed Economy (NX = 0)
GDP/Y = C+I+G
S=I
I=Y – C – G
S= Y – C – G
Private saving = Income left after Tax and Consumption = Y – C – T
National Saving
Public saving = Surplus Tax after government expenditure = T – G
Financial System
 Group of the institution in the economy.
One person’s saving is another’s investment.
 Moves the economy’s scarce resources from savers to borrowers.
Financial Institution
 Financial Markets
 Financial Intermediaries
Rules of national income accounting
Identity
An equation must be true because of the way the variables in the equations are defined.
Clarify how different variables are related to one another.

T = Taxes minus transfer payments

S=Y–C–G
S = (Y – T – C) + (T – G)

Budget Surplus
T–G>0
Budget Deficit
T–G<0

The market for loanable funds

Market
 Those who want to save (Supply funds)
 Those who want to borrow to invest (Demand funds)
One interest rate
 Return to saving
 Cost of borrowing
Assumption
 Single financial market

Supply and demand for loanable funds

Supply – Saving
Demand – Investment, Downward sloping, and Fall in interest rate reduce the cost of borrowing,
Which increases the number of loanable funds.

Cost of loan = Real interest rate

The borrower pays for the loan = Lender receives on their saving

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The interest rate increase, Supply increase, and Demand decrease
Interest rate decrease, Supply decrease, Demand increase

“Investment does not purchase of Stock and Bonds”

Notes
 Saving shift supply curve
 Investment shift demand curve
Increase investment, increase output production, increase GDP, increase employment

Policy 3: Budget Deficit/ Surplus

Government starts with a balanced budget.
 Budget Deficit
o Change in the supply of loanable funds
o Decrease in the supply of savings
 Supply curve shifts left
 Interest rates increase
 Loanable funds Decrease
 Crowding out
 Budget Surplus
o Change in Supply of loanable funds
o Decrease in the supply of savings
 Supply curve shifts right
 Interest rates decrease
 Loanable funds Increase
 Encourage investment

Crowing out
The government borrows to finance the deficit, leaving fewer funds available for investment
Conclusion
 Investment is important for long-run economic growth
 A budget deficit reduces the growth rate and a lower standard of living
 Finance Deficit by borrowing (Selling government bonds)
 Government debt to GDP is a useful measure of government debt relative to its ability to raise
tax revenue

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Chapter 28: Unemployment
MOSPI – NSSO – PLFS

Rural, Male, Formal, Long run, Full employment

Unemployment

Urban, Female, Informal, Short run, Partial employment

Labour Force

Total number of persons employed and unemployed

 Employment Paid employees, self-employed and unpaid workers in a family business.

 Unemployment People not working who have looked for work during the previous 4 weeks
People who would like to work but do not have jobs.
 Out of Labour force Everyone else

Unemployment rate = Number unemployed x 100

Labour force

Labour force participation rate = Labour force x 100

Adult population

Unemployment is not a perfect indicator of joblessness or the health of the labor market.

 It excludes discouraged workers

 It does not distinguish between full-time and part-time work or people working part-time
because full-time jobs are not available
 Some people misreport their work status in the BLS survey.

Despite these issues, the Unemployment rate is still a very useful parameter of the labor market and
economy.

Duration of Unemployment

Most spells of unemployment are short

 Typically, 1/3 of the unemployed have been unemployed for under 5week rest 2/3 for under 14
weeks.
 Only 20% have been unemployed for over 6 months. Yet, most observed unemployment is long-
term.
 The small group of long-term unemployed persons has fairly little turnover. So, it accounts for
most of the unemployment observed over time.
Knowing these facts helps policymakers design better policies to help the unemployed.

Natural rate

 Even when the economy is doing well, there is always some unemployment.
 The normal rate of unemployment around which the actual unemployment rate fluctuates.

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Cyclic Unemployment

 Deviation of the unemployment rate from its natural rate.

 Associated with business cycles.

Structural Unemployment

 Occurs when there are few jobs than workers.

 Usually longer term.
 When the wage is above equilibrium, not enough jobs due to minimum wages, and labor unions.

Frictional Unemployment

 Occur when workers spend time searching for jobs that best suit their skills and tastes.
 It takes time to search for the right jobs. Occur even though there are enough jobs to go around.
 Short-term for most workers
 Labour supply > labor demand

Jobs search

Workers have different tastes and skills and jobs have different requirements.

 Process of matching workers with the appropriate job.

 Sectoral shifts are changes in the composition of demand across industries or the reasons of the
countries. Such a shift displaces some workers, who might search for new jobs appropriate to
their tastes and skills.
 The economy is always changing so frictional unemployment is inevitable.

Public policy and Job search

 Government employment agency

Information about job vacancies to match job and worker.
 Public training programs
Training workers with skills needed in growing industries.

Unemployment Insurance

 A government program that partially protects workers’ income when they become unemployed.
 It increases frictional unemployment.
Its benefits end when a worker takes a job, so he has less incentive to search for a job while
eligible to receive the benefit.
Benefits
 Reduce uncertainty over incomes
 Gives the unemployed more time to search for a job, result in better job search matches, and
results in higher productivity

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Unions

 A worker associates bargains with the employer over wages, benefits, and working conditions.
 Union exerts market power to negotiate higher wages for workers.
 Earns 20% higher wages and gets more benefits than a non-union worker for the same
time of work.
 When a union raises the wage above the equilibrium quantity of labor demanded falls and raises
unemployment.
 Insiders – Workers who remain employed, they’re better off.
 Outsiders – Workers who become unemployed, they’re worse off.
 Some outsider goes to non-unionized labor markets, increase labor supply and reduce
wages in those markets.

Are unions good or bad?

 Favour
 Union counters the market power of large firms. Make firms more responsive to
workers’ concerns.
 Against
 Unions are cartels. They raise wages above equilibrium, cause unemployment or depress
wages in the non-union labor market.

Efficiency wages

 Firms voluntarily pay above-equilibrium wages to boost workers’ productivity.

 Different versions of efficiency wages theory suggest different reasons why firms pay high
wages.

Reasons

1. Worker health
Paying higher wages allows workers to eat better, and makes them healthier, and more
productive.
2. Worker turnover
Hiring and training new workers is costly. Paying high wages gives more incentive to stay.
3. Worker Quality
Offering higher wages attracts better job applicants, and increases the quality of the firm’s
workforce.
4. Worker effort
Workers would work hard or shrink. Shrinkers are fired if caught.
Finding another job is tough. Workers have more incentive to work not to shrink.

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Chapter 29: The monetary system
Money
Money is a set of assets in an economy. Which is a medium of exchange in a particular.
Characteristics
 General acceptable
 Recognizable
 Portability
 Divisibility
 Malleability
 Intrinsic value
 Face value
 Durability
 Uniformity
 Stability
Functions
1. Medium of exchange
2. Unit of account
3. Store of value
 Standard of different payment
 Liquidity
Kinds
1. Commodity money
Takes the form of a commodity with intrinsic value.
2. Fiat money
Used as money because of government decree without intrinsic value.
3. Currency
Paper bills and coins are in the hand of the public.
4. Demand deposit
Balances in a bank account that depositors can access through UPI, debit card, or cheque.
Forms
1. Token coins
Face value > Intrinsic value
2. Standard coin/ full body coin
Face value = Intrinsic value
Banks and Money Supply
 Banks can influence the quantity of demand and supply of deposits.
 Reserves are deposits that the bank received but not loaned out

Deposit is a liability (less & interest is paid by the bank)

Bank
Lending is an asset (more & interest is received by the bank)
 RBI decides the minimum % of reserves kept with the bank.
 CRR increases Money supply decreases.
 Deposit in the bank is recorded as both assets and liabilities.
Reserve ratio
Fraction of deposit that a bank hold
The fractional reserve banking system
 Banks hold a fraction of deposits and can lend out the rest
Money creation
When one bank loans money, the money is generally deposited to another bank. It creates more
deposits and more reserves to be lent.
 When a bank makes a loan from its reserves, the money supply increases.

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The objective of monetary policy
 Maintaining price stability.
 Ensuring the adequate flow of credit to sustain the growth momentum.
 Securing financial stability.
RBI’s tools of monetary control
 Bank rate/ Discount rate (5.65%)
The discount rate is the interest rate RBI charges from the bank for a loan.
 Increasing the discount rate decreases the money supply.
 Decreasing the discount rate increases the money supply.
 Open market operations
 Buys government bond money supply increases.
 Sells government bond money supply decreases.
 CRR (4.5%)
Fraction of deposit that is necessary to hold by the bank.
 Increase reserve requirements, and decrease the money supply.
 Decrease reserve requirements, and increase the money supply.
 SLR (18%)
 LAF
Liquidity adjustment fund allows banks to borrow
LAF is used to aid the banks in adjusting the day-to-day mismatches in liquidity
 Repo rate (5.4%)
The (fixed) interest rate at which the RBI provides overnight liquidity to banks against
collateral of government and other approved securities under the LAF.
o It pushes the liquidity in the system
 Reverse repo rate (3.35%)
The (fixed) interest rate at which the RBI borrows from banks by lending securities.
o It absorbs the liquidity in the system
The credit multiplier
The credit multiplier is the amount of money the banking system generates with each dollar of reserves.
Credit multiplier = 1/Reserve ratio
 Larger the amount, the greater the money supply.
Limitations
Indirect relation between CRR and credit multiplier
 Higher CRR, lesser credit multiplier.
 CRR fixed by RBI range from 3% - 15%
Banking habits of people
 If banking habits are well developed, all transactions would be through the bank and leading to
the expansion of credit.
Supply of securities
 Loans are sanctioned based on securities provided to the banks. If securities are available then
credit creation will be more.
The willingness of people to borrow
 Commercial banks may have enough money to lend. Customers should be willing to borrow from
the banks to facilitate credit multiplier.
Monetary policy of RBI
 While credit is created by a commercial bank. It is controlled by RBI.
 RBI uses various methods of credit control. Thus, influence bank to expand or contract credit.
External drain
It refers to the withdrawal of cash from the banking system by the public.
 It lowers the deposit/reserve of the bank and limits the credit multiplier.
Uniform policy
 If all bank follows a uniform policy related to CRR then the credit multiplier would be smooth. If one
follows liberal and the other follows conservative. Then, the credit multiplier would be affected.
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Chapter 30: Money Growth and Inflation
Money Demand
How much wealth do people want to hold in liquid form
 The quantity of money demanded
 Negative related to the value of money.
 Positive related to price.

Nominal Variable: Measured in monetary units. (Nominal GDP)

Real Variable: Measured in physical units. (Real GDP)

Relative price
The price of one good is divided by the other. Physical units: Real variable
Relative price = Price of good1 = good1 per good2
Price of good2

The classical dichotomy

Separation of a nominal and real variable
 The monetary developments affect the nominal variable, not the real variable.
 Describe the economy in long run.

The neutrality of money

The proposition changes in the money supply do not affect real variables.
 Describe the economy in long run.

The velocity of money

The rate at which money changes hands.
Fairly stable over time.
Velocity = Price level x Real GDP
Money supply

The quantity equation

MxV=PxY

Constant real GDP (Y) Inflation rate = Money growth rate

Growing Y Inflation rate < Money growth rate
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Hyper Inflation
Excessive growth in the money supply
“Prices rise when the government print too much money”
Inflation > 50% per month

Inflation tax
Revenue from printing money.
This applied to people holding money, not wealth.

The fisher effect

The nominal interest rate adjusts one-for-one with changes in the real interest rate.
Nominal interest rate = Inflation rate + Real interest rate

Cost of inflation
 Shoe leather cost
Resources are wasted when inflation encourages people to reduce their money holding.
 Time and transaction cost of more frequent bank withdrawals.
 Menu cost
The cost of changing prices
 Printing new menu, mailing new catalogs, etc
 Misallocation of resources from relative-price variability
 Confusion and inconvenience.
 Tax distortion
Usually based on nominal income, and some are not adjusted for inflation.
 Special cost of unexpected inflation
 Arbitrary redistribution of health
Higher than expected, transfer purchasing power from creditors to debtors.
Lower than expected, transfer purchasing power from debtors to creditors.
High inflation is more variable and less predictable than low inflation.

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Chapter 31: Open economy macroeconomics: Basic concepts
“Trade can make everyone better off”
An open economy interacts freely with other economies around the world.

Exports Domestically produced goods and services sold abroad.

Imports Foreign produced goods and services sold domestically.

Net exports = Trade balance = Exports – Imports

Variables affecting Net exports
 Consumer preference for foreign and domestic goods.
 Price of goods at home and abroad.
 Incomes of the consumer at home and abroad.
 Exchange rate
 Government policies.
Trade surplus Exports > Imports
Trade deficit Exports < Imports
Balanced trade Exports = Imports

Flow of capital
NCO = NX
Export has two effect we send our goods services to foreign nation and trade with foreign asset (currency) (Net
capital outflow)
That increase our purchase of foreign asset (currency) by same amount (Net exports)
Net capital outflow = Net foreign investment
Domestic resident purchase of foreign asset – Foreign resident purchase of a domestic asset
NCO > 0 Capital outflow, NCO < 0 Capital inflow
 Foreign direct investment
Domestic resident actively manages foreign investment.
 Foreign portfolio investment
Domestic residents purchase foreign stock or bonds.
Variable affecting NCO
 The real interest rate paid on foreign assets.
 The real interest rate paid on domestic assets.
 Risk of holding the foreign asset.
 Government policy affecting foreign ownership of domestic assets.

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Saving, investment, and international flow of goods and services
S > I Excess loanable fund flow abroad.
S < I Foreigners are financing some of the country’s investments.

The nominal exchange rates

The rate at which one country’s currency trades for another.
Appreciation Increase in value of the currency.
Depreciation Decreases in the value of the currency.

The real exchange rates

The rate at which one country’s goods and services trade for another.
Real exchange rate = Nominal exchange rate x Domestic price
Foreign price

Law of one price

The notion that a good should sell for the same price in all markets

Purchasing power parity

A unit of any currency should be able to buy the same quantity of goods in all countries.
Based on the law of one price.
e = Foreign price
Domestic price
Limitations
 Many goods cannot easily trade.
 Price difference on these goods cannot be arbitraged away.
 Foreign, domestic goods cannot be a perfect substitute.
 Price differences reflect taste differences.

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Chapter 33: Aggregate demand and aggregate supply
Over the long run real GDP fluctuates over 3% p.a. on average
Recession Period of falling real income and raising unemployment.
Depression Severe recession (Very rare)
Business cycle short-run economic fluctuations.
 Fact 1: Economic fluctuations are irregular and unpredictable.
 Fact 2: Most macroeconomic quantities fluctuate together.
 Fact 3: As output falls, unemployment rises.
 Explaining these fluctuations is difficult, and the theory of economic fluctuation is
controversial.
 Most economists use the theory of aggregate demand and aggregate supply to study fluctuation.
This model differs from the classical economic theories economist use to explain in the long
run.
Aggregate demand/ supply (C+I+G+NX)
Households Consumption C
Firms Investment I
Government expenditure G
Foreign Net Exports NX

The classical Dichotomy

The separation of variables into two groups.
Real Quantities, relative price.
Nominal Measured in terms of money.
To study the short run, we use the new model
The model of aggregate demand and aggregate supply.

The aggregate demand curves.

It shows the quantity of all goods and services demanded in the economy at any given price level.
Downward sloping
1. The wealth effect. (P&C)
Suppose P falls
 Purchasing power rises
 People feel richer
 Cost rises
2. The interest rate effect. (P&I)
Suppose P falls
 Purchasing power rises
 Buy bonds or other assets (Saving increases)
 Interest rates fall
3. The exchange rate effect. (P&NX)
Suppose P falls
 Interest rates fall
 People want to invest in foreign entities.
 Lesser demand for our currency in foreign markets.
 Exchange rate depreciate
 Imports decreased (Expensive), and export increased.
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Aggregate demand shift
Any event that changes C, I, G, or NX. Except for changes in prices.
 Changes in Consumption
 Stock market boom/ hike
 Preference regarding consumption/saving (Trade off)
 Tax hikes/cuts
 Changes in Investment
 Firms buy new capital goods
 Expectation optimism/ Pessimism
 Investment tax credit/incentive
 Interest rates, monetary policy.
 Changes in Government expenditure
 Central spending.
 State/local spending.
 Changes in Net exports
 Booms/recession in our country/ countries that buy our export.
 Appreciation/depreciation results from the foreign exchange rate.

Aggregate supply curve

Long-run aggregate supply

LRAS gives the amount of output the economy produce when employment is at its natural rate.
Why LRAS is vertical?
The output doesn’t depend on prices.
It depends on
 Changes in labor or unemployment rate.
 Immigration
 Government policy reduces the natural unemployment rate.
 Changes in physical or human capital.
 Capital investment
 More people get a college degree.
 Natural calamities affect capital.
 Change in natural resources.
 Discovery of new mines.
 Reduction in the supply of natural resources.
 Changing weather patterns affect agriculture production.
 Change in technology.
 Productivity improves from technological progress.

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Short-run aggregate supply (SRAS)
Over the period of 1-2 years, an increase in price cause an increase in goods and services supplied.

Three theories of SRAS

In each, some type of market imperfection.
Output deviates from its natural rate when the actual price level deviates from the price level people
expected.
1. The sticky wage theory
 Normal wages are sticky in the short run. (Due to labor contracts, and social norms)
 Firms and workers set the nominal wage in advance based on the price level they expect
to prevail (PE).
 P > PE. Higher revenue but low labor cost. Production is profitable, firms increase
production and output.
 Higher prices cause higher output.
2. The sticky price theory
 Many prices are sticky in the short run (Due to menu cost, the cost of adjusting prices)
 Firms set sticky prices in advance based on PE.
 Prices increase, firms with the menu can cost wait to raise prices, their prices are
relatively low, increase demand, increase production.
 Higher prices cause higher output.
3. The misperception theory
 Firms confuse changes in price with changes in the relative price of the products they
sell. If P > P E. Firms may see their price raising before the actual price raising. Firms
may believe their relative price is rising may increase output and employment.
 Higher prices cause higher output.

Y = YN + a (P – PE)
a > 0 measures how much output responds to unexpected price changes.
The imperfections in these theories are temporary. Over time,
Sticky wages and prices become flexible and misperceptions are corrected
In the long run, PE = P, AS supply curve is vertical.

Steps to analyze economic fluctuations.

1. Determine whether the event shifts AD or AS
2. Determine whether the curve shifts are left or right.
3. Use the AD-AS diagram to see how the shift changes Y and P in the short run.
4. Use the AD-AS diagram to see how the economy moves from the new SR eqm to LR eqm.

Stagflation
A period of falling output and rising prices.

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Chapter 34: The influence of monetary and fiscal policy on aggregate demand
The theory of liquidity preference.
 Theory of interest rate (r).
 r adjusts to balance supply and demand for money.
 Assume the money supply is fixed and does not depend on interest rates.
 Money demand reflects how much wealth people want to hold in liquid form.
 Variables that influence money demand. Y, r, P
Money demand
 An increase in output causes an increase in money demand.
 An increase in prices causes an increase in money demand.
 An increase in interest rates causes a decrease in money demand.

The interest rate effect is the most important effect on the Indian economy.

 RBI uses monetary policy to shift the AD curve.

 To change the interest rate and shift the AD curve RBI conducted open market operations to
change MS.

Fiscal policy
The setting of the level of government spending and taxation by government policymakers.
1. Expansionary
 Increase in G or decrease in T.
 Shifts AD right
 Increase MS
2. Contractionary
 Decrease in G or increase in T
 Shifts AD left
 Decrease MS
Marginal propensity to consume (MPC)
The fraction of extra income that households consume rather than save.

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The multiplier effects
The additional shift in AD results when fiscal policy increases income and thereby increases
consumer spending.
Each 1rs increase in G can generate more than a 1rs increase in AD.
Multiplier effect = 1
1 – MPC
The crowding-out effect
Fiscal policy has another effect on AD that works in opposite direction.
The size of the AD shift may be smaller than the initial fiscal expansion.

Changes in taxes
 A tax cut increases households’ take-home pay.
 Households respond by spending a portion of this extra income shifting AD to the right.
 The size of the shift is affected by the multiplier and crowding-out effect.
 A permanent tax cut causes a bigger increase in consumption than a temporary one.
 A cut in the tax rate gives workers an incentive to work more. So, it might increase the number
of goods and services supplied and shift AS to the right. People who believe this effect is larger
are called supply siders.
 Government purchases might affect AS.

Stabilizer
 Keynes: “Animal spirits” Cause waves of pessimism and optimism among households and
firms, leading to shifts in aggregate demand and fluctuations in output and employment.
 When GDP falls below the natural rate use expansionary monetary or fiscal policy to prevent or
reduce recession.
 When GDP rises above the natural rate use contractionary monetary or fiscal policy to prevent
or reduce inflation boom.
Drawbacks
 Monetary policy affects the economy with a long lag.
 Firms make investment plans in advance, so it takes time to respond to changes in r.
 Most economists believe it takes at least 6 months for monetary policy to affect output
and employment.
 Fiscal policy also works with a long lag.
 Changes in G and T require Acts of Congress.
 The legislative process can take months or years.
 Automatic stabilizer
 The tax system
In a recession, taxes fall automatically, which stimulates AG.
 Government spending.
In a recession, more people apply for public assistance. Government spending on these
programs automatically rises, which stimulates AG
 Policy makers need to consider all the effects of their action
 Taxes cuts, short-run effect on AD & employment. Long run on saving and
growth.
 Reduce the rate of money growth. Long-run effect on inflation. Short-run effect
on output and employment.

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