Aggregate output:

Aggregate income:

Components of GDP

Measures

Criteria
GDP Aggregate output and income
Nominal GDP

GDP deflator

Actions taken by a nation’s central bank to affect aggregate output and prices through
GDP, National Income, Personal Income, and Personal Disposable Income
changes in bank reserves, reserve requirements, or its target interest rate.

Goods and services included at imputed values

Functions of money
Medium of exchange
Relationship among Saving, Investment, the Fiscal Balance and the Trade Balance Store of wealth
Unit of account

Wealth effect
Fractional reserve banking Money multiplier = 1 / Reserve requirement

Interest rate effect Aggregate demand

Narrow and broad money
M0 = money supplied by central bank
Real exchange rate effect M1 = M0 + deposits from commercial banks at central bank
M2 = M1 + commercial bank deposit accounts
Aggregate supply M3 = M2 + other liquid assets (bonds, repos, commercial paper)

Shifts in aggregate demand Quantity equation of exchange: M x V = P x Y

M = money supply (nominal)
V = velocity of money circulation (real)
Shifts in short-​run aggregate supply (SRAS) P = inflation/price level (nominal)
Y = GDP/output/income (real)
Quantity theory
Money
Shifts in long-​run aggregate supply (LRAS)
Aggregate demand and supply Money neutrality: M increases => P increases; no change in V and Y

Equilibrium GDP and prices

%∆M = %∆P + %∆Y (because V is almost constant => %∆V = 0)

Long-​run equilibrium
Aggregate output, prices, and economic growth Transactional Increases with value of transactions in an economy, and hence GDP.

Investment Implications of a Decrease in AD Recessionary gap

Precautionary Rises with the volume and value of transactions in the economy, and hence GDP.

Investment Implications of an Increase in AD Resulting in an Inflationary Gap Inflationary gap Demand for money
Falls as returns on other financial assets rises.

Stagflation Speculative
Rises as perceived risk in other financial instruments rises.

Investment Implications of a Shift in AS

Supply of money

Conclusions
Fisher effect: Nominal interest rate = Real interest rate + Inflation

Production function
Monopoly supplier of currency

Model assumptions Production function and potential GDP

Banker to the government and the banker's bank

Growth accounting equation

Lender of last resort

Technology Roles of central bank

Regulator and supervisor of payment systems

Labor supply
Real GDP Conductor of monetary policy

Human capital
Supervisor of banking system

Physical capital stock Sources of economic growth

Economic growth and sustainability Advantages of target inflation
Control inflation (primary) Stable financial market.
Natural resources
Stable economic productivity thanks to predictable price levels.

Roles of central bank and objectives of monetary policy

Public infrastructure
Stable FX rate

Objectives of monetary policy

Others
Full employment

Monetary policy
Labor productivity
Sustainable economic growth

Level of labor productivity Measures of sustainable growth

Moderate long-​term interest rate
Sustainable growth
Growth rate of labor productivity
Operational: independently determine and implement policy rates.
Independence
Measuring sustainable growth
Target: set inflation level and time horizon to achieve target
Qualities of effective central bank
Recurrent expansions and contractions in economic activity affecting broad segments of the economy.
Credibility
Typical of economies that rely mainly on business enterprises.
Has an expected sequence of phases, alternating between expansion and contraction.
Cycles are recurrent, but not in a periodic way or the exact same intensity and duration. Transparency

Classical cycle: fluctuations in the level of economic Discount rate (for when commercial banks provide notes to central bank to borrow money)
activity when measured by GDP in volume terms.

Policy rate Refinancing rate (for when companies borrow money from commercial banks)
Growth cycle: fluctuations in economic activity around the long-​term
potential trend growth level, focusing on how much actual economic Types of cycle
activity is below or above trend growth in economic activity. Tools Repo rate for OMOs

Growth rate cycle: fluctuations in the growth rate of Reserve requirement

economic activity (i.e., GDP growth rate).
Open market operations (OMOs)
Recovery: economy going through the “trough”, actual output is at its
Economics 2 Monetary and fiscal policy
lowest relative to potential output. Economic activity is below potential but Interest rate
is starting to increase, closing the negative output gap.

Credit
Prices and interest rates may increase. Monetary transmission mechanism
(4 channels through which monetary policy affects economy)
Expansion: recovery gains pace, output increases, growth rate is above average. Actual output rises Exchange rate
As expansions continue, the economy may start having shortages in production input. above potential output, and the economy enters the “boom” phase. Consumers increase spending,
and companies increase production, employment, and investment.
Asset price
Overinvestment may deter firms for future investments.

Phases of the cycle (referring to the growth rate cycle) Overview Expected inflation:
Consumers still optimistic. Menu cost
Slowdown: output reaches its highest level relative to potential output (largest Shoe leather cost
Firms rely on overtime rather than new hires. positive output gap); growth rate begins slowing relative to potential output
Costs of inflation
growth, and the positive output gap begins narrowing. Unexpected inflation:
Inflation slows. Inequitable transfers of wealth between borrowers and lenders.
Risk premia in borrowing rates and the prices of other assets.
Reduced information content of market prices.
Confidence declines.
Contraction: actual economic output falls below potential economic output; economy
reaches recession or depression if the fall is large. Contractionary monetary policy: Short-​term rate rises => Investors expect over-​contraction
Firms cut cost by eliminating overtime and laying off. => Recession => Lower inflation => Investors buy long-​term bonds => Bond price rise =>
Long-​term rate falls.
Bond market vigilantes: normally with monetary policy, short-​term and long-​term interest
Recovery: rate move together; but bond vigilantes sometimes prevent this from happening.
Risky assets are repriced upward. Expansionary monetary policy: Short-​term rate falls => Investors expect over-​easing =>
Higher profit expectations for financial assets. Bubble => Higher inflation => Sell long-​term bonds, buy equity => Bond price falls => Long-​
Equity markets are leading indicators. term rate rises.

Contraction: investors prefer safer assets => marginal utility of a safe income stream Deflation:
increases in periods when employment is insecure or declining. Contractionary, expansionary, and limitations Limitations of monetary policy Central bank raises money supply. Solution 1: Zero or negative policy rate
Market conditions and investor behavior AD falls because individuals don't want to raise consumption and firms don't want to
Liquidity trap
raise investments.
Expansion: Solution 2: Quantitative easing (similar to OMO but collateral are riskier bonds and longer-​term)
Commercial banks are not willing to lend.
Boom: testing the limits, high confidence, strong growth.
=> Higher money supply but cannot lower short-​term interest rate.
Firms rely on strong cash flows and borrowing to continue expansions and hiring.
Government/central bank may intervene to stop the economy overheating.
Monetary policies are ineffective because:
Illiquid debt market.
Slowdown: safer assets have higher nominal yields. Developing countries
Lack of central bank credibility.
Central bank dependent on political authority.
When the economy is strong or improving, the willingness of lenders to extend credit, and
on favorable terms, is high.
Responsibility of the national government.

when the economy is weak or weakening, lenders pull back, or “tighten” credit, by making it
Objectives
less available and more expensive.
Influence economic activities and AD.
Redistribute wealth and income.
In a world with financial frictions, business cycles can be amplified, with deeper recessions and more Business cycles Allocate resources among agents and sectors in the economy.
extensive expansions because of changes in access to external financing. Credit cycles and Business cycles
Recessions accompanied by financial disruption episodes, tend to be longer and deeper. Roles and objectives Difficulties
Recoveries combined with rapid growth in credit, risk-​taking, and house prices tend to be stronger.
Impact lag
Misreading economic statistics
Discretionary fiscal policy: government actions to stabilize the economy
Investors' concern with credit cycles Supply shortages: resource constraints
Understand developments in the housing and construction markets. Insufficient budget or high debt ratio (= total debt / GDP)
Assess the extent of business cycle expansions and contractions. Cannot satisfy multiple targets (high employment and low inflation)
Better anticipate policy makers’ actions.

Automatic stabilizers (tax)

Workforce and company costs

Deficits and national debt

Capital spending Business cycle fluctuations from firm perspective

Transfer payments
Inventory levels

Spending Current/revolving spending

Consumer confidence (e.g., through surveys)

Fiscal policy CAPEX

3 types of products: Measures of consumption
Durable goods Retail sales
Direct taxes (on income, wealth, corporate profits, and capital gains)
Non-​durable goods Indicators of consumer spending that also include purchases outside Tools
Services retail establishments, such as utilities and household services. Consumer behavior
Indirect taxes (on goods and services)

Income growth
Revenue
Qualities of effective tax policy:
Simplicity
Saving rates
Efficiency
Fairness
Sensitivity to interest rates and credit cycles: Revenue sufficiency
Home buying and consequently construction activity expand in response to lower loan
interest rates and contract in response to higher loan interest rates.
Implementation
When housing prices are low relative to average incomes, and especially when mortgage
rates are also low, the cost of owning a house falls and demand for housing increases.
Housing prices and mortgage rates rise disproportionately as expansionary cycles mature. For
Housing sector behavior Debt held by citizens has small effect.
Higher employment rate
Demographics: Cyclical behavior in housing occurs around the long-​run growth trend in
housing determined by demographics
Arguments concerning fiscal policy Against
Crowding-​out effect
Impact on economic cycle: have little to do with business cycles, but offer a gauge of how
Larger fiscal deficit => Higher future tax => Lower motivation to work => Lower long-​
quickly the housing market can correct excess and return to growth.
term growth
Debt monetizing: higher government spending => higher debt => investors are more
Fluctuations of exports and imports unwilling to finance => government default or print more money (higher inflation)

When a nation’s currency appreciates, foreign goods seem cheaper than domestic goods to Relationship between fiscal and monetary policy
the domestic population, prompting a relative rise in imports.
Exchange rate External trade sector behavior
At the same time, such currency appreciation makes that nation’s exports more expensive
in global markets and may reduce exports.

Overall effect on exports and imports

Theoretical considerations

Economic indicators

Unemployment

Inflation