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Macroeconomics I
Macroeconomics I
Department of Macroeconomics
MACROECONOMICS I
Module Context:
The module is designed especially for
students taking Macroeconomics at FTU. It
is intended to provide students with an
understanding of important macroeconomic
factors and variables. The course analyses
how macroeconomic variables operate;and it
develops an understandings of the
international money and financial market, in
or outflows of capital. The course also draws
on the debates in real economy and tries to
use both old and new theories to understand
them.
Introduction
2.2.Aggregate Supply
Yield, employment,
Average price,
Inflation,interest,budget,
Trade balance and balance of
International payment,
Economic Growth
Macroeconomics
Macroeconomics
Recession
Recession
Depression
Depression
Models
Models
Macroeconomic
Macroeconomicsystem
system
Inputs
Inputs
Outputs
Outputs
Endogenous
Endogenousvariables
variables
Exogenous
Exogenousvariables
variables
Market
Marketclearing
clearing
Flexible
Flexibleand
andsticky
stickyprices
prices
Microeconomics
Microeconomics
CHAPTER II
D ATA OF MACROECONOMICS
I. Gross domestic products-GDP
Expenditure $
For the economy as a whole, income must equal expenditure.
GDP measures the flow of dollars in this economy.
II.Computing GDP
1.Rules for computing GDP
1) To compute the total value of different goods and services,
the national income accounts use market prices.
Thus, if
$0.50 $1.00
The GDP deflator, also called the implicit price deflator for
GDP, measures the price of output relative to its price in the
base year. It reflects what’s happening to the overall level of
prices in the economy.
In some cases, it is misleading to use base year prices that
prevailed 10 or 20 years ago (i.e. computers and
college). In 1995, the Bureau of Economic Analysis
decided to use chain-weighted measures of
real GDP. The base year changes continuously
over time. This new chain-weighted
Average prices in 2001 measure is better than the more
and 2002 are used to measure traditional measure because it
real growth from 2001 to 2002. ensures that prices will not be
Average prices in 2002 and 2003 too out of date.
are used to measure real growth from
2002 to 2003 and so on. These growth
rates are united to form a chain that is
used to compare output between any two
dates.
3. Methods of computing GDP
*Expenditure approach
GDP = C + I + G + (X-M)
Y
Y == C
C ++ II ++ G
G ++ NX
NX
Totaldemand
Total demand Investment
Investment
fordomestic
for domestic isiscomposed
composed spendingby
spending by
output(GDP)
output (GDP) of
of businessesand
businesses and
households
households Netexports
Net exports
ornet
or netforeign
foreign
Consumption Government demand
demand
Consumption Government
spendingby
spending by purchasesof
purchases ofgoods
goods
households
households andservices
and services
GDP = w + r + i + + D +Te
W: wage, r :rent fixed capital, i: interest,
profit, D: Depreciation, Te: indirect tax
3. The output approach
Example:
One firm gains value added is 80, 1000 firms is
80,000. 80 = total revenues – total cost (production
cost)
II.Gross national products)-GNP
1. Definition:
GNP is the market value of all final goods and
services produced by domestic residents in a
given period of time.
2. Computing methods:
GNP = GDP + Tn
Tn
D D-Depreciation
C NNP-Net National
Te Product
I GNP Td-
NNP NI-National Income
NI TR
G Yd-Disposal Income
(Y) TR (transfer)-
Yd
Td: Direct tax
NX
Gross domestic product (GDP) National income accounts
Consumer Price Index (CPI) Consumption
Unemployment Rate Investment
Stocks and flows Government Purchases
Value added Net Exports
Nominal versus real Labor force
GDP GDP deflator
GNP
NEW
CHAPTER III
AGGREGATE DEMAND
& FISCAL POLICY
Today’s lecture is the first in a series of four
lectures aimed at analysing different (separate)
markets in the economy. This will then enable us to
bring the various markets together and to analyse
the behaviour of the whole economy (this is also
referred to as general equilibrium analysis). Today
we will introduce an analysis of the economy as
originally described by the economist John
Maynard Keynes. His theory of how the
macroeconomy works will help us explain how the
economy’s income (GDP) is determined. Today we
analyse the model in its simplest form and we will
assume that the economy does not have a
government and that it does not trade with the rest
of the world. We will relax these assumptions.
The Keynesian Theory of Income Determination: the theory that
will be presented hereafter was developed by the Cambridge
economist John Maynard Keynes in the wake of the 1920s Great
Depression. He argued that the cause of a low level of income
(GDP) in the economy was given by the lack of AD.
John Maynard Keynes (right) and Harry Dexter White at the Bretton Woods Confer..
Personal and marital life
Born at 6 Harvey Road, Cambridge, John Maynard Keynes
was the son of John Neville Keynes, an economics lecturer at
Cambridge University, and Florence Ada Brown, a successful
author and a social reformist. His younger brother
Geoffrey Keynes (1887–1982) was a surgeon and bibliophile
and his younger sister Margaret (1890–1974) married the
Nobel-prize-winning physiologist Archibald Hill.
Keynes was very tall at 1.98 m (6 ft 6 in).
C f1 (Y ) C MPC.Yd
*Determinants of Consumption:
+Autonomous Consumption (C): this is the
amount of consumption expenditure that
would take place even if people had no
current disposable income
I I
APE C I C I MPC .Y
Y = APE =AD
This equation is called the equilibrium
condition. By replacing the above
expression for aggregate planned
expenditure in the equilibrium condition we
get:
Y APE
Y C I MPC .Y
2.1.Fixed taxation T T
APE C I G C I G MPC.(Y T )
Y APE
Y C I G MPC .(Y T )
1 MPC
Y0 (C I G ) T
1 MPC 1 MPC
MPC Multiplier Effect of taxation
mt
1 MPC
Y0 m(C I G ) mt T
C C MPC (Y T ) C MPC (1 t )Y
II G G
APE C I G C I G MPC (1 t )Y
=>Equilibrium point of economy:
Y APE
Y C I G MPC (1 t ) Y
1
Y0 (C I G )
1 MPC (1 t )
1
m Multiplier of consumption in
1 MPC (1 t )
the closed economy with
Government sector
1 1
m m
1 MPC (1 t ) 1 MPC
*C = C + MPC.(Y-T) = C + MPC.(1-t).Y
*I = I
*G = G
*NX=X-M: netexport
X doesn’t depend on domestic income,therefore
X X
M derives from production inputs, or
consumptions of households=>M increases
when I or Ye rises.
Ta cã: M = MPM.Y
+ B = 0: Budget balance
+ B > 0: Budget surplus
+ B < 0: Budget deficit
*Classification:
Self-sufficiency
Without Money
Barter economy
b. Development of money
Cattle, iron, gold,silver,diamond ….and
banknote today
• Store of value
• Unit of account
• Medium of exchange
• International Money
n 1 n 1
1 (1 ra ) 1 (1 ra )
D 1 (1 ra ) (1 ra ) ... (1 ra ) 1
2 n
1
1 (1 ra ) ra
1 0 1 1
0 < ra < 1 => D 1 1 10 (tû.®)
ra ra 0,1
Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000.
Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1000
Firstbank Lending = (1-rr) $1000 TheTheprocess
processof oftransferring
transferringfunds
funds
Secondbank Lending = (1-rr)2 $1000 from savers to borrowers is called
from savers to borrowers is called
Thirdbank Lending = (1-rr)3 $1000
Fourthbank Lending
financial intermediation.
=. (1-rr)4 $1000 financial intermediation.
..
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] $1000
= (1/rr) $1000
= (1/.2) $1000
= $5000 Money
Moneyand andLiquidity
LiquidityCreation
Creation
III. Central Bank and money supply
U D
Money supply : MS
Where: H0 = U + R and MS = U + D
MS >Ho due to the creation of money from
commercial banks.
b.The Central Bank's Policy Tools: there are
three main tools that the Central Bank can use to
control money supply and implement monetary
policy
used).
ep t t
the r lus the in terms sta
p e
value through th
r s
incu pay
thereo
f. ly re
l just
s wil rety and
t ed State enti
ni
The U rers in its nder any
MD = k.Y–h.i
k-income-elasticity of MD
h-interest rate –elasticity of MD.
i
kY1
h
kY0
h
MD1
MD0
M
0 kY0
Note:
+ i change=>quantity demanded move along
MD, otherthings being equal.
+ Y change=>MD shift rightwards or
leftwards. Depends on income-elastricity of
money demand (k).
+ Slope of MD depends on the interest rate –
elastricity of money demand (h).
kY 1
i MD
h h
2. Money supply
io Eo
MDo
0 M
3. Equilibrium in the Money Market: the
equilibrium in the money market requires
that money supply be equal to money
demand, that Ms=Md
M M f (Y , i ) This
s d
AD- AS MODEL
I. Aggregate Demand
1.Classical theory
P, w flexible
At Full employment (potential output).
AS
AD1
ADo
Y*
2. Keynesian view
Short term
P and w fixed
Positive unemployment rate
Horizontal Aggregate Supply curve at P0
P
SAS
P
AD1
ADo
0
Y
3. Real Aggregate supply
*Short-run: P,w, costs change slowly due to
short term labour force contract, ….=> TC
change stable => P increases => TR increases
=>Firms increase output=>AS increases from
the left to the right.
0 Y* Y
II. AD-AS MODEL
P LAS SAS
AD
0 Y* Y
CHAPTER VI
Labour employment
force
In
unemployment
Working
Populat age
ion Out of
labour force
Out
2. Computing unemployment rate
U
u 100%
L
Unemployment is a problem for the
economy because:
P1Q1 P2 Q2 ... Pn Qn
P
Q1 Q2 ... Qn
Actually, P is difficult to compute, we can
compute inflation as below:
k
i i
P t
Q 0
CPI i 1
k
i i
P 0
i 1
Q 0
CPI2005=1,2x30%+1,4x25%+0,9x15%+1,5x30%=1,295
GDPn i i
P t
Q t
D 100% i 1
n
100%
GDPr
i i
P 0
i 1
Q t
Dt Dt 1
gp 100%
Dt 1
Why is inflation a problem?: When
inflation is present in the economy, money
is losing its value. The higher the inflation
rate, the higher is the rate at which money
is losing value and this fact is the source of
the inflation problem. Inflation is said to be
good for borrowers and bad for lenders,
and so inflation can cause inequalities in the
economy. People on fixed incomes (e.g.
pensioners and students) tend to suffer
most from inflation.
2. Types of inflation
Demand-pull inflation is P
caused by continuing rises in
AS
AD in the economy. The
increase in AD may be caused
by either increases in the
money supply or increases in P1
G-expenditure when the AD1
economy is close to full P0
employment. In general,
demand-pull inflation is AD0
typically associated with a Y*
booming economy. 0 Y
* Cost-push inflation is associated with
continuing rises in costs. Rises in costs may
originate from a number of different sources
such as wage increases and other higher costs of
production (e.g. raw materials).
P AS1
AS0
P1
P0 AD
0 Y
Y1 Y0 Y*
*Structural (demand-shift) inflation arises
when the pattern of demand (or supply)
changes in the economy which results I n
some industries experiencing increased
demand whilst others experience decreased
demand. If prices and wage rates are
inflexible downwards in the contracting
industries, and prices and wage rates rise in
the expanding industries, the overall price
and wage level will rise. The problem will be
made worse, the less elastic is supply to these
shifts.
*Expectations are crucial determinants of
inflation. Workers and firms take account of
the expected rate of inflation when making
decisions. Generally, the higher the expected
rate of inflation, the higher will be the level of
pay settlements and price rises, and hence the
higher will be the resulting actual rate of
inflation.
MV = PY
or in percentage change form:
%
%Change
Changein
inM
M++%
%Change
Changein
inVV==%
%Change
Changein
inPP++%
%Change
Changein
inYY
if V is fixed and Y is fixed, then it reveals that % Change in M is what
induces % Changes in P.
The quantity theory of money states that the central bank, which
controls the money supply, has the ultimate control over the inflation
rate. If the central bank keeps the money supply stable,the price level
will be stable. If the central bank increases the money supply rapidly,
the price level will rise rapidly.
The
Therevenue
revenueraised
raisedthrough
throughthe
theprinting
printingofofmoney
moneyisiscalled
called
seigniorage.
seigniorage. When
Whenthethegovernment
governmentprints
printsmoney
moneyto tofinance
finance
expenditure,
expenditure,ititincreases
increasesthe
themoney
moneysupply.
supply. The
Theincrease
increasein in
the
themoney
moneysupply,
supply,in inturn,
turn,causes
causesinflation.
inflation.Printing
Printingmoney
moneyto to
raise
raiserevenue
revenueisislike
likeimposing
imposingananinflation
inflationtax.
tax.
* Inflation and interest rate
r=i–
This shows the relationship between the
nominal interest rate and the rate of inflation,
where r is real interest rate, i is the nominal
interest rate and p is the rate of inflation, and
remember that p is simply the percentage
change of the price level P.
The Fisher Equation illuminates the distinction between
the real and nominal rate of interest.
Fisher Equation: i = r +
The one-to-one relationship
between the inflation rate and
the nominal interest rate is
the Fisher Effect.
Actual (Market)
Nominal rate of Real rate Inflation
interest of interest
It shows that the nominal interest can change for two reasons: because
the real interest rate changes or because the inflation rate changes.
+gp is high=>i is up to keep equality of r.
Economic growth
I. Definition
y t y t 1
g pct 100%
y t 1
II. Sources of economic growth
1.Human capital
2. Capital accumulation
3. Natural resource
4.Technological knowledge
III.Theories of economic growth
K I
ICOR ICOR
Y Y
Y s
where S=I
Y ICOR
Harrod- Domar model: explains the role of
capital accumulation for economic growth.
s S
(s )
g Y
ICOR
*If ICOR is constant, g increases at the rate of
savings rate.
*Debates: +ICOR is not constant
+Model ignores technology and
human resources
3. Neo-classical economic growth theory
The
The Production
Production Function
Function
The production function represents the
transformation of inputs (labor (L), capital (K),
production technology) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
zY = F (zK ,zL )
2) cc == (1-
(1-ss)y
)y consumption
Output per worker investment
per worker per worker
consumption depends
on savings
per worker
rate
3) yy == (1-
(1-ss)y
)y ++ ii
(between 0 and 1)
i = s f(k)
This equation relates the existing stock of capital k to the accumulation
of new capital i.
The saving rate s determines the allocation of output between
consumption and investment. For any level of k, output is f(k),
investment is s f(k), and consumption is f(k) – sf(k).
y
Output, f (k)
c (per worker)
Investment, s f(k)
y (per worker)
i (per worker)
k
Impact of investment and depreciation on the capital stock: k = i –k
Change in
Capital Stock
Investment Depreciation
Remember investment equals k k
savings so, it can be written:
k = s f(k)– k
Investment, s2f(k)
Investment, s1f(k)
i* = k*
An
Anincrease
increasein
in
the
thesaving
savingrate
rate
causes
causesthe
thecapital
capital
stock
stocktotogrow
growtoto
aanew
newsteady
steadystate.
state.
k1* k2* Capital
per worker, k
c*= f (k*) - k*.
According to this equation, steady-state consumption is what’s left
of steady-state output after paying for steady-state depreciation. It
further shows that an increase in steady-state capital has two opposing
effects on steady-state consumption. On the one hand, more capital
means more output. On the other hand, more capital also means that more
output must be used to replace capital that is wearing out.
The economy’s output is used for
consumption or investment. In the steady
state, investment equals depreciation.
k k Therefore, steady-state consumption is the
Output, f(k)difference between output f (k*) and
depreciation k*. Steady-state
c *gold consumption is maximized at the Golden
Rule steady state. The Golden Rule capital
k*gold k stock is denoted k*gold, and the Golden Rule
consumption is c*gold.
3.2. Conclusions of Solow model
NX = Y - (C + I + G)
NetExports
Net Exports Domestic
Domestic
Output
Output Spending
Spending
This equation shows that in an open economy, domestic spending need
not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
falls short of domestic spending, we import the difference: net exports
are negative.
Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.
Trade Balance
Net Foreign Investment
Net Capital Outflow = Trade Balance
S-I=NX
S-I=NX
If S-I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing.
If S-I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports.
We are now going to develop a model of the
international flows of capital and goods. Then, we’ll
address issues such as how the trade balance responds to
changes in policy.
Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on saving
and investment. We’ll borrow a part of the model from Chapter 3, but
won’t assume that the real interest rate equilibrates saving and
investment. Instead, we’ll allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend
to other countries.
Real
interest S' S
NX = (Y-C(Y-T) - G) - I (r*)
rate, r*
NX = S - I (r*)
NX I(r)
Investment, Saving, I, S
A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
Real
interest S
rate, r*
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
r2*
where S > I.
r1* NX
I(r)
Investment, Saving, I, S
An outward shift in the investment schedule from I(r)1 to I(r)2 increases
the amount of investment at the world interest rate r*.
As a result, investment now
Real exceeds saving I > S, which
interest S means the economy is
rate, r* borrowing from abroad and
running a trade deficit.
r1*
I(r)2
NX I(r)1
Investment, Saving, I, S
In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!
Let’s think about when the US and Japan engage in trade. Each country
has different cultures, languages, and currencies, all of which could
hinder trade. But, because of the foreign exchange market, trade
transactions become more efficient. The foreign exchange market is a
global market in which banks are connected through high-tech
telecommunications systems in order to purchase currencies for their
customers.
The next slide is a graphical representation of the flow of the trade
between the U.S. and Japan, and how the mix of traded things might be
different, but is always balanced. Also, notice how the foreign exchange
market will play the middle-man in these transactions. For instance, the
foreign exchange market converts the supply of dollars from the U.S.
into the demand for yen, and conversely, the supply of yen into the
demand for dollars.
In order for the U.S to pay for its imports of
goods and services and securities from Japan,
it must supply dollars which are then converted
into yen by the
V IC E S foreign
& SE R &
Securities
O O D S exchange
G
market.
DemandYEN Supply$
Foreign
Foreign
Exchange
Exchange
Market
Market
SupplyYEN Demand$
Goods and
Services ES
URI TI
& SEC
To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange 2
American cars for 1 Japanese car.
We can summarize our calculation as follows:
Real Exchange Rate = (120 yen/dollar) (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 Japanese Car
American Car
At these prices, and this exchange rate, we obtain one-half of a Japanese
car per American car. More generally, we can write this calculation as
Real Exchange Rate =
Nominal Exchange Rate Price of Domestic Good
Price of Foreign Good
The rate at which we exchange foreign and domestic goods depends on
the prices of the goods in the local currencies and on the rate at which
the currencies are exchanged.
Nominal
Real Exchange Exchange Ratio of Price
Rate Rate Levels
= e × (P/P*)
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).
Real Exchange Nominal Exchange Ratio of Price
Rate Rate Levels
= e × (P/P*)
The real exchange rate between two countries is computed from the
nominal exchange rate and the price levels in the two countries. If the
real exchange rate is high, foreign goods are relatively cheap, and
domestic goods are relatively expensive. If the real exchange rate is
low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.
How does the level of prices effect exchange rates? It doesn’t. All
changes in a nation’s price level will be fully incorporated into the
nominal exchange rate. It is the law of one price applied to the
international marketplace.
Purchasing Power Parity suggests that nominal exchange rate
movements primarily reflect differences in price levels of nations. It
states that if international arbitrage is possible, then a dollar must
have the same purchasing power in every country. Purchasing
Power Parity does not always hold because some goods are not
easily traded, and sometimes traded goods are not always perfect
substitutes– but it does give us reason to expect that fluctuations in
the real exchange rate will be small and short-lived.
Real The law of one price applied to the
exchange S-I international marketplace suggests that
rate, net exports are highly sensitive to small
movements in the real exchange rate.
This high sensitivity is reflected here
with a very flat net-exports schedule.
NX()
Net Exports, NX
The relationship between the real exchange rate
and net exports is negative: the lower the real
Real S-I exchange rate, the less expensive are domestic
exchange goods relative to foreign goods, and thus the
rate, greater are our net exports.
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
Here the quantity of dollars
NX() supplied for net foreign
investment equals the
0 Net Exports, NX
quantity of dollars demanded
for the net exports of goods
and services.
Real S2-I S1-I Expansionary fiscal policy at home, such as an
exchange increase in government purchases G or a cut in
rate, taxes, reduces national saving.
The fall in saving reduces the supply of dollars
to be exchanged into foreign currency, from
2 S1-I to S2-I. This shift raises the equilibrium real
exchange rate from 1 to 2.
1
NX() A reduction in saving reduces