FOREIGN TRADE UNIVERSITY

Department of Macroeconomics

MACROECONOMICS

Hoang Xuan Binh (Assoc. Prof. PhD.)

Dean of Faculty of International Economics
 CHAPTER I

INTRODUCTION LECTURE PROGRAMME

 Introduction

Module title: Macroeconomics

Semester: I
Year 2022-2023
Level: Undergraduate
Module Convenor: Hoang Xuan Binh
Office hours: 8.00 -12.00 on Monday
Room: B208- Foreign Trade University
(Hanoi Campus)
Tel: 844-32595158 ext 508
Mobile: 091278.2608; 099322.6888
Email:binhhx@ftu.edu.vn
 INTRODUCTION

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

Module aims and objectives:

1.To familiarise the students with some of the most
important macroeconomic variables in the
economy, for example GDP,GNP,CPI,PPI…
2.To introduce students to some important
macroeconomic policies including fiscal and
monetary policies.
3.To examine some different cases in term of using
macroeconomic policies to develop economy.
 Introduction
Learning outcomes
By the end of this module it is expected that students:
1.will have an understanding of how important
macroeconomic variables are interacting in the
economy.
2.will be able to interpret such variables and events as
GDP,GNP,CPI or inflation,unemployment… and relate
them to changes of other variables and events in the
economy.
3.will be ready to explain significant events in real
economy by using economic theories.
4.will be familiar with current debates on open-
economy and able to make a critical assessment of the
various arguments which are put forward.
Teaching and learning methods:
In class contact hours there will be lectures,
discussions and assistance with students’assignment
work,reading and using books. During the seminars the
students will be expected to discuss the provided
topics on the problems of real economy.
Assessment methods:
There is a written assignment and final examination.
It is worthy 30% and 60% respectively. Class
participation is 10% .
Suggested Supplementary Reading
Mankiw, Principles of Economics 7th ed.
Mankiw, Macroeconomics 8th ed. ,
Sloman J., (2003), Economics, 5th ed.
 Lecture programme
Chapter 1: Introduction lecture programme

Chapter 2:The Data of Macroeconomics

Chapter 3:Aggregate Demand and Fiscal policy

Chapter4:Money and Monetary policy

Chapter 5:AD- AS Model

Chapter 6:Inflation and unemployment

Mid term presentation assignment

Chapter 7:Economic growth

Chapter 8: The Open economy

 I.Introduction
Everyone is concerned about macroeconomics
lately. We wonder why some countries are growing faster
than others and why inflation fluctuates. Why?
Because the state of the macroeconomy affects
everyone in many ways. It plays a significant
role in the political sphere while also affecting
public policy and social well-being.

There is much discussion of recessions-- periods in which real

GDP falls mildly-- and depressions, concerns with issues such as
inflation, unemployment, monetary and fiscal policies.
Economists use models to understand what goes on in the economy.
Here are two important points about models: endogenous variables
and exogenous variables. Endogenous variables are those which the
model tries to explain. Exogenous variables are those variables that
a
model takes as given. In short, endogenous are variables within a
model, and exogenous are the variables outside the model.
Price Supply
This is the most famous
P* economic model. It describes
the ubiquitous relationship
Demand between buyers and sellers in
the market. The point of
Q* Quantity intersection is called an
equilibrium.
Economists typically assume that the market will go into
an equilibrium of supply and demand, which is called
the market clearing process. This assumption is central
to the Pho example on the previous slide. But, assuming
that markets clear continuously is not realistic. For
markets to clear continuously, prices would have to
adjust instantly to changes in supply and demand. But,
evidence suggests that prices and wages often adjust
slowly.

So, remember that although market clearing models

assume that wages and prices are flexible, in actuality,
some wages and prices are sticky.
 Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
marketplace. In microeconomics, a person chooses to
maximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many

people trying to maximize their own welfare. Therefore, when
we study macroeconomics, we must consider its
microeconomic foundations.
II. Research aims and research methods:

1. Aims and objectives of macroeconomics

Yield, Economic growth, unemployment,

inflation, budget, Balance of Payments,

2. Research method
- Mathematics, general equilibrium, Walras
methods (equilibrium in all market…
III. Macroeconomics system
1. Inputs
+ Exogenous variables: weather, politics,
population, technology and patents or
know-how
+Endogenous variables: direct impacts-
fiscal policy,monetary policy, external
economic policy
2. Black box: AS+AD
2.1. Aggregate Demand
*Related factors: Price, Income, Expectation…

2.2.Aggregate Supply

* Related factors: Price,production cost,

potential output (Y*)

Y*: maximization of output which economy

can produce, with full-employment and no
inflation.
Full-employment=population–outof working
age - invalids -(pupils + students) – servant-
unwilling to work
3. Outputs

Yield, employment,
Average price,
Inflation,interest,budget,
Trade balance and balance of
International payment,
Economic Growth
Macroeconomics
Recession
Depression
Models
Macroeconomic system
Inputs
Outputs
Endogenous variables
Exogenous variables
Market clearing
Flexible and sticky prices
Microeconomics
 CHAPTER II

DATA OF MACROECONOMICS
I. Gross domestic products-GDP

Gross Domestic Product (GDP) is the

market value of all final goods and
services produced within an economy
in a given period of time.
 Income, Expenditure
And the Circular Flow
There are 2 ways Total income of everyone in the economy
of viewing GDP Total expenditure on the economy’s
output of goods and services
Income $
Labor
Households Firms
Goods

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

GDP = (Price of apples  Quantity of apples)

+ (Price of oranges  Quantity of oranges)
= ($0.50  4) + ($1.00  3)
GDP = $5.00

2) Used goods are not included in the calculation of GDP.

3) The treatment of inventories depends on
if the goods are stored or if they spoil. If
the goods are stored, their value is
included in GDP.

If they spoil, GDP remains unchanged.

When the goods are finally sold out of
inventory, they are considered used goods
(and are not counted).
4) Intermediate goods are not counted in
GDP– only the value of final goods. Reason:
the value of intermediate goods is already
included in the market price.

Value added of a firm equals the value of the

firm’s output less the value of the
intermediate goods the firm purchases.

5) Some goods are not sold in the marketplace

and therefore don’t have market prices. We must
use their imputed value as an estimate of their
value. For example, home ownership and
government services.
The value of final goods and services measured at
current prices is called nominal GDP. It can change
over time either because there is a change in the
amount (real value) of goods and services or a change in
the prices of those goods and services.
Hence, nominal GDP Y = P  y, where P is the price
level and y is real output– and remember we use output
and GDP interchangeably.
Real GDP or, y = YP is the value of goods and services
measured using a constant set of prices.
 Let’s see how real GDP is computed in our apple and
orange economy.

For example, if we wanted to compare output in 2002 and

output in 2003, we would obtain base-year prices, such as 2002
prices.

Real GDP in 2002 would be:

(2002 Price of Apples  2002 Quantity of Apples) +
(2002 Price of Oranges  2002 Quantity of Oranges).
Real GDP in 2003 would be:
(2002 Price of Apples  2003 Quantity of Apples) +
(2002 Price of Oranges  2003 Quantity of Oranges).
Real GDP in 2004 would be:
(2002 Price of Apples  2004 Quantity of Apples) +
(2002 Price of Oranges  2004 Quantity of Oranges).
 GDP Deflator = Nominal GDP
Real GDP

Nominal GDP measures the current dollar value of the output

of the economy.

Real GDP measures output valued at constant prices.

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 = C + I + G + NX

Total demand Investment

for domestic is composed spending by
output (GDP) of businesses and
households Net exports
or net foreign
Consumption Government demand
spending by purchases of goods
households and services

This is the called the national income accounts identity.

*The Factor Incomes Approach: it measures
GDP by adding together all the incomes paid by
firms to households for the services of the
factors of production they hire. According to
this approach, GDP is the sum of incomes in the
economy during a given period

GDP = w + r + i +  + D +Ti

W: wage, r :rent fixed capital, i: interest, 

profit, D: Depreciation, Ti: indirect tax
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 + NFA

NFA: Net Income From Abroad

*3 cases :

+ GNP > GDP (Tn>0): domestic economy has

impacts in other economies.

+ GNP < GDP (Tn<0): foreign economies have

impacts in domestic economy.

+ GNP = GDP (Tn=0): no conclusion

4. Net Economic Welfare -NEW

GDP, GNP doesn’t compute some goods and

services which aren’t sold, or illegal
transactions or activities of black market,
negative externality…
V1 + Value of Rest
+ Value of goods and services which arent sold
+ Revenues from transactions in black market

V2-negative externality for natural

resources,environment, such as noise traffic jam
…
NEW reflects welfare better than GNPm but it is
very difficult to have enough data to compute
NEW,therefore, economists still use GDP and
GNP.
NNP= GNP-D ; Y=NI=NNP-Te=GNP-D-Ti
Yd = NI - (Td-TR) = (C+S)

Tn
D D-Depreciation
C NNP-Net National
Ti 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).

In 1918, Keynes met Lydia Lopokova, a well-known Russian ballerina, and

they married in 1925. By most accounts, the marriage was a happy one.
Before meeting Lopokova, Keynes's love interests had been men,
including a relationship with the artist Duncan Grant and with the writer
Lytton Strachey. For medical reasons, Keynes and Lopokova were unable
to have children, though both his siblings had children of note.
 I. Aggregate Planned Expenditure and
Aggregate Demand

1.Assumptions: a model nearly always starts

with the word ‘assume’ or ‘suppose’. This is
an indication that reality is about to be
simplified in order to focus on the issue at
hand

*Prices, Wages and Interest Rate are

Constant
*The Economy Operates at less than full
Employment: this implies that firms are
willing to supply any amount of the good
at a given price P. In other words, assume
that the supply of goods is completely
elastic at price P. This assumption is
generally valid only in the short run
*Closed Economy and No Government: we
assume that the economy does not trade with
the rest of the world so that both exports and
imports are equal to zero (X=M=0). We also
assume that there is no government in the
economy so that government expenditures and
taxes are equal to zero (G=T=0). This implies
that aggregate demand is therefore reduced to
the following expression:
AD  C + I
1. Aggregate Planned Expenditure

APE reflects the total planned expenditure at

each income, with assumption of given price.

*Households: Consumption  C = f(Yd):

the main determinant of consumption is
surely income, or more precisely
C = f1(Y)
-Firms: to create the demand through their
investment
I = f2(Y)

APE = C + I = f1(Y) + f2(Y)

1.1. Consumption function
*The relationship between consumption expenditures
and disposable income, other things remaining the
same, is called consumption function. The
consumption function that we will use in our model
and that shows the positive link between consumption
and disposable income is the following (figure 1):

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

+Induced Consumption: this is consumption

expenditure that is in excess of autonomous
consumption and that is induced by an
increase in disposable income
+Marginal Propensity to Consume
(MPC): it is the fraction of a change in
disposable income that is consumed. It is
calculated as the change in consumption
expenditures divided by the change in
disposable income that brought it about.
It gives the effect of an additional pound
of disposable income on consumption. The
MPC determines the slope of the
consumption function

C
MPC 
Y
0 < MPC< 1 :This reflects the fact that
people are likely to consume only part of
any increase in income and to save the rest

*Example. The following is an example of

a consumption function:
C = 20 + 0.7xYd
Autonomous Consumption: 20
MPC = 0.7
+Net Private Savings-S: savings by
consumers is equal to their disposable income
minus their consumption
=> S = Yd - C
and, by using the definition of disposable
income this identity can be rewritten as:
S = Y – T – C (but T = 0, no government)
However, given that there is no government in
our simple economy, T=0 and savings are
equal to: S = Y - C
1.2.The Saving Function: the economy’s
savings function can be derived by using the
private savings expression and the
consumption function:
S Y C
S  Y  C  MPC.Y  C  (1  MPC ).Y
S  C  MPS .Y
+The Marginal Propensity to Save (MPS):
the propensity to save tells us how much
people save out of an additional unit of
income. The assumption we made earlier that
MPC is between zero and one implies that
the propensity to save is given by
(1-MPC) and that it is also between 0 and 1.
The Saving Curve: it traces the relationship
between the level of net saving and income
1.3.Investment function (I): the second
expenditure in APE that we will analyse
today is investment

*Determinants of Investment: we can

distinguish four major determinants of
investment

+Increased Consumer Demand: investment is to provide extra capacity.

This will only be necessary, therefore, if consumer demand increases
(enterprises -> buy date from gg to know about consumer demand)

BIG DATA:
+Expectations: since investment is made in
order to produce output for the future,
investment must depend on firms’
expectations about future market conditions

+Cost and Efficiency of Capital Equipment:

if the cost of capital equipment goes down or
machines become more efficient, the return on
investment will increase and firms will invest
more
+Interest rate: the higher the rate of
interest, the more expensive it will be for
firms to borrow the money to finance their
investment expenditures and the less
profitable will the investment be
+Level of Investment in the Economy: in
this model we will take investment as given
or, in other words, we will regard it as an
exogenous variable. The main reason for
taking investment as given is to keep our
model simple. Thus we will assume that
investment is given by a fixed/constant
amount (a bar over a variables indicates
that the variable is regarded as an
exogenous variable) that does not change
with the level of income in the economy:

I  I
APE  C  I  C  I  MPC .Y

*The Determination of Equilibrium

Output: When P, w is constant,the
equilibrium in the goods market requires
that the supply of goods (GDP=Y) equals
the demand for goods (APE):

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
As you can see the above expression is an
equation in one endogenous variable: Y. Thus
we can solve this equation for Y and this will
give us the equilibrium level of output
(Ye)produced in the economy
1
Ye  (C  I )
1  MPC
I  200

*Example 1. Assume that in the economy the

level of autonomous consumption Co=100,
the marginal propensity to consume is
MPC=0.5 and the investment spending is
I=200.

Determine the equilibrium level of output

produced in the economy.

(SOLUTION IN PHOTOS)
2. APE & Ye in closed economy with a
Government Sector

-Firms invest in economy I  I

-Government sector expenditure: G

+G will increase APE and will shift the APE

curve upwards.
+Taxation reduces the level of disposable
income available for consumption and will
tend to reduce APE.
Such a reduction in APE is reflected by a
downward rotation of the APE curve. Why?
 This is due to the fact that taxation reduces
the overall MPC by the household so that
for each extra pound of income the
household will now consume less since some
of the extra income must be paid in taxes

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

2.2. Taxation depends on income: T = t.Y (t:tax rate)

C  C  MPC (Y  T )  C  MPC (1  t )Y

II 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

This reflects that the income based tax is less

efficient than fixed tax.
3. 2. APE & Ye in open-economy with a
Government Sector and foreign trade
*Assuption: T = t.Y (t- taxrate)
Economy has 4 sector

*C = C + MPC.(Y-T) = C + MPC.(1-t).Y
*I = I
*G = G
*NX=X-M: Net Export
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

*MPM (Marginal Propensity to Import): it is

the fraction of an increase in GDP that is
spent on imports. It is calculated as the
change in imports (M) divided by the
change in GDP ( Y) that brought it about,
other things remaining the same. The MPM
is a positive number smaller than one
MPM = M/  Y and 0<MPM <1
 APE  C  I  G  X  M
APE  C  I  G  X   MPC (1  t )  MPM  Y
*Equilibrium point of economy:
Y  APE
Y  C  I  G  X   MPC (1  t )  MPM  Y
1
Y0  (C  I  G  X )
1  MPC (1  t )  MPM
1
m   open-economy multiplier
1  MPC (1  t )  MPM

m” < m’ < m. open-economy multiplier is less efficient

than closed economy multiplier.
The Multiplier Spending Chain
I = £1 million - Marginal Propensity to Consume: mpc = 0.8
Spending in This Round Cumulative Total I
Round N.
1 £1,000,000 (G £1,000,000 (G1)
2 £ 800,000(C2=0.8*G) £ 1,800,000
3 £ 640,000(C3=0.8*C2) £ 2,440,000
4 £ 512,000(C4=0.8*C3) £ 2,952,000
5 £ 409,600(C5=0.8*C4) £ 3,361,600
6 £ 327,680(C6=0.8*C5) £ 3,689,280
7 £ 262,144(C7=0.8*C6) £ 3,951,424
8 £ 209,715(C8=0.8*C7) £ 4,161,139
9 £ 167,772(C9=0.8*C8) £ 4,328,911
10 £ 134218(C10=0.8*C9) £ 4,463,129
................... .............................................. .....................................
.
50 £ 18(C50=0.8*C49) £ 4,999,929
II.Fiscal policy:
1. Fiscal policy: Government use taxation and
consumption to regulate aggregate demand.

2. Classification of fiscal policy

2.1. Expansionary fiscal policy

2.2. Contractionary fiscal policy

3. Fiscal policy and Budget decifit
*State Budget: total sum of revenues and
consumption of Government in given time
(one year)
B=T-G

+ B = 0: Budget balance
+ B > 0: Budget surplus
+ B < 0: Budget deficit
 *Classification:

- Real budget deficit: When consumption >

revenues

-Cyclic budget deficit: when economy faces

recession due to cyclic business.

-Structural budget deficit: is calculated in term

of assumptions with potential output.
where Btt = Bck + Bcc =>Bcc = Btt - Bck
*Note: fiscal policy can reach following
objectives:

+Budget balance=>Y can fluctuate.. .

+Y*=> Budget deficit can happen. When

there is recession in economy, G increase or
T decrease or both to keep high consumption
=> Y rises to Y* but Budget deficit
happens.
4. How to reduce budget deficit
-Inreasing revenues and decreasing
consumption

-Public debt: Government bond

-Borrowings from foreign countries or

international orgnizations

-Printing money or using reserve from

foreign currency
 CHAPTER IV

MONEY AND MONETARY POLICY

I. Money

1. The Meaning and functions of Money

a.Definition of Money: money is any

commodity or token that is generally
acceptable as the means of payment. A means
of payment is a method of settling a debt. In
general terms money can be defined as the
stock of assets that can be readily used to
make transactions. Roughly speaking, the
coins and banknotes in the hands of the public
make up the nation’s stock of money
 Stock of assets
Money Used for transactions
A type of wealth

Self-sufficiency
Without Money
Barter economy
b. Development of money
Cattle, iron, gold,silver,diamond ….and
banknote today

Batter => commodity money=> cash,

cheque, credit card…

2. The Functions of Money: money has three

main purposes. It is a medium of exchange,
a unit of account and a store of value
2.1. Medium of Exchange: it is an object that
is generally accepted in exchange for goods
and services. Money acts as such a medium

2.2. Unit of Account (A Means of

Evaluation): a unit of account is an agreed
measure for stating the prices of goods and
services. It allows the value of one good to
be compared with another

2.3. Store of Value: any commodity or

token that can be held and exchanged later
for goods and services is called a store of
value. Money acts as a store of value.
 Functions of Money

• Store of value
• Unit of account
• Medium of exchange
• International Money

The ease with which money is converted into other things--

goods and services-- is sometimes called money’s liquidity.
3.Types of Money

*Depend on the Liquidity:

M 0= Cash; (Wide Monetary Base) =
Cash in circulation with the public and held by
banks and building societies +Banks’ balances
with the Central Bank

M1 = Cash + Deposit (D: Deposit is unlimited time

deposit). Liquidity of M1 is smaller than M0 but it is still
good to measure the cash in circulation in economy.

M2= M1 + limited time deposit: Liquidity of M2 is very

low, therefore, there are some developed economies such
as US and UK where use to measure the cash in
circulation.
*Money can be divided into:

Fiat Money: money takes different forms.

Money that has no intrinsic value is called fiat
money because it is established as money by
government decree, or fiat

In the UK economy we make transactions with an

items whose sole function is to act as money:
pound coins and banknotes. These pieces of paper
with the portrait of the queen would have little
value if they were not widely accepted as money.
Commodity Money: although fiat money is
the norm in most economies today,
historically most societies have used for
money a commodity with some intrinsic
value.
Money of this sort is called commodity
money and the most widespread example of
commodity money is gold
II. Central Bank and creation money of commercial
bank

1.Banks are the Financial Intermediaries. They are

private firms licensed by the Central Bank under the
Banking Act to take deposits and make loans and
operate in the economy.

Retail Banks: they specialise in providing branch

banking facilities to member of the general public
but they do also lend to businesses albeit often on a
short-term basis. They are the most important banks
in the UK for the functioning of the economy and for
the implementation of monetary policy
2. The creation of Money by commercial banks

The Creation of Money: banks create

money. However this does not mean that
they have smoke-filled back rooms in
which counterfeiters are busily working.
Notice that most money is deposits, not
currency. What banks create is deposits
and they do so by making loans. But the
amount of deposits they can create is
limited by their reserves
Desired Reserver rate

Required Reserve Rate

Excessive Reserve Rate

 The Deposit Multiplier: this is the amount
by which an increase in bank reserves is
multiplied to calculate the increase in bank
deposits. It is given by the following
formula:
Change in Deposit
Deposit Multiplier 
Change in Reserves

Alternatively, it can also be defined as:

1
Deposit Multiplier 
Desired Reserve Ratio
if banks want to keep 10% of their deposits as
reserves, so that the desired reserve ratio is 0,10 (ra),
the deposit multiplier is given by the following
expression:1/ra =10. See example
 Banking Desired
Deposits Lending
system reserve (ra)
NH1 1 1.ra (1-ra)
NH2 (1-ra) (1-ra).ra (1-ra)2
NH3 (1-ra)2 (1-ra)2 .ra (1-ra)3
... ... ... ...
NH(n+1) (1-ra)n (1-ra)n .ra (1-ra)n+1

n 1 n 1
2 n 1  (1  ra ) 1  (1  ra )
D  1  (1  ra )  (1  ra )  ...  (1  ra )  1  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.

Firstbank Secondbank Thirdbank

Balance Sheet Balance Sheet Balance Sheet
Assets Liabilities Assets Liabilities Assets Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640
Loans $800 Loans $640 Loans $512

Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1000
Firstbank Lending = (1-rr)  $1000 The process of transferring funds
Secondbank Lending = (1-rr)2  $1000 from savers to borrowers is called
Thirdbank Lending = (1-rr)3  $1000
Fourthbank Lending =. (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 and Liquidity Creation
III. Central Bank and money supply

1. Roles of Central Bank

*Supervision of Monetary System: the central

bank oversees the whole monetary system
and ensures that banks and financial
institutions operate as stably and as
efficiently as possible

*Government’s Bank: the central bank is the

acts as the government’s agent both as its
banker and in carrying out monetary policy
2. Functions of Central Bank

*To Issue Notes: the Central Bank is the

sole issuer of banknotes. The amount of
banknotes issued by Central Bank depends
largely on the demand for notes from the
general public
For example, BOE issues banknotes in
England and Wales (in Scotland and
Northern Ireland retail banks issue
banknotes).
*It Acts as a Bank
+To the Government: the government deposits its
revenues from taxation in the central bank and uses
CB in order to borrow money from the market
+To other Recognised Banks: all banks licensed by
CB hold operational balances in the CB. These are
used for clearing purposes between the banks and to
provide them with a source of liquidity
+To Overseas Central Banks: these are deposits in
sterling held by overseas authorities as part of their
official reserves and/or purposes of intervening in
the foreign exchange market in order to influence
the exchange rate of their currency.
*It Manages the Government’s Borrowing
Programme: whenever the government runs a
budget deficit (it spends more than what it
receives in taxes) it will have to finance that deficit
by borrowing. It can borrow by using bonds
(gilts), National Savings certificates or Treasury
bills. The CB organises this borrowing

*It Supervises the Financial System: it advises

banks on good banking practice. It discusses
government policy with them and reports back
to the government. It requires banks to maintain
adequate liquidity: this is called prudential
control.
*It Provides Liquidity to Banks – Lender of
Last Resort: it ensures that there is always
an adequate supply of liquidity to meet the
legitimate demands of depositors in
recognised banks

*It Operates the Government’s Monetary

and Exchange Rate Policy
+Monetary Policy: the CB manipulates the
interest rate in the economy and influence
the size of the money supply
+Exchange Rate Policy: the CB manages the
country’s gold and foreign currency
reserves
3. The Supply of Money
*Definition of Money Supply: the quantity of
money available is called the money supply. In
an economy that uses fiat money, such as
most economies today, the government
controls the supply of money: legal
restrictions give the government a monopoly
on the printing of money

*Monetary Policy: the control over the money

supply is called monetary policy
4. Implement of money supply
a.Measures of Money Supply:
Recall that we can denote money supply as
the sum of currency and deposits
M  C  D
Money Currency Demand Deposits

Central Bank issues H0, (Basic Money, High

Powered Money), H0 < M0. Ho is divided into
U and R
+ Sectors keep a part of Ho, denote as U. U
can’t create other means of payment and it
can be decrease due to damages..in the
circulation. Assuption, U is constant.

+ The rest of Ho denote as R (Ho = U +R). The

banking system will use R to create money as
followings:
 1
D R
ra

Basic Money (H0)

U R

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

*Reserve Requirements: these are regulations

by the central bank that impose on banks a
minimum reserve-deposit ratio. An increase in
reserve requirements raises the reserve-deposit
ratio and thus lowers the money multiplier and
the money supply
*Discount Rate: it is the interest rate that the
central bank charges when it makes loans to
banks. Banks borrow from the central bank
when they find themselves with too few
reserves to meet reserve requirements. The
lower the discount rate, the cheaper are
borrowed reserves and the more banks
borrow at the central bank’s discount
window.

=> discount rate decreases =>the monetary

base and the money supply go up.
*Open-Market Operations: they are the
purchases and sales of government bonds by
the central bank.
When the central bank buys (sells) bonds
from (to) the public, the pounds it pays
(receives) for the bonds increase (decrease)
the monetary base and thereby increase
(decrease) the money supply.

The term 'Open Market' refers to commercial

banks and the general CB conducts an open
market operation, it does a transaction with a
bank or some other business but it does not
transact with the government
Example of US economy?
In the United States, monetary policy is conducted
in a partially independent institution called the
Federal Reserve, or the Fed.
 • To expand the Money Supply:
ury B ond
USTh.e beTarrereofndathsise Uheniretebyd Stproplmeised
ates The Federal Reserve buys U.S. Treasury Bonds
and pays for them with new money.
y bo ci
the prin h it
Treasur
ment of hic
the repay the interest w ated
e pl us rm s st
valu e te
rough th
incurs th
ther eo f. y
stly repa
s will ju d
ted State an
The Uni in its entirety
er s y
its bear efault under an
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will not
ances.
circumst

• To reduce the Money Supply:

nt
Preside
e of the
Signatur
______
_______
______

The Federal Reserve sells U.S. Treasury Bonds

and receives the existing dollars and then
destroys them.
 The Federal Reserve controls the money
supply in three ways.

1) Open Market Operations (buying and

selling U.S. Treasury bonds).
USTh.e T
be
reeraofsutry
ar
ury b
d is
on
he
BitoednSdtatiessed
he Un
reby
prom
rinci
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h it
2)  Reserve requirements (never really
Treas ayment of erest whic ed

used).
ep t t
the r lus the in terms sta
p e
value through th
r s
incu pay
thereo
f. ly re
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s wil rety and
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ni

3) Discount rate which member banks

The U rers in its nder any
ea u
its b t default
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will ces.
rc umstan
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sident
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(not meeting the reserve requirements)

of th
ture
Signa
____
_____
_____
_____

pay to borrow from the Fed.

IV. Money market
1. Money Demand: the demand for money
refers to the desire to hold money: to keep your
wealth in the form of money, rather than
spending it on goods and services or using it to
purchase financial assets such as bond or
shares
2.Reasons for Holding Money
The Transactions Motive: since money is a
medium of exchange it is required for
conducting transactions.
The Precautionary Motive: unforeseen
circumstances can arise, such as a car
breakdown. Thus individuals often hold
some additional money as a precaution

The Speculative Motive: certain firms and

individuals who wish to purchase financial
assets such as bonds or shares may prefer
to wait if they feel that their price is likely
to fall. In the meantime they will hold idle
money balances instead
3.The Demand for Money Function: the
relationship between the demand for money
and the interest rate is described by the demand
for money function
 
d
M  f (Y , i )
This expression simply states that the demand
for money is a function (f) of income Y and the
interest rate I
d
M = denotes the nominal money demand
Y = denotes nominal income (GDP) and it
captures the overall level of transactions in the
economy.
In fact, it is reasonable to assume that the
overall level of transactions is roughly
proportional to nominal income. The positive
sign above Y denotes that there is a positive
relationship between income and demand for
money: the higher the level of income
(transactions) the higher the demand for
money
i = is the interest rate and the negative sign
above it denotes the negative relationship
between the interest rate and the demand for
money. The higher the interest rate, the
smaller the demand for money since
individuals prefer to hold their wealth in
bonds
d. Determinant of money demand

*Level of price:
MDn (nominal Money Demand computing
based on researched price (usually higher than
based price)
MDr (real Money Demand, computing depend
on based price (constant price).

 MDn 
P  
 MDr  MD  const


 MDn 
P  
 MDr  MD  const

*Interest rate (i)
i increases (decreases) => MD decreases
(increases)
*Income (Y)

Y increases (decreases) => MD increases

(decreases)
Money demand function can be written:

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, other things 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

* The Determinants of Money supply

-The level of price: nominal MS doesn’t depend
on P but real MS does because:
MS n
MS n  m  H 0 MS r 
P

-Central Bank: i can change but MS maybe

constant If CentralBank doesn’t want to
change MS.
i MSo

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
s d
M M  f (Y , i )
This equilibrium condition tells us that the
interest rate must be such that people are
willing to hold and amount of money equal
to the existing supply. This equilibrium
relation is also called LM and will be
discussed in more detail in the next lecture
*Note:

+ If I # i0 =>imbalance between supply and

demand which puts pressure to push I up
or down to equilibrium point i0. When MS,
MD changes =>quilibrium point (E)
changes which leads to changes of i0.
V. Monetary policy:

1. Expansionary monetary policy

2.Contractionary monetary policy

 CHAPTER V

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.

*Long-run: P,w, costs change=>TC increases=>

no engine to increases output, Y at potential out.
AS tends to be vertical at Y*.
P LAS SAS

0 Y* Y
II. AD-AS MODEL

P LAS SAS

AD
0 Y* Y
 CHAPTER VI

INFLATION AND UNEMPLOYMENT

I.Unemployment

Unemployment is the number of people of

working age who are without work, but
who are available for work at current
wage rates. If the figure is to be expressed
as a percentage, then it is a percentage of
the total labour force.
-The labour force is defined as: those in
employment (including the self-employed,
those in the armed forces and those on
government training schemes) plus those
unemployed.

-The labour force doesn’t include people

who are out of working age, students,
pupils, invalids. People who are at working
age but unwilling to work doen’t belong to
labour force
 Labour force

Labour employment
force
In
unemployment
Working
Populat age
ion Out of
labour force

Out
2. Computing unemployment rate

u - Unemployment Rate): to be expressed by

fraction of unemployment with the total
labour force. It can be expressed by
percentage as the formula below:
U (Unemployed): L (Labour Force):

U
u   100%
L
Unemployment is a problem for the
economy because:

Output and incomes are lost.

Human capital depreciates.
Crime may increase.
Human dignity suffers.
3. Types and causes of unemployment:

Frictional unemployment occurs when

people leave their jobs, either voluntarily or
because they are sacked or made redundant,
and are then unemployed for a period of
time while they are looking for a new job.
They may not get the first job they apply for,
despite a vacancy existing. The employer
may continue searching, hoping to find a
better-qualified person.
Likewise, unemployed people may choose not
to take the first job they are offered. Instead,
they may continue searching, hoping that a
better job will turn up. The problem is that
information is imperfect. Employers are not
fully informed about what labour is available;
workers are not fully informed about what
jobs are available and what they entail. Both
employers and workers, therefore, have to
search: employers searching for the right
labour and workers searching for the right
jobs.
Structural Unemployment refers to
unemployment arising because there is a
mismatch of skills and job opportunities
when the pattern of demand and production
changes. Examples in the UK include
unemployment resulting from a decline in the
production of textiles, shipbuilding, cars, coal
and steel. Those workers who become
structurally unemployed are available for
work but they have either the wrong skills for
the jobs available or they are in the wrong
location.
Demand-deficient Unemployment is also
referred to Keynesian unemployment.
Demand-deficient unemployment occurs
when aggregate demand falls and wages and
prices have not yet adjusted to restore full
employment. Aggregate demand is deficient
because it is lower than full-employment
aggregate demand which implies that output
is less than full employment output.
Classical Unemployment describes the
unemployment created when the wage is
deliberately maintained above the level at
which the labour market clears. It can be
caused either by the exercise of trade union
power or by minimum wage legislation
which enforces a wage in excess of the
equilibrium wage rate.
II.Inflation
1. Definition
Inflation is a rise in the average price of goods
over time.
The term deflation is used to describe a fall in
the average price of goods over time.

Deflation is very rare, but when it occurs it can

cause serious problems in the economy. The
inflation rate is the percentage change in the
price level.
2. Computing inflation
Gp:price growth rate Pt  Pt 1
gp  100%
Pt 1
t-time
Pt-1: at previous time
Pt: : at current time (research time)
P is to be expressed as follows:

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

Where CPI is the consumer price index and t is

time. The consumer price index measures how
much more a basket of goods that represents
goods purchased by the average householder
costs today compared with some previous time
period.
 Name CPI (I2005/2004) %
A 1,2 30%
B 1,4 25%
C 0,9 15%
E 1,5 30%

CPI2005=1,2x30%+1,4x25%+0,9x15%+1,5x30%=1,295

CPI t  CPI t 1 CPIt-1:

gp  100%
CPI t 1 CPIt:
Note: CPI doesnt reflect changes in quality of
goods and services or of new goods and services.
+ GDP (D: Deflator)
n

GDPn  i i
P t
Q t

D  100%  i 1
n
 100%
GDPr
 i i
P 0

i 1
Q t

D-GDP reflects changes in prices of total fianl

goods and services compare with based
price,therefore, this describes inflation rate.

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

*Moderate Inflation: inflation rate < 10%/n¨m,

prices increases slowly..

Moderate inflation can spur production

because price increases leading to highet profit
for enterprises,therefore, firms will increases
quantity.

*Galloping Inflation: inflation rate is from 10%

to 99% per year. This type will destroy economy
and curb engines of economy.
*Hyper Inflation: is defined as inflation that
exceeds 100% percent per year.
Cagan 50% per month

Costs such as shoe-leather and menu costs are

much worse with hyperinflation– and tax systems
are grossly distorted. Eventually, when costs
become too great with hyperinflation, the money
loses its role as store of value, unit of account and
medium of exchange. Bartering or using
commodity money becomes prevalent.
In 1920s (1922-12/1923) Weimar Germany, CPI
increased from 1 to 10 millions
*Expected inflation: depends on expectation of
individuals about gp in the future. Its impacts is
small but help to adjust production cost.

+Unexpected inflation: derives from exogenous

shocks and unexpected factors inside economy.
The inconvenience of reducing money
holding is metaphorically called the
shoe-leather cost of inflation, because
walking to the bank more often induces
one’s shoes to wear out more quickly.

When changes in inflation require printing

and distributing new pricing information,
then, these costs are called menu costs.

Another cost is related to tax laws. Often

tax laws do not take into consideration
inflationary effects on income.
Unanticipated inflation is unfavorable because it arbitrarily
redistributes wealth among individuals.

For example, it hurts individuals on fixed pensions. Often these

contracts were not created in real terms by being indexed to a
particular measure of the price level.

There is a benefit of inflation– many economists say that some

inflation may make labor markets work better. They say it
“greases the wheels” of labor markets.
3. Causes 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.

*Inflation and Money: equilibrium point of

money market
MS n
 MS r  MDr  kY  hi
P
 In other words, if Y is fixed (from Chapter 3) because it depends
on the growth in the factors of production and on technological
progress, and we just made the assumption that velocity is constant,

MV = PY
or in percentage change form:
% Change in M + % Change in V = % Change in P + % Change in Y
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 revenue raised through the printing of money is called
seigniorage. When the government prints money to finance
expenditure, it increases the money supply. The increase in
the money supply, in turn, causes inflation. Printing money to
raise revenue is like imposing an inflation tax.
* Inflation and interest rate

Economists call the interest rate that the bank pays

the nominal interest rate and the increase in your
purchasing power the real 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.

+Economy has high i lead to high gp or i can

explains gp of economy.

+If real gp > expected gp => borrowers get

advantages
+If real gp < expected gp => lenders get
advantages
4.Policies to deal with inflation

4.1.Fiscal policy comprises changes in

government expenditure and/or taxation. The
aim is to affect the level of AD through a policy
known as demand management. In the case of
controlling inflation, this involves reducing
government expenditure and/or increasing
taxation in what is called a deflationary fiscal
policy. Such policies are likely to be effective if
inflation has been diagnosed as demand-pull since
a reduction in government expenditure or an
increase in income tax will reduce aggregate
demand in the economy.
4.2.Monetary policy is concerned with influencing
the money supply and the interest rate. In terms
of controlling inflation, the government can aim to
reduce the money supply thus reducing spending
and, therefore, the aggregate demand, or it can
increase the interest rate so as to increase the cost
of borrowing. Both policies can be seen as
deflationary monetary policy. Since monetarists
view the growth of the money supply as being the
main cause of inflation, any control of inflation
from a monetarist viewpoint must involve control
of the money supply.
4.3.Prices and incomes policy aim to limit and,
in certain cases, freeze wage and price
increases. In the past they have either been
statutory or voluntary. Statutory prices and
incomes policies have to be enforced by
government legislation, such as the EU
minimum wage legislation. With a voluntary
prices and incomes policy the government
aims to control prices and incomes through
voluntary restraint, possibly by obtaining the
support of the unions and employers.
4.4. Supply-side policy is concerned with
instituting measures aimed at shifting the
aggregate supply curve to the right. Supply-
side economics is the use of microeconomic
incentives to alter the level of full employment
and the level of potential output in the
economy. If inflation is caused by cost-push
pressures, supply-side policy can help to
reduce these cost pressures in two ways:
(1) by reducing the power of trade unions
and/or firms (e.g. by anti-monopoly
legislation) and thereby encouraging more
competition in the supply of labour and/or
goods, (2) by encouraging increases in
productivity through the retraining of labour,
or by investment grants to firms, or by tax
incentives, etc.
4.5.Learning to live with inflation involves
accepting the fact that inflation is here to stay
when standard anti –inflationary policy measures
appear ineffective. In such a situation we just
have to learn to live with inflation. Learning to
live with inflation involves the government,
employers and workers taking inflation into
account in their everyday transactions. For
example, the government/employers may use
indexation in wage/pensions contracts. Indexation
is when wages or pensions are increased in line
with the current rate of inflation. Indexation is
aimed at nullifying the effects of inflation.
 CHAPTER VII

Economic growth
I. Definition

An increase on potential output

Economic growth or developments?

II.Computing of economic growth
*Computed by % changes in real GDP
Yt  Yt 1
gt   100%
Yt 1
+gt: according to real GDP

*gpct : by GDP per capita ( Ýn case

population increases faster than GDP)

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

1. Classical theory of Adam Smith vµ Malthus

Land plays an important role for economic

growth.

+Adam Smith: gold age

+Malthus: dull age

 2. Economic growth theory of Keynes

I increases => outputs and income

increase=> capital .acc is up=> G should
invest to push AD, lead to ecnomic growth.

ICOR (Incremental Capital-Output Ratio )

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

Solow model or Solow-Swan Model

3.1. Introduction: paper of economic

growth were issued in 2/1956 and 11-1956
of two economists are Solow and Swan

*Why it is neo-classical theory: use the

role of market and government
The Solow Growth Model is designed to show how
growth in the capital stock, growth in the labor force,
and advances in technology interact in an economy,
and how they affect a nation’s total output of
goods and services.

Let’s now examine how the

model treats the accumulation
of capital.
 Let’s analyze the supply and demand for goods, and
see how much output is produced at any given time
and how this output is allocated among alternative uses.

The Production 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 )

Income is some function of our given inputs

Key Assumption: The Production Function has constant returns to scale.
This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )

Output is some function of the amount of

Per worker capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )

Output is some function of the amount of

Per worker capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
 MPK = f (k + 1) – f (k)
The production function shows
y how the amount of capital per
worker k determines the amount
f(k)
of output per worker y=f(k).
MPK The slope of the production function
1 is the marginal product of capital:
if k increases by 1 unit, y increases
by MPK units.
k
 1) y=c+i

2) c = (1-s)y consumption
Output per worker investment
per worker per worker

consumption depends
on savings
per worker
rate
3) y = (1-s)y + i
(between 0 and 1)

Investment = savings. The rate of saving s

4) i = sy is the fraction of output devoted to investment.
 Here are two forces that influence the capital stock:

• Investment: expenditure on plant and equipment.

• Depreciation: wearing out of old capital; causes capital stock to fall.

Recall investment per worker i = s y.

Let’s substitute the production function for y, we can express investment
per worker as a function of the capital stock per worker:

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

Depreciation is therefore proportional

to the capital stock.
k
Investment
and Depreciation
Depreciation, k
At k*, investment equals depreciation and
capital will not change over time. Below k*,
investment
exceeds
Investment, s f(k) depreciation,
i* = k* so the capital
stock grows.
Above k*, depreciation
exceeds investment, so the
capital stock shrinks.
k1 k* k2 Capital
per worker, k
 The Solow Model shows that if the saving rate is high, the economy
will have a large capital stock and high level of output. If the saving
Investment
and
rate is low, the economy will have a small capital stock and a
Depreciation low level of output. Depreciation, k

Investment, s2f(k)
Investment, s1f(k)
i* = k*
An increase in
the saving rate
causes the capital
stock to grow to
a new steady 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

+The role of savings for economics growth

+Capital accumulation is good for short-run

economic growth

+Techonology is the determinant of long-

run economic growth
4. Policies for economic growth

4.1. Increasing domestic savings and investment

4.2. Attracting FDI

4.3. Improving human resources

4.4. R&D of new techonology

4.5. Stability of politics and economy

4.6. The open-door policy

4.7. Curbing growth of population

 CHAPTER VIII

The Open Economy

 Y = C + I + G + NX

Total demand Investment

is composed spending by Net exports
for domestic
of businesses and or net foreign
output
households demand
Consumption Government
spending by purchases of goods
households and services
Notice we’ve added net exports, NX, defined as EX-IM. Also, note that
domestic spending on all goods and services is the sum of domestic
spending on domestics goods and services and on foreign goods and
services.
 Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:

NX = Y - (C + I + G)

Net Exports Domestic

Output
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.

Let’s call this S, national saving.

So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX

Trade Balance
Net Foreign Investment
 Net Capital Outflow = Trade Balance

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 negative, we have a trade deficit. We would be net

borrowers in world financial markets, and we are importing more
goods than we are exporting.

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.

Consider a small open economy with perfect capital mobility in

which it takes the world interest rate r* as given, denoted r = r*.

Remember in a closed economy, what determines the interest rate is the

equilibrium of domestic saving and investment--and in a way, the world
is like a closed economy-- therefore the equilibrium of world saving and
world investment determines the world interest rate.
 Y = Y = F(K,L) The economy’s output Y is fixed by the
factors of production and the production
function.
C = C (Y-T) Consumption is positively related to
disposable income (Y-T).
I = I (r) Investment is negatively related to the
real interest rate.
NX = (Y-C-G) - I The national income accounts identity,
or NX = S - I expressed in terms of saving and investment.
Now substitute our three assumptions from Chapter 3 and the condition
that the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.
 Real
interest S In a closed economy, r adjusts to
rate, r* equilibrate saving and investment.
NX
In a small open economy, the
r* interest rate is set by world
financial markets. The difference
between saving and investment
rclosed determines the trade balance.
r*'
I(r)
NX
Investment, Saving, I, S
In this case, since r* is above rclosed and saving exceeds investment,
there is a trade surplus.
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.

Real
interest S' S
NX = (Y-C(Y-T) - G) - I (r*)
rate, r*
NX = S - I (r*)

The result is a reduction in national

saving which leads to a trade deficit,
r* where I > S.

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
Exchange
Market
SupplyYEN Demand$
Goods and
Services
URI TI ES
& SEC

In order for Japan to pay for its imports of

goods and services and securities from the
U.S., it must supply yen which are then converted
into dollars by the foreign exchange market.
The exchange rate between two countries is the price at which
residents of those countries trade with each other.
 -relative price of the currency of two countries
-denoted as e

-relative price of the goods of two countries

-sometimes called the terms of trade
-denoted as 
The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.
Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?

e S$ D$ shifts rightward and increases

the nominal exchange rate, e.
e1 This is known as appreciation
B
A of the dollar.
e0
Events which decrease the
demand for the dollar, and thus
D  decrease e would be a
$

D$ depreciation of the dollar.

$
Dollar Value of Transactions
 
The real exchange rate is the relative price of the goods of two
countries. That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.

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

NX2 NX1 Net Exports, NXthe supply of dollars which

causes the real exchange rate
to rise and causes net exports
to fall.
Real S-I(r1*) S-I (r2*) Expansionary fiscal policy abroad reduces
exchange world saving and raises the world interest
rate,  rate from r1* to r2*.
The increase in the world interest rate reduces
investment at home, which in turn raises the
supply of dollars to be exchanged into foreign
1
currencies.
2 As a result, the equilibrium
NX() real exchange rate falls from
1 to 2.
NX1 NX2 Net Exports, NX
Real S-I2 S-I1 An increase in investment demand raises
exchange the quantity of domestic investment from I1
rate,  to I2.
As a result, the supply of dollars to be
exchanged into foreign currencies falls
from S-I1 to S-I2.
2
This fall in supply raises the
1 equilibrium real exchange
NX() rate from 1 to 2.

NX2 NX1 Net Exports, NX