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Unformatted text preview: Macroeconomics Study Sheet
Macroeconomics studies the determination of economic aggregates.
- Output tends to rise in the long run (long-term economic growth), but
fluctuates in the short run (business cycles).
Peak Real GDP Trough Recession Expansion
Time Short term fluctuations in output and employment (business cycle)
- - In the short run, employment fluctuates with output.
→ Unemployment rate = percentage of people in the labour force who are
Inflation refers to the process of rising prices.
→ Inflation rate = annual percentage change in the price level.
The real interest rate is equal to the nominal interest rate, adjusted for inflation.
The exchange rate is defined as the number of units of domestic currency
required to purchase one unit of foreign currency.
Circular flow of income and expenditure (Y = C + I + G + NX):
Households C S M YD
sector NT Government I Abroad G
C+I+G+NX Measurement of National Income
GDP = value of all final goods and services produced in an economy during a
specified period of time. Value of domestic output (GDP) = value of the expenditure on that output = total
claims to income that are generated by producing that output.
→ Three alternative ways to measure income.
GDP by value added:
Value of a firm’s production – value of intermediate goods bought from other
GDP from the expenditure side:
Ca + Ia + Ga + (Xa – IMa).
GDP from the Expenditure Side Gross domestic product Investment (I) - Expenditures by households on goods and
services. - Consumption (C) Expenditures on capital equipment and
buildings by firms.
Expenditures on new homes by households.
Change in business inventories. - - Expenditures on goods and services by all
levels of the government.
Does not include transfer payments! - Value of exports minus value of imports. - Gov´t expenditures (G)
Net exports (Xa – IMa) Wages, salaries, and
Gross domestic product Net dom. product at market prices Net dom. income at factor cost GDP from the income side:
Factor payments + depreciation + indirect taxes (net of subsidies).
GDP from the income side Interest and
income - Total payments by firms for labour
services. - Net interest payments to
Payments for the use of land
(incl. rent for housing). - - Business profits - Total profits made by corporations.
Net income of farmers and nonfarm unincorporated businesses Indirect taxes less
subsidies - To account for the difference
between factor cost and market
prices. Capital consumption
allowance (depreciation) - To account for the difference
between net and gross domestic
product. Short-run versus long-run Macroeconomics
Potential GDP depends on the amount of factors available, the normal factor
utilization rate, and factor productivity.
→ Changes in any of these variables change potential and actual GDP.
→ There is little, or no effect on the output gap.
Actual GDP may differ from potential GDP because the factor utilization rate is
different from its normal level.
→ Changes in aggregate demand change the factor utilization rate.
→ The output gap widens.
→ Adjustments in factor prices bring the factor utilization rate back to it normal
→ The output gap closes.
output gap Actual GDP
output gap Time The simplest Short-Run Macro Model
Aggregate desired expenditure (AE) = C + I + G + (X – IM).
Assume that consumption expenditure (C) is solely determined by disposable
- C(YD) = autonomous consumption + MPC * YD.
Aggregate desired expenditure depends on national income.
- C, I, and IM tend to increase as national income increases.
Eqm occurs when aggregate desired expenditure = actual national income.
- This condition implies that desired saving = desired investment.
Planned exp. < real GDP 45° line
AE Planned exp. = real GDP Planned exp. > real GDP Real GDP An increase in autonomous expenditure results in an even larger increase in real
- Multiplier effect.
Multiplier = 1/(1 – slope of AE) > 1. Adding Government and Trade to the simple Macro Model
Public saving = net taxes (T) – government purchases (G).
→ Public saving increases as eqm national income rises.
Net exports (NX) = exports (X) – imports (IM).
→ Net exports decrease as eqm national income rises.
Eqm national income occurs where …
… desired aggregate expenditure (AE) = actual national income (Y).
… desired national saving = national asset formation.
planned exp. 45° line Desired AE < Y AE Desired AE = Y Desired AE > Y Real GDP The presence of imports and income taxes reduce z and thus the size of the
→ z = (1 – t)MPC – m.
The government expenditure multiplier is smaller than the government tax
→ Balanced-budget increase in government purchases has a mild expansionary
→ However, effect is smaller than that of deficit-financed increase in expenditure.
Government expenditure (simple) multiplier
Government tax multiplier
Balanced budget multiplier …1…
1 – MPC
1-z Output and Prices in the Short Run
The aggregate demand curve (AD) illustrates the negative relationship between
eqm real GDP and the price level.
Changes in AE (other than changes in the price level) result in a shift of AD.
The short-run aggregate supply curve (SRAS) illustrates the positive
relationship between price level and quantity of aggregate output supplied,
holding technology and factor prices constant.
→ Changes in input prices result in a shift of SRAS.
→ Intersection of AD and SRAS.
SRAS Excess supply P0
Real GDP Aggregate demand and aggregate supply shocks result in shifts of AD and SRAS,
→ The steeper SRAS, the smaller the size of the multiplier. Output and Prices in the Long Run
Output gap = difference between actual output (Y) and potential output (Y*).
→ Potential output is equal to an economy’s long-run aggregate supply (LRAS).
Both aggregate demand and aggregate supply are subject to continual random
→ These shocks lead to temporary changes in real GDP.
→ Real GDP returns to potential GDP through adjustment in input prices. Price level LRAS Price level LRAS SRAS1 SRAS0 SRAS0 E2 P2 E1 P1
P0 SRAS1 Long-run effect of a
demand shocks Y0=Y* Y1 AD0 E2 AD0
LRAS Price level E0 E1 P2 AD1 E0 P0
P1 AD1 Y1 Y0=Y* Real GDP SRAS0 = SRAS2
Long-run effect of a
supply (SRAS) shock E0 = E2 P0 E1 P1 AD0 Y0=Y* Y1 Real GDP Short run eqm is given by the intersection of AD and SRAS.
Long run eqm is given by the intersection of AD and LRAS.
→ LRAS is vertical at Y = Y*.
→ In the long run, total output is determined solely by conditions of aggregate
Price level LRAS0 LRAS1 Price level LRAS The effects of positive
and negative long-run
E1 P1 E1 P1
AD0 E0 AD1
AD0 Y0* Y1* Real GDP Y0 * Real GDP Fiscal policy may be used to stabilize output and employment.
→ Discretionary fiscal policy:
Change in government expenditure or taxes initiated by an act of parliament.
→ Automatic stabilization:
Change in government expenditure or taxes triggered by the state of the
Most economists today believe that changes in the supply of money …
… have important short-run effects on real GDP and employment.
… have no real effects in the long-run, i.e. in the long run, only the price level
Money serves as medium of exchange, store of value, and unit of account.
The banking system in Canada consists of two main elements:
- Bank of Canada (Canada’s central bank).
- Commercial banks.
Commercial banks can create money, because they only need to hold small
reserves to back their deposit liabilities.
→ Desired reserve ratio (v):
Fraction of its deposits that a commercial bank wants to hold as reserves.
→ ∆ Deposits = ∆ Reserves/v
The Bank of Canada controls the money supply because it has almost complete
control over reserves. Money, Output, and Prices
Present value of an asset:
- Sum of discounted future payments that it generates.
→ Inversely related to the interest rate.
- Equal to the asset’s market price.
(1 + i)n
R2 + … +
PV of a sequence of payments over T periods
(1 + i)T
(1 + i)
(1 + i)2
PV of a perpetual stream of payments
Present Value and the Interest Rate
PV of a single future payment in n years Simple model in which people can divide wealth between bonds and money:
- Money: needed for transactions, precaution, and speculation.
→ Opportunity cost of holding money = interest rate on bonds.
Nominal demand for money depends on real GDP, interest rate, and price level.
Real demand for money = nominal demand for money divided by the price level.
- Varies directly with real GDP and inversely with the interest rate.
An increase (decrease) in the money supply leads to a fall (rise) in interest rates.
→ Aggregate demand rises (falls).
Effect of monetary policy on the price level and real GDP:
- Long run: Only the price level is affected (neutrality of money).
- Short run: Monetary policy is most effective if LP is steep, and ID and SRAS
are flat. Effect of changes in the money supply on real GDP and the price level: short-run
interest MS0 MS1 If ID is flat, a given fall in
the interest rate results in
a relatively large rise in
investment. If LP is steep, a given
rise in MS results in a
relatively large fall in
the interest rate. E0 i0 Rate of
interest E1 i1 ID
LP M0 M1 Quantity of money I1 I0 Price level Investment LRAS
SRAS0 E2 P2 E1 P1
P0 E0 Y0=Y* Y1 AD1
Real GDP Monetary Policy
Major tools the Bank of Canada uses to control the money supply are:
- Open market operations.
- Government deposit shifting.
A rise (fall) in the money supply results in a fall (rise) of interest rates.
- Investment and net exports rise (fall).
- Aggregate demand and eqm real GDP rise (fall).
The Bank of Canada’s policy variables are real GDP and the price level.
- Money supply and interest rates are used as intermediate targets.
Policy instruments are reserves in the banking system (or the monetary base).
Long execution lag of monetary policy makes monetary fine-tunig difficult.
→ Policy may have a destabilizing effect. Inflation
Inflation = process of rising prices.
Without monetary validation, demand (supply) shocks cause temporary bursts of
→ Inflationary (recessionary) gaps are removed by rising (falling) factor prices
→ SRAS shifts leftward (rightward).
→ Real GDP returns to potential GDP, the price level rises (falls).
→ Real GDP returns to potential GDP and the price level to its initial level.
Price level LRAS
SRAS0 E2 P2 E1 P1
P0 AD1 E0 AD0 Y0=Y* Y1
Price level Real GDP LRAS
P1 AD3 P0 E0 Y* Y AD2
Real GDP Only with continuing monetary validation can inflation initiated by either
supply or demand shocks continue indefinitely.
The Phillips curve describes the relationship between unemployment and the rate
of change of wages.
- Short run: Phillips curve is downward sloping (SRPC).
- Long run: Phillips curve is vertical at U* (LRPC). Rate of change
of wages LRPC
U1 U* Unemployment rate Disinflation = reduction in the rate of inflation.
- Cost = cost of the recession that is generated by the process (sacrifice ratio). Unemployment
Cyclical unemployment is the difference between the actual level of employment
Two opposing theories that try to explain causes of cyclical unemployment:
- New Classical theories (no involuntary unemployment).
- New Keynesian theories (involuntary employment).
- Tendency of employers to smooth income of
employees by paying a steady money wage and
letting profits and employment fluctuate to
absorb effects of temporary changes in demand. - Changing prices and wages in response to
minor and temporary changes in demand is
costly and time consuming (only infrequent
adjustment). Efficiency wages - Paying a wage premium may be profitable if it
raises workers´ efficiency. Union bargaining - Those already employed (union members) will
wish to bid up wages (above eqm). Long-term employment
relationships Menu costs and wage
contracts NAIRU is composed of frictional and structural unemployment. Budget Deficits and Surpluses
Annual budget deficit = change in outstanding debt = (G + TR + i * D) – T
Primary budget deficit = (G + TR) - T
The budget deficit function (B) describes the inverse relationship between the
budget deficit and real GDP. $ CAD
Real GDP B Cyclically adjusted deficit (CAD): estimate of the gov´t budget deficit for Y = Y*.
→ Changes in CAD determine the stance of fiscal policy.
Change in debt-to-GDP ratio: ∆d = x + (r – g)d
If taxpayers are not purely Ricardian, a reduction in taxes along with an
increase in the budget deficit will result in crowding out of …
… investment (closed economy).
… net exports (open economy).
→ Government deficits redistribute resources away from future generations
An increase in government debt may impede the conduct of monetary and fiscal
Even with positive overall deficits the debt-to GDP ratio may be falling. Economic Growth
Economic growth is the increase in potential output due to:
- Increases in factor supplies.
- Increases in factor productivity.
Investment in productive capacity results in a rightward shift of LRAS.
The neoclassical theory of growth displays …
… diminishing returns when one factor is increased on its own.
… constant returns when all factors are increased proportionately.
Along a balanced growth path, capital and labour grow proportionately.
- GDP rises, but GDP per capita is unchanged (no improvement in living
New growth theories treat technological change as endogenous.
Some modern growth theories diplay constant or increasing returns to investment.
→ Emphasize the unlimited potential of knowledge-driven technological
Resource exhaustion and pollution put limits to growth. International Trade
Gains from trade arise from different opportunity costs.
→ Specialization in the activity in which opportunity costs are lowest. → World producion increases.
→ Consumption possibilities increase.
Wheat Wheat Country A Country B Consumption
… with trade Consumption
… with trade … without trade;
slope = - 1/2 … without trade;
slope = - 3/2
Wine Wine Additional gains from trade arise in cases of:
→ Economies of scale, greater product variety, learning-by-doing.
Patterns of trade:
→ Countries export goods for which they have a comparative advantage.
→ Countries import goods for which they have a comparative disadvantage.
Terms of trade:
→ Ratio of the average price of a country´s exports to the average price of its
→ Determines the division of the gains from trade. Trade Policy
Free trade through specialization, allows for maximization of world output.
There are some national objecitves that are used arguments against free trade.
Common methods of protection:
→ Tariffs, quotas, voluntary export restrictions, nontariff barriers.
($) S pW + tariff
pW A C B D
D q0 q3 q4 q1 Quantity World trade organization (WTO):
→ Created in 1995 as the successor to GATT.
→ Contains a formal dispute-settlement mechanism.
Different forms of regional trade agreements:
→ Free trade areas, customs unions, common markets.
→ Establishes a free-trade area among Canada, Mexico, and the United States. Exchange Rates and Balance of Payments
Balance of payments accounts:
→ Current account + capital account + official financing account ≡ 0.
Exchange rate: price of foreign currency in terms of domestic currency.
→ Fall (rise) in the exchange rate = appreciation (depreciation) of the domestic
Supply of foreign exchange:
→ Transactions that represent a receipt in Canada´s balance of payments.
→ Supply curve is upward sloping.
Demand for foreign exchange:
→ Transactions that represent a payment in Canada´s balance of payments.
→ Demand curve is downward sloping.
Flexible exchange rate regime:
→ Exchange rate is determined by demand and supply from capital and current
Fixed exchange rate regime:
→ Balance on the official financing account has to offset the excess demand /
of foreign exchange arising from capital and current account.
Purchasing power parity (PPP): PCanada = e * PAbroad. ...
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- Spring '10