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Macroeconomics Study Sheet
MACROECONOMICS
- 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 ).
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 unemployed. - 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).
THE MEASUREMENT OF
NATIONAL INCOME
- GDP = value of all final goods and services produced in an economy during a specified period of time Volumes
- 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 firms.
- GDP from the expenditure side: Ca + I (^) a + Ga + (Xa – IMa). - GDP from the income side : Factor payments + depreciation + indirect taxes (net of subsidies). - Implicit GDP deflator = Nominal GDP * 100 Real GDP
CONSUMPTION
(C)
Expenditures by households on goods and services.
I NVESTMENT (I)
Expenditures on capital equipment and buildings by firms. Expenditures on new homes by households. Change in business inventories.
G OV´ T
EXPENDITURES
(G)
Expenditures on goods and services by all levels of the government. Does not include transfer payments!
G
ROSS DOMESTIC PRODUCT
NET EXPORTS
(X A – IM A)
Value of exports minus value of imports. GDP from the Expenditure Side W AGES, SALARIES , AND SUPPLEMENTAR Y LABOUR INCOME
Total payments by firms for labour services.
I NTEREST AND
MISCELLANEOUS INVESTMENT INCOME
Net interest payments to households. Payments for the use of land (incl. rent for housing).
N
ET DOM
.^ INCOME AT FACTOR COSTBUSINESS
PROFITS
Total profits made by corporations. Net income of farmers and non- farm unincorporated businesses
N
ET DOM
.^ PRODUCT AT MARKET PRICES
I NDIRECT TAXES
LESS SUBSIDIES
To account for the difference between factor cost and market prices.
G
ROSS DOMESTIC PRODUCT
C APITAL
CONSUMPTION ALLOWANCE (DEPRECIATION )
To account for the difference between net and gross domestic product. GDP from the income side
SHORT RUN VS. 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 level. → The output gap closes.
Potential GDP and actual GDP
T HE SIMPLEST SHORT-RUN M ACRO M ODEL
- Aggregate desired expenditure (AE) = C + I + G + (X – IM).
- Assume that consumption expenditure (C) is solely determined by disposable income (YD).
- **C(YD) = autonomous consumption + MPC *** YD.
Marginal Propensity to Consume: Slope of the consumption function
The Consumption Function: Savings and Dissavings
- Aggregate desired expenditure depends on national income.
C(YD )
C
500
400
300
200
100
100 200 300 400 500 Y D
Saving
Dissaving
C
500
400
300
200
100
100 200 300 400 500 YD
Slope = MPC = 150/ = 0.
∆YD = 200
∆C = 150
C(YD )
Autonomous consumption
Time
Actual GDP
Potential GDP
Negative output
Positive output
Financial sector
Government
Firms
Households
Abroad
Y
C
NT
S
G
X
I
C+I+G+N
M
Time
Trough
Real GDP
Potential
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- 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.
Aggregate planned Expenditure vs. Real GDP
- An increase in autonomous expenditure results in an even larger increase in real GDP.
- 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.
Expressing desired aggregate expenditure as a function of Y as well.
- The presence of imports and income taxes reduce z and thus the size of the multiplier : → z = (1 – t)MPC – m. - The government expenditure multiplier is smaller than the government tax multiplier. → Balanced-budget increase in government purchases has a mild expansionary effect. → However, effect is smaller than that of deficit- financed increase in expenditure.
Government expenditure (simple) multiplier
1 – z
Government tax multiplier
- MPC
1 – z Balanced budget multiplier
1 – MPC
1 - z Multipliers
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.
Aggregate Demand Curve
Shifts in the AD curve (aggregate demand shocks)
- 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.
Supply side of the Economy
- Macroeconomic equilibrium: → Intersection of AD and SRAS.
Price level
Y 0 Real GDP
AE =
AE 1
AE 0
Desired AE
1,
1,
1,
800
600
Y 0 Y 1 Real GDP
E 0
AD 0
Price level
130
Y 0 Y 1 Real GDP
E 1
∆A
E 1
∆Y
AE 2
AE 0
AE 1
Aggregate planned exp. 1,
1,
1,
800
600
600 800 1,000 1,200 1,400 Real GDP
AD 0
Decrease in price level
Increase in price level
AD
Price level
130
600 800 1,000 1,200 1,400 Real GDP
Increase in price level
Decrease in price level
AE
Aggregate planned exp. 1,
800
600
400
200
200 400 600 800 1,000 Real GDP
Desired AE < Y 45°
Desired AE > Y
Desired AE = Y
AE
Aggregate planned exp. 1,
800
600
400
200
200 400 600 800 1,000 Real GDP
Planned exp. < real 45°
Planned exp. > real
Planned exp. = real
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Advances to banks Gov´t of Canada deposits Foreign-currency assets
Deposits of banks (reserves) Other assets Foreign-currency liabilities Other liabilities and capital Assets and Liabilities of the Central bank in Canada: Bank of Canada Assets Liabilities Reserves Demand deposits Mortgage and non-mortgage loans
Savings deposits
Canadian securities
Time deposits
Foreign- currency assets
Gov´t of Canada deposits
Other assets Foreign-currency liabilities Shareholders´ equity Other liabilities
Assets and Liabilities of Commercial Banks in Canada
- 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.
Assets Liabilities Cash and other reserves
200 Deposits 1000
Loans 900 Capital 100 1100 1100 Initial, hypothetical balance sheet of a commercial bank:
Assets Liabilities Cash and other reserves
220 Deposits 1100
Loans 980 Capital 100 1200 1200 Suppose that the Bank of Canada buys $100 worth of securities on the open market.
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.
PV of a single future payment in n years
R…
(1 + i) n
PV of a sequence of payments over T periods
R 1 .. + R 2 + … +
RT …
(1 + i) (1 + i) 2 (1 + i)T
PV of a perpetual stream of payments
R…
i
Present Value and the Interest Rate
- 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.
Liquidity preference function (LP)
- 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.
Liquidity preference theory of interest
Effect of changes in the money supply on real GDP and the price level: long run
Effect of changes in the money supply on real GDP and the price level: short run
SRAS 0
Price level
P 2
P 1
P 0
Y 0 =Y* Y 1 Real GDP
AD 0
LRAS
AD 1
SRAS 1
E 1
Exces s
Exces s
Nominal rate of interest
i (^2)
i (^0)
i (^1)
M 2 M 0 M 1 Quantity of money
LP
E
Nominal rate of interest
i (^0)
i (^1)
M 0 M 1 Quantity of money
LP
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MONETARY POLICY IN CANADA
- Major tools the Bank of Canada uses to control the money supply are:
- Open market operations.
- Government deposit shifting.
Private households Assets Liabilities Bonds - Deposits + Commercial bank Assets Liabilities Reserves +100 Demand deposits
Bank of Canada Assets Liabilities Bonds +100 Com. bank deposits
Open Market Operations
Commercial bank Assets Liabilities Reserves +100 Gov´t deposits + Bank of Canada Assets Liabilities Gov´t deposits - Com. Bank deposits
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. Y > Y* (inflationary gap) - U < U* (excess demand for labour) - Wages and unit costs tend to rise. Y < Y* (recessionary gap) - U > U* (excess supply of labour) - Wages and unit costs tend to fall. Adding Inflation to the Model
Constant Inflation
- Without monetary validation, demand (supply) shocks cause temporary bursts of inflation. → 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.
Demand Shocks
Supply Shocks
- 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.
- Long run : Phillips curve is vertical at U*.
Phillips Curve
- 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 and NAIRU.
- Two opposing theories that try to explain causes of cyclical unemployment:
- New Classical theories (no involuntary unemployment).
- New Keynesian theories (involuntary employment).
Long-term employment relationships
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.
Menu costs and wage contracts
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).
- NAIRU is composed of frictional and structural unemployment.
Rate of change of wages
W 2
W 1
U 1 U* Unemployment rate
NAIRU
E 2
SRAS 0
Price level
P 2
P 1
P 0
Y 1 Y 0 =Y* Real GDP
AD 0
AD 1
SRAS 1
E 2
SRAS (^0)
Price level
P 2
P 1
P 0
Y 0 =Y* Y 1 Real GDP
AD 0
LRAS
AD 1
SRAS (^1)
E 1
E 0
SRAS (^0)
Price level
P 2
P 1
P 0
Y* Y Real GDP
AD 0
LRAS
AD 1
SRAS 1
AD 2
SRAS 2
AD 3
E 0
E 2
SRAS (^0)
Price level
P 2
P 1
P 0
Y = Y* Real GDP
AD 0
AD 1
SRAS (^1)
E 1
AD 2
SRAS 2
