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Macro - Review

Macro - Review. GDP = C + I + G + NX MV = P Q (= $GDP). Circular Flow. GDP: Real and Nominal. Gross Domestic Product (GDP): the market value of all final goods and services produced within a country during a year. GDP = C + I + G + Ex – Im = C + I + G + NX

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Macro - Review

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  1. Macro - Review GDP = C + I + G + NX MV = P Q (= $GDP)

  2. Circular Flow

  3. GDP: Real and Nominal • Gross Domestic Product (GDP): the marketvalue of all finalgoods and services produced within a country during a year. GDP = C + I + G + Ex – Im = C + I + G + NX • Real GDP adjusts for inflation Nominal GDP = $GDP = P x Q $ GDP = GDP Deflator x Real GDP Real GDP = Q = $GDP/P = Nominal GDP divided by (deflated by) the GDP Price Deflator

  4. Price Indexes (Base Year = 100) • Consumer Price Index (CPI) • cost over time of a typical bundle of goods and services purchased by households. CPI = Cost of Typical Market Basket Now divided by Cost of the Same Basket in Base Year Inflation Rate = {Change in CPI} ÷ {Initial CPI} • GDP Price Deflator (GDP Price Index) • measures average prices over time of all goods and services included in GDP.

  5. number unemployed number in the Labor Force Unemployment Unemployment rate: % of labor force not working. Rate ofUnemployment = • Unemployed persons: not working and looking • Labor force: Employed + unemployed noninstitutionalized persons 16+ years of age • Underemployed workers are treated as employed • Discouraged workers are not in the labor force • “Natural” or normal rate of unemployment (NAIRU) • Seasonal Unemployment • Frictional Unemployment: searching for jobs • Structural Unemployment: Imperfect match between employee skills and requirements of available jobs. • Cyclical Unemployment : Results from business cycle

  6. Interest Rates: Nominal and Real • Nominal Interest Rate (i): the interest rate observed in the market. • Real Interest Rate (r): the nominal rate adjusted for inflation (). Real Interest Rate = Nominal Interest Rate – Inflation Rate r = i -  • Low real interest rates spur business investment spending (the I in C + I + G + NX)

  7. Aggregate Demand (AD): the economy-wide demand for goods and services. • Aggregate demand curve relates aggregate expenditure for goods and services to the price level • The aggregate demand curve slopes downward owing to price-level effects: • Wealth Effect (Real Wealth/Real Balances) • Interest Rate Effect • International Trade Effect (Substitution)

  8. Shifting Aggregate Demand Curve

  9. Factors that Affect AD  Shifts in AD AD = C + I + G + NX • Consumption • Income • Wealth • Interest Rates • Expectations/Confidence • Demographics • Taxes • Investment • Interest Rates • Technology • Cost of Capital Goods • Capacity Utilization • Expectations/Confidence • Government Spending • Net Exports • Domestic & Foreign Income • Domestic & Foreign Prices • Exchange Rates • Government Policy

  10. Aggregate Supply • Aggregate Supply (AS): the quantity of real GDP produced at different price levels. Short-run Aggregate Supply SRASslopes upward • a higher price level (holding production costs and capital constant in short-run)  higher profit margins • firms want to produce more. Long Run Aggregate Supply LRAS is vertical: higher prices cannot elicit more output in the long-run. • Resource costs are NOT fixed in the long-run. • As prices rises, workers demand and get higher wages Profits don’t rise with price in long-run AS is set by production possibilities in the long-run

  11. Aggregate Supply: Short – Run & Long – Run

  12. Aggregate Demand and Supply Equilibrium: Short-run and long-run responses to increase in aggregate demand

  13. Aggregate Expenditures = AE = GDP Y = AE = C + I + G + NX • Disposable income = Yd =Y-T = after tax income. Yd = Y - T = C + S Consumption is related to disposable income (Y-T). C = Ca +cYd where c = Marginal Propensity to Consume = mpc Ca = Autonomous consumption • Additional income not consumed is saved mpc + mps =1

  14. Aggregate Expenditures = AE = GDP In a closed economy,savingeither finances private investment (I) or the government’s deficit (G – T) S = I + (G – T) at equilibrium Investment can be crowded out by the deficit I = S – (G-T) • Leakages from the spending stream (S + T) = Injections to the spending stream (I + G) • S + T = I + G

  15. Shifts in the Consumption Function • Expected Future Income • An increase in expected future income will cause current consumption to rise and your saving to fall. • Wealth • An increase in wealth raises current consumption and lowers current saving. • Expected Real Interest Rate • Higher real return  incentive to save more … but • Higher return to saving less needs to be put aside to achieve the same desired future savings. • Net effect: increased real interest rates reduce consumption and increase saving. • Demographics • Taxes – Ricardian Equivalence: Anticipation of Future Taxes

  16. Demand-Side Equilibrium and the MultiplierAt equilibrium: Y = C + I + G + NX = AEIncrease in Y = Spending Multiplier x {Increase in Autonomous Spending}Multiplier = 1/(mps + mpi)

  17. From Aggregate Expenditure toAggregate Demand:As price level rises, real money balances decrease and consumption function shifts owing toi) wealth effectii) interest rate effectiii) international competition

  18. Demand-Side Policy: Greater Spending Means Higher Prices (c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.) Price Level AD1 AD Y? Real GDP

  19. Fiscal Policy: Some Definitions • Fiscal policy: government spending and taxing • Demand-side policies • Supply-side policies: • Discretionary Fiscal Policy: aimed at achieving a policy goal. • Automatic Stabilizer: fiscal policy that changes automatically and countercyclically as income changes. • Progressive taxes • Unemployment insurance • Welfare payments / other transfer payments

  20. Functions of Money • Medium of exchange • Unit of account • Standard of Deferred Payment • Store of value

  21. Multiple Creation of Bank Deposits  M1Fractional Reserve Banking System: R = .1Deposit expansion multiplier = 1/R(when banks lend all excess reserves andpublic redeposits proceeds of loans into the banking system  no leakages)

  22. The Fed’s Policy Tools 1) Reserve Requirements 2) Discount rate “primary credit rate” 3) Open market operations • Manage the public’s expectations Inflation Targeting?

  23. Fed Policy LinkagesTools – Intermediate Targets – Goals

  24. Equation of Exchange: relates quantity of money to nominal GDP • M = money supply (some aggregate) • V = velocity of money (of the aggregate) • P = price level • Q = real GDP • PQ = nominal GDP MV = PQ (Note: V = PQ/M) Money Demand • Transactions demand • Precautionary demand • Speculative demand … fear decline in the value of other assets, so hold money as a safeguard.

  25. How Money Supply Changes Affect GDP

  26. Aggregate Demand and Supply Phillips Curve

  27. Starting at (1): 5% unemployment and 3% inflation. People believe inflation will continue at 3%  Curve I. • Then Fed hypes inflation to 6%  unemployment falls to 3% (Point 2 on Curve I). • Expectations adjust to 6% inflation  Wage demands up  Economy moves to point (3) Unemployment returns to 5%. • If expectations adjust instantly, e.g., anticipating Fed’s policy, economy moves directly from (1) to (3). Expectations and the Phillips Curve

  28. Expectations Formation • Adaptive Expectations: expectations of the future based on history • The public acts on its expectations The present depends on the past • Rational Expectations: expectation based on all available relevant information. • The public understands how the economy works. • The public knows the structure and linkages between variables in the economy. • The public anticipates policy actions and their consequence • The public acts now on its expectations The present depends on the future

  29. New Classical Economics:Rational Expectations  Policy Ineffectiveness{Expansionary policy  movement from 1 to 3}

  30. Macroeconomic ViewpointsLaissez - FaireClassical Monetarist New ClassicalActivist/InterventionistKeynesian New Keynesian

  31. The Modern Keynesian Model:Sticky Prices Demand Management Policies Can Stabilize an Unstable Economy

  32. Long and Variable Policy Lags • 1. Recognition Lag: policymakers need time to realize that there is a problem. • 2. Reaction Lag: they need time to formulate an appropriate policy response. • 3. Effect Lag: policy takes time to implement and work through the economy. • Countercyclical policies can become procyclical policies, worsening fluctuations

  33. Determinants of Growth • Size and quality of the labor force • Capital • Land/Natural Resources … are not a necessary condition for economic growth … they can be acquired through trade. • Technology

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