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ECON 141
Dr. Ashraf Nakibullah
University of Bahrain
February 2011
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ECON 141: MACROECONOMICS
HOW TO USE THIS WORKBOOK?
This workbook contains notes on certain topics of the course ECON 141. Thus, notes on all topics
are not included in this workbook. In many places tables are provided but relevant numbers
(information) in those tables are missing. I will explain those concepts in the class and we will together
workout those tables only in the class. Many graphs provided in this workbook. However, for many
graphs, relevant curves are missing.
Again, I will explain those graphs in the class and we will
workout those graphs together only in the class.
This workbook also contains exercises and some sample questions that may be useful for your
midterms and final examination.
You must bring this workbook whenever you attend a class.
WARNING: This is NOT a (complete) Study Guide. You should use this workbook with the Textbook by Parkin and the Study Guide by Mark Rush for Macroeconomics.
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

What is macroeconomics?
Objectives of the course
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INTRODUCTION
In macroeconomics we study the total or aggregate performance of an entire economy (or country). Thus
macroeconomic behavior reflects the behaviors of many individuals and firms interacting in markets.
These markets of the economy are added together (or aggregated). Thus in macroeconomics we study the
aggregate market(s). In microeconomics, on the other hand, we study an individual market, say, a coke
market or a fish market. But in macroeconomics we study all markets taken together. Otherwise, the basic
ideas of microeconomics and macroeconomics are the same. For example, we can ask how the price of
coke is determined and how much coke is consumed? Answer to these questions are provided by
microeconomics. We learn from microeconomics that the price of coke and the amount consumed are
determined by the market demand and supply of coke. In macroeconomics we do not study an individual
market such as coke market, but all markets together. An economy produces and consumes many
different goods and services. In macroeconomics we add all these goods and services traded in different
markets and call it aggregate output (GDP).
All these goods have their own prices. From prices of all these goods we make an average price,
called the price level (or index). Thus the price level or index includes many prices of goods and services
the country produces and consumes. The use of aggregation and emphasis on aggregate or total quantities
such as aggregate output is the primary factor that distinguishes macroeconomics from microeconomics.
Otherwise, we ask the similar question, for example, how the aggregate output and the price level of the
economy (country) are determined. In this course, we will find out how macroeconomics answers this
question.
Macroeconomics also studies the policies that government uses to try to affect economic
performances. The two most important policies are fiscal policy and monetary policy. Fiscal policy
concerns government spending and taxation and monetary policy determines the rate of growth of the
country's money supply and is under the control of a government agency known as the central bank. In
this course, we will also study these policy options in details. We start with the basic concepts of
macroeconomics namely gross domestic product (GDP) and the price level.
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Important concepts

GDP

Intermediate and final goods

Capital, gross and net investment

NX > 0  lending to rest of the world

NX < 0  borrowing from the rest of the world

Private, government and national saving

Flows, stocks, and wealth

The expenditure approach of measuring GDP

The income approach of measuring GDP

GDP, NDP, and NDI

Nominal and real GDP

Price level: GDP deflator

Economic growth rate; Potential GDP

Standard of Living (Economic welfare)

Business Cycle
4
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MEASURING GDP AND ECONOMIC GROWTH
(Chapter 21)
Gross Domestic Product (GDP)
Gross Domestic Product (GDP) is the market value of all final goods and services newly produced
within the border of a country in a given period of time.
In this definition of GDP, there are several features and technical terms that you must understand.
These are:
 Market value
 Final goods and services
 Newly produced
 Within the border of a country
 In a given period of time.
Market Value:
Market value of a good = (price of the good)(quantity of the good produced).
A country produces meat (measured in kg), milk (measured in liter), petroleum (measured in barrel)
etc. GDP is obtained by adding all final goods and services a country produces. But we cannot add
physically, that is we cannot, for example, add kg with liter. That is why, we first obtain market value
of each good and add them all. The following example shows how to obtain GDP.
Suppose a country produces and consumes only two (final) goods: Good 1 (food) and Good 2
(clothing). Quantities and prices of these goods for two different years are given in table 1 below.
GDP in 2009 = GDP2009 = market value of Good 1 in 2009 + market value of Good 2 in 2009
= P 1Q 1 + P 2Q 2 =
GDP2010 =
Final Good:
The important word is final. There are two types of goods: (1) final goods and (2) intermediate goods.
Final goods are those goods that are available for immediate consumption or use. Intermediate goods
are those produced goods (or raw materials) that are needed to make final goods in the same period that
they themselves were produced. For example, flour produced and then used to make bread in the same
year is an intermediate good. In this case flour is intermediate good to the final good bread. A good
could be both intermediate and final goods depending on the use of the good. For example, you buy 5
eggs. You boil 2 of them and eat them, these 2 eggs are final good. You use the rest 3 eggs to make a
cake. Then these 3 eggs are intermediate good and cake is the final good.
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The important point is that GDP includes only the values of final goods. To understand why, consider
the following example.
Suppose an economy (or country) has only two firms. Firm 1 produces textiles (clothes), employing
labors and using machines. It then sells the textile for BD2000 to firm 2, which produces expensive
female dresses. Firm 1 pays its labors (and machines) BD1200 and keeps what remains, BD800, as
profit. Firm 2 buys the textiles and uses those textiles, together with labors and sewing machines, to
make dresses. Revenues from dress sales are BD6000. Of the BD6000, BD2000 goes to pay for textile
and BD2500 goes to workers of firm 2, leaving BD1500 in profit. We summarize all information in
table 2 below.
Table 2
Firm 1: Textile Mill
Revenues from sales
BD2000
Expenses (Wages)
1200
Profit
800
Firm 2: Dress Producer
Revenues from sales
Expenses
Wages
Textile
BD6000
4500
2500
2000
Profit
1500
Note: Costs of factors production labors and machines are included in wages.
Because textile is an intermediate good that is used in the production of the final good, dress, thus
should not be counted in GDP which is the value of only final goods. This simple example shows that
the value (BD2000) of intermediate good textile is included in the value of the final good dress. If we
include in GDP the value of dresses produced, we do not want to include also the value of textiles sold,
which is already included in the value of dresses. So when we count only the values of final goods to
get GDP, values of all intermediate goods used to produce those final goods are automatically counted.
Note that if we included both the values of intermediate and final goods in GDP, it would be double
counting (counting the same production twice). To avoid double counting GDP only includes final
goods.
Within the border of a Country:
Only goods and services that are produced within the border of a country count as part of that country’s
GDP. For example, suppose a Bahraini person (or a firm) is working (or doing business) in Dubai
(UAE). Values of their production are part of UAE’s GDP. Similarly, the value of British worker’s
production in Bahrain is part of Bahrain’s GDP.
In a given period of time:
GDP measures the values of production in a given period of time. For example, suppose it says that
Bahrain’s GDP in 2008 were 8235 million dinar. It means the values of all new goods and services
Bahrain produced in the whole year of 2008 starting from January to December were 8235 million
dinar.
Newly produced:
As a measure of current economic activity, GDP includes only goods and services that are newly
produced within the current year. GDP does not include purchases or sales of goods that were
produced in previous years. Thus, the value of goods produced this year is counted in this year’s GDP.
The year of production, not the year of sale, determines allocation of GDP. Suppose a house newly
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built in 2009 but sold in 2010. Then the market price of the house counted in the GDP of 2009 not in
the GDP of 2010.
GDP and the Circular Flow of Expenditure and Income
In terms of all economic activities, an economy can be divided into four sectors:
Each sector has its own expenditure. So, there are four components of expenditures for four different
sectors. Expenditure of the household sector is known as consumption expenditure and is denoted by C.
Expenditure of firms is known as investment and denoted by I, expenditure of government is known as
government purchases and expenditure of the rest of the world or international sector is known as net
exports and denoted as NX.
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Consumption expenditures (C): Consumption expenditure or simply consumption consists of the
goods and services bought by households or consumers. It includes both buying of nondurable goods
(such as food and clothing) and durable goods (such as cars and TV’s). It also includes services bought
by households. Services include the work done for consumers by individuals and firms such as haircuts
and doctor visits. Buying new houses by households for living is NOT included in C.
Investment (I): Investment refers to the purchase of new capital goods, such as machines, tools
buildings, or houses, computer systems, airplanes, and trucks. Firms buy machines or plants to get
more output in the future. People buy houses or apartments to get housing services in the future. This is
the justification for making both under the same heading “investment’. Investment also includes
inventory investment.
Inventories are a firm’s stocks of unsold finished goods, goods in process, and raw materials.
Inventory investment is the amount by which inventories increase during the period. Suppose
Bahrain Furniture Company (BFC), produced 300 furniture in 2002 and sold 275 of them in 2002, the
other 25 furniture remained in BFC’s inventory of unsold furniture. This means BFC’s inventory
increased by 25 furniture and the company’s inventory investment was 25 furniture in 2002. Take
another example, suppose a baker began the year 2003 with BD100 worth of flour in her storeroom,
and at the end of the year she was holding BD125 worth of flour. The difference of BD125 – BD100 =
BD25 worth of flour was the baker’s inventory investment during the year 2003. When a firm adds
unsold output to inventory, we can think of the firm as buying goods from itself.
Thus, the purchase of new plant, equipment, and buildings and the additions to inventories are
investment (I).
Note: Both capital goods and inventory investment are treated as final goods and included in GDP.
Here is the reason why. A capital good is a good that is itself produced and used to produce other
goods. However, unlike intermediate good, a capital good is not used up in the same period that is
produced.
Government Purchases (G): Government purchases are goods and services bought by governments.
G includes such items as military equipment, roads and bridges, and services that government workers
provide. G does not include transfer payments to individuals.
Transfer payments are cash transfers from governments to households and firms. Examples of
transfer payments are social insurance, unemployment benefits, welfare payments to the poor, and
subsidies. Transfer payments are opposite of taxes. Transfer payments are simply direct payments of
money from the government to people. Transfer payments are not included in G or GDP because they
are NOT purchases of goods or services.
Net Exports (NX): Net exports take into account trade with other countries. Net exports are the value
of all goods and services exported to other countries minus the value of all goods and services imported
from other countries. NX = value of exports (X) – value of imports (M). NX can be positive (NX > 0),
zero (NX = 0) or negative (NX < 0).
Let us denote
X = exports
M = imports
If exports are greater than imports, that is X > M, this means NX > 0, this means the country is selling
more than the country is buying from abroad. That is, if NX = (X – M) > 0, then the country is lending
an amount equal to X – M to the rest of the world. If exports are less than imports, that is X < M or
imports are greater than exports M > X, then NX < 0, this means the country is buying more than the
country is selling abroad. That is, if NX = (X – M) < 0, then the country is borrowing an amount equal
to M – X to the rest of the world.
Summing the four components of expenditures, we have:
Total or aggregate expenditure = C + I + G + NX
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Exercise
Place each of the following transactions (sells) in one of the four components of expenditure: C, I, G
and NX.
(a) Bahrain Oven manufacturer sells an oven to the Bahrain Defense Force (BDF)
(b) Bahrain Oven manufacturer sells an oven to a private company Bahrain Bakery making cakes
using the oven.
(c) Bahrain Oven manufacturer sells an oven to Mrs. Lulwa (a housewife).
(d) Bahrain Oven manufacturer sells an oven to Saudi Arabia
(e) Bahrain Oven manufacturer makes an oven to be sold next year.
Exercise
(a) A country had C equal to $1 billion, G equal to $700 million, I equal to $500 million, and
imports were $200 million less than exports, what was the country’s GDP?
(b) A country had C equal to $1 billion, G equal to $700 million, I equal to $500 million, and
imports were $300 million more than exports, what was the country’s GDP?
Circular flow of expenditure and income indicates that the economy’s total expenditure and its total
income must be equal because every transaction has two sides – a buyer and a seller. Thus GDP can be
determined in two ways:
 The total expenditure on goods and services, or
 By the total income of everyone in the economy
Let us denote
Y = income, X = exports, and M = imports, then
Since GDP = aggregate (total) income (Y) = aggregate (total) expenditures, we can write
Y = C + I + G + X – M.
Examples
1. If Europe’s imports are greater than Europe’s exports, the
(a) rest of the world borrows from the Europe
(b) Europe borrows from the rest of the world
(c) Europe’s NX is negative
(d) Both (b) and (c) are true
2.
If Bahrain’s exports are BD2400 million and imports are BD2,134
(a) Bahrain borrowing BD266 from the rest of the world
(b) Bahrain lending BD266 to the rest of the world
(c) Bahrain lending –BD266 to the rest of the world
3.
Which of the following is NOT capital
(a) Building
(b) Machine
(c) Company stocks and bonds
(1)
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MEASURING GDP
As mentioned above GDP is aggregate expenditures or aggregate income. This means GDP can be
measured by these two approaches:
 The expenditure approach
 The income approach
The Expenditure Approach
The expenditure approach measures GDP by adding four expenditures C, I, G, and NX that we
discussed above. Exact name of these four expenditures are
C = personal consumption expenditure
I = gross private domestic investment
G = government purchases of goods and services
NX = net exports of goods and services = Exports – imports.
We have already discussed these components above. Note that I = investment = gross investment
= gross private domestic investment. Thus gross private domestic investment is in short known as
investment. Thus, GDP measured by the expenditure approach is given as
GDP = C + I + G + NX.
The Income Approach
There are five components of income, depending on the way income is earned:
Compensation to employees:
The wages (salaries) earned by workers.
Proprietors’ income: Income of self-employed, small businesses (for example, private doctors’
clinic, farmers etc). Many self-employed people own some capital (examples are a farmer’s tractor or a
dentist’s X-ray machine), so proprietors’ income include both labor income and capital income.
Rental income: Income earned by individuals who own land or buildings (apartments) that they rent
to others.
Net interest:
the interest domestic businesses receive minus the interest they pay.
Corporate profits:
the income of corporations after wages, interest, rents, and other costs have
been paid.
Adding these five components, one arrives to net domestic income (NDI) at factor cost. To go from
NDI to GDP, one needs to adjust a bit as follows:
NDI at factor cost
+ Net indirect taxes
= NDP = Net domestic product
+ Depreciation
= GDP
Net indirect taxes = (indirect taxes – subsidies). An indirect tax is a tax paid by consumers when they
purchase goods and services. GDP measured by the expenditure approach uses final prices of goods
and services; for some goods indirect taxes such as sales tax are added to get final prices and for some
goods subsidies are subtracted to get final prices. Thus, we need to add net indirect tax to NDI to
calculate GDP using income approach so that both methods give the same number. Depreciation is
wear and tear of capital. Capital goods – machinery and buildings – wear out while they are being used
to make goods. This wear and tear should be treated as a cost of production and therefore is subtracted
in calculating NDI (income received by domestic factors of production or their owners). So
depreciation must be added back to get GDP so that both approaches give the same number.
Finally, net domestic product (NDP) is
NDP = GDP – depreciation.
= NDI + Net indirect taxes
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Example
Consider the following data (in billion $) for a country in a particular year:
Personal consumption expenditure
Exports
Corporation Profits
Net interest
Government Purchases of goods and services
Imports
Net taxes
Rental income
Gross private domestic investment
Personal income taxes
Depreciation
Indirect taxes
Proprietor’s income
Subsidies
Compensation of employees (wages)
4627
716
536
400
1175
818
1260
28
1037
1300
716
970
473
391
4005
Question 1: Calculate GDP, NDI and NDP using both expenditure and income
approach.
Answer is given in table 3 below.
Table 3
Expenditure Approach
(Billion $)
Personal consumption exp (C)
Gross private dom. investment (I)
Government Purchases (G)
Net Export (NX)
GDP =
- Depreciation =
NDP =
4627
1037
1175
-102
6737
-716
6021
Income Approach
(Billion $)
Compensation to employees
Proprietors' income
Rental income
Net interest
Corporate profit
NDI =
+ Net indirect tax
+ Depreciation
GDP =
4005
473
28
400
536
5442
579
716
6737
Question 2: What was the value of total output?
Answer: Value of total output = GDP = $6737 billion.
In table 3, net indirect tax = indirect tax – subsidies = 970 – 391 = 579, and also note that net domestic
product (NDP) = GDP – depreciation = NDI + net indirect tax = 5442 + 579 = 6021 in the income
approach.
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Bahrain’s GDP, NDP and NDI in 2008 are given in table 4 below.
Nominal and Real GDP
To understand the difference between nominal and real GDP, consider table 5 below. Again, suppose a
country produces and consumes only two (final) goods: Good 1 (food) and Good 2 (clothing).
Quantities and prices of these goods for three different years are given in table 5.
Suppose 2009 is the base year.
Nominal GDP in 2008 = (P1 in 2008)(Q1 in 2008) + (P2 in 2008)(Q2 in 2008) =
Nominal GDP in 2009 = (P1 in 2009)(Q1 in 2009) + (P2 in 2009)(Q2 in 2009) =
Nominal GDP in 2010 = (P1 in 2010)(Q1 in 2010) + (P2 in 2010)(Q2 in 2010) =
You can see that nominal GDP is the value of goods and services measured at current prices. Compare
nominal GDP of 2008 and 2009. You can see that nominal GDP of 2009 is higher than 2008, still the
country produced and consumed less food and less clothing. The country was less well-off in 2009 than
2008 still the nominal GDP of 2009 was higher than 2008. You can also see that nominal GDP in 2010
was the highest and also the country produced and consumed more food and clothing. This example
shows that comparing only nominal GDP of different years, we cannot say for sure that a country
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produced and consumed more goods and services in one particular year than any other years. That is,
nominal GDP is not the measure of well-being of a country.
A better measure of well-being is to calculate real GDP. We calculate real GDP as follows:
Real GDP in 2008 = (P1 in 2009)(Q1 in 2008) + (P2 in 2009)(Q2 in 2008) =
Real GDP in 2009 = (P1 in 2009)(Q1 in 2009) + (P2 in 2009)(Q2 in 2009) =
Real GDP in 2010 = (P1 in 2009)(Q1 in 2010) + (P2 in 2009)(Q2 in 2010) =
You have seen that to compute real GDP, a base year is chosen (here 2009). Goods and services are
added up using 2009 base year prices to value the goods of different years. Thus, real GDP is the value
of goods and services measured at constant (base year) prices. Comparing real GDP of different years
(see table 5), we can say for sure that a country produced more goods and services in one particular
year than any other year if the real GDP of that particular is higher than any other year.
CALCULATING PRICE LEVEL (or Price Index)
Price level is average level of prices of goods and services in a given period (relative to the prices in
base year). One measure of price level is GDP deflator.
The GDP Deflator
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Exercise
Suppose 2002 GDP deflator is 100, and 2006 deflator was 107 and nominal GDP per person was
$214,000. What was the real GDP per person in 2006?
MEASURING ECONOMIC GROWTH
The economic growth rate is the percentage change in the quantity of goods and services (real GDP)
produced from one year to the next. That is, economic growth rate is calculated as
Economic growth rate =
Re al GDP this year  Re al GDP last year
x100
Re al GDP last year
For example, real GDP was BD3,600 million in 2005 and BD3,400 million in 2004. So the economic
growth rate in (during) 2005 was:
Economic growth rate =
BD 3600  BD 3400
x100 = 5.88%
BD 3400
THE USES AND LIMITATIONS OF REAL GDP
Economists use estimates of real GDP (or economic growth) for two reasons:
 To compare the standard of living over time
 To compare the standard of living across countries
Standard of Living (or Economic welfare) is a measure of the general state of economic well-being
of the people of the country. The standard of living over time usually improves when the production of
all the goods and services (real GDP per person) grows over time. Real GDP per person is the real GDP
divided by the population. Real GDP per person tells us the value of goods and services that the
average person can enjoy. For example, consider the following table:
Country
USA
Bahrain
Year
1958
Real GDP per person
$12,883
2008
$38,422
1975
$6,890
2005
$13,798
This table shows real GDP person in 2008 was 3 times its 19958 level – that is, $38,422 /$12,883 = 3.
In other words, the standard of living of the US people have improved 3 times in 50 years. On the other
hand, the well-being or the standard of living of the Bahrain people have improved 2 times
($13,798/$6,890 = 2) or doubled in 30 years.
We can also compare the standard of living across countries. Table above also shows that during 2005
– 2008, the standard of living of the US people was about 3 times the standard of living of the Bahraini
people.
Potential real GDP
When all the economy’s labor, capital, land, and entrepreneurial ability are fully employed, the value
of production (or real GDP) is called potential real GDP. That means, if a country produces its
potential GDP, it would have full employment. That is why the quantity of real GDP at full
employment is called potential GDP.
Potential real GDP = Potential GDP = Real GDP at full employment.
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Real GDP Fluctuations (Business Cycle)
A business cycle is the periodic but irregular up-and-down movement in production (real GDP) and
jobs (or employment) around the potential GDP. In another words, a business cycle is the pattern of
short-run upward and downward movements in production and jobs.
Real GDP
(Y)
Real GDP
YP
Time
YP = Potential GDP.
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Points A, E etc are called PEAKS of the cycle and points C, G etc are called TROUGH of the cycle.
Recession: Recession is a period during which real GDP decreases and unemployment (jobless)
increases. In above figure from points A to C and from points E to G are recessions.
Expansion: Expansion is a period during which real GDP increases and unemployment (jobless)
decreases or employment increases. In above figure from points C to E is expansion.
Points B, D and F represent full-employment or in those cases country has zero cyclical
unemployment.
Limitations of Real GDP
Real GDP measures the value of goods and services that are bought in markets. Some of the factors
that influence the standard of living and that are not part of GDP are





Household production – Real GDP omits household production ( all household or home
production is omitted).
Underground economic activity – Real GDP omits underground economy. The underground
economy is not counted. The underground economy is the part of the economy that is
deliberately hidden from the government to avoid taxes and regulations or because the goods
and services produced are illegal. Because underground economic activity is not reported, it is
omitted from GDP
Health and life expectancy – Real GDP omits health and life expectancy. Neither people’s
health nor life expectancy are indicated by real GDP.
Leisure time – Real GDP omits leisure time. That is, the value of leisure time is omitted.
Environmental Quality – Real GDP omits environmental quality. The consequences of
adverse environmental (pollution) and beneficial environmental changes are omitted. For
example, production of ALBA (aluminum) is included in real GDP. But when aluminum is
produced, it pollutes the air and environment that causes breathing and health problems for the
people in the country. This pollution problem is not counted as a negative part of GDP.
Thus, real GDP is an accepted but not a perfect measure of standard of living.
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Question
Assume a country has the following statistics: its GDP is $26.5 million, consumption expenditure is
$20 million, government purchases of goods and services is $3 million, exports of goods and services
to foreigners is $2 million, and imports of goods services from foreigners is $2.5 million, indirect tax is
$1 million, depreciation is $0.8 million, and total subsidies is $0.5 million.
a)
b)
c)
d)
e)
f)
g)
h)
What was this country's value of net exports of goods and services?
Was this a lending or borrowing country? Explain why?
What was this country’s investment?
What was this country's total income?
What was this country's value of total production?
What was this country's value of total output?
What was this country's value of net indirect tax?
What was this country’s net domestic income?
SAMPLE MULTIPLE CHOICE QUESTIONS
1.
In calculating GDP, the purchase of new house counts as
(a) an addition to inventory
(b) investment
(c) consumption expenditure
2.
Which of the following transactions would be included in 1999 GDP?
(a) 1999 purchase of a house built in 1997
(b) 1999 purchase of a famous old painting
(c) the purchase of a car produced in 1999
(d) 1999 purchase of a used car
Questions 3-6 refer to the following problem.
Suppose the only goods produced and consumed in an economy are food and clothing. The following
table shows data on the quantities and prices of output in different years:
Year
1995
1996
Food
(quantity)
1000
1200
Price of
Food
$5
$5
Clothing
(quantity)
500
550
Price of
clothing
$6
$8
Prices are in dollars per unit. Take year 1995 as the base year.
3.
4.
5.
6.
What was the nominal GDP for 1996?
(a) 10,400
(b) $10,400
(c) 12,400
(d) $12,400
What was the real GDP for 1996?
(a) $9,300
(b) 9,300
(c) $9,900
(d) 9,900
Refer to above table, what was the GDP deflator for 1996?
(a) $125.2
(b) 125.2
(c) $111.8
(d) 111.8
Refer to above table, what was the economic growth rate during 1996?
(a) 16.25%
(b) 30%
(c) 10%
(d) 15%
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7.
Real GDP is criticized as a measure of economic welfare because
(a) real GDP omits underground economic activity
(b) real GDP does not take account of the pollution (or degradation of the environmental quality)
(c) real GDP does not include leisure time available to a society
(d) all of the above answers are correct
8.
Underground economic activity
(a) is production of illegal goods such as illegal drugs
(b) exists because of avoidance of taxes
(c) exists to avoid government regulation
(d) all of the above answers are correct
9.
Pollution _________ economic welfare
(a) increases
(b) reduces
(c) does not affect
10. Another name of depreciation is
(a) the value added
(b) additional expenditure
(c) capital consumption expenditure
11. The circular flow of income involves the principle that
(a) in every economic exchange one party takes advantage of the other party
(b) the seller of a good receives less than the buyer spends
(c) the seller of a good receives more than the buyer spends
(d) the seller of a good receives the same amount as the buyer spends
12. If exports are $100 less than imports, how much is the net exports (NX)?
(a) $100 million
(b) –$100 million
(c) zero
(d) cannot be answered
Consider the following data (in million dinar) for a country in 1997:
Personal consumption expenditure
1380
Compensation of employees (wages)
1400
Corporation Profits
300
Net interest
100
Government purchases of goods and services
590
GDP
2435
Gross private domestic investment
415
Net taxes
700
Rental income
150
Depreciation
90
Proprietor’s income
220
Ashraf Nakibullah
For questions 13 – 18 refer to the table above
13. What was the country’s net domestic product (NDP)?
(a) 2435
(b) 2345
(c) 1735
(d) 2525
14. What was the country’s net export (NX)?
(a) 50
(b) 40
(c) –40
(d) –50
15. The country is a
(a) borrower
(b) lender
16. What was the country’s net domestic income (NDI)?
(a) 2178
(b) 2165
(c) 2170
(d) 2175
17. How much were households and businesses saving?
(a) 1055
(b) 355
18. How much were the national saving?
(a) 465
(b) 355
(c) 820
19
Ashraf Nakibullah
IMPORTANT CONCEPTS

Working Age Population, Labor Force, and Unemployed

Labor Force participation rate and Unemployment Rate

Discouraged workers

Frictional Unemployment

Structural Unemployment

Cyclical Unemployment

Natural Rate of Unemployment and Full-employment

The consumer price index (CPI)

Cost of CPI basket

Inflation

Inflation rate
20
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MONITORING JOBS AND INFLATION
(Chapter 22)
Population, Working-age Population, Labor force participation rate, Unemployment rate
P
O
P
U
L
A
T
I
Working Age Population (WAP)
(!5 years and above)
N
Young (less than 15)
and Institutionalized
People
Not in
Labor Force
(NLF)
Labor Force (LF)
Employed
O
Unemployed
First, total population is divided into two groups: (1) working age population and (2) young and
institutionalized people.
Working age population (WAP) are those people who are 15 years old and above and they are able
and allowed to work. For some countries WAP are counted from 16 years and above. People less than
15 years old are considered as young and they are NOT allowed to work. Institutionalized people are
mentally and physically handicapped people and people in jails and they are either unable to work or
not allowed to work. Thus, young and institutionalized people are excluded from the unemployment
problem of a country.
Working age population (WAP) are then divided into two groups: (1) labor force (LF) and (2) not in
labor force. Labor force is then divided into two groups: (1) employed and (2) unemployed. Thus,
Labor Force = number of people employed + number of people unemployed.
Examples of people not in labor force are: retired people, full-time students, housewives,
discouraged workers etc. Discouraged workers: When jobs are difficult to get, job seekers become
increasingly frustrated. After repeated rejections from getting jobs, these workers often get so
discouraged that they stop looking for a job. Thus, discouraged workers are NOT considered
unemployed because they are not actively seeking work.
Employed: A person in the working age population is said to be employed if the person has a full-time
or a part-time job.
Unemployed: A person in the working age population is said to be unemployed is the person has no
job but actively looking or searching for a job. Thus, a person who has no job but never tries to find a
job will not be considered as unemployed.
Exercise
Ahmed is 25 years old (part of WAP), has no job, would like to have a job but never tries to find a job.
What is Ahmed’s labor market status?
The Labor Force Participation Rate (LFPR) =
Labor Force
100 
WAP
LFPR indicates the number of people in the WAP who are actively participating (as employed or
unemployed) in the labor market. For example, if the LFPR is 65%, this means out of 100 people in the
WAP, 65 of them are either working or looking for a job (unemployed).
 If labor force participation rate (LFPR) increases without changing working age population
(WAP), this means number of people in labor force is rising.
 If LFPR) increases, this implies labor force (LF) increases (grows) faster rate than the increase
(growth) of the WAP.
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The Unemployment Rate: The amount of unemployment is an indicator of the extent to which people
who want jobs can’t find them. The unemployment rate is the percentage of the people in the labor
force who are unemployed.
Unemployment Rate =
Number of people unemployed
100 
Labor Force
The Employment–to–population Ratio: It is an indicator of the number of the people of working age
who have jobs implies both the availability of jobs and degree of match between people’s skills and
jobs and it is the percentage of people of working age population (WAP) who have jobs.
Employment–to–population Ratio =

Number of people employed
100 
WAP
If employment-to-population ratio increases, this means country creates more jobs faster rate
than the WAP has grown.
Exercise
A country reported the following statistics in 2010: Labor force participation rate was 250 million,
labor force was 160 million and employment was 152 million of which 30 million were part-time
workers.
(a) Calculate the number of people unemployed and the unemployment rate.
(b) What was the total number of people employed?
(c) Calculate employment- to- population ratio.
(d) Calculate the number of people who were not in the labor force.
(e) Calculate the labor force participation rate.
Exercise
Labor force
100
200
Not in labor
force
30
40
Employed
workers
100
80
Unemployed
Workers
10
Labor force
participation
rate
74.8%
Unemployment
rate
5%
Fill the missing numbers in the above table
Aggregate Hours: Aggregate hours are the total number of hours worked by all the people employed
both full-time and part-time during a year.
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Types of Unemployment
Frictional Unemployment: Frictional unemployment arises mainly due to entering and reentering
into labor force. There is a friction between deciding to get a job and actually finding a job and between
old and new jobs.
Examples:
1.
2.
3.
4.
Students after a finishing their training or degrees, start looking for a job. During the time they
start looking for a job and getting a job, these people remain frictional unemployment.
A woman reenters the labor force and looks for job after spending time at home raising a
child.
Sometimes people quit their jobs. During the time they quit (say, for better payment) and
getting another job, these people remain frictionally unemployed.
Workers get fired because their job performance or effort is unacceptable and then start
looking for another job in their profession.
Thus frictional unemployment is a product of the short run movement of workers between jobs and of
first time job seekers. Workers quit one job and soon find another; students graduate and soon find a
job. This kind of unemployment cannot be eliminated from any country.
Structural Unemployment: Structural unemployment arises due to economy’s structural or
technological change such as computerization, automaton, and robotization.
Examples:
1. Assembly line (for example cars, soft-drink, bakery assembly) workers who have replaced by
machines, robots etc.
2. The invention of computers reduced the demand for typewriters and as a result workers in
typewriters industry lost their jobs.
3. Cars have replaced horse or donkey drawn carriages as the main form of transportation, firms
used to make horse drawn carriages gone out of business (bankrupt) and their workers lost
their jobs.
4. Cars and electronics manufacturing workers from North America and Europe lost their jobs
because of international competition from Japan.
Workers who are displaced or lost their jobs by technological or structural change, usually do not have
required (necessary) skills or training to maintain their level of income in another industry. Rather
than accept a much lower salary, these workers tend to prolong their job search. Most countries go
through structural change and it is natural to have structural unemployment and again cannot be
eliminated.
Cyclical Unemployment: Cyclical unemployment is related to the country’s real GDP. During the
recession, real GDP decreases and with it cyclical unemployment increases. During the expansion
phase of the business cycle, real GDP increases and with it cyclical unemployment decreases. Because
cyclical unemployment fluctuates with the business cycle, it is called cyclical unemployment. Unlike
frictional and structural unemployment, cyclical unemployment could be zero or negative. At the
potential GDP, cyclical unemployment is zero. At less than potential GDP, country has a positive
cyclical unemployment and at more than potential GDP, country has a negative cyclical
unemployment. Note that negative unemployment means employment.
Exercise
1. For the following time periods, describe Iqbal’s labor market status. When Iqbal is unemployed,
tell whether it is frictional, structural, or cyclical unemployment.
(a) When Iqbal was 17 years old, he started last year of his school from September 23, 1996 to
June 15, 1997.
(b) He started looking for a job beginning from July 1, 1997. On September 15, he received a job
in a private company.
(c) From September 15, 1997 to April 30, 1998 he worked full-time.
(d) On April 30, 1998 the company employed him as a part-time worker even though Iqbal
wanted a full-time job.
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(e) On June 30, with worsening economic conditions (recession) of the country, Iqbal got fired
(lost job) and started looking for a new job till September 31.
(f) On October 1, Iqbal became convinced that he could not get a job, so until November 30, he
only socialized with his friends, troubling his parents and did not look for a job.
(g) On December 1, his uncle gave him a job which he accepted.
Natural Rate of Unemployment and Full Employment
The Consumer Price Index (CPI)
The consumer price index (CPI) is a measure of the average of prices paid by the urban consumers
for a fixed “basket” of consumer goods and services. The CPI is the name of another price level. The
CPI measures the prices of only the goods and services bought by urban consumers. CPI includes
prices of imported goods bought by consumers.
The CPI basket consists of the items (goods and services) that an average an average urban household
buys.
The CPI is calculated as:
CPI in current year =
Cost of CPI Basket in current year
x100
Cost of CPI Basket in the base year
That is, CPI compares cost in current period to cost in the base period.
If the current year is 2010, then
CPI in 2010 =
Cost of CPI Basket in 2010
x100 .
Cost of CPI Basket in the base year
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Example
Suppose a typical family consumes 3 goods. Quantities purchased of these goods are given in table 1.
Prices of these goods in two different years 2009 (base year) and 2010 are also given in table 1 below.
Cost of CPI basket in the base year (2009) prices =
Cost of CPI basket at the current period (2010) prices =
CPI in 2010 =
Inflation rate
The inflation rate is the percentage change in the price level (CPI) from one year to the next year and it
is calculated as
Inflation rate =
CPI this year  CPI last year
x100
CPI last year
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Question 1
Apple Juice
Quantity
Purchased
10
Prices in the
base year
(2003)
$4
Prices in the
Current year
(2004)
$3
Bananas
15
$3
$4
Good
a.
b.
c.
d.
Cloth
5
$5
Calculate the cost of CPI basket in the base year
Calculate the cost of CPI basket in the current year
Calculate CPI in 2004
Calculate inflation rate in 2004.
$7
Question 2
Good
Orange Juice
Quantity
(2007)
200
Price
(2007)
$2
Quantity
(2008)
220
Price
(2008)
$3
Shirts
15
$10
18
$8
Suppose 2007 is the base period.
a. What quantities are in the CPI basket?
b. What is the cost of the CPI basket using 2007 prices?
c. What is the cost of the CPI basket using 2008 prices?
d. What is the CPI in 2008?
e. What is the inflation rate in 2008?
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27
SAMPLE MULTIPLE CHOICE QUESTIONS
1.
A country in 1997 had 5% unemployment rate out of 20,000 in labor force. In the same year the
country’s total number of people not in the labor force was 13,330. What was the country’s labor
participation rate in 1997?
(a) 60%
(b) 71%
2.
Working age population are
(a) people who are over the age 16 years and has full-time job.
(b) people who have job or looking for job.
(c) people over the age 15 who are not in hospital, jail, mental hospital and other institutions.*
3.
A country’s potential GDP is $4000 million. Its real GDP is now $3500 million. This means, the
country’s
(a) Frictional unemployment increased.
(b) Cyclical unemployment increased.
(c) Structural unemployment increased.
4.
Who of the following is frictionally unemployed?
(a) Beth, who lost her job because of foreign competition and is unemployed until retrained
(b) John, a fishery worker who is searching for a better job closer to home
(c) Bob, a steelworker who lost his job but has stopped looking for a job because he thinks he
won’t be able to find a job now.
(d) Amanda, an office worker who lost her job because of a slowdown in the economy
5.
Aggregate hours
(a) are the total number of hours worked by people working full-time.
(b) are the total number of hours worked by all people employed.
6.
Which of the following is not part of the labor force
(a) a person who will start a new job in one month time.
(b) a discouraged worker.
(c) a person not working and has not tried to find a job
(d) both (b) and (c)*
7.
Which of the following is called unemployed?
(a) Has no work, want to work but no longer looking for work.
(b) Not working and looking for work.
Component
Employed (full-time)
Employed (part-time)
Under 15
Unemployed
Housewives and retired
Number of people (millions)
105
30
60
15
50
Important note: sometimes exam question says under 15 and other times under 16. Both are
acceptable because in some countries people under 15 are not included in working age population and
other countries people under 16 are not included in working age population.
8.
Referring table above, the unemployment rate is
(a) 8%
(b) 10%
9.
Referring table above, how many people are not in labor force
(a) 50
(b) 110
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10. Referring table above, the labor force participation rate is
(a) 75%
(b) 70%
11. Price index in year 2 is 117 and year 3 is 125. What is the inflation rate in (during) year 3?
(a) 17%
(b) 6.8%
12. GDP declines during
(a) the movement from below potential GDP back to the potential GDP.
(b) the movement from peak to trough
13. The CPI
(a) Compares the cost in the current period to the cost in the reference base period of a basket of
goods typically consumed in the base period
(b) Measures the increase in the price of the goods included in GDP
14. A country’s natural rate of unemployment is 6%, and its structural rate of unemployment is 2%.
This means the country has
(a) 4% of cyclical unemployment
(b) 4% of frictional unemployment
(c) zero percent cyclical unemployment
15. A country’s natural rate of unemployment is 6%, its structural rate of unemployment is 2% and the
current unemployment 7%. This means the country has
(a) 1% of cyclical unemployment
(b) 4% of frictional unemployment
(c) both (a) and (b) are true.
Ashraf Nakibullah
Important Concepts

Money or nominal wage, real wage

Long Run Aggregate supply (LAS) curve

Short Run Aggregate Supply (SAS) curve

Aggregate Demand (AD)

Short Run Equilibrium

Long Run Equilibrium

Economic Growth and Inflation

The Business Cycle and Corresponding Unemployment in the short run

Below full-employment equilibrium

Above full-employment equilibrium

Recessionary gap

Inflationary gap

Stagflation
29
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AGGREGATE SUPPLY AND AGGREGATE DEMAND
AGGREGATE SUPPLY (AS)
Aggregate supply (AS) shows the total supply of all goods and services (or real GDP) produced in the
economy per month or year. A country can supply more real GDP if its technology improves and has
more factors of production such as labor and capital and other inputs (or resources).
A firm’s production decision depends of two types of prices: price of the good or service the firm is
producing and the prices of those factors or inputs the firm needs to produce the good or the service.
Thus, for the economy as a whole there are two sets of prices:
(a) Prices of goods and services. Firms use these prices to calculate their revenues. Average price
of these goods and services is called the price level such as GDP deflator.
(b) Prices of factors of production such as labor and capital and other economic resources. Firms
use these prices to calculate their costs of production. These prices are not included in the
price level.
Nominal wage: Nominal (or money) wage is the amount of money (dinar or dollar or pound) a labor
earns per hour (or week or month).
Real wage: Real wage is the nominal wage rate adjusted for inflation. That is, real wage is the wage
measured in units of output or the wage measured in purchasing power units.
For the economy as a whole, real wage rate is equal to nominal wage rate divided by the price level
multiplied by 100. Table 1 provides some hypothetical numbers and shows how to calculate real wage.
Year
1998
1999
2000
2001
Nominal wage
rate per hour ($)
10
12
13
15
Real wage rate =
Table 1
Price level
1999 = 100
98
100
110
112
Real wage rate
(in 1999 dollars)
10.2
12
11.8
13.4
No min al wage rate
x100
Pr ice level
The real wage, rather than nominal wage, guides the decision of labors and firms because it measures
the amount of goods that a person can buy with his/her wages. That is, to a labor what is important is
the real wage not the nominal wage.
3.1 Long-Run Aggregate Supply (LAS) Curve
The long-run aggregate supply curve shows the relationship between the quantity of real GDP supplied
and the price level in the long run when real GDP equals potential GDP. LAS curve is shown in
figure1.
Price
You can see from Figure 1
Level
LAS
that LAS curve is vertical at
potential GDP (YP). This means
a country always produces the
P1
potential GDP in the long run
or has full-employment
P0
in the long run. LAS curve is
vertical at potential GDP means
Figure 1
along the LAS curve, as the price
level changes, real GDP remains
at potential GDP. That is, in the
YP
Real GDP
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31
long run, real GDP is the same for all price level. In the long run, the level of output or real GDP is
determined by the amounts of capital and labor and by the available technology. Thus, it does not
depend on the price level. What happens, suppose price level increases 10% from P 0 to P1 in figure 1.
then nominal wage and prices of other resources change in the same proportion (10%). This means the
costs of production adjusts completely to the change in the price level and as a result neither profits nor
production change. Real wage is the same along an LAS curve; profits also remain the same along a
LAS curve.
Movement Along and Shift of the LAS Curve
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3.2 Short-Run Aggregate Supply (SAS) Curve
The short-run aggregate supply (SAS) shows a relationship between the quantity of real GDP supplied
and the price level in the short run when nominal wage and prices of other resources remain the same.
A typical SAS curve is
shown in figure 2. It is
Price
positively slopped; as the price
Level
level increases from P0 to P1
SAS
quantity of real GDP supplied
P1
B
increases from Y0 to Y1.
As price level increases
P0
A
from P0 to P1, firms revenue
increases, but costs of
production do not increase
Figure 2
as much as the increase in
revenues and as a result
firms profit increases. Thus
Y0
Y1
Real GDP
along a SAS curve, when the
price level increases, real wage decreases and firms profit increases.
Movement Along the SAS Curve
Only changes in the price level cause movement along a SAS curve. For example, changes in price
level from P0 to P1 would cause a movement from point A to point B along the SAS curve in figure 2.
Factors that Shift SAS Curve
Shift in the SAS curve means entire SAS curve shifts to the right or left at each price level. In
particular,
Increase in SAS curve = SAS curve shifts to the right.
Decrease in SAS curve = SAS curve shifts to the Left.
Factors that shift SAS curve are:
(1) The same factors that shift that LAS curve would also shift the SAS curve. For
example, increase in resources (increase in full-employment of labor, capital,
technology) would increase both LAS and SAS and as a result both LAS and SAS
curves would shift to the right.
(2) Changes in the price of resources. If price of labor or price of raw materials change,
SAS curve shifts. For example, if nominal or money wage (price of labor) increases,
SAS decreases and SAS curve shifts to the left. Note, change in prices of resources
only shift SAS curve and DO NOT shift LAS curve.
Important differences between LAS and SAS
LAS CURVE
Price level
Changes: Price level increases
as moving upward along a LAS
curve
Money or nominal wage
Changes: Money wage and price
level change in the same
proportion as moving up or
down along a LAS curve
Real Wage
Remains the same (does not
change). That is real wage is the
same along a LAS curve
Changes in nominal wage
Movement along the LAS
curve.
Profit
Remains the same along a LAS
curve
SAS CURVE
Changes: Price level increases
as moving upward along a SAS
curve
Remains the same (does not
change). That is money or
nominal wage is the same along
a SAS curve
Changes: Real wage changes.
Real wage decreases (or
increases) as moving upward (or
downward) along a SAS curve.
Shifts of the SAS curve. If
nominal wage increases (or
decreases), SAS curve shifts to
the left (or right)
Changes: Profit increases (or
decreases) as moving upward
(or downward) along a SAS
curve.
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Exercise
Consider the figure below
Price level
(P)
LAS
Suppose nominal wage at point A is
equal $600 per week. Answer the
following questions:
1. How much is the real wage at point A?
2. How much is the nominal wage at point B?
3. How much is the nominal wage at point C?
4. What is potential GDP of the country?
5. How much is the nominal wage at point D?
SAS
SAS
120
100
C
D
B
A
300
Real GDP (Y)
AGGREGATE DEMAND (AD)
A country’s aggregate demand (AD) refers to total demand for the goods and services produced in that
country in a year. In all our references, aggregate demand is real aggregate demand for real GDP.
Aggregate demand is sum of real consumption expenditure (C), investment (I), government purchases
(G), and net exports (NX):
AD = C + I + G + NX.
Thus AD for Bahrain is the total amount of final goods and services produced in Bahrain that people,
businesses, government, and foreigners would buy.
AD Curve
AD curve shows a negative relationship between the quantity of real GDP demanded and the price
level when all other things remain the same.
As you can see from the AD curve in
Figure 3, when price level increases
from P0 to P1, quantity of real GDP
demanded decreases from Y0 to Y1.
That is, AD curve slopes downward.
The AD curve slopes downward
for two reasons:
1. Wealth Effect
2. Substitution Effect
Price
Level
Figure 3
P1
B
P0
A
Wealth Effect: When price level
increases, other things remain the
AD
same, peoples real wealth decreases
(or purchasing power of wealth
Y0
Y1
Real GDP
decreases). When real wealth
decreases, people save more and
consume less (or buy less goods and services); that is, quantity of real GDP demanded decreases.
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Substitution Effect: When price level increases, other things remain the same, interest rate increases
and as a result aggregate spending such as consumption and investment decreases; that is, quantity of
real GDP demanded decreases.
Movement along an AD curve: Only changes in the price level cause movement along an AD curve.
For example, changes in price level from P 0 to P1 would cause a movement from point A to point B
along the AD curve in figure 3.
Factors that changes or Shift AD curve
The main factors that change or shift AD are:
 Expectations
 Fiscal policy
 Monetary policy
 The world economy
Expectations
(1) Expected future income: If people expect a lower (or higher) future income, they buy less (or more)
now, and as a result AD curve shifts to the left (or right). (2) Expected future inflation rate: An increase
in the expected future inflation rate increases AD and AD curve shifts to the right. (3) Expected future
profit (or loss): An increase in the expected future profit (or loss) increases (or decreases) the
investment (I) the firms plan to do and as a result AD curve shifts to the right (or left).
Fiscal Policy
Fiscal policy refers to changes in government purchases (∆G) or changes in taxes (∆T). When
government purchases increase (G↑) or taxes decrease (T↓), AD increases and AD curve shifts to the
right. Remember AD = C + I + G + NX; thus if G increases, other things remain the same, AD curve
shifts to the right. When T increases, other things remain the same, consumption decreases (C↓) and as
a result AD decreases and AD curve shifts to the left.
P
P
AD
AD
Y
AD Shifts to right due to G↑ or T↓.
Y
AD shifts to the left due to G↓ or T↑
Monetary Policy
Monetary policy refers to changes in money supply (∆M) or changes in interest rates. When quantity of
money in the country increases (M↑) or interest rates decrease, AD increases and AD curve shifts to the
right. When people have more money, other things remain the same, they buy more goods and services
and AD curve shifts to the right. When interest rate increases, other things remain the same,
consumption and investment decrease (C↓, I↓) and as a result AD decreases and AD curve shifts to the
left.
P
P
AD
Y
AD Shifts to right due to M↑ or (interest rate)↓.
AD
Y
AD shifts to the left due to M↓ or (interest rate)↑
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World Economy
Foreign exchange rate (E) and foreign income also shifts the AD curve.
(1) Foreign exchange rate or simply exchange rate (E) is the amount of foreign money you can buy
with your home money. For example, E = $2.65/BD means one dinar can buy $2.65. If exchange
rate increases or rises (E↑), net export decreases (NX↓) and AD curve shifts to the left:
E↑ → NX↓ → AD ↓ → AD curve shifts to the left.
(2) An increase in foreign income, increases net export and AD curve shifts to the right.
(Foreign income)↑ → NX↑ → AD↑ → AD shifts to the right.
MACROECONOMIC EQUILIBRIUM
 Short-Run Macroeconomic equilibrium
 Long-Run Macroeconomic equilibrium
Short-Run Macroeconomic equilibrium
Short-Run Macroeconomic equilibrium occurs at the intersection of SAS and AD curves as shown in
figure 4.
Price
Level
SAS0
P2
F
P0
E
A
Figure 4
P1
C
B
AD0
Y0
Real GDP
Short run equilibrium is at point A of figure 4. Y0 is the short run equilibrium real GDP and P 0 is the
short-run price level. Any price level below P 0 (for example at P1), the quantity of real GDP demanded
(point B) is greater than the quantity of real GDP supplied (point C) and the economy has excess
demand (or shortage) of (B – C) and the excess demand would push the price level up to the
equilibrium price level P0. Any price level above P0 (for example at P2), the quantity of real GDP
demanded (point F) is less than the quantity of real GDP supplied (point E) and the economy has
excess supply (or surplus) of (E – F) and the excess supply would push the price level down to the
equilibrium price level P0.
Long-Run Macroeconomic equilibrium
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Economic growth and Inflation
Suppose economy is initially at long-run equilibrium with price level P0 = 110 as shown in figure
below.
Price level
LAS0
(P)
P0 = 110
AD0
YP
Real GDP (Y)
Now the economy experiences technological improvement and at the same time firms expect a higher
profit in the future. So the LAS shifts from LAS0 to LAS1 and simultaneously AD curve shifts from
AD0 to AD1. There will be economic growth (increase in potential real GDP), but the economy may
or may not experience inflation (rise in the price level) depending on the relative shift of the AD and
LAS curves as shown below.
Price level
LAS0
LAS1
P0 = 110
This figure shows economic growth (increase
in potential GDP) with no inflation. Price level
remains at P0 = 110. AD and LAS change by the
same proportion.
AD1
AD0
Real GDP
Price level
LAS0
LAS1
P1 = 120
P0 = 110
AD1
This figure shows economic growth (increase
in potential GDP) with inflation. Price level
increases to P1 = 120. AD changes more than
change in LAS. There is inflation rate about 9%.
AD0
Real GDP
Price level
LAS0
LAS1
P0 = 110
This figure shows economic growth (increase
in potential GDP) with negative inflation. Price
level decreases. AD shifts less than LAS.
AD0 AD1
Real GDP
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Business cycle and three types of short run macroeconomic equilibrium
The business cycle occurs because AD and SAS fluctuate but the money wage does not adjust quickly
enough to keep real GDP at potential GDP. Three types of short-run equilibrium possible:
 Below (or less than) full-employment
 Full-employment
 Above full-employment
P
SAS
P
LAS
LAS
SAS
B
A
AD
AD
1400
3000
Real GDP
3000
Real GDP
Figure 5: Below full-employment Eq.
Figure 6: Full-employment equilibrium
Short run equilibrium GDP = Y0 =1400
Potential GDP = YP = 3000
Y0 < YP  Recessionary Gap (RG)
= 3000 – 1400 = 1600
Short run eq GDP = long run eq GDP
= potential GDP = Y P = 3000
P
Real GDP
(Y)
LAS
C
SAS
4400
IG
C
3000
B
RG
1400
AD
3000
4400 (Y)
Figure 7: Above full-employment eq.
Short run equilibrium GDP = Y0 = 4400
Y0 > YP  Inflationary Gap (IG)
= 4400 – 3000 = 1400
Real GDP
A
Year
Figure 8: Business Cycle Diagram
(Fluctuations in Real GDP)
Recessionary GAP = RG = 3000 – 1400 = 1600
Inflationary GAP = IG = 4400 – 3000 = 1400
Figure 5 shows the economy’s present short run equilibrium is at point A with real GDP equal to 1400.
Since the economy’s present short run equilibrium (Y0 =1400) is below potential GDP (YP = 3000), the
economy has below full-employment. Point A in AD-AS diagram of figure 5 corresponds to point A of
business cycle diagram of figure 8. Figure 6 shows the full-employment equilibrium. Figure 7 shows
the economy’s present short run equilibrium is at point C with real GDP equal to 4400. Since the
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economy’s present short run equilibrium (Y0 =4400) is above potential GDP (YP = 3000), the economy
has above full-employment. Point C in AD-AS diagram of figure 7 corresponds to point C of business
cycle diagram of figure 8. The amount by which potential GDP (YP) exceeds the real GP (Y0) is called
recessionary gap.
Recessionary gap = YP – Y0 = 3000 – 1400 = +1600
The amount by which real GDP exceeds the potential GDP is called inflationary gap.
Inflationary gap = Y0 – YP = 4400 – 3000 = +1400.
Exercise: Consider the following table
Price level
90
Aggregate Demand
(Millions of Dinar)
2,000
Short-run Aggregate
Supply
(Millions of Dinar)
1,400
Long-run Aggregate
Supply
(Millions of Dinar)
1,900
100
1,800
1,600
1,900
110
1,600
1,800
1,900
120
1,400
2,000
1,900
130
1,200
2,200
1,900
1.
At P = 100, the economy has an excess demand or excess supply?
2.
At P = 120, the economy has an excess demand or excess supply?
3.
What are the short-run equilibrium real GDP and price level of the economy?
4.
Whether the country has an inflationary or a recessionary gap and by how much?
5.
What is the full-employment GDP? Draw AD, SAS, and LAS curves.
6.
Is there any cyclical unemployment? Explain. Is it positive, negative or zero?
7.
What the government could do to achieve full-employment?
8.
If the government of the country would like to achieve full-employment, using economic
policies, which of the following it would do?
(a) By increasing G or decreasing T, it shifts the AD curve to the right to achieve fullemployment
(b) By increasing money or decreasing interest rate, it shifts the AD curve to the right to
achieve full-employment
(c) Both (b) and (c)
9.
From the data above, when the economy is at its short-run equilibrium, as the time passes
(a) SAS curve shifts rightward
(b) SAS curve shifts leftward
(c) LAS curve shifts rightward
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Fluctuations in AD and AS
Suppose an economy is initially (or originally) at a long run full-employment equilibrium. Starting
from this full-employment equilibrium, suppose one of the following things happen
i. firms expect a (huge) loss in the future.
ii. money or nominal wage and price of other factors of production (or price of
inputs) increase.
iii. both (i) and (ii) happen at the same time.
What would happen in the short-run in terms of real GDP, employment, and the price level?
i. Firms expect a loss in the future
The economy was initially at point A
in figure 9. When firms expect a loss
in the future, AD decreases, and
as a result AD curve AD0 shifts to AD1.
New short-run equilibrium is at point B
in figure 8 at the intersection of new AD
curve AD1 and SAS0 curve.
In the new short-run equilibrium, you
can see that real GDP decreases
to Y1 and with the decrease in real
GDP, employment decreases. The
economy now has less than
full-employment (cyclical
unemployment). Price level decreases
to P1.
Price
Level
LAS
SAS0
Figure 9
P0
A
AD0
YP
Real GDP
ii. Nominal or money wage and price of other factors of production (or price of inputs) increase.
The economy was initially at point A
in figure 10. When price of factors of
Price
LAS
production increases, firms cost of
Level
SAS0
production increases and as a result SAS
decreases and SAS curve shifts up to the
left to SAS1. New short-run equilibrium
is at point C in figure 9 at the intersection
of new SAS curve SAS1 and AD0 curve.
P0
A
Real GDP decreases to Y1 and with the
decrease in real GDP, employment
Figure 10
decreases or unemployment increases.
The economy now has below
full-employment (cyclical
AD0
unemployment). Price level increases
to P1. It creates Stagflation.
YP
Real GDP
Stagflation is a combination of recession and inflation. In figure 10, we started with full-employment.
Then due to increase factor prices, economy moved to below full-employment means the economy
moved to recession. It also creates inflation because price level increased from P 0 to P1. So we had a
combination of recession and inflation or stagflation.
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iii. both (i) and (ii) happen at the same time.
The economy was initially at point A
in figure 11. When price of factors of
Price
LAS
production increases and at the same
Level
SAS0
time firms expect loss, both
AD and SAS curves shift. SAS curve
Figure 11
shifts to SAS1 and AD curve shifts
to AD1. One possible, new short-run
P0
A
equilibrium is at point E in figure 10.
In the new short-run equilibrium E, real
GDP decreases and employment decreases
or unemployment increases. The price
AD0
level increases. Note that when SAS
decreases and at the same time AD
decreases, real GDP and employment
definitely decrease but price level
YP
Real GDP
is indeterminate meaning that
price level may increase, decrease, or remain the same. In the example of figure 11, price level
increases to P1 and real GDP decreases to Y1.
Effects of Government’s Economic Policies
How the government’s economic policies such as fiscal policy (changes in G or T) or monetary policy
(changes in money or interest rates) affects real GDP, employment, and price level. Remember,
Expansionary fiscal policy = increase in G or decrease in T
Expansionary monetary policy = increase in money or decrease in interest rate
If G increases or tax decreases or money increases or interest rate decreases, AD curve shifts to the
right.
Consider an economy in long run equilibrium (or full employment equilibrium). Remember, in the long
run an economy has full employment. Starting from this full employment position, suppose quantity of
money increases or government increases its expenditure (G). The change in any one of these factors
will shift the AD curve to the right and will affect the economy’s output (real GDP), employment, and
inflation in short run and long run. That is, there will be short run and long run effects.
I. Short Run Effect
The economy is initially in long run full employment equilibrium at point A in figure 12 with Real
GDP equal to YP and price level P0. Now increase in any one of those factors mentioned above will
shift the AD curve from AD0 to AD1. The new short run equilibrium is at point B.
Price
Level
LAS
SAS0
P1
P0
B
A
Figure 12
AD0
AD1
YP
Y1
Real GDP
At the new short run equilibrium B, real GDP increases from Y P to Y1 and with the increase in real
GDP, employment increases (or unemployment decreases). We also see that in the short run price level
increases from P0 to P1 in figure 12. That is, economy now has inflation.
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II. Long run Effect
In the new short run equilibrium B in figure 13, workers nominal wage remains the same as in point A.
Since the price level has increased from P0 to P1, workers now have a lower real wage (nominal wage
divided by price level) at point B compared to point A. That is, workers purchasing power has
decreased. Firms on the other hand have a higher
Price
Level
SAS1
LAS
SAS0
P2
C
P1
B
A
Figure 13
P0
AD1
AD0
YP
Y1
Real GDP
profit at point B compared to point A. (Remember, moving upward along a SAS curve gives a higher
profit.) Then, at the new short run equilibrium B, workers are unhappy (because their purchasing power
decreased) and firms are happy (because their profits are higher). So, workers demand a higher nominal
wage. Firms to keep their workers and higher profits, raise nominal wage. When nominal wage
increases, SAS curve shifts up and to the left. As the nominal wage increases, SAS curve keeps on
shifting till it reaches SAS1. Point C in figure 8 is the new long run equilibrium. In the long run, there is
no increase in real GDP (real GDP comes backs to YP) and employment, only price level increases to
P2.
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Question
Price level
80
90
100
110
120
130
140
Real GDP demanded
(billions of 2005 dollars)
1650
1500
1350
1200
1050
900
750
Real GDP supplied
(billions of 205 dollars)
750
900
1050
1200
1350
1500
1650
The table above shows a country’s aggregate demand and supply schedules. The country’s potential
GDP is $1000 billion.
1.
Plot the AD, SAS and LAS curves.
2.
What are the short-run equilibrium real GDP and price level of the economy?
3.
What is the long-run equilibrium real GDP?
4.
What is the full-employment GDP?
5.
Is the country’s short-run equilibrium a full-employment equilibrium, below full-employment
equilibrium, or above full-employment equilibrium? What is the recessionary gap (if any)? What is
the inflationary gap (if any)?
6.
Suppose government purchases (G) increases by $150 billion. What would happen to AD, SAS
and LAS curves? How do real GDP and price level change in the short run? Draw the new
equilibrium.
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Exercise: True or false
(a)
(b)
(c)
(d)
(e)
(f)
(g)
(h)
(i)
(j)
Along a LAS curve, price level increases but prices of labor (nominal wages) do not change.
Along a LAS curve, firms profit increases or decreases.
A change in nominal wage shifts both LAS and SAS curves.
Along a SAS curve, nominal wages remain the same.
As one moves upward along a SAS curve, firms profit increases.
The term “monetary policy” refers to the government’s spending more money to purchase
more goods and services.
If the price level increases, real wealth decreases and when real wealth decreases, people save
more.
When the price level rises and other things remain the same, interest rates rise.
When price level increases, SAS increases.
When price level increases, AD decreases.
SAMPLE MULTIPLE CHOICE QUESTIONS
1.
2.
Suppose that the money wage in the economy increases by 8 percent. As a result
(a) the SAS will decrease
(b) the LAS will decrease
(c) the LAS will increase and the SAS will decrease
If the economy is at the natural rate of unemployment,
(a) real GDP > potential GDP
(b) real GDP = potential GDP
(c) real GDP < potential GDP
(d) all of the above can occur when the economy is at the natural rate of unemployment
3.
Along a SAS, quantity of real GDP supplied increases as the price level increases because
(a) total revenue increases more than the increase in cost of production and as a result profit
increases.
(b) prices of goods and services and prices of factors production change in the same proportion.
(c) total revenue increases more than the increase in cost of production and as a result profit
decreases.
(d) prices of goods and services increase but prices of factors production decrease.
4.
A downward shift in the aggregate demand (AD) curve could be caused by
(a) a decrease in the future expected inflation.
(b) a decrease in expected future income.
(c) a decrease in government expenditure (G).
(d) all of the above.
5.
If LAS curve shifts more than the increase in AD curve, the result will be
(a) no inflation in the economy.
(b) there will be a negative inflation (or deflation) in the economy.
(c) there will be inflation in the economy.
(d) none of the above is true.
6.
Suppose the price level rises and the nominal wage remains constant. This is represented by
(a) an upward movement along the LAS curve
(b) an upward movement along the SAS curve
(c) a leftward shift of the SAS curve and the LAS curve
7.
If firms expect that their future profit will be higher, then
(a) the SAS curve will shift to the right.
(b) the AD curve will shift to the right
(c) the AD curve will shift to the left
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8.
A country has more than potential (or above full employment) equilibrium in the short run. The
country will
(a) eventually adjust to a long run equilibrium with a higher price level
(b) eventually adjust to a long run equilibrium with a lower price level
9.
A country has less than potential (or below full employment) equilibrium in the short run. The
country will
(a) eventually adjust to a long run equilibrium with a higher price level
(b) eventually adjust to a long run equilibrium with a lower price level
10. Equilibrium real GDP increases while the equilibrium price level does not change. This
could happen as a result of a simultaneous
(a) increase in both AD and SAS curves.
(b) decrease in both AD and SAS curves.
(c) increase in AD and decrease in SAS curve.
(d) decrease in AD and increase in SAS curve.
11. A fall in the foreign exchange rate (E↓) of the national currency
(a) increases AD
(b) increases NX
(c) both (a) and (b) true
Price
Level
LAS
SAS
SAS
120
110
A
B
100
AD
AD
2000
5000
Real GDP
12. Refer to the figure above. Suppose the economy is now at point B. The economy will be in a longrun equilibrium at a price of
(a) 120
(b) 110
(c) 100
13. Refer to the figure above, Suppose the economy is now at point A. As the time passes, the
economy will be in an equilibrium at a price of
(a) 120
(b) 110
(c) 100
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Questions 14 and 15 refer the following figure
Price
Level
LAS1
LAS2
SAS
AD
Real GDP
14. In the above figure, there is inflationary gap
(a) if the LAS curve is LAS1
(b) if the LAS curve is LAS2
(c) both of the above answers are correct
15. In the above figure, there is recessionary gap
(a) if the LAS curve is LAS1
(b) if the LAS curve is LAS2
(c) both of the above answers are correct
Ashraf Nakibullah
Important Concepts

Gross and Net Investments

Nominal and Real Interest Rates

ID curve

Movement and Shift of ID curve

SS curve

Disposable income

Shift of SS curve

Determination of Real Interest Rate
46
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FINANCE, , SAVING AND INVESTMENT
Capital, Gross Investment, Depreciation and Net Investment
Capital is the machine, plant, equipment, tools, buildings, and inventories of raw materials and
semifinished goods that are used to produce other goods and services. Company stocks and bonds are
NOT considered capital in economics.
Quantity of capital changes because of investment and depreciation.
Gross investment = purchase of new capital goods. That is total amount spent on new capital is called
gross investment. That gross investment is known as simply investment (I) in short.
Investment = I = Gross investment.
Change in the value of capital is called net investment:
Net investment = amount of the capital stock increases during the period.
= capital stock at end of the period – capital stock in the beginning of the period.
Capital goods do not last forever, but rather tend to depreciate or wear out over time. Thus,
depreciation is the reduction (decrease) in capital stocks that occur over time when they are used.
Gross investment = I = net investment + depreciation.
Net investment = gross investment – depreciation.
Exercise 1
At the beginning of the year, a company had a capital stock of 6 machines. During the year, the
company scrapped (destroyed) 3 machines and purchased 4 machines.
1. What was the company’s gross investment?
2. What was the company’s depreciation?
3. What was the company’s net investment?
4. What was the company’s capital stock at the end of the year?
Exercise 2
Suppose capital stock is 250 in the beginning of a year, gross investment (new capital) is 40, and the
capital stock wears out at a rate of 10%. What is the value of capital stock at the end of the year?
Exercise 3
Ahmed is an internet service provider. On December 2009, he bought an existing business with servers
and a building worth BD200,000. During the first year of operation, his business grew and bought new
servers for BD150,000. The market value of his old servers fell by BD35,000.
1. What was Ahmed’s gross investment, depreciation, and net investment during 2010?
2. What is the value of Ahmed’s capital at the end of 2010?
Exercise 4
A company makes total investment of $800 million in new buildings and its depreciation is $50
million.
(a) What is its gross investment?
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(b) What is its net investment?
THE MARKET FOR LOANABLE FUNDS
All financial markets (loan markets, bond markets and stock markets) are grouped into a single market
for loanable funds. The market for loanable funds is the aggregate of all the individual financial
markets.
Here we treat investment as the demand for loanable funds.
How Investment is Financed
Note that household’s income (Y) is consumed (C), saved (S), or paid in net taxes (T). That is
Y=C+S+T
(1)
where S = private saving (or households and private business saving). Thus private saving is
Private (household) saving = S = Y – C – T.
(2)
Government budget surplus = government saving = T – G
(3)
National saving = NS = household saving + government saving
NS = S + (T – G) = (Y – C – T) + (T – G) = Y – C – G.
Now remember from chapter 1 that Y (or GDP) also equals the sum of the items of aggregate
expenditure:
Y = C + I + G + (X – M).
(4)
Using equations (1) and (4), we can write
C+S+T=C+I+G+X–M
(5)
Equation (5) can be written as
I = S + (T – G) + M – X = NS + (M – X)
(6)
Equation (6) tells us that the country’s investment (I) is financed by household’s saving (S),
government surplus or saving (T – G) and by borrowing from the rest of the world (X – M).
Alternatively, investment (I) is financed by national saving (NS) and by borrowing from the rest of
the world (X – M).
Note that a government budget surplus (T > G) contributes funds to finance private investment (I), but
a government deficit (T < G) reduces the funds for investment.
If we import more than export meaning (M > X), we borrow (M – X) from the rest of the world to
finance our investment. If we export more than import (M < X), we lend (X – M) to the rest of the
world to finance other countries investment.
Exercise 4
A country had the following data: income (Y) = $200,000, taxes (T) = $60,000, government purchases
(G) = $45,000, consumption (C) = $120,000
1. What was the country’s private saving or households and businesses saving?
2. What was the government saving (or government surplus)?
3. What was the national saving?
4. Suppose the country’s exports (X) = $65,000 and imports (M) = $70,000.
(a)
Is the country lending or borrowing from the rest of the world and by how much?
(b)
What was the country’s investment?
(c)
How much investment is financed by household and government saving and how
much investment is financed by the lending or borrowing from the rest of the world?
5. Instead, suppose the country’s exports (X) = $80,000 and imports (M) = $70,000.
(a)
Is the country lending or borrowing from the rest of the world and by how much?
(b)
What was the country’s investment?
(c)
How much investment is financed by national saving and how much investment is
financed by the lending or borrowing from the rest of the world?
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Examples
1. Investment is financed by
(a) national saving
(b) government spending
(c) borrowing from rest of the world
(d) by (a) and (c).
2.
Suppose a country’s taxes (T) were $90,000, government purchases (G) were $75,000 and the
national saving was $50,000, how much were households and businesses saving?
(a) $65,000
(b) $35,000
Nominal and Real Interest Rates
Nominal interest rate is the amount paid as interest per dinar borrowed for each period. That is,
nominal interest is the interest rate expressed in terms of money. Real interest rate is the nominal
interest rate on an asset adjusting for inflation rate. To understand the difference, suppose you have
made a one-year simple loan of 100 dinar with a nominal interest rate of 5%. At the end of the year you
have 105 dinar = (100 dinar + 5 dinar gain in nominal interest income). So, you gained 5%. That is, you
would be able to buy 5% more goods and services if there were no inflation. What about if there were
3% inflation rate over the course of the year? Inflation rate 3% means, you would be able to buy 3%
less goods and services at the end of the year. That is, you lost 3% in purchasing power, so your real
gain or real interest rate was 2% = 5% gain in nominal interest rate – 3% loss due to inflation rate.
This simple calculation shows that
Real interest rate = Nominal interest rate – inflation rate.
THE DEMAND FOR LOANABLE FUNDS: INVESTMENT DECISIONS
A firm’s investment depends on the real interest rate and the expected profit rate. Real interest rate is
the opportunity cost of investment.
Demand for Loanable Funds (DLF) or Investment Demand (ID) Curve
Remember, real interest is the opportunity cost of investment. Other things remaining the same, the
higher the real interest rate, the smaller is the quantity of loanable funds demanded, and the lower the
real interest rate, greater is the quantity of loanable funds demanded.
The demand for loanable funds (DLF) curve is negative the relationship between the quantity of
loanable funds demanded and the real interest rate, when all other things remain the same.
Real Interest
Rate (%)
10
5
Figure 1: Demand for Loanable
Funds (DLF) curve
B
A
DLF or ID
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300
550
Loanable funds (Million $)
Exercise 5
Suppose a company decides to take a loan (borrow) $100 million to build a new warehouse (or
factory). So, this is an investment decision. The company expects to get return of $5 million a year
from this investment.
1. Would the firm build the factory (or do the investment) and make a profit if the real interest is
4.5% a year?
2. Would the firm build the factory (or do the investment) and make a profit if the real interest is
5.2% a year?
Movement along a DLF curve can happen only when real interest rate changes. For example, one can
move from point A to point B only when real interest rate increases from 5% to 10%.
Shifts of DLF curve
DLF curve shifts when the expected profit rate changes (with no change in the real interest rate. From
now on we will sometime use small r to denote real interest rate.
r = real interest rate
r
In figure 2, DLF curve shifts to the right
from DLF1 to DLF2 due to increase in the
firm’s expected profit rate. That is,
if firm’s expected profit rate increases
DLF curve shifts to the right and when
expected profit rate decreases the DLF
curve shifts to the left. Note that shift
of DLF curve occurs when there is no
change in real interest rate.
In figure 2, DLF increases from
$30,000 to $45,000 because expected
profit rate increased and no change in
real interest rate (5%).
Figure 2
5%
DLF2
DLF1
30,000
45,000 Loanable Funds
During expansion phase of the business cycle, firm’s expected profit rate increases and as a result
during expansion DLF curve shifts to the right. During recession phase of the business cycle, firm’s
expected profit rate is lower and as a result during recession DLF curve shifts to the left. Technological
advance or improvement also increases firm’s expected profit rate and as a result with technological
advancement DLF curve shifts to the right.
Question: Which of the following would shift the DLF curve to the rightward?
(a) increase in expected profit rate
(b) decrease in real interest rate
(c) decrease in the taxes paid by firms or businesses
(d) economy enters the expansion phase of a business cycles
(e) economy enters the recession phase of the business cycle
(f) technological advance or improvement (g) only (a), (c), (d) and (f).
THE SUPPLY OF LOANABLE FUNDS: SAVING DECISION
Let us define
Y = income
C = consumption
S = Saving
T = tax
YD = Y – T = disposable income
Thus disposable income (YD) is the income remaining after tax. Remember income is spent as
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51
Y=C+S+T
Y–T=C+S
YD = C + S
The supply of loanable funds (SLF) or saving supply (SS) curve shows the positive relationship
between the quantity of loanable funds supplied and the real interest rate (when all other things remain
the same). This positive relation is shown in figure 3.
SLF or SS
Real Interest
rate (r)
Figure 3
YD
2200
2200
=
=
=
C
1500
+
+
+
S
700
900
5%
B
(r = 3%)
(r = 5%)
3%
A
Here we see that there is no change in
disposable income (YD = 2200), but
still saving increased because real
interest rate increased from 3% to 5%.
700
900 Loanable funds
Real interest rate can be thought as a return on supply of loanable funds (saving). So, when real interest
rate increases, other things such as disposable income, wealth remain the same, still people save more.
In figure 3, we see real interest rate increases from 3% to 5% and as a result one moves along the SLF
curve from point A to point B. It is important to note that movement along a SLF curve can only
happen when real interest rate changes. Thus along a SLF curve only real interest rate changes but all
other things such as disposable income, wealth, expected future income remain the same.
Factors that Shift of SLF Curve
Factors that shift or change SS curve are:
 Disposable income
 Wealth
 Expected future income
 Default risk
Consider the following table and figure 4 below.
r
SLF1
SLF2
Figure 4
YD
2200
=
=
=
C
1500
1800
+
+
+
S
700
900
(r = 3%)
(r = 3%)
3%
A
C
Here we see that there is no change in real
interest rate (r = 3%), but saving
increased from 700 to 900 because
disposable income increased from 2200 to 2700.
700
900
Saving (S)
Going from point A to point C in figure 4 represents shift of the SLF curve from SLF1 to SLF2.
Important point to note that the real interest rate at point A is the same (3%) as the real interest rate at
point C. That is, a shift in SLF curve means there is no change in real interest rate but still supply of
loanable funds has changed because either disposable income, wealth or expected future income has
changed. Figure 4 shows that disposable income increased from 2200 to 2700 and as a result supply
increased from 700 to 900.
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52
Disposable income: When households have more disposable income, other things remain the same,
they save more and the SLF curve shifts to the right. Similarly, when households have less disposable
income, other things remain the same, they save less and the SLF curve shifts to the left.
Wealth: Remember wealth is the value of all things that people own or accumulation of savings. When
people’s wealth increases, other things remain the same, they tend to save less and the SLF curve shifts
to the left.
Expected future income: If people expect a lower future income, other things remain the same, they
save more now and as a result SLF curve shifts to the right. If people expect a higher future income,
other things remain the same, they save less now and as a result SLF curve shifts to the left.
Default Risk: Default risk is the risk that a loan will not be repaid. The higher the default risk, the
smaller is the supply of loanable funds (SLF shifts to the left).
Equilibrium in the Capital Market: Determination of Real Interest Rate
Investment is demand for loans and saving is the supply of loans. Thus, investment is the demand for
loanable funds and saving is the supply of loanable funds.
investment = demand for loanable funds
saving = supply of loanable funds
Real interest rate is the price of loan (or loanable funds). So, the price of loanable funds or real interest
rate is determined by the demand and supply of loananle funds. This is shown in figure 5 below.
Real Interest
Rate (r)
%
SLF
Figure 5
r0 = 5%
A
DLF
500
Loanable Funds (million $)
In figure 5, loanable funds market equilibrium is at point A and r0 is the equilibrium real interest rate at
which quantity of loanable funds demanded and supplied is equal ($500 million).
Any r > r0 (=5%, equilibrium interest rate), there is surplus in the loan market and interest rate
decreases to r0. For example, if the interest rate exceeds 5% a year, the quantity of loanable funds
supplied exceeds the quantity demanded. In this case, borrowers find it easy to get funds, but lenders
are unable to lend all the funds they have available. Real interest falls until the quantity of funds
supplied equals the quantity of funds demanded.
Similarly, Any real interest rate (r) less the r0 (the equilibrium real interest rate), there is shortage in the
loan market and interest rate increases to r0. For example, if the interest rate is less than 5% a year, the
quantity of loanable funds supplied is less than the quantity demanded. In this case, borrowers can’t get
the funds they want, but lenders are able to lend all the funds they have available. So, the real interest
rises until the quantity of funds supplied equals the quantity of funds demanded.
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Exercise
In the figure below, the initial demand for loanable funds curve is DLF0 and the initial supply of
loanable funds curve is SLF0.
Real Interest
Rate (r)
%
SLF0
5%
DLF0
1500
Loanable funds
1.
Suppose an economic expansion raises people’s disposable income and raises
expected profit rate. In the figure show what happens to DLF and SLF curves.
2.
Suppose there was a recession that lowers expected profit and decreases people
wealth. In the figure show what would happen to DLF and SLF curve.
3.
Suppose there was technological progress. In the figure show what would happen to
DLF and SLF curve.
4.
Suppose people expect a higher future income. What would happen to real interest
rate?
5.
In the figure above, suppose real interest rate increased to 7%. This could be caused
by
(a)
(b)
(c)
(d)
Recession that lowers expected profit rate
An increase in people’s disposable income
A decrease in people’s wealth
Expansion that raises expected profit rate
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SAMPLE MULTIPLE CHOICE QUESTIONS
1.
In economics capital is the
(a) amount of financial assets such as stocks and bonds people hold
(b) quantity of machines, plant, inventories
(c) both (a) and (b) are true
2.
A country’s nominal interest rate increases from 5% to 10%. The country’s investment (I)
(a) must be decreased
(b) must be increased
(c) may remain the same
(d) cannot be answered given the information above
3.
The capital stock increases if
(a) net investment is positive
(b) net investment is negative
(c) gross investment is greater than net investment
4.
A fall in the real interest rate
(a) increases investment demand
(b) increases investment (or increases quantity of investment demanded)
5.
Suppose expected profit rate is 10% and real interest is 12%,
(a) the firm will take or undertake the project
(b) the firm will not undertake the project
6.
If real interest rate is above equilibrium interest rate, then
(a) lenders will be unable to find borrowers willing to borrow all the available funds and the real
interest rate will fall.
(b) Borrowers will be unable to borrow all the funds they want to borrow and the real interest rate
will rise.
7.
Economic recession causes
(a) firms’ expected profit rate to decrease and as a result ID curve shifts to the left
(b) firms’ expected profit rate to increase and as a result ID curve shifts to the left.
(c) firms’ expected profit rate to increase and as a result ID curve shifts to the right
8.
If expected profit rate increases
(a) there will be a movement along a ID curve
(b) the ID curve shifts to the right
(c) the ID curve shifts to the left
9.
A rise in the real interest rate
(a) increases saving supply
(b) increases saving (or increases quantity of saving supplied)
10. A decrease in disposable income causes
(a) movement along a SS curve
(b) shifts of the SS curve to the left
(c) shifts of the saving supply curve to the right
11. A simultaneous (or at the same time) economic expansion and increase in disposable income
causes
(a) real interest to increase
(b) real interest to decrease
(c) real interest to be unchanged
(d) any one of the above may happen
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Question 1
Case A: Nominal interest rate 6%; Inflation rate 2%.
Case B: Nominal interest rate 18%; inflation rate 16%.
(a) Which case would have the higher investment?
(b) Which case would have the higher saving?
Question 2
Real Interest Rate
(%)
2
4
6
8
(a)
(b)
(c)
(d)
Demand for loanable funds
(in 2005 dollar)
10,000
8,000
6,000
2,000
Supply of loanable funds
(in 2005 dollar)
4,000
6,000
8,000
10,000
Draw the demand and supply curves for the loanable funds.
What is the equilibrium real interest rate?
What is equilibrium investment? Equilibrium saving?
What is the situation in the loanable funds market when the real interest rate is 3%? Is there a
shortage or surplus of loanable funds?
(e) Describe what happens to the equilibrium real interest rate and equilibrium investment if the
economy is hit by a recession and show the effect on your graph.
Ashraf Nakibullah
Important Concepts

Medium of Exchange

Unit of Account

Store of Value

M1

M2

Balance Sheet of Commercial Banks

Investment securities

Reserves: Actual and Required

How Banks Create Money?

Multiple Deposit Creation

The Central Bank

Required reserve ratio

Discount rate

Open market operation
56
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MONEY AND BANKING
What is money?
Money is anything that is accepted for payments and settling debt.
FUNCTIONS MONEY
Three Functions of Money: Medium of exchange
Unit of account
Store of Value
Medium of Exchange
A medium of exchange is an object that is generally accepted in exchange of goods and services.
Money acts such a medium. Without money, it would be necessary to exchange goods and services
directly for other goods and services – an exchange called barter that requires double coincidence of
wants. For example, a vegetable seller needs milk must find a milkman who wants vegetable. Money
guarantees that there is double coincidence of wants because the money received by the vegetable
seller can always use it to buy milk or anything else.
Unit of Account
A unit of account is a measure for stating prices. It serves two purposes: (1) it is simply a pricing
mechanism and (2) it simplifies the counting of prices. Money provides the term in which prices are
quoted and debts are recorded. The usual unit of account in Bahrain is Bahraini Dinar. People quote
prices in dinars and write totals on price tags in dinars. A car dealer tells you that a car costs BD6000,
not 500 shirts (even though it may amount to the same thing).
Store of Value
A store of value is any good or asset that people can store while it maintains some or all its value. If
you work today and earn BD100, you can hold the money and spend it tomorrow, next week, next
month, or next year. If you decide to spend next year, it maintains (or stores) most of value if prices do
not rise much. With rising prices (inflation), money may lose some of its value but still maintain most
of its value.
Exercise
Indicate which of the three primary functions of money is illustrated by each statement
(a) Ahmed buys a TV by writing a check
(b) John drops the coins from his pocket into a box in his study desk.
(c) The prices of goods in a jail were stated in terms of cigarettes
(d) A BD500 price tag on a computer
(e) Beth calculates that the opportunity cost of her time was $10 per hour.
(f) Jack purchases a gift of $50 for his parents
(g) The role of money that would not be provided if bananas were to serve as money
MEASURES MONEY
Money consists of Currency and Deposits at banks and other financial institutions.
Currency: The paper notes and coins that you use in Bahrain (or any other country) today are known
as currency. They are money because the government declares them so.
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Deposits. Deposits at banks and other financial institutions are also money. Deposits are money
because they can be converted into currency and they are used to settle debts.
Official measures of money:
M1 = Currency held outside banks + private demand or checking deposits + traveler’s check
M2 = M1 + private time and saving deposits + money market mutual funds
Important note: Currency held by banks is not part of money and is not included in M1 or M2.
Moreover, deposits are money but checks or credit cards are not money.
BANKS (or COMMERCIAL BANKS)
Commercial banks or simply banks are financial intermediaries. A financial intermediary is an
institution that stands between lenders and borrowers. It borrows itself and then relends those funds
(money) to the borrowers. A commercial bank borrows currency (notes and coins) from the people
(public), issuing a deposit in exchange. Then it uses the money it has borrowed to make loans to firms
or individuals who it believes will repay them. Banks earn profits by lending the money that people
deposit and charging higher interest rates to borrowers than the interest rates that they pay to
depositors. For example, you may earn 3% interest on the money in your bank account, but the bank
lends most of the money you deposited, perhaps charging 10% interest. The difference covers the
bank’s costs and provides a profit for the bank’s owners.
In summary: Banks are depository institutions that accept deposits and making loans.
A simplified balance sheet of commercial banks
Table 1 is a simplified (consolidated) balance sheet of banks.
Table 1
Consolidated balance sheet of Banks [in million (m) dinar]
Assets
Liabilities
Reserves
Notes and coins (vault cash)
Reserve with the central bank
200
Deposits
800
Investment Securities
100
Borrowing
50
Loans
700
Other liabilities
Total
1000
160
40
Total
150
1000
Table 1 shows the assets and liabilities of all (or consolidated) commercial banks of a hypothetical
country. For any bank has this kind of structure for any country. The banking system’s liabilities are
the deposits, which are the bank’s debts or obligations to the public. That is, these are the money that
public deposited with the banks. In this case total deposits are 800 m. Banks also sometimes borrow
money. Borrowing from the central bank is known as the discount loan. In table 1, borrowing is 50 m.
By definition, its total assets are also 1000 m. In asset side we see two major items: Banks’ reserves or
simply reserve and loans. Out of total deposits banks’ keep a small part as reserves and rest they use to
make loans. Banks are profit maximizing institutions. If a bank kept all its deposits as reserves, it
would not make any profit. More loans they can make, more profit they earn. In table 1, loan is 700 m.
Investment securities are long-term government bonds and other bonds. These bonds earn interest
income for banks.
Reserves: Actual and Required
Reserves are the money that banks hold to backup their deposits. Banks hold reserves for two reasons:
1.
They need money to give to people who make withdrawals from the accounts. This is
shown in table 1 as Notes and Coins broadly known as Vault Cash. Note banks keep
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59
only a fraction of its total deposit. Notes and coins are currency held by banks
inside banks and as mentioned above it is not included in M1 or M2.
2. Banks also hold reserves because the government (the central bank) requires them to
hold a certain fraction of deposits as reserves.
We will use the following symbols:
R = total (or actual) reserves
D = deposits.
r = required reserve ratio
RR = required reserves
Required reserves are the reserves that banks are required to hold by Banking Regulation and the
required reserve ratio (r) is calculated as
r
Re quired reserves RR

Deposits
D
 RR = (r)(D)
Excess Reserves (ER) are actual reserves (R) minus required reserves (RR):
ER= R – RR.
Whenever banks have excess reserves, they are able to make loans that create money. The following
example will help you to understand these concepts. Table 2 is a hypothetical balance sheet of a
commercial bank named Falcon Bank. In the liability side, it has only deposits (D) and on the asset side
it has only reserves (R) and loans (L).
Table 2
Balance sheet of Falcon Bank
(million dinar)
Assets
Reserves
Liabilities
50
Loans
150
Total
200
Deposits
200
Total
200
Here reserve (R) is 50. Suppose the required reserve ratio is 20% by the regulation. This means, Falcon
bank’s required reserves must be equal to 40 million dinar out of 200 million dinar of deposits:
RR = (r)(D) = (.2)(200) = 40
However, the Falcon bank is keeping 50 million dinar as reserves. This means, the bank has an excess
reserves of 10 million dinar:
ER = R – RR = (50 – 40 ) = 10.
Remember, loan is the main source of a bank’s income and profit. More loans may earn more profit.
Table 3 shows how the Falcon Bank by keeping excess reserves equal to zero or by keeping actual
reserves exactly equal to required reserves will increase loan and profit.
Table 3
Balance sheet of Falcon Bank
Assets
Reserves
Liabilities
40
Loans
160
Total
200
Deposits
200
Total
200
In table 3, the Falcon Bank actual reserves are 40 million dinar which are exactly equal to required
reserves and excess reserves are equal to zero. By keeping reserves exactly equal to required reserves,
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the bank has increased loan by 10 million dinar (equal to excess reserves) and as a results its profit will
may increase.
Exercise 1:
Assets
Liabilities
Reserve
10000
Loan
50000
Total
60000
Deposits
60000
Total
60000
Required reserve ratio (r) is 15%.
1.
The bank’s excess reserve is __________
2.
The bank can provide an additional (or more) loan equal to ___________.
Exercise 2:
A bank with $1 billion in deposits hold $70 million in cash, $80 million on deposits with the Fed
(central bank), and owns $100 million in government securities. If the reduction in the required
reserves generates excess reserves of $30 million and prior to change the bank had no excess reserves.
This means the initial required reserve ratio was ______________ and the new required reserve ratio is
_______________.
HOW BANKS CREATE MONEY?
In all our following discussions, we make three important assumptions:
1. Banks are able to make as much loan as they are allowed to.
2. Banks always keep reserves equal to required reserves.
3. People take loans and deposit back to their banks.
Consider the initial balance sheet of banks (that is, for the whole banking system) as in table 4 in which
liability side has only checking deposits of 1000 and asset side has only reserves and loans.
Table 4
Initial situation
Assets
Liabilities
Reserves
100
Loans
900
Total
1000
Deposits
1000
Total
1000
This banking system has 10% required reserve ratio. Now suppose people go to their banks and deposit
100 of currency in their checking accounts.
Multiple Deposit Creation
We will now see that when the banking system is supplied with 100 extra deposits (or checking
deposits are increased by 100), at the end (in the final balance sheet) deposits increase by a multiple of
the extra deposits. This process is called multiple deposit creation. You need to know how it works and
how we obtain final balance. Start with the initial balance sheet as in table 4:
Consolidated balance sheet of commercial banks
Initial situation
Assets
Liabilities
Reserves
100
Loans
900
Total
1000
Deposits
1000
Total
1000
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Required reserve ratio (r) is 10%, so initially the banking system has reserves equal to required reserves
and it always keeps reserves equal to required reserves. Now 100 additional (extra) money is deposited.
Step 1
Assets
Liabilities
Reserves
100 + 10
Loans
900 + 90
Total
1100
Deposits
1000 + 100
Total
1100
In step 1, required reserve is 10 = 0.1×100. That means, it immediately creates excess reserves equal to
90 will be available for new loan. That is, loan is immediately increased by 90. Thus a direct result of
100 addition deposit is that a new money of 90 is created. This is equal to increased loan of 90.
Step 2
Assets
Liabilities
Reserves
110 + 9
Loans
990 + 81
Deposits
1100 + 90
Total
Total
In step 2, people who took new loan of 90 will deposit in their banks and as a result deposit increases
by 90. Then 10% goes to the required reserve which is equal to 9 = 0.1×90 and then excess reserve of
81 will be the additional loan. This increased loan of 81 is deposited back and the process continues till
we reach the final balance sheet:
.
.
.
Final Balance sheet
Assets
Liabilities
Reserves
100 + 100
Loans
1800
Total
2000
Deposits
2000
Total
2000
How to construct the final balance sheet?
1. Start with initial reserve of 100 and add to it the initial extra deposit of 100. Thus, the
final reserve in the final balance sheet is 200 (an increase by 100).
2. Because ER = 0, R = RR + ER = RR. That is, R = RR. This means, r = RR/D = R/D
or we can write D = R/r. In the final balance sheet new or final total reserve is 200
(that is, 100 original plus increase in reserve by 100). Thus new deposit, D = 200/.1 =
2000, which means in the final balance sheet deposits increased by 1000.
∆D = final deposit – initial deposit = 2000 – 1000 = 1000.
3. New or final loan is equal 2000 – 200 = 1800, that is, loan increased by 900.
Money supply will increase by 900.
∆Money = ∆M = ∆loan = ∆L = 1800 – 900 = 900.
The basic idea of why money supply increases when deposit increases is that the bank can increase
their loans as deposits increase. This increase in loans gets multiplied many times to get a final
increase in money supply. In every step loan increases and as a result money supply increases.
Thus change in loan is equal to change in money supply (M = 900). Similarly, when deposits
decrease, loan decreases and money supply decreases.
Alternatively, we can arrive to the final deposit of the final balance sheet using the deposit expansion
multiplier which is defined as:
Ashraf Nakibullah
Deposit (expansion) multiplier =
62
1
.
r
In our example required reserve ratio ( r ) is 10%, thus in our example deposit multiplier is 10 times:
Deposit (expansion) multiplier =
1
1

 10.
r 0. 1
Exercise
A bank’s total liabilities are $3000 and it has checking deposits of $500, saving deposits of $1000, time
deposits of $1200, loans of $2300, government securities of $460, currency (notes and coins) in the
vault of $190, and reserves (deposits) with the central bank of $53. The bank is holding only required
reserves.
(a) What is the amount of this bank’s reserves?
(b) What is the bank’s total deposit?
(c) Make the initial balance sheet of this bank.
(d) What is this bank’s (required) reserve ratio out of total deposit?
(e) What is the deposit (expansion) multiplier?
Now suppose an individual deposited $150 more in this bank. That is, the initial extra deposit was now
$150.
(f) What is the excess reserve of the bank immediately after this extra deposit?
(g) How much additional loan can be made by the bank immediately after this extra deposit?
(h) Make the final balance sheet of the bank.
(i) What would be the change in quantity of money?
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63
THE CENTRAL BANK
A central bank is the government authority in charge of controlling and regulating the country’s money
supply and financial markets. There is one central bank for each country. The central of the US is
known as the Federal Reserve System or FED. The central bank of Bahrain is known as the Central
Bank of Bahrain, CBB (formerly known as Bahrain Monetary Agency - BMA). The central bank uses
policy tools or instruments to control money supply and thereby carrying out monetary policy.
Monetary policy is something of changing money supply and interest rates.
A central bank has many tools or instruments to control money supply. Three most discussed tools are
(1) Required reserve ratio
(2) Discount rate
(3) Open market operations
(1) Required reserve ratio: A central bank sets required reserve ratios, which are the minimum
percentages deposits that banks must hold as reserve. If 4% is the required reserve ratio, then
banks must keep at least 4% of their deposits with the central bank.
An increase in the required reserve ratio increases the banks reserves (R) and as a result loan
decreases, and when loan decreases money supply decreases. Similarly, money supply increases if
required reserve ratio decreases.
(2) Discount rate: The discount rate is the interest rate the central bank charges (commercial) banks
when banks borrow (reserve) money from the central bank. An increase in the discount rate raises
cost of borrowing reserves from the central bank, thereby decreases banks reserves which
decreases banks loan and as a result money supply decreases.
(3) Open market operations: Open market operations (OMO) are the purchase and sell of
government bonds (securities) by the central bank. When the central bank through OMO,
purchases government bonds, money supply increases. When the central bank through OMO, sales
government bonds, money supply decreases.
Let us see how it works. Table 5 is a balance sheet of a commercial bank – Bank A.
Assets
Table 5: Bank A (in million $)
Liabilities
Reserves
10
Loans
90
Total
100
Deposits
100
Total
100
The Bank A’ preferred RR is 10%. Now suppose the central bank buys 1 million worth of government
bonds from Mr. David. Mr. David after receiving 1 m from the central bank deposits to Bank A and as
a result both the banks deposit and reserves will increase immediately by 1 million. That is, change in
reserve will be R = 1 m and this will increase loans which will increase deposits. The final balance
will be as shown in table 6.
Table 6
Assets
Liabilities
Reserves
11
Loans
99
Total
110
Deposits
110
Total
110
So every step loan increases that will ultimately increase money supply. Thus, we have seen when the
central bank buys government bonds through OMO, money supply increases. The opposite is also true,
whenever the central bank sells government bonds through OMO, money supply decreases.
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Change in money supply
The central banks all over the world use mainly the open market operations to increase or decrease
money supply. One way to calculate change in money supply from open market operation is as
follows:
∆M = m∆R
where m is called money multiplier. When central bank purchases government securities ( bonds),
usually ∆R > 0 which means money supply increases and when it sells securities, usually ∆R < 0 which
means money supply decreases.
Exercise
1.
Suppose money multiplier is 5. If the central bank sells $5 million securities, the quantity of
money will
(a) decreases by $5 million
(b) increases by $25 million
(c) decreases by $25 million
2.
What do “purchase of securities” and “decrease in the discount rate” have in common?
(a) both increases loan and money supply
(b) both are open market operations
(c) both increases money supply
Question
Consider a bank which has checking deposits of $300 million, saving deposits of $900
million, reserves are 8% of total deposits, deposits or reserve in the central bank (FED) $30
million and loans are $800 million. There is no other liabilities in liabilities side and the bank
do not keep excess reserve (ER = 0).
1.
How much are the total assets of the bank?
2.
How much are the “all other assets” of the bank?
3.
How much is the currency (notes and coins) in the vault?
4.
How much is the (required) reserve ratio of the bank?
5.
How much is the deposit (expansion) multiplier of the bank?
Now suppose people deposit $500 in currency in their checking accounts.
6.
As a direct result of people’s deposit, the banks will create new money equal to _____________.
7.
As a direct result of people’s deposit, the banks will create new loan equal to _____________.
8.
How much is the change in reserve?
9.
In the final balance sheet, deposit is _________ and loan is ________.
SAMPLE MULTIPLE CHOICE QUESTIONS
Questions 1 to 4 refer to the following balance sheet of a bank.
Assets
Liabilities
Reserve
12000
Loan
48000
Total
60000
Deposits
60000
Total
60000
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1.
The bank does not hold any excess reserve. What is the required reserve ratio?
(a) 10%
(b) 15%
(c) 20%
(d) 25%
2.
You deposit 5000. As a direct result of your deposit the bank will create
(a) 5000 of new money
(b) 4000 of new money
(c) 3000 of new money
3.
Eventually money will increase by
(a) 5000
(b) 20000
(c) 15000
4.
Consider the above initial balance sheet. A customer deposits $400 in the Bank. After the deposit,
but before any other action, the bank will have excess reserves of
(a) $400.
(b) $320.
(c) $380.
(d) not enough information is given to answer the question.
5.
A customer deposits $500 in his Bank. All banks have a reserve ratio of 20 percent. Banks hold no
excess reserves. The amount of new deposits eventually created is
(a) $400.
(b) $1,500.
(c) $1,600
(d) $2,500.
6.
If the central bank increases discount rate, which of the following is true?
(a) loan decreases
(b) money supply decreases
(c) AD supply curve shifts to the left
(d) real GDP decreases and unemployment increases
(e) all of the above.
7.
Suppose money multiplier is 5. If the central bank purchases $5 million government securities
(bonds), the quantity of money will
(a) increases by $5 million
(b) increases by $25 million
(c) decreases by $25 million
(d) decreases by $5 million
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Important Concepts

Meaning of Inflation

Inflation rate

Demand-pull Inflation

Cost-push inflation

Gainer and loser from Inflation in the labor market

Gainer and loser from Inflation in the capital market

Phillips curve

Short-run Phillips curve
66
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INFLATION
(Chapter 29)
Inflation is a continually (persistently) rising price level. One time jump (rise) in the price level is not
inflation. Inflation is a process in which the price level is continually rising and money is losing value.
Inflation rate is the percentage change in the price level. If this year’s price level is P 1 = 130 and last
year’s price level is P0 = 125, this year’s inflation rate is: Inflation rate = {(P 1 – P0)/P0}*100 = {(130 –
125)/125}*100 = 4%.
Inflation can result from either an increase in aggregate demand (AD) or a decrease in aggregate supply
(SAS). These two sources are called
 Demand–pull
 Cost–push
DEMAND-PULL INFLATION
An inflation that results from an initial increase in aggregate demand is called demand-pull inflation.
Demand-pull inflation can arise from any factor that increases AD such as
1. Increase in the quantity of money
2. Increase in government purchases
3. Increase in exports
We now explain the process how the demand pull inflation arises from continually increasing money
supply as shown in figure 1 below.
Figure 1: Demand-pull inflation
Start at point 1. An increase in AD (say, due to increase in money supply) shifts AD 1 to AD2. Real
GDP increases more than potential GDP, money wage increases and SAS curve shifts from SAS 1 to
SAS2. Economy moves from point 1 to 1’ to 2 and price level increases from P 1 to P2. Then a
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continually rising money supply shifts AD curve right from AD2 to AD3 to AD4. In that case real GDP
would be greater than potential GDP and money wage increases and SAS curve shifts from SAS 2 to
SAS3 to SAS4. The economy moves from point 2 to 2’ to 3 to 3’ to 4. The result is that price level P
rises continually from P1 to P2 to P3 to P4. That is, we have inflation. Although any of several factors
can increase AD, only a continuous increase in the money supply can cause or sustain inflation.
Note: The demand-pull inflation starts when money increases or G increases or export increases.
COST-PUSH INFLATION
An inflation that results from initial increase in costs is called cost-push inflation. Two main sources
of increases in costs are
1. An increase in money wage rate
2. An increase in the money prices of raw materials
We now explain the process how the cost-push inflation arises from continually increase in costs as
shown in figure 2 below.
Figure 2: Cost-push inflation
Start at point 1 in figure 2. Now suppose cost of production such as nominal (money) wage or prices of
raw materials increase that will shift SAS1 to SAS2. Economy moves to point 1’ with a lower real GDP
(recession) and a recessionary gap equal to (YP – Y’); price level increases to P1’. Economy at point 1’
has stagflation. Stagflation is a combination of recession and inflation. Suppose that government has
employment target or goal of full employment (YP). Since at point 1’, real GDP is less than potential
GDP (Y’ < YP), government increases money or increases G or decreases T so that AD 1 shifts to AD2
and the economy moves to point with higher price level P 2. Then once in point 2, money wage
increases that will shift SAS curve left to SAS3. Economy moves to point 2’ again (Y’ < Y P).
Government cannot increase G or decrease T continually, so the government increases money supply
that shifts AD2 to AD3. Thus a continuous increase in money wage followed with increase in money
supply economy moves from point 1  1’  2  2’ 3  3’ 4 and price level P rises continually
from P1 to P2 to P3 to P4 and there is cost-push inflation.
Note: Cost-push inflation starts when money wage increases or prices of raw materials increases.
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EFFECTS OF UNANTICIPATED INFLATION
Labor Market
1.
2.
Redistribute income between employers and workers. When AD increases and causes inflation,
profit is higher than expected, so the owners of the firms (employers) gain at the expense of the
workers.
Higher than anticipated inflation lowers real wage rate, increases the quantity of labor demanded
makes jobs easier to find, and lowers the unemployment rate
Capital Market
1.
2.
Redistribute income among creditors (lenders) and borrowers (debtors). If the inflation rate is
unexpectedly high, borrowers gain but lenders lose. If the inflation rate is unexpectedly low,
borrowers lose but lenders gain.
When the inflation rate is higher than anticipated, the real interest is lower than anticipated,
borrowers want to borrow more and lenders want to lend less.
THE PHILLIPS CURVE: Inflation and Unemployment
Phillips curve is a curve that shows the relationship between the inflation rate and the unemployment
rate. There are two time frames for Phillips curves.
The Short-Run Phillips Curve
The short-run Phillips curve shows the tradeoff between the inflation rate and unemployment rate
holding constant the expected inflation rate and natural rate of unemployment.
Figure 3 illustrates a short-run Phillips curve (SRPC)—a downward-sloping curve.
Figure 3 shows that the negative relationship between the inflation rate and unemployment rate is
explained by the AS-AD model. An unexpectedly large increase in aggregate demand raises the inflation
rate and increases real GDP, which lowers the unemployment rate. So a higher inflation is associated
with a lower unemployment, as shown by a movement along a short-run Phillips curve.
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SAMPLE MULTIPLE CHOICE QUESTIONS
Year
1
2
3
4
Price level
(P)
100
120
140
160
P
SAS3
LAS
SAS2
140
E
G
120
110
100
D
SAS1
C
F
B
A
AD3
AD2
AD1
Y
1. Refer to the table and graph above. Economy moves from point A (year 1) to C (year 2) to point E
(year 3). This means the economy has
a. positive and decreasing inflation rate
b. positive and increasing inflation rate
2. Refer to above figure and start at point A and the economy moves to point B
a. real wage increases
b. real wage decreases
c. real wage remains the same
3. Refer to above figure and start at point A. An increase in money wage that triggers the cost-push
inflation will initially move the economy to
a. point B
b. point F
4. Refer to above figure and start at point A. An increase in money supply that triggers the demandpull inflation will initially move the economy to
a. point B
b. point F
5. Refer to the figure above, the demand-pull inflation moves the economy
a. from A to B to C to D to E
b. from A to F to C to G to E
6. Refer to the figure above, the cost-push inflation moves the economy
a. from A to B to C to D to E
b. from A to F to C to G to E
7. Inflation that is higher than expected transfer resources from
a. workers to employers and lenders to borrowers
b. workers to employers and borrowers to lenders
a. employers to workers and lenders to borrowers
8. Moving along a short-run Phillips curve indicates
a. high inflation is related to lower unemployment and vice versa
b. high inflation is related to higher unemployment
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Important Concepts

Slope of the consumption function

MPC, MPS, and marginal propensity to import

MPC + MPS = 1

Aggregate planned expenditure

Slope of aggregate expenditure curve

Induced expenditure

Autonomous expenditure (A)

Actual expenditure and planned expenditure

Equilibrium expenditure

Multiplier =

Y
1
1


A 1  MPC MPS

Change in equilibrium GDP = Y  

Aggregate expenditure (AE) and aggregate demand (AD)
( Eq. GDP )
Y

(autonomous exp enditure ) A
1


 1 
A  
A
 1  MPC 
 MPS 
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Important Assumption
The Keynesian model of aggregate expenditures assumes that both individual prices and the price level
are fixed in the short run.
Aggregate planned expenditure (AE) is the sum of planned consumption expenditure (C), planned
investment (I), planned government purchases (G) and planned exports minus imports (NX).
AE = C + I + G + NX
Consumption Function
The consumption function shows a positive relationship between consumption expenditure and
disposable income.
Let, Y = income (real GDP), T = taxes, and disposable income (YD) = income – taxes. Income (Y) is
used as:
Y=C+S+T
which can be written as
Y – T = C + S.
Since disposable income YD = Y – T, we can write
YD = C + S.
Consider the following table:
Disposable
Income
Taxes
Income
(Y)
(T)
(YD)
0
50
100
150
200
250
Planned
consumption
(C)
60
95
130
165
200
235
Planned
saving
(S)
MPC
MPS
Table shows that planned consumption increases as disposable income increases. Figure below depicts
the consumption function.
C
450 line
Consumption function
200
Figure 1
60
0
Slope of the consumption function =
200
Disposable income (YD)
C
=
YD
Autonomous consumption is the amount of consumption when disposable income is zero. In the table,
autonomous consumption is 60. In figure 1, it is shown that autonomous consumption is 60 when YD =
0. Autonomous consumption is the amount of consumption that is NOT influenced by income or it is
independent of income.
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Consumption cannot be zero (why?) but income or disposable income can be zero and saving can be
negative.
Induced consumption is the consumption above autonomous consumption. In the table, all
consumptions starting from 60 and above are induced consumption. Induced consumption is the
amount of consumption that is influenced by income or it is dependent of income.
Marginal propensity to consume (MPC)
The MPC indicates the change in consumption due to a change in disposable income. Thus, MPC is
defined as
MPC =
C
= slope of the consumption function.
YD
In the table suppose YD increases from 50 to 100, so that ∆YD = 100 – 50 = 50 and as a result C
increases from 95 to 130, so that ∆C = 130 – 95 = 35, so that
MPC =
C 130  95 35


 0.7
YD 100  50 50
How we understand MPC?
When there is NO tax or tax is fixed, MPC can be defined either change in C divided by change in
disposable income (∆YD) or change in C divided by change in income (∆Y). That is,
MPC =
C
C

YD Y
From the table above, we have
MPC =
C 130  95
C 130  95

 0.7 

YD 100  50
Y 110  60
Saving Function
The saving function shows a positive relationship between saving and disposable income. Note that S =
YD – C. When saving is negative, it is called dissaving. Thus, dissaving occurs when consumption is
greater than disposable income, that is S < 0 when C > YD.
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Marginal propensity to save (MPS)
The MPS indicates the change in saving due to a change in disposable income or income. Thus, MPS is
defined as
MPS =
S
= slope of the saving function.
YD
In the table suppose YD increases from 50 to 100, so that ∆YD = 100 – 50 = 50 and as a result S
increases from –45 to –30, so that ∆S = –30 – (–45) = 15, so that
MPS =
S
15

 0.3
YD 50
How we understand MPS?
The MPC and MPS always add to 1.
MPC + MPS = 1.
Import function and marginal propensity to import
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Autonomous Expenditures (A)
Autonomous expenditures are independent of income or real GDP. Investment (I) and government
purchases are assumed to autonomous expenditure. Exports of a country are also autonomous
expenditure. Thus, there are four autonomous expenditures in this model and they are
3. Autonomous consumption (Ca)
4. Investment (I)
5. Government purchases (G)
6. Exports.
Sum of these autonomous expenditures (A) is
A = Ca + I + G + exports.
Sum of expenditures is
AE = C + I + G + exports – imports = C + I + G + NX
Table 2 summarizes discussions above.
Table 2
Real
GDP
(Y)
0
100
200
300
400
500
600
700
Consumption
I
70
130
190
250
310
370
430
490
Planned Expenditure
Gov.
Investment
purchases
Exports
(I)
(G)
10
40
30
Imports
0
10
20
30
40
50
60
70
Aggregate
planned
Expenditure
(AE)
150
Few things you need to understand in this table. First of all, autonomous consumption is C a = 70,
autonomous investment is 10, autonomous government purchase is 40 and autonomous export is 30.
Thus the autonomous expenditures are equal to 150:
A = Ca + I + G + exports = 70 + 10 + 40 + 30 = 150
Another way to find out autonomous expenditure is the aggregate expenditure when income or real
GDP is equal to zero.
Induced expenditures are expenditures that change with real GDP. In the table, consumption (above
70) and imports are induced expenditures because they change (increase) as real GDP changes
(increases).
We have taken 1st column and the last column of table 2 and put in the table 3.
Real
GDP
(Y)
0
100
200
300
400
500
600
700
Table 3
Aggregate
planned
Expenditure
(AE)
150
200
250
300
350
400
450
500
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The positive relationship between aggregate planned expenditure and real GDP is described as the
aggregate expenditure (AE) curve and it is shown as AE curve (line) in figure 2 below.
Aggregate planned
Expenditure (AE)
AE
300
Figure 2
150
0
Slope of the AE curve =
300
Real GDP (Y)
(aggregate planned exp enditure) AE


(real GDP)
Y
Equilibrium expenditure
Equilibrium expenditure is same as the equilibrium real GDP. Equilibrium expenditure in table 2 is 300
when Y = AE = 300. Using a figure, we can find the equilibrium expenditure or equilibrium GDP at the
intersection of AE curve and 450 line at the point A in figure 3 below.
450
AE
AE
300
A
Figure 3
150
300
Real GDP (Y)
Equilibrium expenditure = Equilibrium GDP = 300
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Determination of equilibrium expenditure or equilibrium Real GDP
Table 4
Planned Aggregate
Unplanned
Expenditure (AE)
Inventory Change
150
-150
200
-100
250
-50
300
0
350
50
400
100
Real GDP
(Y)
0
100
200
300
400
500
Real GDP and
Employment
Increasing
Increasing
Increasing
Constant
Decreasing
Decreasing
Equilibrium expenditure is the level of aggregate expenditure that occurs when planned aggregate
expenditure equals real GDP. Thus, in table 4, equilibrium expenditure and real GDP is 300. We can
write the equilibrium condition as
Real GDP = AE
Y = C + I + G + NX.
In figure 4, equilibrium is at point A with real GDP and AE equal to 300 at which 45 0 line intersects
AE line.
AE
450
AE
A
150
Figure 4
100
200
300
400
Real GDP (Y)
The question is how the economy gets to the equilibrium level of real GDP at point A? To understand
this, what happens if the economy’s real GDP is 100 which is less than equilibrium GDP 300. When
the economy’s real GDP is 100, economy’s planned aggregate expenditure is 200. AE = 200 is greater
than production Y =100. If firms have inventories or stocks of goods available, they sell more than they
produce, thus unplanned inventories decrease or go down. If firms do not have inventories of goods,
they have to turn away customers who wants to buy goods but now cannot. Firms in response to
declining inventories or unsatisfied customers raise output, so output or real GDP increases. Thus,
whenever, real GDP (Y) is below the equilibrium level (Y < AE), real GDP is increasing.
If GDP is above equilibrium (Y > AE) means firms are producing more than they can sell, firms
unplanned inventories increase and in response firms decrease production and real GDP decreases.
Equilibrium real GDP is at which AE exactly equal to real GDP (or production).
Note: A decrease (fall) in inventory is synonymous (or same) as the negative inventory investment.
Similarly, an increase (rise) in inventory is synonymous as the positive inventory investment.
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Changes in equilibrium GDP
Suppose there no tax and assume that both export and net export s are autonomous.
When autonomous expenditures increase (or decrease), aggregate expenditure (AE) increases (or
decreases) by the amount of increase (or decrease) in autonomous expenditures, AE curve shifts up (or
down), and equilibrium real GDP increases (or decreases). Consider table 5 below:
Table 5
Real
GDP
(Y)
0
C
70
Planned Expenditure
I0
I1
G
10
40
NX
30
Aggregate Planned
Expenditure
AE0
AE1
150
100
120
10
40
30
200
200
170
10
40
30
250
300
220
10
40
30
300
400
270
10
40
30
350
500
320
10
40
30
400
600
370
10
40
30
450
700
420
10
40
30
500
Original equilibrium real GDP is 300. In figure 5, the original equilibrium is at point A and original AE
curve is AE0.
450
AE
AE0
A
Figure 5
150
300
Real GDP
Now suppose an autonomous expenditure such as autonomous investment (I) increases by 50. Original
I0 = 10 and new I1 = 60, so ∆I = 60 – 10 = +50. As a result, AE increases by 50 and AE curve shifts up
by 50 to AE1 at each level of real GDP. New equilibrium is at point B in figure 5. You can determine
from table 5 and figure 5 that the new equilibrium real GDP is 400.
We find that autonomous investment increased by only 50 but equilibrium GDP increased by 100. That
is, equilibrium GDP increased twice (or 2 times) than the increase in I. That is, equilibrium GDP
increases 2 multiples of investment increase, hence the name multiplier.
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MULTIPLIER
(Assume NO IMPORTS and NO TAX)
Definition: Multiplier indicates how many times (or multiples) equilibrium GDP would increase when
autonomous expenditure(s) increases by one unit. Multiplier shows as autonomous expenditure
changes , real GDP changes by a larger amount. That is, multiplier is greater than 1.
In other words,
changes in equilibriu m real GDP
Y

changes in autonomous exp enditures A
Y
 1  Y  A.
Multiplier =
A
Multiplier =
Remember, there are four autonomous expenditures: (1) autonomous consumption, (2) investment (I),
(3) government purchases, and (4) exports.
Suppose, autonomous expenditure is autonomous investment (I), then ΔA = ΔI we can write multiplier
as
Multiplier =
Y
I
Use small letter m to indicate multiplier so that
Multiplier = m =
Y
I
 ∆Y = m(∆I)
This implies that we can determine the changes in equilibrium GDP (∆Y) if we know the value of
multiplier (m) and changes in any autonomous expenditure such as I. The value of multiplier can be
obtained as
m=
1
1

1  MPC MPS
where MPC = marginal propensity to consume and marginal propensity to save, MPS = 1 – MPC. Then
you can determine the changes in equilibrium GDP as
1


 1 
I  
 I.
1  MPC 
 MPS 
∆Y = mΔI= 
In table 5,
MPC =
C
50

= .5
I 100
So that for table 5, multiplier is
m=
1
1
1
1


 = 2.
1  MPC MPS 1  .5 .5
Now go back to table 5. Now you can see why in table 5 equilibrium GDP increases by 100 (from 300
to 400) when I increased by 50. This is because ∆Y = m(∆I) = 2(50) = 100.
Determinants of multiplier (or Factors that multiplier depends on)
Discussion above shows that the value of multiplier depends on MPC or MPS. If MPC increases
multiplier increases, on the other hand, if MPS increases, multiplier decreases. That is, multiplier and
MPC are directly (or positively) related and multiplier and MPS are inversely (or negatively) related.
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Exercise: Consider the following figure
450
AE2
Aggregate planned
Expenditure (AE)
AE1
280
200
0
1.
2.
3.
4.
5.
6.
400
600
Real GDP (Y)
How much is the autonomous expenditure along AE1?
How much is the autonomous expenditure along AE2?
How much is the change in autonomous expenditure?
How much is the multiplier?
Starting with original equilibrium GDP equal to 400, now G increased by 30, what
would be the new equilibrium GDP?
What is the slope of the AE1 curve? AE2 curve?
Exercise
In the economy of the Happy Island, autonomous consumption expenditure is $100 million, and the
marginal propensity to save is 0.4. Investment is $70 million, government purchases are $80 million,
and there are no taxes. The island does not trade with the rest of the world.
(a) What is the island’s autonomous aggregate expenditure?
(b) Draw the aggregate expenditure curve.
(c) What is the size of island’s multiplier?
(d) What is the island’s aggregate planned expenditure and what is happening to inventories when real
GDP is $800 million?
(e) What is the economy’s equilibrium aggregate expenditure?
(f) The government of the island needs to increase real GDP by $200 million in order to eliminate
cyclical unemployment (or to achieve full-employment). How much the government needs to
increase its expenditure to achieve the goal of full-employment?
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Price level and AE Curve
Price level is fixed along an AE curve. For example, price level along AE 0 in figure 6 is 110. That is,
any point on AE0, the price level is 110.
Aggregate planned
Expenditure (AE)
AE0 (P0 = 110)
300
Figure 6
150
0
300
Real GDP (Y)
When price level increases, autonomous consumption decreases. Increase in price level also increases
interest rate. Increase in interest rate decreases investment. Thus when price level increases
consumption and investment decrease and as a result aggregate expenditure decreases and AE curve
shifts down. In figure 6, AE shifts down to AE 1 when price level increases from P0 = 110 to P1 = 120.
Conclusion: Along an AE curve price level is fixed. When price level increases (or decreases),
AE curve shifts down (or up)
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Derivation of AD Curve
Suppose an economy’s original equilibrium real GDP is 400 and original price level is P 0 = 110.
Equilibrium is at point A in figure 7 and original AE curve is AE0.
450
AE
AE0(P0 = 110)
AE1(P1 = 120)
A
200
B
Figure 7
100
200
400
Real GDP
A’
Figure 8
Price
Level
P1 = 120
B’
P0 = 110
200
400
Real GDP
Original equilibrium is at point A in figure 7. This means when price level is P 0 = 110, quantity of real
GDP demanded is 400. This is shown in figure 8 as point A’. Now suppose price level increases to P 1 =
120. Increase in price level decreases autonomous consumption and autonomous investment and as a
result AE decreases and AE curve shifts down to AE 1 in figure 7. New equilibrium is at point B in
figure 7 and new equilibrium GDP is 200. Thus, when price level increases to P 1 = 120, quantity of real
GDP demanded decreases to 200. This is shown as point B’ in figure 8. Connecting points such as A’,
B’, etc, we obtain the aggregate demand curve AD0 as shown in figure 8.
Shifts in AD curve
Suppose an autonomous expenditure such as investment or government purchase increases (with no
change in the price level), AE curve shifts up and AD curve shifts to the right.
If some factors other than a change in the price level increases autonomous expenditure, AE curve shits
upward and the AD curve shifts rightward.
Point A is the original equilibrium as shown in all figures (figures 9 and 10 below). Thus P 0 = 110 is
the original price level and Y0 is the original equilibrium real GDP. Now suppose investment or
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government purchase increases and as a result AE curve shifts up from AE 0 to AE1 in figure 9. Note
that price level along both AE0 to AE1 is P0 =110, so that price level did not change.
450
AE
AE1
AE0
B
A
Figure 9
Real GDP
Y0
Y2
Price
Level
SAS0
P1
C
Figure 10
P0
A
B
AD1
AD0
Real GDP
Y0
Y1
Y2
Increase of AE from AE0 to AE1 in figure 9 increases real GDP from Y0 to Y2. This means, AD curve
in figure 10 must have shifted from AD0 to AD1 (since price level did not change).
An increase in AD in the Short Run
In the short run, an increase in I or G shifts AE up from AE0 to AE1 and shifts AD curve to the right
from AD0 to AD1 in the short run.
If the price level is fixed in the short run, point B is the new equilibrium, and we see equilibrium real
GDP in the short run increases to Y2 and with it employment increases (unemployment decreases). The
real GDP increases to Y2 as shown in both figures 9 and 10.
If price level is changing (adjusted) in the short run, equilibrium is at point C as shown in figure 10.
Thus, if price level changes, the increase in real GDP in the short run would be Y1 (figure 10) and the
price level in short run increases to P1.
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Important:
In the short-run when prices are flexible, the multiplier effect is smaller
than when the price level is fixed.
An increase in AD in the long run
Price level
LAS
SAS1
SAS0
P2
P0
A
Figure 11
AD1
AD0
Y0 Y1
Real GDP
Suppose the economy was initially in full-employment equilibrium A with potential real GDP Y0. With
increase in I or G shifts AE curve up and AD curve shifts to AD 1 in figure 11 and real GDP increases to
Y1. In the long run, all prices including nominal wage change. Thus, nominal wage rates increase and
as a result SAS0 curve shifts to SAS1 as shown in figure 11. The price level rises from P 0 to P2 and real
GDP returns from Y1 to Y0. In the long run there is no increase in output. This means, in the long run,
multiplier is zero.
Exercise: Consider table below for a country for which no tax, no export and no import.
(a)
(b)
(c)
(d)
(e)
(f)
(g)
Income or
output,
Real GDP
(Y)
Planned
consumpti
on (C)
Planned
investment
(I)
Planned
Government
expenditures
(G)
100
200
300
400
500
600
110
170
230
290
350
410
50
50
50
50
50
50
60
60
60
60
60
60
How much is the autonomous consumption?
How is the autonomous aggregate expenditure?
How much is the MPS?
How much is the aggregate planned expenditure when real GDP is 200?
What is happening to unplanned inventories when real GDP is 600?
What is the size of the multiplier?
If investment increases by 100 to 150, how much is the new equilibrium GDP?
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Summary
Important things to remember
1.
The Keynesian model of aggregate expenditures assumes that both individual prices and the
price level are fixed in the short run.
2.
MPC is the slope of the consumption function. MPC = ∆C/∆YD where YD is disposable
income; or MPC = ∆C/∆Y where Y is income or real GDP.
3.
MPC + MPS = 1 → MPS = 1 – MPC.
4.
Autonomous expenditures are expenditures that are independent of real GDP. That is,
autonomous aggregate expenditures do not change when GDP changes. Autonomous
aggregate expenditures are sum of autonomous consumption, investment and government
purchases.
5.
Slope of an aggregate expenditure (AE) line is: slope = ∆AE/∆Y.
6.
Definition of multiplier (m): m = ∆(Equilibrium GDP)/∆(Autonomous EXP) = ΔY/ΔA. For
example, Ca increases by 40, I increases by 50, G decreases by 60 and exports increases by 20.
And as a result real GDP increases by 100. So that change in equilibrium GDP is 100 and
change in autonomous expenditure is A = (40 + 50 – 60 + 20) = 50 and change in eq. GDP is
Y = 100. So that
multiplier m = Y /A = 100/50 = 2.
7.
Formula for multiplier: m =
8.
assumes that there is NO tax and NO Imports. In general multiplier also depends on marginal
propensity to import which is zero if no import. Value of a multiplier is greater than 1. The
multiplier effect occurs because an autonomous change in expenditure causes an induced
change in consumption expenditure.
Along an AE line price level is fixed. When price level increase real wealth decreases and real
interest rate increases and as a result AE decreases and AE curve shifts down. Thus, when
price level increases (or decreases) AE curve shifts down (or up). In general, an increases (or
decrease) in autonomous expenditure that is NOT caused by a change in price level results in
AE curve shifts up (or down) and AD curve shifts to the right (or left).
9.
Multiplier effect is smaller when price level changes than when price level is fixed.
10. Long run multiplier is zero.
1
1

. In calculating multiplier, this chapter
1  MPC MPS
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SAMPLE MULTIPLE CHOICE QUESTIONS
1.
When disposable income is $500 million, planned consumption is $250 million. When
disposable income is $300 million, planned consumption is $100 million. Then planned saving
is _______ when disposable income is $500 and MPS is ______.
(a) $250; 0.75
(b) $250; 0.25
2.
If the real interest rate falls, the consumption function and AE function ______ and
________________ AD curve.
(a) shifts upward; movement downward along*
(b) shifts downward; movement upward along
3.
If the wealth increases, the consumption function and AE function _________ and
________________ the AD curve
(a) shifts upward; movement downward along*
(b) shifts downward; movement downward along
4.
The slope of the aggregate expenditure curve equals the change in
(a) planned expenditure divided by the change in real GDP
(b) real GDP divided by the change in planned expenditure
5.
Suppose investment increases by $40 billion and equilibrium GDP increases by $100 billion.
All other autonomous expenditures remain the same. What is the multiplier?
(a) 2
(b) 2.5
6.
Suppose investment (I) increases by $40 billion, autonomous consumption increases by $10
billion and export decreases by $30 billion and equilibrium GDP increases by $40 billion. All
other autonomous expenditures remain the same. What is the multiplier?
(a) 2
(b) 2.5
7.
Suppose there is no tax and no import. Planned saving increases by $25 billion when
disposable income increases by $100 billion. What is the multiplier?
(a) 3
(b) 4
8.
Multiplier shows as _____________ changes, real GDP changes by a __________ amount..
(a) autonomous expenditure; larger (or greater)
(b) aggregate expenditure; smaller
(c) autonomous expenditure; smaller
(d) aggregate expenditure; larger
9.
The larger the value of MPC _________ is the multiplier and larger the value of
MPS____________ is the multiplier
(a) larger; larger
(b) larger; smaller
10. In the short run, with fixed price level and no import or tax, a decrease in investment
(a) decreases real GDP by a smaller amount
(b) decreases real GDP by a greater amount
11. If the price level increases, AE curve shifts
(a) upward and we move along the AD curve
(b) downward and we move along the AD curve
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12. In the short run, which of the following is fixed and does not change when real GDP changes?
(a) planned consumption
(b) planned import
(c) planned export
(d) all of the above answers are correct
13. If disposable increases by 200, consumption increases by
(a) more than 200
(b) less than 200
(c) exactly 200
14. When disposable income equals $800 billion, planned consumption equals $600 billion, and
when disposable income equals $1,000 billion, planned consumption equals $640 billion.
What is the MPS?
(a) 0.8
(b) 0.4
(c) 0.2
(d) cannot be determined from the information given
15. Which of the following is true
(a) The multiplier effect occurs because an autonomous change in expenditure causes an
induced change in consumption expenditure
(b) The multiplier is greater than 1 because one person’s spending becomes another
person’s income
(c) Because of multiplier, a one-time change in autonomous expenditure will cause more
additional income than initial change in autonomous expenditure
(d) All of the above are true.
16. MPC or MPS is
(a) greater than 1
(b) less than 1
(c) greater than 1 but less than 2
17. Autonomous consumption
(a) increases with income
(b) is independent of income
(c) is independent of income and must be equal to zero
(d) decrease with income.
Ashraf Nakibullah
Important Concepts

Meaning of Fiscal Policy

Budget deficit, budget surplus and balanced budget

Expansionary fiscal policy

Contractionary fiscal policy

Discretionary fiscal policy

Automatic fiscal policy

Government Purchase (G) Multiplier

Tax (T) Multiplier

Balanced budget multiplier

Discretionary Fiscal Stabilization

Recessionary gap

Inflationary gap
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FISCAL POLICY
(Chapter 31)
Fiscal policy refers to changes in government purchases (G) or changes in taxes (T).
We will consider only lump-sum tax (T). Lump-sum tax does not depend on income (real GDP). That
is, T is independent of income.
Expansionary fiscal policy = increase in G (G > 0) or decrease or cut in T (T < 0).
Contractionary fiscal policy = decrease in G (G < 0) or increase in T (T > 0).
Government budget
If G > T, government has budget deficit
If G < T, government has budget surplus and
If G = T, government has balanced budget.
Discretionary fiscal policy – fiscal policy initiated by parliament (congress)
Automatic fiscal policy – fiscal action required by the state or condition of the economy.
GOVERNMENT PURCHASE (G) MULTIPLIER
Remember G is an autonomous expenditure. Suppose only G changes. Then change in autonomous
expenditure (ΔA) is equal to change in G (ΔG). That is, ΔA = ΔG.
G multiplier = m = (EQ. GDP)/A = Y/G. But remember multiplier formula is m = 1/1 – MPC.
1


G. Thus we find change in equilibrium GDP if we know
 1  MPC 
This means, Y = (m)G = 
MPC and change in G.
Example
Suppose MPC = 0.75 and original equilibrium is $3000 million. G increases by 100, that is, ΔG = 100.
Then equilibrium GDP increases by
1


 1 
G  
100  4  100  400.
 1  MPC 
 1  0.75 
Y = (m)G = 
That is, equilibrium GDP increases by 400 and the new equilibrium GDP is $3000 + $400 = $3400
million.
This example shows the effect of changes in G is multiplied 4 throughout the economy. G increases by
100 but GDP increases by 400 (4 times). This is because G purchases generate changes in
consumption expenditure through MPC.
TAX (T) MULTIPLIER
T is an autonomous tax. So, T multiplier = m = (EQ. GDP)/T = Y/T. But,
T multiplier formula is m =
 MPC
1  MPC
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This means,
  MPC 
T .
 1  MPC 
Y = (m)T = 
Thus we find change in equilibrium GDP if we know MPC and change in T.
Example
Suppose MPC = 0.75 and original equilibrium is $3000 million. Now T increases by 100, that is, ΔT =
100. Then change in equilibrium is given as
  MPC 
  0.75 
T  
100  3  100  300.
 1  MPC 
 1  0.75 
Y = (m)T = 
That is, equilibrium GDP decreases by 300 and the new equilibrium GDP is $3000 – $300 = $2700
million.
This example shows the effect of changes in T is multiplied 3 throughout the economy. T increases by
100 but GDP decreases by 300 (3 times). This is because changes in T generate changes in
consumption expenditure through MPC.
BALANCED BUDGET MULTIPLIER
Suppose G = $1000 million and T = $1000 million. This means government has balanced budget.
Suppose MPC = .75, original equilibrium GDP = $3000 million. Now suppose G increases by 100 (G
= +100) and also T increases by 100 (T = +100), so that budget remains balanced. The balanced
budget multiplier is the multiplied effect on AD of a simultaneous (at the same time) change in G and
T that leave the balanced budget unchanged. In our case G = +100 and T = +100 leave the balanced
budget unchanged. But the balanced budget multiplier is positive. You can see why, we have shown
when G increased by 100, equilibrium GDP increased by 400 and when T increased by 100,
equilibrium GDP decreased by 300, so overall GDP still increased by 100 = (400 – 300).
Discretionary Fiscal Stabilization
When government takes an expansionary fiscal policy (G increases or T decreases) with no change in
the price level, AE curve shifts up AD curve shifts to the right. Similarly, with a contractionary policy
(G decreases or T increases), AD curve shifts to the left.
How discretionary fiscal policies can help to eliminate recessionary gap and inflationary gap?
Price
Level
Price
Level
LAS
LAS
SAS0
SAS0
P0
B
A
AD 0
P0
AD0
Y0
YP
Figure 1
In figure 1, the country has less-than
full-employment. Since Y0 < YP, it
has a recessionary gap equal to
(YP – Y0 ). Here expansionary
fiscal policy can eliminate the
recessionary gap.
Real GDP
YP
Y0
Real GDP
Figure 2
In figure 2, the country has more-than
full-employment and inflationary gap
equal to (Y 0 – YP ). Here contractionary
fiscal policy can eliminate the inflationary
gap.
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Eliminating recessionary gap using expansionary fiscal policy. First consider figure 1. At present
economy is at point A with real GDP equal to Y0. Since the country’s present GDP Y0 is less than
potential GDP YP, the country at present has a recessionary gap equal to (Y P – Y0). Government can
use a discretionary expansionary fiscal policy to eliminate the recessionary gap. When government uses
expansionary fiscal policy of increasing G or decreasing T, the aggregate expenditure (AE) increases
and the multiplier increases induced expenditure and as a result AD curve shifts to the right. AD curve
shifts to AD1 in figure 1, so that at the new equilibrium at point C in figure 1, the economy has fullemployment and the recessionary gap is eliminated.
Eliminating inflationary gap using contractionary fiscal policy. Next consider figure 2. At present
economy is at point B with real GDP equal to Y0. Since the country’s present GDP Y0 is more than
potential GDP YP, the country at present has a inflationary gap equal to (Y 0 – YP). Government can use
a discretionary contractionary fiscal policy to eliminate the inflationary gap. When government uses
contractionary fiscal policy of decreasing G or increasing T, the aggregate expenditure (AE) decreases
and the multiplier increases induced expenditure and as a result AD curve shifts to the left. AD curve
shifts to AD1 in figure 2, so that at the new equilibrium at point E in figure 2, the inflationary gap is
eliminated.
SAMPLE MULTIPLE CHOICE QUESTIONS
1.
If the government wants to use fiscal policy to increase real GDP, it could
a. cut T or increase G
b. increase T or decrease G
2.
Suppose potential GDP is $300 million and present real GDP is $350. Economy has _________
gap and to eliminate ______________ policy should be used.
a. recessionary; expansionary
b. inflationary; contractionary
3.
Suppose government revenue comes from income tax and suppose tax rate is 20%. Suppose
income is $100 million and government purchase (G) is $17 million. Then the government has a
budget
a. deficit by $3 million.
b. surplus of $3 million
c. surplus of $83 million
4.
An increase in G approved by the parliament (congress) helped to increase GDP is an example of
a. automatic fiscal policy
b. discretionary fiscal policy
5.
If government spends more than it receives in tax revenue, then government has
a. budget surplus
b. budget deficit
c. balanced budget