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VWL II / Macroeconomics
Summary Stockmann
SS 01
Introduction to Macroeconomics
A. 3 Equivalent approaches
- output: value added of all goods and services produced in the ec.
- income: sum of all incomes received in producing the output of the ec.
- expenditure: total spending of final goods and services of the ec.
B. Domestic: refers to all ec. Activity within a country (territory)
National: refers to all ec. Activitiy of all residents of a country (even outside)
C. Product
 GDP = GNP – NFP (net foreign exchange: diff. of what we send & receive abroad)
D. Income
National Income NI = NNP (net national product) – indirect taxes
Personal disposable income PDI = GDP + NFP + TR (transfer payments by the
government) + INT (net interest payments  public debt) – T (taxes)
E. Expenditure
GDP = C + I + G + NEX
F. Current Account CA = trade balance TB + net factor income NFI
 measures the amount that a country lends or borrows from other countries
( + if lending > borrowing, - if borrowing > lending)
G. Capital Account records international trade in assets, f.e. buying or selling a house in
Italy is CA, but renting it to someone belongs to the capital account
H. Problems with National account measures
- only includes market activities, households aren’t included
- underground activities are naturally not included, but still represent a large
share (f.e. Italy…)
- Environment-Pollution: countries with more stringent environment standards
may record lower output
I. Savings (flow) and Wealth (stock)
- Wealth: income - spendings
= assets – liabilities (längerfristige Verbindlichkeiten, z. B. Hypozins)
- private saving Sp = PDI – consumption
- govt. saving Sg = T – (G + TR + INT) = T – GR
- natl. saving Sn = Sp + Sg = GDP + NFP – C * G
J. Saving and the current account
Sn = GDP + NFP – C * G = I + CA
CA = Sn – I  CA = T – GN + Sp * I
1. Chapter 5: Macroeconomic Issues and Measurement
1. GDP
(Gross Domestic Product): measures the economy’s total production of final
market goods and services: market value (factor cost + indirect taxes) of final
goods and services produced in a country during a certain period of time
GDP = C + I + G + NEX
VWL II / Macroeconomics
Summary Stockmann
1.1 Nominal GDP:
1.2 Real GDP:
1.3 GDP-deflator:
1.4 Definitions :
SS 01
GDP measured in money
= MV = Py
GDP measured in prices of a certain base year (inflation-adjusted);
remains constant if production of goods doesn’t change
F (l, k) = c + i
Nominal vs. Real:
(output of nominal year )(price of real year) = price in real $
measures the average change in price between 2 years
P = nominal GDP / real GDP
P = MV / y
C = Consumption, G = Governmental purchase, K = Capital
I = Investment (create new capital), NEX = Net exchange (ExportsImports)
P = GDP-deflator, y = real GDP, M = money supply, V = velocity of $
1.5 Employment
 unemployment rate: %-age of unemployed people in labor force:
= 100 x (number of unemployed / (number of employed + number of unemployed))
1.6 Recession: low GDP relative to its trend value
Measure the economy’s price level:
1.7 CPI:
consumer price index = measures average nominal prices of goods and
services that a typical consumer buys (im Warenkorb)
= 100 x total costs of goods now / total costs of goods in base year
1.8 PPI:
producer price index = measures the average price of goods that a typical
producer buys
 3 main problems of price indexes:
- substitution bias: supply of product 1 decreases, thus its prices is raised;
consumers will purchase more of (the cheaper) product 2. CPI measures only the
increase in price&neglects substitution: CPI overstates increase in cost of living!
- new-good bias: impossible to compare price level before to level now with new
products introduced to market: differences. N.G.s are put into CPI with a delay of
several years; thus, inflation is overstated for the period new good is not included.
- quality-change bias: how much better is a newly invented product compared to
commone ones? If product prices rises by 10%, and so does quality, how much
have prices really increased?
1.8 GNP
1.9 NNP
(Gross National Product) = measures the country’s total income
= GDP + NFP (receipts of factor income – payments o.f.i.from rest of world)
(Net National Product) = GNP – depreciation
2. Chapter 6: Simple Models of GDP, Prices and Employment
2.1
2.2
2.3
2.4
Money Supply = amount of money available for economy to use
Depression = severe recession (people keep $ instead of spending it)
Production Function = total production an economy can obtain from its intput in
labor, capital and natural resources
A. Average product of labor = total production / number of hours worked
VWL II / Macroeconomics
Summary Stockmann
2.5
2.6
2.7
2.8
2.9
SS 01
B. Marginal product of labor = add. production obtained from increasing labor little
C. Law of diminishing returns = rasing quantity of input leads to redution of
marginal output (the more I work the weaker I am the less efficient my work, i.c. my
output, is)
Velocity of Money V: how many times is money (bills, coins) being spent in a year
= nominal GDP / nominal money supply
Equation of exchange: MV = Py
 nominal money supply x its velocity = price level x real GDP
Neturality of money: real GDP does not depend on money supply
Model with trade
- equilibrium wage: everyone who wants to work has a job
- unemployment: caused by changes in supply and demand of job sectors
- equilibrium unemployment: results from continuing changes in supplies and
demands and the costs of searching for and matching jobs in the labor market;
reaches its equilibrium level when rate of job destruction = rate of job creation
- Full employment: economy with unemployment equal to its equilibrium rate
Unemployment
unemployment
supply
Minimum wage
demand
employment
 causes of unemployment:
- deficit aggregate demand, international competition, unemployment-friendly
institutions (f.e. unemployment insurance, labor market regulations), lack of skills
 Policies to encounter unemployment
- effectiveness, cost, side effects
2.10
Examples of this chapter
a. Kennywood Park
Decrease in M as well as proportional decrease in P (economy’s price level) has no
further effects – decrease in M without proportional decrease in P will have no
effects if it happens based on surprise. Otherwise a depression will be caused.
b. Robinson Crusoe
His real GDP = number of berries picked, depending on the hours worked
(production function). He’s got choices: he can build machines (new capital) to
pick more berries faster: he can invest: he can sacrifice time and today to obtain
more output in the future: the new capital will bost his production curve
VWL II / Macroeconomics
Summary Stockmann
SS 01
3. Chapter 7: Interest Rates, Savings and Investment
3.1
Loan Market: created by trade (borrowing / lending): borrowers demand, lenders
supply loans
Price of a loan = interest rate ( percentage per year of the amount loaned)
Equilibrium interest rate / loans: quantity of loans supplied = quantity demanded
Interest rate formula: if I borrow X dollars for 1 year, I pay back X(1+R) dollars
 Equilibrium in the loan market: (as well as trade market)
Quantity of loans supplied (savings S) = quantity demanded (investment I) + DEF
Savings = Income Y – taxes T – consumption C
 Y – T – C = I + DEF
 DEF = G – T
 Y = C + I + G (in absence of international trade)
3.2
3.3
3.4
3.5
3.6
3.7
3.8
3.9
 with international trade: Y = C + I + G + NEX
connection between equlibrium in loan and trade market!!
Discounted Present Value of some amount of money in the future = its value today
X dollars payable N years from now is worth X/(1+R)N dollars now
 today dollar is worth more than a dollar in the future
Investments I: an investment is profitable if the discounted present value of the
benefits from the investment exceeds the expenditure on the investment. If a firm
invests – using their own money – it would be like borrowing money from themselves;
they could have loaned it to someone else ( opportunity costs)
Problems:
- only expected, not actual benefits can be calculated
- calculation must include after-tax costs and benefits
- benefit must be sufficient to repay in case of loss (risk)
Government budget deficit DEF = government spending in excess of tax receipts
during some period of time: DEF = government spending G – Taxes T
Total demand for loans = demand by firms (mostly) for investment plus the
government budget deficit
Supply of Loans : curves slopes upward: rise in interest rate = rise in return of lending
 shows the amounts of $ peotle want to save&lend at different interest rates
Nominal interest rate R = annual dollar interest payment expressed as a percentage
of the dollar amount borrowed
Real interest rate r = interest rate adjusted for inflation ( Π ) to measure the gain in
purchasing power (relative price of good at 2 points in time)
Low real interest rates: make goods today relatively cheaper in terms of future goods
High real i.r. : v.v., people sacrifice more future goods for each good they buy now
Fisher Equation: connects real and nominal interest rates: R = r + Π
 high level of inflation causes high nominal interest rates
 relative price = 1 + real interest rate
Summary of basic model:
Economy has money supply, chosen by government, and capital stock, resulting from
past investments. Its real GDP depends on technology’s inputs of labor and capital. It
has firms who demand, and people who supply labor services; this demand for and
supply of determine equilibrium employment. The supply of and demand for loans
determine the real interest rate, savings and investment.
VWL II / Macroeconomics
Summary Stockmann
3.10
3.11
3.12
3.13
3.14
SS 01
The price level P = MV / y, changes in M, V and y create inflation. Next year’s capital
stock rises as a result of this year’s investment.
Increase in consumer patience: reduces equilibrium real interest rate and raises
equilibrium savings and investment (raises supply of loans)
Technical progress: raises output (new capital), thus consumption and real GDP
Raise in productivity: raises output & demand for loans (more benefits for investment)
Effects of a tax cut (considering before- and after-tax wages)
 tax rate on income is the tax per dollar, as a percentage
 supply of labor (people who work) depends on the after-tax wage
 marginal and average tax rates, f.e. up to 20’000.- income 20% taxes, above 30%,
is an average of 23%. If I earn 30’100, I pay more than average on marginal taxes. A
drop in average taxes reduces, a drop in marginal taxes raises equilibrium employment
Tax revenue & government borrowing: tax cut without cut in govt. spending = deficit
Increase in govt. borrowing raises demand for loans
What do people do with the extra money?
 they spend it on consumption, supply of loans remains unchanged
 people save most of the money, supply of loans is being raised
- crowding out (private) investment: government borrowing (due to tax cuts) raises
the real interest rate, reducing the equilibrium amount of investment
Business Cycles Theories
1. Classical: Prices (wages) adjust quickly to clear markets. Supply shocks are the
main source of business cycles: Govt. policy to fight recessions is misguided and
harmful (Everything is in equilibrium)
2. Keynesian (Disequilibrium); Prices adjust slowly, due to lack of information:
Demand shocks are the main source of macroeconomic fluctuations. The large
failures of the market systems can be corrected by govt. policy
4. Chapter 8: Economic Growth
4.1 Economic growth (requires savings and investment) = rise in real GDP per person
 real GDP is currently about $ 6000 per person
 an economy’s GDP depends on its technology&its available inputs of labor&capital
4.2 An economy’s Production possibilities frontier PPF = graphs the combinations of
various goods that it can produce with its litmited resources and technology
 Rate of economic growth, f.e. from 1900-2000 =
1/100 x (real GDP p.p. in 2000 – real GDP p.p in 1900) / real GDP p.p. in 1900
4.3 Rule of 72: if growth rate of variable is X %/year, then variable doubles after 72/X years
Ex.: GDP grows at 2%/year, GDP will double after about 36 years (72/2)
4.4 Per-Person production function
Real GDP = A F(l, k) (A measures improvements in technology)
Real GDP per person = y/l = A f(k/l)  depends on technology and capital p.p. (k/l)
4.5 Economic Growth without technical change
 economy can increase its capital by investing without changes in technology
 rate of economic growth depends on the equilibrium amout of investment: as k/l rises,
the benefit of additional investment falls due to diminishing returns
VWL II / Macroeconomics
Summary Stockmann
SS 01
Steady State = long-run equilibrium in which capital p.p. remains constant
Savings curve
Real
GDP
p.p.
Production Function
Steady State equilibrium
Capital p.p.
4.6 Technical change and economic growth
Resulting mostly from investment; shifts prod. Fct. Without any increase in capital
4.7 Investment in human capital
 an economy’s effective labor input is its labor input adjusted for knowledge and
skills: increases in human capital (education) resemble increases in quantity of labor; they
add to the economy’s effective labor input: if effective labor input and capital stock are
being raised, GDP is also, even without any technical change!
4.8 Fixed and exhaustable natural resources: fixes physical quantities
a) renewable resources are natural resources that can be replenished, f.e. trees
b) Fixed resources cannot be replenished , but are not depletet in production, f.e. land
c) Exhaustible resources cannot be physically replenished and are depleted in
production, f.e. coal
 they cause diminishing returns for investments in physical and human capital
4.9 Externalities and Growth
 private benefit of producing a good or investing in research is the benefit to the
people who produce it or invest
 Social benefit is the benefit to everyone in society of the production or investment
 positive externality occurs when the social benefit of producing a good or investing
in research exceed the private benefit
4.10Features shared by high growth countries:
- high share of investment in GDP
- High primary and secondary school enrolment rates
- Low govt. distortions of the market
- High trade openness
4.11Features shared by high productivity countries
- have institutions that favor production over diversion
- are open to international trade
- have at least some private ownership
- speak an international language
- are located in a temperate latitude from the equator
5. Inflation: too much money chasing too few goods
5.1
Inflation = continuing increase in the price level; measured by percentage increase in
CPI, GDP deflator or PPI over some period of time. It is also the growth rate of the
price level (which is measured by price indexes such as CPI, PPI or GDP-deflator)
VWL II / Macroeconomics
Summary Stockmann
5.2
5.3
5.4
5.5
5.6
5.7
5.8
SS 01
Nominal Variables = quantities measured in units of money
Nominal Prices = money prices of goods and services
Real Variables = quantities measured in units of goods&service or of base-year money
Real Prices = opportunity costs of goods, measured in terms of other goods
Ex. 1: 1 sandwich = 3$, 1 drink = 1$ (nominal prizes = 3 & 1 $ respectively)
relative price for 1 sandwich, measured in terms of drinks, is 3 drinks; the
average nominal price level is 2.
Ex. 2: Price levels can change withough any changes in relative prizes; if all nominal
prices double, the relative price level stays unaffected: the relative price for
sandwiches is now 4 drinks per sandwich, the nominal price is raised to
3.20(sandwich) and falls to 0.80(drink), leaving the price level at 2, as before
Equation of Exchange: MV = Py (y = real GDP)
Nominal Money supply M: total dollar value of all paper money and coins in the ec.
Velocity of money V: number of times someone spends each dollar per year
Price Level P: average nominal price of g&s in the economy measured by price index
P = MV / y  P depends on M,V&y; increases in any lead to reactions
Ex.1: ec. produces 10 final goods (y = 120/year); M = 60; so a good is bought for 6$
If V = 1/month, then:
Equation of Exchange: 60*12 = 6*120
In terms of price level: 60*1 / 10 = 60*12 / 120
If V = 1/year, then:
E.o.E.: 60*1 = 0.5*120
Money Demand
Opportunity cost of owning money = interest rate I could have earned from bank
Relative Cost of Money in terms of goods = 1/P; number of goods sacrificed for
each unit of money, f.e. if good costs 2$, I sacrifice half a good for every dollar I keep
Quantity of Money demand at some relative price of money is the amount of money
that people would choose to own, given current conditions such as their income and
wealth, the usefulness of money and the costs and benefits of owning other assets
 the relative cost of $ falls, if the quantity demanded rises
 when nominal prices double, people need twice as much $ to buy the same goods
 quantity of $ demanded rises as GDP rises: the richer they get, the more they spend
 quantity of $ demanded falls, as nominal interest rate rises; opportunity cost of
holding money rises: increases in nominal interest rate raiseV, decreases reduce it
 Demand for money Md= Py/V
Equilibrium price level = equates quantity of money demanded and the one supplied
 It rises when
- nominal money supply rises
- nominal interest rate rises, raising V
- real GDP, y, falls
Adjustment to equilibrium:
 if price level is below its equilibrium level (=relative price of $ is above its equ.
Level), then quantity of $ supplied exceeds quantity demanded (ex. Apples): people
have more money, thus spend more
 as they spend more money, nominal prices rise, moving ec. toward equ.; the
relative price of money, 1/P, falls, raising the quantity of money demanded
 the price level raises, until quantity of $ demanded = quantity supplied  equ.
Currency Reforms: govt. replaces old currency with new & adjusts all nominal values
in the ec., keeping all real values the same: doesn’t affect real GDP
VWL II / Macroeconomics
Summary Stockmann
SS 01
 inflation works like a reverse currency reform
5.9
5.10
5.11
5.12
5.13
Equilibrium Inflation = growth rate of equilibrium price level:
% P = % M +% V -% y
f.e. : Velocity V remains constant, growth rate of money supply M is 8% per year, and
the growth rate of real GDP y is 3%, then inflation is 5%
Short-run&Long-run inflation and money supply growth
Over short periods of time, P and M aren’t closely related, in the long run, they are
closely connected
Inflation and nominal interest rate: Inflation causes high nominal interest rates (R)
R = r + ∏e, r = real interest rate, ∏e = expected rate of inflation
 mostly, r doesn’t at all or only changes slightly when inflation occurs; it could fall
slightly with higher inflation; it is the nominal interest rate that rises as inflation rises
Exchange Rate e = price of one money in terms of another / price of foreign money
Appreciation = less of one currency is necessary to buy one unit of foreign $: e falls
Depreciation = more of one currency is needed to buy one unit of foreign $: e rises
 possibility to compare prices in different countries: P = e*Pforeign = exchange rate
 a countrie’s money tends to depreciate if that country has higher inflation
Suggested Causes of Inflation and their fallacies
a) Greed:
- high profits by raising prices? Doesn’t lead to continuous increase (inflation)
- ignores equilibrium-theory: if M, V, y don’t change, P doesn’t, either: only factors
that affect the growth rate can affect inflation!
b) Monopoly sellers:
- no competition = higher prices; problem: they do charge the highes possible prices
that give them highes profit, but they keep it at that level and don’t raise it!
- They charge high relative prices, but the equ. Price level averages nominal prices
c) Low Productivity:
- real GDP is lower, price level higher, but not increasing
- Low growth rate of productivity on the other hand may cause low rate of real
GDP, thus high rate of inflation: that’s only a small effect, though
d) Government Regulations, f.e. low productivity
- may cause low real GDP and a high price level; they cause a rising price level only
if they reduce the growth rate of real GDP; only small effect!
e) Increase in the price of an important good
- increase in price of particular good can cause inflation only if it affects growth rate
of $ or velocity, or if it reduces growth rate of real GDP
f) High Wages
- might cause high, but not rising prices
- cost-push inflation: Inflation caused by high wages or other costs of production):
only temporary
- wage-price-spiral due to governmental and union action
g) Rising interest rates
- confusion of relative prices with the nominal price level
h) Government Budget Deficit
a) print more money
 Govt. spends more than it collects in taxes
b) borrow money
- a) M and P increase, causing temporary inflation
- b) demand for loans increases, raising interest rate, raising V and P
i) International Competition
- not a valuable argument that sellers can’t raise prices without losing business to
foreign sellers: confusion of relative with nominal prices
VWL II / Macroeconomics
Summary Stockmann
SS 01
5.14
5.15
5.16
Competition reduces relative prices of goods, but has no effect on nominal price
level, unless it affects M, V or y
Effects of Inflation
Inflation Tax = the loss of people when inflation reduces purchasing power of assets
Gain to Govt. from inflation tax = losses to holders of money
 Unexpected Inflation: creates winners (Debtors) and losers (Creditors)
 Expected Inflation: Nominal i.r. exceeds real i.r. by rate of inflation
 Indexing Contracts: nominal wage automatically changes with price level
Inflation: Good or Bad?
- waste of time and resources, also resources in final markets by trying to avoid loss
- permanent changes in nominal value leads to mistakes and creates uncertainty
- raises certain taxes untransparently
- unexpected inflation harms people by redistributing income
+ people feel – falsly – happy due to their higher nominal wages (only adapted)
Supressed Inflation = inflation that would occur without governemental controls on
wages and prices, but that doesn’t fully occur due to those controls
6. Money and financial intermediaries
6.1
6.2
6.3
6.4
Definitions
Medium of exchange = asset that sellers generally accept as a payment for goods etc.
Store of value = any good/asset you can store while it maintains some or entire value
Unit of account = measure for stating prices (f.e. $, yen, CHF)
Pure gold standard = when people use gold coins as money
Gold exchange standard = paper money backed by gold stored in warehouses is used
Fiat money = paper money, not backed by a commodity: you can’t trade it for a
particular commodity at a fixed nominal price
Measuring the money supply
Currency = paper money and coins owned by people and business firms
Demand deposit = balance in bank accounts you can withdraw on by writing a check
3 measures of money supply:
M1 = sum of currency, demand deposits&other checkable deposits&traveler’s cheques
M2 = M1 + sum of balances in savings accounts, money market mutual funds&similar
Monetary base = currency + bank reserves (controlled by Fed)
Bank reserves = deposits a bank has not loaned
Fractional reserve banking = keeping only fraction of deposits and lending the rest
Ex. 1: A puts 100$ into his bank account, the bank keeps 10 and lends 90 to B: I have
thus increased M1 and M2 by 90$.
Ex. 2: (bank keeps 10%)
- A puts 100$ in his bank account: monetary base, M1&2 remain unchanged,
currency falls by 100, bank reserves rise by 100
- Bank keeps 10$, lends 90$ to B: M1 rises by 90$
- B spends the 90$ to buy shoes from C who puts it in his bank account:
- Bank keeps 9$, lends 81$ to D: M1 rises by another 81$, summing up to 171$
- D spends 81$ to buy goods from E, who puts the amount in his bank account
- His bank keeps 8.10$ and lends 71.90 to F: M1 increases to 243.90$ etc.
M1 Money Multiplier = ratio of M1 to the monetary base: M1MM = M1 / mb or
M1MM = deposits / reserves (In Ex. 2, M1MM was 9: bank keeps 9, gives 1 away)
 using M1MM: changes in M1 = M1MM * monetary base (measures effects)
Federal reserve system
VWL II / Macroeconomics
Summary Stockmann
6.5
6.6
6.7
6.8
6.9
SS 01
Central bank = bank for banks
Federal reserve system = central bank in US
3 tools to conduct monetary policy
 open market operations: Fed sale or purchase of US govt. bonds: open market
purchase (buying) expands and o.m. sales (selling) bonds contracts the monetary base
 discount window lending: Fed lends money to banks at the: mb rises
Federal Reserve discount rate = interest rate Fed charges banks for short-term loans
Federal Funds rate = interest rate banks charge each other for short-term interactions
 reserve requirements&other bank regulations = reserves Fed requires bank to hold
Fed can increase M1mm by reducing required reserves
Financial intermediaries = gather money from savers and lend it to borrowers(banks)
bank run = many people try to withdraw their money at the same time from bank that
lacks sufficient reserves. In a banking panic, many banks face runs at the same time
Deposit insurance: can prevent bank runs (guarantee), but pushes risky investments
Short-run effects of Fed Policies
 Looser monetary policy refers to Fed actions that increase growth rate of money
supply or decrease the federal funds rate (by expanding o.m. purchases or increasing
lending to banks at the discount window
 Tighter monetary policy refers to Fed actions that reduce growth rate of money
supply or increase the federal funds rate (by reducing open market purchases or by
reducing the lending at the discount window)
7. Business Cycles: aggregate demand and supply
7.1
7.2
7.3
7.4
7.5
Booms and Recessions: typical BC has 2 parts: a recession and a recovery (expansion)
Simple model of recession
 real GDP&employment fall, unemployment rises; recession begins at peak of a BC
and continues till its trough (low point), when a recovery or expansion begins,
continuing until the next peak
Ex. 1: firms produce 100 goods / year, so real GDP = 100
Nominal money supply = $1000 / year, V = 1 /year, price level thus $10 /good
 now: M falls to $900, V still = 1, so equilibrium price level new = $9 / good
Nominal GDP falls to $900, real GDP remains 100, though (money is neutral)
Ex. 2: as Ex. 1, but this time, P can’t change!
M falls, but P is still $10/good, so people can only afford to buy 90 goods/year
This leads to a reduction of the firms output by 90: recession occurs
MV = Py
 a fall in money supply while V given reduces MV, thus Py must fall also
Nominal Prices are Sticky Prices = they take time to adjust to their new equilibrium
levels following changes in supply or demand (price level is sticky in the short run:
thus real GDP falls instead of P; fall in money supply reduces total spending)
Aggregate Demand = total demand for all g&s produced in a country in given year
 A.D. Curve = shows total amount of g&s people, firms and govt. would choose to
buy at each possible price level, given M and V; involves the ec. nominal price level
graphs the equation of exchange, P = MV / y; (MV = ec. Total spending per year)
MV = C + G + I + NEX: both sides of equation show aggregate demand
Changes in A.D.
 changes in money supply or velocity:
- Increase in consumption: decrease in savings reduce supply of loans; increasing
y&raising nominal interest rate, raising V, raising A.D.
VWL II / Macroeconomics
Summary Stockmann
SS 01
-
Increase in Investment: demand for loans rises, increasing y, raising nominal
interest rate, raising V, raising A.D.
- Increase in G: Govt. borrowing raises demand for loans, raising y. Or, Govt. could
raise additional taxes, reducing after-tax income, reducing savings, decreasing
supply of loans and raising y.
 Increases in C, I and G raise aggregate demand
r
Interest
r2
Rates
r1
S2
An increase in consumption spending
reduces saving, which reduces supply of
loans from S1 to S2. This raises the real
interest rate from r1 to r2, which raises
nominal interest rate and velocity. Thus,
Aggregate Demand (MV) rises!
S1
D
Loans
7.6
Aggregate Supply = total supply of g&s produced in that country in a given year
 A.S. Curve = shows total amount of g&s that firms would produce and try to sell
at each possible price level
 A.S. Curve is a vertical in the long run: involves nominal price level of economy
Production doesn’t depend on nominal variables (like P) only on real variables (k,l…)
Money is neutral in the long run
Changes in Long-run A.S.:
- increases in technology, capital, worker’s skills, efficient use of resources raise AS
- It decreases when equlibrium inputs fall….
- Since A.S.Curve is vertical,changes in A.D. affect the price level, but not real GDP
 A.S. Curve slopes upward in the short run; with complete sticky prices, it’s a
horizontal line
short- and long-run effects of a decrease in A.D.
P
long-run AS
B
P1
A
C
y2
short-run AS
AD1
AD2
FE
y
y (full employment)
 A rise in A.D. raises the price level and real GSP in the short tun; a fall in A.D. lowers
them in the short run. If a change in A.D. is permanent, then the price level continues to rise
or fall rarther in the long run, while real GDP returns to its long run equilibrium level. This
model of A.D. and supply forms the basis for most Economic analyses of business cycles.
VWL II / Macroeconomics
Summary Stockmann
SS 01
8. Business Cycles 2: Applicaitons of aggregate demand and supply
8.1
8.2
Federal Reserve open-market purchases
a) in the long run
- increase in money supply will raise all nominal prices in the same proportion: price
level increases, and with it the nominal interest rate. Demands for loans raise along
with the supply of loans, thus, real interest rate doesn’t change
b) in the short run
- if prices are completely sticky in the short run, AS curve is a horizontal line
- raise money supply and thus supply of loans; raising AD and temporarily real
GDP, but reducing the real interest rate in the short run
- nominal interest rate, on one hand, tends to be reduced due to the declining real
interest rate, but, on the other, the jump in inflation, tends to raise it. Due to the
sticky price level, though, inflation is small and the nominal interest rate falls.
Philipps Curves
a) short-run Philipps Curve: high inflation accompanies low unemployment and v.v.
b) long-run PC (vertical line at natural rate of employment)
Inflation
Unemployment rate
8.3
 in the short run
- high inflation accompanies low unemployment, and vice versa
 in the long run
- when price level adjusts to its new equilibrium, economy returns to the fullemployment level of output and the natural rate of employment
- natural rate of employment = unemployment rate that occurs when the economy
produces full-employment level of output(=equilibr. employment)&depends on:
 factors that increase unemployment
+ larger and more frequent changes in supply and demand (more unemployed)
+ increase in income of unemployed people (reduce willingness of acception jobs)
+ union policies that raise wages (firms rduce quantity of labor)
+ government regulations and taxes (f.e. makes it costly to fire employees)
 factors that reduce unemployment
- decrease in cost of searching for jobs (easier finding good matches)
- increase in availability of good information about job opportunities
- increase in labor mobility (people are willing to accept jobs in other cities /regions)
Three theories in aggregate supply
a) sticky-price model (= new keynesian model)
nominal price level is sticky in the short run: AS curve slopes upward
Explanation: menu cost: actual cost of changing (print new menus etc.)
Ex. 1: firm experiences increase in demand for their product but believe it to be only
temporary: they will leave their prices unchanged. If they anticipate increases
in the long run, they will adapt prices if their price differs sufficiently from the
new, future equilibrium price. Thus, overall price level will fall only part: after
VWL II / Macroeconomics
Summary Stockmann
SS 01
a while, all firms change their prices, and real GDP returns to its fullemployment level: end of recession
8.4
b) sticky-wage theory
nominal wages are sticky in the short run: workers sign long-term contracts
Explanation: falling price level raise real wage above its equlibrium level; as a result,
the firms want fewer workers; this decrease in employment reduces real GDP, creating
a recession. It ends, when workers sign new, adapted contracts, and thus nominal
wages adjust and economy returns to its long-run equilibrium.
 change in money supply only affects employment and real GDP when it happens
unexpectedly; if one expects it, people can prepare in advance
c) imperfect information
sellers sometimes make mistakes
Explanation: a surprise fall in the money suply creates a surprise fall in the price level;
some sellers might think that the relativ price of a good has fallen, too, although only
the nominal price has decreased.
According to this model, people are only unemployed when they prefer unemployment
to their current job opportunities; everyone is able to find a job at some wage
Aggregate-Demand mulitplier = shows the ulitmate increase in AD that results from
exogenous $1 rise in spending  ripple effects
Exogenous change = change in underlying conditions that affects other variables in a
model (f.e. change in consumer taste for pizzas)  further effects&changes
 direct and indirect effects
 size depends on two factors:
- elasticity on demands for loans: large increase in interest rate = more inelastic
demand for loans
- how much does V increase as interest rate rises?
9. Monetary Policy
9.1
9.2
monetary policy: refers to changes in the nominal money supply through open market
operations or other actions of a nation’s central bank;
FED follows countercyclical policy
a) Activist View of policy maintains that the economy often operates inefficiently on
its own and that governement macroeconomics policies can improve its efficiency
 looser (expansionary) monetary policy increases the gorwth rate
of the money supply, decreasing the federal funds rate
 tighter monetary policy reduces the growth rate of the money
supply, raising the federal funds rate
b) Laissez-faire view of policy maintains that the economy ususally operates
efficiently on its own and that even when it doesn’t, active governemnt policies will
more likely aggravate inefficiencies and create new inefficencies than alleviate
problems
 discretionary policy: policy makers choose policy actions (like open-market
operations on a daily basis, based on their own best jedgements and discretion
 policy rule: specific statement of policy actions an agency will follow with future
- simple policy rule: requires particular policy regardless of e. circumstances
- contingent policy rule: states specifically how policies will depend on particular
circumstances: “if conditions are x, then policy will be y”
Problems with discretionary policy
VWL II / Macroeconomics
Summary Stockmann
SS 01
1) Lags complicate the effects of the policies, reducing the effectiveness of
discretionary policies and raising the danger of overreaction
 FED needs time to react to economic changes
 lags between FED policy actions and its effects on economy
2) FED lacks enough information to follow good discretionary policies
 lack of information about current changes in economy
 lack of information about how effects of the policies will be:
Lucas Critique = says that people don’t always respont the same way to a change in
economic conditions or govt. policies, because their responses depend partly on their
expectations about the future, and those can change
Credible policy rule = rule that people believe policymakers will follow, perhaps
because these have incentives to follow those rules
Commitment to policy rules = is made, when a policy maker does something to
guarantee its implementation
 can credible policy rulees shift short-run Phillips Curve? Yes (expectations)
3) D. p. affect people’s incentives in ways that hinder the economy’s performance
 a credible rule for actions can lead to better results than even the best case-by-case
discretionary actions!
 time consistent policy: best case-by-case decisions are the same as the decisions
suggested by the best policy rule
 time inconsistent policy: best case-by-case decisions differ from decisions that the
best policy rule would suggest, f.e. choice that currently seems best for today and
tomorrow no longer is when tomorrow comes, even without new information
Targets of Monetary Policy
Society chooses goals for its monetary policy: rules or discretion, resulting to choosing
which rules or which economic indicators will be used, respectively
- targeting federal funds rate: FED conducts discretionary policies with informal
rule to keep nominal federal funds rate at a target level
- targeting foreign exchange rate:
 fixed (pegged) exchange-rate system: government buys or sells country’s
currencs in foreign exchange markets in whatever amounts are necessary to keep
its exchangerate fixed to some foreign currency
 a devaluation occurs when a country that fixes its exchange rate at a
certain level changes that level so that its money loses value in terms of
foreign money (exchange rate rises)
 floating exchange-rate system: government doesn’t actively trade in foreign
exchange markets to try to influence exchange rates
 managed –float exchange-rate system: combines elements of the above:
governement sometimes trades in foreign exchange markets to try to influence
exchange rate without trying to maintain a fixed rate
 currency boards = institution whose sole purpose is to keep a foreign
echange rate fixed by acting as a residual buyer or seller of the country’s
money at that price (usually replaces central bank)
9.3
10. Fiscal Policy
10.1
Fiscal Policy: refers to government actions that affect total govt. spending, tax rates
and revenues, and the govt. budget surplus or deficit
- off-budget surplus = reflects money that govt. will need in the future to meet its
social security obligations (surplus: excess of tax revenue over spending)
- on-budget deficit = best indicator of budget situation
VWL II / Macroeconomics
Summary Stockmann
10.2
10.3
10.4
10.5
10.6
SS 01
Debts, Deficits and Surpluses
 Govt. has Budget Surplus: Tax Revenue – (smaller) govt. spending
 Govt. has Budget Deficit (negative surplus): govt. spending – (smaller) tax revenue
govt. must either print or borrow money to spend in excess of its tax revenue
shows current-year borrowing
A government budget deficit raises government’s debt, and a surplus reduces it!
 Govt. has Balanced Budget: tax revenue = govt. spending
 government debt = amount of money govt. has borrowed in past and owes now
Effects of transfer payments
Transfer payments = payments of money by govt. to people (f.e. social security,
unemployment payments etc.); it is a redistribution of income
Ex. 1: AD rises when govt. transfers money from people who save most of each dollar
to people who spend most of each dollar: they also reduce supply of loans, raising the
real interest rate and decreasing savings and investment
Ex. 2: AS may be reduced due to transfer payments (social security program reduces
labor supply), which affects the economy’s capital stock
Effects of government purchases
AD = C + I + G + NEX
Effects depend on
a) how well govt. spending substitutes for private spending
Ex.1: govt. raises taxes when raising spending: budget deficit does not increase
AD rises, when govt. raises spending on goods that substitute poorly for spending htat
people already do on their own; and it falls, when it raises spending for goods that
substitute very well for spending that people already do on their own, f.e.:
Govt. starts lunch program and buys you the same lunch every day you would have
bought for yourself and raises taxes to do so: that has no effect and AD; if they spend
money on national defense, now, people reduce their private consumption as a result!
b) how productive the govt. spending is
Govt. spending on infrastructure lowers firm’s cost in producting and distributing
goods; an increase in govt. spending on productive goods can raise AS as well as AD.
c) how the govt. pays for its spending
Govt. either borrows money (raises govt. debt) or raises taxes (present / future)
 time path of taxes: f.e., govt. can cut taxes THIS YEAR if it raises taxes next year
to repy what it borrowed: to do this, govt. must raise discounted present value of
future tax revenue by amount borrowed this year:
Ex.2: govt. spends $100 this and $100 next year, nominal interest rate = 10%
Discounted present value of govt. spending is: $100 + $100/1.10 = $191
- now: govt. could $100 this and $100 next year: would result in d.p.v. of tax
receipts of $191, same as d.p.v. of spending
- govt. could raise no taxes this and $210 taxes next year
- govt. could collect $191 this year and no taxes next year etc.
Automatic changes in govt. budget deficits with GDP
Automatic stabilizer = feature of govt. policy that automatically changes taxes or
spending to try to reduce fluctuations in real GDP without any explicit actions of govt.
- when AD falls, reducing real GDP, tax payments fall (reduced incomes)
 pensions: about $1 Trillion
 Social Security: about $4 Trillion
- privately held govt. debt = govt. debt ownde by people and business firms
Rules vs. discretion in fiscal policy
Discretionary: main argument against rules bases on their inflexibility
VWL II / Macroeconomics
Summary Stockmann
10.7
10.8
SS 01
1) Lags: for one, in implementing policies, for the other, in the effects of fiscal
policies on the economy: these make it difficult to improve ec. performance with
discretionary fiscal policy
2) Lack of sufficient information
Rules:
1) credible rules can improve ec. performance by changing peoples incentives
Fiscal policies and economic growth
Can affect long-run economic growth by changing national savings
National savings = private savings + govt. savings = y – T – C = y – G – C
Rent-Seeking = use of time, money and other resoures to try to get govt. benefits
(spending, tax changes, or regulations targeted to some special-interest group)
- results from possibility that govt. will take discretionary policy actions with
benefits or harm to various special groups. Rent seeking is economically
inefficient, because resources devoted to rent seeking have opportunity cost: could
be used to produce goods
11. International Trade
11.1
Exports = sales of goods and services to people in other countries
Imports = purchases of g&s from people in other countries
Balance of international trade = exports – imports
11.2 Comparative Advantage of a country in making a product when it can produce that
product at a lower opportunity cost than other countries can
11.3 Arguments in favor of international trade
- promotes economic efficiency: helps consumers and producers
- adds to competition facing domestic products, helps countries specialize
- spreads modern technology
11.4 Production and Consumption Possibilities
Without international trade, every country is limited to consuming only the goods it
can produce itself; international trade allows every country to increase consumption of
every good available.
11.5 The size of gains from trade
- consumers of importing country gain(A+B), producers lose(Area A), net gain = B
- consumers of exporting country lose(Area C), producers gain(Area C+D), n.g. = D
Winners in each country gain enough that they could compensate the losers
Importing Country
Exporting Country
P
Supply
$12
$10
A
B
C
D
$7
Demand
Q
Q
Take, f.e. the US and Mexico. In the US, they sell a product for $12, in Mexico for $7; the
new equ. Price with international trade is 10. Consumers in Mexico pay more now, consumers
in the US pay less. Firms in Mexico produce more, the ones in the US less.
(static gains from international trade)
VWL II / Macroeconomics
Summary Stockmann
11.6
SS 01
how big are the gains from international trade?
a) dynamic gains from trade:
- benefits of increased productivity and innovation due to international trade;
increase in specialization raises speed and productivity, increase in competition
increases innovation
b) extra gains from trade in industries with economies of scale
- reduce the average cost in producing products in large quantities (in some
industries); specialization
c) political gains from trade
- benefits of increased interdependencies among nations; reinforces trust, improves
conversation and understanding, reduces risk of war: social and political benefits
11.7 Balances of trade and the current account
Current account: measures the amount that a country lends to or borrows from other
countries; a country has a CA surplus when it lends, a CA deficit when in borrows
Net debtor = nation that owes; pays interest&makes loan payments to other countries
Net creditor = nation that borrows; collects interest and repayments of past loans
CA surplus = Trade balance surplus + net income from foreign investment & transfer
payments
11.8 Causes of CA deficits
- country saves less than it invests (by borrowing extra money from other countries)
- CA changes when demand or supply of loans changes in any country; unless
people save all the money they get from a tax cut, govt. budget deficit raises
demand for loans more than the supply
- Other factors: tax policies, changes in technology, changes in tastes etc.
11.9 Protectionism = govt. restricts international trade to protect domestic business
11.10 Trade Restrictions
a) Tariff = tax on imports
- if country only buys small fraction of world output, a tariff only has a small effect
Ex.1: US put tax on tea (new price PUS); thus, tea producers in the States also rise their
prices to PUS, consumers buy less, total sales of tea fall, imports fall also: ineffective!
- if country buys big enough fraction, a tariff can actually reduce world price of that
certain good!
b) Import quota = direct limit on number of imported goods of a certain type
- profit to people who are allowed to import good; can buy it at low world price PW,
and sell them at high price PUS.
c) VER = voluntary export restraints (limit export to avert threat of trade
restrictions from another country, f.e. Japanese cars)
11.11 World Trade OG
WTO = international organization&series of related treaties to reduce trade restriction
NAFTA (north american), EU
11.12 Common Arguments for Protectionism
a) domestic firms need trade restrictions to compete in world markets (high wages)
 every country has comparative advantages in certain sectors; plus, level of wages
adjusts so that firms in every country can compete in the world market (productivity)
b) trade restrictions protect domestic jobs
 trade restrictions save jobs in some, eliminate jobs in other industries
c) trade restrictions raise wages
 restricting international trade reduces a country’s total income
d) trade restrictions level the playing field
 trade restrictions reduce economic efficiency and redistribute income from
domestic consumers to protected domestic producers
VWL II / Macroeconomics
Summary Stockmann
SS 01
 Dumping (exporting firms charge lower prices than in their own countries);
consumers save money and spend it on domestic money, anyway
e) temporary trade restrictions help new industries get started
 if a new business is expected to be paying well, investors will be found!
f) trade restrictions help national defense
 with free trade, countries may import war material
g) Strategic trade policy can morce other nations towards freer trade
 those often involve threats to impose new trade restrictions unless other nations
reduce their own trade restrictions; helps to reduce worlwide trade restrictions
11.13 Causes of Protectionism
Result mostly from political action by the interest groups who benefit from restrictions