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BASIC MACROECONOMICS
IMBA Managerial Economics
Lecturer: Jack Wu
Major Macroeconomic Problems



National Income: Low Economic Growth Rate
Employment Opportunity: High Unemployment
Rate
Cost of Living: High Inflation Rate
How to Measure National Income?

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
Gross Domestic Product (GDP)
Gross National Product (GNP)
GDP (Purchasing Power Parity)
Gross Domestic Product


Gross domestic product (GDP) is a measure of the
income and expenditures of an economy.
It is the total “Market value” of “all final” “goods
and services” “produced” “within a country” in a
“given period of time”.
Formula of GDP

GDP (Y) is the sum of the following:
 Consumption



(C)
Investment (I)
Government Purchases (G)
Net Exports (NX)
Y = C + I + G + NX
GDP(PPP)

Gross Domestic Product (GDP) at Purchasing Power
Parity (PPP)
Gross National Product

GNP is the total income earned by a nation’s
permanent residents. It differs from GDP by
including income that citizens earn abroad and
excluding income that foreigners earn here.
Unemployment Rate
Unemployment rate =
Number unemployed
 100
Labor force
Consumer Price Index

The consumer price index (CPI) is a measure of the
overall cost of the goods and services bought by a
typical consumer.
Calculating Inflation Rate

Compute the inflation rate: The inflation rate is
the percentage change in the price index from
the preceding period.
Inflation Rate in Year 2 =
CPI in Year 2 - CPI in Year 1
 100
CPI in Year 1
HOW CAN GDP INCREASE?

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

Consumption increases
Investment increases
Government purchase increases
Net export increases
Consumption


Autonomous consumption spending
Derived consumption spending
=c*(disposable income)
C: marginal propensity to consume
Disposable income= income - tax
Investment




Domestic or Foreign Direct investment
Investment is affected by real interest rate (nominal
interest rate – inflation)
Portfolio investment (ex: buying shares) is
considered as Saving
National Saving = Private Saving +Public Saving
The Market for Loanable Funds
Real
Interest
Rate
Supply of loanable funds
(from national saving)
Equilibrium
real interest
rate
Demand for loanable
funds (for domestic
investment and net
capital outflow)
Equilibrium
quantity
Quantity of
Loanable Funds
Copyright©2003 Southwestern/Thomson Learning
Nominal Interest rate and Money
Market


Money supply
Money demand
Fiat Money in the Economy


Currency is the paper bills and coins in the hands of
the public.
Demand deposits are balances in bank accounts that
depositors can access on demand by writing a
check.
Money Supply
M1:Narrowly defined money supply
_ M1A
_ M1B
 M2: Broadly defined money supply

Open-Market Operations

Open-Market Operations
 The
money supply is the quantity of money available in
the economy.
 The primary way in which the Fed changes the money
supply is through open-market operations.
 The
Fed purchases and sells U.S. government bonds.
Money Creation through the bank



When one bank loans money, that money is
generally deposited into another bank.
This creates more deposits and more reserves to be
lent out.
When a bank makes a loan from its reserves, the
money supply increases.
Money Multiplier



The money multiplier is the reciprocal of the reserve
ratio:
M = 1/R
With a reserve requirement, R = 20% or 1/5,
The multiplier is 5.
Tools of Money Control

The Fed has three tools in its monetary toolbox:
 Open-market
operations
 Changing the reserve requirement
 Changing the discount rate
**The discount rate is the interest rate the Fed charges
banks for loans.
Motives of Money Demand



Transaction motive (Price, income)
Precautionary motive (Price, income)
Speculative motive (interest rate)
Money Market Equilibrium




The interest rate and quantity demanded of money
are negatively related. Therefore, the money demand
curve is downward sloping.
The quantity supplied of money is controlled by Fed.
Therefore, the money supply curve is vertical.
As money demand increases, the interest rate is higher.
As money supply increases, the interest rate is lower.
Figure
Interest Rate
MS1
MS2
MS3
M1
M2
M3
r1
r2=r3
Money Quantity
Liquidity Trap

When the money demand is perfectly elastic at a
low interest rate, the increase in money supply
would not have any impact on the interest rate.
International Trade and Exchange Rate

Net Export is affected by exchange rate.
Nominal Exchange Rate


The nominal exchange rate is the rate at which a
person can trade the currency of one country for the
currency of another.
The nominal exchange rate is expressed in two
ways:
 In
units of foreign currency per one U.S. dollar.
 And in units of U.S. dollars per one unit of the foreign
currency.
Figure
Nominal Exchange
Rate (NT$/US$)
30
S
S1
E**
E*
29
Q*
Q**
D
US Dollar
Real Exchange Rate


The real exchange rate is the rate at which a person
can trade the goods and services of one country for
the goods and services of another.
The real exchange rate compares the prices of
domestic goods and foreign goods in the domestic
economy.
 If
a case of German beer is twice as expensive as
American beer, the real exchange rate is 1/2 case of
German beer per case of American beer.
Formula
Nominal exchange rate  Domestic price
Real exchange rate =
Foreign price
The Market for Foreign-Currency Exchange
Real
Exchange
Rate
Supply of dollars
(from net capital outflow)
Equilibrium
real exchange
rate
Demand for dollars
(for net exports)
Equilibrium
quantity
Quantity of Dollars Exchanged
into Foreign Currency
Copyright©2003 Southwestern/Thomson Learning
Short-Run Economic Fluctuation

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•
Economic activity fluctuates from year to year.
A recession is a period of declining real incomes, and
rising unemployment.
A depression is a severe recession.
Fluctuations in the economy are often called the
business cycle.
The Aggregate-Demand Curve...
Price
Level
P
P2
1. A decrease
in the price
level . . .
Aggregate
demand
0
Y
Y2
Quantity of
Output
2. . . . increases the quantity of
goods and services demanded.
Copyright © 2004 South-Western
Shifts

Shifts arising from
 Consumption
 Investment
 Government
 Net
Exports
Purchases
Demand Curve Shifts

Price
Level
P1
D2
Aggregate
demand, D1
0
Y1
Y2
Quantity of
Output
The Long-Run Aggregate-Supply Curve
Price
Level
Long-run
aggregate
supply
P
P2
2. . . . does not affect
the quantity of goods
and services supplied
in the long run.
1. A change
in the price
level . . .
0
Natural rate
of output
Quantity of
Output
Copyright © 2004 South-Western
Long-Run Aggregate Supply Curve



The Long-Run Aggregate-Supply Curve
 The long-run aggregate-supply curve is vertical at the
natural rate of output.
 This level of production is also referred to as potential
output or full-employment output.
Any change in the economy that alters the natural rate of
output shifts the long-run aggregate-supply curve.
The shifts may be categorized according to the various factors
in the classical model that affect output.
Long-Run Growth and Inflation
2. . . . and growth in the
money supply shifts
aggregate demand . . .
Long-run
aggregate
supply,
LRAS 1980 LRAS 1990 LRAS 2000
Price
Level
1. In the long run,
technological
progress shifts
long-run aggregate
supply . . .
P 2000
4. . . . and
ongoing inflation.
P 1990
Aggregate
Demand, AD2000
P 1980
AD1990
AD1980
0
Y 1980
Y 1990
Quantity of
Output
3. . . . leading to growth
in output . . .
Y 2000
Copyright © 2004 South-Western
Short-Run Aggregate Supply Curve
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Short-run fluctuations in output and price level should
be viewed as deviations from the continuing long-run
trends.
In the short run, an increase in the overall level of
prices in the economy tends to raise the quantity of
goods and services supplied.
A decrease in the level of prices tends to reduce the
quantity of goods and services supplied.
The Short-Run Aggregate-Supply Curve
Price
Level
Short-run
aggregate
supply
P
P2
2. . . . reduces the quantity
of goods and services
supplied in the short run.
1. A decrease
in the price
level . . .
0
Y2
Y
Quantity of
Output
Copyright © 2004 South-Western
The Long-Run Equilibrium
Price
Level
Long-run
aggregate
supply
Equilibrium
price
Short-run
aggregate
supply
A
Aggregate
demand
0
Natural rate
of output
Quantity of
Output
Copyright © 2004 South-Western
Two Causes of Economic Fluctuation


Shifts in Aggregate Demand
 In the short run, shifts in aggregate demand cause fluctuations in the
economy’s output of goods and services.
 In the long run, shifts in aggregate demand affect the overall price level
but do not affect output.
An Adverse Shift in Aggregate Supply
 A decrease in one of the determinants of aggregate supply shifts the
curve to the left:



Output falls below the natural rate of employment.
Unemployment rises.
The price level rises
A Contraction in Aggregate Demand
2. . . . causes output to fall in the short run . . .
Price
Level
Long-run
aggregate
supply
Short-run aggregate
supply, AS
AS2
3. . . . but over
time, the short-run
aggregate-supply
curve shifts . . .
A
P
B
P2
P3
1. A decrease in
aggregate demand . . .
C
Aggregate
demand, AD
AD2
0
Y2
Y
4. . . . and output returns
to its natural rate.
Quantity of
Output
Copyright © 2004 South-Western
An Adverse Shift in Aggregate Supply
1. An adverse shift in the shortrun aggregate-supply curve . . .
Price
Level
Long-run
aggregate
supply
AS2
Short-run
aggregate
supply, AS
B
P2
A
P
3. . . . and
the price
level to rise.
Aggregate demand
0
2. . . . causes output to fall . . .
Y2
Y
Quantity of
Output
Copyright © 2004 South-Western
Policy Responses to Recession

Policy Responses to Recession
 Policymakers
may respond to a recession in one of the
following ways:
 Do
nothing and wait for prices and wages to adjust.
 Take action to increase aggregate demand by using
monetary and fiscal policy.
Fed’s Monetary Injection

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The Fed can shift the aggregate demand curve when
it changes monetary policy.
An increase in the money supply shifts the money
supply curve to the right.
Without a change in the money demand curve, the
interest rate falls.
Falling interest rates increase the quantity of goods
and services demanded.
A Monetary Injection
(b) The Aggregate-Demand Curve
(a) The Money Market
Interest
Rate
r
2. . . . the
equilibrium
interest rate
falls . . .
Money
supply,
MS
Price
Level
MS2
1. When the Fed
increases the
money supply . . .
P
r2
AD2
Money demand
at price level P
0
Quantity
of Money
Aggregate
demand, AD
0
Y
Y
Quantity
of Output
3. . . . which increases the quantity of goods
and services demanded at a given price level.
Copyright © 2004 South-Western
Fiscal Policy


When policymakers change the taxes, the effect on
aggregate demand is indirect—through the
spending decisions of firms or households.
When the government alters its own purchases of
goods or services, it shifts the aggregate-demand
curve directly.
Two Macroeconomic Effects

There are two macroeconomic effects from the
change in government purchases:
 The
multiplier effect
 The crowding-out effect