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? 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

U n em p lo y m en t ra te =N u m b er u n e m p lo y ed

L ab o r fo rce 1 0 0

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.

In fla tio n R a te in Y ear 2 =C P I in Y ea r 2 - C P I in Y ea r 1

C P I in Y ea r 1 1 0 0

HOW CAN GDP INCREASE?

Consumption increases Investment increases Government purchase increases Net export increases

Consumption

Autonomous consumption spending Derived consumption spending =c*(disposable income)

C: marginal propensity to consumeDisposable 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

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Quantity ofLoanable Funds

RealInterest

RateSupply of loanable funds(from national saving)

Demand for loanablefunds (for domesticinvestment and net

capital outflow)

Equilibriumquantity

Equilibriumreal interest

rate

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

M3M2M1

r2=r3

r1

MS3MS

1 MS2

Money Quantity

Interest Rate

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

30E**

E*

D

Q**Q*

29

S S1

US Dollar

Nominal Exchange Rate (NT$/US$)

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

R eal ex ch an g e ra te =N o m in a l ex ch an g e ra te D o m estic p rice

F o re ig n p rice

The Market for Foreign-Currency Exchange

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Quantity of Dollars Exchangedinto Foreign Currency

RealExchange

RateSupply of dollars

(from net capital outflow)

Demand for dollars(for net exports)

Equilibriumquantity

Equilibriumreal exchange

rate

Short-Run Economic Fluctuation 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...

Quantity ofOutput

PriceLevel

0

Aggregatedemand

P

Y Y2

P2

1. A decreasein the pricelevel . . .

2. . . . increases the quantity ofgoods and services demanded.

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Shifts

Shifts arising from Consumption Investment Government Purchases Net Exports

Demand Curve Shifts

Quantity ofOutput

PriceLevel

0

Aggregatedemand, D1

P1

Y1

D2

Y2

The Long-Run Aggregate-Supply Curve

Quantity ofOutput

Natural rateof output

PriceLevel

0

Long-runaggregate

supply

P2

1. A changein the pricelevel . . .

2. . . . does not affect the quantity of goods and services supplied in the long run.

P

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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

Quantity ofOutput

Y1980

AD1980

AD1990

Aggregate Demand, AD2000

PriceLevel

0

Long-runaggregate

supply,LRAS1980

Y1990

LRAS1990

Y2000

LRAS2000

P1980

1. In the long run,technological progress shifts long-run aggregate supply . . .

4. . . . andongoing inflation.

3. . . . leading to growthin output . . .

P1990

P2000

2. . . . and growth in the money supply shifts aggregate demand . . .

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Short-Run Aggregate Supply Curve 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

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

1. A decreasein the pricelevel . . .

2. . . . reduces the quantityof goods and services

supplied in the short run.

Y

P

Y2

P2

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The Long-Run Equilibrium

Natural rateof output

Quantity ofOutput

PriceLevel

0

Short-runaggregate

supply

Long-runaggregate

supply

Aggregatedemand

AEquilibriumprice

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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

Quantity ofOutput

PriceLevel

0

Short-run aggregatesupply, AS

Long-runaggregate

supply

Aggregatedemand, AD

AP

Y

AD2

AS2

1. A decrease inaggregate demand . . .

2. . . . causes output to fall in the short run . . .

3. . . . but over time, the short-runaggregate-supplycurve shifts . . .

4. . . . and output returnsto its natural rate.

CP3

BP2

Y2

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An Adverse Shift in Aggregate Supply

Quantity ofOutput

PriceLevel

0

Aggregate demand

3. . . . and the price level to rise.

2. . . . causes output to fall . . .

1. An adverse shift in the short-run aggregate-supply curve . . .

Short-runaggregatesupply, AS

Long-runaggregate

supply

Y

AP

AS2

B

Y2

P2

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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

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

MS2Moneysupply, MS

Aggregatedemand, AD

YY

P

Money demand at price level P

AD2

Quantityof Money

0

InterestRate

r

r2

(a) The Money Market (b) The Aggregate-Demand Curve

Quantityof Output

0

PriceLevel

3. . . . which increases the quantity of goods and services demanded at a given price level.

2. . . . theequilibriuminterest ratefalls . . .

1. When the Fedincreases themoney supply . . .

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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