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the book. All rights reserved. # DEFINITIONS ------------* GDP = PIB = C + I + G + NX where C = consumption I = investment G = gov expenditures NX = net exports real GDP = GDP at constant prices GNP = GDP + factor payments from abroad - factor payments to abroad :: total income earned by residents of a nation GNI = GNP :: GNI calculates the GNP by summing income, not output value GDP deflator = nominal GDP / real GDP :: an indicator of what's happening to the level of prices NNP = GNP - depreciation Notes: - There is 'investment' only when new goods are added to the economy, like when building a house from scratch. - Used goods are not counted toward the GDP: they are not an addition to the economy. - When inventories get bigger even if the goods are not sold, it is still counted toward the GDP. - For intermediary goods, we only count the added value at each step, or equivalently, the value of the final good. - Some goods which aren't traded need to be imputed a value, such as the rent homeowners would pay themselves. * CPI CPI is an indicator of the level of prices, using the change in price of a basket of goods. Different from the GDP deflator for 3 reasons: - the GDP deflator reflects the level of all prices, not just those bought by consumers - the GDP deflator includes only domestic goods, the change in price of imports is not reflected - the CPI is calculated with a fixed set of goods, substitution from one product to another or new products are not accounted for * Unemployment rate = # of unemployed / labor force * 100 where labor force is all the workers and those looking for a job or on a temporary layoff. Discouraged workers are not counted, neither are retirees and full-time students. Okun's law :: the unemployment is negatively related to the GDP growth Percentage Change in Real GDP = 3% - 2*Change in the Unemployment Rate # GENERAL EQUILIBRIUM MODEL --------------------------This is clasical/neoclassical theory, aka the general equilibrium model The production depends on the quantity of the factors of production and on
productivity (the ability to go from input to output). MV = PT or MV = PY where M = money V = velocity P = typical price T = # of transactions (PT) = the amount of money that changes hands Y = C + I + G Assumptions: - money is neutral, does not affect real variables - velocity of money is constant - long run :: prices are flexible - capital, labor and thus ouput, is fixed - the competitive firm is a price taker, it takes the price of inputs, outputs, and wages as given. It will then choose the quantity of each to maximize profits - savings = Y - C - G = I - the role of money is ignored - no trade with other countries - full employment - capital stock and labor force are fixed - ignored the role of short-tun sticky prices Consequences: - to maximize profits, the competitive firm must hire until the marginal product of labor equals the real wage (the wage in terms of the firm's output) - the competitive firm does the same for capital :: rent or buy more until the marginal product of capital equals the real rental price (the price in terms of the firm's output) - if we assume constant returns to scale, then economic profit for the competitive firm is nil - each factor of production is paid its marginal productivity :: this is how output is distributed in this model - at the equilibrium interest rate, the demand for goods and services equals the supply - at the equilibrium interest rate, households’ desire to save balances firms’ desire to invest, and the quantity of loanable funds supplied equals the quantity demanded - when gov purchases increase with no tax bump, the purchases are financed with bonds and it crowds out investment. Consumption is increased because disposable income is larger - a tax cut has the same effects as an increase in gov purchases - investment can be stoked by new technology or milder tax laws - investment depends negatively on the real interest rate - the money supply determines the nominal value of output - the central bank has complete control over inflation (quantity of money theory) # IN THE OPEN ECONOMY --------------------Y = C + I + G + NX
where NX = net exports National income accounts :: S - I = NX :: net capital outflow (net foreign investment) = trade balance real exchange rate = nominal exchange rate * ratio of price levels Assumptions: - the economy is small and does not affect the world interest rate Consequences: - if the world interest rate is higher than what would prevail in the closed economy, the economy experiences a trade surplus - if the world interest rate is lower than what would prevail in the closed economy, the economy experiences a trade deficit - starting from balanced trade, a change in fiscal policy that reduces national saving leads to a trade deficit - an increase in the world interest rate due to a fiscal expansion abroad leads to a trade surplus - The real exchange rate is related to net exports. When the real exchange rate is lower, domestic goods are less expensive relative to foreign goods, and net exports are greater - The trade balance (net exports) must equal the net capital outﬂow, which in turn equals saving minus investment. Saving is ﬁxed by the consump tion function and ﬁscal policy; investment is ﬁxed by the investment function and the world interest rate - at the equilibrium real exchange rate, the supply of dollars available from the net capital outﬂow balances the demand for dollars by foreigners buying our net exports - when savings drop from an increase in G or a tax cut, or when investment is stoked by a tax credit, NX falls too - a protectionist trade policy raises the real exchange rate. Despite the shift in the net-exports schedule, the equilibrium level of net exports is unchanged. This lowers the amount of trade. Notes: - (quote) Yet trade deﬁcits are not always a reﬂection of economic malady.When poor rural economies develop into modern industrial economies, they sometimes ﬁnance their high levels of investment with foreign borrowing. In these cases, trade deﬁcits are a sign of economic development. For example, South Korea ran large trade deﬁcits throughout the 1970s, and it became one of the success stories of economic growth.The lesson is that one cannot judge economic performance from the trade balance alone. Instead, one must look at the underlying causes of the international flows # UNEMPLOYMENT -------------Summary: - The natural rate of unemployment is the steady-state rate of unemployment. It
depends on the rate of job separation and the rate of job ﬁnding - Because it takes time for workers to search for the job that best suits their individual skills and tastes, some frictional unemployment is inevitable.Various government policies, such as unemployment insurance, alter the amount of frictional unemployment - Structural unemployment results when the real wage remains above the level that equilibrates labor supply and labor demand. Minimum-wage legislation is one cause of wage rigidity. Unions and the threat of unionization are another. Finally, efficiency-wage theories suggest that, for various reasons, firms may find it profitable to keep wages high despite an excess supply of labor - Whether we conclude that most unemployment is short term or long term depends on how we look at the data. Most spells of unemployment are short. Yet most weeks of unemployment are attributable to the small number of long-term unemployed - The unemployment rates among demographic groups differ substantially. In particular, the unemployment rates for younger workers are much higher than for older workers.This results from a difference in the rate of job separation rather than from a difference in the rate of job ﬁnding - The natural rate of unemployment in the United States has exhibited longterm trends. In particular, it rose from the 1950s to the 1970s and then started drifting downward again in the 1990s.Various explanations have been proposed, including the changing demographic composition of the labor force, changes in the prevalence of sectoral shifts, and changes in the rate of productivity growth - Individuals who have recently entered the labor force, including both new entrants and reentrants, make up about one-third of the unemployed.Transitions into and out of the labor force make unemployment statistics more difficult to interpret # INFLATION ----------The costs of expected inflation include shoeleather costs, menu costs, relative price variability, tax distortions, and the inconvenience of making inﬂation corrections. addition, unexpected inﬂation causes arbitrary redistributions of wealth between debtors and creditors. One beneﬁt of inﬂation is that it improves the functioning of labor markets by allowing real wages to equilibrium levels without cuts in nominal wages. # EXOGENOUS GROWTH MODEL -----------------------Instead of focusing on a snapshot of the economy, we study the long run and introduce dynamic variables. the cost of In possible reach
y = f(k) i = sy delta k = sf(k) - d*k where delta k = change in capital stock d = depreciation rate c = f(k) − d*k where c = steady-state consumption at the golden rule level * Golden rule The golden rule level is the level at which consumption per worker is maximized. At that level, more capital will bring more depreciation and less consumption. Whereas less capital would not provide as much output and consumption. MPK = d * Population growth At this point, there is nothing to explain sustained growth. We need to add population growth and technological progress. delta k = i - (d + n)*k = sf(k) - (d + n)*k where n = population growth The golden rule level is now MPK = d + n * Technological progress We include technological progress: F = (K,L*E) where E = efficiency of labor We no longer use variables 'per worker' but rather variables 'per effective worker'. delta k = i - (d + n + g)*k = sf(k) - (d + n + g)*k MPK = d + n + g where g = labor-augmenting technological progress With technological progress, total ouput grows at rate n + g. * Endogenous growth theories Endogenous growth theories try to explain technological progress and to not assume diminishing returns to capital or constant returns to scale Assumptions: - there is a steady state toward which an economy will go - production function has constant returns to scale - at the steady-state, the investment equals d * k Consequences: - saving rate is a key determinant of the steady-state capital stock - steady-state capital stock. If the saving rate is high, the economy will have a large capital stock and a high level of output. If the saving rate is low, the economy will have a small capital stock and a low level of output
- a persistent budget deficit will lowe the saving rate and lead to lower capital stock - at the golden rule level, the marginal productivity of capital equals the depreciation rate - when the economy begins above the Golden Rule, reaching the Golden Rule produces higher consumption at all points in time.When the economy begins below the Golden Rule, reaching the Golden Rule requires initially reducing consumption to increase consumption in the future - whether or not a policymaker would try to reach the golden rule level depends on the weight he puts on current generations v. future ones - when accounting for population growth, a part of the break-even investment replaces the depreciated capital (d*k), and the other part ensures that capital per worker is constant (n*k) - with a population growth of n, total ouput must also grow by n if the economy is in the steady-state. This does not explain increasing standards of living, but it explains sustained growing output in part - although a high saving rate yields a high steady-state level of output, saving by itself cannot generate persistent economic growth - the Solow model shows that an economy’s rate of population growth is another long-run determinant of the standard of living. The higher the rate of population growth, the lower the level of output per worker - only technological progress can explain increasing living standards - in the steady state of the Solow growth model, the growth rate of income per person is determined solely by the exogenous rate of technological progress # AGGREGATE SUPPLY AND AGGREGATE DEMAND --------------------------------------Notes: - In the short run, prices are fixed - Real money balances = M/P - The aggregate demand curve is drawn for a fixed money supply: if the Fed decreases the money supply, the curve will shift inward - The long run aggregate supply curve does not depend on price level. It is thus vertical when x is income and y is price level - The short run aggregate supply curve is horizontal because prices are sticky - Over long periods of time, prices are ﬂexible, the aggregate supply curve is vertical, and changes in aggregate demand affect the price level but not output. Over short periods of time, prices are sticky, the aggregate supply curve is ﬂat, and changes in aggregate demand do affect the economy’s output of goods and services - Supply shock = price shock # IS-LM MODEL ------------A model to view how income changes in the short run where prices are fixed or a
model to view what makes the AD curve shift. IS = investment and savings LM = liquidity and money The interest rate is what influences investment and money and is thus the link between the two axes. E = C(Y − T) + I + G where E = planned expenditure C = propensity to consume T = taxes I and G are exogenous Y = E * Keynesian cross - The Keynesian cross superposes planned expenditure and actual expenditure - the economy is in equilibrium when Y = E: actual expenditure = planned expenditure - delta Y / delta G is the gov purchases multiplier :: it is larger than one because when gov purchases, it raises income literally, but also raises consumption for the citizens, which raises income again, and so on - delta Y / delta G = 1/(1 - MPC) :: found using algebra and geometric series - When gov cuts taxes, delta Y / delta T is the tax multiplier - delta Y / delta T = -MPC/(1 - MPC) :: found using algebra and geometric series * IS curve Y = C(Y - T) + I(r) + G - The IS curve slopes downward :: an increase in the interest rate decreases investment and planned expenditure, and so incomes - In summary, the IS curve shows the combinations of the interest rate and the level of in- come that are consistent with equilibrium in the market for goods and services.The IS curve is drawn for a given ﬁscal policy. Changes in ﬁscal policy that raise the demand for goods and services shift the IS curve to the right. Changes in ﬁscal policy that reduce the demand for goods and services shift the IS curve to the left * Theory of liquidity preference - real money balances = M/P :: both variables are exogenous - according to the theory of liquidity preference, the supply and demand for real money balances determine what interest rate prevails in the economy - the curve is downward sloping with the interest rate against the real money balances * LM curve M/P = L(r, Y ) :: supply of real money balances - plots the interest rate against the level of income :: the more one earns, the more they need real money balances - in summary, the LM curve shows the combinations of the interest rate and the level of income that are consistent with equilibrium in the market for real money balances.The LM curve is drawn for a given supply of real money balances. Decreases in the supply of real money balances shift the LM curve
upward. Increases in the supply of real money balances shift the LM curve downward. * AD curve - we can summarize these results as follows: A change in income in the IS–LM model resulting from a change in the price level represents a movement along the aggregate demand curve. A change in income in the IS–LM model for a fixed price level represents a shift in the aggregate demand curve - expansionary fiscal policy (an increase in government purchases or a decrease in taxes) shifts the IS curve to the right.This shift in the IS curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary ﬁscal policy shifts the IS curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left - expansionary monetary policy shifts the LM curve downward. This shift in the LM curve lowers the interest rate and raises income.The increase in income represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary policy shifts the LM curve upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the left * Pigou effect As prices fall and real money balances increase, households should feel wealthier and spend more, thus increasing the economy's ouput * Third equation Keynesianism and classical theory can both use the IS-LM model but each one has a different third equation classical theory :: Y is fixed keynes :: P is fixed # MUNDELL-FLEMING ----------------IS* :: Y = C(Y - T) + I(r*) + G + NX(e) LM* :: M/P = L(r*,Y) Those curves are plotted for the exchange rate against income. Assumption: - we fix the interest rate to the world's interest rate - small open economy with perfect capital mobility - the interest rate is floating Consequences: - the interest rate is determined by the world's interest rate - the LM* curve is vertical - fiscal policy in an open economy is offset by the trade balance :: if gov spends more money, it will not raise income. There will be a shortage of loanable funds and the exchange rate will appreciate since the interest rate is fixed. Because of that, the net exports are going to fall
- in a closed economy an increase in the money supply increases spending because it lowers the interest rate and stimulates investment. In a small open economy, as soon as an increase in the money supply puts downward pressure on the domestic interest rate, capital flows out of the economy as investors seek a higher return elsewhere. This capital outﬂow prevents the domestic interest rate from falling. In addition, because the capital outﬂow increases the supply of the domestic currency in the market for foreign-currency exchange, the exchange rate depreciates. The fall in the exchange stimulates net exports. Hence, in a small open economy, monetary policy influences income by altering the exchange rate rather than the interest rate - the trade policy cannot affect income, just the exchange rate * With a fixed exchange rate - a fiscal expansion raises income :: gov spending raises income, but the exchange rate is fixed, so arbitrageurs sell foreign currency to the central bank, effectively provoking an increase in the money supply and shifting the LM* curve outward, raising income at the equilibrium - monetary policy has no effect because the exchange rate and the interest rate is fixed, arbitrageurs will keep the balance - the fixed exchange rate can be changed thought :: that's another form of monetary policy - devaluation will increase net exports and income - revaluation will diminish net exports and income - trade policy can increase net exports and income :: an import quota will shift the net exports schedule to the right and thus IS* curve to the right, which will attract money from arbitrageurs and shift the LM* curve to the right. Income has increased under the new equilibrium * With a risk premium IS* :: Y = C(Y - T) + I(r* + 0) + G + NX(e) LM* :: M/P = L(r* + 0,Y) - When the risk premium increases, the domestic interest rate increases. This shifts the IS* curve to the left as it reduces investment, and shifts the LM* curve to the right, as the demand for money supply decreases. Income thus rises and the currency depreciates. This sounds good but it isn't: 1) the central bank might want to avoid depreciation and would decrease money supply 2) depreciation increases the price of imported goods, causing increase in price level 3) in times of doubt, citizens will increase their demand for money balances All those consequences will shift the LM* curve inward * Fixed and floating x-rates There are advantages to both floating and fixed exchange rates. Floating exchange rates leave monetary policymakers free to pursue objectives other than exchange-rate stability. Fixed exchange rates reduce some of the uncertainty in international business transactions.
# AGGREGATE SUPPLY -----------------Y = natY + a(P - Pe) where a > 0 natY = natural rate of output P = price level Pe = expected price level If the price level is higher than the expected price level, output exceeds its natural rate. If the price level is lower than the expected price level, output falls short of its natural rate * Sticky-wage model The assumption is that wages are sticky in the short run. Consequences: - when price level rises, the real wage is lower and labor cheaper - lower wages induces firms to hire more - additional labor produces more output - Thus price level and output are positively related * Imperfect-information model It is hard to know for sure whether the price level is local or global, and even if we know the nominal price, it is hard to know the relative price to others goods. Rationally, but maybe mistakenly, when the price of a firm's product increases, the firm will try to produce more. * Sticky-price model Prices are sometimes sticky for the same reasons they were in the Mundell-Fleming model. When firms expect a high price level, they expect high costs. Those firms that fix prices in advance set their prices high. These high prices cause the other ﬁrms to set high prices also. Hence, a high expected price level Pe leads to a high actual price level P. When output is high, the demand for goods is high.Those firms with ﬂexible prices set their prices high, which leads to a high price level.The effect of output on the price level depends on the proportion of firms with flexible prices. * Phillips curve Inflation depends on: - expected inflation - deviation of unemployment from the natural rate - supply shocks Inflation is negatively related to unemployment in the short run PI = PIe - b(u - ue) + v where PI = inflation PIe = expected inflation :: inflation inertia if replaced by last year's inflation u = unemployment v = supply shock
b = relationship coefficient between inflation and unemployment * The sacrifice ratio The percentage of a year’s real GDP that must be forgone to reduce inﬂation by 1 percentage point * Natural-rate hypothesis Fluctuations in aggregate demand affect output and employment only in the short run. In the long run, the economy returns to the levels of output, employment, and unemployment described by the classical model. Some have challenged this :: hysteresis is the term used to describe the effects of aggregate demand on the long run A recession can have permanent effects if it changes the people who become unemployed. For instance, workers might lose valuable job skills when unemployed, lowering their ability to find a job even after the recession ends. # POLICY DEBATES ---------------* Lucas critique The traditional policy evaluation that relies on econometrics measures does not factor in the expectations of people. * Time inconsistency An institution sometimes has an incentive to renege a previous commitment. Citizens know that and it makes the policy by rule harder. # MISC -----There are two expectational variables in the comprehensive model :: expected inflation and expected price level Y = K = L = MPL MPK G = T = output capital labor time = marginal productivity of labor = marginal productivity of capital government purchases tax revenue
lowercase letters usually stand for 'per worker'