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CH 04 (1,2,3)


S(d)= Y-C(d)- G
changes in ^current income
consumption saving both increases
changes in ^future income - C ^n saving falls
Changes in ^expected real interest rate
subsitution effect - Saving rises
income effect..... for a saver
negative effect on saving as less saving will be required to achieve higher target
.................................for a borrower
positive effect on saving - since loss of wealth
overall - probable rise
changes in ^wealth ^C lowers saving
changes in Govt Purchases- financed by current taxes - reduces after tax in comeOR CURRENT INCOME WILL FALL - so saving falls
Changes in Taxesif ppl do not see future tax rise due to todays tax cut -... then
todays taxCUT -^ in C n decrease savings
in presence of ricardian equivalence proposition- no change in consumption or
saving cause today tax cut is financed by higher future taxes therefore offsetting
the effect on current income.

CH 04
Investment *fluctuates sharply- corelated with busines cycles
desired capital stock - amt of capital which leads to max profit
-depends on Cost n Benifit of additional unit of capital
-benifit of investment is MPK(f)
user cost per each unit of capital K= real interest cost + depriciation
uc= rpk + dpk = (r+d)pk
----------------------------------------------*determination of desired capital stock

graph of MPK(F) and K on the x-axis.

where uc is a straight line.
MPKf falls as K rises due to diminishing marginal productivity
profits are max when desired capital stock is achieved where MPKf=UC
-------------------------------------------------factors that shift desired capital stock are all those factors which can shift MPKf or
which includes
-depriciation rate , real interest rate, Price of the Capital or technological
-------------------------------------------------TAXES AND DESIRED CAPITAL STOCK
tax adjusted MPKf
MPKf = UC/ (1-T)
-An increase in Tax---- raises tax-adjusted user cost and ->reduces the Desired
Capital stock
- A fall in Tax - Increases deired capital stock.
Factors that increase Desired Capital stock
( Increase in MPK , A fall in taxes)
decrease in desired capital stock
( A fall in MPK , an Increse in Taxes)
- we assume revenues are taxed but in reality only PRofits are.
....- so deppriciation reduces taxes
.....- and investement credit reduces tax when the firms by new investment
----------------------------------------------------INVESTMENT AND THE STOCK MARKET
if mkt value is > replacement cost , firms should invest more.
Q= Capitals Market Value / Its Replacement Cost
q < 1 dont invest
q > 1 invest more q= V/(pkK )
MKT value (V) = stock price x no. of shares
Replacement costs = price of a new capital pk x K
^MPKf -- ^V---^q
falling real interest rates----^V--^q
decrease in cost of the capital pk ---^q
Net investment = Change in Capital Stock Kt+1 - Kt
New Capital ^Capital stock--- Gross Investment

Capital stock depriciates-- reducing the capital stock

Net Investment= Gross Investment - Depriciation.
It- dkt
# Gross investment
# Net Investment
# Gross > Net
It = K*-Kt + dKt
*Desired net INCREASE in Capital Stock over the year (K*-Kt)
* Investment needed to replace depriciated capital (dkt)
------------------------------------------DESIRED INVESTMENT is basically Desired Capital Stock K*
^real interest rate Desired Capital Stock (K*) MPKf = UC
Any factor that shifts either MPKf or UC shifts K*
Since UC = rpk+ dpk therefore ^rpk --> ^UC
when UC will shift upwards MPKF and Uc will intersect at left meaning decrease in
the K*/ Deired Investment
^effective tax rate Tax adjusted MPKf
MPKf= UC/( 1- T)
***An increase in the Tax reduces the Desired Capital Stock***
^T -> decrease in UC --> decrease in K*
^MPKf -> Rise in Desired Capital Stock

CH 04
4.3 Good market Equillibrium
* real interest rate adjusts to bring goods market into equilibrium
Y= Cd + Id + G
Since, Desired Savings = Desired Investment
Sd = Id
Sd = Y- Cd - G
-----------------------------------SAVING - INVESTMENT diagram
y- axis real interest rate
x- asis Sd and Id
equilibrium where Sd=Id
------------------------------sample table
real interest rate | Output Y | Cd | Id | G|
Desired National Saving | Aggregate Demand for Goods
Sd = Y- Cd -G
| Y= Cd + Id +G

------------------------------------Saving Curve / shifts right due to

- ^ in Current Output
C^ S^
- fall in future output
- A fall in wealth
- A rise in taxes
Saving Curve shifts left
- Temperory increase in G
------------------------------------------Investment Curve \ shifts right
- fall in the effective tax rate
- rise in MPKf
CH 05 (1,2,3,4,5)
Current Account CA
Net exports NX
Net Factor Patyments NFP
Net Unilateral Transfers NUT
(payments made from one country to another)
(real assets eg. houses , financial assets eg. stocks n bonds )
Capital and Financial account KFA
Capital Account ( unlateral transfers of Assets)
Financial Account
> Financial inflow
(home country sells assets to foreigners)
> Financial Outflow
(home country purchases assets from the foreigners)
CA + KFA + Statistical discrepencies = 0
------------------------------------------transactions in official reserve assets are conducted by CENTRAL BANK
foreign govt securities , bank deposits, bonds , SDRs of IMF and gold
Balance of payments Surplus means a country has increasing official reserve assets.
Net increase in official reserve assets= Government resrve assets -foreign central
bank holdings of US dollar assets

Net foreign assets = a foreign assets - its liabilities

(official resrves)= (govt reserves) - (holdings of foreign assets)
Net Increase in foreign assets = Current Account Surplus
:> A CA surplus implies , KFA deficit !
:> A CA deficit implies , KFA surplus,net decline in holdings of foreign assets
----------------------------------------------CA surplus =
= KFA deficit
=net acqusition of foreign assets
=net foreign lending
-net exports ( if NFP and NUT = 0 )
----------------------------------------------5.2 Goods Market equilibrium in an Open Economy
Savings = Investment + Current Account
S(d) = I(d) + CA
*Assumption= NUT+NFP =0
Since, CA is equavalent to
-> KFA deficit
-> net foreign aquisition of assests
-> net foreign lending
-> net exports (NX) ( if NFP and NUT =0 )
therefore we can also say in open economy,
S(d) = I(d) + NX
Alternatively, Y= C(d) + I(d) + G + NX
NX = Y - (Cd + Id + G)
or NX = Y - (Absorbtion)
-------------------------------------------5.3 Goods Market Equilibrium in SMALL open Economy
- too small to affect the world real interest rate (rw)
* Assumption:
- residents of small open economy can borrow or lend at expected world real
interest rate.
y-axis world real interest rate (rw)
x-axis Sd / and Id \ (billions of dollars)
equilibrium where Sd = Id

Above the equilibriium- Foreign lending} Sd>Id , NX>0

amount measured from x-axis
Below the equlibrium - Foreign Borrowing} Sd<Id. NX<0
if Sd = Id , NX = 0
given Y , G , rw, Cd , Id we can find

desired absorbtion = Cd + Id + G
Net Exports NX = Y - (absorption)
Net foreign lending NX = Net foerign lending
Desired National Saving Since , Y= Cd + Id + G
is also => Y= Cd + Sd + G
therefore, Sd= Y- Cd - G
or simply , Sd= Id + NX
------------------------------------------------EFFECTS OF ECONOMIC SHOCKS
Anything that ^Sd relative to Id at a given world real interest rate , Increases the
Net foreign lending/ Current Account
^Sd ( ^Y , future output falls , or G falls)
Id decreases ( A fall in MPK , an Increase in Taxes )
-----------------Anything that ^Id relative to the Sd at given rw , decreases Net foreign lending /
Current Account
Sd falls ( Y falls , G increases)
Id^ ( An increase in MPKf , a decrease in taxes)
distance between the saving curve and investment curve on the the world real
interest rate line is CURRENT ACCOUNT SURPLUS
the shift in either saving/investment i.e from S to S1 or I to I1 is a result of change in
some factor which can be measure as a distance between the two points on the line
of world real interest rate.
----------------------------------------------5.4 Goods market equilibrium in LARGE OPEN ECONOMY
- an economy large enough to affect the world real interest rate.
- world real interest rate moves to equlibrate desired international lending of one
country with the desired national borrowing by another.
- The equilibrium is determined such that a CA surplus of one country is *equal in
magnitude* to the CA deficit of another.

Home Country and Foreign country shares same world real interest rate.
the distance between Saving and investment curves in both home n foreign is equal
in magnitude (from x-axis)

Changes in world real interest rate.

- Any factor that increases desired national lending to borrowing of another country
causes the rw to FALL
-----------------------------------------------WHY (U.S) CA DEFICIT CONTINUES TO INCREASE?
1) Lower foreign demand
( slow economic growth in other countries so they save more , invest more in us)
2) Better international investment oppurtunities
3) Higher Oil prices
( US imports much oil than it exports, doubling oil prices led to decline in GDP by
4) Increased saving by developing countries.
what can future hold ?
Probable rise in import prices and fall in exports, (dues to fall in value of dollar)
leading to lower imports and higher exports , reducing CA deficit
------------------------------------------------5.5 Fiscal Policy and the Current Account
twin deficit: when "govt budget deficit" is accompanied with "CA deficit" its called a
twin deficit.
An ^in budget deficit raises the CA deficit only if, it reduces the Sd. that happens in
two cases.
1) Govt Purchases
If govt budget deficit is caused by govt purchases
then Sd declines and so does the CA deficit increase.
2) Tax-Cut
if Govt budget deficit is caused by Tax-Cut then theres no affect on CA deficit if
But if people do not foresee future rise in taxes due to todays tax cut , they will
consume more and save less, so CA deficit will increase too causing twin deficit.
This can be shown on graph , shifting of Sd from S to S1 due to any of the above
reason such as increase in govt purchases or tax cut.

The distance between the points on world real interest rate from S1 to Id shows the
CA surplus DECREASE.
------------------------------------------------CH 07 (1,2,3,4,5)
Money : Assets that are widely used and accepted as payment
-----------------------------------------------FUNCTIONS OF MONEY
1. Medium of Exchange (- seperate transactions,
- less cost in time,
- allows specialization)
2. Unit of Account ( -Simplifies comparisons,
-countries with HIGH INFLATION may use
different unit of account, so they
constantly dont have to change prices)
3. Store of Value (- hold wealth, for small periods)
------------------------------------------------MEASURING MONEY
monetary aggregates
M1 : - currency and travellers checks held by public
- Demand deposits ( which pay no interest)
- Other checkable deposits ( which may pay interest)
*all components of M1 are used in making payments.
M2 : M1 + ( less moneylike assets)
- saving deposits
- small time deposits
- nonistitutional MMMFs balances
- money market demand assets MMDAs
------------------------------------------------MONEY SUPPLY (M)
money supply = money stock = amt of available money in the market
^M when c.b uses new printed money to buy financial assets from the public
Central bank can increase or decrease money supply through open market purchase
and sale called open market operations
------------------------------------------------7.2 PORTFOLIO ALLOCATIONS AND DEMAND FOR ASSETS
1. Expected Return (returns not known in advance)

- Bank account : Interest rate

- Corporate stocks: dividend yield + % ^stock price
2. Risk
( degree of uncertainity in an assets return)
3. Liquidity
(ease n quickness money can be traded)
4. Time of Maturity
Money holding descions depends on how much they value liquidity against the low
Asset Demand: The amount a wealth holder wants of an asset.
------------------------------------------------7.3 DEMAND FOR MONEY
quantity of monetary assets people want to hold in their portfolios.
Determinants of Money Demand (Md) are
1. Price level (P)
2. Real income (Y)
3. Interest rates (i) ( on nonmonetary assets and on monetary)
1. Price level
(Nominal money demand is propotional to price level)
2. Real Income
( - money demand isn't propotional but directly propotional,
-As real income increases , a company's financial sophistaction grows use of credit
cards/atm )
3. Interest Rates
(-An increase in interest rate on non monetary assets , decreases money demand
- An increase in the interest rate on mmoney increases money demand)
-----------------------------------------------MONEY DEMAND FUNCTION
Md = P x L( Y, i)
where, i is nominal interest rate on nonmonetary assets.
Md and P are propotional
Md increases when ^Y and decreases when i decreases.
since i = r + er

Md = P x L (Y, r+re)

Md/P = L(Y, i)
-----------------------------------------------DETERMINANTS OF Md
An increase in

Causes Md to


rise propostionally
Real income
rise less than proptionally
real interest rate
expected infaltion
nominal interest rate
on non monetray assets
6. nominal interest rate
7. wealth
( part of an increase of wealth might be money)
8. liquidity of alternative assets
9. efficiency of payment technologies fall
------------------------------------------------ELASTICITIES OF MONEY DEMAND
Elasticity; % change in Md caused by 1 % change in some factor
1. Price Elasticity ( P )
(of Md is UNITARY , so Md is propotional to price level)
2. Income Elasticity ( Y )
- Positive and less than one:
(higher income increases money demand but less than
3. Interest Elasticity
- Small and negitive : (higher ineterest rate on nonmonetary assets reduces
money demand slightly )
------------------------------------------------VELOCITY AND THE QUANITY THEORY OF MONEY
Velocity (V) how much money turns over each year
V = Nominal GDP/ Nominal Money Supply
quantity theory of Money: Real money demand is propotional to real income
Md / P = k Y
Assumes that k constant is velocity
------------------------------------------------7.4 ASSET MARKET EQUILIBRIUM
an aggregate asumption
All assets grouped in M1(currency n checkin accounts) and M2 (stocks and bonds)
M1 , interest rate im , supply fixed at M
M2 , interest rate i = r+ re , supply fied NM
*equlibrium occurs when Money Supply = Money demand
Md + NMd = Aggregate nominal wealth
M + NM = Aggregate Nominal wealth ( supply of assets )

(Md- M) + (NMd- NM) = 0

Excess demand for MONEY and excess demand for NONMONETRAY ASSETS = 0
Therefore we can say, If Money Supply= Money Demand
and so, Nonmonetary Assets = Nonmonetary demand
then entire asset market is in equilibrium
------------------------------------------------Asset Market equilibrium condition
M/P = L(Y, r + re)
re , is fixed for now
Y , is determined by the level of employment using
Given Y , goods market equilibrium determines r
with all other variables given we can determine Price level
P= M/ L(Y, r+re)
* Price level is a ratio of NOMINAL money supply to
REAL money demand
doubling Ms would double price level.
------------------------------------------------7.5 MONEY GROWTH AND INFLATION
Inflation is closely related to GROWTH RATE of Money Supply
* If the asset market is in equilibrium, the inflation rate equals the growth rate
Nominal money Supply minus growth rate of Real money demand.
*in the LONG RUN , i is constant.
let ny be the elasticity of money
pie = delta M/M - ny delta Y/Y
------------------------------------------------- Money demand doesnt matter much in cases of high inflation , no matter how well
or poorly an economy is doing
- So large inflation differences must be due to nominal money supply
Q. why do countries let money supply to grow if they know it causes inflation?
1. sometimes govt has only one option to finance govt expenditures by printing new
2. especially true for v poor countries or in political crises.
i = r + re

Factors that determine expected inflation

1. Increase in money growth , increase in expected inflation.
2. Expected inflation would equal the current inflation if
->money growth and
->real income
remains stable
Q. how can we find out peoples expectations ?
1. through surveys and
2. implict expectations from bond interest rates
US issues two kinds of bonds :
2. TIIS Treasury Inflation Indexed Securities
(makes real interest payments by adjusting interest and principal for inflation)
------------------------------------------------Measuring Inflation expectations
The interest rate differential:
Interest rates on nominal bonds - Interest rates on TIIS bonds
- Its a rough measure
1.- TIIS have lower risk , so measured expected inflation maybe too high
2.- TIIS bonds are not as liquid , so measure can be really low
- The net effect of the two is likely to be small so the expected inflation maybe
about right
------------------------------------------------CH 08 BUSINESS CYCLES
directions ( procyclic , countercyclic and acyclic )
timings (coincident , leading , lagging , unclassified)
1. Production
2. Expenditures
3. Labour Market Variables
4. Money and Inflation
5. Financial Variables
Industrial production procyclic and COINCIDENT
procyclic and COINCIDENT
business fixed investment PRO , COINCIDENT
residential and inventory invest PRO , LEADING
government purchases PRO ,________


Avg labour productivity PRO , LEADING
real wage PRO ,_____
money supply pro LEADING
inflation pro , LAGGING
stock prices
nominal ineterst rates
real ineterst rates
ACYCLIC , _____


1. Industrial production
2. consumption
3. business fixed investment
4. employment
1. Residential and inventory investment
2. Average labour productivity
3. Money Supply
4. Stock Prices
1. Inflation
2. Nominal interest rate
1. Govenrment Purchases
2. Real wages
1. Unemployment
1. Real Interest rate