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INTRODUCTION TO MACROECONOMICS
MODULE

TEACHING ASSISTANTS OF MICROECONOMICS AND

MACROECONOMICS
UNDERGRADUATE ECONOMICS PROGRAM
FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITAS PADJADJARAN
2020
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 ACKNOWLEDGEMENT
In the name of Allah, The Most Gracious, The Most Merciful
Alhamdulillah, all praises to Allah SWT, The Almighty, for giving
belief, health, confidence and blessing for the writers to accomplish this Module
of Introduction to Macroeconomics. Shalawat and Salam be upon our prophet
Muhammad SAW, who has brought us from the darkness into the brightness and
guided as into the right way of life.
In this opportunity, we would like to express our deep gratitude to the
Head of Department of Economics, all of the lecturers, and those who contributed
in the process of making this module. All of your kindness and help means a lot
to us. Thank you very much. Hopefully this module can be the short guide for the
students in order to deepen their understanding about Macroeconomics.

List of the Module Writers:

1. Moh. Taufan 120210160085

2. Zaki Intan C. 120210160094
3. Syarifah Rahmani P 120210170060
4. Anindito Widiatmojo 120210170061
5. M. Daffarel Putra A. 120210170064
6. Fariza Zahra K. 120210170076
7. Retno Mayudian P. 120210170080
8. Karmila Peronika S. 120210170081
9. Adlan Ramadhan 120210170114

Acknowledge and Agree,

Head of Undergraduate Program of Department of Economics

Rudi Kurniawan, S.E., MSi., Ph.D.

NIP. 19700310199702100

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 CONTENTS

CHAPTER 1 INTRODUCTION, MEASURING NATION’S INCOME AN

COST OF LIVING ................................................................................................... 5
CHAPTER 2 SAVING, INVESTMENT, AND THE FINANCIAL
SYSTEM ................................................................................................................. 16
CHAPTER 3 PRODUCTION, GROWTH AND UNEMPLOYMENT ..... 24
CHAPTER 4 THE MONETARY SYSTEM .................................................... 34
CHAPTER 5 MONEY GROWTH AND INFLATION................................. 39
CHAPTER 6 THE MACROECONOMICS OF OPEN ECONOMICS ....... 46
CHAPTER 7 AGGREGATE DEMAND, AGGREGATE SUPPLY, AND
THE INFLUENCE OF MONETARY AND FISCAL POLICY ON
AGGREGATE DEMAND ................................................................................... 51
CHAPTER 8 THE SHORT-RUN TRADE OFF BETWEEN INFLATION
AND UNEMPLOYMENT & SIX DEBATES OVER MACROECONOMIC
POLICY.. ................................................................................................................ 59

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 CHAPTER 1
INTRODUCTION, MEASURING NATION’S INCOME AN COST
OF LIVING

 Scarcity: the limited nature of society’s resources

 Economics: the study of how society manages its scarce
resources

The Ten Principles of Economics

 How people make decisions

1. People face trade-offs
o Efficiency: the property of society getting the most it can
from its scarce resources
o Equality: the property of distributing economic prosperity
uniformly among the members of society
2. The cost of something is what you give up to get it
o Opportunity cost: whatever must be given up to obtain
some item
3. Rational people think at the margin
o Rational people: people who systematically and
purposefully do the best they can to achieve their
objectives
o Marginal change: a small incremental adjustment to a plan
of action
4. People respond to incentives

 How people interact

5. Trade can make everyone better-off
6. Markets are usually a good way to organize economic activity
o Market economy (the invisible hand): an economy that
allocates resources through the decentralized decisions of
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 many firms and households as they interact in markets for
goods and services

7. Governments can sometimes improve market outcomes

o Property rights: the ability of an individual to own and
exercise control over scarce resources
o Market failure: a situation in which a market left on its
own fails to allocate resources efficiently
o Externality: the impact of one person’s actions on the well-
being of bystander
o Market power: the ability of a single economic actor (or
small group of actors) to have a substantial influence on
market prices

 How the economy works as a whole

8. A country’s standard of living depends on its ability to produce
goods and services
o Productivity: the quantity of goods and services produced
from each unit of labor input
9. Prices rise when the government prints too much money
o Inflation: an increase in the overall level of prices in the
economy
10. Society faces a short-run trade-off between inflation and
unemployment
o Business cycle: fluctuations in economic activity, such as
employment and production

Thinking Like an Economist

 Economist try to address their subject with a scientist’s
objectivity
 Economist make assumptions in order to make the world
easier to understand

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 Economist use different assumptions to answer different
questions
 Economist use models to simplify reality in order to improve
our understanding of the world
 The economist as policy adviser
o Positive statements: claims that attempt to describe the
world as it is
o Normative statements: claims that attempt to prescribe
how the world should be

Measuring Nation’s Income

 Microeconomics: the study of how households and firms
make decisions and how they interact in markets
 Macroeconomics: the study of econ omy in aggregate,
including inflation, unemployment, and economic growth
The measurement of GDP
 Gross domestic product (GDP): the market value of all final
goods and services produced within a country in a given
period of time
 Components of GDP
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
o Consumption: spending by households on goods and
services, with the exception of purchases of new housing
o Investment: spending on business capital, residential
capital, and inventories
o Government purchases: spending on goods and services
by local, state, and federal governments
o Net exports: spending on domestically produced goods by
foreigners (exports) minus spending on foreign goods by
domestic residents (imports)
 Nominal GDP: the production of goods and services valued at
current prices
 Real GDP: the production of goods and services valued at
constant prices

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 GDP Deflator: measure of the price level calculated as the
ratio of nominal GDP to real GDP times 100,
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐺𝐷𝑃
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 = × 100
𝑅𝑒𝑎𝑙 𝐺𝐷𝑃

 Inflation rate: the percentage change in the price index from

the preceding period
 Inflation rate using GDP deflator,
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 2
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 2 − 𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 1
= × 100
𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑖𝑛 𝑦𝑒𝑎𝑟 1

 Is GDP a good measure of economic well-being? GDP is a good

measure of economic wellbeing for most—but not all—
purposes. Large GDP does help us to lead good lives, but GDP
excludes:
o Leisure
o The value of goods and services produced at home
o The quality of the environment
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 o The distribution of income
 Other measures of income
o Gross national product (GNP)
o Net national product (NNP)
o National income
o Personal income
o Disposable personal income

Measuring the Cost of Living

 Consumer price index (CPI): A measure of the overall cost
of the goods and services bought by a typical consumer
 How the CPI is calculated
1. Fix the basket by surveying consumers to find the basket
of goods and services bought by the typical consumer
2. Find the prices of each of the goods and services in the
basket at each point in time
3. Compute the basket’s cost. Use the data on prices to
calculate the cost of the basket of goods and services at
different times
4. Choose a base year and compute the index. Designate one
year as the base year, the benchmark against which other
years are to be compared,

𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑡ℎ𝑖𝑠 𝑦𝑒𝑎𝑟

𝑪𝒐𝒏𝒔𝒖𝒎𝒆𝒓 𝒑𝒓𝒊𝒄𝒆 𝒊𝒏𝒅𝒆𝒙 = × 100
𝑃𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟

5. Compute the inflation rate using CPI,

𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 2 − 𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 1
𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 𝑖𝑛 𝑦𝑒𝑎𝑟 2 = × 100
𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 1

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 Core CPI: a measure of the overall cost of consumer goods
and services excluding food and energy

 Producer price index: a measure of the cost of a basket of

goods and services bought by firms

 Problems in computing the cost of living

1. Substitution bias: the prices do not change proportional
year by year, then the CPI has ignored the possibility of
consumer substitution
2. Introduction of new goods: when there is a new goods on
the market, consumer will have more choice, so the CPI
does not reflect the change in the purchasing power of
money
3. Unmeasured quality change: something that is difficult to
measure

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 The GDP Deflator Vs. The Consumer Price Index
1. GDP deflator reflects the prices of all goods and services
produced domestically, whereas the CPI reflects the
prices of all goods and services bought by consumers
2. The CPI compares the price of a fixed basket of goods
and services to the price of the basket in the base year.
The GDP deflator compares the price of currently
produced goods and services to the price of the same
goods and services in the base year

Correcting Economic Variables for the Effects of Inflation:

 A price index such as the CPI measures the price level and
thus determines the size of the inflation correction, such as to
compare dollar figure from the past to a dollar figure in the
present
 Indexation: the automatic correction by law or contract of a
dollar amount for the effects of inflation
 Nominal Vs. Real Interest Rate
o Nominal interest rate: the interest rate as usually
reported without a correction for the effects of inflation
o Real interest rate: the interest rate corrected for the
effects of inflation,
𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 = 𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 − 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒

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 CHAPTER 1
INTRODUCTION, MEASURING NATION’S INCOME AND COST
OF LIVING

TRUE OR FALSE

1. Indonesia doesn’t produce the Samsul phone. However, many

Indonesians like using it. Therefore, the price increase of a
Samsul phone made in China will increase both Indonesia’s
CPI and GDP deflator.
2. If Baby Yoda decides to produce telur gulung at the price
equals to the cost of producing one more telur gulung, we can
say that Baby Yoda acts rationally.
3. When people say that the government should raise the
minimum wage, that’s called a positive statement.
4. Greater use of fuel-efficient cars after gasoline prices increase
illustrates unmeasured quality change problem in the
construction of the CPI.
5. GDP is a perfect measure for economic well-being because
large GDP helps us lead good lives.

ESSAY

1. Explain why taxes adversely effect the allocation of resources

on market economy!

2. Talking with your friend on the phone for 10 minutes would

give you a benefit that you value at about $3. Your cell phone
service costs you $30 per month, $0.25 per minute for
whatever calls you make plus $0.10 for every message. You
usually talk for 123 minutes on the phone and send 12 chats
via message a month. After looking at how much a 10 minutes
call would averagely cost you, rationally do you decide to talk
with your friend?

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3. Many years ago, Florida Man paid $500 to put together a
record collection. Today, he sold his albums at a garage sale
for $100. How does this sale affect current GDP?

4. Consider an economy that produces only chocolate bars. In

year 1, the quantity produced is 3 bars and the price is $4. In
year 2, the quantity produced is 4 bars and the price is $5. In
year 3, the quantity produced is 5 bars and the price is $6.
Year 1 is the base year.
a. What is nominal GDP for each of these three years?
b. What is the percentage growth rate of real GDP from
year 2 to year 3?
c. What is the inflation rate as measured by the GDP
deflator from year 2 to year 3?

5. What components of GDP (if any) would each of the following

transactions affect? Explain.
a. Jatinangor hires workers to repave “Bolong-bolong
Highway”.
b. Kariyam from produces a Sosis Solo and sells it to
MamaMakan, a catering company.
c. The central government sends your grandmother a
Bantuan Langsung Tunai check.
d. You pay a hairdresser for a haircut.
e. Ford sells a Mustang from its inventory to Dobleh family.

6. Fill in the blanks:

Nominal GDP
Real GDP (in
GDP (in Deflator
Year 2000
current (base year
dollars)
dollars) 2000)
1970 3,000 1,200
1980 5,000 60
1990 6,000 100
2000 8,000

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 2010 15,000 200
2020 10,000 300
2030 20,000 50,000

7. Below are some data from the land of milk and honey.
Year Pmilk Qmilk Phoney Qhoney
2016 $1 100 quarts $2 50 quarts
2017 1 200 2 100
2018 2 200 4 100
a. Compute nominal GDP, real GDP, and the GDP deflator
for each year, using 2016 as the base year.
b. Compute the percentage change in nominal GDP, real
GDP, and the GDP deflator in 2017 and 2018 from the
preceding year. For each year, identify the variable that
does not change. Explain why your answer makes sense.
c. Did economic well-being increase more in 2017 or 2018?
Explain.

8. A dozen eggs cost $0.88 in January 1980 and $2.11 in January

2015. The average wage for production workers was $7.58
per hour in January 1980 and $19.64 in January 2015.
a. By what percentage did the price of eggs rise?
b. By what percentage did wage rise?
c. In each year, how many minutes did a worker have to
work to earn enough to buy a dozen eggs?
d. Did workers’ purchasing power in terms of eggs rise, or
fall?

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9. Jatinangor town idolizes the TV show Koplo Pantura. All they
produce and consume are karaoke machines and CDs in the
following amounts:

Karaoke Machines CDs

Year
Q P Q P
2017 10 $40 30 $10
2018 12 60 50 12
a. Using a method similar to the CPI, compute the
percentage change in the overall price level. Use 2017 as
the base year and fix the basket at 1 karaoke machine
and 3 CDs.
b. Using a method similar to the GDP deflator, compute the
percentage change in the overall price level. Also use
2017 as the base year.
c. Is the inflation rate in 2018 the same using the two
methods? Explain why or why not.

10. Nike Ardella and Rayisa work in the same industry. Nike
Ardella’s salary was $60,000 per year in 1989 and Rayisa’s
salary was $102,700 in 2017. Government statistics show a
CPI of 152 for 1989 and 237 for 2015.
a. Find how much Nike Ardella’s 1989 salary is worth in
2017.
b. Did Nike Ardella enjoy a higher or lower standard of
living than Rayisa?

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 CHAPTER 2
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

 Financial system : The group of institutions in the economy

that help to match one person’s saving with another person’s
investment. “When a country saves a large portion of its GDP,
more resources are available for investment in capital that
raises a country’s productivity and living standard (at a later
time).”
 Financial Market (Direct)
1. The Stock Market
A certificate that represents a claim to partial ownership
in a firm and hence a share of the profits that the firm
makes.
2. The Bond Market
A certificate of indebtedness that specifies the obligations
of the borrower to the holder of the bond.
 Financial Intermediaries (Indirect)
1. Banks
An institution that take in the deposits from savers and
use these deposits to make loans to borrowers
2. Mutual Funds
An institution that sells shares to the public and uses the
proceeds to buy a portofolio of stocks and bonds
 Saving and investment in the national income account
“Saving and Investment are important determinants of long-
run growth in GDP and living standards.”

 GDP Equation

Open Economy Closed Economy

Y = C+ I+ G+ NX Y=C+I+G
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Y =C+I+G

Y – C – G (National Saving (S)) = I

Saving = Investment / (S = I)

or

National Saving = Private Saving + Public Saving

S = (Y–T–C) + (T–G)

Saving = Investment / (S = I)

“In closed economy saving is equal to investment”

 Some Important Identities

National Saving (S) S=Y–C–G

Investment I=Y–C–G
Private Saving Y–T–C
Public Saving T–G
Budget Surplus T>G
Budget Deficit T<G

 The market for loanable fund : The market in which those

who want to save supply funds and those who want to borrow
to invest demand funds
 Loanable funds = all income that people have chosen to save
and lend out, and to the amount that investors have chosen to
borrow to fund new investment projects.
 Supply and Demand for Loanable Funds
1. Saving is the source of the supply of loanable funds
2. Investment is the source of the demand for loanable funds
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 3. The supply and demand for loanable funds depend on the
real interest rate (interest rate)

“When interest rate is high, the quantity of loanable funds

demanded falls as the interest rate rises. And the quantity of
loanable funds supplied rises. Otherwise.”

 Policy 1 : Saving Incentives

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 “If a reform of the tax laws encouraged greater saving (Saving
Incentives). the result would be lower interest rates and greater
investment.”

 Policy 2 : Investment Incentives

“if a reform of the tax laws encouraged greater investment

(Investment Inventives), the result would be higher interest rates
and greater saving.”

 Policy 3 : Government Budget Deficits and Surpluses

1. Budget Deficit is an excess of government spending over
tax revenue
2. Budget Surpluses is an excess of tax revenue over
government spending
3. Budget Balanced is an equal of government spending and
tax revenue

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“if the government’s budget swing to a deficit, the result would be
higher interest rates, reduced supply of loanable funds, and the
quantity of investment falls.”

4. Crowding Out is the reduction in investment because of

government borrowing.

Many demanders of loanable funds are discourage

because of the higher interest rate. It makes fewer families
buy a new homes, and fewer firms choose to build a new
factory. This condition is called “reduction in investment”

“When the government borrows to finance its budget deficit,

it crowds out private borrowers who are trying to finance
investment”

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 CHAPTER 2

SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

TRUE OR FALSE

1. Public Saving is tax revenue that the government has left after
paying for its consumption.
2. An decrease in interest rate add the quantity supplied for
money, and the money supply curve slopes upward.
3. If someone buy stock from a corporation, it’s adds to the
nation’s saving rather than investment.
4. The term interest rate in loanable funds is talking about the
real (rather than nominal) interest rate.
5. The effect of a Government Budget Surplus resulting the supply
curve for loanable funds would shift to the left, driving the
equilibrium interest rate up.

ESSAY

1. What is the role of the financial system? Name and describe

two markets that are part of the financial system in U.S.
Economy.
2. What is private saving, public saving, and national saving? How
are they related? Explain it.
3. Draw and label a graph showing equilibrium in the market for
loanable funds and explain why the demand for loanable funds
slopes downward and the supply of loanable funds slopes
upward
4. What is a government budget deficit? How does it affect
interest rate, investment, and economic growth
5. Draw a graph when government run a change in the tax that
might increase private saving. How would it affect the market
for loanable funds?

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6. In macroeconomist mind, explain how they are able to
distinguish the terms between investment and saving. Then
explain this condition either entering investment or saving and
explain why you choose it.
a. When your family take out a loan from the banks and buy
a new house.
b. When you use your $250 paycheck to buy stock in
UNILEVER.
c. When your friend earns $50 and deposits it in his account
at the bank.
d. When you borrow $2,000 from a bank to buy a car to use
in your business.
7. Now suppose that :
 Y = $15 billion
 C = $9 billion
 G = $1.5 billion
 T = $1 billion

Let’s assume that we’re in a closed economy, and find

investment, national saving, private saving, and public saving.

8. Suppose Economist in England, a closed economy, have

collected the following information about the economy for a
particular year :
 GDP equals 10,000
 Consumption equals 6,000
 Tax revenue equals 1,500
 Government purchases equals 1,700

The economist also estimate that the investment function is

I = 3,300 – 100r

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 Where r is the country’s real interest rate, expressed as a
percentage. Calculate private saving, public saving, national
saving, investment, and the equilibrium interest rate.

9. Suppose that Compass is considering building a new shoes

making factory
a. Assuming that Compass needs to borrow money in the
banks, why would an increase in interest rates affect
Compass decision about whether to build the factory?
b. If Compass has enough of its own money to finance the
new factory without borrowing, would an increase in
interest rates affect Compass decision about whether to
build the factory? Explain it.
10. Suppose that we’re in Open Economy with this situations :
 C = $85,890
 I = $125,000
 G = $56.700
 X = $65.000
 M = $55.000
 T = $60,000

Calculate GDP, National Saving, Private Saving, and Public

Saving. Does it has budget deficit or budget surplus?

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 CHAPTER 3
PRODUCTION, GROWTH, AND UNEMPLOYMENT
Living standard differs among country can be answered by
simple answer –productivity. Productivity is the quantity of
goods and services produced from each unit of labor input.

 How Productivity is Determined?

1) Physical Capital per Worker

Factors the stock of equipment and structures that are
used to produce goods and services.

2) Human Capital per Worker

Letting the knowledge and skills that workers acquire
through education, training, and experience

3) Natural Resources per Worker

The inputs into the production of goods and services that
are provided by nature, such as land, rivers, and mineral
deposits

4) Technological Knowledge
Society’s understanding of the best ways to produce
goods and services

The Production Function

𝑌 = 𝐴𝐹(𝐾, 𝐿, 𝐻, 𝑁)

where F is a function that shows how the inputs are combined to

produce output. A is a variable that reflects the available
production

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technology. As technology improves, A rises, so the economy
produces. Y denotes the quantity of output, L the quantity of labor,
K the quantity of physical capital, H the quantity of human capital,
and N the quantity of natural resources more output from any
given combination of inputs.

 Economic Growth and Public Policy

So far, we have determined that a society’s standard of living

depends on its ability to produce goods and services and that its
productivity in turn depends on physical capital per worker,
human capital per worker, natural resources per worker, and
technological knowledge. What can government policy do to raise
productivity and living standards?

1) Saving and Investment

One way to raise future productivity is to invest more
current resources in the production of capital. Because
resources are scarce, devoting more resources to
producing capital requires devoting fewer resources to
producing goods and services for current consumption.
That is, for society to invest more in capital, it must
consume less and save more of its current income.
2) Diminishing Returns and the Catch-Up Effect
Diminishing return is the property whereby the benefit
from an extra unit of an input declines as the quantity of
the input increases.

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 This figure shows how the amount of capital per worker
influences the amount of output per worker. Other
determinants of output, including human capital, natural
resources, and technology, are held constant. The curve
becomes flatter as the amount of capital increases because
of diminishing returns to capital.

The property of diminishing returns to capital: Other

things being equal, it is easier for a country to grow fast if
it starts out relatively poor. This effect of initial conditions
on subsequent growth is sometimes called the catch-up
effect

3) Investment from Abroad

investment from abroad is one way for a country to grow.
Even though some of the benefits from this investment
flow back to the foreign owners, this investment does
increase the economy’s stock of capital, leading to higher
productivity and higher wages.

4) Education
Some economists have argued that human capital is
particularly important for economic growth because

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 human capital conveys positive externalities. An
externality is the effect of one person’s actions on the well-
being of a bystander. An educated person, for instance,
might generate new ideas about how best to produce
goods and services.

5) Health and Nutrition

The term human capital usually refers to education, but it
can also be used to describe another type of investment in
people: expenditures that lead to a healthier population.
Other things being equal, healthier workers are more
productive. The right investments in the health of the
population provide one way for a nation to increase
productivity and raise living standards.

6) Property Rights and Political Stability

Property rights refer to the ability of people to exercise
authority over the resources they own. This property
rights goes hand-in-hand with political stability because
the rights to hold a property must be maintained by some
higher order. Government can provide such order by
applying rules and punishment for those who neglect.

7) Free Trade
Trade made by a country is a crucial component in which
country can grow. Nation itself cannot satisfy their
people’s demand, even though it can people will be better
off if nation tend to open trade. Through export and
import can a nation ignite significant measure to increase
productivity.

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 8) Research and Development
The primary reason that living standards are higher today
than they were a century ago is that technological
knowledge has advanced.

9) Population Growth
A large population means more workers to produce goods
and services. The tremendous size of the Chinese
population is one reason China is such an important
player in the world
Economy

 Unemployment : people who were available for work, and

had tried to find employment during the previous four weeks.
It also includes those waiting to be recalled to a job from
which they had been laid off.

 Unemployed people are a part of labor force (the total

number of workers, including both the employed and the
unemployed). People who are not in labor force, although
they are not working, is not count in unemployment
measurement.

 Formulas

𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 = 𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑 + 𝑛𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑟𝑎𝑡𝑒 = 𝑥 100
𝐿𝑎𝑏𝑜𝑟 𝑓𝑜𝑟𝑐𝑒

𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒
𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 𝑃𝑎𝑟𝑡𝑖𝑐𝑖𝑝𝑎𝑡𝑖𝑜𝑛 𝑟𝑎𝑡𝑒 = 𝑥100
𝐴𝑑𝑢𝑙𝑡 𝑃𝑜𝑝𝑢𝑙𝑎𝑡𝑖𝑜𝑛

28
 The normal rate of unemployment around which the
unemployment rate fluctuates is called the natural rate of
unemployment, and the deviation of unemployment from its
natural rate is called cyclical unemployment

 Types of Unemployment

Frictional Unemployment = unemployment that results

o
because it takes time for workers to search for the jobs
that best suit their tastes and skills
o Seasonal Unemployment = Seasonal unemployment when
people are unemployed at particular times of the year
when demand for labour is lower than usual.
o Structural Unemployment = unemployment that results
because the number of jobs available in some labor
markets is insufficient to provide a job for everyone who
wants one
o Cyclical Unemployment = is the component of overall
unemployment that results from economic upturns and
downturns.
 Minimum Wage Law

29
 Minimum wage law or referred as “Upah Minimum Rakyat” in
Indonesia is an unemployment from a Wage above the
Equilibrium Level In this labor market, supply and demand
are balanced at the wage WE (see figure below).. At this
equilibrium wage, the quantity of labor supplied and the
quantity of labor demanded both equal LE. By contrast, if the
wage is forced to remain above the equilibrium level, perhaps
because of a minimum-wage law, the quantity of labor
supplied rises to LS and the quantity of labor demanded falls
to LD. The resulting surplus of labor, LS – LD, represents
unemployment

 The Theory of Efficiency Wages

Efficiency wage is above-equilibrium wages paid by firms to

increase worker productivity. These are the types of
efficiency-wage:

30
1. Worker Health = Better-paid workers eat a more
nutritious diet, and workers who eat a better diet are
healthier and more productive
2. Worker Turnover = Firms may find it profitable to pay
wages above the equilibrium level to reduce worker
turnover
3. Worker Quality = When a firm pays a high wage, it attracts
a better pool of workers to apply for its jobs and thereby
increases the quality of its workforce
4. Worker Effort = High wages make workers more eager to
keep their jobs and thus motivate them to put forward
their best effort.

31
 CHAPTER 3

PRODUCTION, GROWTH AND UNEMPLOYMENT

TRUE OR FALSE
1. If the Indonesia government emphasizes more on
property rights and states that citizenship matters to own
a property, then abroad will build a factory in Indonesia
2. The productivity function is a notional function to
describe absolute variable which affect production
3. Disabled worker must be included when measuring labor
force participation rate
4. If Indonesia adopts closed economy, economic growth will
proliferate especially on the 4th main pillar of
macroeconomics set by Central Bank
5. If higher union power has been established, this means
labor who is not participates in union has a better
bargaining power to negotiate to firms.

ESSAY
1. Using macroeconomics theory, can a nation overinvest in
capital? How can this happen?

2. Nation can be said enjoy a higher growth if the nation can

produce larger quantities of goods and services by itself, if
this true, then why would nation need to export and
import goods and services as well?

3. In your opinion, are the resources you devote to your

education a form of consumption or a form of investment?

4. Should we view government spending on health programs

as a form of consumption or investment? Would you
distinguish between health programs for the young and
health programs for the elderly?
32
5. If a country decides to spend more on investment rather
than consumption, will everyone from different age group
will satisfy with this decision? If so, why?
6. Why is it that education and health expenditure can’t tip to
one side in order for country enjoy production growth?

7. In June 2009, at the trough of the Great Recession, the

Bureau of Labor Statistics announced that of all adult
Americans, 143,322,000 were employed, 12,332,000 were
unemployed, and 89,008,000 were not in the labor force.
Use this information to calculate:
a. The adult population
b. The labor force
c. The labor-force participation rate
d. The unemployment rate

8. Consider an economy with two labor markets—one for

manufacturing workers and one for service workers.
Suppose initially that neither is unionized. a. If
manufacturing workers formed a union, what impact
would you predict on the wages and employment in
manufacturing? b. How would these changes in the
manufacturing labor market affect the supply of labor in
the market for service workers? What would happen to
the equilibrium wage and employment in this labor
market?

9. Is unemployment typically short-term or long-term?

Explain.

10. How do unions affect the natural rate of unemployment?

33
 CHAPTER 4
THE MONETARY SYSTEM
 Money is the set of assets in an economy that people
regularly use to buy goods and services from other people
 The function of money :
a. Medium of exchange : an item that buyers give to
sellers when they want to purchase goods and services
b. Unit of account : the yardstick people use to post
prices and record debts
c. Store of value : an item that people can use to transfer
purchasing power from the present to the future
 Liquidity : the ease with which an asset can be converted
into the economy’s medium of exchange
 The kind of money :
a) Commodity money : money that takes the form of a
commodity with intrinsic value
b) Fiat money : money without intrinsic value that is
used as money by goverment decree
 Two measures of the money stock for the U.S.
economoy :
a) M1 = currency + demand deposits + travelers checks +
other checkable deposits
b) M2 = savings deposits + small time deposits + money
market mutual funds + a few minor categories + M1
 Demand deposits : balances in bank accounts that
depositors can access on demand by writing a check
 Traveler’s checks : a certified note issued by a bank that
may be used by travelers as a risk-free substitute for
paper currency.

34
 Central bank : an institution designed to oversee the
banking system and regulate the quantity of money in the
economy
 Money supply : the quantity of money available in the
economy
 Reserves : deposits that banks have received but have not
loaned out
 Reserve ratio : the fraction of deposits that banks hold as
reserves
 Central bank has two related jobs :
a) To regulate banks and ensure the health of the
banking system
b) To control the quantity of money supply (monetary
policy)
 Money creation with Fractional-Reserve Banking:
Example : suppose that First National has a reserve ratio
of 1/10, or 10 percent. This means that it keeps 10 percent
of its deposits in reserve and loans out the rest. Now let’s
look again at the bank’s T-account:

First National has $100 in liabilities because making the

loans did not alter the bank’s obligation to its depositors.
But the bank has two kinds of assets: It has $10 of reserves
in its vault, and it has loans of $90.
 Money multiplier : the amount of money the banking
system generates with each dollar of reserves

35
 Money multiplier = 1/R
 Tools of monetary policy :
a) Open market operations : the purchase and sale of
U.S. goverment bonds by the fed
b) Discount rate : the interest rate on the loans that the
Fed makes to banks
c) Reserve requirements : regulations on the minimum
amount of reserves that banks must hold against
deposits

36
 CHAPTER 4
THE MONETARY SYSTEM

TRUE OR FALSE
1. When the Soviet Union began breaking up in the late
1980s, cigarettes began replacing the ruble as the medium
of exchange even though the ruble was legal tender. The
cigarettes provide an example of fiat money.
2. When you purchase school supplies at the bookstore using
cash, you are using money as an unit of account.
3. Banks cannot influence the money supply if they are
required to hold all deposits in reserve.
4. If BI buys bonds in the open market, the money supply
decreases.
5. When individuals deposit money in banks and banks loan
out some of these deposits, the quantity of money in the
economy increases.

ESSAY
1. Explain three tools of monetary policy from central bank!
2. Explain about money and its main function!
3. What is the difference commodity money and fiat money?
Why do people accept fiat currency in trade for good and
services?
4. What is meant by the term “lender of last resort?” In what
circumstances might the Fed be a lender of last resort?
5. Explain why banks can influence the money supply if the
required reserve ratio is less than 100 percent?
6. Explain how each of the following changes the money
supply.
a. the Fed buys bonds
37
 b. the Fed raises the discount rate
c. the Fed raises the reserve requirement
7. Are credit cards and debit cards money? What’s the
difference between credit and debit cards?
8. Which two of the The Principles of Economics imply that
the Fed can profoundly affect the economy?
9. Why can’t the Fed control the money supply perfectly?
10. If the economy of Indonesia, there are 10000 pieces of Rp
100.000
a. if the society holds the money as cash, how much is the
money in the economy?
b. if the society saves their money as the bank accounts
and the reserve ratio is 100%, how much money in the
economy?
c. if the society holds money in cash and bank account in
the same number, while bank reserve ratio is 50%, how
much is the money in the economy?
d. if the society saves all their money in bank, and bank
decreases the reserve ratio by 25%, how much is the
money now?

38
 CHAPTER 5
MONEY GROWTH AND INFLATION
Classical Theory

 We begin our study of inflation by developing the quantity

theory of money. This theory is often called “classical”
because it was developed by some of the earliest economic
thinkers
 Relationship between the price level and the value of
money is negative. A rise in the price level means a lower
value of money because each dollar in your wallet now
buys a smaller quantity of goods and services (when a
price level is high so the value money is low).
1
𝑣𝑎𝑙𝑢𝑒 𝑜𝑓 𝑚𝑜𝑛𝑒𝑦 =
𝑝

P = the number of dollars needed to buy goods and

services
 The supply and demand for money determines the value
of money.
a) he quantity of money demanded depends on the
interest rates (short run) and the average of price
level in the economy in the long run (long run).
b) The quantity of money supplied determined by
Fed using monetary policy.
 Quantity theory of money is a theory asserting that the
quantity of money available determines the price level
and that the growth rate in the quantity of money
available determines the inflation rate.
a) The quantity equation:
𝑀𝑥𝑉=𝑃𝑥𝑌
V is velocity of money; p is price level; Y is the quanitity of
output ; M = the quantity of money.
39
 b) The quantity theory in growth rates
%∆𝑀 + %∆ 𝑉 = %∆𝑃 + %∆ 𝑌

 The goal of monetary injection is to stimulate the

production by increased the money supply. Money
injection which is not balanced with an increase in output
causes the price level rises and the value of money falls, it

is shown on the graph below :

 Classical dichotomy is the separation of the determinants

of real and nominal variables. it is important to separate
the variables because different forces influence real and
nominal variables (monetary neutrality).
a) Nominal variables are measured in monetary
units, example : nominal GDP
b) Real variables are measured in physical units,
example : real GDP, wage adjusted to inflation and
relative price
 Monetary neutrality the proposition that changes in the
money supply do not affect real variables. An analogy of
monetary neutrality : When a central bank doubles the
money supply, all prices double, and the value of the unit
of account falls by half.

40
  Velocity of money the rate of how many number of times
a dollar bill changes hands in a given period of time.
According to the quantity theory, the formula is:
𝑃𝑥𝑌
𝑉=
𝑀

V is velocity of money; p is price level; Y is the quantity of

output ; M = the quantity of money.
 Hyperinflation is defined as inflation that exceeds 50
percent per month, which is just over 1 percent a day. This
phenomenon may occur when the government prints too
much money.
 inflation tax the revenue the government raises by
creating money causing the price level rises, and the
dollars in your wallet become less valuable. Thus, the
inflation tax is like a tax on everyone who holds money.
 Fisher effect the one-for-one adjustment of the nominal
interest rate to the inflation rate. it is analyzed by the
fisher equation :
𝑖 =𝑟+𝜋
i is nominal interest rate; r is real interest rate; π is
inflation.

The Cost of Inflation

 When prices rise, each dollar of income buys fewer goods

and services this meand inflation cause a fall in the
purchasing power. But it is an inflation fallacy, because
most people earn their incomes by selling their services,
such as their labor, inflation in incomes goes hand in hand
with inflation in prices. Thus inflation does not in itself
reduce people’s real purchasing power.

41
 Shoeleather costs the resources wasted (time and
convenience) when inflation encourages people to reduce
their money holdings.
 Menu costs is the costs of changing prices. an analogy of
menu cost: the typical U.S. firm changes its prices on its
menu about once a year, but during hyperinflations firms
must change their prices daily or even more often to keep
up with all the prices within the economy.
 Relative-Price Variability and the Misallocation of
Resources because When inflation distorts relative prices,
consumer decisions are distorted and markets are less
able to allocate resources to their best use.
a study case: if the inflation rate is 12 percent per year,
Kantin Unpad’s relative prices will automatically fall by 1
percent each month. The restaurant’s relative prices will
be high in the early months of the year, just after it has
printed a new menu, and low in the later months.
 Inflation-induced tax distortion, because lawmakers
often fail to take inflation into account when writing the
tax laws.
 Confusion and Inconvenience, accountants incorrectly
measure firms’ earnings when prices are rising over time.
Which in turn impedes financial markets in their role of
allocating the economy’s saving to alternative types of
investment
 A Special Cost of Unexpected Inflation: Arbitrary
Redistributions of Wealth
 Inflation is bad, but deflation may be worse. deflation
often arises because of broader macroeconomic
difficulties. falling prices result when some event, such as
a monetary contraction, reduces the overall demand for
goods and services in the economy

42
 CHAPTER 5
MONEY GROWTH AND INFLATION

TRUE OR FALSE

1. According to the Fisher effect, when the inflation rate rises,

the nominal interest rate rises by the same amount so that
the real interest rate remains the same.
2. inflation makes them poorer because it raises the cost of
what they buy.
3. The principle of monetary neutrality asserts that changes in
the quantity of money influence nominal variables but not
real variables in short run.
4. If an economy always has inflation of 10 percent per Year
there is an inflation cost that will not suffer.
5. Hyperinflations occur when the government runs a
large budget deficit, which the central bank finances with a
substantial monetary contraction.

ESSAY
1. Explain the difference between nominal and real variables
and give two examples of each. According to the principle of
monetary neutrality, which variables are affected by changes
in the quantity of money?
2. It is sometimes suggested that the Federal Reserve should try
to achieve zero inflation. If we assume that velocity is
constant, does this zero-inflation goal require that the rate of
money growth equal zero? If yes, explain why. If no, explain
what the rate of money growth should equal.
3. Suppose that this year’s money supply is $1000 billion,
nominal GDP is $50 trillion, and real GDP is $5 trillion.
43
 a) What is the price level? What is the velocity of money?
b) Suppose that velocity is constant and the economy’s
output of goods and services rises by 5 percent each
year. What will happen to nominal GDP and the price
level next year if the Fed keeps the money supply
constant?
4. Explain whether the following statements are true, false, or
uncertain and five explanation on tour answer!
a) “Inflation hurts borrowers and helps lenders, because
borrowers must pay a higher rate of interest.”
b) “If prices change in a way that leaves the overall price
level unchanged, then no one is made better or worse
off.”
c) “Inflation does not reduce the purchasing power of most
workers.”
5. What are the costs of inflation? Give 4 example along with the
cases!
6. Suppose that a country’s inflation rate increases sharply.
What happens to the inflation tax on the holders of money?
Why is wealth that is held in savings accounts not subject to a
change in the inflation tax? Can you think of any way holders
of savings accounts are hurt by the increase in the inflation
rate?
7. Recall that money serves three functions in the economy.
What are those functions? How does inflation affect the
ability of money to serve each of these functions?
8. Suppose that Indonesian people expect inflation to equal 5
percent, but in fact, prices rise by 7.2 percent. Describe how
this unexpectedly high inflation rate would help or hurt the
following:
a) the government
b) a homeowner with a fixed-rate mortgage
c) a union worker in the second year of a labor contract
44
 d) a college that has invested some of its endowment in
government bonds
9. If nominal GDP is $400, real GDP is $200, and the money
supply is $100, then what is the price level and the velocity of
money? use calculation and draw the curve!
10. According to the quantity theory of money, which variable in
the quantity equation is most stable over long periods of
time? Why?

45
 CHAPTER 6
THE MACROECONOMICS OF OPEN ECONOMICS

 Open economy is an economy that interacts freely with

other economies around the world.

 Net export is the value of a nation’s exports minus the

value of its imports, also called trade balance. The
situation when export exceeds the value of import, the
trade balance is surplus. In contrast, when the value of
exports is less than the value of imports, the trade balance
is deficit. If exports equal imports it called balanced
trade.

 Net capital outflow (NCO) is the acquisition of foreign

assets by domestic resident minus the acquisition of
domestic asset by foreigners. Due to every international
transaction involves an exchange rate of an asset for a
good or service, an economy’s net foreign investment
always equal its net export.

 As you may recall, the term net exports appeared earlier in

the book when we discussed the components of gross
domestic product. The economy’s GDP (denoted Y) is
divided among four components: consumption (C),
investment (I), government purchases (G), and net exports
(NX). We write this as :
𝑌 = 𝐶 + 𝐼 + 𝐺 + 𝑁𝑋
Recall that national saving is the income of the nation that
is left after paying for current consumption and
government purchases. National saving (S) equals
investment (I) and net export (NX). If we rearrange the
equation to reflect this fact, we obtain
𝑌 − 𝐶 − 𝐺 = 𝐼 + 𝑁𝑋
𝑆 = 𝐼 + 𝑁𝑋

46
 Because net exports (NX) also equal net capital outflow
(NCO), we can write this equation as :
𝑆 = 𝐼 + 𝑁𝐶𝑂
𝑃𝑢𝑏𝑙𝑖𝑐 𝑠𝑎𝑣𝑖𝑛𝑔
= 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑖𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡
+ 𝑛𝑒𝑡 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 𝑜𝑢𝑡𝑓𝑙𝑜𝑤

 Nominal exchange rate is the relative price of the

currency of two countries. The situation when the nominal
exchange rate changes which each dollar buys more
foreign currency, the dollar is said appreciate or
strengthen. In contrast, when nominal exchange rate
changes and lead dollar buys less foreign currency, the
dollar is said depreciate or weaken.

𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦
𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒 =
𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑐𝑢𝑟𝑟𝑒𝑛𝑐𝑦

 Real exchange rate is the relative price of the goods and

service.

𝑅𝑒𝑎𝑙 𝑖𝑛𝑡𝑒𝑟𝑒𝑠𝑡 𝑟𝑎𝑡𝑒

𝑁𝑜𝑚𝑖𝑛𝑎𝑙 𝐸𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 𝑥 𝐷𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒
=
𝐹𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒

 Purchasing power parity (PPP) is a theory of exchange

rates whereby a unit of any given currency should be able
to buy the same quality of goods in all countries. This
theory implies that the nominal exchange rate between
the currencies of two countries should reflect levels in
those countries. As a result, countries with relatively low
inflation should have appreciating currencies.

 Two markets are central to the macroeconomics of open

economies: the market for loanable funds and the
market for foreign-currency exchange. In the market
for loanable funds, the real interest rate adjusts to balance
the supply of loanable funds (from national saving) and
47
 the demand for loanable funds (for domestic investment
and net capital outflow). In the market for foreign-
currency exchange, the real exchange rate adjusts to
balance the supply of dollars (from net capital outflow)
and the demand for dollars (for net exports). Because net
capital outflow is part of the demand for loanable funds
and because it provides the supply of dollars for foreign-
currency exchange, it is the variable that connects these
two markets.

 A policy that reduces national saving, such as a

government budget deficit, reduces the supply of
loanable funds and drives up the interest rate. The higher
interest rate reduces net capital outflow, which reduces
the supply of dollars in the market for foreign-currency
exchange. The dollar appreciates, and net exports fall.

 Although restrictive trade policies, such as tariffs or

quotas on imports, are sometimes advocated as a way to
alter the trade balance, they do not necessarily have that
effect. A trade restriction increases net exports for any
given exchange rate and, therefore, increases the demand
for dollars in the market for foreign-currency exchange. As
a result, the dollar appreciates in value, making domestic
goods more expensive relative to foreign goods. This
appreciation offsets the initial impact of the trade
restriction on net exports.

 When investors change their attitudes about holding

assets of a country, the ramifications for the country’s
economy can be profound. In particular, political
instability can lead to capital flight, which tends to
increase interest rates and cause the currency to
depreciate.

48
 CHAPTER 6
THE MACROECONOMICS OF OPEN ECONOMICS

TRUE OR FALSE

1. A country with positive net exports has both a trade surplus

and trade deficit.
2. Depreciation in the Indonesia exchange rate means that
Indonesian goods have become more expensive relative to
foreign goods. And Indonesia’s imports will be larger.
3. The supply of loanable funds comes from investment; the
demand for loanable funds comes from national savings and
net capital outflow.
4. In the market for foreign currency exchange, net capital
outflow represents the quantity of dollars demanded for
buying a foreign assets and net exports represent the
quantity of dollars supplied for the purpose of buying U.S. net
exports of good and services.
5. Holding other things constant, an appreciation of a nation’s
currency causes. Exports will increase and imports will
decrease.
ESSAY

1. What’s closed economy and open economy? What’s the real

difference of Open-Economy and Closed-Economy on
calculating GDP? Write the equation!
2. Supposed that Indonesian wheat is Rp 15.000/kg, and U.S
Wheat is US$ 0,5 /kg. If the nominal exchange rate is Rp
US$/Rp12.000. Please calculate the real exchange rate
between U.S and Indonesia wheat !

49
3. How would the following transactions affect Indonesia net
capital outflow? Also, state whether each involves direct
investment or portfolio investment?
a. Indomie company establishes an office in Malaysia
b. Yamaha expands its factory in Jatinangor, Indonesia
c. Gojek company sells its stock to a French investor
d. An Indonesian investor buys a stock from UK Company.
4. This picture shows the German money supply, the German
price level, and the nominal exchange rate (measured as U.S.
cents per German mark) for that period. Can you explain
what’s the relationship between exchange rate, price level,
and monetary policy?

5. It is possible to have a real exchange rate appreciation and a

nominal exchange rate depreciation at the same time. Why?
6. What happen to the demand in market of loanable funds
when NCO>0 and NCO<0?
7. In he market for foreign currency exchange, the supply curve
(from net capital outflow) is vertical. Why?
8. Explain with a graph the effect of a government budget deficit
in market for foreign-currency exchange!

50
9. Explain with a graph the effects when government imposes
import quota on imported goods in market for foreign
currency exchange!
10. Explain with a graph the effect of capital flight in a country!

CHAPTER 7
AGGREGATE DEMAND, AGGREGATE SUPPLY, AND THE
INFLUENCE OF MONETARY AND FISCAL POLICY ON
AGGREGATE DEMAND
 Economic activity fluctuates from year to year.

 Recession is a period of declining real incomes and rising

unemployment and depression is a severe recession.

 Three key facts about economic fluctuations :

1. Economic fluctuations are irregular and unpredictable
2. Most Macroeconomic quantities fluctuate together
3. As output falls, unemployment rises

 Explaining short-run economic fluctuations:

51
 1. The assumptions of classical economics
2. The reality of short-run fluctuations
3. The model of aggregate demand and aggregate supply

 THE MODEL OF AGGREGATE DEMAND AND AGGREGATE

SUPPLY is the model that most economists use to explain
short-run fluctuations in economic activity around its long-run
trend

Aggregate Demand

 Aggregate demand curve is a curve that shows the quantity of

goods and services that households, firms, the government,
and customers abroad want to buy at each price level.

 The four components contributes to the aggregate demand are

GDP (Y) is the sum of its consumption (C), investment (I),
government purchases (G), and net exports (NX).

 Why the aggregate demand curve slopes downward:

1. The wealth effect: The price level and consumptions.
2. The interest-rate effect: The price level and
investment.
3. The exchange-rate effect: The price level and net
exports.

 Why the aggregate demand curve might shift:

1. Shifts arising from changes in consumption
2. Shifts arising from changes in investment

52
 3. Shifts arising from changes in government
purchases
4. Shifts arising from changes in net exports

Aggregate Supply

 The aggregate-supply curve tells us the total quantity of goods

and services that firms produce and sell at any given price
level.

 Why the aggregate supply curve slopes upward in the short

run :
1. The sticky-wage theory
2. The sticky-price theory
3. The misperceptions theory

 In the long run, the quantity of output supplied depends on

the economy’s quantities of labor, capital, and natural
resources and on the technology for turning these inputs into
output. Because the quantity supplied does not depend on the
overall price level, the long-run aggregate-supply curve is
vertical at the natural level of output or full-employment
output.

 Natural level of output or full-employment output is the

production of goods and services that an economy achieves in
the long run when unemployment is at its normal rate.

 Why might the short run and long run aggregate supply curve
shift:
1. Shifts arising from changes in labor
53
 2. Shifts arising from changes in capital
3. Shifts arising from changes in natural resources
4. Shifts arising from changes in technology
5. Shifts arising from changes in the expected price
level (short run)

 Two causes of Economic Fluctuations:

1. The effects of a shift in aggregate demand
2. The effects of a shift in aggregate supply

 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.

 Shifts in aggregate supply can cause stagflation, a period of

falling output and rising prices (combination of recession and
inflation).

 Policymakers who can influence aggregate demand can

potentially mitigate the adverse impact on output but only at
the cost of exacerbating the problem of inflation.

 Four steps to analyzing economic fluctuations:

1. Decide whether the event shifts the aggregate-
demand curve or the aggregate-supply curve (or
perhaps both).
2. Decide the direction in which the curve shifts.
3. Use the diagram of aggregate demand and
aggregate supply to determine the impact on
output and the price level in the short run.
4. Use the diagram of aggregate demand and
aggregate supply to analyze how the economy

54
 moves from its new short-run equilibrium to its
new long-run equilibrium.

 How Monetary policy influences aggregate demand:

1. Theory of liquidity preference tells Keynes’s
theory that the interest rate adjust to bring money
supply and money demand into balance.
2. The aggregate demand curve slopes downward is
caused of three reason : the wealth effect, the
interest rate effect, the exchange rate effect.
3. Change in money supply.
4. The role of interest-rate targets in fed policy.
5. The zero lower bound.

 How fiscal policy influences aggregate demand:

1. Change in government purchase.
 The multiplier effect, is an additional shifts
in aggregate demand that result when
expansionary fiscal policy increases
income and thereby increase consumer
spending Multiplier = 1 / (1 – MPC)
 The crowding out effect, is the offset
aggregate demand that results when
expansionary fiscal policy raises the
interest rate and thereby reduces
investment spending.

2. Change in taxes.
A tax increase depresses consumer spending and
shifts aggregate demand curve the the left and vice
versa.

 Using policy to stabilize the economy:

 The case for active stabilization policy
Monetary policy can offset any changes in fiscal policy
if done correctly
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 The case against active stabilization policy
Monetary policy lags in its effect on the economy
 Automatic Stabilizer
Changes in fiscal policy that stimulate aggregate
demand when the economy goes into a recession
without policymakers having to take any deliberate
action.

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 CHAPTER 7
AGGREGATE DEMAND, AGGREGATE SUPPLY, AND THE
INFLUENCE OF MONETARY AND FISCAL POLICY ON
AGGREGATE DEMAND

TRUE OR FALSE
1. When potential real GDP is equal to actual real GDP, there is
no unemployment.
2. A significant increase in wages will shift aggregate supply
curve to the right in the short run.
3. When the government decided to reduce their spending, then
the aggregate supply curve will decrease or shift to the left in
the short run.
4. If the central Bank wants to expand aggregate demand, it can
increase the money supply, which would increase the interest
rate.
5. To find spending multiplier, we have to calculate one divided
by marginal propensity to consume.

ESSAY
1. There are three reasons the aggregate demand curve is
downward sloping. What are they? Explain each reason!
2. Why the long run aggregate supply curve is vertical?
3. For each of the following, what will happen to the price level
and real GDP in the short run?
a. An increase in government spending
b. An increase in the wages that businesses must pay
workers
c. The country ‘s currency appreciates
d. Increase in human capital which significantly improves
productivity

57
4. What is the differences between monetary and fiscal policy?
Explain briefly!
5. Assume an economy is at full employment, but then
consumer spending falls. What will most likely happen in the
short run? Analyze with graphs!
6. What is stagflation? Please show in the graph!
7. Does the price level affect interest rate? How can you tell?
Explain Briefly!
8. What most likely happen in an economy in the long run if the
central bank decided to increase the money supply which
effect interest rates and investment? Analyze with graphs!
9. What is marginal propensity to consume and marginal
propensity to save? Please give an example!
10. How can the money supply affect the interest rate? Explain
briefly and show in the graph!

58
 CHAPTER 8
THE SHORT-RUN TRADE OFF BETWEEN INFLATION AND
UNEMPLOYMENT & SIX DEBATES OVER MACROECONOMIC
POLICY

THE PHILLIPS CURVE

 Phillips curve is the short-run relationship between inflation

and unemployment, which is a trade-off
 Determinant for variables in the Phillips curve
Unemployment: labor market
Inflation: money supply

1. Origin of Phillips Curve

↓ unemployment → ↑ inflation,
↑ unemployment → ↓ inflation.

low unemployment → high

aggregate demand → ↑ wages and
prices (↑ inflation)

2. Aggregate Demand, Aggregate Supply, and The Phillips Curve

 Aggregate demand and aggregate supply can determine
how much price and how much quantity produced in the
economy. Price can determine the inflation and quantity can
determine the unemployment rate

59
 This figure shows how aggregate demand and aggregate
supply (A) can move the Phillips curve (B).

High AD Low AD
↑ AD→ ↑ Q → ↑P ↓ AD→ ↓Q → ↓P
↑ Q → ↓ rate of unemployment ↓ Q → ↑ rate of unemployment
↑ P = ↑ inflation ↓ P = ↓ inflation

 Monetary and fiscal policy can move along an economy in

Phillips curve because they can shift AD curve

SHIFT IN PHILLIPS CURVE

1. Role of Expectation
 Long-Run Phillips Curve

The vertical long-

run Phillips curve
illustrate monetary
neutrality, there is
no trade-off between
inflation and
unemployment.

o In the long run, regardless of the inflation rate, output is at its

natural level and unemployment is at its natural rate.
o Natural means a steady state, it represents the
hypothetical unemployment rate consistent with aggregate
production being at the "long-run" level.

 Short-Run Phillips Curve

𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑛𝑎𝑡𝑢𝑟𝑎𝑙 𝑟𝑎𝑡𝑒 𝑎𝑐𝑡𝑢𝑎𝑙 𝑒𝑥𝑝𝑒𝑐𝑡𝑒𝑑
= − 𝛼 ( - )
Rate 𝑜𝑓 𝑢𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑖𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛

60
o This equation implies there is no stable short-run Phillips
curve. Each SR Phillips curve reflects an expected rate of
inflation.
o SR Phillips curve intersects with LR Phillips curve at the
expected rate of inflation.
o When expected inflation changes, the short-run Phillips curve
shifts.
o The higher the expected rate of inflation means the curve is
more representing the SR trade-off between inflation and
unemployment

This figure shows people get used to higher inflation rate → higher
expectations of inflation. With higher expected inflation, firms and
workers setting higher wages and prices.

o SR Phillips curve → shifts to the right.

Causing higher inflation without any reduction in
unemployment.

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2. Role of Supply Shock

This figure shows how aggregate demand and aggregate

supply (A), when there is a shock in AS curve, can shift the
Phillips curve (B).

o The SR Phillips curve can also shift because shock of aggregate

supply.
o A supply shock directly affect firm’s costs of production,
causing a change in price.
o A change in supply shock (ex: adverse supply shock) → shift
the SRAS curve to the left, causing the price rise and quantity
falls
o The shift in SRAS causing change in Phillips curve, shifting the
SR Phillips curve to the right, causing inflation and
unemployment rise.

COST OF REDUCING INFLATION

1. Sacrifice Ratio
the number of percentage points of annual output lost in the
process of reducing inflation by one percentage point
 Central bank must pursue contractionary monetary policy, and
will contract aggregate demand

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 Contract aggregate demand leads to reducing the quantity of
goods and services that firm produces, causing unemployment
to rise
2. Rational Expectation
the theory that people optimally use all the information they have,
including information about government policies, when
forecasting the future

SIX DEBATES OVER MACROECONOMIC POLICY

PRO CON
Economies fluctuate on Stabilization policy
Should Monetary
their own and more does not affect the
and Fiscal
stable economy economy
Policymakers Try
benefits everyone, so immediately because
to Stabilize the
stabilization policy is it has lags and the
Economy?
needed economy can
readjust itself
SPENDING TAX CUT
Should the Government spending Tax cut can increase
Government Fight directly adds AD, if the both AD and AS.
Recessions with government gives tax Rapid government
Spending Hikes cuts, the cuts may spending may be
Rather Than Tax rather be saved than wasteful and require
Cuts? spent future tax increases

ANTI-DISCRETION PRO-DISCRETION
(RULE) Discretion have
Should Monetary
Discretion can leads to flexibility to react in
Policy Be Made
abuse of power, unforeseen events,
by Rule Rather
incompetence, and also time-inconsistency &
Than by
time-inconsistency political business
Discretion?
cycles problems are
not clear

63
 PRO CON
Zero inflation has costs The benefits of zero
Should the
that only temporary, inflation are rather
Central Bank Aim
but the result has small, but the costs
for Zero Inflation?
permanent benefits of reaching zero
inflation are large.
PRO CON
Should the Debt place burden in Cutting budget deficit
Government future taxpayers, can also lower
Balance Its inheriting large debt welfare (education,
Budget? will lower the future health, etc)
living standard
PRO CON
Should the Tax High saving means high Increasing the
Laws Be investment, which can incentive to save
Reformed to leads to raise in labor means increasing the
Encourage production, wages, and tax burden on those
Saving? income who can least afford
it.

64
 CHAPTER 8

THE SHORT-RUN TRADE OFF BETWEEN INFLATION AND

UNEMPLOYMENT & SIX DEBATES OVER MACROECONOMIC
POLICY

TRUE OR FALSE
1. When the Federal Reserve increases the money supply and
expands aggregate demand, it moves the economy along the
short-run Phillips curve to a point with higher inflation and
lower unemployment.
2. If the Federal Reserve increases the rate of money growth and
maintains it at the new higher rate, eventually expected
inflation will increase, and the short-run Phillips curve will
shift upward.
3. When an adverse supply shock shifts the short-run aggregate
supply curve to the left, it also shifts the short-run Phillips
curve to the right, which cause inflation and also
unemployment fall.
4. In the long run, regardless of the monetary policy pursued by
the central bank, output is at its natural level and
unemployment is at its natural rate.
5. A change in aggregate demand and aggregate supply caused by
change in monetary and fiscal policy can lead to long-run
fluctuation in production and unemployment.

ESSAY
1. Draw the Phillips curve. Use the model of aggregate demand
and aggregate supply to show how policy can move the
economy from a point on this curve with high inflation to a
point with low inflation.
2. Does inflation and unemployment would be related in the long
run? Give your explanation and draw the graph.
65
 3. Suppose there is a tornado in western Oklahoma, causing a
supply shock for wheat. What will happen in aggregate demand
and aggregate supply curve for wheat? How will it affect the
Phillips curve? Explain it with graph.
4. How does expected inflation shifts the short-run Phillips
curve? Draw the graph to explain.
5. Show the effect of disinflationary monetary policy in the short-
run and long-run Phillips curve by drawing the graph.
6. Would you rather have a high inflation and low unemployment
or low inflation but high unemployment?
7. What is sacrifice ratio and why is it a cost of reducing inflation?
8. Does the monetary and fiscal policy have lags? Give your
explanation.
9. Why tax cuts can increase both aggregate demand and
aggregate supply?
10. Should the government aim for zero inflation or not? Give your
explanation.

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67