Sesiune

PPT1

Major concerns of Macroeconomics:

 Economic growth (ensuring a steady rate of increase in national income)

 Employment (keeping a low level of unemployment)

 Price stability (low, stable rate of inflation)

 External stability (favourable balance of payments)

 Income distribution (equitable distribution of income)

Flexible vs. Sticky prices:

 Price flexibility is a good assumption for studying long-run phenomena

 Over short periods, prices are fixed

Circular Flow Model:

 The CFM illustrates how economic agents interact on aggregate markets

 2 types of flows:

◦ Real flows: flows of outputs (goods and services) and inputs (labour, capital, land,
entrepreneurship=factors of production)

◦ Monetary flows (aggregate expenditure – on goods and services – and aggregate

income – of inputs/factors of production: wages, interest, rent, profit)

 2 markets: for goods and services (firms=S; households=D); for inputs/factors of production
(households=S; firms=D)

Savings and Investment:

 Businesses save a part of their profits = retained earnings

 Households do not consume everything=household saving

 The sum of the 2 (aggregate savings) can be used to finance investment

 INVESTMENT is the addition of capital stock to the economy (made by firms)

The Government:

 Governments use fiscal policies to get money (income) to support their expenditures (G)
  Income: direct taxes (on income), social security payments (both household and corporate),
indirect taxes (on goods and services), tariffs on the purchase of imported goods, profits of
nationalised companies/industries;from selling such companies; rent on government-owned
land/building

 Expenditure: capital expenditure (building new schools, hospitals); current expenditure (salaries
of public sector employees); transfer payments (benefits for the unemployed, child allowances,
payments for the disabled)

CFM:

 Households receive income that is spent on taxes to the govt, goods and services or saved
through financial markets

 Firms receive revenue from sale of goods&services; the money is used to pay for factors of
production

 Households and firms borrow in financial markets to buy investment goods (houses, factories
etc.)

 The govt receives revenue from taxes and uses it to pay for govt purchases (T>G – public saving
= budget surplus; G>T-budget deficit)

Injections = Withdrawals/Leakages

 Injections = I+G+X

 Withdrawals=S+T+M

 I+G+X=S+T+M

 If withdrawals increase without a corresponding increase in injections then the income will fall
to a new equilibrium, so less income will be circulating

 If injections increase without a corresponding increase in withdrawals then the income will
increase to a new equilibrium, so more income will be circulating

PPT2

The Circular Flow:

 GDP – total income from bread production (wages for employees and profit for shareholders) –
THE INCOME METHOD

 GDP – total expenditure on bread purchases – THE EXPENDITURE METHOD

 GDP – total output as sum of value added - THE OUTPUT METHOD

  The 3 values should be equal (double-entry accounting)

In every transaction, the buyer’s expenditure becomes the seller’s income.Thus, the sum of all
expenditure equals the sum of all income.

Rules for computing GDP: GDP=market value of all final goods and services produced within an
economy in a given period of time

1. MARKET PRICES are used to compute GDP

2. Used goods are not included, GDP measures the value of CURRENTLY produced goods and
services (the sale is a transfer, not an addition to the economy’s income)

3. Production for inventory increases GDP just as much as production for final sale.

4. The value of intermediate goods is not included in the GDP, but the final value (avoiding
double-counting)

5. Housing services and other imputations

 Assigning values for goods/services that are not traded (police, firefighters etc.) and valuing
them at their cost

 Home production and consumption are not included in GDP (DIY)

 Underground/hidden economy is not included in GDP (for tax evasion reasons or illegal
activites)

=> GDP is an imperfect measure of economic activity

Limitations of data:

 Inaccuracies (different methods of gathering data)

 Unrecorded/underrecorded economic activity – informal markets (DIY, hidden economy-illegal

activity, tax evasion)

 External costs (GDP does not include resources depletion)

 Other quality of life concerns (GDP does not include free activities: volunteering, caring for the
elderly, raising children)

 Composition of output (weight of defence, capital goods etc. that do not increase the standard
of living)

Real vs. Nominal GDP:

 Nominal GDP- value of goods and services measured at current prices Σq1p1
  Changes in nominal GDP can be due to:

 changes in prices

 changes in quantities of output produced

 Real GDP- value of goods and services measured using a constant set of prices Σq1p0

 Changes in real GDP can only be due to changes in quantities, because real GDP is
constructed using constant base-year prices.

GDP Deflator:

 GDP DEFLATOR = NOMINAL GDP/REAL GDP x 100

 It shows the price evolution in an economy

 Rate of inflation = GDP deflator – 100

The Components of Expenditure:

1. Consumption (C) :

 goods and services bought by households

• nondurable goods (e.g. food, clothing)

• durable goods (cars, TVs, computers)

• services (health care services, haircuts, air travel, dry cleaning)

2. Investment (I) :

 Def 1: goods bought for future use (as factor of production)

• business fixed investment (purchase of plant and equipment by firms)

• residential fixed investment (purchase of new housing by households and landlords)

• inventory investment (increase/decrease in firms’ inventories)

• NET INVESTMENT=(GROSS) INVESTMENT-CFC (depreciation)

3. government spending (G) :

 goods and services bought by state and local administrations

 4. net exports (NX):

 Taking foreign trade into account

 NX=X-M (export-import)
5. Y = GDP = C+I+G+NX = sum of aggregate expenditure
6. Aggregate income (AY)=Aggregate expenditure (AE)

GNP vs. GDP:

 Gross National Product (GNP):

total income earned by the nation’s factors of production, regardless of where located

 Gross Domestic Product (GDP):

total income earned by domestically-located factors of production, regardless of nationality.

GNP=GDP+ (factor payments from abroad) – (factor payments to abroad) = GDP+NFP (net factor
payment)

NNP and NDP:

 NNP=GNP-depreciation of capital

 NDP=GDP-depreciation of capital

 Depreciation of capital=consumption of fixed capital

 GNP+NT (net transfers)=GNDI=GDP+NFP+NT

Consumer Price Index (CPI)=A measure of the overall level of prices

 It tracks changes in the typical household’s cost of living

 Used to adjust contracts for inflation
 Allows prices comparisons from different years

How CPI is constructed:

1. Survey consumers to determine composition of the typical consumer’s “basket” of goods.

2. Every month, collect data on prices of all items in the basket; compute cost of basket

3. CPI in any month equals: Σq0p1/ Σq0p0 x 100

 The value of a past amount in today’s money=The nominal sum at that moment*CPI 1/CPI0
 WEIGHTS REMAIN FIXED OVER TIME
 RATE OF INFLATION=PERCENTAGE CHANGE IN CPI
CPI may overstate inflation for reasons such as: CPI may overstate inflation for reasons such as:

 Substitution bias: The CPI uses fixed weights,

so it cannot reflect consumers’ ability to substitute toward goods whose relative prices have
fallen.

 Introduction of new goods: The introduction of new goods makes consumers better off and, in
effect, increases the real value of money. But it does not reduce the CPI, because the CPI uses
fixed weights.

 Unmeasured changes in quality:

Quality improvements increase the value of money, but are often not fully measured.

CPI vs. GDP Deflator:

 GDP deflator measures prices of all goods produced, CPI measures prices of goods consumed

 GDP deflator includes domestically produced goods, CPI includes goods produced domestically
and abroad

 the basket of goods: CPI: fixed (Laspeyres index); GDP deflator: changes every year (Paasche
index)

Categories of the population:

 employed (E)
working at a paid job

 unemployed (U)
not employed but looking for a job

 labor force (L)

the amount of labor available for producing goods and services; L=E+U

 not in the labor force

not employed, not looking for work = POPULATION - L

Two important labor force concepts:

 unemployment rate
percentage of the labor force that is unemployed = U/L x 100

 labor force participation rate

the fraction of the adult population
that ‘participates’ in the labor force = L/adult population x 100

 The current account (CA) of a country is the consolidated statement of income and expenditure
  Incomes from non-residents: 1 )exports; 2) non-residents pay for the use of factors of production
owned by the residents; 3) transfers are received from non-residents

 Expenditure to non-residents: 1) imports; 2) the residents pay for the use of factors of production
owned by non-residents ; 3) transfers paid to non-residents

 => CA=NX (net export)+NFP (net factor payment)+NT (net transfers)

 AE=(C+I+G)+NX=DA+NX

 C+I+G=DA (domestic absorption)

 DA+NX=GDP

 GDP+NFP=GNP
 GNP+NT=GNDI

 GNDI=C+I+G+NX+NFP+NT =>

 GNDI=DA+CA

 GNDI=the total income a nation can use either for consumption or for saving

 GNDI=C+I+G+CA

 GNDI-C-G=I+CA

 S-I=CA

PPT3

The Aggregate Expenditure Function:

AE=C+I+G+(X-M)=DA+NX

The Consumption Function:

 C = C0 + MPC xYd

 C0 –autonomous consumption

 Induced part of consumption: MPC xYd

 where Yd=Y-T = disposable incomeYd=C+S

Consumption determinants:

 Expectations regarding prices, employment, income

 Credit conditions and interest rate

  Wealth

 Other non-economic factors: traditions, customs, psychological, sociological, historic,

geographic, geopolitical conditions

 C0 –depends on economic & non-economic factors: income level, expectations regarding P &
national income

Consumption Function

Consumption & Saving Functions

Saving and Dissaving

APC, APS:

 APC-average propensity to consume=C/Yd=consumption rate

 APS-average propensity to save=S/Yd=saving rate

Introducing the multipliers:

 kI=1/MPS=1/(1-MPC)  ; ΔY= kI* ΔI

 kG=1/MPS=1/(1-MPC)  ; ΔY= kG* ΔG

 kT=-MPC/MPS=-MPC/(1-MPC)  ; ΔY= kT* ΔT

 kTr=MPC/MPS=MPC/(1-MPC)  ; ΔY= kTr* ΔTr

Investment:

 Investment function I=I(r), r-real interest rate

 Real interest rate=nominal interest rate-rate of inflation

 The real interest rate is

– The cost of borrowing

– The OC of using one’s own funds

When r increases, I decreases (borrowing becomes more expensive)

Investment determinants:

 Investment depends on: real interest rate (inverse relationship), availability of credits; firms’
expected profits; future expected state of the economy, expected technological changes, risk
and uncertainty
  For an investment to be profitable (to pay off):

 -A0+A1/(1+r)+ A2/(1+r)2+...+ AN/(1+r)N>0, A0 initial investment; A1-AN –cash flows for the years to
come, N-number of years; r-real interest rate

Planned investment:

 Desired/planned investment = the additions to capital stock and inventory planned by firms

 Actual investment = actual amount of investment

The Investment Function:

Government Purchases (G) and taxes T:

 Assume govt spending and taxes are exogeneous:

 G=T balanced budget

 G>T budget deficit – govt. debt – it has to borrow from financial markets

 G<T budget surplus – it can be used to pay outstanding debts (public saving)

The Keynesian Model Aggregate output eq.

Stability of the Equilibrium

S=I approach of equilibrium

Shifts in planned expenditure:

If G increases => planned expenditure increases => an upward shift

If G falls => planned expenditure falls => a downward shift

If T falls= > planned expenditure increases => an upward shift

If T increases= > planned expenditure falls => a downward shift

Net export function:

NX=X-M
X=X0

M=M0+MPM xY, M0 is autonomous import

Export, import, net export functions

Export, import, net export functions

 1) Y=Y1 => NX=0

 2) Y>Y1 => NX<0

 3) Y<Y1 => NX>0

PPT4

Aggregate Demand/Aggregate Supply

 AD=total spending on goods & services in a period of time at a given price level

 AD=C+I+G+NX

 Downward sloping curve

Shape of AD
Changes in AD

 A change in the overall price level (P) generates a movement along the AD curve

 A change in C, I, G or NX will shift the AD curve (an increase-shift to the right; a decrease-shift to
the left)

Changes in C:

 Changes in income: Y increases=> C increases

 Changes in interest rates: r increases => borrowing falls => C falls => AD falls (r, C inverse
correlation)

 Changes in wealth = assets owned (vs. income=money earned):

– p of real estate increases => consumers feel wealthier => C increases, S falls, borrowing
increases

p of stocks & shares increases => C increases

 Changes in expectations/consumer confidence (direct correlation)

 Household indebtedness (r falls, cheap money=>C increases) (inverse rel)

Changes in I:

 Interest rate increases => saving increases, investment falls (inverse rel)

 Changes in national income level: Y increases => C increases=>there is a pressure on firms to

invest in plant & eq to meet the increase in demand=> induced investment (direct correlation)

 Technological changes (investing to remain competitive)

 Expectations/business confidence

Changes in G:

 G varies according to the objectives of the govt

Changes in NX=X-M:

 Changes in income:

– Foreign income increases => X increases

– Income increases => M increases (because C and I increase and have to be covered
from imported goods too)
  Exchange rate

– Stronger currency=>exports become more expensive=>X falls; M increases

Changes in NX (cont’d):

 Type of policy:

– Liberalised: M increases, X falls

– Protectionist: M falls, X increases

 Relative inflation rate:

– Inflation rate RO> inflation rate BG => Romanian goods are less competitive, Romanian X
falls, M increases

– Inflation rate RO< inflation rate BG => Romanian goods are more competitive, Romanian
X increases, M falls

Govt policy affecting AD:

 A. Fiscal policy-spending & taxation rates: G, T

 1. expansionary FP => AD increases

(ex. lower taxes, higher G)

 2. contractionary/deflationary FP=> AD falls

 B. Monetary policy (MP)-money supply (M), interest rate (i)

 When i (base rate/discount rate/prime rate) set by CB falls => I increases => AD increases
(expansionary/loose MP)

 When i (base rate/discount rate/prime rate) set by CB increases=> I falls => AD falls
(contractionary/tight MP)

Aggregate Supply:

 AS=total amount of G&S that all industries in the economy produce at every given P (sum of all S
curves of all industries)

SRAS (short-run aggregate supply):

 Upward sloping

 In the SR – prices (wages) are fixed

  SR: Y increases => average costs increase => P increases => direct correlation

SRAS curve:

Changes in AS:

 A change in P => movement along the curve

 shifts of SRAS=supply-side shocks (costs increase=> SRAS falls; costs decrease=> SRAS increases)

 Costs changes due to: changes in wages, in costs of basic raw materials, in imported goods
prices, in govt subsidies/taxes

LRAS:

Two approaches:

 1. New classical (monetarist) LRAS

- Perfectly inelastic/vertical

- full-employment level of output =potential output

 - Ypotential only depends on the quantity and quality of factors of production, not on P

 2. Keynesian AS

No SR vs. LR distinction

1. Perfectly elastic at low levels of activity; Y increases => costs are constant due to spare capacity
of the economy

2. Approaching Ypot, spare capacity is being used up, fp are scarce, as Y increases, the price of fp
increases – upward sloping

3. Ypot; Y cannot increase more, all fp are employed, perfectly inelastic (Y can only increase if
there is an increase in quantity/quality of fp)

Shifts in LRAS (Keynesian):

Shifts in LRAS (new classical):

Supply-side policies:

 1. interventionist policies

– Investment in human capital

– R&D

– Provision&maintenance of infrastructure

– Direct support for business/industrial policies

– Financial subsidies

 2. market-based policies

– Reduction in taxes

– Labour market reforms (reduction in trade union power; reduction/elimination of

min.wages; reduction of unemployment benefits)

– Deregulation

– Privatisation

– Policies meant to increase competition and efficiency

PPT5

Short-run equilibrium output:

 AD=SRAS
Long-run equilibrium (1):

 AD=LRAS NEW CLASSICAL APPROCH:

 Any change in AD leads to a change in P only;

 The economy will always move automatically, without govt intervention, to its long-run eq
(free markets are important in this view)

Figura

 Yf = initial LR eq output

 AD increases=>(SR) Y increases to Y1 (inflationary gap), P increases

 P increases due to higher fp prices (fp are scarcer); production costs increase=>SRAS falls (left
shift)

 Then, higher costs of production result in no real gain, so Y is reduced to Yf back again

 Only price is bigger than in the beginning, Y remains at the initial level

 Yf = initial LR eq output

 AD falls =>(SR) Y falls to Y1 (deflationary gap), P falls

  P falls due to lower fp prices ; production costs fall =>SRAS increases (right shift)

 Only price is lower than in the beginning, Y remains at the initial level

Long-run equilibrium (2):

 AD=LRAS KEYNESIAN APPROACH

 LRAS has 3 ranges (recall LRAS)

 Range 1: Y<Ypotential =>deflationary gap (output gap) (there is unused labour and/or capital)

 If AD increases => Y increases, but not P (there is still spare capacity)

  Range 2, Y is still < Ypot

 If AD increases even more => inflationary pressure, fp become scarcer and more expensive, Y
and P increase

 Range 3: Y=Ypot and if AD

increases => only inflation

Demand-side policies:

 The govt intends to increase AD

through expansionary policies
(=> increase in employment)

 Contractionary policies reduce AD (=> fall in inflation)

Changes in LRAS:

1 – the initial eq is important; if Y<Ypot, then an increase in LRAS has no effect in Y; when LRAS
increases, there is a increased potential, but AD is not enough; the govt should intervene

2 – LRAS increases => P falls, Ypot increases

Paradigm shift:

 Classical economists – free market +minimal govt intervention

 After 1930-govt intervention required (to increase AD)

 Then new classical economists

 After 2007-2009 recession, revival of Keynesian theory

PPT6

The functions of money:

• Store of value – it transfers purchasing power from the present to the future

– I win the lottery and keep the money until next year to spend it (although inflation
impacts on the value of the prize)

• Unit of account – the common unit by which everyone measures prices and values (a yardstick)

– The price of this car is EUR 15,000

• Medium of exchange – used to purchase things (liquidity)

– One can use the money to buy goods and services.

Types of money:

1) FIAT money

- no intrinsic value

- ex: paper currency

2) COMMODITY money

- with intrinsic value

- ex: gold coins – the economy is on gold standard

How the quantity of money is controlled:

• Quantity of money available – money supply

• The control of money supply – monetary policy carried out by Central Banks

• Ways of controlling money supply – open market operations (buying/selling govt bonds) when
the govt want to increase M, it buys bonds

when the govt want to decrease M, it sells bonds

• Currency (paper and coin)

• Deposits in current accounts (with instruments such as debit cards, cheques)

• EURO AREA:

• M1 – currency (euro notes + coin in circulation) + overnight deposits

• M2 – M1+ longer-term deposits

• M3 – M2+ other money market instruments

The quantity theory of money:

• QUANTITY EQUATION (TRANSACTIONS):

Money x Velocity = Price x Transactions

MV = PT, T-total no. of transactions, P-overall price level, V- transactions velocity of money,
measuring the rate at which money circulates in the economy, M-quantity of money

• QUANTITY EQUATION (OUTPUT):

Money x Velocity = Price x Output

 MV = PY, Y-output/income/real GDP, P-overall price level/GDP deflator, V- transactions velocity
of money, measuring the rate at which money circulates in the economy, M-quantity of money

--> MV=nominal GDP

Money demand function & Quantity equation:

• M/P – real money balances measure the purchasing power of the stock of money

• Money demand function (M/P)d = kY

• K=1/v-constant – how much money people want to hold for every unit of income

--> The quantity of real money balances demanded is proportional to real icome

Cont’d:

• money demand = money supply

• (M/P)d = M/P

• kY=M/P <=> MV=PY, where V=1/k

Assumption: v is constant, then M determines nominal value of output, PY

%ΔM+%ΔV=%ΔP+%ΔY

%ΔM - controlled by the Central Bank

%ΔV=0 (V is assumed constant)

%ΔP=rate of inflation

%ΔY – given

=> Growth in money supply determines the rate of inflation

Seigniorage:

• Raising money by printing money = seigniorage (inflation tax=real value of money falls)

• => M increases => inflation

Inflation and interest rates:

• Recall:

... Nominal interest rate (the one paid by the bank)

... Real interest rate

r=i-π (real i.r.=nominal i.r.-rate of inflation)

or

i=r+π (Fisher equation)

Money demand and the nominal interest rate:

• Recall... (M/P)d = kY ...quantity of real money balances demanded is proportional to real income
or... demand for real money balances depends only on real income Y

The cost of holding money:

• Holding money brings no interest

• Buying govt bonds/depositing it in a savings account – one earns the nominal interest rate – the
opportunity cost of holding money

(M/P )d = real money demand, depends on

 Nominal interest rate

i is the opp. cost of holding money

 Level of real income

higher Y Þ more spending

Þ so, need more money

(L is used for the money demand function because money is the most liquid asset)

L(i, Y)

Equilibrium:

M
 L (r   e , Y )
P

 The supply of real money balances

 Real money demand

Social costs of inflation:

1. costs when inflation is expected

2. additional costs when inflation is different than what people had expected.

Costs of unexpected inflation:

 • If p turns out different from pe, then some gain at others’ expense.

Example: borrowers & lenders

• If p > pe, then debtor wins, creditor loses

because the debtor repays the loan with less valuable euros.

• If p < pe, then creditor wins, debtor loses because the repayment is worth more than
anticipated

=> Uncertainty for debtors & creditors

• variable and unpredictable:

• Arbitrary redistributions of wealth

• Higher uncertainty

Hyperinflation:

• p ³ 50% per month

• All the costs of moderate inflation described

above become huge under hyperinflation.

• Money ceases to function as a store of value, and may not serve its other functions (unit of
account, medium of exchange).

• People use barter or a stable foreign currency.

Causes of hyperinflation:

• When the central bank prints money, the price level rises (excessive growth of M)

• If it prints money rapidly enough, the result is hyperinflation.

• When a government cannot raise taxes or sell bonds, it must finance spending increases by
printing money.

• In theory, the solution to raising money is simple: issuing govt bonds (debt) .In the real world,
the govt prints money

How can one stop hyperinflation:

• Fiscal policies: reducing G, increasing T

• Then, there would be no need for printing money

 • Money growth slows down

Views on inflation:

• Demand-pull inflation – total spending > production capacity; all resources are used - prices will
rise (“too much spending chasing too few goods”)

• Cost-push inflation – average cost of output rises, profits fall, supply falls, so prices rise (supply
shocks: abrupt increases in costs of inputs->increase in production costs -> increase in prices)

Inflation effects:

• Inflation hurts:

• Fixed-income receivers

• Savers

• Creditors

• Inflation does not hurt/helps:

• Flexible-income receivers

• Debtors

• Deflation – decrease in the price level

• Disinflation – decrease in the rate of inflation

PPT7:

Natural Rate of Unemployment:

• Natural rate of unemployment:

the average rate of unemployment around which the economy fluctuates.

• In a recession, actual unemployment rate >NRU

• In a boom, actual unemployment rate < NRU

The model of NRU, Notations:

L = no. of workers in labor force

E = no. of employed workers

U = no. of unemployed
 U/L = unemployment rate

1. L is exogenously fixed.

2. During any given month,

s = fraction of employed workers

that become separated from their jobs,

f = fraction of unemployed workers

that find jobs.

s = rate of job separations

f = rate of job finding

The steady state condition:

• The labor market is in steady state, or long-run equilibrium, if the unemployment rate is
constant.

• The steady-state condition is:

s ´E = f ´U

Solving for the “equilibrium” U rate:

U s

L s f

Policy regarding the NRU:

• In order to reduce NRU, a policy should

– Either lower s

– Or increase f

Job Search & Frictional Unemployment:

• frictional unemployment: caused by the time it takes workers to search for a job

• occurs because

 workers have different abilities, preferences

 jobs have different skill requirements

  geographic mobility of workers is not instantaneous

 flow of information about vacancies and job candidates is imperfect

Sectoral shifts:

• SS = changes in the composition of demand among industries or regions

• It takes time for workers to change sectors,

so sectoral shifts cause frictional unemployment.

Public Policy and Job Search:

 Govt employment agencies:

disseminate info about job openings to better match workers & jobs

 Public job training programmes:

help workers displaced from declining industries get skills needed for jobs in growing
industries

Unemployment insurance (UI):

• It pays part of a worker’s former wages for a limited time after losing their job.

• UI increases search unemployment, because it:

– reduces the opportunity cost of being unemployed

– reduces the urgency of finding work

– hence, reduces f

• The longer a worker is eligible for UI,

the longer the duration of the average duration of unemployment

Unemployment from real wage rigidity

Structural unemployment: the unemployment resulting from real wage rigidity and job rationing.

Unemployment results because the composition of the labour force does not respond immediately to
the new structure of job opportunities (structural unemployment)

Reasons for wage rigidity:

1. Minimum wage laws

 The minimum wage is well below the eq. wage for most workers
 The minimum wage may exceed the eq. wage of unskilled workers
 2. Labor unions
 Unions exercise monopoly power to secure higher wages for their members
 When the union wage > the eq. Wage => unemployment
 Employed union workers are insiders whose interest is to keep wages high
 Unemployed non-union workers are outsiders and would prefer wages to be lower
(so that labour demand would be high enough for them to get jobs)
3. Efficiency wages (employers offer high wages as incentive for workers’ productivity and
loyalty)
 High wages increase worker productivity because they
 attract higher quality job applicants
 increase worker effort and reduce “shirking”
 reduce turnover, which is costly
 improve health of workers
 The increased productivity justifies the cost of paying above-equilibrium wages. =>
unemployment
 Frictional unemployment – short-term
 Structural unemployment – long-term

Full employment:

• FE-when the economy is experiencing only frictional + structural unemployment

• FE-no cyclical unemployment

• Full-employment rate of unemployment = NRU

• At NRU the economy produces its potential output (the economy is fully employed)

GDP Gap:

• GDP gap=actual GDP-potential GDP

• GDP gap > 0 (rate of unemployment < NRU) or < 0 (rate of unemployment > NRU)

Cyclical unemployment:

• Caused by a decline in total spending – it begins with a recession phase

PPT8:

The level of economic activity, the amount of buying and selling changes over time.

o These periods of expansion and slowdown are referred to as the business cycle.

o Business cycle is the study of the fluctuations in economic growth around the
trend growth.
Business Cycle Phases:

 Peak-temporary maximum of business activity, near/full employment, level of real output is

at/very close to the economy’s capacity; price level is likely to rise; from this point, output
begins to decline
 Recession-decline in total output, real incomes, employment; (two successive quarters of
negative economic growth)
 Contraction - real output is going down from the previous time period
 Depression- severe recession
 Trough-output and employment “bottom out”; the decline ends
 Recovery-follows recession
 Expansion-real GDP, income, employment rise tending to reach again full employment

Trends:

• A trend is the underlying long-term movement in a data series.

o The previous figure shows the trend against the actual data. The trend shown is upward,
but trends can be downward or constant.

Causes of BC:

• Changes in total level of spending, including household spending decisions

• Confidence and expectations

• Innovations

• Productivity changes & firms’ decision making

• Government policy

• Monetary phenomenon

• External sources

Affected industries:

• During recession, industries producing capital goods and consumer durables suffer greater
output and employment declines than do service and nondurable consumer goods industries

PPT9:

Phillips curve: shows the short-run trade-off between inflation and unemployment

Choices :

 low unemployment with high inflation

  low inflation with high unemployment

 anything in between

 We have learned that in the short run, society faces a trade-off between inflation and
unemployment.

 à this relationship is called the “Philips Curve”

 But, in the long run, inflation and unemployment are unrelated because:

 The inflation rate is mainly affected by growth in the money supply.

 Unemployment (the “natural rate”) depends on the wage, labor unions, and the process
of job search.

 We have learned that in the short run, society faces a trade-off between inflation and
unemployment.

 à this relationship is called the “Philips Curve”

 But, in the long run, inflation and unemployment are unrelated because:

 The inflation rate is mainly affected by growth in the money supply.

 Unemployment (the “natural rate”) depends on the wage, labor unions, and the process
of job search.

 We have learned that in the short run, society faces a trade-off between inflation and
unemployment.

 à this relationship is called the “Philips Curve”

 But, in the long run, inflation and unemployment are unrelated because:

 The inflation rate is mainly affected by growth in the money supply.

  Unemployment (the “natural rate”) depends on the wage, labor unions, and the process
of job search.

The Cost of Reducing Inflation:

 Disinflation: a reduction in the inflation rate

 To reduce inflation, Central Banks must slow the rate of money growth, which reduces AD

 Short run:
Output falls and unemployment rises.

 Long run:
Output & unemployment return to their natural rates. Disinflation requires enduring a period of

high unemployment and low output.