MACROECONOMICS REVIEWER

MODULE 5
Measuring Economic Performance: Income Determination MODULE 4, PART 2-
MACROECONOMICS
Some national income relationships Assumption:
 National Income = GDP
 Disregard depreciation Recall that GDP is both total income in an economy and total
expenditure on the economy’s output of goods and services: Y = C + I + G + NX
A Simple Economy
 Y = output, without government purchases and NX
 Output produced = output sold
 Output unsold (accumulated inventories) part of investment
 All output is either sold or invested
 Output sold is expressed in terms of the as component of demand as C & I

Y≡C+I (1)
Some Important Identities
Relationship among saving, consumption and GDP. How will income be allocated?
 Part will be spent on consumption, part will be saved. Thus
Y ≡ S + C (2)
S – private sector saving
Putting together (1) and (2)
C + I ≡ Y≡ C + S (3)
Components of demand allocation of demand
 Means output produce = output sold
 The value of output = to income received and income received in turn is spent on goods
or save
 Identity (3) can be written as:
I ≡ Y – C ≡ S (4)
Means investment is identically equal to saving

Introducing Government and Foreign Trade

 Y≡ C + I + G + NX (5)
G – government
NX – net export (export – import)

Now, part of income is spent on taxes and private sector receives net transfers in addition to
national income. Then,
YD ≡ Y + TR – TA (6)
Disposable income is allocated to consumption and saving
YD ≡ C + S (7)

Rearranging (5) and (6), we have

YD – TR + TA ≡ C + I + G + NX (8)
Putting identity (7) to (8)
C + S – TR + TA = C + I + G + NX (9)
Rearrange
S – I ≡ (G + TR – TA) + NX (10)
(G + TR – TA) – government budget deficit (BD) – excess of government spending over its
receipts; BS = TA – (G + TR), the budget deficit is negative budget surplus.
G + TR – total government expenditure (government purchases and transfer payments) TA –
taxes received by government
NX – net export also called trade surplus, if NX is negative, we have trade deficit Thus, saving
over investment in the private sector = government budget deficit + the trade surplus

Surplus and Deficit

 If TA > G, the government runs a budget surplus because it receives more money than it
spends.
 The surplus of TR - G represents public saving.
 If G > TA, the government runs a budget deficit because it spends more money than it
receives in tax revenue.
 For the economy as a whole, saving must be equal to investment. S = I

Interest Rates, Exchange Rate

  Interest rates – the rate of payment on a loan or other investment, over and above
principal repayment, in terms of annual percentage
 Nominal interest rates given the return in loans in current peso (or $)
 Real interest rates given the return in peso of constant value (subtract inflation from
nominal interest rate)
 Exchange rate – is the price of one country’s currency in terms of another’s

MODULE 6: Economic Growth

Economic growth has been defined in two ways. In the first place, economic growth is defined
as increase in an economy’s real national income or gross national product (GNP,) over a
period of time. In other words, economic growth means rising trend of national product at
constant prices. This definition has been criticized by some economists as inadequate and
unsatisfactory.
Therefore, the second and better way of defining economic growth is to do so in terms of per
capita income. Thus, economic growth means the annual increase in real per capita income of a
country. Professor Arthur Lewis writes that “economic growth means the growth of output per
head of population”.
Since the main aim of economic growth is to raise the standard of living of the people, the
second way of defining economic growth which runs in terms of per capita income is considered
to be better. However, the concept of economic growth is generally used in both these senses,
that is, in the sense, of increase In GNP or in per capita real income over a period. Economic
growth of a country is a major measure of macro economic performance of a country.
John Maynard Keynes, one of the most influential economic thinkers of all time, once said that
“in the long run, we are all dead”. He made this statement because he was primarily concerned
with explaining and reducing short-term fluctuations in the level of business activity.
Economic growth is usually measured by the annual percent change in real output of goods and
services per capita. Improvements in and greater stocks of land, labor, capital and entrepreneurial
activity will lead to greater economic growth and shift the production possibilities frontier/curve
outward.
A country’s standard of living depends on its ability to produce goods and services. Within a
country there are large changes in the standard of living over time.
According to the Rule of 70, if you take a nation’s growth rate and divide it into 70, you have the
approximate time it will take to double the income level (ex 70/3.5)
Rising productivity plays a key role in determining standard of living and long run economic
growth. Productivity refers to the amount of goods and services produced for each hour of a
worker’s time. A nation’s standard of living is determined by the productivity of its workers.

Measuring the Cost of Living

The consumer price index is used to monitor changes in the cost of living over time. When the
consumer price index rises, the typical family has to spend more dollars to maintain the same
standard of living. Economists use the term inflation to describe a situation in which the
economy’s overall price level is rising. The inflation rate is the percentage change in the price
level from the previous period. Inflation is a closely watched aspect of macroeconomic
performance and is a key variable guiding macroeconomic policy. The goal of the consumer
price index is to measure changes in the cost of living. In other words, the consumer price index
tries to gauge how much incomes must rise in order to maintain a constant standard of living.
The consumer price index, however, is not a perfect measure of the cost of living. Three
problems with the index are widely acknowledged but difficult to solve.

Productivity
The term productivity refers to the quantity of goods and services that a worker can produce for
each hour of work. Productivity is the key determinant of living standards and that growth in
productivity is the key determinant of growth in living standards. The key role of productivity in
determining living standards is as true for nations as it is for stranded sailors. A nation can enjoy
a high standard of living only if it can produce a large quantity of goods and services To
understand the large differences in living standards we observe across countries or over time, we
must focus on the production of goods and services. But seeing the link between living standards
and productivity is only the first step. It leads naturally to the next question: Why are some
economies so much better at producing goods and services than others?

Determinants of Economic Growth (How productivity is determined)

At minimum, there are identified four factors that contributed to economic growth in some if not
in all countries
1. Physical capital - the stock of equipment and structures that are used to produce goods and
services is called physical capital, or just capital. It includes goods like tools, machinery and
factories that have already been produced and are now producing other goods and services.
Combining workers with more capital makes workers more productive. Physical capital inputs
(machines, tools, buildings, inventories). Physical capital is goods that have already been
produced and are not producing other goods and services. Combining workers with more capital
makes workers more productive. Thus, capital investment can lead to increase in labor
productivity, when the economy has a low level of capital per worker. Some economists believe
on the diminishing marginal returns to capital can help explain the variation in growth rates
between rich and poor countries. An important feature of capital is that it is a produced factor of
production. That is, capital is an input into the production process that in the past was an output
from the production process.

2. Human capital.
Human capital is the economist’s term for the knowledge and skills that workers acquire through
education, training, and experience. Human capital includes the skills accumulated in early
childhood programs, grade school, high school, college, and on-the-job training for adults in the
labor force. It is the quantity and quality of labor resources (labor and human capital). Labor can
be improved through investment in human capital, that is education, on-the-job training and
experience can improve the quality of labor Labor - when workers acquire qualitative
improvements, output increases. Workers with large stock of human capital are more productive
than those with small stocks of human capital.

3. Natural resources – Natural resources are inputs into production that are provided by nature,
such as land, rivers, and mineral deposits. Natural resources take two forms: renewable and
nonrenewable. The abundance of natural resources can enhance output. Natural resource base
can affect the initial development process, but sustained growth is influenced by other factors.
Increase in the use of inputs provided by the land (natural resources). An abundance of natural
resources (fertile soil, raw materials, etc) can enhance output. However, natural resource base
can affect the initial development process, but sustained growth is influenced by other factors.
Although natural resources can be important, they are not necessary for an economy to be highly
productive in producing goods and services. Japan, for instance, is one of the richest countries in
the world, despite having few natural resources.
4. Technological knowledge (new ways of combining given quantities of labor, natural
resources, and capital inputs) allowing greater output than previously possible. It is the progress
in technology that drives productivity. The process of technological advance involves invention
and innovation. Innovation is the adoption of the product or process. Technological advances
permit us to economize on one or more inputs used in the production process. Given the above,
no single factor is capable of completely explaining economic growth patterns because economic
growth is a complete process involving many important factors, no one of which completely
dominates. Those in countries with relatively scarce and therefore more costly labor would
benefit more from labor-saving innovations and so would be likely to be leaders in such
innovations. Similarly, those in countries with relatively scarce and therefore more costly land
would likely be leaders in innovative ways to conserve land.
New Growth Theory
The greater the reward for new technology, the more research and technology will occur.
Economic growth can continue unimpeded as long as we keep coming up with new ideas. It is
ideas that drive economic growth, economic growth comes from increases in value, rearranging
fixed amounts of matter and making new combinations that are more valuable.

Public Policy and Economic Growth

Impact of economic growth includes increase in the real income of the population, stimulates
political freedom and democracy
Saving rates, investment, capital and economic growth. One of the most important
determinants of economic growth is savings. Generally speaking, higher levels of saving will
lead to higher rates of investment and capital formation, and therefore to greater economic
growth.
Infrastructure (highways, port, bridges, information technology, etc) is critical to economic
coordination and activity. Poor infrastructure is a major deterrent to economic growth.
Research and development. Larger rewards for research and development (R&D) would spur for
even more rapid economic growth. R&D are activities undertaken to create new products and
processes that will lead to technological progress. Larger rewards to research and development
would spur rapid economic growth.
The protection of property rights. Economic growth rates tend to be higher in countries where
the government enforces property rights more vigorously. Property rights give owners the legal
right to sell their properties – land, labor or capital. Without property rights, life would be a huge
“free for all”. Economists call the government’s ability to protect private property rights and
enforce contracts the rule of law.
Free trade and economic growth. Allowing free trade can also lead to greater output because of
the principle of comparative advantage. Essentially, the principle of comparative advantage
suggests that if two nations or individuals with different resource endowments and production
capabilities specialize in producing a smaller number of goods and services and engage in trade.
Total output will rise.
Education, investment in human capital, is important to improving standards of living and
economic growth. Subsidizing education is an investment that can increase the skill level of the
population and raise the standard of living. With economic growth, illiteracy rates fall and formal
education grows.

Population and Economic Growth

If population were to expand faster than output, per capita output would fall; population growth
would inhibit growth with a larger population. With a larger population however comes a larger
labor force. Also, economies of large scale production may exist in some forms of production, so
larger markets associated with greater populations, so larger markets associated with greater
population. Thus, population growth may increase per capita output in resource rich countries,
they have more resources for each labourer to produce with. They are more likely to be able to
exploit economies of large-scale production and they are more likely to have rapidly expanding
technology.
The Malthusian prediction. Reverend Thomas Malthus formulated a theoretical model that
predicted per capita economic growth would eventually become negative and that wages would
ultimately reach equilibrium at subsistence level, or just large enough to provide enough income
to stay alive. In some countries, the Malthusian dilemma posed by population growth and
diminishing returns is a problem, and they may suffer as a result of population growth. As
population increases, the number of workers increases, and with greater labor inputs available,
output also goes up. At some point however, output will increase by diminishing amounts
because of the law of diminishing returns, which states that if you add variable amounts of one
input (labor) to fixed quantities of another input (e.g. land), output will rise but by diminishing
amounts (because of the land-labor ration falls, less land is available per worker). In countries
with a fixed supply of land and little if any technological advance, Malthus’s assumptions are not
far from the reality. Population control is one way to hold down the rate of population increase,
to prevent the Malthusian subsistence wage result.

MODULE 7
SAVING, INVESTMENT, AND THE FINANCIAL SYSTEM

In this module, we discuss how the financial system works. It starts with the introduction of
financial institutions and financial intermediaries

Introduction

Imagine that you decide to start your own business—an economic forecasting firm. Before you
make any money selling your forecasts, you have to incur substantial costs to set up your
business. How do you obtain the funds to invest in these capital goods for the business? Perhaps
you are able to pay for them out of your past savings. More likely, however, like most
entrepreneurs, you do not have enough money of your own to finance the start of your business.
As a result, you have to get the money you need from other sources.

There are various ways for you to finance these capital investments. You could borrow the
money, perhaps from a bank or from a friend or relative. In this case, you would promise not
only to return the money at a later date but also to pay interest for the use of the money.
Alternatively, you could convince someone to provide the money you need for your business in
exchange for a share of your future profits, whatever they might happen to be. In either case,
your investment is being financed by someone else’s saving. Another way of a company can get
money is through retained earnings.

Some people in the economy are seeking to save some of their income for the future, whereas,
others are seeking to borrow in order to finance investments that would grow their businesses.
How do we get these two groups together?

Financial institutions exist to facilitate the channeling of saving into investment. The financial
system consists of those institutions in the economy that help to match one person’s saving with
another person’s investment. The financial system is composed of both financial markets and
financial intermediaries. Firms can obtain resources to invest in capital by using retained
earnings (the profits that are reinvested in the firm rather than distributed as dividends to
shareholders). But there are several other methods they can use as well, including selling stocks
or bonds in the financial markets or borrowing from financial intermediaries such as banks.

As discussed before, saving and investment are key ingredients to long-run economic growth:
When a country saves a large portion of its GDP, more resources are available for investment in
capital, and higher capital raises a country’s productivity and living standard. At any time, some
people want to save some of their income for the future, and others want to borrow in order to
finance investments in new and growing businesses. What brings these two groups of people
together? What ensures that the supply of funds from those who want to save balances the
demand for funds from those who want to invest? In here, we examine how the financial system
works and discuss the following:
 The large variety of institutions that make up the financial system in our economy.
 the relationship between the financial system and some key macroeconomic variables—
notably saving and investment.
 develop a model of the supply and demand for funds in financial markets. In the model,
the interest rate is the price that adjusts to balance supply and demand. The model shows
how various government policies affect the interest rate and, thereby, society’s allocation
of scarce resources.

FINANCIAL MARKETS

Financial markets are the institutions through which a person who wants to save can directly
supply funds to a person who wants to borrow. The two most important financial markets are the
bond market and the stock market. The values of securities (stocks and bonds) sold in
financial markets change with expectations of benefits and costs. For example, if people expect
corporate earnings to rise, prospective stockholders increase what they would be willing to pay
for the fixed amount of securities while existing stockholders become more reluctant to sell,
leading to increased prices. If present business conditions or expectations about future profits
worsen, stock prices will fall. Economic policies of the government, business conditions in
foreign countries and inflation influence the price of stocks. During periods of rising securities
markets, optimism is generally great, and bussiness are more likely to invest in a new capital
equipmeent. During periods of pessimism, stock prices fall and businesses reducve expenditures
on new capital equipment, partly because financing such equipment by stock sales is more
costly.

The Bond Market. When Intel, the giant maker of computer chips, wants to borrow to finance
construction of a new factory, it can borrow directly from the public. It does this by selling
bonds. A bond is a certificate of indebtedness that specifies the obligations of the borrower to
the holder of the bond. Put simply, a bond is an IOU. It identifies the time at which the loan will
be repaid, called the date of maturity, and the rate of interest that will be paid periodically until
the loan matures. The buyer of a bond gives his or her money to Intel in exchange for this
promise of interest and eventual repayment of the amount borrowed (called the principal ). The
buyer can hold the bond until maturity or can sell the bond at an earlier date to someone else.

Characteristic of a Bond
1. Bond’s term—the length of time until the bond matures. Some bonds have short terms, such
as a few months, while others have terms as long as 30 years. The interest rate on a bond
depends, in part, on its term. Longterm bonds are riskier than short-term bonds because
holders of long-term bonds have to wait longer for repayment of principal. To compensate
for this risk, long-term bonds usually pay higher interest rates than short-term bonds.

2. credit risk—the probability that the borrower will fail to pay some of the interest or principal.
Such a failure to pay is called a default. Borrowers can (and sometimes do) default on their
loans by declaring bankruptcy. When bond buyers perceive that the probability of default is
high, they demand a higher interest rate to compensate them for this risk.

3. The third important characteristic of a bond is its tax treatment—the way in which the tax
laws treat the interest earned on the bond. The interest on most bonds is taxable income, so
that the bond owner has to pay a portion of the interest in income taxes. By contrast, when
state and local governments issue bonds, called municipal bonds, the bond owners are not
required to pay federal income tax on the interest income. Because of this tax advantage,
bonds issued by state and local governments pay a lower interest rate than bonds issued by
corporations or the federal government.

The Stock Market. Another way for Intel to raise funds to build a new semiconductor factory is
to sell stock in the company. Stock represents partial ownership in a firm and is, therefore, a
claim to the profits that the firm makes. The owners of corporations own shares of stock in the
company and are called stockholders. The sale of stock to raise money is called equity finance,
whereas the sale of bonds is called debt finance. Although corporations use both equity and debt
finance to raise money for new investments, stocks and bonds are very different. The owner of
shares of Intel stock is a part owner of Intel; the owner of an Intel bond is a creditor of the
corporation. If Intel is very profitable, the stockholders enjoy the benefits of these profits,
whereas the bondholders get only the interest on their bonds. And if Intel runs into financial
difficulty, the bondholders are paid what they are due before stockholders receive anything at all.
Compared to bonds, stocks offer the holder both higher risk and potentially higher return.

The prices at which shares trade on stock exchanges are determined by the supply and demand
for the stock in these companies. Because stock represents ownership in a corporation, the
demand for a stock (and thus its price) reflects people’s perception of the corporation’s future
profitability. When people become optimistic about a company’s future, they raise their demand
for its stock and thereby bid up the price of a share of stock. Conversely, when people come to
expect a company to have little profit or even losses, the price of a share falls.

Two primary types of stock are preferred stock and common stock.
Preferred stock is a stock that pays fixed, regular dividend payments despite the profits of the
corporation.
Common stock – residual claimants of corporate resources who receive a proportion of profits
based upon the ratio of shares held.

FINANCIAL INTERMEDIARIES

Financial intermediaries are financial institutions through which savers can indirectly provide
funds to borrowers. The term intermediary reflects the role of these institutions in standing
between savers and borrowers. Two of the most important financial intermediaries are banks and
mutual funds.

1. Banks are the financial intermediaries with which people are most familiar. A primary job of
banks is to take in deposits from people who want to save and use these deposits to make
loans to people who want to borrow. Banks pay depositors interest on their deposits and
charge borrowers slightly higher interest on their loans. The difference between these rates of
interest covers the banks’ costs and returns some profit to the owners of the banks. Besides
being financial intermediaries, banks play a second important role in the economy: They
facilitate purchases of goods and services by allowing people to write checks against their
deposits. In other words, banks help create a special asset that people can use as a medium of
exchange. A medium of exchange is an item that people can easily use to engage in
transactions. A bank’s role in providing a medium of exchange distinguishes it from many
other financial institutions. Stocks and bonds, like bank deposits, are a possible store of value
for the wealth that people have accumulated in past saving, but access to this wealth is not as
easy, cheap, and immediate as just writing a check.

2. Mutual Funds. A mutual fund is an institution that sells shares to the public and uses the
proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and
bonds. The shareholder of the mutual fund accepts all the risk and return associated with the
portfolio. If the value of the portfolio rises, the shareholder benefits; if the value of the
portfolio falls, the shareholder suffers the loss. The primary advantage of mutual funds is that
they allow people with small amounts of money to diversify. A second advantage claimed by
mutual fund companies is that mutual funds give ordinary people access to the skills of
professional money managers. The managers of most mutual funds pay close attention to the
developments and prospects of the companies in which they buy stock. These managers buy
the stock of those companies that they view as having a profitable future and sell the stock of
companies with less promising prospects. This professional management, it is argued, should
increase the return that mutual fund depositors earn on their savings.
Retained earnings. Instead of using its profits to pay out dividends, a firm might takesome of its
profits and plow them back into the company for new capital equipment. Retained earnings is the
practice of using coporate profits for capital investment rather than dividend payouts.
SUMMING UP, an economy contains a large variety of financial institutions. In addition to the
bond market, the stock market, banks, and mutual funds, there are also pension funds, credit
unions, insurance companies, and even the local loan shark. These institutions differ in many
ways. When analyzing the macroeconomic role of the financial system, however, it is more
important to keep in mind the similarity
of these institutions than the differences. These financial institutions all serve the same goal—
directing the resources of savers into the hands of borrowers.

SAVING AND INVESTMENT IN THE NATIONAL INCOME ACCOUNTS

Events that occur within the financial system are central to understanding developments in the
overall economy. As we have just seen, the institutions that make up this system—the bond
market, the stock market, banks, and mutual funds— have the role of coordinating the
economy’s saving and investment. Saving and investment are important determinants of long-run
growth in GDP and living standards. As a result, macroeconomists need to understand how
financial markets work and how various events and policies affect them.

The rules of national income accounting include several important identities. An identity is an
equation that must be true because of the way the variables in the equation are defined. Identities
are useful to keep in mind, for they clarify how different variables are related to one another.
Here we consider some accounting identities that shed light on the macroeconomic role of
financial markets.

SOME IMPORTANT IDENTITIES

Recall that gross domestic product (GDP) is both total income in an economy and the total
expenditure on the economy’s output of goods and services. GDP (denoted as Y) is divided into
four components of expenditure: consumption (C), investment (I), government purchases (G),
and net exports (NX). We write

Y =C + I + G+ NX

This equation is an identity because aggregate expenditures that shows up on the left-hand side
also shows up in one of the four components on the right-hand side. Because of the way each of
the variables is defined and measured, this equation must always hold.

To simplify our analysis, assume that the economy is closed. A closed economy is one that does
not interact with other economies. In particular, a closed economy does not engage in
international trade in goods and services, nor does it engage in international borrowing and
lending. Of course, actual economies are open economies—that is, they interact with other
economies around the world. In a closed economy, net export is zero, so we can write the
equation

Y =C + I + G

Thus, GDP (Y) is the sum of consumption

THE MARKET FOR LOANABLE FUNDS

GDP and economic growth depend on the extent of productive resources and the rate at which
they increase. In order for an economy to grow, there must be investment. Firms invest in new
capital and new production techniques.

Assume the loanable funds market is a single big financial market where savers save and
borrowers borrow. The economy’s market for loanable funds, like other markets in the economy,
is governed by supply and demand.

The supply of loanable funds comes from those people who have some extra income they want
to save and lend out. This lending can occur directly, such as when a household buys a bond
from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank,
which in turn uses the funds to makeloans. In both cases, saving is the source of the supply of
loanable funds.

The demand for loanable funds comes from households and firms who wish to borrow to make
investments. This demand includes families taking out mortgages to buy homes. It also includes
firms borrowing to buy new equipment or build factories. In both cases, investment is the source
of the demand for loanable funds.

The interest rate is the price of a loan. It represents the amount that borrowers pay for loans
and the amount that lenders receive on their saving. Because a high interest rate makes
borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate
rises. Similarly, because a high interest rate makes saving more attractive, the quantity of
loanable funds supplied rises as the interest rate rises. In other words, the demand curve for
loanable funds slopes downward, and the supply curve for loanable funds slopes upward.
The nominal interest rate is the interest rate as usually reported— the monetary return to saving
and cost of borrowing. The real interest rate is the nominal interest rate corrected for inflation; it
equals the nominal interest rate minus the inflation rate. Because inflation erodes the value of
money over time, the real interest rate more accurately reflects the real return to saving and cost
of borrowing. Therefore, the supply and demand for loanable funds depend on the real (rather
than nominal) interest rate

When the interest rate adjusts to balance supply and demand in the market for loanable funds, it
coordinates the behavior of people who want to save (the suppliers of loanable funds) and the
behavior of people who want to invest (the demanders of loanable funds).

We can now use this analysis of the market for loanable funds to examine various government
policies that affect the economy’s saving and investment. Because this model is just supply and
demand First, we decide whether the policy shifts the supply curve or the demand curve. Second,
we determine the direction of the shift. Third, we use the supply-and-demand diagram to see how
the equilibrium changes.

POLICY 1: TAXES AND SAVING

To see the effects of this policy, consider a 25-year-old individual who saves 1,000 and buys a
30-year
bond that pays an interest rate of 9 percent. In the absence of taxes, the 1,000 grows to $13,268
when the individual reaches age 55. Yet if that interest is taxed at a rate of, say, 33 percent, then
the after-tax interest rate is only 6 percent. In this case, the P1,000 grows to only P5,743 after 30
years. The tax on interest income substantially reduces the future payoff from current saving and,
as a result, reduces the incentive for people to save. In response to this problem, many
economists and lawmakers have proposed changing the tax code to encourage greater saving

Under a consumption tax, income that is saved would not be taxed until the saving is later spent;
in essence, a consumption tax is like the sales taxes that many states now use to collect revenue.
A more modest proposal is to expand eligibility for special accounts, such as Individual
Retirement Accounts, that allow people to shelter some of their saving from taxation. Let’s
consider the effect of such a saving incentive on the market for loanable funds,

First, which curve would this policy affect? Because the tax change would alter the incentive for
households to save at any given interest rate, it would affect the quantity of loanable funds
supplied at each interest rate. Thus, the supply of loanable funds would shift. The demand for
loanable funds would remain the same, because the tax change would not directly affect the
amount that borrowers want to borrow at any given interest rate.

Second, which way would the supply curve shift? Because saving would be taxed less heavily
than under current law, households would increase their saving by consuming a smaller fraction
of their income. Households would use this additional saving to increase their deposits in banks
or to buy more bonds. The supply of loanable funds would increase, and the supply curve would
shift to the right
Finally, we can compare the old and new equilibria. In the figure, the increased supply of
loanable funds reduces the interest rate. The lower interest rate raises the quantity of loanable
funds demanded. That is, the shift in the supply curve moves the market equilibrium along the
demand curve. With a lower cost of borrowing, households and firms are motivated to borrow
more to finance greater investment. Thus, if a change in the tax laws encouraged greater saving,
the result would be lower interest rates and greater investment.

POLICY 2: TAXES AND INVESTMENT

Suppose that Congress passed a law giving a tax reduction to any firm building a new factory. In
essence, this is what Congress does when it institutes an investment tax credit, which it does
from time to time.

First, would the law affect supply or demand? Because the tax credit would reward firms that
borrow and invest in new capital, it would alter investment at any given interest rate and,
thereby, change the demand for loanable funds. By contrast, because the tax credit would not
affect the amount that households save at any given interest rate, it would not affect the supply of
loanable funds

Second, which way would the demand curve shift? Because firms would have an incentive to
increase investment at any interest rate, the quantity of loanable funds demanded would be
higher at any given interest rate. Thus, the demand curve for loanable funds would move to the
right

The increased demand for loanable funds raises the interest rate, and the higher interest rate in
turn increases the quantity of loanable funds supplied, as households respond by increasing the
amount they save. This change in household behavior is represented here as a movement along
the supply curve. Thus, if a change in the tax laws encouraged greater investment, the result
would be higher interest rates and greater saving.

Module 8
1 AGGREGATE DEMAND AND AGGREGATE SUPPLY

In the short run, output fluctuates with shifts in either aggregate supply or aggregate demand; in the long
run, only aggregate supply affects output. In economics, output is the quantity of goods and services
produced in a given time period. The level of output is determined by both the aggregate supply and
aggregate demand within an economy. National output is what makes a country rich, not large amounts
of money. For this reason, understanding the fluctuations in economic output is critical for long term
growth. There are a series of factors that influence fluctuations in economic output including increases in
growth and inputs in factors of production. Anything that causes labor, capital, or efficiency to go up or
down results in fluctuations in economic output.

Short-Run Economic Fluctuations

• Economic activity fluctuates from year to year.
• In most years production of goods and services rises.
• On average, production in the U.S. economy for example has grown by about 3 percent per year.

How about the Philippines? ____________

• In some years normal growth does not occur, causing a recession. A recession is a period of declining
real incomes, and rising unemployment. A depression is a severe recession.
THREE KEY FACTS ABOUT ECONOMIC FLUCTUATIONS
• Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called the
business cycle.
• Most macroeconomic variables fluctuate together.
• As output falls, unemployment rises.

Objective:
• Differentiate between short-run and long-run effects of nominal fluctuations

The Basic Model of Economic Fluctuations

Two variables are used to develop a model to analyze the short-run fluctuations.
1. The economy’s output of goods and services measured by real GDP.
2. The overall price level measured by the CPI or the GDP deflator

The Basic Model of Aggregate Demand and Aggregate Supply

Aggregate supply is the total amount of goods and services that firms are willing to sell at a given price
in an economy. The aggregate demand is the total amounts of goods and services that will be purchased
at all possible price levels. In a standard AS-AD model, the output (Y) is the x-axis and price (P) is the y-
axis. Aggregate supply and aggregate demand are graphed together to determine equilibrium. The
equilibrium is the point where supply and demand meet to determine the output of a good or service . •
Economist use the model of aggregate demand and aggregate supply to explain short-run fluctuations in
economic activity around its long-run trend. The aggregate supply-aggregate demand model is the basic
macroeconomic tool for studying output fluctuations and the determination of the price level and the
inflation rate. The tool is used to understand why the economy deviates from a path of smooth growth
over time and to explore the consequences of government policies intended to reduce unemployment,
smooth output fluctuations, and maintain stable prices.

Aggregate Demand
Aggregate demand is the sum of the demand for all final goods and services in the economy. It can also
be seen as the quantity of real GDP demanded at different price levels. The four components of aggregate
demand are consumption (C), investment (I), government purchases (G) and net export (X – M) or equal
to C + I + G + (X – M). net export is the difference between the value of exports and value the value of
imports.
Consumption is by far the largest component in aggregate demand (around 70%). Understanding the
determinants of consumption, then is critical to an understanding of the forces leading to changes in
aggregate demand, which in turn, changes total output and income.

Investment. Changes in investment spending are often responsible for changes in the level of economic
activity. Investment expenditure is the most unstable category of GDP; it is sensitive to changes in
economic, social and political variables. Many factors are important in determining the level of
investment. Good business conditions “induce” firms to invest because a healthy growth in demand for
products in the future seems likely, based on current experience.

Government Purchases include spending by the government (national, regional, local) for the purchase
of new goods and services produced. Government purchases include education, highways, police
protection, and others.

Net Exports (X – M). Models that include the effects of international trade are called open economy
models. Exports are goods and services that we sell to foreign customers; imports are goods and services
that we buy from foreign companies. Exports and imports can alter aggregate demand. If exports are
greater than imports we have positive net export. If imports are greater than exports, net exports are
negative. Trade deficits of negative net exports lower aggregate demand , other things being equal; trade
surpluses increase aggregate demand, other things equal.

The Aggregate Demand Curve

The aggregate demand curve is a graph that shows the inverse relationship between the price level and
real gross domestic product. It reflects the total amount of real goods and services that all groups together
want to purchase at each price level in a given period. The AD curve slopes downward, reflecting an
inverse relationship between the overall price level and the quantity of real GDP demanded. The
aggregate demand curve slopes downward, reflecting an inverse relationship between the overall price
level and the quantity of real GDP demanded. When the price level increase, the quantity of RGDP
demanded decreases; when the price level decreases, the quantity of RGDP demanded increases. The
aggregate demand curve is downward sloping because of the real wealth effect, the interest rate effect
and the open economy effect.
a. Real wealth effect (the price level and consumption).
An increase in the price level reduces real wealth (value of cash assets) and would consequently
decrease your planned purchases of goods and services (decrease in purchasing power), lowering the
quantity of RGDP demanded. If price level falls, would increase the value of cash assets, increasing
the purchasing power and increasing RGDP demanded. In summary, a decrease in the price level
makes consumers feel more wealthy, which in turn encourages them to spend more. This increase in
consumer spending means larger quantities of goods and services demanded.

b. Interest rate effect (the price level and investment).

If the price falls, households and firms will need to hold less money to conduct their day-to day
activities and therefore shift their excess money into interest earning assets (households and firms
therefore reduce their holdings or money and save more → supply of loanable funds increases →
interest rates fall →households and firms are encouraged to borrow and spend →RGDP demanded
increases. If the price level rises → households and firms increase their holdings of money (need to
borrow money) → demand on loanable funds increases → interest rates rise → households and firms
are discouraged from borrowing and spending (give up plans to buy new cars or houses and delay
investment) → RGDP demanded decreases. In summary: A lower price level reduces the interest rate,
which encourages greater spending on investment goods. This increase in investment spending means
a larger quantity of goods and services demanded.

c. Open economy effect (price level and net export) or exchange rate effect. If the price level in the
country rises relative to the price level in other countries, exports will become relatively more
expensive and foreign imports will become relatively less expensive. Some domestic consumers
will shift from buying domestic goods to buying foreign goods (imports). Some foreign
consumers will stop buying domestically produced goods. Exports will fall and imports will rise.
Thus, net exports will fall, therefore reducing the amount of RGDP purchased. A lower price
level makes exports less expensive and foreign imports more expensive. So consumers (local and
foreign) will buy more domestic goods. This will increase net exports, thereby increasing the
amount of RGDP. When a fall in the country’s price level causes interest rates to fall, the real
exchange rate depreciates, which stimulates country’s net exports. The increase in net export
spending means a larger quantity of goods and services demanded. Shifts versus Movement along
the Aggregate Demand Curve A change in the price level causes a movement along the AD
curve, not a shift in the AD curve. The real wealth effect, the interest rate effect and the open
economy effect – that result in the downward slope of the AD curve – each generate a movement
along the AD curved, in reaction to changes in the general price level. Aggregate demand is made
up of total spending, C + I + G + NX. Any change in these factors will cause the AD curve to
shift. Anything that changes the amount of total spending in the economy (holding price levels
constant) will affect the aggregate demand curve. An increase in any component of GDP (C, I, G
or X – M) will cause the AD curve to shift rightward. Conversely, decreases in C, I, G, or X – M
will shift aggregate demand leftward.
Aggregate Demand Curve Shifters
INCREASES IN AGGREGATE DEMAND (Rightward Shift)
DECREASES IN AGGREGATE DEMAND (Leftward Shift)
Consumption (C) ✓ Lower personal taxes ✓ A rise in consumer confidence ✓ Increase in wealth
✓ Greater stock market ✓ An increase in transfer payments ✓ Increase in population

Consumption (C) ✓ Higher personal taxes ✓ A fall in consumer confidence ✓ Reduce stock
market wealth ✓ A reduction in transfer payments ✓ Consumer debt Investment (I) ✓ Increase in
business confidence Investment (I) ✓ Higher real interest rates 4 INCREASES IN AGGREGATE
DEMAND (Rightward Shift) DECREASES IN AGGREGATE DEMAND (Leftward Shift) ✓

Lower real interest rate ✓ Optimistic business forecasts ✓ Lower business taxes ✓ Pessimistic
business forecasts ✓ Higher business taxes Government Purchases (G) ✓ An increase in

government purchases Government Purchases (G) ✓ A reduction in government purchases Net

Exports (X – M) ✓ Income increases abroad (economic boom), which will likely increase the sale

of domestic goods Net Exports (X – M) ✓ Income falls abroad (economic slowdowns), which
leads to a reduction in the sale of domestic goods (exports) The Aggregate Supply Curve
Aggregate supply curve is the relationship between the total quantity of final goods and services
that suppliers are willing and able to produce/supply at a given price level. It represents how
much RGDP suppliers are willing to produce at different price levels. Short-run aggregate supply
(SRAS) curve is the graphical relationship between RGDP and the price level when output prices
can change but input prices are unable to adjust. Long-run aggregate supply (LRAS) curve is the
graphical relationship between RGDP and the price level when output prices and input prices can
fully adjust to economic changes. The Short-run Aggregate Supply Curve The SRAS curve is
positively slopes because at higher price level, producers are willing to supply more real output
and at lower price levels, they are willing to supply less real output. Two possible explanations
for this: the profit effect and the misperception effect • Profit effect. When the price level rises,
output prices rise relative to input prices (costs), raising producers’ short-run profit margins. With
the short-run profit effect, the increased profit margins make it in producers’ self-interest to
expand production and sales at higher price levels. If the price level falls, output prices fall and
producers’ profits tend to fall. This is because many input costs are relatively constant in the short
run. When output price levels fall, producers find it more difficult to cover their input costs and,
consequently, reduce their levels of output. • Misconception effect. Producers can be fooled by
price changes in the short run. This means that producers can be fooled into thinking that the
relative prices of the items they are producing are rising and mistakenly increase production. The
Long-run Aggregate Supply Curve In the long run, the aggregate supply curve is vertical. In the
long run, input prices change proportionately with output prices. The position of the LRAS curve
is determined by the level of capital, land, labor and technology at the natural rate of output,
RGDP. The long run is a period long enough for the price of all –inputs to fully adjust to changes
in the economy. Along the long run supply curve, two sets of prices are changing: the price of
outputs and the price of inputs. For example, a 10% increase in the price of goods and services is
matched by a 10% increase in the price of inputs. The LRAS curve is thus insensitive to the price
level. The LRAS curved is perfectly vertical, reflecting the fact that the level of RGDP producers
are willing to supply is not affected by changes in the price level. It is positioned at the natural
rate of output where all resources are fully employed. That is, in the long r5un, firms will always
produce at the maximum level allowed by their capital, labor and technological inputs regardless
of the price level. 5 Shifts in the Aggregate Supply Curve Any change in the quantity of any
factor of production – capital, land, labor or technology – can cause a shift in both the long run
and short run supply curves. • Capital. Changes in the stock of capital will alter the amount of
goods and services the economy can produce. Investing in capital improves the quantity and
quality of the capital stock, which lowers the cost of production in the short run. This cause a
shift in the SRAS curve rightward. Investment in human capital such as education and on-th-job
training, cause productivity to rise, thus the SRAS curve shifts to the right because more skilled
workforce lowers the cost of production. The LRAS curve also shifts to the right, because greater
output is achievable on a permanent or sustainable basis. • Technology and Entrepreneurship.
Improved technology and inventions increase productivity across the board. These activities shift
both the short run and long run aggregate supply curves rightward by lowering costs and
expanding real output possibilities. • Land (natural resources). An increase in natural resources
lower the cost of production and expand the economy’s sustainable rate of output, shifting both
the short run and long run aggregate supply curve to the right. • The labor Force. The addition of
workers to the labor force, ceteris paribus, can in crease aggregate supply. The expanded labor
force also increase the economy’s potential output increasing LRAS. • Government regulations.
Increases in government regulations can make it more costly for producers, and results Factors
that Shift the SRAS Curve Wages and other inputs Temporary supply shocks Factors that may
shift both the short run and/or the long run aggregate supply depending on whether the effects are
temporary or permanent An Increase in Aggregate Supply (Rightward shift) A decrease in
Aggregate Supply (Leftward Shift) Lower cost ✓ Lower wages ✓ Other input prices fall Higher

costs ✓ Higher wages ✓ Other input prices rise Government Policy ✓ Tax cuts ✓ Deregulation ✓
Lower trade barriers Government Policy ✓ Overregulation ✓ Waste and inefficiency ✓ Higher

trade barriers ✓ Stagnation ✓ A decline in labor productivity ✓ Capital deterioration Economic

growth ✓ Improvements in human and physical capital ✓ Technological advances ✓ An increase
in labor Unfavorable weather, natural Disasters and wars Favorable weather Why the Aggregate-
Supply Curve Slopes Upward in the Short Run 1. The Misperceptions Theory • Changes in the
overall price level temporarily mislead suppliers about what is happening in the markets in which
they sell their output: 6 • A lower price level causes misperceptions about relative prices. • These
misperceptions induce suppliers to decrease the quantity of goods and services supplied. 2. The
Sticky-Wage Theory • Nominal wages are slow to adjust, or are “sticky” in the short run: ✓

Wages do not adjust immediately to a fall in the price level. ✓ A lower price level makes
employment and production less profitable. ✓ This induces firms to reduce the quantity of goods
and services supplied. • Prices of some goods and services adjust sluggishly in response to
changing economic conditions: ✓ An unexpected fall in the price level leaves some firms with

higher-than-desired prices. ✓ This depresses sales, which induces firms to reduce the quantity of
goods and services they produce TWO CAUSES OF ECONOMIC FLUCTUATIONS • An
Adverse Shift in Aggregate Supply • A decrease in one of the determinants of aggregate supply
shifts the curve to the left: • Output falls below the natural rate of employment. • Unemployment
rises. • The price level rises. The Effects of a Shift in Aggregate Supply • Stagflation • Adverse
shifts in aggregate supply cause stagflation—a period of recession and inflation. • Output falls
and prices rise. • Policymakers who can influence aggregate demand cannot offset both of these
adverse effects simultaneously. • Policy Responses to Recession • Policymakers may respond to a
recession in one of the following ways: • Do nothing and wait for prices and wages to adjust. •
Take action to increase aggregate demand by using monetary and fiscal policy. Summary • All
societies experience short-run economic fluctuations around long-run trends. • These fluctuations
are irregular and largely unpredictable. • When recessions occur, real GDP and other measures of
income, spending, and production fall, and unemployment rises. • Economists analyze short-run
economic fluctuations using the aggregate demand and aggregate supply model. • According to
the model of aggregate demand and aggregate supply, the output of goods and services and the
overall level of prices adjust to balance aggregate demand and aggregate supply. • The aggregate-
demand curve slopes downward for three reasons: a wealth effect, an interest rate effect, and an
exchange rate effect. • Any event or policy that changes consumption, investment, government
purchases, or net exports at a given price level will shift the aggregate-demand curve. • In the
long run, the aggregate supply curve is vertical. • The short-run, the aggregate supply curve is
upward sloping. • The are three theories explaining the upward slope of short-run aggregate
supply: the misperceptions theory, the sticky-wage theory, and the sticky-price theory. • Events
that alter the economy’s ability to produce output will shift the short-run aggregate-supply curve.
• Also, the position of the short-run aggregate-supply curve depends on the expected price level. •
One possible cause of economic fluctuations is a shift in aggregate demand. • A second possible
cause of economic fluctuations is a shift in aggregate supply. • Stagflation is a period of falling
output and rising prices. 7 Macroeconomic Equilibrium Determining Macroeconomic
Equilibrium The short run macroeconomic equilibrium occurs at the intersection of the aggregate
demand curve and the short run aggregate supply curve. A short run equilibrium is also a long run
equilibrium only if it is at potential output on the long run aggregate supply curve. Short run
equilibrium can change when the AD curve or the short run AS curve shifts rightward or
leftward; but the long-run equilibrium level of RGDP only changes when the LRAS curve shifts.
At other times, the shifts occur unexpectedly and these unexpected shifts are called shocks. The
underlying determinant of shifts in short run AS is production costs. Recessionary gap – the
output gap that occurs when the actual output is less than the potential output Inflationary gap –
the output gap that occurs when the actual output is greater than the potential output. Inflationary
gap can happen temporarily – as firms encourage workers to work overtime, extend the hours of
part time workers, hire recently retired employees, reduce frictional unemployment through more
extensive searches for employees, and so on. However, this cannot be sustained in the long run.
The Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run
aggregate supply Long-run aggregate supply Aggregate demand Equilibrium A price Copyright
© 2004 South-Western Figure 8 A Contraction in Aggregate Demand Quantity of Output Price
Level 0 Short-run aggregate supply, AS Long-run aggregate supply Aggregate demand, AD P A
Y AD2 AS2 1. A decrease in aggregate demand . . . 2. . . . causes output to fall in the short
run . . . 3. . . . but over time, the short-run aggregate-supply curve shifts . . . 4. . . . and output
returns to its natural rate. P3 C P2 B Y2 Copyright © 2004 South-Western Demand-pull inflation
– a price level increase due to an increase due to an increase in aggregate demand Stagflation – a
situation in which lower growth and higher prices occur together, it’s a leftward shift in the AS
curve. A drop in consumer confidence would decrease the demand for consumer goods, other
things being equal, which would reduce (shift left) the AD curve, resulting in lower price level,
lower real output, an increased unemployment in the short-run for a given short-run aggregate
supply curve. Cost-push inflation – a price-level increase due to a negative supply shock or
increases in input prices such as the increase in oil prices. An increase in oil prices, shifts the
SRAS curve to the left as a result, the price level increases and real output falls. Firms demand
fewer workers as a result of higher input costs that cannot be passed on to consumers. This lower
demand, in turn, leads to higher prices, lower real output, and more unemployment – and a
recessionary gap. However, recessions are not all bad – they can at least show the rate of
inflation. Cost push inflation may cause a recessionary gap, so may decrease in AD. Households,
firms and governments buy fewer goods and services at every price level. In response to this drop
in demand, output falls and the price level falls. Therefore, in the short run, this fall in AD causes
higher unemployment and a reduction in output – and it too can lead to a recessionary gap. 8
Thus, starting from a long-run equilibrium on the long run aggregate supply curve, cost-push
inflation causes the price level to rise, real output to fall and unemployment to rise in the short
run. If world oil prices fell sharply, it would increase (shift right) the short-run AS curve,
resulting in a lower price level, greater real output, and reduced unemployment in the short run
for a given aggregate demand curve. It is possible for the economy to self-correct through
declining wages and prices. For example, during a recession, laborers and other input suppliers
are willing to accept lower wages and prices for the use of their resources, and the resulting
reduction in production costs increases the short-run supply curve. Eventually the economy
returns to the long-run equilibrium and a lower price level. Wages and input prices maybe slow to
adjust, especially downward. This downward wage and price inflexibility may lead to prolonged
periods of recession. Wage and price inflexibility is the tendency for prices and wages to only
adjust slowly downward to changes in the economy What Causes Wages and Prices to be Sticky
Downward? 1. Firms may not be able to legally cut wages because of long-term labor contracts or
a legal minimum wage. Efficiency wages may also limit a firm’s ability to lower wage rates.
Higher wages will lead to greater productivity. In the efficiency wage model, employers pay their
employees more than the equilibrium wage as a means to increase efficiency. Proponents of this
theory suggest that higher-than-equilibrium wages might attract the most productive workers,
lower job turnover, and training costs and improve morale. Efficiency wage lead to greater
amount of unemployment. The efficiency wage could also cause wages to be inflexible
downward. If firms are paying efficiency wages, they may be reluctant to lower wages in a
recession, leading to downward wage inflexibility. 2. Menu costs may cause price inflexibility to
occur. The higher price level in an inflationary environment is often reflected slowly, prices are
gradually changed so as to incur fewer menu costs (the cost of changing posted prices). Because
businesses are not likely to change all their prices, then we can say that some prices are sticky or
slow to change. Adjusting to an Inflationary Gap If the economy is an inflationary gap, actual
output is greater than potential output, because of this, the price level is higher than workers
anticipated, workers become disgruntled (dissatisfy) with wages that have not adjusted to the new
price level. Consequently, workers and other suppliers demand higher prices to be willing to
supply their inputs. As input prices respond to the higher level of output prices, the short-run
aggregate supply curve shifts to the left. Suppliers will continually seek higher prices of their
inputs until they reach long-run equilibrium. At that point, input suppliers’ purchasing power is
restored to the natural rate at new higher price level. The Classical and Keynesian
Macroeconomic Model Historically, the two primary approaches to macroeconomics have been
the classical school and the Keynesian school. • The classical school of thought believed that
wages and prices adjust quickly to changes in supply and demand. French economist Jean
Baptiste Say formulated a notion since dubbed Say’s law, which in simplest form states that
“supply creates its own demand”. More precisely, the production of goods and services creates
income for owners of inputs used in production, which in turn creates a demand for goods. Say’s
law establishes that full employment can be maintained because total spending will be great
enough for firms to sell all the output a fully employed economy can produce. • Keynes rejected
Say’s law because, in addition to spending income from production on goods and services, it can
go toward saving, hoarding or taxes. • Potential real output is the level of real output the economy
can produce without leading to inflation. • If the economy is producing less than potential output,
unemployment is less than its natural rate. • When prices are sticky, the SRAS curve is flat,
meaning that changes in AD result in little change in the price level, but significant changes in
 RGDP 9 • Price stickiness is likely when the economy has excess capacity, but less likely when
the economy is operating at full capacity • The classical school held that persistent high
unemployment would not occur in a market economy, so the high unemployment in the Great
Depression – a central aspect of it – appeared to be something the classical approach could not
explain.

Module 9
THE AGGREGATE EXPENDITURES MODEL
Macroeconomics Introduction
■ In this module, we explore the causes of the business cycle by examining the effect of
fluctuations in total spending (i.e., aggregate expenditure) on real GDP (total production).
■ Aggregate expenditure (AE) - the total amount of spending in the economy: the sum of
consumption, planned investment, government purchases, and net exports.
■ During some years, AE increases about as much as does the production of goods and services:
■ Most firms sell about what they expected to sell and they will remain in production and
employment unchanged.
■ During other years, AE increases more than the production: firms will increase production and
hire more workers.
■ However, during some years AE didn’t increase as much as total production - Firms cut back
on production and laid off workers.

The Aggregate Expenditure Model?

■ Aggregate expenditure model: A macroeconomic model that focuses on the short-run
relationship between total spending and real GDP, assuming that the price level is constant.
➢ It is used to study the business cycle involving the interaction of many economic variables.
■ This model will focus on short-run determination of total output in an economy.
■ The key idea of AE model: In any particular year, the level of GDP is determined mainly by
the level of AE that have several components.
■ Economists began to study the relationship between fluctuations in AE and fluctuations in
GDP during the Great depression of the 1930s:
➢ In 1936, John M. Keynes systematically analyzed this relationship in his famous book (The
general Theory of Employment, Interest, and Money) and identified four categories of AE
that together equal to GDP Aggregate Output and Aggregate Income (Y)
■ Aggregate output is the total quantity of goods and services produced (or supplied) in an
economy in a given period.
■ Aggregate income is the total income received by all factors of production in a given period.
■ Aggregate output (income) (Y) is a combined term used to remind you of the exact equality
between aggregate output and aggregate income.
■ When we talk about output (Y), we mean real output, not nominal output. Output refers to the
quantities of goods and services produced, not the dollars in circulation. Four components of
aggregate expenditure
The four components in our model will be the same four that we introduced in a previous chapter
as the components of GDP:
■ Consumption (C): Spending by households on goods and services
■ Planned investment (I): Planned spending by firms on capital goods, and by households on
new homes
■ Government purchases (G): Spending on all levels of government on goods and services
■ Net exports (NX): The value of exports minus the value of imports
■ Aggregate expenditure is total spending in the economy: the sum of consumption, planned
investment, government purchases, and net exports. Planned investment vs. actual investment
Our aggregate expenditure model uses planned investment, rather than actual investment; in this
way, the definition of aggregate expenditures is slightly different from GDP.
■ The difference is that planned investment spending does not include the build-up of
inventories: goods that have been produced but not yet sold:
■ Planned investment = Actual investment – unplanned change in inventories
Although some measures actual investment, we will assume that their measurement is close
enough to planned investment to use in our estimates of aggregate expenditures. Hence, for the
economy as a whole, we can say that actual investment spending (IS) will be greater (less) than
planned IS when there is an unplanned increase (decrease) in inventories. Actual investment will
equal planned investment only when there is no unplanned change in inventories.

Macroeconomic equilibrium
Equilibrium in the economy occurs when spending on output is equal to the value of output
produced; that is: Aggregate expenditure = GDP This should look “obvious”: AE = C + I + G +
NX GDP = C + I + G + NX
■ The difference is that in the first equation, I is “planned investment”, whereas in the second, I
is “actual investment”.
■ So macroeconomic equilibrium occurs when planned investment equals actual investment,
i.e. no unplanned change in inventories
.
Adjustments to Macro Equilibrium
■ Increases and decreases in AE cause the year-to-year fluctuations in GDP.
■ When AE is greater than GDP, inventories will decline, and GDP and total employment will
increase.
■ When AE is less than GDP, inventories will increase, and GDP and total employment will
decrease.
■ Only when AE equals GDP will the economy be in macroeconomic equilibrium.
▪ Economists forecast what will happen to each component of AE. If they forecast that AE will
decline in the future, that is equivalent to forecasting that GDP will decline and that the economy
will enter a recession.
▪Individuals and firms closely watch these forecasts because fluctuations in GDP can have
dramatic effects on wages, profit, and employment.
▪When economists forecast that AE is likely to decline and the economy is headed for a
recession, the gov. may implement macro policies to head on the decline in AE and avoid the
recession. The relationship between aggregate expenditure and GDP Just like markets for a
particular product may not be in equilibrium (quantity supplied may not equal quantity
demanded at the current price), the economy may not be in equilibrium.
Determining the Level of Aggregate Expenditure in the Economy
■ Each of the components of aggregate expenditure plays a different role in the determination of
equilibrium aggregate expenditure.
■ We will explore them in this section. We discuss the determinants of the four components of
aggregate expenditure and define marginal propensity to consume and marginal propensity to
save

The Circular Flow Diagram with Households and Firms Income, Consumption, and Saving (Y,
C, and S)
■ A household can do two, and only two, things with its income: It can buy goods and services—
that is, it can consume—or it can save.
■ Saving is the part of its income that a household does not consume in a given period.
Distinguished from savings, which is the current stock of accumulated saving.
■ All income is either spent on consumption or saved in an economy in which there are no taxes.
S  Y − C Consumption
■ A key decision in the circular flow model is how much households spend on consumption. In
The General Theory, Keynes argued that household consumption is directly related (highly
correlated) to its income.

Determinants of consumption
The most important variables that determine the level of consumption:
1. Current disposable income – ➢ Disposable income (DI) is the income remaining to
HHs after paying the personal income tax and receiving gov. transfer payments. ➢
Consumer expenditure is largely determined by how much money consumers receive in a
given year: ➢ Personal income – Personal income taxes + transfer payments. ➢ Income
expands most years; hence so does consumption.

2. Household wealth ➢ A household’s wealth can be thought of as its assets (like homes,
stocks and bonds, and bank accounts) minus its liabilities, loans that it owes (mortgages,
 student loans, etc.). ➢ Households with greater wealth spend more on consumption, e.g.
an extra $1,000 in wealth will result in $40-$50 in extra annual consumption spending,
holding constant the effect of income. ➢ Since shares of stock are an important
component of HH’s wealth, consumption should increase with stock prices.

3. Expected future income

▪ Most people prefer to keep their consumption fairly stable from year to year, a process known
as consumption-smoothing.
▪ Both current income and expected future income need to be considered to determine current
consumption.
▪ So consumption relates both to current and future income.

4. The price level

▪ Changes in the price level affect consumption mainly through their effect on HH’s wealth.
▪ As prices rise, household wealth falls. Consequently, higher prices result in lower
consumption spending.

5. The interest rate

▪ Higher real interest rates encourage saving rather than spending; so they result in lower
spending, especially on durable goods. The relationship between consumption and income:
How strong is the relationship between income and consumption?
▪ Panel (a) shows the relationship between consumption and income. The points represent
combinations of real consumption spending and real disposable income for the years 1960 to
2010.
▪ In panel (b), we draw a straight line through the points from panel (a). The line, which
represents the relationship between consumption and disposable income, is called the
consumption function.
▪ The slope of the consumption function is the marginal propensity to consume. As the
graphs demonstrate, the answer is “very strong”. A straight line describes this consumption
function very well: households spend a consistent fraction of each extra dollar on
consumption. Marginal propensity to consume (MPC)
■ Economists use marginal analysis to the relationship between changes in disposable
income and changes in consumption.
■ Marginal propensity to consume (MPC): the amount by which consumption spending
changes when disposable income changes.
■ The marginal propensity to consume (MPC) is the slope of the consumption function, the
amount by which consumption spending increases when disposable income increases given
by the formula: 𝑀𝑃𝐶 = 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑐𝑜𝑛𝑠𝑢𝑚𝑝𝑡𝑖𝑜𝑛 𝐶ℎ𝑎𝑛𝑔𝑒 𝑖𝑛 𝑑𝑖𝑠𝑝𝑜𝑠𝑎𝑏𝑙𝑒 𝑖𝑛𝑐𝑜𝑚𝑒 = ∆𝐶
∆𝑌𝐷
■ We can also use the MPC to determine how much consumption will change as income
changes: ∆C = MPC x ∆YD. Consumption and national income
■ The distinction between national income and GDP is relatively minor; for this simple
model, we will assume they are equal, and use the terms interchangeably. Since: Disposable
income = National income − Net taxes
■ where “net taxes” are equal to taxes minus transfer payments, we can write: National
income = GDP = Disposable income + Net taxes
■ If we assume that net taxes do not change as national income changes, we have the result
that any change in disposable income is the same as the change in national income.
■ We will use this in the graph on the next slide.
■ 16 The relationship between consumption and national income The table shows the
relationship between consumption and national income for an imaginary economy, keeping
net taxes constant. As national income rises by $2,000 billion… … consumption rises by
$1,500 billion. • We can also graph the consumption function using national income rather
than disposable income. • The slope of the consumption function between point A and point
B is equal to the change in Consumption which is the marginal propensity to consume for
this economy is: 𝑀𝑃𝐶 = Δ𝐶/Δ𝑌 = $1,500 billion/$2,000 billion = 0.75 Income, Consumption,
and Saving By definition, disposable income not spent is saved. Therefore National income =
Consumption + Saving + Taxes 𝑌 = 𝐶 + 𝑆 + 𝑇 Any change in national income can be
decomposed into changes in the items on the right hand side: Δ𝑌 = Δ𝐶 + Δ𝑆 + Δ𝑇 We
assume net taxes do not change, so Δ𝑇 = 0; then Δ𝑌 = Δ𝐶 + Δ𝑆 Dividing through by Δ𝑌
gives: ∆𝑌 ∆𝑌 = ∆𝐶 ∆𝑌 + Δ𝑆 Δ𝑌 Marginal propensity to save ∆𝑌 ∆𝑌 = ∆𝐶 ∆𝑌 + Δ𝑆 Δ𝑌 1 =
∆𝐶 ∆𝑌 + Δ𝑆 Δ𝑌
 ■ Δ𝑆 Δ𝑌 is the amount by which savings changes, when (disposable) income changes. This is
known as the marginal propensity to save (MPS). We can rewrite the equation above as 1 =
𝑀𝑃𝐶 + 𝑀𝑃𝑆
■ That is, the marginal propensity to consume plus the marginal propensity to save must
equal 1.
■ Part of any increase in income is consumed, and the rest is saved.
An Aggregate Consumption Function
■ For simplicity, we assume that points of aggregate consumption, when plotted against
aggregate income, lie along a straight line. C = a + bY • The slope of the consumption
function (b) is called the marginal propensity to consume (MPC), or the fraction of a change
in income that is consumed, or spent. 0  b

Module 9
FISCAL POLICY

Macroeconomics Stabilization Policy

• Fiscal Policy is a part of macro economics.

• One major function of the government is to stabilize the economy.

• Stabilization policy is an attempt to dampen the fluctuations in the economy's level of output through
time to achieve low inflation and low unemployment.

• The government's attempt to stabilize the economy is known as fiscal policy, while the Federal
Reserve’s (Central Bank) attempt at stabilization is called monetary policy.

• Keynesian economics, when the government changes the levels of taxation and governments spending,
it influences aggregate demand and the level of economic activity.

Fiscal Policy
• Fiscal policy is the attempt by the government to deliberately manipulate its budget position with a goal
of stabilizing prices, promoting growth, and minimizing unemployment. • Two scenarios that potentially
leave room for fiscal policy are recessionary gaps and inflationary gaps. Recessionary Gap • A
recessionary gap occurs when actual equilibrium output (YE ) is less than potential output (YP ), or YE <
YP . The amount of the recessionary gap is the difference between potential and actual output. In this
case, the economy has an unemployment rate above the natural rate of unemployment. The short-run
equilibrium occurs at the intersection of Aggregate Demand and Aggregate Supply at YE . Because the
economy is below potential output, there is room for fiscal policy to boost the economy to its full
employment level Inflationary Gaps An inflationary gap occurs when equilibrium output exceeds
potential output, or YE > YP . An inflationary gap occurs when equilibrium output exceeds potential
output, or YE > YP . The amount of the inflationary gap, is the horizontal difference between actual and
potential output. In this case, the unemployment rate is below the natural rate, which puts upward
pressure on wages and, hence, prices. Again, there is room for fiscal policy to slow the economy to
reduce the inflationary pressure. Adding Government to the Fixed-Price Model With the fixed-price
model the Aggregate Demand/Aggregate Supply model with an upward-sloping Aggregate Supply curve
could be used as well, but the multiplier effects would be smaller. Equilibrium output in the fixed-price
model without government expenditures was simply Y = C + I. With inclusion of G in the model,
equilibrium output is now Y = C + I + G -shifts the Aggregate Demand curve to the right. Note that with
a flat Aggregate Supply curve, the price level does not change when government expenditures are added
to Aggregate Demand. The figure illustrates that, given the price level, the three components of
Aggregate Demand sum to the equilibrium level of output YE . Tools of Fiscal Policy The government
has three "tools" to conduct fiscal policy: 1.change in the level of government expenditures, 2.change in
taxes, and 3.change in transfer payments. Change in Government Expenditures The government
purchases billions pesos of goods and services each year. This increase in government expenditures-- like
any autonomous component of Aggregate Demand--shifts the Aggregate Demand curve to the right (from
AD0 to AD1 ), which leads to the usual multiplier effects. So in the fixed price model with a simple
output multiplier, a $1 change in G ultimately increases Y by 1/(1-MPC) × change in G For example,
suppose that the economy is in a recessionary gap of ₱800, and the marginal propensity to consume
(MPC) in the economy is 0.75. How much should government expenditures be changed in order to
eliminate the recessionary gap? The answer is not ₱800, but ₱200 because the multiplier in this example
is 4. The increase in government expenditures will induce more consumption spending as incomes rise.
Conversely, a decrease in government expenditures shifts the Aggregate Demand curve to the left, which
leads to a decline in output. Remember that multiplier effects come into play in this case as well, only in
the reverse direction. Change in Taxes The government sets tax policy, which determines how much of
the nation's gross income will be taxed. The income tax is a proportional tax in that a percentage of each
person's income is taxed. The total amount of tax each person pays depends on her income. When the
government raises taxes, more of a person's gross income goes to the government so she has less
disposable income for personal use. Less disposable income leads to less consumption. An increase in
taxes, therefore, shifts the Aggregate Demand curve to the left as in the figure The Tax Multiplier • Tax
changes are also subject to the output multiplier effect, but the process is slightly more complicated than
that for a change in government expenditures. A change in the tax rate impacts Aggregate Demand
indirectly by first reducing disposable income, which then reduces consumption. If taxes rise, disposable
income falls. The decline in disposable income reduces consumption, but not by the full amount of the
income decline. When taxes rise, disposable income falls by the MPC times the change in disposable
income because only a portion of the lost income would have been consumed. • Recall that the multiplier
effect is given by the formula • For an increase in taxes, the initial decrease in Aggregate Demand is not
the amount of the tax change, but the MPC times the tax change, or The Tax Multiplier • Because we are
ultimately interested in the relationship between a change in output and a change in taxes, we rewrite the
above equation as: • Then, for an increase in taxes, the initial decrease in Aggregate Demand is not the
amount of the tax change, but the MPC times the tax change, or • The term -MPC/(1-MPC) is the tax
multiplier. • For example, if the MPC is 0.8, then the tax multiplier is -0.8/(1-0.8) = - 4. • Note that the tax
multiplier is smaller and has the opposite sign as the simple output multiplier. The smaller size is because
the effect of a tax increase on Aggregate Demand is indirect. The opposite sign is because an increase in
taxes decreases output. Conversely, a decrease in taxes increases output. Change in Transfer Payments
•Transfer payments (TR) are distributions of income to individuals who do not directly work for the
income. •If the government increases transfer payments, disposable income rises, and thus consumption
increases shifts the AD curve to the right. •Conversely, a decrease in transfer payments shifts the
Aggregate Demand curve to the left. Expansionary and Contractionary Fiscal Policy If the economy is in
a recessionary gap, the government will want to stimulate Aggregate Demand via expansionary fiscal
policy. Expansionary policy is implemented via some combination of these three tools: • increase
government expenditures, • decrease taxes, or • increase transfer payments. If the economy is in an
inflationary gap, the government will want to reduce Aggregate Demand via contractionary fiscal policy.
Contractionary policy is implemented via some combination of these three tools: • decrease government
expenditures, • increase taxes, or • decrease transfer payments. Fiscal Policy with an upward-sloping AS
Curve If the Aggregate Supply curve is upward sloping rather than horizontal (as we assume in the fixed-
price model), then two things are different about fiscal policy: • An increase in government expenditures
increases both output and the price level • Output multiplier effects will be smaller because some of the
impact will be felt in higher prices The closer that the economy is to its potential output, the smaller the
impact on output, and the larger the impact on prices Discretionary Fiscal Policy vs. Automatic
Stabilizers Discretionary fiscal policy is policy that must be deliberately enacted by Congress and/or the
President. Inherent difficulties arise in conducting good discretionary fiscal policy. First, there are severe
time lags. Lags result from any of these three sources: • Recognition lag: the time needed for legislators to
recognize that policy needs to be changed due to a change in the business cycle. • Implementation lag: the
time needed to change the policy. Decisions on taxes, transfer payments, and government spending are
usually made with more concern for politics than for economics. • Impact lag: the time elapsed between
the implementation of the changed policy and its impact on the economy. A second difficulty is that the
growth in the budget deficit has made discretionary fiscal policy less of an option. Deliberate increases in
government spending are not popular because they increase the budget deficit. Automatic stabilizers •
Automatic stabilizers are policies that increase government outlays and decrease taxes automatically
during recessions, and reduce government outlays and increase taxes automatically during inflationary
periods. • No deliberate government action is required. • Examples are welfare payments, unemployment
insurance, and proportional income taxes. • These policies are free from politics, recognition and
implementation lags. Supply-Side Economics • Supply-side economics is a school of thought that
challenges the emphasis of Keynesian economics on the demand side of the economy. • The goal is to
achieve growth by stimulating the supply side of the economy. Supply-siders wish to increase economic
growth and spur the economy by stimulating the supply side of the economy. Supply-side economics
wishes to conduct policy with the goal of shifting the Aggregate Supply curve to the right. Such a policy
leads to higher output and a lower price level (or in the real world, lower rates of inflation). The outcome
seems to be the best of both possible worlds: a world of high employment and low inflation. Unleashing
Labor and Capital Resources • A supply-side theme is that government regulations and high taxes
constrain the growth of the supply-side of the economy. • Policy reforms call for reductions in income
taxes and business taxes such as capital gains taxes to encourage labor and capital formation. The Laffer
Curve Won’t tax cuts increase the budget deficit? Yes, unless: • government spending is also reduced in
conjunction with the tax cuts, or • the economy is on the right side of the Laffer curve. If the tax
reductions stimulate enough growth in GDP by increases in labor and capital supply, then the tax base,
and potentially tax revenues, increase over time. The Laffer Curve The Laffer curve plots the tax rate
against tax revenues. To the left of point B, a tax cut results in tax revenue declines. But to the right of
point B, tax cuts actually increase tax revenue.

MODULE 11
MONETARY INSTITUTIONS, MONEY AND MONETARY POLICY

Content
What is Money
Kinds of Money
Measuring Money
Demand for Money
Supply for Money
The Bangko Sentral ng Pilipinas
Financial Institutions
The Federal Reserve System
Monetary Policy

What is Money

Money is anything that is generally accepted in exchange for goods and services. Money refers to all
things that are generally acceptable as means of payment for goods and services (medium of exchange)
and as payment of debts (standard of deferred payment). Money is the set of assets in an economy that
people regularly use to buy goods and services from other people. Money has four important functions in
the economy:

1. As a medium of exchange – It is the primary function of money, which is to facilitate transactions and
to lower transaction costs. A medium of exchange is anything that is readily acceptable as payment.
That is sellers will accept it as payment in a transaction. Money is not the only medium of exchange
rather it is the only medium that is generally accepted for most transactions.
The barter system is inefficient. Barter is the direct exchange of goods and services without the use of
money. Barter is inefficient compared to money because a person may have to make several trades
before receiving something that is truly wanted.
2. A unit of account. By providing a universally understood unit of account, money serves to lower the
information costs involved in making transactions. A unit of account is the yardstick people use to
post prices and record debts.
3. A store of value. Money can serve as a means of saving or storing things of value in an efficient
manner. Money is both cheaper and easier to store than other goods. A store of value is an item that
people can use to transfer purchasing power from the present to the future.
4. A means of deferred payment – the attribute of money that makes it easier to borrow and to repay
loans. Because the value of money fluctuates less than specific commodities, it imposes fewer risks
on borrowers and lenders.

Liquidity is the ease with which an asset can be converted into the economy’s medium of exchange.

Kinds of Money

a. Commodity money takes the form of a commodity with intrinsic value.

Examples: Gold, silver, cigarettes.
b. Fiat money is used as money because of government decree. It does not have intrinsic value.
Examples: Coins, currency, check deposits.
G7DigiBanc

Measuring Money

Coins, paper currency, demand and other checkable deposits, and traveler’s checks are all forms of
money. Currency consists of coins and/or paper created to facilitate the trade of goods and services and
the payment of debts. These are the paper bills and coins in the hands of the public.

Currency as a legal tender – means coins and paper money officially declared to be acceptable for the
settlement of financial debts. Legal tender is fiat money – a means of exchange that has been established
not by custom and tradition or because of the value of the metal coin but by government declaration.

Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Demand Deposits and other Checkable Deposits.

Most of the money that we use for day-to-day transaction however is not official legal tender. Rather it is
monetary instrument that has become “generally accepted” in exchange over the years, and has now by
custom and tradition, become money. Demand deposits are balances in bank accounts that depositors can
access on demand by simply writing checks. Transactions deposits are deposits that can be easily
converted to currency or used to buy goods and services directly. Traveler’s checks are transaction
instruments easily convertible into currency.

Demand deposits and other checkable deposits have replaced paper and metallic currency as the major
source of money used for larger transactions for several reasons:
a. Ease and safety of transactions
b. Lower transaction costs
c. Provide record of financial transaction

Credit Cards
A credit card is generally acceptable in exchange for goods and services. A credit card payment is
actually a guaranteed loan available on demand to cardholder, which merely defers the cardholder’s
payment for a transaction using a demand deposit.

Savings Account

Non-transaction deposits (they are near money assets but not money itself). Near money means are
transaction deposits that are not money but can be quickly converted into money. They are not
transactions deposit because they cannot be used directly to purchase a good or service and not a direct
medium of exchange. Non-transaction deposits are fund account that cannot be used for payment directly
but must be converted into currency for general use. People use these accounts primarily because they
generally pay higher interest rates than transactions deposits. Types of transactions deposits are: (a)
savings account and time deposits.

Money market mutual funds are interest-earning accounts provided by brokers that pool funds into such
investments as Treasury bills.

Stocks and bonds are not generally considered to be money because (a) it will take few days for you to
receive payment for the sale of stock and (b) the value of the stock fluctuates over time. Liquidity is the
ease with which one asset can be converted into another asset or into goods and services.

The Money Supply

The supply of money maybe viewed in terms of monetary aggregates
M1 – refers to the narrow definition of money which consist of currency in circulation plus demand or
checking deposits (checkable deposits and traveler’s check)
M2 – this refers to M1 + savings and small time deposits + non-institutional money market mutual fund
shares + money market deposit accounts
M3 – refers to money supply, peso savings, time deposits plus deposit substitutes of money-generating
banks and negotiable order withdrawal accounts.
RM – this is the reserve money which represents liabilities of the Bangko Sentral ng Pilipinas (BSP) to
the public sector in the form of currency in circulation and to the banking sector in the form of
cash reserves

Money supply is determined by the behavior of three principal actors:

a) the public affects through their demand for currency and deposits as represented by the currency-
deposit ratio
b) the banks’ behavior maybe represented by the reserve-deposit ratio which refers to coins and
paper bills that are held by banks and those which they deposit to BSP
c) The BSP behavior affects the stock of high powered money or the monetary base and it is through
this that the BSP affects money supply.

How was Money Backed?

Money is Money Backed? No longer backed by gold. The true backing is our faith that others will accept
it from us in exchange for goods and services.

Financial Institutions

The financial or monetary system is a network of markets and institutions that transfer funds from
individuals and groups who save money to individuals and groups who want to borrow money. These
financial institutions consist of banks and non-banks institutions.

Banks are classified as: (a) universal and commercial banks, (b) rural banks, (c) thrift banks which
include savings and mortgage banks, private development banks, microfinance institutions and stock
savings and loan associations.
Examples of non-bank institutions (a) contractual savings institutions such as insurance companies, (b)
investment institutions like mutual funds, (c) securities market institutions comprises of securities brokers
and dealers, (d) credit card companies and (e) pawnshops

Financial or monetary institutions are important in an economy because of the following major functions
or roles:

1. They allocate or channel savings efficiently from savers to borrowers

2. They provide information, liquidity, and risk-sharing services
3. They provide flexibility and divisibility of funds for the users and sources of these funds
4. They are essential for ensuing capital formation and economic growth

The Bangko Sentral ng Pilipinas was established in June 15, 1948 with the following objectives:

a) To maintain the monetary stability in the country

b) To preserve the international value of the peso
c) To promote rising level of production, employment and real income

Financial Institutions

1. Commercial banks – financial institutions organized to handle everyday financial transactions of

businesses and households through demand deposit accounts and savings accounts and by making
short-term commercial and consumer loans

2. Savings and loan associations – financial institutions organized as cooperative associations that hold
demand
deposits and savings of members in the form of dividend-bearing shares and make loans, especially
home mortgage loans.

3. Credit unions – financial cooperatives made up of depositors with a common affiliation.

Reserve Requirements

Banks are required to keep a fraction of their deposits in reserve known as reserve requirement. It is
needed for the control of money supply. It is the quantity of money that the bank is required to deposit
with the Central Bank so that it has minimum levels of reserve for its lending operations. Thus the
banking system can create a larger money supply.

Required reserve ratio is the percentage of deposits that a bank must hold at the reserve bank or Central
Bank. The higher the reserve requirement, the less is the potential amount of new deposit money that can
be generated. Hence, the less is the expansion of money supply.

The money multiplier measures the potential amount of money that the banking system generates with
each amount of money reserve.

New loans mean new money (demand deposits) which can increase spending as well as the money
supply.

Reserved Required Ratio

 Required reserves are the amount of cash or reserves – the percentage of deposits that a bank must
hold at the federal reserve bank or in bank vaults.
 Excess reserves – reserve levels held above that required by the CBP
 Banks make money (profits) by loaning out their deposits at a higher interest rate than they pay their
depositors. However, it is the extension of new loans in search of profits that creates new demand
deposits, thereby increasing the stock of money.
 Is the borrower of money wealthier? No, even though borrowers have more money to buy goods and
services, they are not any richer, because the new liability, the loan has to be repaid.

The Money Multiplier

Money multiplier measures the potential amount of money that the banking system generates with each
peso reserves. The multiplier effect is a chain reaction of additional income and purchases that results in a
final increase in total purchases that is greater than the initial increase in purchases.

Potential money creation = initial deposit x money multiplier

The banking system as a whole can potentially create money equal to several times the amount of total
reserves or new money equal to several times the amount of excess reserves; the exact amount maybe
determined by the money multiplier, which is equal to 1 divided by the reserve requirement (1/R). The
larger the reserve requirement, the smaller the money multiplier.

Potential money creation because some banks could choose not to lend all their excess reserves but may
keep some extra newly acquired cash assets in that form. Moreover, some borrowers may not spend all
their newly acquired bank deposits or they may wait for a considerable period before doing so.

The volume of money and the volume of bank loans both increase or decrease at the same time because
issuing new bank loans adds to the money supply, while calling in existing bank loans reduces the money
supply.

Each bank involved in the process of multiple expansions of the money supply can lend up to the amount
of its excess reserves. But the excess reserves created by each peso deposited in a bank equals 1 minus the
required ratio. The lower this reserve requirement, the greater the excess reserves created by each new
deposit that will be loaned out in this process.

The Demand for Money

Three motives for holding money

a) Transactions motive refers to the holding of money to enable people and firms to pay off their
daily transactions
b) Precautionary motive for holding money arises because household and firms cannot predict
exactly their level of expenditures per unit time and the inflows of income as well. For
contingency purposes or unforeseen circumstances
c) Speculative or portfolio allocation motive refers to the holding of money for the purpose of taking
advantage of market opportunities

Monetary Policy

The following are the instruments the BSP uses to control money supply in order to maintain price
stability and the convertibility of the currency. If there is too much money held by households and firms,
then this can result in overspending and if manufacturers of goods and services cannot catch up with the
increase in consumption, inflation can occur. If too little money circulating, then unemployment of
resources can occur because will not be receiving as much revenues to pay off their cost of production.
The important instruments of monetary control used by BSP include:

1. Reserve requirement – the percentage of deposits that banks are mandated to keep in their vaults
for safekeeping required by BSP. BSP mandates all banks to keep a certain percentage of their
deposits as reserves for the purpose of servicing day-to-day withdrawals and unexpected heavy
withdrawals during bank runs or in times of other emergencies. It decreases reserve requirement
if it wants to increase money supply in circulation.
Banks may deem it necessary to keep in their vaults an additional percentage of their deposits in
addition to the required reserve requirement. This is called excess reserve.

2. Rediscount rate – is the interest charge by the BSP to banks who wish to borrow from it. To
contract money supply using this instrument, the BSP has to increase the rediscount rate to
discourage banks from borrowing at higher interest rates. As an expansionary monetary policy,
the BSP must decrease the rediscount rate

3. Open market operations, refers to the buying and selling of government securities by the BSP.
Open market purchase means buying of government securities (e.g. bonds) from private
individuals or firms by BSP. Open market sale refers to the sale of government securities to
private individuals or firms by BSP. If BSP wants to contract money supply, it has to engage in
open market sale of government securities. In this way, the BSP sells the securities to the public
and “gets” the money in return. Hence, lesser money will be circulating in the economy because
people are holding bonds instead of cash. On the other hand, if BSP wants to expand money
supply, it has to engage in open market purchase.

If the Fed wants to stimulate the economy (increase aggregate demand) it will increase the money
supply by buying government bonds, lowering the reserve ratio, and/or lowering the discount
rate. If the Fed wants to restrain the economy (decrease aggregate demand) it will lower the
money supply by selling government bonds, increasing the reserve ratio and/or raising the
discount rate.

The Federal Reserve System

The Federal Reserve (Fed) serves as the nation’s central bank.

• It is designed to oversee the banking system.
• It regulates the quantity of money in the economy.

Banks can influence the quantity of demand deposits in the economy and the money supply.

Money Creation with Required Reserve

• When a bank makes a loan from its reserves, the money supply increases.
• The money supply is affected by the amount deposited in banks and the amount that banks loan.
• Deposits into a bank are recorded as both assets and liabilities.
• The fraction of total deposits that a bank has to keep as reserves is called the
reserve ratio.
• Loans become an asset to the bank.
• When one bank loans money, that money is generally deposited into another bank.
• This creates more deposits and more reserves to be lent out.
• When a bank makes a loan from its reserves, the money supply increases.

Money, Interest Rates and Aggregate Demand

The Money Market

The money market is the market where money demand and money supply determine the equilibrium
nominal interest rate. When the Fed acts to change the money supply by changing one of its policy
variables, it alters the money market equilibrium.

People hold money because of transactions demand, precautionary demand and asset demand for money.
For asset demand, people prefer assets that are more liquid to those that are less liquid.

The Demand for Money and the Nominal Interest Rate

 The quantity of money demanded varies inversely with interest rates (a movement along the money
demand curve) and directly with income (a shift of the money demand curve). Monetary policies that
increase the supply of money will lower interest rates in the short run, other things being equal.
 When interest rates are higher, the opportunity cost – in terms of the interest income on alternative
assets – of holding monetary assets is higher, and persons will want to hold less money.
 The demand for money depends on the price level. If the price level increases, buyers will need more
money to purchase their goods and services and vice versa.
 An increase in the level of income will increase the amount of money that people want to hold for
transaction purposes for any given interest rate; the demand for money therefore shifts to the right.
The money demand curve slopes downward because at the lower interest rate, the opportunity cost of
holding money is lower.

The Supply of Money

 The money supply is effectively almost perfectly inelastic with respect to interest rates over their
plausible range, as controlled by Federal Reserve policies.

Money Market Equilibrium

 Money market equilibrium occurs at the intersection of the money demand and money supply curves.
At the equilibrium nominal interest rate, the quantity of money demanded equals the quantity of
money supplied.

 Money market and aggregate demand curve. When the price level increase, people desire to hold
more money – an increase in the demand for money. The increase in the demand for money causes
the interest rate to rise. The increase in interest leads to a reduction in RGDP demanded.

 An increase in the money supply causes interest rate to fall in the short run. At lower interest rates,
households and businesses invest more and buy more goods and services, shifting the aggregate
demand curve to the right.

 When the demand curve for money shifts outward, the FED must settle for either a higher interest
rate, a greater money supply or some combination of both. The Fed cannot completely control both
the growth in the money supply and the interest rate. If it attempts to keep the interest rate steady, it
must increase the growth in the money supply. If it tries to keep the growth of money supply in
check, the interest rate will rise.

 The problem with targeting the money supply is that the demand for money fluctuates considerably in
the short run – and this leads to large fluctuations in interest rates. Keeping interest rates in check
 also creates problem. Expanding the money supply during a boom eventually leads to inflation, and
contracting the money supply during a recession makes the recession even worse.

Expansionary and Contractionary Monetary Policy

 An expansionary monetary policy at less than full employment can cause an increase in real GDP and
price level. An expansionary monetary policy at full employment can temporarily increase real GDP,
but in the long run only the price level will increase.
 If in combating a recessionary gap,, it can increase the money supply, which lead to an shift in
aggregate demand. The result is greater RGDP of a higher price level. The expansionary monetary
policy has moved the economy to the natural rate (where RGDP = potential GDP).
 The Fed can engage in contractionary monetary policy if the economy faces an inflationary gap. It
can decrease in money supply, which would lead to a shft to left of the AD curve. The result is a
lower price level and the economy moves to the natural rate.

Money and Inflation

The amount of money in circulation and the overall price level are closely linked. The inflation rate tends
to be greater in periods of rapid monetary expansion than in periods of slower growth in the money
supply.

The equation of exchange (quantity equation) – shows the relationship between money and the price level

MxV=PxQ
where M – money supply (usually M1 or M2)
V – velocity of money
P – price level
Q – real output (RGDP)

Velocity of money – a measure of how frequently money is turned over or the intensity with which
money is used.
 The faster money circulates, the higher the velocity. Velocity is defined as the nominal or current
value of output divided by money supply
 V = Nominal GDP/M

Quantity theory of money and prices – a theory of the connection between the money supply and the price
level when the velocity of money is constant

Growth rate of the money supply growth rate of the price level (inflation rate)
+ growth rate of velocity = + growth rate of real output

Example: if money growth is 5%/year, growth of real output is 3%/yr and velocity has not changed at all
(0%), then the growth rate of prices (inflation rate is 2%. If velocity remains constant, then the growth
rate of velocity (the %age change from one year to the next) will be zero. Then

Inflation rate=growth rate of the money supply−growth rate of real GDP

In this, three possible scenarios:

a. If money supply grows faster rate than real GDP, then there will be inflation
b. If money supply grows at a slower rate than real GDP, then there will be deflation
c. If money supply grows at the same rate as real GDP{, the price level will be stable.

Hyperinflation. The relationship between the growth rate of the money supply and the inflation rate is
particularly strong when there is very rapid inflation, called hyperinflation

Monetary policy faces somewhat different implementation problems from those faced by fiscal policy.
Both face difficult forecasting and lag problems; however, the Fed can take action much more quickly.
But its effectiveness depends largely on the reaction of the private banking system to its policy changes
and its intended effects can be offset by global and nonbank financial institutions, over which the Fed
lacks jurisdiction.

Policy Mix

The question of the monetary-fiscal policy mix arise because:

a. Expansionary monetary policy reduces the interest rate while expansionary fiscal policy increases the
interest rate
b. Expansionary fiscal policy increases output while reducing level of investment expansionary
monetary policy increases output and the level of investment.

The Phillips Curve

The inverse relationship between the rate of unemployment and the changing level of prices has been
observe d in many periods. This relationship is credited to economist A.H. Phillips in 1950 published a
paper what has since been called the Phillips curve. The Phillips curve relationship can also be seen
indirectly from AD/AS model. At higher rates of inflation, the rate of unemployment is lower, while
during periods of relatively stable or falling prices, unemployment is substantial. In short, the cost of
lower unemployment appears to be greater inflation, and the cost of greater price stability appears to be
higher unemployment.

The Growth and World Trade

Voluntary trade occurs because the participants feel that they are better off as a result of the trade.
A nation, geographic area, or even a person can gain from trade if the good or service is produced
relatively cheaper than anyone else can produce it. That is, an area should specialize in producing and
selling those items that it can produce at a lower opportunity cost than others. Comparative advantage
occurs when a person or country can produce a good or service at a lower opportunity cost than others

However, to achieve any of the gains from comparative advantage and specialization, there must be trade.
Through trade and specialization in products in which it has a comparative advantage, a country can enjoy
a great array of goods and services at a lower cost.

Consumer surplus – is the difference between the price a consumer is willing and able to pay forfor an
additional unit of a good and the price the consumer actually pays; for the whole market, it is the sum of
all the individual consumer surpluses – the area below the market demand curve and above the market
price..

Producer surplus – the difference between what a producer is paid for a good and the cost of producing
that unit of the good; for the market, it is the sum of all the individual sellers’ producer surpluses – the
area above the supply curve and below the market price.
The total gain to the economy from trade is the sum of the consumer surplus and the producer surplus.
That is, consumers benefit from additional amounts of consumer surplus and producers benefit from
additional amounts of producer surplus.

With free trade and exports, domestic producers gain more than domestic consumers lose
With free trade and imports, domestic consumers gain more domestic producers lose.

The Balance of Payments

 Balance of payments – the record of international transactions in which a nation has engaged over a
year
 The BOP is made up of the current account and the capital account, as well as an “error term” called
the statistical discrepancy.
 Current account – record of a country’s imports and exports of goods and services, net investment
income, and net transfers.
 Capital account – records the foreign purchases or assets in the domestic economy (a monetary
inflow) and domestic purchases of assets abroad (a monetary outflow)
 The balance of trade refers strictly to the import and export of goods (merchandise) from/to other
nations. If our imports of foreign goods are greater than our exports, we are said to have a balance-of-
trade deficit.

Exchange Rates

 Exchange rate – the price of one unit of a country’s currency in terms of another country’s currency.
 The exchange rate for a currency is determined by the supply of and demand for that currency in the
foreign exchange market
 If the dollar appreciates in value relative to foreign currencies, foreign goods become more
inexpensive in the U.S. consumers, increasing US demand for foreign goods.
 The demand for foreign currencies is known as a derived demand because the demand for a foreign
currency derives directly from demand for foreign goods and services or for foreign investment.
 It is the supply of and demand for a foreign currency that determine the equilibrium price (exchange
rate) of that currency.