Chapter 1 – Introduction to Macroeconomics

Long-Run Economic Growth – difference between developed and developing nations

Average labor productivity – the amount of output produced per unit of labor input
 because today’s typical worker is so much more productive (while working less hours), Americans
enjoy significantly higher standard of living.

Business Cycles: short-run, but sometimes sharp, contractions and expansions in economic activity

Recessions are usually accompanied by an increase in unemployment.

 Unemployment rate = # unemployed / total labor force
 Can remain high, even when economy is doing well

Inflation: prices of goods and services are rising over time (inflation rate = % increase in average level of
prices over some period)
 Extremely high inflation rate (hyperinflation), economy tends to function poorly

Open economy: on that has extensive trading and financial relationships with others

When exports exceed imports, a trade surplus exists (the US, pre-1980).

Macroeconomic policy:
 Fiscal policy: determined at state level, concerning spending and taxation
 Monetary policy: determines rate if growth nation’s money supply (Central Bank)

Aggregation: process of summing individual economic variables to obtain economy-wide totals

What do macroeconomists do? Forecasting, analysis, research, theory,

Two schools of thought..

(1) The Classical Approach: if there are free markets and individuals conduct economic affairs in
their own best interests (“invisible hand”), the overall economy will work well.
 Assumption: wage and price flexibility; no intervention (min wage)
(2) The Keynesian Approach: slow wage and price adjustment meant that quantities demanded
might not equal quantities supplied for long periods. More in favor government role.

Stagflation: high unemployment + high inflation (1970s US)

Chapter 2 – The Measurement and Structure of the National Economy
The national income accounts are an accounting framework used in measuring current economic
activity.

3 different measures (same result):

(1) Product approach: amount of output produced (excluding intermediate stages)

(2) Income approach: amount of income received by producers

(3) Expenditure approach: amount of spending by ultimate purchasers

***all 3 give identical measurements of amount of current economic activity

Total production = total income = total expenditure (called the “fundamental identity of national income
accounting)

Gross domestic product (GDP) = market value of final goods and services newly produced within period

- Homemaking and child-rearing services without pay are not included in GDP.
- N offsetting deduction to account for the fact that nonrenewable resources are being depleted.
 National income accounts attach no explicit value to a clean river.
- Underground economy: includes both legal, hidden activities and illegal (both included in GDP)
- GDP includes only goods and services that are newly produced within current period

Intermediate goods and services: those used up in production of other goods and services in the same
period that they themselves were produced (e.g., flour produced to make bread in same year)

Final goods and services: end products of a process (… the bread)

Capital good: a good that is itself produced and is used to produce other goods (unlike intermediate
good, capital good is not used in the same period that it is produced)

Inventory: inventory investment is treated as a final good and thus part of GDP because increased
inventories on hand imply greater productive capacity in future.

Gross National Product (GNP) = market value of final goods and services newly produced by domestic
factors of production during the current period, whereas GDP is production taking place within a
country.  GDP = GNP – NFP (net factor payments from abroad)
4 major categories of spending are added to get GDP (Y), known as “income expenditure identity”:
(1) Consumption (C)
a. Spending by domestic households (including abroad)
(2) Investment (I)
a. New capital goods + increases in firms’ inventory holdings
(3) Government purchases (G)
a. Recently have been about 1/6th of GDP in the US
(4) Net exports of goods and services (NX)
a. Exports minus imports
Statistical discrepancy: arises because data on income are compiled from different sources than data on
production. National income + statistical discrepancy = Net National Product (NNP)

Private disposable income = Y + NFP + TR (transfers received by govt.) + INT (Govt debt interest) + T
(taxes)

Net government income = T – TR – INT

Nominal variables: all those measured in terms of current market value  problematic if comparing two
different points in time…

Real GDP = physical volume of an economy’s final production using the prices of a base year.

Real vs. Nominal GDP 

Price Index = a measure of the average level of prices for some specified set of goods and services,
relative to the prices in a specified base year.

Consumer Price Index (CPI) = measures prices of consumer goods (available monthly)

Inflation = percentage rate of increase in the price index per period

Interest Rates

An interest rate is a rate of return promised by a borrower to a lender (there are many different ones)

- Real interest rate = rate at which the real value (or purchasing power) of the asset increases over time
- Nominal interest rate = rate at which nominal value of an asset increases over time

Real Interest Rate = Nominal Interest Rate – Inflation Rate

[Expected Real Interest Rate = Nominal Interest Rate – Expected Rate of Inflation]
** This is the correct interest rate to use for studying most economic decisions
Lecture #3 – Production and Employment

• General: Y = A  F(K, N)
• Cobb-Douglas Production Function
• Y = A K0.3 N0.7
• Observe data on Y, K, N
• Compute A
•
Y
Total Factor Productivity = A =
K N 0.7
0.3

N.B. This formula describes the measurement of A; it is not a definition of A.

If K/N increases, then Y/N will increase if A is constant.

Real Wage Rate

• W = nominal wage rate ($15/hour)

• P = price level ($3/good)
 w = W / P = real wage rate
o $15 / $3 = 5 goods per hour

• Labor Supply Curve

• Factors that Shift the Labor Supply Curve
• Wealth
• Expected future real wage
• Aggregate Labor Supply Curve
• Intensive Margin: people change number of hours supplied
• Extensive Margin: change in number of people in labor force
• Population
• Participation rate
Full Employment

Labor Market Equilibrium  Ȳ = AF ( K , N̄ )

• Production Function: Y = 900K0.5N0.5

• K = 100
• Marginal Product of Labor: MPN = 450K0.5N -0.5
• Labor Supply: NS = 25w2
• Solution:
• MPN = 4500N -0.5
• Substitute MPN for w in labor supply curve
• N = NS = 25(4500N -0.5)2 = 25(4500)2N –1
• N2 = 25(4500)2 which implies N = 5(4500) = 22500
• Check: MPN = 4500N -0.5 = 4500/150 = 30; when w = 30, NS = 25(30)2 = 22500
• Y = 900(100)0.5(22500)0.5 = 900(10)(150) = 1,350,000

In full-employment, the equilibrium real wage equals MPN

Wage /Hr Wage

Unit Labor Costs  ULC= =
Unit of Output /Hr Unit of Output

Adverse Productivity Shock Shifts of the Labor Demand Curve

Taxes and
Labor
Demand
 • No Taxes Levied on Firm
• MPN = w
• Tax on Firm Revenue (expenses not deductible)
• (1-t)(MPN) = w
• Tax on Profits
• (1-t)(MPN) = (1-t)w, so MPN = w

Effect of Temporary Adverse Productivity Shock on Labor Market Equilibrium

Adverse Productivity Shock (A Falls)
• Labor demand curve shifts downward
• Real wage falls
• Ń falls
• Ý = AF ( K , N ) falls because Ń falls and A falls
• Ý falls by a greater percentage than A falls

Lecture #4 – Labor Supply & Unemployment

 • Price of Leisure = Real Wage
• Pure Income Effect: A Gift
o Labor supply decreases
• Pure Substitution Effect: One-Day Increase in Real Wage
o Labor supply increases

Increase in Real Wage

• Temporary Increase
• Weak income effect
• Substitution effect dominates income effect
• Labor supply increases
• Permanent Increase
• Strong income effect
• If income effect dominates substitution effect, then labor supply decreases

Empirical Impact of Increase in Real Wage on Labor Supply…

Employed

• Employed if Worked:
• At all as a paid employee
• In own business or own farm
• 15 hours or more in family-owned enterprise
• Employed if did not work but …
• had job or business from which temporarily absent due to illness, bad weather,
vacation, childcare problems, labor dispute, maternity/paternity leave, or other family
or personal obligations
• Not counted as employed if:
• Only work was work around the home
• Volunteer work for religious and charitable organizations

Unemployed if meet all three criteria

1. Not employed during reference week
2. Was available for work, except for temporary illness
3. Made specific efforts to find employment sometime during 4-week period
Okun’s Law: Output and Unemployment

Ȳ −Y
• Level Form  =2 ( u−ū )
Ȳ
ΔY Δ Ȳ
• Growth Rate Form  = −2 Δu
Y Ȳ
ΔY
• Average growth rate of = 3% per year  =3−2 Δu
Y

One version of Okun's law has stated very simply that when unemployment falls by 1%, gross national
product (GNP) rises by 3%. Another version of Okun's law focuses on a relationship between
unemployment and GDP, whereby a percentage increase in unemployment causes a 2% fall in GDP.
Lecture #5 – Consumption and Saving: Basic Analytics

Budget Constraint

cf = (a + y  c)(1+r) + yf

• c = consumption in current period

• cf = consumption in future period
• a = assets at beginning of current period
• y = after-tax labor income in current period
• yf = after-tax labor income in future period
• r = real after-tax rate of return on assets carried from current period to future period

• present value of lifetime consumption = present value of lifetime resources

PVLC = c + cf / (1+r) = a + y + yf / (1+r) = PVLR

Optimal Consumption/Saving
 Saving = Income – Consumption  s = y – c

Summary of Income Effects

Slope of Indifference Curve (with no impatience)

Slope = – (c f /c)1/s

σ = intertemporal elasticity of substitution

• Slope of indifference curve = – (1+r)(c f /c)1/σ

• Find point such that slope of indifference curve = slope of budget line
• (1+r)(c f /c)1/σ = 1+r, so c f /c = [(1+r)/(1+r)]σ
• c f = [(1+r)/(1+r)]σ c (*)
• From budget constraint, c + c /(1+r) = PVLR
f

• Use (*) to obtain c + (1+r)σ -1(1+r)-σc = PVLR

• Therefore, [1 + (1+r)σ -1 (1+r)-σ]c = PVLR
c = PVLR/ [1 + (1+r)σ -1 (1+r)-σ]
• Perfect consumption smoother (s = 0):
 • c = PVLR/ [1 + (1+r)-1] = [(1+r)/(2+r)]PVLR

Example: Role of Time Preference

• a = 20, y = 130, y f = 66, r = 0.1, σ = 2

• Recall: c = PVLR/ [1 + (1+r)σ -1 (1+r)-σ]
• PVLR = 20 + 130 + 66/1.1 = 210
• Case I: r = 0
• c = 210/ [1 + (1+0.1)(1+0)-2] = 210/2.1 = 100
• s = y – c = 130 – 100 = 30
• cf = (a+s)(1+r) + yf = (20+30)(1.1) + 66 = 121
• Slope of IC = -(1+0)(121/100)1/2 = - 1.1
• Case II: r = 0.1
• c = 210/ [1 + (1+0.1)(1+0.1)-2] = 210/[1 + 1/1.1] = 210/[2.1/1.1] = 110
• s = y – c = 130 – 110 = 20
• cf = (a+s)(1+r) = (20+20)(1.1) + 66 = 110
• Slope of IC = -(1+0.1)(110/110)1/2 = - 1.1

real after-tax interest rate = (1-tax rate on interest) x nominal interest rate - inflation rate
Lecture #6 – Consumption and Saving: Applications of the Basic Analytic Framework

Effect of Real Interest Rate on Budget Line

• Increase in the real interest rate

• Budget line rotates clockwise (becomes steeper)
• …through No-Borrowing-No-Lending point

• Income Effect
• Lender: consumption increases, saving falls
• Borrower: consumption falls, saving increases
• Pure Substitution Effect
• Consumption falls, saving increases

EXAMPE  y f = 0 so consumer is a net lender

• Income effect: increase in r increases c

• PVLR = a + y + yf/(1+r) is independent of r
• With r = 0, c = PVLR/ [1 + (1+r)σ -1 ]
• Case I: σ = 0 (no substitution effect)
• c = PVLR/ [1 + (1+r)-1 ]
• Increase in r increases c, reduces saving
• Income effect dominates substitution effect
• Case II: σ = 1
• c = PVLR/ 2
• Increase in r has no effect on c or saving
• Income and substitution effects offset each other
• Case III: σ = 2
• c = PVLR/ [1 + (1+r) ]
• Increase in r reduces c, increases saving
• Substitution effect dominates income effect

Effect of Increase in Interest Rate 

 • Sensitivity of Consumption to Income
ΔC
• Marginal Propensity to Consume: MPC=
ΔY

• Excess Sensitivity of Consumption to Income

• Actual MPC is higher than predicted by model
• Borrowing Constraints
• Contribute to excess sensitivity of consumption to income

Ricardian Equivalence

The Ricardian equivalence is an economic hypothesis holding that consumers are forward looking and
so internalize the government's budget constraint when making their consumption decisions.

This means that attempts to stimulate an economy by increasing debt-financed government spending
will not be effective because investors and consumers understand that the debt will eventually have to
be paid for in the form of future taxes.

The theory argues that people will save based on their expectation of increased future taxes to be
levied in order to pay off the debt, and that this will offset the increase in aggregate demand from the
increased government spending.

This implies that Keynesian fiscal policy will be ineffective at boosting economic output and growth.

• Current period
• Cut current taxes by $100
• Issue $100 of bonds
• Future period
• Repay bonds with interest: $100(1+r)
• Increase taxes by $100(1+r)
• Effect on PVLR:
$ 100 (1+ r )
• + $ 100− =0
1+r
Lecture #7– Capital Investment

User Cost of Capital: An Example

• Relevant Information About Machine

• Current price of new machine: pK = $100
• Price of one-year-old machine next year = $85
• Interest rate, r = 8% per year
• Cost of Using Machine for One Year
• Depreciation: $100 – $85 = $15 per unit of capital per year
• Depreciation rate, d = 15% per year
• Interest cost: 8% of $100 = $8 per unit of capital per year
• Total Cost = $23 per unit of capital per year

General Formula: uc = (r + d)pK

Components of Depreciation

• Depreciation of capital
• Physical depreciation at rate dpK
• Decrease in real price of new capital
−∆ p K
• −∆ p K = pK
pK
∆ pK
• (
Depreciation d p K = δ −
pK )
pK

• Additional component of depreciation

• Spread between purchase and sale price (costly reversibility)
• Increases user cost of capital

• Current price of capital, pK = $100

• Physical depreciation, d = 20% per year
−Δ p K
• Decrease in real price of new capital, =¿5% per year
pK
∆ pK
•
(
Depreciation d p K = δ −
pK ) pK

• d p K =( 20 %+ 5 % ) $ 100per year = $25 per year

One-Time vs. Ongoing Decrease in pK

The Desired Capital Stock

• It (Investment at time, t) = K* – (1 – d)Kt

• Lags and Investment
• Anything that increases K* also increases investment

Effect of Decrease in User Cost of Capital

Effect of Increase in Expected Future TFP

Capital Income Taxes

• (1 – t) MPKf = (r + d)pK
( r +d ) p K
• MP K f =
1−τ
( r +d ) p K
• Tax-adjusted user cost:
1−τ
 • Effective Tax Rate on Capital

 Taxable capital income = gross capital income minus capital investment

Positive Tax Revenue with Zero Effective Tax Rate on Capital

Effect of Increase in Effective Tax Rate on Capital

Tobin’s Q

V
• Definition: Q ≡
pK K
• V is market value of firm
• pKK is replacement cost of firm’s capital stock
• Investment is an increasing function of Q

Fundamental Value of a Firm

 MPK × K
V=
r −gV

Factors Affecting Investment via Tobin’s Q

MPK increases
• Q increases, so I increases
r increases
• Q decreases, so I decreases
gV increases
• Q increases, so I increases
pK increases
• Q decreases, so I decreases

Lecture #8 – National Saving and Investment

• Private Saving (Sprivate)

• Disposable income – consumption
• (Y + NFP + TR + INT – T ) – C
• Government Saving (Sgovernment)
• Government sector income – G
• (T – TR – INT ) – G
• National Saving (S)
S = Sprivate + Sgovernment = Y + NFP – C – G
S = (C+I+G+NX) + NFP – C – G = I + NX +NFP
S = I + CA

Uses of Private Saving

National Saving: S = I + CA
Private Saving: Sprivate = S – Sgovernment
• Sprivate = I + CA + (– Sgovernment)
• Capital formation (I)
• Acquisition of net foreign assets (CA)
• Acquisition of government debt (–Sgovernment)
Stocks and Flows: Wealth and Saving

• Balance Sheet (stock): National Wealth

Capital stock
Net foreign assets
• Income Statement (flow): National Saving
Capital formation (I)
Acquisition of net foreign assets (CA)

Effects of Fiscal Policy on Private Saving and Government Saving

Impact on Saving
∆S = ∆Y – ∆C – ∆G = (∆Y – ∆T – ∆C) + (∆T – ∆G)
∆Spvt = ∆Y – ∆T – ∆C
∆Sgovt = ∆T – ∆G
∆S = ∆Spvt + ∆Sgovt
Government Budget Constraint
PVT = PVG + Current Debt, where
PVT = present value of T
PVG = present value of G

• Ricardian Consumer
• ∆C = 0.4 x ∆PVLR
• Non-Ricardian Consumer
• Binding borrowing constraint so ∆C = ∆Y – ∆T
• Assume ∆Y = 0 (Y remains at its FE level)
• ∆S = – ∆C – ∆G
• ∆Spvt = – ∆T – ∆C
• ∆Sgovt = ∆T – ∆G
• ∆S = ∆Spvt + ∆Sgovt

Goods Market Equilibrium in a Closed Economy

• Alternative Forms of Equilibrium Condition

• Output = Aggregate Demand for Goods
Y = C d + Id + G
• Desired Saving = Desired Investment
Sd = Y – C d – G = I d

Saving-Investment Diagram
Effect of Current Income Effect of Wealth

More
examples…
Lecture #9 – A Framework for the Open Economy

The Current Account

• Net Exports of Goods and Services (NX)

• Net (Primary) Income from Abroad
(virtually equivalent to NFP)
• Net Unilateral Transfers (NUT)
(secondary income)
CA = NX + NFP + NUT

The Financial Account

International Flows of Assets

- Financial Account Balance (FA)
o Financial Inflows
 Sales of U.S. assets to foreigners
o minus Financial Outflows
 Purchases of foreign assets by U.S. residents
o plus Net Inflows from net sales of financial derivatives
Current Account + Financial Account = 0

Acquisition of Net Foreign Assets

Two Equivalent Measures

- Financial account deficit (–FA)
- Current account surplus (CA)

Is the United States the World’s Largest Debtor?

Goods Market Equilibrium in an Open Economy

• Two Alternative Equivalent Conditions (assume NFP = NUT = 0)

• NX = Y – (Cd + Id + G)
= output – desired absorption

• NX = (Y – Cd – G) – Id
= Sd – Id

…if absorption is higher than GDP, country has CA deficit

Lecture #10 – Saving, Investment, and the Current Account

Small Open Economy

• Real Interest Rate Fixed at r = rw

• NX = CA = Sd – Id
(assume NFP = NUT = 0, so NX = CA)
• Temporary Adverse Productivity Shock

(1) Saving falls

(2) Investment unchanged
(3) CA falls

Example: Oil Discovery

Increase in MPKf and in Future Output

(1) Investment increases

(2) Saving falls
(3) CA falls
Large Open Economies

• Determination of World Real Interest Rate

• World supply of goods = World demand for goods
• Y + YFor = Cd + Id + G + CdFor + IdFor + GFor
• World saving = World investment
• (Y – Cd – G) + (YFor – CdFor – GFor)= Id + IdFor
• Sd + SdFor = Id + IdFor
• Desired int’l borrowing = Desired int’l lending
• (Sd – Id) + (SdFor – IdFor) = 0
• CA + CAFor = 0

Equilibrium World Real Interest Rate

EXAMPLE: German Reunification

• Increase in G
• S curve shifts to left
• Increase in MPKf
• I curve shifts to right
• Implications
• Real interest rate increases
• German CA balance falls

Fiscal Policy and the Current Account

• Critical Factor: Effect on National Saving

• CA = (Y – Cd – G) – Id
(assume NFP = NUT = 0)

Government Budget Deficit and Current Account Deficit

  Budget Deficit Due to Increase in G
o Saving falls and CA falls
 Budget Deficit Due to Decrease in T
o if Cd rises, saving falls and CA falls
o if Cd unchanged (Ricardian Equivalence), Cd and CA unchanged

Twin Deficits

• Government Budget Deficit and CA Deficit

• U.S. experience
• Early 1980s: supports twin deficits
• Federal tax rebate, 1975: contrary to twin deficits
• 1990s: contrary to twin deficits
• Experience of other countries
• Germany: increased CA deficit and budget deficit
• Canada, Italy mid 1980s large budget deficits without severe CA deficits

Lecture #11 – Asset Markets, Money, and Prices

Functions of Money

(1) Medium of exchange (Avoids need for “double coincidence of wants”)

(2) Store of value
(3) Unit of account
Money Supply

Controlled by Central Bank (Fed)

• Open-market operations
• Open-market purchase
• Increases money supply
• Open-market sale
• Decreases money supply

Portfolio Allocation

• Characteristics of Assets
• Expected return
• Risk
• Liquidity
• Asset Demands
• Desire high expected return, low risk, high liquidity
• Asset demands sum to total wealth

Major Factors that Affect the Nominal Demand for Money

• Price Level
• Money demand is proportional to price level
• Real Income
• Higher real income increases money demand less than proportionally
• Interest Rates
• Higher interest rate on non-monetary assets reduces money demand
 • BUT, higher interest rate on money increases money demand)

Opportunity Cost of Holding Money

Money Demand Function

• Nominal Demand for Money

• M d =P× L ( Y , r + π e )
• Real Demand for Money
Md e
• =L ( Y ,r + π )
P
• Example
Md 0.67 e −0.1
• =h Y ( r + π )
P

Elasticities of Money Demand

• Income Elasticity of Money Demand, hY

• Positive
• Less than one
• Interest Elasticity of Money Demand, hi
• Negative
• Small
Md 0.67 e −0.1
• Example: =h Y ( r + π )
P
• hY = 0.67
• hi = -0.1

Other Factors that Affect the Demand for Money

• Wealth
• Risk
• Liquidity of Alternative Assets
• Payment Technologies
Velocity of Money

• Ratio of GDP to Money Supply

• Number of times per year a dollar is used to buy part of GDP
PY Y Y
• V≡ = =
M M /P L ( Y ,i )

Asset Market Equilibrium

• Asset Demands
• Md + Bd = Aggregate Nominal Wealth
• Asset Supplies
• M + B = Aggregate Nominal Wealth
• (Md – M) + (Bd – B) = 0
M
• Asset Market Equilibrium Condition: =L ( Y , r + π e )
P

Equilibrium Price Level

M
P=
L ( Y ,r + π e )

M
• Equivalently, P=
L (Y , i )

• P is Proportional to M, given Y and i

Money Growth and Inflation

ΔP ΔM ΔL ( Y , i )
π≡ = −
P M L( Y , i )

Long Run
• Constant money growth
• Constant nominal interest rate
ΔM ΔY
π= −ηY
M Y

M1 and M2
M1 = coins and currency in circulation + checkable (demand) deposit + traveler's checks. M2 = M1 +
savings deposits + money market funds + certificates of deposit + other time deposits.