Macro 2 - 2021-22 - BUH - English

TRƯỜNG ĐẠI HỌC NGÂN HÀNG TP.
HỒ CHÍ MINH
KHOA KINH TẾ QUỐC TẾ
BỘ MÔN KINH TẾ ỨNG DỤNG
BÀI GIẢNG
KINH TẾ HỌC VĨ MÔ 2
(MACROECONOMICS 2)
HỌC KỲ 2 NĂM HỌC 2021-2022
Giảng viên: Ths.Trần Mạnh Kiên
1
ĐỀ CƯƠNG MÔN HỌC
KINH TẾ VĨ MÔ 2
HỌC KỲ 2 NĂM HỌC 2021-2022
1. Mã số môn học
2. Tổng số tín chỉ: 3
3. Điều kiện tham dự: Không cần
4. Giảng viên: ThS. Trần Mạnh Kiên;
- Email: kientm@buh.edu.vn
- Facebook: http://www.facebook.com/kienkinhte (trên FB hàng ngày có link các bài báo, các bạn nên nhấn Theo dõi để đọc. Sinh
viên cần trao đổi nên inbox trên FB cho tiện)
5. Giới thiệu môn học
Môn học giới thiệu những nét tổng quát về kinh tế vĩ mô; nội dung và ý nghĩa của các biến số kinh tế vĩ mô; những khái niệm kinh
tế vĩ mô cơ bản như lạm phát, thất nghiệp, tăng trưởng kinh tế và một số vấn đề khác có liên quan. Môn học cũng giới thiệu một số mô hình
căn bản và các chính sách kinh tế vĩ mô như chính sách tài khóa, chính sách tiền tệ…
6. Mục tiêu của môn học
Giúp sinh viên hiểu những mô hình nâng cao về kinh tế vĩ mô để hiểu sâu hơn cách thức cách thức vận hành của nền kinh tế và các
chính sách kinh tế vĩ mô của chính phủ.
Nâng cao tư duy phê phán (critical thinking), cởi mở trong lĩnh vực kinh tế thông qua việc tìm hiểu các lý thuyết kinh tế khác nhau.
2
7. Đề cương tổng quát
Chương 1: Giới thiệu
Chương 2: Số liệu kinh tế vĩ mô nâng cao
Chương 3: Thu nhập quốc dân
Chương 4: Tiền tệ và lạm phát
Chương 5: Nền kinh tế mở
Chương 6: Tăng trưởng kinh tế
Chương 7: Mô hình IS-LM
Chương 8: Mô hình Tổng cung-Tổng cầu 2
Chương 9: Nền kinh tế mở trong ngắn hạn
Chương 10: Một số cuộc tranh luận trong kinh tế vĩ mô
8. Tài liệu tham khảo
[1]. Tài liệu bắt buộc: Bài giảng kinh tế vĩ mô. Nguyễn Văn Ngọc. Dịch từ quyển Macroeconomics. Mankiw, N.Gregory (2002).
[2]. Tài liệu đọc thêm:
9. Đánh giá
- Chuyên cần (10% điểm)
- Tiểu luận cá nhân (20% điểm)
- Tiểu luận nhóm (20%)
- Thi cuối kỳ (50% điểm). Trắc nghiệm và tự luận. Được sử dụng tài liệu
3
2/14/2022
Important issues in macroeconomics Part 1

Macroeconomics
N. Gregory Mankiw
Macroeconomics - the study of the economy as a
whole - addresses many topical issues, such as:
• What causes recessions? What is “government
stimulus,” and why might it help?
• How can problems in the housing market spread
The Science of to the rest of the economy?
Macroeconomics
• What is the government budget deficit? How
does it affect workers, consumers, businesses,
Presentation Slides and taxpayers?
© 2019 Worth Publishers, all rights reserved
Important issues in macroeconomics Part 2 U.S. real GDP per capita (2009 dollars)
Macroeconomics - the study of the

economy as a whole - addresses many
topical issues, such as:
• Why does the cost of living keep rising?
• Why are so many countries poor? What
policies might help them grow out of
poverty?
• What is the trade deficit? How does it
affect a country’s well-being?
2/14/2022
U.S. Inflation Rate U.S. unemployment rate (% of labor force)
Economic models Example of a model: Supply and demand for new cars
• …are simplified versions of more complex • Shows how various events affect the price and
realities quantity of cars
 with irrelevant details stripped away • Assumes the market is competitive: each buyer
and seller is too small to affect the market price
• …are used to:
Variables
 show relationships between variables
Qd = quantity of cars that buyers demand
 explain the economy’s behavior
Qs = quantity of cars that producers supply
 devise policies to improve economic P = price of new cars
performance
Y = aggregate income
Ps = price of steel (an input)
2/14/2022
The demand for cars Digression: Functional notation
• Demand equation: Qd = D (P, Y ) • General functional notation

shows only that the variables are related.
• Shows that the quantity of cars consumers
demand is related to the price of cars and
aggregate income
• A specific functional form shows the precise

quantitative relationship.
 Example:
D (P, Y ) = 60 – 10P + 2Y
The market for cars: Demand The market for cars: Supply
Demand equation: Supply equation:

Q d = D (P, Y ) Q s = S (P, PS )
The demand curve The supply curve

shows the shows the
relationship between relationship between
quantity demanded quantity supplied and
and price, other price, other things
things equal. equal.
2/14/2022
The market for cars: Equilibrium The effects of an increase in income
Demand equation:
Q d = D (P, Y )
An increase in income
increases the quantity
of cars consumers
demand at each price…
…which increases
the equilibrium price
and quantity.
The effects of a steel price increase Endogenous vs. exogenous variables
Supply equation: • The values of endogenous variables are

determined in the model.
Q s = S (P, PS )
• The values of exogenous variables are
An increase in Ps determined outside the model: the model takes
reduces the quantity of
their values and behaviors
cars producers supply at
each price… as given.
• In the model of supply and demand for cars,
…which increases
the market price and  endogenous variables: P, Qd, Qs
reduces the quantity.
 exogenous variables: Y, Ps
2/14/2022
NOW YOU TRY

The use of multiple models, part 1
Supply and demand
1. Write down demand and supply equations • No single model can address all the
for smartphones, include two exogenous issues we care about.
variables in each equation. • For example, our supply–demand model
2. Draw a supply–demand graph for of the car market…
smartphones and identify the equilibrium • can tell us how a fall in aggregate
price and quantity. income affects price and quantity of cars
3. Use your graph to show how a change in • cannot tell us why aggregate income
one of your exogenous variables affects falls
the model’s endogenous variables.
The use of multiple models, part 2 Prices: Flexible vs. sticky, part 1
• We will learn different models for studying • Market clearing (Sự cân bằng của thị trường):
different issues (e.g., unemployment, inflation, An assumption that prices are flexible and adjust
long-run growth). to equate supply and demand.
• For each new model, you should keep track of: • In the short run, many prices are sticky (cứng
• its assumptions nhắc) - adjust sluggishly in response to changes
in supply or demand. For example:
• which variables are endogenous and which
are exogenous • many labor contracts fix the nominal wage for
a year or longer
• the questions it can help us understand and
those it cannot • many magazine publishers change prices only
once every 3 to 4 years Sticky Price.pptx
2/14/2022
Prices: Flexible vs. sticky, part 2 Outline of this book (1 of 2)
• The economy’s behavior depends partly on Introductory material (Chapters 1, 2)

whether prices are sticky or flexible:
Classical theory (Chapters 3–7)
• If prices are sticky (short run), demand may How the economy works in the long run,
not equal supply, which explains:
when prices are flexible
• unemployment (excess supply of labor)
Growth theory (Chapters 8, 9)
• why firms cannot always sell all the goods The standard of living and its growth rate
they produce
over the very long run
• If prices are flexible (long run), markets clear, Business cycle theory (Chapters 10–14)
and the economy behaves very differently.
How the economy works in the short run,
when prices are sticky
Outline of this book (2 of 2)

CHAPTER SUMMARY, PART 1
• Macroeconomic theory (Chapters 15–17) • Macroeconomics is the study of the economy as a
Macroeconomic dynamics, models of consumer whole, including
behavior, theories of firms’ investment decisions  growth in incomes
• Macroeconomic policy (Chapters 18–19)  changes in the overall level of prices
Stabilization policy, government debt and
deficits, financial crises  the unemployment rate
• Macroeconomists attempt to explain the economy
and to devise policies to improve its performance.
3 The
CHAPTER 1 National
Science
Income
of Macroeconomics
2/14/2022

• Economists use different models to examine
different issues.
• Models with flexible prices describe the economy in
the long run; models with sticky prices describe the
economy in the short run.
• Macroeconomic events and performance arise from
many microeconomic transactions, so
macroeconomics uses many of the tools of
microeconomics.
3 The
CHAPTER 1 National
Science
Income
of Macroeconomics
5/1/2022
Macroeconomics SYLLABUS
N. Gregory Mankiw • National Income Accounting;
• The Goods Market;
• Financial markets;
• The Classical Model and the quantity theory of money;
• Monetary policy, banking system and money multiplier;
• The short run IS-LM Model;
The Data of
• Fiscal policy, Government Debt and Budget Deficits;
Macroeconomics
• The Labour Market, Price, Production, Unemployment and Inflation;
• The medium run AS-AD Model;
Presentation Slides • Long-run economic growth;
• The open economy issues.
3 The
CHAPTER 2
1 National
Science
Data Income
of Macroeconomics
of Macroeconomics
Gross domestic product: Expenditure and The circular flow

income
Two definitions:
• Total expenditure on domestically produced
final goods and services.
• Total income earned by domestically located
factors of production.
Expenditure equals income because

every dollar a buyer spends
becomes income to the seller.
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NOW YOU TRY

Value added
Identifying value added
• Value added is the value of output minus • A farmer grows a bushel of wheat and sells it to
the value of the intermediate goods used a miller for $1.00.
to produce that output • The miller turns the wheat into flour and sells it
to a baker for $3.00.
• The baker uses the flour to make a loaf of bread
and sells it to an engineer for $6.00.
• The engineer eats the bread.
Compute the value added at each stage
of production and GDP.
Final goods, value added, and GDP The expenditure components of GDP
• GDP = value of final goods produced GDP (Y) is the sum of the following:
= sum of value added at all stages  Consumption (C) - Households
of production  Investment (I) - Firms
 Government Purchases (G) - Government
• The value of the final goods already
 Net Exports (NX) - Foreign
includes the value of the intermediate
An important identity:
goods, so including intermediate and final
goods in GDP would be double counting.
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Consumption (C) U.S. consumption, 2016

Definition: The value of all goods and services
Total (billions of Per Person
bought by households, including:
dollars) (dollars)
• Durable goods Gross Domestic 18,624 57,638
last a long time. product
Examples: cars, home appliances Consumption 12,821 39,677
• Nondurable goods Nondurable 2,710 8,388
goods
last a short time.
Durable goods 1,411 4,367
Examples: food, clothing
Services 8,699 26,922
• Services
are intangible items purchased by consumers.
Examples: dry cleaning, air travel
Investment (I) U.S. investment, 2016
• Spending on capital, a physical asset used in

future production dollars) (dollars)
• Includes: Gross Domestic 18,624 57,638
product
• Business fixed investment—Spending on
Investment 3,057 9,461
plant and equipment
Nonresidential fixed 2,316 7,168
• Residential fixed investment—Spending investment
by consumers and landlords on housing Residential fixed 706 2,185
units investment
Inventory investment 35 109
• Inventory investment—The change in the
value of all firms’ inventoriesTồn kho.pptx
3
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Government Spending (G) U.S. government spending, 2016
• G includes all government spending on

goods and services. Total (billions of Per Person
dollars) (dollars)
• G excludes transfer payments Gross Domestic 18,624 57,638
(e.g., unemployment insurance payments) product
because they do not represent spending Government 3,268 10,113
on goods and services. Spending
Federal 1,231 3,811
Defense Military Expenditure 729 2,256
Nondefense 503 1,555
Net Exports (NX) U.S. net exports, 2016
• NX = Exports – Imports
• Exports: the value of g&s (goods and dollars) (dollars)
services) sold to other countries Gross Domestic 18,624 57,638
product
• Imports: the value of g&s purchased
Net Exports −521 −1,613
from other countries
Exports 2,215 6,854
• Hence, NX equals net spending from Imports 2,736 8,647
abroad on our g&s.
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NOW YOU TRY Why output = expenditure

An expenditure-output puzzle?
Suppose a firm: • Unsold output goes into inventory and is
• produces $10 million worth of final goods counted as “inventory investment” . . .
whether or not the inventory buildup was
• sells only $9 million worth intentional.
• Does this violate the expenditure = output
identity? • In effect, we are assuming that firms
purchase their unsold output.
Stocks vs. Flows Stocks vs. flows: examples
• A stock is a quantity
measured at a point in Stock Flow
Flow Stock
time. A person’s wealth A person’s annual
• Example: savings
“The U.S. capital stock Number of people Number of new
was $10 trillion on with college degrees college graduates this
January 1, 2016.”
year
• A flow is a quantity
The government debt The government
measured per unit of
time. budget deficit
• Example: “U.S.
investment was $2
trillion during 2016.”
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NOW YOU TRY

Investment vs. capital
Stock or flow?
Note: Investment is spending on new capital. • The balance on your credit card statement
Example (assuming no depreciation): • How much time you spend studying
• 1/1/2018: • The size of your MP3/iTunes collection
Economy has $10 trillion worth of capital
• The inflation rate
• During 2018:
investment = $2 trillion
• The unemployment rate
• 1/1/2018:
Economy will have $12 trillion worth of capital
An important and versatile concept GNP vs. GDP
We have now seen that GDP measures: • Gross National Product (GNP):
Total income earned by the nation’s factors of
• total income production, regardless of where located.
• total output • Gross Domestic Product (GDP):

Total income earned by domestically located
• total expenditure factors of production, regardless of nationality.
• the sum of value added at all stages in the • GNP – GDP = factor payments from abroad
production of final goods minus factor payments to abroad
• Examples of factor payments: wages, profits,

rent, interest and dividends on assets
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NOW YOU TRY

GNP vs. GDP in select countries, 2012
Discussion question
Country GNP GDP GNP – GDP
In your country, (% of GDP)
which would you Bangladesh 127,672 116,355 9.7
Japan 6,150,132 5,961,066 3.2
want to be bigger: China 8,184,963 8,227,103 −0.5
GDP or GNP? United States 16,514,500 16,244,600 1.7
India 1,837,279 1,8585,740 −1.2
Why? Canada 1,821,424 1,779,635 2.3
Greece 250,167 248,939 0.5
Iraq 216,453 215,838 0.3
Ireland 171,996 210,636 −18.3
Italy 2,085,049 2,082,518 -0,12
GNP and GDP in millions of current U.S. dollars.
NOW YOU TRY

Real vs. nominal GDP
Real and nominal GDP
• GDP is the value of all final goods and
services produced. 2015: 2015: 2016: 2016: 2017: 2017:
P Q P Q P Q
• Nominal GDP measures these values
Good A $30 900 $31 1,000 $36 1,050
using current prices.
• Real GDP measures these values using Good B $100 192 $102 200 $100 205
the prices of a base year.
• Compute nominal GDP in each year.
• Compute real GDP in each year, using
2015 as the base year.
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NOW YOU TRY

Real and nominal GDP, answers
Real GDP controls for inflation
• Nominal GDP multiply Ps and Qs from same • Changes in nominal GDP can be due to:
year • changes in prices
2015: $46,200 = $30 × 900 + $100 × 192
• changes in quantities of output produced
2016: $51,400
• Changes in real GDP can only be due to
2017: $58,300
changes in quantities because real GDP is
• Real GDP multiply each year’s Qs by 2010 Ps constructed using constant base-year
2015: $46,200 prices.
2016: $50,000
2017: $52,000 = $30 × 1050 + $100 × 205
U.S. nominal and real GDP, 1960–2014 GDP deflator
• Inflation rate: the percentage increase in

the overall level of prices.
• One measure of the price level: GDP
deflator
Definition:
Nominal GDP
GDP deflator = 100 
Real GDP
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NOW YOU TRY NOW YOU TRY

GDP deflator and the inflation rate
GDP deflator and the inflation rate, answers
• Use your previous answers to compute the GDP

deflator in each year.
• Use the GDP deflator to compute the inflation

 2016 GDP deflator  2015 GDP deflator  ×100
rate from 2015 to 2016 and from 2016 to 2017. 2016 Inflation Rate =
2015 GDP deflator
Understanding the GDP deflator, part 1 Understanding the GDP deflator, part 2
Example with three goods

NGDPt P1t Q1t  P2tQ2t  P3tQ3t
• For good i = 1, 2, 3 GDP deflatort  
RGDPt RGDPt
• Pit = the market price of good i in month t  Q1t   Q2t   Q3t 
  P1t    P2t    P3t
• Qit = the quantity of good i produced in month t  RGDPt   RGDPt   RGDPt 
• NGDPt = nominal GDP in month t The GDP deflator is a weighted average of prices.
The weight on each price reflects
• RGDPt = real GDP in month t
that good’s relative importance in GDP.
Note that the weights change over time.
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Two helpful facts for working with percentage Two helpful facts for working with percentage
changes, part 1 changes, part 2
1. For any variables X and Y, 2. Percentage change in (X/Y )

percentage change in (X × Y ) ≈ percentage change in X
≈ percentage change in X − percentage change in Y
+ percentage change in Y
Example: GDP deflator = 100 × NGDP / RGDP
Example: If your hourly wage rises 5% and
you work 7% more hours, then your wage If NGDP rises 9% and RGDP rises 4%, then the
income rises approximately 12%. inflation rate is approximately 5%.
Chain-weighted real GDP Consumer price index (CPI)
• Over time, relative prices change, so the base • A measure of the overall level of prices
year should be updated periodically. • Published by the Bureau of Labor Statistics
• In essence, chain-weighted real GDP updates (BLS)
the base year every year, so it is more accurate • Uses:
than constant-price GDP.
• tracking changes in the typical household’s
• Your textbook usually uses constant-price real cost of living
GDP because:
• adjusting many contracts for inflation
• the two measures are highly correlated (“COLAs”)
• constant-price real GDP is easier to compute • allowing comparisons of dollar amounts over
time
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NOW YOU TRY

How the BLS constructs the CPI Compute the CPI
1. It surveys consumers to determine the Basket: 20 For each year,
composition of the typical consumer’s “basket”
pizzas, 10 compute:
of goods
compact discs • the cost of the
2. Every month, it collects data on the prices of all
items in the basket and computes the cost of Prices: basket
the basket Pizza CDs • the CPI (using 2015
3. CPI in any month equals 2015 $10 $15
as the base year)
Cost of basket in that month 2016 11 15
100  2017 12 16 • the inflation rate
Cost of basket in base period
2018 13 15 from the preceding
year
NOW YOU TRY The composition of the CPI’s “basket”

Compute the CPI, answers
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Cấu tạo giỏ hàng tính CPI ở Việt Nam Understanding the CPI, part 1
Example with three goods

For good i = 1, 2, 3
Ci = amount of good i in the CPI’s basket

Pit = price of good i in month t
Et = cost of the CPI basket in month t

Eb = cost of the basket in the base period
Understanding the CPI, part 2 Why the CPI may overstate inflation
• Substitution bias:
E P C + P2t C2 + P3t C3 The CPI uses fixed weights, so it cannot reflect
CPI in month t  t  1t 1
Eb Eb consumers’ ability to substitute toward goods whose
relative prices have fallen.
C  C  C 
  1  P1t   2  P2t   3  P3t • Introduction of new goods:
 Eb   Eb   Eb  The introduction of new goods makes consumers better
off and, in effect, increases the real value of the dollar.
But it does not reduce the CPI because the CPI uses
The CPI is a weighted average of prices. fixed weights.
The weight on each price reflects • Unmeasured changes in quality:
that good’s relative importance in the CPI’s basket. Quality improvements increase the value of the dollar
but are often not fully measured.
Note that the weights remain fixed over time.
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NOW YOU TRY

The size of the CPI’s bias Questions for discussion
• In 1995, a Senate-appointed panel of experts 1. If your grandmother receives Social Security,
estimated that the CPI overstates inflation by how is she affected by the CPI’s bias?
about 1.1% per year. 2. Where does the government get the money to
• The BLS therefore made adjustments to reduce pay COLAs to Social Security recipients?
the bias. 3. If you pay income and Social Security taxes,
• Now, the CPI’s bias is probably under 1% per how does the CPI’s bias affect you?
year. 4. Is the government giving your grandmother too
much of a COLA?
5. How does your grandmother’s “basket” differ
from the CPI’s? Does this affect your answer to
Q4?
CPI vs. GDP deflator The PCE deflator

Prices of capital goods: • Another measure of the price level: personal
• included in GDP deflator (if produced domestically) consumption expenditures (PCE) deflator, the
• excluded from CPI ratio of nominal to real consumer spending
Prices of imported consumer goods: • How the PCE is like the CPI:
• included in CPI
- only includes consumer spending
- includes imported consumer goods
• excluded from GDP deflator
The basket of goods:
• How the PCE is like the GDP deflator:
- the “basket” changes over time
• CPI: fixed
• GDP deflator: changes every year
• The Federal Reserve prefers PCE.
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The GDP deflator, CPI, and PCE deflator Categories of the population
• Employed
working at a paid job
• Unemployed
not employed but looking for a job
• Labor force
the amount of labor available for producing
goods and services; all employed plus
unemployed persons
• Not in the labor force
not employed, not looking for work
NOW YOU TRY

Two important labor-force concepts Computing labor statistics
• Unemployment rate U.S. adult population by group, June 2017
percentage of the labor force that is • Number employed = 153.2 million
unemployed • Number unemployed = 7.0 million
• Labor-force participation rate • Adult population = 255.0 million
fraction of the adult population that
Calculate
“participates” in the labor force - that is, is
working or looking for work Lao động bất mãn
• the labor force
• the unemployment rate
• the labor force participation rate
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Computing labor statistics, answers Computing percentage changes
Data: E = 153.2, U = 7.0, POP = 255.0 Suppose
Labor force • population increases by 1%

L = E + U = 153.2 + 7.0 = 160.2 • labor force increases by 3%
Unemployment rate • number of unemployed persons increases by

U/L × 100% = (7.0/160.2) × 100% = 4.4% 2%
Labor force participation rate Compute the percentage changes in the labor-
L/POP × 100% = (160.2/255.0) × 100% = 62.8% force participation and unemployment rates.
NOW YOU TRY

Computing percentage changes, answers
The establishment survey
LFPR = L/POP • The BLS obtains a second measure of
L increases 3%, POP increases 1%, employment by surveying businesses, asking
so LFPR increases 3% – 1% = 2%. how many workers are on their payrolls.
U rate = U/L • Neither measure is perfect, and they occasionally
diverge due to:
U increases 2%, L increases 3%,
so U-rate increases 2% – 3% = –1%. • treatment of self-employed persons
Note: The changes in LFPR and U-rate are shown as a • new firms not counted in establishment survey
percentage of their initial values, not in percentage points! • technical issues involving population
Example: If the initial value of LFPR is 60.0%, a 2%
inferences from sample data
increase would bring it to 61.2% because 2% of 60 equals
1.2.
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The measures of employment growth

CHAPTER SUMMARY,PART 1
• Gross domestic product (GDP) measures both
total income and total expenditure on the
economy’s output of goods and services.
• Nominal GDP values output at current prices; real
GDP values output at constant prices. Changes in
output affect both measures, but changes in
prices affect only nominal GDP.
• GDP is the sum of consumption, investment,
government purchases, and net exports.
3 The
CHAPTER 2
1 National
Science
Data Income
of Macroeconomics
of Macroeconomics
CHAPTER SUMMARY
• The overall level of prices can be measured
by either:
 the consumer price index (CPI), the price of a
fixed basket of goods purchased by the typical
consumer, or
 the GDP deflator, the ratio of nominal to real
GDP.
• The unemployment rate is the fraction of the labor
force that is not employed.
3 The
CHAPTER 2
1 National
Science
Data Income
of Macroeconomics
of Macroeconomics
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IN THIS CHAPTER, YOU WILL LEARN:

Macroeconomics
N. Gregory Mankiw
What determines the

economy’s total output/income
How the prices of the factors
of production are determined
National Income: How total income is distributed
Where it Comes What determines the demand
From and Where It for goods and services
Goes How equilibrium in the goods
market is achieved
Presentation Slides
CHAPTER 3 National
NationalIncome
Income
Outline of model (1 of 2) Factors of production
A closed economy, market-clearing model K = capital:

• Supply side tools, machines, and structures used in
 factor markets (supply, demand, price) production
 determination of output/income L = labor:

• Demand side the physical and mental efforts of workers
 determinants of C, I, and G
• Equilibrium
 goods market
 loanable funds market
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The production function: Y = F (K,L) Returns to scale: A review
• Shows how much output (Y) the economy • Initially Y1 = F (K1 , L1 )

can produce from K units of capital and L • Scale all inputs by the same factor z:
units of labor KLA.pptx
K2 = zK1 and L2 = zL1
• Reflects the economy’s level of technology (example: if z = 1.2, then all inputs are
• Exhibits constant returns to scale increased by 20%)
• What happens to output, Y2 = F (K2, L2 )?
• If constant returns to scale, Y2 = zY1
• If increasing returns to scale, Y2 > zY1
• If decreasing returns to scale, Y2 < zY1
Returns to scale: Example 1 Returns to scale: Example 2
F  K , L  = KL F  K , L  = K 2 + L2
2 2
F  zK , zL  =  zK  zL  F  zK , zL  =  zK    zL 
= z 2KL = z 2  K 2 + L2 
= z 2 KL constant = z 2F  K , L 
increasing
= z KL returns to
returns to
scale for any z
= zF  K , L  scale for any
>0
z>1
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Returns to scale Answers, part (a)
Determine whether each of these production
K2
functions has constant, decreasing, or increasing F (K , L ) =
returns to scale: L
2
K2 F (zK ,zL ) =
 zK  =
z 2K 2
=Z
K2
(a) F  K , L  = zL zL L
L
= zF  K , L 
(b) F  K , L  = K + L
constant returns to
scale for any z > 0
NOW YOU TRY

Assumptions
Answers, part (b)
1. Technology is fixed.
F K,L  = K + L 2. The economy’s supplies of capital and labor are
F  zK , zL  = zK + zL fixed at:
= z K + L  K = K and L = L
= zF  K + L 
constant returns to
scale for any z > 0
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Determining GDP The distribution of national income
• Output is determined by the fixed factor • determined by factor prices, the prices
supplies and the fixed state of technology: per unit firms pay for the factors of
production

Y = F K,L   wage = price of L
 rental rate = price of K
Notation How factor prices are determined
• Factor prices are determined by supply

• W = nominal wage and demand in factor markets.
• R = nominal rental rate • Recall that the supply of each factor is
• P = price of output fixed.
• W /P = real wage • What about demand?
(measured in units of output)
• R /P = real rental rate
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Demand for labor Marginal product of labor (MPL)
• Assume that markets are competitive: each Definition:

firm takes W, R, and P as given. The extra output the firm can produce using
• Basic idea: A firm hires each unit of labor if an additional unit of labor (holding other
the cost does not exceed the benefit. inputs fixed):
• cost = real wage MPL = F (K, L +1) – F (K, L)
• benefit = marginal product of labor

Compute and graph MPL Compute and graph MPL, Answers
L Y MPL
a. Determine MPL at each 0 0 n.a.
value of L. 1 10 ?
b. Graph the production 2 19 ?
function. 3 27 8
c. Graph the MPL curve 4 34 ?
with MPL on the vertical 5 40 ?
axis and L on the 6 45 ?
horizontal axis.
7 49 ?
8 52 ?
9 54 ?
10 55 ?
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MPL and the production function Diminishing marginal returns

Y
output As more labor is
• As one input is increased (holding other
added, MPL falls
F (K , L )
inputs constant), its marginal product falls.
MPL • Intuition:
1
If L increases while holding K fixed,
MPL
machines per worker falls, worker
1
productivity falls.
Slope of the production
MPL
function equals MPL
1
L
labor

Identifying diminishing returns Identifying diminishing returns, answers
Which of these production functions have Which of these production functions have
diminishing marginal returns to labor? diminishing marginal returns to labor?
a) F  K , L  = 2K +15L
a) F  K , L  = 2K +15L
No, MPL = 15 for all L
b) F  K , L  = KL
b) F  K , L  = KL
c) F  K , L  = 2 K +15 L Yes, MPL falls as L rises
c) F  K , L  = 2 K +15 L
Yes, MPL falls as L rises
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MPL and labor demand MPL and labor demand, answers
L Y MPL L Y MPL
Suppose W/P = 6. Suppose W/P = 6.
0 0 n.a. 0 0 n.a.
• If L = 3, should the firm hire more • If L = 3, should the firm hire more
or less labor? Why? 1 10 10 or less labor? Why? 1 10 10
2 19 9 2 19 9
• If L = 7, should the firm hire more Answer: More because the benefit
or less labor? Why? 3 27 8 of the 4th worker (MPL = 7) 3 27 8
4 34 7 exceeds its cost (W/P = 6) 4 34 7
5 40 6 • If L = 7, should the firm hire more 5 40 6
6 45 5 or less labor? Why? 6 45 5
7 49 4 Answer: Less because the 7th 7 49 4
8 52 3 worker adds MPL = 4 units of 8 52 3
output but costs the firm W/P = 6.
9 54 2 9 54 2
10 55 1 10 55 1
MPL and the demand for labor

The equilibrium real wage
Tiền-sức mạnh.pptx
Black Death-Wage.pptx
Units of
output Each firm hires labor Labor The real wage
Units of
up to the point where output supply adjusts to equate
MPL = W/P. labor demand with
Real supply.
wage
MPL,
Labor Equilibrium
real wage MPL,
demand Labor
Units of labor, L demand
Quantity of labor L Units of labor, L
demanded
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Determining the rental rate The equilibrium real rental rate

• We have just seen that MPL = W/P. Units of The real rental rate
• The same logic shows that MPK = R/P: output Supply of adjusts to equate
capital
demand for capital
Diminishing returns to capital: with supply.
MPK falls as K rises
The MPK curve is the firm’s demand curve for
renting capital. equilibrium MPK,
Firms maximize profits by choosing K such that R/P demand for
capital
MPK = R/P.
K Units of capital, K
The neoclassical theory of distribution How income is distributed to L and K

• States that each factor input is paid its W
Total labor income = L  MPL  L
marginal product P
R
• A good starting point for thinking about Total capital income = K  MPK  K
P
income distribution
If production function has constant returns to
scale, then
Y  MPL  L  MPK  K
national labor capital

income income income
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The ratio of labor income to total income Labor productivity and wages
in the United States, 1960–2010 Kê biên tài sản
Theory: wages depend on labor productivity

U.S. data:
Time Growth Rate of Growth Rate of
Period Labor Productivity Real Wages
1960–2016 2.0% 1.8%
1960–1973 3.0 2.7
1973–1995 1.5 1.2
1995–2010 2.6 2.2
2010–2016 0.5 0.9
Explanations for rising inequality Outline of model (2 of 2)
From The Race Between Education and A closed economy, market-clearing model
Technology by Goldin and Katz:
 Technological progress has increased the
demand for skilled relative to unskilled
workers. Wage Gap.pptx
 Due to a slowdown in expansion of education,

the supply of skilled workers has not kept up.
 Result: Rising gap between wages of skilled
and unskilled workers.
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Demand for goods and services Consumption, C
Components of aggregate demand: • Disposable income is total income minus

C = consumer demand for goods and total taxes: Y – T.
services • Consumption function: C = C (Y – T )
I = demand for investment goods
• Definition: Marginal Propensity to
G = government demand for goods and
Consume (MPC) is the change in C when
services
disposable income increases by one dollar.
(closed economy: no NX )
The consumption function Investment, I
• The investment function is I = I (r ), where r

denotes the real interest rate, the nominal
interest rate corrected for inflation.
• The real interest rate is:
 the cost of borrowing
 the opportunity cost of using one’s
own funds to finance investment
spending
So, I depends negatively on r
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The investment function Government spending, G
• G = government spending on goods and

services
• G excludes transfer payments (for
example, Social Security benefits,
unemployment insurance benefits)
• Assume that government spending and
total taxes are exogenous:
G = G and T = T
The market for goods and services The loanable funds market
• A simple supply–demand model of the

 Aggregate demand: C (Y  T )  I (r )  G
financial system.
 Aggregate supply: Y  F (K , L ) • One asset: “Loanable Funds”
• Demand for Funds: Investment
 Equilibrium: Y = C (Y  T )  I (r )  G
• Supply of Funds: Saving
• “Price” of Funds: Real Interest Rate
The real interest rate adjusts
to equate demand with supply.
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Demand for funds: Investment Loanable funds demand curve
The demand for loanable funds . . .

• comes from investment:
Firms borrow to finance spending on
plant and equipment, new office
buildings, etc. Consumers borrow to buy
new houses.
• depends negatively on r:
r is the “price” of loanable funds (cost of
borrowing).
Supply of funds: Saving Types of saving
• The supply of loanable funds comes from • Private saving = (Y – T) – C

saving:
• Households use their saving to make
• Public saving = T – G
bank deposits and purchase bonds and • National saving, S
other assets. These funds become
= private saving + public saving
available to firms to borrow and finance
investment spending. = (Y –T ) – C + T – G
• The government may also contribute to =Y–C–G
saving if it does not spend all the tax
revenue it receives.
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NOW YOU TRY

Notation: Δ = change in a variable
Calculate the change in saving
For any variable X, ΔX = “change in X ” Suppose MPC = 0.8 and MPL = 20.
Δ is the Greek (uppercase) letter delta For each of the following, compute ΔS:
Examples: a. ΔG = 100
 If ΔL = 1 and ΔK = 0, then ΔY = MPL. b. ΔT = 100
ΔY
More generally, if ΔK = 0, then MPL = . c. ΔY = 100
ΔL
 Δ(Y − T ) = ΔY − ΔT , so d. ΔL = 10
ΔC = MPC × (ΔY − ΔT )
= MPC ΔY − MPC ΔT
NOW YOU TRY

Calculate the change in saving, answers Budget surpluses and deficits
ΔS = ΔY  ΔC  ΔG = ΔY  0.8(ΔY  ΔT )  ΔG • If T > G, budget surplus = (T – G)

= 0.2 ΔY + 0.8 ΔT  ΔG = public saving.
a. ΔS =  100 • If T < G, budget deficit = (G – T) and
b. ΔS = 0.8 ×100 = 80 public saving is negative.
c. ΔS = 0.2 ×100 = 20 • If T = G, balanced budget, public saving =
d. ΔY = MPL × ΔL = 20 ×10 = 200, 0.
ΔS = 0.2 × ΔY = 0.2 × 200 = 40. • The U.S. government finances its deficit by
issuing Treasury bonds - that is, borrowing.
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U.S. federal government surplus/deficit, U.S. federal government debt, 1940–2016

1940–2016 Budget Deficit-Vietnam.pptx
Loanable funds supply curve Loanable funds market equilibrium
S = Y  C (Y  T )  G S = Y  C (Y  T )  G
National saving
does not depend
on r, so the supply
curve is vertical.
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The special role of r Digression: Mastering models
• r adjusts to equilibrate the goods market and the To master a model, be sure to know:
loanable funds market simultaneously: 1. Which of its variables are endogenous and
If the loanable funds market is in equilibrium, which are exogenous.
then 2. For each curve in the diagram, know:
Y–C–G=I a. Definition
Add (C +G ) to both sides to get b. intuition for slope
Y = C + I + G (goods market equilibrium) c. all the things that can shift the curve
Thus, 3. Use the model to analyze the effects of each
item in 2c.
Mastering the loanable funds model (1 of 2) CASE STUDY: The Reagan Deficits (1 of 2)
Things that shift the saving curve: • Reagan policies during early 1980s:
• public saving • increases in defense spending: ΔG > 0
• fiscal policy: changes in G or T • big tax cuts: ΔT < 0
• private saving • Both policies reduce national saving:
• preferences
• tax laws that affect saving
• 401(k)
• IRA
• replace income tax with consumption tax
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CASE STUDY: The Reagan Deficits (2 of 2) Are the data consistent with these results? Bội chi
Quantity Easing Kích cầu-lãng phí
1970s 1980s
T−G −2.2 −3.9
S 19.6 17.4
r 1.1 6.3
l 19.9 19.4
T – G, S, and I are expressed

as a percentage of GDP.
All figures are averages over
the decade shown.
NOW YOU TRY

The effects of saving incentives Mastering the loanable funds model (2 of 2)
• Draw the diagram for the loanable funds Things that shift the investment curve:
model.
• some technological innovations
• Suppose the tax laws are altered to
provide more incentives for private saving. • to take advantage of some
(Assume that total tax revenue T does not innovations, firms must buy new
change.) investment goods
• What happens to the interest rate and • tax laws that affect investment
investment?
• example: investment tax credit
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An increase in investment demand Saving and the interest rate
• Why might saving depend on r ?

• How would the results of an increase in
investment demand be different?
• Would r rise as much?
• Would the equilibrium value of I change?
An increase in investment demand

C H A P T E R S U M M A R Y, PA R T 1
when saving depends on r
• Total output is determined by:
 the economy’s quantities of capital and labor
 the level of technology
• Competitive firms hire each factor until its
marginal product equals its price.
• If the production function has constant returns to
scale, then labor income plus capital income
equals total income (output).
CHAPTER 3 National
NationalIncome
Income
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C H A P T E R S U M M A R Y, PA R T 2 C H A P T E R S U M M A R Y, PA R T 3
• A closed economy’s output is used for • A decrease in national saving causes the interest
consumption, investment, and government rate to rise and investment to fall.
spending. • An increase in investment demand causes the
• The real interest rate adjusts to equate the interest rate to rise but does not affect the
demand for and supply of: equilibrium level of investment if the supply of
 goods and services. loanable funds is fixed.
 loanable funds.
CHAPTER 3 National
NationalIncome
Income CHAPTER 3 National
NationalIncome
Income
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Macroeconomics
N. Gregory Mankiw
The classical theory of

inflation Kind of Inflation
• Causes
• Effects
Inflation: Its • social costs
Causes, Effects, “Classical”—assumes prices
and Social Costs are flexible and markets
clear
Applies to the long run
Presentation Slides
3 The
CHAPTER 5
1 National
Inflation
Science
Income
of Macroeconomics
U.S. inflation and its trend, 1960–2014, part 1 U.S. inflation and its trend, 1960–2014, part 2
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The quantity theory of money Velocity, part 1
• A simple theory linking the inflation rate to • Basic concept: the rate at which money
circulates
the growth rate of the money supply.
• Definition: the number of times the average
• Begins with the concept of velocity… dollar bill changes hands in a given time
period
• Example: In 2018,
• $500 billion in transactions
• money supply = $100 billion
• The average dollar is used in five transactions in
2018
• So, velocity = 5
Velocity, part 2 Velocity, part 3
This suggests the following definition: Use nominal GDP as a proxy for total
transactions.
T
V Then,
M
where P Y
V 
V = velocity M
where
T = value of all transactions
P = price of output (GDP deflator)
M = money supply
Y = quantity of output (real GDP)
P × Y = value of output (nominal GDP)
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The quantity equation Money demand and the quantity equation, part 1
The quantity equation • M/P = real money balances, the

purchasing power of the money supply.
M×V=P×Y
• A simple money demand function:
follows from the preceding definition of
velocity. (M/P )d = k Y
It is an identity: it holds by definition of the Where:
variables. k = how much money people wish to hold
for each dollar of income.
(k is exogenous)
Money demand and the quantity equation, part 2 Back to the quantity theory of money
• Money demand: (M/P)d = k Y Starts with quantity equation

• Quantity equation: M × V = P × Y V= V
• The connection between them: k = 1/V Then, the quantity equation becomes:
• When people hold lots of money relative to M ×V = P ×Y
their incomes (k is large), money changes Assumes V is constant and exogenous:
hands infrequently (V is small).
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The quantity theory of money, part 1 The quantity theory of money, part 2
M ×V = P ×Y • Recall from Chapter 2:

How the price level is determined: The growth rate of a product equals the sum
of the growth rates.
• With V constant, the money supply
determines nominal GDP (P ×Y). • The quantity equation in growth rates:
• Real GDP is determined by the

economy’s supplies of K and L and the
production function (Chapter 3).
• The price level is P = (nominal
GDP)/(real GDP).
The quantity theory of money, part 3 The quantity theory of money, part 4
π (Greek letter pi ) ΔP
π= ΔM ΔY
denotes the inflation P π= 
M Y
rate:
The result from the ΔM ΔP ΔY • Normal economic growth requires a certain
= + amount of money supply growth to
preceding slide: M P Y
facilitate the growth in transactions.
Solve this result ΔM ΔY • Money growth in excess of this amount

π= 
for π: M Y leads to inflation.
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The quantity theory of money, part 5 Confronting the quantity theory with data
The quantity theory of money implies:

ΔM ΔY
π= 
M Y 1. Countries with higher money growth
rates should have higher inflation rates.
ΔY/Y depends on growth in the factors of
production and on technological progress 2. The long-run trend in a country’s inflation
(all of which we take as given, for now). rate should be similar to the long-run
Hence, the quantity theory predicts a one- trend in the country’s money growth rate.
for-one relationship between changes in the
money growth rate and changes in the
Are the data consistent with these
inflation rate. implications?
International data on inflation and money growth U.S. inflation and money growth, 1960–2014, part 1
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U.S. inflation and money growth, 1960–2014, part 2 Seigniorage
Inflation and money growth • To spend more without raising taxes or

have the same long-run trends
as the quantity theory predicts.
selling bonds, the government can print
money.
• The “revenue” raised from printing money
is called seigniorage (pronounced SEEN-
your-idge).
• The inflation tax: Đổi tiền.pptx
Printing money to raise revenue causes

inflation. Inflation is like a tax on people
who hold money.
Inflation and interest rates The Fisher effect
• Nominal interest rate, I not adjusted for The Fisher equation: i = r + π

inflation Chapter 3: S = I determines r .
• Real interest rate, r adjusted for inflation: Hence, an increase in π causes an equal
r=i−π increase in i.
This one-for-one relationship is called the
Fisher effect.
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U.S. inflation and nominal interest rates, 1955-2015 Inflation and nominal interest rates in 48 countries

Applying the theory Applying the theory, answers
Suppose V is constant, M is growing 5% per year, Y is V is constant, M grows 5% per year, Y grows 2%
growing 2% per year, and r = 4. per year, r = 4.
a. Solve for i.
a. First, find π = 5 − 2 = 3.
b. If the Fed increases the money growth rate by 2
Then, find i = r + π = 4 + 3 = 7.
percentage points per year, find Δi.
c. Suppose the growth rate of Y falls to 1% per year. b. Δi = 2, the same as the increase in the money
growth rate.
• What will happen to π?
c. If the Fed does nothing, Δπ = 1.
• What must the Fed do if it wishes to keep π constant?
To prevent inflation from rising, the Fed must reduce the
money growth rate by 1 percentage point per year.
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Two real interest rates Money demand and the nominal interest rate
Notation: • In the quantity theory of money, the

• π = actual inflation rate demand for real money balances depends
(not known until after it has occurred) only on real income Y.
• Eπ = expected inflation rate • Another determinant of money demand:
the nominal interest rate i.
Two real interest rates:
• i – Eπ = ex ante real interest rate: • the opportunity cost of holding money
the real interest rate people expect at the time (instead of bonds or other interest-
they buy a bond or take out a loan earning assets).
• i – π = ex post real interest rate: • So, money demand depends negatively on
the real interest rate actually realized i.
The money demand function, part 1 The money demand function, part 2
d d
M P  = L  i ,Y  M P  = L  i ,Y 
(M/P)d = real money demand, depends = L  r + Eπ , Y 
• negatively on i When people are deciding whether to hold
i is the opposite cost of holding money money or bonds, they don’t know what
• positively on Y inflation will turn out to be.
higher Y increases spending on g&s Hence, the nominal interest rate relevant for
so increases the need for money money demand is r + Eπ.
(L is used for the money demand function because
money is the most liquid asset.)
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Equilibrium What determines what?
M
= L  r + Eπ , Y 
P
P adjusts to ensure Y = F ( K , L )
How P responds to ΔM What about expected inflation?
• Over the long run, people don’t consistently over-

M or under-forecast inflation,
= L  r + Eπ , Y  so Eπ = π on average.
P
• In the short run, Eπ may change when people get
• For given values of r, Y, and Eπ, a change new information.
in M causes P to change by the same • Example: The Fed announces it will increase M
percentage - just like in the quantity theory next year. People will expect next year’s P to be
of money. higher, so Eπ rises.
• This affects P now, even though M hasn’t
changed yet...
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How P responds to ΔEπ The classical view of inflation
M • The classical view:

= L  r + Eπ , Y  A change in the price level is merely a
P
change in the units of measurement.
For given values of r, Y, and M,
Then, why is inflation a
 Eπ   i (the Fisher effect) social problem?
d
  M P 
  P to make  M P  fall
to re-establish eq'm
NOW YOU TRY

Discussion question
A common misperception
Why is inflation bad? • Common misperception:

What costs does inflation impose on society? inflation reduces real wages
• List all the costs you can think of. • This is true only in the short run, when
• Focus on the long run. nominal wages are fixed by contracts.
• Think like an economist. • (Chapter 3) In the long run, the real wage
is determined by labor supply and the
marginal product of labor, not the price
level or inflation rate.
• Consider the data . . .
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The CPI and average hourly earnings, 1965–2015 The social costs of inflation
…fall into two categories:

1. costs when inflation is expected
2. costs when inflation is different from what people
had expected
The costs of expected inflation: 1. Shoeleather cost The costs of expected inflation: 2. Menu costs
• Definition: the costs and inconveniences of • Definition: the costs of changing prices.
reducing money balances to avoid the inflation
tax. • Examples:
• If π increases, i increases (why?), so people • cost of printing new menus and mailing
reduce their real money balances. out catalogs
• Remember: In long run, inflation does not affect • time spent trying to decide on what the
real income or real spending. new prices should be
• The same monthly spending but lower average • The higher is inflation, the more frequently
money holdings means more frequent trips to the
firms must change their prices and incur
bank to withdraw smaller amounts of cash.
these costs.
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The costs of expected inflation: 3. Relative price

The costs of expected inflation: 4. Unfair tax treatment
distortions
• Firms facing menu costs change prices Some taxes, such as the capital gains tax, are not
infrequently. adjusted to account for inflation.
• Example: Example:
A firm issues new catalog each January. • Jan 1: you buy $10,000 worth of Apple stock
As the general price level rises throughout the
year, the firm’s relative price will fall. • Dec 31: you sell the stock for $11,000, so your
nominal capital gain is $1,000 (10%).
• Different firms change their prices at different
times, leading to relative price distortions . . . • Suppose π = 10% during the year.
Your real capital gain is $0.
. . . causing microeconomic inefficiencies in
the allocation of resources. • Yet, you must pay taxes on your $1,000
nominal gain!
The costs of expected inflation: 5. General The costs of unexpected inflation: Arbitrary
inconvenience redistribution of purchasing power
• Inflation makes it harder to compare • Many long-term contracts are not indexed
nominal values from different time periods. but are based on Eπ.
• This complicates long-range financial • If π turns out to be different from Eπ , then
planning. some gain at others’ expense.
Example: borrowers and lenders
• If π > Eπ , then (i − π) < (i − Eπ )
and purchasing power is transferred
from lenders to borrowers.
• If π < E π, then purchasing power is
transferred from borrowers to lenders.
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Additional cost of high inflation: Increased uncertainty One benefit of inflation
• When inflation is high, it’s more variable • Nominal wages are rarely reduced, even
and unpredictable: π turns out different when the equilibrium real wage falls.
from Eπ more often, This hinders labor market clearing.
and the differences tend to be larger,
though not systematically positive or • Inflation allows the real wages to reach
negative. equilibrium levels without nominal wage
cuts.
• So, arbitrary redistributions of wealth are
more likely. • Therefore, moderate inflation improves the
functioning of labor markets.
• This increases uncertainty, making risk-
averse people worse off.
Hyperinflation What causes hyperinflation?
• Common definition: π ≥ 50% per month • Hyperinflation is caused by excessive

• All the costs of moderate inflation money supply growth.
described above become HUGE under • When the central bank prints money, the
hyperinflation. price level rises.
• Money ceases to function as a store of • If it prints money rapidly enough, the result
value, and it may not serve its other is hyperinflation.
functions (unit of account, medium of
exchange).
• People may conduct transactions with
barter or a stable foreign currency.
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A few examples of hyperinflation Siêu lạm phát.pptx Diên Hồng.pptx Why governments create hyperinflation
Country Period CPI inflation M2 growth
% per year % per year • When a government cannot raise taxes or
Israel 1983-85 338% 305% sell bonds, it must finance spending
Brazil 1987-94 1,256 1,451 increases by printing money.
Bolivia 1983-86 1,818 1,727
Ukraine 1992-94 2,089 1,029 • In theory, the solution to hyperinflation is
Argentina 1988-90 2,671 1,583 simple: stop printing money.
Dem. 1990-96 3,039 2,373
Republic of • In the real world, this requires drastic and
Congo/Zaire painful fiscal restraint.
Angola 1995-96 4,145 4,106
Peru 1988-90 5,050 3,517
Zimbabwe 2005-07 5,316 9,914
The classical dichotomy, part 1 The classical dichotomy, part 2
Real variables: measured in physical units— Nominal variables: measured in money

quantities and relative prices, for example: units—for example:
• quantity of output produced • nominal wage: dollars per hour of work
• real wage: output earned per hour of • nominal interest rate: dollars earned in the
work future by lending one dollar today
• real interest rate: output earned in the • price level: number of dollars needed to
future by lending one unit of output today buy a representative basket of goods
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The classical dichotomy, part 3 CHAPTER SUMMARY, PART 1

• Recall: Real variables were explained in Chapter • Velocity: the ratio of nominal expenditure to money
3, nominal ones in Chapter 5. supply, the rate at which money changes hands
• Quantity theory of money
• Classical dichotomy: the theoretical separation
• assumes velocity is constant
of real and nominal variables in the classical
model, which implies nominal variables do not • concludes that the money growth rate determines
affect real variables. the inflation rate
• applies in the long run
• Neutrality of money: idea that changes in the
• consistent with cross-country and time-series data
money supply do not affect real variables.
• In the real world, money is approximately neutral
in the long run.
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CHAPTER SUMMARY, PART 2 CHAPTER SUMMARY, PART 3

• Nominal interest rate Costs of inflation
• equals real interest rate + inflation rate • Expected inflation
• the opposite cost of holding money shoeleather costs, menu costs, tax and relative
• Fisher effect: Nominal interest rate moves one-for- price distortions, inconvenience of correcting figures
one with expected inflation. for inflation
• Money demand • Unexpected inflation
all of the above plus arbitrary redistributions of
• depends only on income in the quantity theory
wealth between debtors and creditors
• also depends on the nominal interest rate
• if so, then changes in expected inflation affect the
current price level
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• Hyperinflation • Classical dichotomy
• caused by rapid money supply growth when money • In classical theory, money is neutral—does not
is printed to finance government budget deficits affect real variables.
• stopping it requires fiscal reforms to eliminate • So, we can study how real variables are determined
the government’s need for printing money without reference to nominal ones.
• Then, money market eq’m determines price level
and all nominal variables.
• Most economists believe the economy works this
way in the long run.
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Macroeconomics
N. Gregory Mankiw
…about the natural

rate of unemployment:
• what it means
Unemployment and • what causes it

the Labor Market • understanding its
behavior in the real
world
Presentation Slides

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Actual and natural rates of unemployment,

Natural rate of unemployment
U.S., 1960–2014
• Natural rate of unemployment:
The average rate of unemployment around which the
economy fluctuates.
• In a recession, the actual unemployment rate rises above
the natural rate.
• In a boom, the actual unemployment rate falls below the
natural rate.
A first model of the natural rate Assumptions
Notation: 1. L is exogenously fixed.

L = # of workers in labor force 2. During any given month,
E = # of employed workers s = rate of job separation, fraction of employed workers
who lose or leave his/her jobs
U = # of unemployed
f = rate of job finding, fraction of unemployed workers
U/L = unemployment rate who find jobs
s and f are exogenous
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The transitions between employment and

The steady-state condition
unemployment
• Definition: the labor market is in steady state, or long-run
equilibrium, if the unemployment rate is constant.
• The steady-state condition is:
Finding the “equilibrium” unemployment rate Example:
f ×U = s ×E • Each month,
= s ×(L – U) • 1% of employed workers lose their jobs (s = 0.01)
• 19% of unemployed workers find jobs (f = 0.19)
= s ×L – s ×U
• Find the natural rate of unemployment:
Solve for U/L:
(f + s) × U = s × L
so,
U s 0.01
U s = = = 0.05, or 5%
= L s + f 0.01+ 0.19
L s+f
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Policy implication Why is there unemployment? (1 of 2)
A policy will reduce the natural rate of unemployment only if • If job finding were instantaneous (f = 1), then all spells of
it lowers s or increases f. unemployment would be brief, and the natural rate would
be near zero.
• There are two reasons why f < 1:
1. job search
2. wage rigidity
Job search and frictional unemployment Sectoral shifts
• Frictional unemployment: caused by the time it takes • sectoral shifts: changes in the composition of demand
workers to search for a job among industries or regions
• occurs even when wages are flexible and there are • example: technological change
enough jobs to go around more jobs repairing computers, fewer jobs repairing
• occurs because typewriters
• workers have different abilities, preferences • example: a new international trade agreement
• jobs have different skill requirements labor demand increases in export sectors, decreases in
import-competing sectors
• geographic mobility of workers not instantaneous
• These scenarios result in frictional unemployment.
• flow of information about vacancies and job
candidates is imperfect
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More examples of sectoral shifts, part 1 More examples of sectoral shifts, part 2
• Industrial revolution (1800s): agriculture declines, Government programs affecting unemployment include:
manufacturing soars
• Government employment agencies
• Energy crisis (1970s): demand shifts from larger cars to
disseminate info about job openings to better match
smaller ones
workers and jobs.
• Health care spending as % of GDP:
1960: 5.2 2000: 13.8 • Public job training programs
1980: 9.1 2010: 17.9 help workers displaced from declining industries get
skills needed for jobs in growing industries.
In our dynamic economy,

smaller sectoral shifts occur frequently,
contributing to frictional unemployment.
Unemployment insurance (UI) Benefits of UI
• UI pays part of a worker’s former wages for a limited time • By allowing workers more time to search:
after the worker loses his/her job. • UI may lead to better matches between jobs and
• UI increases frictional unemployment because it reduces workers
• the opportunity cost of being unemployed • which would lead to greater productivity and higher
• the urgency of finding work incomes
• f
• Studies: The longer a worker is eligible for UI, the longer
the average spell of unemployment.
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Unemployment from real wage rigidity, part 1

Why is there unemployment? (2 of 2)
U s If the real
The natural rate of unemployment: =
L s+f wage is stuck
above its
equilibrium
level, there
• Two reasons why f < 1: aren’t enough
DONE  1. job search jobs to go
Next  2. wage rigidity around.
Unemployment from real wage rigidity, part 2

Reasons for wage rigidity
1. minimum-wage laws
If the real
Then, firms must ration the 2. labor unions
wage is stuck
scarce jobs among workers.
above its
equilibrium 3. efficiency wages
level, there
aren’t enough Structural unemployment: The
jobs to go unemployment resulting from real
around. wage rigidity and job rationing.
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1. Minimum-wage laws 2. Labor unions
• The minimum wage may exceed the equilibrium wage of • Unions exercise monopoly power to secure higher wages
unskilled workers, especially teenagers. for their members.
• Studies: a 10% increase in minimum wage reduces teen • When the union wage exceeds the equilibrium wage,
employment by 1–3% unemployment results.
• But, the minimum wage cannot explain the majority of the • Insiders: employed union workers whose interest is to
natural rate of unemployment, as most workers’ wages keep wages high
are well above the minimum wage. • Outsiders: unemployed non-union workers who prefer
equilibrium wages, so there would be enough jobs for
them
Union membership and wage rations by industry, 2013 3. Efficiency wages
Industry # Employed U % of Wage ratio • Theories in which higher wages increase worker
(1,000s) total productivity by:
Private sector (total) 104,737 6.9 122.6
• attracting higher-quality job applicants
Government (total) 20,450 37.0 121.1
Construction 6,244 14.0 151.7
• increasing worker effort, reducing “shirking”
Mining 780 7.2 96.4 • reducing turnover, which is costly to firms
Manufacturing 13,599 10.5 107.2 • improving health of workers (in developing countries)
Retail trade 14,582 4.9 102.4 • Firms willingly pay above-equilibrium wages to raise
Transportation 4,355 20.4 123.5 productivity.
Finance, insurance 6,111 1.1 90.2
• Result: structural unemployment
Professional services 12,171 2.1 99.1
Education 4,020 13.0 112.6
Health care 15,835 7.5 114.9
wage ratio = 100 × (union wage) / (nonunion wage)
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NOW YOU TRY The median duration of unemployment

Question for discussion The duration of unemployment typically
• Use the material we’ve just covered to rises in recessions—but its rise in 2008–
2010 was unprecedented.
come up with a policy or policies to try to
reduce the natural rate of unemployment.
• Note whether your policy targets frictional
or structural unemployment.
Other measures of unemployment

Discouraged workers
Variable Description Rate
• discouraged workers: workers who have given up on U-1 Persons unemployed 15 weeks or longer, as a percent of the
looking for a job and are considered out of the labor force civilian labor force (includes only very long-term unemployed) 1.7
• marginally attached workers: persons not in the labor U-2 Job losers and persons who have completed temporary jobs, as
a percent of the civilian labor force (excludes job leavers) 2.1
force who want and are available for work and who have
looked for a job but have not recently looked for work U-3 Total unemployed, as a percent of the civilian labor force (official
unemployment rate) 4.3
• Discouraged workers are included in marginally
U-4 Total unemployed, plus discouraged workers, as a percent of the
attached workers. civilian labor force plus discouraged workers 4.7
U-5 Total unemployed plus all marginally attacehd workers, as a

percent of the civilian labor force plus all marginally attached
workers 5.3
U-6 Total unemployed, plus all marginally attached workers, plus total
employed part time for economic reasons, as a percent of the
civilian labor force plus all marginally attached workers 8.6
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Labor force participation Unemployment in Europe, 1960–2013
Why unemployment rose in Europe but not the United

States Percentage of workers Turkey 7%
South Korea 12
covered by collective United States 12
Shock bargaining, selected Poland 15
Technological progress shifting labor demand from unskilled countries Japan 17
to skilled workers in recent decades Israel 26
Effect in United States Canada 29
An increase in the “skill premium”—the wage gap between United Kingdom 30
skilled and unskilled workers Greece 42

Switzerland 49
Effect in Europe Germany 58
Higher unemployment, due to generous government Australia 60
benefits for unemployed workers and strong union presence Spain 78
Italy 80
Netherlands 85
Sweden 89
Belgium 96
France 98
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• The natural rate of unemployment • Structural unemployment
 definition: the long-run average, or “steady-state,” rate of  results from wage rigidity: the real wage remains above
unemployment the equilibrium level
 depends on the rates of job separation and job finding  caused by: minimum wage, unions, efficiency wages
• Frictional unemployment • Duration of unemployment
 due to the time it takes to match workers with jobs  most spells are short term
 may be increased by unemployment insurance  but most weeks of unemployment are attributable to a
small number of long-term unemployed persons
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• Unemployment in the United States. 6. European unemployment
 multiple measures of unemployment: U-3, U-6, etc.  has risen sharply since 1970
 decline in the labor-force participation rate  probably due to generous unemployment benefits,
strong union presence, and a technology-driven shift in
demand away from unskilled workers
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Macroeconomics
N. Gregory Mankiw
Accounting identities for the
open economy
The small open-economy model
• what makes it “small”
• how the trade balance and
exchange rate are
The Open determined
Economy • how policies affect trade
balance and exchange
rate
Presentation Slides
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Revisited
Imports and exports of selected countries, 2013 In an open economy,
• Spending need not equal Output

• Saving need not equal Investment
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Preliminaries GDP = expenditure on domestically produced g & s
C C d C f superscripts:
I Id If
d = spending on Y  C d  I d  G d  EX
domestic goods
G G d G f f = spending on  (C - C f )  (I - I f )  (G - G f )  EX
foreign goods
EX = exports =  C  I  G  EX - (C f  I f  G f )
foreign spending on domestic goods
IM = imports = C f + I f + G f  C  I  G  EX - IM
= spending on foreign goods
NX = net exports (a.k.a. the “trade balance”)  C  I  G  NX
= EX – IM
The national income identity Trade surpluses and deficits

in an open economy
NX = X – IM = Y – (C + I + G)
Y = C + I + G + NX
• Trade surplus:
or, NX = Y – (C + I + G ) Output > Spending and Exports (X) > Imports
(IM)
domestic Size of the trade surplus = NX
net exports spending • Trade deficit:
Spending > Output and Imports > Exports
output Size of the trade deficit = –NX
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International capital flows The link between trade and capital flows
• Net capital outflow NX = Y – (C + I + G )

=S–I implies
= net outflow of “loanable funds” NX = (Y – C – G ) – I
= net purchases of foreign assets the country’s =S–I
purchases of foreign assets minus foreign
purchases of domestic assets trade balance = net capital outflow
• When S > I, country is a net lender Thus,
• When S < I, country is a net borrower a country with a trade deficit (NX < 0)
is a net borrower (S < I ).
U.S.: the world’s largest debtor nation
• Every year since the 1980s: huge trade deficits and

Saving, net capital inflows (that is, net borrowing from abroad)
investment, • As of December 31, 2014:
and the trade • U.S. residents owned $24.7 trillion worth of foreign
balance assets
1960–2014 • Foreigners owned $31.6 trillion worth of U.S.
Saving-US.pptx Trade Balance-Vietnam.pptx
assets
• U.S. net indebtedness to the rest of the world:
$6.9 trillion—higher than any other country, hence
U.S. is the “world’s largest debtor nation”
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Saving and investment in a National saving: The supply of loanable funds

small open economy
An open-economy version of the loanable funds model

from Chapter 3. S  Y - C (Y - T ) - G
Includes many of the same elements:
 production function Y  Y  F (K , L ) As in Chapter 3,
 consumption function C  C (Y - T ) national saving
does not depend on
 investment function I  I (r ) the interest rate
 exogenous policy variables G  G , T T
Assumptions about capital flows Investment:

The demand for loanable funds
a. Domestic and foreign bonds are perfect
r Investment is still a
substitutes (same risk, maturity, etc.)
downward-sloping function
b. Perfect capital mobility: of the interest rate,
no restrictions on international trade in assets but the exogenous
c. Economy is small: world interest rate…
r*
cannot affect the world interest rate, denoted r* …determines the
country’s level of
investment.
a and b imply r = r* I (r )
c implies r* is exogenous I (r* ) S, I
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If the economy were closed… But in a small open economy…
r r
S the exogenous S
…the interest world interest
rate would rate determines
adjust to investment… NX
equate r*
investment …and the
and saving: rc difference rc
between saving
I (r ) and investment
I (r )
determines net
I (rc ) S, I capital outflow
S and net exports I1 S, I
Three experiments: 1. Fiscal policy at home Fiscal Policy-Trade Deficit.
1. Fiscal policy at home r S2 S1

An increase in G
2. Fiscal policy abroad or decrease in T
reduces saving. NX2
*
3. An increase in investment demand r 1
(exercise) Results: NX1

I  0
NX  S  0
I (r )
I1 S, I
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NX and the federal budget deficit (% of GDP), 2. Fiscal policy abroad

1965–2014
r
Expansionary S1
NX2
fiscal policy
abroad raises r 2*
NX1
the world r1*
interest rate.
Results:
I  0 I (r )
NX  -I  0
I (r 2* ) I (r1* ) S, I
NOW YOU TRY ANSWERS

3. An increase in investment demand 3. An increase in investment demand
r r
Use the S S
ΔI > 0, NX2
model to
determine r* ΔS = 0, r*
the impact of net capital
an increase outflow and
NX1 NX fall NX1
in investment
by the I (r ) 2
demand on
NX, S, I, and I (r )1 amount ΔI I (r ) 1
net capital
outflow. I1 S, I I1 I2 S, I
22 23
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The nominal exchange rate The real exchange rate
e = Nominal Exchange Rate, the relative = real exchange rate, the

price of domestic currency in terms of relative price of domestic
foreign currency goods in terms of foreign
(example: VND per dollar) goods
(example: Japanese Big
Macs per U.S. Big Mac)
Understanding the units of ε ~ McZample ~
e P * one good: Big Mac

ε 
P price in U.S:
P* = $2.50
(VND per $)  ($ per unit U.S. goods)
 price in Vietnam:
VND per unit Vietnamese goods P = 100.000 VND
nominal exchange rate
VND per unit U.S. goods
 e = 20.000 VND/$ To buy a Vietnamese Big
VND per unit Vietnamese goods Mac, someone from U.S
*
e P
ε  would have to pay an
Units of Vietnamese goods P amount that could buy
 2 U.S Big Macs.
per unit of U.S. goods 20.000 VND/$  $2 .5 1
 
100.000 VND 2
 0 .5
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ε in the real world and our model How NX depends on ε
• In the real world: If ε rises:

We can think of ε as the relative price of a
• Vietnam goods become more expensive
basket of domestic goods in terms of a
relative to foreign goods
basket of foreign goods.
• In our macro model: • exports fall, imports rise
There’s just one good, “output.” • net exports fall
So ε is the relative price of one country’s
output in terms of the other country’s
output.
U.S. net exports and the real exchange rate, 1973–2015 The net exports function
The net exports function reflects this

inverse relationship between NX and ε :
NX = NX(ε )
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The NX curve for the Vietnam The NX curve for the U.S.
1/ε At low enough values of

1/ε ε, Vietnamese goods
ε2 become so expensive
that we export less than
so Vietnamese
When ε is we import
net exports will
relatively high, be high
Vietnamese
goods are ε1
relatively
inexpensive NX (ε) NX (ε)
0 NX NX(ε2) 0 NX
NX(ε1)
How ε is determined (1 of 2) How ε is determined
• The accounting identity says NX = S – I Neither S nor I 1/ε

S 1 - I (r *)
• We saw earlier how S – I is determined: depends on ε,
so the net capital
• S depends on domestic factors (output, outflow curve is
fiscal policy variables, etc.) vertical.
• I is determined by the world interest rate ε1

ε adjusts to
r*
equate NX NX(ε )
• So, ε must adjust to ensure with net capital
outflow, S - I. NX 1 NX
NX (ε ) = S - I ( r *)
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Interpretation: supply and demand Four experiments

in the foreign exchange market
1/ε 1. Fiscal policy at home
demand: S 1 - I (r *)
Foreigners need
dollars to buy 2. Fiscal policy abroad
U.S. net exports.
3. An increase in investment demand
supply: ε1 (exercise)
Net capital
outflow (S - I ) NX(ε ) 4. Trade policy to restrict imports
is the supply of
NX
dollars to be NX 1
invested abroad.
1. Fiscal policy at home 2. Fiscal policy abroad
1/ε S 2 - I (r *) S 1 - I (r *) An increase in r* 1/ε S 1 - I (r1 *)

A fiscal expansion S 1 - I (r 2 * )
reduces
reduces national
investment,
saving, net capital
increasing net
outflow, and the ε1
ε2 capital outflow
supply of dollars
and the supply of
in the foreign
dollars in the
exchange ε1 foreign exchange ε2
market…
market…
NX(ε ) NX(ε )
…causing the real
NX …causing the real NX
exchange rate to rise NX 2 NX 1 NX 1 NX 2
exchange rate to
and NX to fall.
fall and NX to rise.
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NOW YOU TRY 4. Trade policy to restrict imports

3. Increase in investment demand
At any given ε, 1/ε
1/ε an import quota S -I
Determine the S1 - I1 reduces IM,
impact of an
increases NX,
increase in ε2
increases demand
investment
for dollars.
demand on ε1
net exports, ε1
NX (ε 2)
net capital Trade policy doesn’t
outflow, NX(ε ) affect S or I , so NX (ε 1)
and the real capital flows and the
NX NX
exchange rate. NX 1 supply of dollars NX1
remain fixed.
40
4. Trade policy to restrict imports Thương mại tự do.pptx

The determinants of the nominal exchange rate, part 1
Results: 1/ε • Start with the expression for the real

S -I exchange rate:
Δε > 0
(demand e×P
increase) ε2 ε =
P*
ΔNX = 0
(supply fixed) ε1
• Solve for the nominal exchange rate:
ΔIM < 0 NX (ε 2)
(policy) NX (ε 1)
ΔEX < 0
P*
NX e =ε ×
(rise in ε ) NX1 P
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The determinants of the nominal exchange rate The determinants of the nominal exchange rate
P*
So e depends on the real exchange rate and the e  ε 
P
price levels at home and abroad…
Rewrite this equation in growth rates
…and we know how each (see “arithmetic tricks for working with percentage changes,”
of them is determined: M* * * Chapter 2 ):
 L (r *   *, Y )
P*
e ε P * P ε
P *   *
-   * - 
e  ε  e ε P P ε
P
 For a given value of ε,
M
 L (r *   , Y ) the growth rate of e equals the difference
NX (ε )  S - I (r *) P
between foreign and domestic inflation rates.
Inflation differentials and nominal exchange rates Purchasing-power parity (PPP), part 1
for a cross section of countries
Two definitions:
• a doctrine that states that goods must sell
at the same (currency-adjusted) price in
all countries
• the nominal exchange rate adjusts to
equalize the cost of a basket of goods
across countries
Reasoning:
arbitrage, the law of one price
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Purchasing Power Parity (PPP) Purchasing Power Parity (PPP)
PPP: e × P = P* Cost of a basket of If e = P*/P, *

foreign goods, in P
then ε  e  * 
P P
 1
foreign currency. P P P*
and the NX curve is horizontal:
Cost of a basket of Cost of a basket of
domestic goods, in domestic goods, in ε S -I Under PPP,
foreign currency. domestic currency. changes in
 Solve for e : e = P*/ P (S – I ) have no
ε =1 NX impact on ε or e.
 PPP implies that the nominal exchange rate
between two countries equals the ratio of the
countries’ price levels.
NX
Does PPP hold in the real world? CASE STUDY: The Reagan Deficits Revisited
1970s 1980s Actual Closed Small open
No, for two reasons:
change economy economy
1. International arbitrage is not possible G-T 2.2 3.9   
• nontraded goods S 19.6 17.4   
• transportation costs r 1.1 6.3   no change
2. Different countries’ goods are not perfect substitutes I 19.9 19.4   no change
Yet PPP is a useful theory: NX -0.3 -2.0  no 
change
• It’s simple and intuitive.
ε 115.1 129.4  no 
• In the real world, nominal exchange rates tend toward change
their PPP values over the long run.
Data: Decade averages; all except r and ε are expressed as

a percentage of GDP; ε is a trade-weighted index.
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The U.S. as a large open economy A fiscal expansion in three models
• So far, we’ve learned long-run models for two A fiscal expansion causes national saving
extreme cases: to fall.
• closed economy (Chapter 3) The Closed Largedepend
effects of this open Small open
on openness
economy economy economy
and size.
• small open economy (Chapter 5) r rises rises, but not as no change
much as in a closed
• A large open economy—like the U.S.—falls economy
between these two extremes. I falls falls, but not as no change
much in a closed
• The results from large open-economy analysis economy
are a mixture of the results for the closed and NX no change falls, but not as falls
small open-economy cases. much as in an open
economy
• For example . . .

• Net exports—the difference between: • National income accounts identities
 exports and imports • Y = C + I + G + NX
 a country’s output (Y) and its spending (C + I + • trade balance NX = S – I net capital
G) outflow
• Net capital outflow equals: • Impact of policies on NX
 purchases of foreign assets minus foreign • NX increases if policy causes S to rise
purchases of the country’s assets or I to fall
 the difference between saving and investment • NX does not change if policy affects
3 The
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neither
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I (example: trade policy)
of Macroeconomics
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• Exchange rates • How the real exchange rate is determined
• nominal: the price of a country’s currency in terms  NX depends negatively on the real exchange
of another country’s currency rate, other things equal
• real: the price of a country’s goods in terms of  The real exchange rate adjusts to equate NX
another country’s goods with net capital outflow
• The real exchange rate equals the nominal rate
times the ratio of prices of the two countries.
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• How the nominal exchange rate is
determined:
 e equals the real exchange rate times the
country’s price level relative to the foreign
price level.
 For a given value of the real exchange
rate, the percentage change in the
nominal exchange rate equals the
difference between the foreign and
3domestic
CHAPTER 13
1 The
National
TheScience
Open of inflation
Income
Economy rates.
Macroeconomics
Revisited
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Macroeconomics
N. Gregory Mankiw
About the closed-economy

Solow model
How a country’s standard of
Economic Growth living depends on its saving
I: Capital and population growth rates
Accumulation How to use the “Golden Rule”
and Population to find the optimal saving rate
and capital stock
Growth
Presentation Slides
3 The
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Economic
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of Macroeconomics
I
Why growth matters (1 of 2) World Growth.pptx Why growth matters (2 of 2)
• Data on infant mortality rates: Anything that affects the long-run rate of
• 20% in the poorest 1/5 of all countries economic growth - even by a tiny amount -
• 0.4% in the richest 1/5 will have huge effects on living standards in
• In Pakistan, 85% of people live on less than $2/day. the long run.
• One-fourth of the poorest countries have had Annual Increase in Increase in Increase in
famines during the past 3 decades. growth rate standard of standard of standard of
• Poverty is associated with oppression of women and of income living after living after living after
minorities. per capita 25 years 50 years 100 years
2.0% 64.0% 169.2% 624.5%
Economic growth raises living standards and
reduces poverty…. 2.5% 85.4% 243.7% 1,081.4%
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The lessons of growth theory The Solow model
…can make a positive difference in the lives • due to Robert Solow, won Nobel Prize for
of hundreds of millions of people. contributions to the study of economic growth
• a major paradigm:
These lessons help us
• widely used in policymaking
• understand why poor countries are poor
• benchmark against which most recent
• design policies that can help them grow growth theories are compared
• learn how our own growth rate is affected • looks at the determinants of economic growth
by shocks and our government’s policies and the standard of living in the long run
How the Solow model is different from Chapter

The production function (1 of 2)
3’s model, part 1
KLA.pptx
1. K is no longer fixed: investment causes it • In aggregate terms: Y = F (K, L)

to grow, depreciation causes it to shrink • Define: y = Y/L = output per worker
2. L is no longer fixed: population growth k = K/L = capital per worker
causes it to grow • Assume constant returns to scale:
3. the consumption function is simpler zY = F (zK, zL) for any z > 0
4. no G or T (only to simplify presentation; • Pick z = 1/L. Then
we can still do fiscal policy experiments) • Y/L = F (K/L, 1)
5. cosmetic differences • y = F (k, 1)
• y = f(k) where f(k) = F(k, 1)
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The production function (2 of 2) The national income identity
• Y = C + I (remember, no G)
• In “per worker” terms:
y=c+i
where c = C/L and i = I /L
Note: This production
function exhibits
diminishing MPK.
The consumption function Saving and investment
• s = the saving rate, the fraction of income • Saving (per worker) = y – c

that is saved (s is an exogenous = y – (1–s)y
parameter) = sy
Note: s is the only lowercase variable that • National income identity is y = c + i
is not equal to its uppercase version divided
Rearrange to get i = y – c = sy
by L
(investment = saving, as in Chapter 3!)
• Consumption function: c = (1–s)y (per
worker) • Using the results above,
i = sy = sf(k)
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Depreciation
Output, consumption, and investment
Output per f(k)

worker, y Output per
worker
Consumption
per worker
c1
y1 sf(k)
Investment
per worker
i1
δ = the rate of depreciation
k1 Capital per = the fraction of the capital stock that

worker, k wears out each period
Capital accumulation The equation of motion fork
The basic idea: Investment increases

the capital stock; depreciation reduces it.
change in capital stock = investment – depreciation

• The Solow model’s central equation
Δk = i – δk
• Determines behavior of capital over time . . .
Since i = sf(k) , this becomes:
• . . . which, in turn, determines behavior of all the other
endogenous variables because they all depend on k.
• Example:
income per person: y = f(k)
consumption per person: c = (1 – s) f(k)
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The steady state, part 1 The steady state

Investment
and
depreciation δk
sf(k)
• If investment is just enough to cover
depreciation
[sf(k) = δk],
then capital per worker will remain constant:
Δk = 0.
• This occurs at one value of k, denoted k*, called
k* Capital per
the steady-state capital stock. worker, k
Moving toward the steady state Moving toward the steady state
Δk = sf(k) − δk Investment Δk = sf(k) − δk
Investment and
and δk depreciation δk
depreciation
sf(k) sf(k)
investment Δk
depreciation
Δk
k1 k* Capital per k1 k2 k* Capital per

worker, k worker, k
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Δk = sf(k) − δk Δk = sf(k) − δk
Investment Investment
and δk and δk
depreciation depreciation
sf(k) sf(k)
Δk Δk
investment
depreciation
k2 k* Capital per k2 k* Capital per

worker, k worker, k
Δk = sf(k) − δk Δk = sf(k) − δk
Investment Investment
and δk and δk
depreciation depreciation
sf(k) Summary: sf(k)
As long as k < k*,
investment will exceed
depreciation,
and k will continue to
Δk grow toward k*.
k2 k3 k* Capital per k3 k* Capital per

worker, k worker, k
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NOW YOU TRY

A numerical example, part 1
Approaching k* from above
• Draw the Solow model diagram, labeling Production function (aggregate):
the steady state k*. Y = F (K , L) = K × L = K 1/2L1/2
• On the horizontal axis, pick a value To derive the per-worker production
greater than k* for the economy’s initial function, divide through by L:
1/2
capital stock. Label it k1. Y K 1/2L1/2  K 
= = 
L L L
• Show what happens to k over time.
Does k move toward the steady state or Then substitute y = Y/L and k = K/L
away from it? to get y = f (k ) = k 1/2
Approaching the steady state: A numerical

A numerical example, part 2
example
Assume: Assumptions : y = k ; s = 0.3; δ = 0.1;initial k = 4.0
• s = 0.3 Year k y c i δk Δk
1 4.000 2.000 1.400 0.600 0.400 0.200
• δ = 0.1 2 4.200 2.049 1.435 0.615 0.420 0.195
3 4.395 2.096 1.467 0.629 0.440 0.189
• initial value of k = 4.0 4 4.584 2.141 1.499 0.642 0.458 0.184
5 4.768 2.184 1.529 0.655 0.477 0.178
10 5.602 2.367 1.657 0.710 0.560 0.150
25 7.321 2.706 1.894 0.812 0.732 0.080
100 8.962 2.994 2.096 0.898 0.896 0.002
∞ 9.000 3.000 2.100 0.900 0.900 0.000
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Solve for the steady state Solve for the steady state, answers
Continue to assume
Δk = 0 definition of steady state
s = 0.3, δ = 0.1, and y = k ½
s f (k *) = δk * eq'n of motion with Δk = 0
Use the equation of motion
0.3 k *  0.1k * using assumed values
Δk = s f(k) − δk
to solve for the steady-state values of k, y, k*
3  k*
and c. k*
Solve to get: k*  9 and y *  k *  3
Finally, c*  (1  s ) y *  0.7  3  2.1
Prediction: Countries with higher rates of

An increase in the saving rate saving and investment
An increase in the saving rate raises investment…
• The Solow model predicts that countries
…causing k to grow toward a new steady state:
Investment
with higher rates of saving and investment
and δk will have higher levels of capital and
depreciation income per worker in the long run.
s2 f(k)
s1 f(k) • Are the data consistent with this
prediction?
k
k 1* k 2*
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International evidence on investment rates

The Golden Rule: Introduction
and income per person
Income per 100,000 • Different values of s lead to different steady states.
person in How do we know which is the “best” steady state?
2009
(log scale) • The “best” steady state has the highest possible
10,000
consumption per person: c* = (1–s) f(k*).
• An increase in s
• leads to higher k* and y*, which raises c*
1,000 • reduces consumption’s share of income (1–s), which
lowers c*.
• So, how do we find the s and k* that maximize c*?
100
0 10 20 30 40 50
Investment as percentage of output
(average 1961-2009)
The Golden Rule capital stock, part 1 The Golden Rule capital stock
steady state
the Golden Rule level of capital, output and
*
k gold = depreciation
the steady-state value of k that δ k*
maximizes consumption Then, graph

f(k*) and δk*, f(k*)
To find it, first express c* in terms of look for the
k*: point where *
c gold
the gap between Sgold f(k*)
them is biggest.
* *
i gold   k gold
* *
y gold  f (k gold ) *
k gold steady-state
capital per
1. To reach the 2… the economy
Golden Rule needs the right worker, k*
Staeady State saving rate
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The Golden Rule capital stock The transition to the Golden Rule steady state
• The economy does NOT have a tendency

c* = f(k*) − δk* δ k* to move toward the Golden Rule steady
is biggest where the
state.
slope of the f(k*)
production function • Achieving the Golden Rule requires that
equals Sgold f(k*) policymakers adjust s.
the slope of the *
c gold
depreciation line: • This adjustment leads to a new steady
MPK = δ
state with higher consumption.
*
k gold steady-state
• But what happens to consumption during
Below the Golden Rule
Steady State, increases in
Above the Golden Rule
Steady State, increases in
capital per the transition to the Golden Rule?
steady capital raises steady capital reduce worker, k*
steady state consumption steady state consumption
Starting with too much capital Starting with too little capital
If k *  k gold
*
If k *  k gold
*
then increasing c*
then increasing c* y
requires an y
requires a fall in s. increase in s.
c
In the transition to c Future generations
the Golden Rule, enjoy higher
consumption is i consumption,
higher at all points but the current i
in time. one experiences
t0 an initial drop t0
time time
in consumption.
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Population growth Break-even investment
• Assume that the population and labor force • (δ + n)k = break-even investment, the
grow at rate n (exogenous): amount of investment necessary to keep k
L constant.
n
L • Break-even investment includes:
• Example: Suppose L = 1,000 in year 1 • δ k to replace capital as it wears out
and the population is growing at 2% per • n k to equip new workers with capital
year (n = 0.02). (Otherwise, k would fall as the existing capital stock is
spread more thinly over a larger population of
• Then ΔL = n L = 0.02 × 1,000 = 20, so L
workers.)
= 1,020 in year 2.
The equation of motion for k The Solow model diagram

Δk = s f(k) − (δ+n)k
 With population growth, Investment,
the equation of motion for k is: break-even
investment (δ + n ) k
Δk = s f(k) − (δ + n) k
sf(k)
actual
break-even
investment
investment
k* Capital per
worker, k
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The impact of population growth Prediction
Investment, • The Solow model predicts that countries

break-even (δ +n2) k with higher population growth rates will
investment
(δ +n1) k have lower levels of capital and income per
An increase in n worker in the long run.
causes an sf(k)
increase in break- • Are the data consistent with this
even investment, prediction?
leading to a lower
steady-state level
of k.
k2* k1* Capital per

worker, k
International evidence on population growth

and income per person
The Golden Rule with population growth
Income per 100,000
person in
To find the Golden Rule capital stock,
2009 express c* in terms of k*:
(log scale)
10,000
1,000
100
0 1 2 3 4 5
Population growth
(percent per year, average 1961-2009)
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International evidence on investment rates Alternative perspectives on population growth,

and income per person part 1
The Malthusian model (1798)
• Predicts population growth will outstrip the
Earth’s ability to produce food, leading to the
impoverishment of humanity.
• Since the time of Malthus, world population
has increased sixfold, yet living standards are
higher than ever.
• Malthus neglected the effects of technological
progress.
Alternative perspectives on population growth,

part 2 Macroeconomics
N. Gregory Mankiw
The Kremerian model (1993)
• Posits that population growth contributes to
economic growth.
• More people = more geniuses, scientists, and
engineers, so faster technological progress. Economic Growth
II: Technology,
• Evidence, from very long historical periods: Empirics, and
• As world population growth rate increased, so did the rate of Policy
growth in living standards.
• Historically, regions with larger populations have enjoyed Presentation Slides
faster growth.
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IN THIS CHAPTER, YOU WILL LEARN: Introduction
In the Solow model of Chapter 8,

How to incorporate
technological progress in the • the production technology is held constant.
Solow model
• income per capita is constant in the steady
About policies to promote
growth state.
About growth empirics: Neither point is true in the real world:
confronting the theory with
facts • 1900–2016: U.S. real GDP per person grew
Two simple models in which by a factor of 8.58, or 1.9% per year.
the rate of technological
progress is endogenous • examples of technological progress abound
(see the next slide).
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Science
Income
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I
Technological progress in the Solow model,

Examples of technological progress
part 1
• U.S. farm sector productivity nearly tripled from 1950 to • A new variable: E = labor efficiency
2012.
• The real price of computer power has fallen an average • Assume:
of 30% per year over the past three decades. Technological progress is labor-
• 2000: 361 million Internet users, 740 million cell phone augmenting:
users it increases labor efficiency at the
2016: 3.4 billion Internet users, 5.0 billion cell phone
users exogenous rate g:
• 2001: iPod capacity = 5GB, 1,000 songs. Not capable of ΔE
playing episodes of Game of Thrones. g=
E
2018: iPod touch capacity = 64GB, 30,000 songs. Can
play episodes of Game of Thrones.
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Technological progress in the Solow model, Technological progress in the Solow model,
part 2 part 3
We now write the production function as: • Notation:
y = Y / LE = output per effective worker
Y = F ( K, L × E )
k = K / LE = capital per effective worker
 where L × E = number of effective workers
• Production function per effective worker:
 Increases in labor efficiency have the
same effect on output as increases in the y = f(k)
labor force. • Saving and investment per effective worker:
s y = s f(k)
Technological progress in the Solow model,

Technological progress in the Solow
part 4
model
(δ + n + g) k = break-even investment: Δk = s f(k) − (δ +n +g)k
Investment,
the amount of investment necessary to keep break-even
k constant. investment
(δ+n +g ) k
Consists of: sf(k)
• δ k to replace depreciating capital
• n k to provide capital for new workers
• g k to provide capital for the new
“effective” workers created by
technological progress k* Capital per
worker, k
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Steady-state growth rates in the Solow model The Golden Rule with technological progress
with tech. progress
To find the Golden Rule capital stock,
Steady-State express c* in terms of k*:
Variable Symbol
Growth Rate
Capital per effective k = K/(E × L) 0
worker
Output per effective y = Y/(E × L) = f(k) 0
worker
Output per worker Y/L = y × E g
Total output Y = y × (E × L) n+g
Growth empirics: Balanced growth Growth empirics: Convergence, part 1
• The Solow model’s steady state exhibits • Solow model predicts that, other things
balanced growth: many variables grow at the equal, poor countries (with lower Y/L and
same rate. K/L) should grow faster than rich ones.
• The Solow model predicts that Y/L and K/L
• If true, then the income gap between rich
grow at the same rate (g), so K/Y should be
constant. This is true in the real world.
and poor countries would shrink over time,
causing living standards to converge.
• The Solow model predicts that real wage
grows at the same rate as Y/L, while real • In the real world, many poor countries do
rental price is constant. Also true in the real NOT grow faster than rich ones. Does this
world. mean the Solow model fails?
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Growth empirics: Convergence, part 2 Growth empirics: Convergence, part 3
• No, the Solow model does not fail because it • What the Solow model really predicts is
predicts that, other things equal, poor countries conditional convergence: countries
(with lower Y/L and K/L) should grow faster than converge to their own steady states, which
rich ones.
are determined by saving, population
• In samples of countries with similar savings growth, and education.
and population growth rates, income gaps
shrink about 2% per year. • This prediction comes true in the real
• In larger samples, after controlling for world.
differences in saving, population growth, and
human capital, incomes converge by about
2% per year.
Growth empirics: Factor accumulation vs. Growth empirics: Factor accumulation vs.
production efficiency, part 1 production efficiency, part 2
• Differences in income per capita among • Possible explanations for the correlation between
countries can be due to differences in: capital per worker and production efficiency:
1. capital—physical or human—per worker • Production efficiency encourages capital
2. the efficiency of production (the height of the accumulation.
production function) • Capital accumulation has externalities that
• Studies: raise efficiency.
• Both factors are important. • A third, unknown variable causes
• The two factors are correlated: countries with capital accumulation and efficiency to be
higher physical or human capital per worker higher in some countries than others.
also tend to have higher production efficiency.
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Growth empirics: Growth empirics:

Production efficiency and free trade Production efficiency and free trade
 Since Adam Smith, economists have argued that  To determine causation, Frankel and Romer
free trade can increase production efficiency and exploit geographic differences among countries:
living standards.
 Some nations trade less because they are farther
 Research by Sachs & Warner: from other nations, or landlocked.
 Such geographical differences are correlated with
Average annual growth rates, 1970–89 trade but not with other determinants of income.
open closed
 Hence, they can be used to isolate the impact of
trade on income.
developed nations 2.3% 0.7%
 Findings: increasing trade/GDP by 2% causes
developing nations 4.5% 0.7% GDP per capita to rise 1%, other things equal.
CHAPTER 9 Economic Growth II 68 CHAPTER 9 Economic Growth II 69
Policy issues: Evaluating the rate of saving,

Policy issues
part 1
• Are we saving enough? Too much? • Use the Golden Rule to determine whether
• What policies might change the saving rate? the U.S. saving rate and capital stock are
• How should we allocate our investment between too high, too low, or about right.
privately owned physical capital, public • If (MPK − δ) > (n + g), the U.S.
infrastructure, and human capital?
economy is below the Golden Rule
• How do a country’s institutions affect production
steady state and should increase s.
efficiency and capital accumulation?
• What policies might encourage faster • If (MPK − δ) < (n + g), the U.S.
technological progress? economy is above the Golden Rule
steady state and should reduce s.
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Policy issues: Evaluating the rate of saving, Policy issues: Evaluating the rate of saving,
part 2 part 3
To estimate (MPK − δ), use three facts about the 1. k = 2.5 y
U.S. economy:
2. δk = 0.1 y
1. k = 2.5 y
The capital stock is about 2.5 times one year’s 3. MPK × k = 0.3 y
GDP.
To determine δ, divide 2 by 1:
2. δk = 0.1 y
δk 0.1y 0.1
About 10% of GDP is used to replace = δ= = 0.04
depreciating capital. k 2.5 y 2.5
3. MPK × k = 0.3 y
Capital income is about 30% of GDP.
Policy issues: Evaluating the rate of saving, Policy issues: Evaluating the rate of saving,
part 4 part 5
1. k = 2.5 y • From the last slide: MPK − δ = 0.08
2. δk = 0.1 y • U.S. real GDP grows an average of 3% per
3. MPK × k = 0.3 y year, so n + g = 0.03
• Thus,
To determine MPK, divide 3 by 1:
MPK − δ = 0.08 > 0.03 = n + g
MPK × k 0.3 y 0.3
=  MPK = = 0.12 • Conclusion:
The U.S. is below the Golden Rule steady state:
k 2.5 y 2.5
Increasing the U.S. saving rate would increase
consumption per capita in the long run.
Hence, MPK − δ = 0.12 − 0.04 = 0.08
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Policy issues: Allocating the economy’s

Policy issues: How to increase the saving rate
investment, part 1
• Reduce the government budget deficit (or • In the Solow model, there’s one type of capital.
increase the budget surplus). • In the real world, there are many types, which we
• Increase incentives for private saving: can divide into three categories:
• Reduce capital gains tax, corporate income • private capital stock
tax, and estate tax, as they discourage saving. • public infrastructure
• Replace federal income tax with a • human capital: the knowledge and skills that
consumption tax. workers acquire through education
• Expand tax incentives for IRAs (individual • How should we allocate investment among these
retirement accounts) and other retirement types?
savings accounts.
Policy issues: Allocating the economy’s

Possible problems with industrial policy
investment, part 2
Two viewpoints: • The government may not have the ability to
1. Equalize tax treatment of all types of capital in “pick winners” (choose industries with the
all industries and let the market allocate highest return to capital or biggest
investment to the type with the highest marginal externalities).
product.
• Politics (e.g., campaign contributions)
2. Industrial policy:
rather than economics may influence which
Government should actively encourage
investment in capital of certain types or in industries get preferential treatment. Nhà máy ngàn tỷ.pptx
certain industries because it may have positive

externalities that private investors don’t
consider.
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Policy issues: Establishing the right Establishing the right institutions: North versus
institutions South Korea
• Creating the right institutions is important • After WW2, Korea split
into:
for ensuring that resources are allocated to
• North Korea with
their best use. Examples: institutions based on
• Legal institutions, to protect property authoritarian communism
rights. • South Korea with
Western-style democratic
• Capital markets, to help financial capital capitalism
flow to the best investment projects. • Today, GDP per capita is
over 10 times higher in S.
• A corruption-free government, to Korea than in N. Korea.
promote competition, enforce contracts,
etc.
Policy issues: Encouraging technological CASE STUDY: Is free trade good for economic
progress growth? Part 1
• Patent laws: • Since Adam Smith, economists have
encourage innovation by granting temporary argued that free trade can increase
monopolies to inventors of new products production efficiency and living standards.
• Tax incentives for R&D
• Research by Sachs & Warner:
• Grants to fund basic research at universities
• Industrial policy: Average annual growth rates, 1970–89
encourages specific industries that are key for
rapid technological progress (subject to the Open Closed
preceding concerns). Developed nations 2.3% 0.7%
Developing nations 4.5% 0.7%
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CASE STUDY: Is free trade good for economic

Endogenous growth theory
growth? Part 2
• To determine causation, Frankel and Romer • Solow model:
exploit geographic differences among countries:
• Sustained growth in living standards is
• Some nations trade less because they are due to technological progress.
farther from other nations or landlocked.
• Such geographic differences are correlated
• The rate of technological progress is
with trade but not with other determinants of exogenous.
income. • Endogenous growth theory:
• Hence, they can be used to isolate the impact • In this set of models, the growth rate of
of trade on income.
productivity and living standards is
• Findings: increasing trade/GDP by 2% causes endogenous.
GDP per capita to rise 1%, other things equal.
Endogenous growth theory The basic model, part 1

• Solow model: • Production function: Y = A K
• Growth rate is affected by k (capital intensity) where A is the amount of output for each unit of
• Higher k lowers the growth rate capital (A is exogenous and constant)
• Country’s growth rate decreases as k increases; • Key difference between this model and Solow:
• Those countries with higher k grows slower MPK is constant here, diminishes in Solow
• Endogenous growth theory: • Investment: sY
• Depreciation: δK
• Equation of motion for total capital:
• ΔK = sY − δK
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The basic model, part 2 Does capital have diminishing returns or not?
ΔK = sY − δK • It depends on the definition of capital.

• If capital is narrowly defined (only plant and
Divide through by K and use Y = A K to get:
equipment), then yes.
ΔY ΔK
= = sA  δ • Advocates of endogenous growth theory
Y K
argue that knowledge is a type of capital.
• If s A > δ, then income will grow forever, • If so, then constant returns to capital is
and investment is the “engine of growth.” more plausible, and this model may be a
good description of economic growth.
• Here, the permanent growth rate depends
on s. In Solow model, it does not.
A two-sector model, part 1 A two-sector model, part 2
• Two sectors: • In the steady state, manufacturing output

• manufacturing firms produce goods. per worker and the standard of living grow
• research universities produce knowledge that at rate
increases labor efficiency in manufacturing. ΔE / E = g (u).
• u = fraction of labor in research (u is exogenous) • Key variables:
• Manufacturing production function: • s: affects the level of income but not
• Y = F [K, (1 − u )E L] its growth rate (same as in the Solow
• Research production function: ΔE = g (u)E model)
• Capital accumulation: ΔK = s Y − δK • u: affects level and growth rate of
income
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DISCUSSION QUESTION The merits of raising

Facts about R&D
u
Question: 1. Much research is done by firms seeking profits.
2. Firms profit from research:
In what ways would raising u (that is, Patents create a stream of monopoly profits.
devoting more labor to research) benefit
There is extra profit in being first on the market
the economy? What are the costs of with a new product.
raising u?
3. Innovation produces externalities that reduce the
cost of subsequent innovation.
Much of the new endogenous growth theory
attempts to incorporate these facts into models
to better understand technological progress.
Is the private sector doing enough R&D? Economic growth as “creative destruction”
• The existence of positive externalities in • Schumpeter (1942) coined term “creative destruction” to
describe displacements resulting from technological
the creation of knowledge suggests that progress:
the private sector is not doing enough • The introduction of a new product is good for
R&D. consumers but often bad for incumbent producers,
who may be forced out of the market.
• But there is much duplication of R&D effort
• Examples:
among competing firms.
• Luddites (1811–1812) destroyed machines that
• Estimates: displaced skilled mill workers in England.
social return to R&D ≥ 40% per year • Walmart displaces many mom-and-pop stores.
• Thus, many believe the government should
encourage R&D.
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• Key results from the Solow model with • Empirical studies
technological progress:  The Solow model explains balanced growth,
 The steady-state growth rate of income per person conditional convergence.
depends solely on the exogenous rate of  Cross-country variation in living standards is
technological progress. due to differences in capital accumulation and in
 The United State has much less capital than the production efficiency.
Golden Rule steady-state level. • Endogenous growth theory: Models that
• Ways to increase the saving rate:  examine the determinants of the rate of
 increase public saving (reduce budget deficit) technological progress, which Solow takes as given.
 tax incentives for private saving  explain decisions that determine the creation of
knowledge through R&D.
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• The Solow growth model shows that, in the • If the economy has more capital than the
long run, a country’s standard of living Golden Rule level, then reducing saving will
depends: increase consumption at all points in time,
 positively on its saving rate making all generations better off.
If the economy has less capital than the
 negatively on its population growth rate Golden Rule level, then increasing saving
• An increase in the saving rate leads to: will increase consumption for future
generations, but reduce consumption for the
 higher output in the long run
present generation.
 faster growth temporarily
 but not faster steady-state growth
3 The
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Science
Income
Growth
of Macroeconomics
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Income
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Macroeconomics
About the IS curve and its
N. Gregory Mankiw relationship to:
• the Keynesian cross
• the loanable funds
model
About the LM curve and its
Part 1 relationship to:
Aggregate Demand • the theory of liquidity
I: Building the IS- preference
LM Model How the IS–LM model
determines income and the
Presentation Slides interest rate in the short run
when P is fixed
3 National
CHAPTER 11National
Aggregate
Income
Income
Demand I
Context, part 1 Context, part 2

• Chapter 10 introduced the model of aggregate demand • This chapter develops the IS–LM model,
and aggregate supply.
the basis of the aggregate demand curve.
• Long run:
• prices flexible • We focus on the short run and assume the
• output determined by factors of production and price level is fixed (so the SRAS curve is
technology horizontal).
• unemployment equals its natural rate • Chapters 11 and 12 focus on the closed-
• Short run: economy case. Chapter 13 presents the
• prices fixed open-economy case.
• output determined by aggregate demand
• unemployment negatively related to output
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The Keynesian cross Elements of the Keynesian cross
• A simple closed-economy model in which income consumption function : C = C(Y  T)

is determined by expenditure.
government policyvariables : G = G , T = T
(due to J. M. Keynes)
• Notation:
for now, plannedinvestment is exogenous : I = I
I = planned investment planned expenditure : PE = C(Y  T ) + I + G

PE = C + I + G = planned expenditure Equilibrium condition:
Y = real GDP = actual expenditure actual expenditure = planned expenditure
• Difference between actual and planned Y = PE
expenditure = unplanned inventory investment
Graphing planned expenditure Graphing the equilibrium condition
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The equilibrium value of income Increasing Government Expenditure
AE
At Y1, AE2 = C +I + G2
there is now an
unplanned
drop in
inventory… AE1 = C + I + G1
G
…so firms
increase output,
and income rises
toward a new
equilibrium at Y2.
Y1 Y2 Y
Y
Solving for ΔY (1 of 2) The government purchases multiplier
Y = C + I + G equilibrium condition definition: the increase in income resulting from a
$1 increase in G.
ΔY  ΔC  ΔI  ΔG in changes
 ΔC  ΔG because I exogenous
In this model, the govt purchases multiplier equals
 MPC ΔY  ΔG because ΔC  MPCΔY ΔY 1
=
ΔG 1 MPC
Example: If MPC = 0.8, then
Collect terms with Solve for ΔY :
ΔY on the left side 1 An increase in G

ΔY = 
 ΔY 1
of the equals sign:  × ΔG = =5 causes income to
 1 MPC  ΔG 1  0.8 increase 5 times as
(1  MPC)× ΔY = ΔG much!
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Why the multiplier is greater than 1 An increase in taxes

AE
• Initially, the increase in G causes an equal
Initially, the tax AE =C1 +I +G
increase in Y: ΔY = ΔG. increase reduces
consumption and AE =C2 +I +G
• But Y causes C therefore AE:
which causes further Y
At Y1, there is now an
C = MPC T
which then causes further C unplanned
inventory buildup…
…so firms reduce
which then causes further Y output, and
income falls
• So the final impact on income is much toward a new Y
AE2 = Y2 Y
bigger than the initial ΔG. equilibrium AE1 = Y1
Solving for ΔY (2 of 2) The tax multiplier, part 1
ΔY = ΔC + ΔI + ΔG eq’m condition in changes Definition: the change in income resulting
= ΔC I and G exogenous
from a $1 increase in T :
= MPC ×  ΔY  ΔT  ΔY  MPC
=
Solving for ΔY : (1 MPC)  ΔY   MPC  ΔT ΔT 1  MPC
If MPC = 0.8, then the tax multiplier equals
ΔY  0.8  0.8
  MPC  = = = 4
Final ΔY =  ΔT 1  0.8 0.2
 × ΔT
result:  1  MPC 
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NOW YOU TRY

The tax multiplier, part 2
Practice with the Keynesian cross
. . . is negative: Use a graph of the Keynesian cross to show
A tax increase reduces C, which reduces income. the effects of an increase in planned
. . . is greater than one (in absolute value): investment on the equilibrium level of
A change in taxes has a multiplier effect on income. income/output.
. . . is smaller than the govt spending multiplier:
Consumers save the fraction (1 – MPC) of a tax
cut, so the initial boost in spending from a tax cut is
smaller than from an equal increase in G.
NOW YOU TRY

The IS curve
Practice with the Keynesian cross, answer
At Y1, there is Definition: a graph of all combinations of r
now an and Y that result in goods market equilibrium
unplanned
drop in example: actual expenditure (output)
inventory . . .
= planned expenditure
. . . so firms
increase The equation for the IS curve is:
output, and
income rises Y = C (Y  T ) + I (r) + G
toward a new
equilibrium.
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Relationship between r and I Deriving the IS curve

AE AE =Y AE2 =C +I (r2 )+G
r I
r  I AE1 =C +I (r1 )+G
 AE
r1
 Y
Y1 Y2 Y
r
r2
r1
r2
IS
I2 I
I1
20 Y1 Y2 Y
When the IS curve is negatively sloped Fiscal policy and the IS curve
• A fall in the interest rate motivates firms to • We can use the IS–LM model to see how

increase investment spending, which fiscal policy (G and T) affects aggregate
drives up total planned spending (PE). demand and output.
• To restore equilibrium in the goods market, • Let’s start by using the Keynesian cross to
output (a.k.a. actual expenditure, Y) must see how fiscal policy shifts the IS curve . . .
increase.
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Shifting the IS curve: G NOW YOU TRY

Shifting the IS curve: ΔT
AE
AE =Y AE2=C +I (r1 )+G2
• At any value of r, • Use the diagram of the Keynesian cross or
G  AE  Y AE1=C +I (r1 )+G1 loanable funds model to show how an
• …so the IS curve increase in taxes shifts the IS curve.
shifts to the right.
• If you can, determine the size of the shift.
• The horizontal r
Y1 Y2 Y
distance of the
IS shift equals
r1
1
Y  G
1 MPC Y
IS1 IS2
Y1 Y2 Y
24
NOW YOU TRY

The theory of liquidity preference
Shifting the IS curve: ΔT, answer
At any value of • due to John Maynard Keynes
r, T  C 
• a simple theory in which the interest rate is
PE
determined by money supply and money
. . . so the IS demand
curve shifts to
the left.
The horizontal
distance of the
IS curve shift
equals
MPC
ΔY = ΔT
1MPC
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Money supply Money demand
The supply of Demand for
real money real money
balances is balances:
fixed:
d
s
M P  = L( r )
M P  =M P
How the Central Bank
Equilibrium
raises the interest rate
r
• To increase r,
Central Bank
reduces M
r2
r1
L (r )
M2 M1
M/P
P P
31
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CASE STUDY: Monetary tightening and interest CASE STUDY: Monetary tightening and
rates, part 1 interest rates, part 2
• Late 1970s: π > 10% The effects of a monetary tightening on
nominal interest rates
• Oct 1979: Fed Chair Paul Volcker Short run Long run
announces that monetary policy would aim Model Liquidity preference Quantity theory,
to reduce inflation (Keynesian) Fisher effect
(classical)
• Aug 1979–April 1980: Fed reduces M/P Prices Sticky Flexible
8.0% Prediction Δi > 0 Δi < 0
Actual 8/1979: i = 10.4% 8/1979: i = 10.4%
• Jan 1983: π = 3.7% outcome 4/1980: i = 15.8% 1/1983: i = 8.2%
How do you think this policy change would
affect nominal interest rates?
The LM curve Deriving the LM curve
Now let’s put Y back into the money (a) The market for

(b) The LM curve
demand function: real money balances
r r
d LM
M P  = L(r,Y )
r2 r2
The LM curve is a graph of all combinations
of r and Y that equate the supply and L2 (r2 , Y2 )
r1 r1
demand for real money balances.
L1 (r1 , Y1 )
The equation for the LM curve is: M/P Y1 Y2
M1 Y
M P = L(r,Y ) P
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Why the LM curve is upward sloping How M shifts the LM curve

(a) The market for
• An increase in income raises money real money balances (b) The LM curve
demand. r r
LM2
• Since the supply of real balances is fixed,
there is now excess demand in the money LM1
market at the initial interest rate. r2 r2
• The interest rate must rise to restore r1 r1
equilibrium in the money market. L (r , Y1 )
M/P Y1 Y
M2 M1
P P
NOW YOU TRY ANSWERS

Shifting the LM curve Shifting the LM curve
• Suppose a wave of credit card fraud
(a) The market for
causes consumers to use cash more real money balances
(b) The LM curve
frequently in transactions. r r
LM2
• Use the liquidity preference model to show LM1
how these events shift the LM curve. r2 r2
L (r2 , Y1 )
r1 r1
L (r1 , Y1 )
M1 M/P Y1 Y
P
3939
Tran Manh Kien
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Preview of Chapter 5
Macroeconomics
N. Gregory Mankiw
In Chapter 5, Part 2 we will
• use the IS–LM model to analyze the impact of
policies and shocks.
• learn how the aggregate demand curve
comes from IS-LM. Part 2
• use the IS–LM and AD–AS models together Aggregate Demand
to analyze the short-run and long-run effects II: Applying the IS-
of shocks. LM Model
• use our models to learn about the Great Presentation Slides
Depression.
IN THIS CHAPTER, YOU WILL LEARN The Short-run Equilibrium
• The IS curve represents
equilibrium in the
r
LM
How to use the IS–LM model to goods market.
analyze the effects of shocks, Y  C (Y  T )  I (r )  G
fiscal policy, and monetary policy
• The LM curve represents
How to derive the aggregate equilibrium in the
demand curve from the IS–LM money market.
model M P  L (r ,Y ) IS
Several theories about what • The intersection determines Y

caused the Great Depression the unique combination of Y Equilibrium Equilibrium
and r that satisfies interest level of
equilibrium in both markets. rate income
3 National
CHAPTER 11National
Aggregate
Income
Income
Demand I 43
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Policy analysis with the IS-LM model An Increase in Government Purchases

1. IS curve shifts right
Y  C (Y  T )  I (r )  G r 1
LM by G r
1  MPC LM
M P  L (r ,Y ) causing output &
income to rise
• We can use the IS-LM re 2. This raises money r2
model to analyze the demand, causing the
2.
effects of interest rate to rise…
IS r1
• Fiscal policy: G 3 …which reduces
1. IS2
and/or T Ye Y investment, so the final
increase in Y
• Monetary policy: M 1 IS1
is smaller than G
1  MPC
Y1 Y2 Y
3.
Tran Manh Kien 44 Tran Manh Kien 45
A Tax Cut Monetary policy: An increase in M
1. Consumers save
(1MPC) of the tax cut, r r
LM 1. M > 0 shifts LM1
so the initial boost in
spending is smaller for
the LM curve go to
T than for an equal
the right LM2
G… r1
r2 2. …causing the
and the IS curve shifts
2. interest rate to fall
by MPC r2
T r1
1  MPC 3. …which increases
1. IS2 investment,
2. …so the effects on IS
r and Y are smaller causing output &
IS1 income to rise.
for T than for an
equal G.
Y1 Y2 Y1 Y2 Y
Y
3.
Tran Manh Kien
46 Tran Manh Kien 47
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Interaction between monetary and fiscal policy The Fed’s response to ΔG > 0
• Model: • Suppose Congress increases G.
• Monetary and fiscal policy variables (M, • Possible Fed responses:
G, and T) are exogenous. 1. Hold M constant
• Real world: 2. Hold r constant
• Monetary policymakers may adjust M in 3. Hold Y constant
response to changes in fiscal policy or
• In each case, the effects of ΔG are
vice versa.
different . . .
• Such interactions may alter the impact of
the original policy change.
Response 1: Hold M constant Response 2: Hold r Constant
• If Congress r • If Congress raises G, r
raises G, the IS LM1 the IS curve shifts LM1
curve shifts right. right. LM2
• To keep r constant,
• If Central Bank Central Bank
r2
holds M constant, r2
increases M to shift
then LM curve r1
r1 LM curve right.
doesn’t shift.
IS2 • Result: IS2
• Result:
IS1 ∆Y = Y3 – Y1 IS1
∆Y = Y2 – Y1
Y1 Y ∆r = 0
∆r = r2 – r1 Y2 Y1 Y2 Y3 Y
5
0
Tran Manh Kien Tran Manh Kien
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Response 3: Hold Y constant Shocks in the IS-LM model, part 1

r IS shocks: exogenous changes in the
• If Congress raises G, LM2
the IS curve shifts demand for goods and services.
right. LM1
Examples:
• To keep Y constant, r3
Fed reduces M • stock market boom or crash
to shift LM curve left. r2 g change in households’ wealth
g ΔC
• Result: IS2
r1
∆Y = 0 IS1 • change in business or consumer
confidence or expectations
∆r = r3 – r1
Y1 Y2 Y g ΔI and/or ΔC
5
2
NOW YOU TRY

Shocks in the IS-LM model, part 2
Analyze shocks with the IS-LM model
LM shocks: exogenous changes in the Use the IS–LM model to analyze the effects of
demand for money. 1. a housing market crash that reduces
consumers’ wealth
Examples: 2. consumers using cash in transactions more
• A wave of credit card fraud increases frequently in response to an increase in
demand for money. identity theft
• More ATMs or the Internet reduce money For each shock,
demand. a. use the IS–LM diagram to determine the
effects on Y and r.
b. figure out what happens to C, I, and the
unemployment rate.
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ANSWERS, PART 1 ANSWERS, PART 2
Housing market crash Increase in money demand
IS shifts left, causing LM shifts left, causing
r and Y to fall. r to rise and Y to fall. LM2
r r
LM1 LM1
C falls due to lower C falls due to lower r2
wealth and lower r1 income, r1
income, I falls because
r2
I rises because r is higher
r is lower IS1 IS1
IS2 u rises because
u rises because Y Y is lower Y
Y2 Y1 Y2 Y1
Y is lower (Okun’s law)
(Okun’s law)
56 57
CASE STUDY: The U.S. recession of 2001, part CASE STUDY: The U.S. recession of 2001, part 2
1
• During 2001: Causes: 1) Stock market decline g C
• 2.1 million jobs lost, unemployment rose
from 3.9% to 5.8%.
• GDP growth slowed to 0.8% (compared
to 3.9% average annual growth during
1994–2000).
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CASE STUDY: The U.S. recession of 2001, part CASE STUDY: The U.S. recession of 2001, part
3 4
Causes: 2) 9/11 Fiscal policy response: shifted IS curve
• increased uncertainty right
• fall in consumer and business confidence
• tax cuts in 2001 and 2003
• result: lower spending, IS curve shifted left
• spending increases
Causes: 3) Corporate accounting scandals
• airline industry bailout
• Enron, WorldCom, etc.
• NYC reconstruction
• reduced stock prices, discouraged investment
• Afghanistan war
CASE STUDY: The U.S. recession of 2001, part

What is the Fed’s policy instrument? Part 1
5
Monetary policy response: shifted LM curve • The news media commonly report the Fed’s
right policy changes as interest rate changes, as if the
Fed has direct control over market interest rates.
• In fact, the Fed targets the federal funds rate—
the interest rate banks charge one another on
overnight loans.
• The Fed changes the money supply and shifts
the LM curve to achieve its target.
• Other short-term rates typically move with the
federal funds rate.
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What is the Fed’s policy instrument? Part 2 IS-LM and aggregate demand
Why does the Fed target interest rates • So far, we’ve been using the IS–LM model

instead of the money supply? to analyze the short run, when the price
1. They are easier to measure than the level is assumed to be fixed.
money supply. • However, a change in P would shift LM
2. The Fed might believe that LM shocks and would therefore affect Y.
are more prevalent than IS shocks. If so,
targeting the interest rate stabilizes • The aggregate demand curve (introduced
income better than targeting the money in Chapter 10) captures this relationship
supply. between P and Y.
Deriving the AD curve Monetary policy and the AD curve

r r LM(M1/P1)
LM(P2)
Intuition for slope r2 The Fed can increase r2
LM(M2/P2)
LM(P1) aggregate demand:
of AD curve: r1
r1
P g (M/P ) M g LM shifts right
IS IS
g LM shifts left Y2 Y1 Y g r Y1 Y2 Y
P P
g r g I
g I P2
g Y at each
P1
g Y P1 value of P
AD AD2
AD1
Y2 Y1 Y Y1 Y2 Y
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IS-LM and AD-AS in the short run and in the

Monetary policy and the AD curve long run
r
LM
Expansionary fiscal Recall from Chapter 10: The force that
r2
policy (G and/or T) moves the economy from the short run to the
r1
increases agg. demand: IS2 long run is the gradual adjustment of prices.
IS1
T g C
Y1 Y2 Y In the short run equilibrium, if then over time, the price level will
g IS shifts right P Y >Y rise
Y <Y fall
g Y at each Y =Y remain constant
value of P P1
AD2
AD1
Y1 Y2 Y
The SR and LR effects of an IS shock Monetary policy and the AD curve

r r LRAS
LRAS LM(P )
1
A negative IS shock A negative IS shock LMP1
shifts IS and AD left, shifts IS and AD left,

IS2
causing Y to fall. IS1 causing Y to fall.
IS1
IS2
Y Y Y2 Y
P
P LRAS LRAS
P1 SRAS1
SARS
P1
AD1
AD2 AD2
AD1
Y Y
Y2 Y
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The SR and LR effects of an IS shock The SR and LR effects of an IS shock

r
r LRAS LM(P1) LRAS LM(P1)
In the new short-run In the new short-run
equilibrium, Y  Y IS1 equilibrium, Y  Y IS1
IS2 IS2
Y Y
Y Over time, P gradually Y
P
P LRAS
falls, causing: LRAS
SRAS1 SRAS1
P1 • SRAS to move down P1
• M/P to increase,
AD1 which causes LM AD1
AD2 AD2
to move down
Y Y
Y Y
The SR and LR effects of an IS shock The SR and LR effects of an IS shock

r r
LRAS LM(P1) LRAS LM(P1)
LM(P2) LM(P2)
IS1 This process continues IS1

IS2 until economy reaches a IS2
Y long-run equilibrium with Y
Over time, P gradually P
Y Y
P
falls, causing: LRAS Y Y LRAS
SRAS1 SRAS1
• SRAS to move down P1 P1
SRAS2
• M/P to increase, P2 SRAS2 P2
which causes LM AD1 AD1

AD2 AD2
to move down
Y Y
Y Y
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NOW YOU TRY ANSWERS, PART 1
Analyze SR & LR effects of ΔM Short-run effects of ΔM
a. Draw the IS-LM and AD-AS r LRAS LM(M /P ) LM and AD shift right. r LRAS LM(M /P )
1 1 1 1
diagrams as shown here. r1 LM(M2/P1)
b. Suppose Fed increases M. r2
Show the short-run effects r falls, Y rises above Y
IS IS
on your graphs.
c. Show what happens in the Y Y Y Y2 Y
transition from the short run P LRAS P LRAS
to the long run.
d. How do the new long-run SRAS1
P1 P1 SRAS
equilibrium values of the
endogenous variables AD2
AD1 AD1
compare to their initial
values? Y Y Y Y2 Y
76 77
ANSWERS, PART 2 The Great Depression

Transition from short run to long run
Over time, r LRAS LM(M /P )
1
2 1
3
 P rises r3 = r1 LM(M2/P1)
 SRAS moves upward r2
IS
 M/P falls
 LM moves leftward Y
Y Y2
P LRAS
New long-run eq’m P3 SRAS
 P higher P1 SRAS
 all real variables back at AD2
their initial values AD1
Money is neutral in the long run. Y Y2 Y
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THE SPENDING HYPOTHESIS: Shocks to the IS THE SPENDING HYPOTHESIS: Reasons for the
curve IS shift
• Asserts the Depression was largely due to • Stock market crash reduced consumption
an exogenous fall in the demand for goods • Oct 1929–Dec 1929: S&P 500 fell 17%
and services—a leftward shift of the IS • Oct 1929–Dec 1933: S&P 500 fell 71%
curve.
• Drop in investment
• Evidence: • Correction after overbuilding in the 1920s.
output and interest rates both fell, which is
• Widespread bank failures made it harder to
what a leftward IS shift would cause. obtain financing for investment.
• Contractionary fiscal policy
• Politicians raised tax rates and cut spending
to combat increasing deficits.
THE MONEY HYPOTHESIS: A shock to the LM THE MONEY HYPOTHESIS AGAIN: The effects
curve of falling prices, part 1
• Asserts that the Depression was largely • Asserts that the severity of the Depression
due to the huge fall in the money supply. was due to a huge deflation:
• Evidence: M1 fell 25% during 1929–1933. P fell 25% during 1929–1933.
• But, two problems with this hypothesis: • This deflation was probably caused by the
• P fell even more, so M/P actually rose fall in M, so perhaps money played an
slightly during 1929–1931. important role after all.
• Nominal interest rates fell, which is the • In what ways does a deflation affect the
economy?
opposite of what a leftward LM shift
would cause.
21
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THE MONEY HYPOTHESIS AGAIN: The effects THE MONEY HYPOTHESIS AGAIN: The effects
of falling prices, part 2 of falling prices, part 3
• The stabilizing effects of deflation: The destabilizing effects of expected
• P g (M/P) g LM shifts right g Y deflation:
• Pigou effect: E π
P g (M/P ) g r  for each value of i
g consumers’ wealth  g I because I = I (r)
g C g planned expenditure and agg. demand 
g IS shifts right g income and output 
g Y
THE MONEY HYPOTHESIS AGAIN: The effects

Why another Depression is unlikely
of falling prices, part 4
The destabilizing effects of unexpected deflation: • Policymakers (or their advisers) now know much
debt-deflation theory more about macroeconomics:
P (if unexpected) • The Fed knows better than to let M fall so
g transfers purchasing power from borrowers to much, especially during a contraction.
lenders • Fiscal policymakers know better than to raise
taxes or cut spending during a contraction.
g borrowers spend less, lenders spend more
• Federal deposit insurance makes widespread
g if borrowers’ propensity to spend is larger
bank failures very unlikely.
than lenders’, then aggregate spending falls,
the IS curve shifts left, and Y falls • Automatic stabilizers make fiscal policy
expansionary during an economic downturn.
22
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CASE STUDY: The 2008-2009 financial crisis Interest rates and house prices
and recession
• 2009: Real GDP fell, u-rate approached 10%
• Important factors in the crisis:
• early 2000s Federal Reserve interest rate policy
• subprime mortgage crisis
• bursting of house price bubble, rising foreclosure
rates
• falling stock prices
• failing financial institutions
• declining consumer confidence, drop in spending on
consumer durables and investment goods
Change in U.S. house price index and rate of new House price change and new foreclosures,
foreclosures, 1999–2009 2006:Q3–2009:Q1
23
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U.S. bank failures by year, 2000–2011 Major U.S. stock indexes

(% change from 52 weeks earlier)
Consumer sentiment and growth in Real GDP growth and unemployment

consumer durables and investment spending
24
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• IS–LM model AD curve
• shows relationship between P and the IS–LM
 a theory of aggregate demand
model’s equilibrium Y.
 exogenous: M, G, T, • negative slope because
P exogenous in short run, Y in long run P g (M/P) g r g I g Y
 endogenous: r, • expansionary fiscal policy shifts IS curve right,
Y endogenous in short run, P in long run raises income, and shifts AD curve right.
• expansionary monetary policy shifts LM curve
 IS curve: goods market equilibrium right, raises income, and shifts AD curve right.
 LM curve: money market equilibrium • IS or LM shocks shift the AD curve.
3 National
CHAPTER 11National
Aggregate
Income
Income
Demand I 3 National
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Aggregate
Income
Income
Demand I
 Keynesian cross • Theory of liquidity preference
 basic model of income determination  basic model of interest rate determination
 takes fiscal policy and investment as exogenous  takes money supply and price level as exogenous
 fiscal policy has a multiplier effect on income  an increase in the money supply lowers the interest rate
 IS curve • LM curve
 comes from Keynesian cross when planned investment  comes from liquidity preference theory when money
depends negatively on interest rate demand depends positively on income
 shows all combinations of r and Y that equate planned  shows all combinations of r and Y that equate demand
expenditure with actual expenditure on goods and for real money balances with supply
services
3 National
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Income
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Demand I 3 National
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Demand I
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• IS–LM model
 The intersection of the IS and LM curves shows the
unique point (Y, r ) that satisfies equilibrium in both
the goods and money markets.
3 National
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Demand I
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Macroeconomics
N. Gregory Mankiw Facts about the business
cycle
How the short run differs from
the long run
An introduction to aggregate
demand
Introduction to An introduction to aggregate
supply in the short run and in
Economic the long run
Fluctuations How the model of aggregate
demand and aggregate
supply can be used to analyze
Presentation Slides the short-run and long-run
effects of “shocks.”
3 The
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1 National
Introduction
Science
Income
of Macroeconomics
to Economic Fluctuations
Growth rates of real GDP, consumption

Facts about the business cycle
• GDP growth averages 3–3.5% per year over the long run,
with large fluctuations in the short run.
• Consumption and investment fluctuate with GDP, but
consumption tends to be less volatile and investment
more volatile than GDP.
• Unemployment rises during recessions and falls during
expansions.
• Okun’s law: the negative relationship between GDP and
unemployment
2/14/2022
Growth rates of real GDP, consump., investment Unemployment
%
change
from 4
quarters
earlier
Okun’s law
Index of leading economic indicators
• Published monthly by the Conference

Board.
• Aims to forecast changes in economic
activity 6–9 months into the future.
• Used in planning by businesses and
government, despite not being a perfect
predictor.
2/14/2022
Components of the LEI index Index of leading economic indicators, 1970–2012
• Average workweek in manufacturing

• Initial weekly claims for unemployment insurance
• New orders for consumer goods and materials
• New orders, nondefense capital goods
• ISM new orders index
• New building permits issued
• Index of stock prices
• Lending credit index
• Yield spread (10-year minus 3-month) on Treasuries
• Index of consumer expectations
Time horizons in macroeconomics Recap of classical macro theory (Chapters 3-9)
• Long run • Output is determined by the supply side:

Prices are flexible, responding to changes • supplies of capital, labor
in supply or demand. • technology
• Short run • Changes in demand for goods and
Many prices are “sticky” at a services (C, I, G) only affect prices, not
predetermined level. quantities.
• Assumes complete price flexibility.
The economy behaves much • Applies to the long run.
differently when prices are sticky.
2/14/2022
When prices are sticky The model of aggregate demand and supply
. . . output and employment also depend on • The paradigm most mainstream

demand, which is affected by: economists and policymakers use to think
• fiscal policy (G and T) about economic fluctuations and policies to
stabilize the economy
• monetary policy (M)
• Shows how the price level and aggregate
• other factors, like exogenous changes in output are determined
C or I
• Shows how the economy’s behavior is
different in the short run and in the long run
Aggregate demand The quantity equation as aggregate demand
• The aggregate demand curve shows the • From Chapter 4, recall the quantity
relationship between the price level and equation:
the quantity of output demanded. MV =PY
• For this chapter’s intro to the AD/AS • For given values of M and V, this equation
model, we use a simple theory of implies an inverse relationship between P
aggregate demand based on the quantity and Y . . .
theory of money.
• Chapters 10–12 develop the theory of
aggregate demand in more detail.
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The downward-sloping AD curve Shifting the AD curve
An increase in P
the price level
causes a fall in
real money An increase in
balances (M/P), the money supply
causing a shifts the AD
decrease in the curve to the right.
demand for
goods and AD2
services.
AD1
Aggregate supply in the long run The long-run aggregate supply curve
• Recall from Chapter 3: In the long run,

output is determined by factor supplies and
technology
Y = F (K , L )
Y is the full-employment or natural
level of output, at which the economy’s
resources are fully employed.
“Full employment” means that unemployment
equals its natural rate (not zero).
2/14/2022
Long-run effects of an increase in M Aggregate supply in the short run

P • Many prices are sticky in the short run.
LRAS
An increase • For now (and through Chapter 12), we
in M shifts
assume
AD to the
P2
right. • all prices are stuck at a predetermined
In the long run,
this raises the level in the short run.
price level… P1
AD2 • firms are willing to sell as much at that
AD1 price level as their customers are willing
…but leaves to buy.
Y Y
output the same.
• Therefore, the short-run aggregate supply
(SRAS) curve is horizontal.
The short-run aggregate supply curve Short-run effects of an increase in M
The SRAS P
curve is In the short run
…an increase
horizontal: when prices are
in aggregate
sticky,…
The price level demand…
is fixed at a
predetermined
level, and firms SRAS
P
sell as much AD2
as buyers
demand. AD1
…causes Y1 Y2 Y
output to rise.
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From the short run to the long run The SR & LR effects of ΔM > 0
Over time, prices gradually become “unstuck.”

When they do, will they rise or fall? A = initial P LRAS
equilibrium
In the short-run then over time,
equilibrium, if P will… B = new short-
run eq’m P2 C
Y Y rise
after Fed B SRAS
Y Y fall increases M P A AD2
Y Y remain constant AD1
C = long-run
The adjustment of prices is what moves equilibrium
Y Y2 Y
the economy to its long-run equilibrium.
How shocking! The effects of a negative demand shock
• shocks: exogenous changes in aggregate P

AD shifts left, LRAS
supply or demand depressing output
• Shocks temporarily push the economy away from and employment
full employment. in the short run.
B A SRAS
• example: exogenous decrease in velocity Over time, P
If the money supply is held constant, a decrease prices fall and
P2 C AD1
the economy
in V means people will be using their money in
moves down its AD2
fewer transactions, causing a decrease in
demand curve
demand for goods and services. toward full Y2 Y Y
employment.
2/14/2022
Supply shocks CASE STUDY: The 1970s oil shocks, part 1
• A supply shock alters production costs, affects • Early 1970s: OPEC coordinated a
the prices that firms charge (also called price reduction in the supply of oil.
shocks).
• Oil prices rose
• Examples of adverse supply shocks:
• Bad weather reduces crop yields, pushing up 11% in 1973
food prices. 68% in 1974
• Workers unionize, negotiate wage increases. 16% in 1975
• New environmental regulations require firms
• Such sharp oil price increases are supply
to reduce emissions. Firms charge higher
prices to help cover the costs of compliance.
shocks because they significantly impact
production costs and prices.
• Favorable supply shocks lower costs and prices.
CASE STUDY: CASE STUDY: The 1970s oil shocks, part 3

The 1970s oil shocks
The oil price shock Predicted effects

LRAS
P of the oil shock:
shifts SRAS up,
causing output and • inflation #
employment to fall. • output $
B SRAS2 • unemployment #
P2
In absence of …and then a
further price A SRAS1 gradual recovery
P1
shocks, prices will
fall over time and AD
economy moves
back toward full Y
Y2 Y
employment.
2/14/2022
CASE STUDY: The 1970s oil shocks, part 4 CASE STUDY: The 1980s oil shocks
Late 1970s: As 1980s: A

the economy favorable supply
was recovering, shock—a
oil prices shot significant fall in
up again, oil prices.
causing another As the model
huge supply predicts, inflation
shock! and
unemployment
fell.
Stabilization policy Stabilizing output with

monetary policy
stabilization policy: policy actions aimed at
P LRAS
reducing the severity of short-run economic
fluctuations. The adverse
supply shock
example: using monetary policy to combat B SRAS2
moves the P2
the effects of adverse supply shocks economy to
A SRAS1
point B. P1
AD1
Y
Y2 Y
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Stabilizing output with

monetary policy CHAPTER SUMMARY, PART 1
• Long run: prices are flexible, output and
But the Fed P LRAS employment are always at their natural rates, and
accommodates the classical theory applies.
the shock by Short run: prices are sticky, shocks can push
raising agg. output and employment away from their natural
demand. B C SRAS2
P2 rates.
A • Aggregate demand and supply: a framework to
results: P1
P is permanently AD2 analyze economic fluctuations
AD1
higher, but Y
remains at its full- Y
employment level. Y2 Y
3 The
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1 National
Introduction
Science
Income
of Macroeconomics

• The aggregate demand curve slopes downward. • Shocks to aggregate demand and supply cause
• The long-run aggregate supply curve is vertical fluctuations in GDP and employment in the short
because output depends on technology and factor run.
supplies but not prices. • The Fed can attempt to stabilize the economy with
• The short-run aggregate supply curve is horizontal monetary policy.
because prices are sticky at predetermined levels.
3 The
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1 National
Introduction
Science
Income
of Macroeconomics
to Economic Fluctuations 3 The
CHAPTER 10
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Introduction
Science
Income
of Macroeconomics
5/1/2022

Macroeconomics
N. Gregory Mankiw
About the Mundell–Fleming

model
(IS–LM for the small open
economy)
The Open Economy About causes and effects of
Revisited: The interest rate differentials
Mundell-Fleming Arguments for fixed versus
Model and the floating exchange rates
Exchange-Rate
How to derive the aggregate
Regime demand curve for a small
Presentation Slides open economy
3 The
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1 National
TheScience
OpenIncome
Economy
of Macroeconomics
Revisited
The Mundell-Fleming model The IS* curve: Goods market equilibrium
Key assumption:
Y  C (Y  T )  I (r *)  G  NX (e )
• Small open economy with perfect capital
mobility: r = r* The IS* curve is drawn
• Goods market equilibrium—the IS* curve: for a given value of r*.
Y  C (Y  T )  I (r *)  G  NX (e ) Intuition for the slope:
Where
 e   NX   Y
e = nominal exchange rate
= foreign currency per unit domestic
currency
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Equilibrium in the Mundell-Fleming model

The LM* curve: Money market equilibrium
Y  C (Y  T )  I (r *)  G  NX (e )
M P  L (r *,Y )
M P  L (r *,Y )
The LM* curve:
• is drawn for a given
value of r*.
• is vertical because,
given r*, there is only
one value of Y that
equates money
demand with supply,
regardless of e.
Floating and fixed exchange rates Fiscal policy under floating exchange rates
• In a system of floating exchange rates, e Y  C (Y  T )  I (r *)  G  NX (e )

is allowed to fluctuate in response to M P  L (r *,Y )
changing economic conditions. e
LM1*
• In contrast, under fixed exchange rates, At any given value of e,

a fiscal expansion e2
the central bank trades domestic for
increases Y,
foreign currency at a predetermined price. shifting IS* to the right.
e1 IS2
• Next, policy analysis: Results:
• in a floating exchange rate system e > 0, Y = 0
IS1
• in a fixed exchange rate system
Y1 Y
2
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Lessons about fiscal policy Monetary policy under floating exchange rates
• In a small open economy with perfect Y  C (Y  T )  I (r *)  G  NX (e )

capital mobility, fiscal policy cannot affect M P  L (r *,Y )
real GDP. e LM1* LM2*
An increase in M
• Crowding out shifts LM* right
• closed economy: because Y must rise e1
Fiscal policy crowds out investment by to restore eq’m in
causing the interest rate to rise. the money market.
e2
Results:
IS1*
• small open economy: e < 0, Y > 0
Fiscal policy crowds out net exports by Y1 Y2 Y
causing the exchange rate to appreciate.
Lessons about monetary policy Trade policy under floating exchange rates
• Monetary policy affects output by affecting the Y  C (Y  T )  I (r *)  G  NX (e )

components of aggregate demand:
M P  L (r *,Y ) e LM 1*
• closed economy: M → r → I → Y
At any given value of e,
• small open economy: M → e → NX → Y e2
a tariff or quota reduces
• Expansionary monetary policy does not raise imports, increases NX,
world aggregate demand; it merely shifts and shifts IS* to the right. e1
IS 2*
demand from foreign to domestic products. Results:
IS 1*
• So, the increases in domestic income and e > 0, Y = 0
employment are at the expense of losses Y1 Y
abroad.
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Lessons about trade policy, part 1 Lessons about trade policy, part 2
• Import restrictions cannot reduce a trade • Import restrictions on specific products

deficit. save jobs in the domestic industries that
• Even though NX is unchanged, there is produce those products but destroy jobs in
less trade: export-producing sectors.
• The trade restriction reduces imports. • Hence, import restrictions fail to increase
total employment.
• The exchange rate appreciation reduces
exports. • Also, import restrictions create sectoral
shifts, which cause frictional
• Less trade means fewer “gains from trade.” unemployment.
Fixed exchange rates Fiscal policy under fixed exchange rates
• Under fixed exchange rates, the central bank

stands ready to buy or sell the domestic currency Under
Underfloating
floatingrates,
rates,
for foreign currency at a predetermined rate. afiscal
fiscalpolicy
expansion
is ineffective e LM1* LM 2*
would raise e.
at changing output.
• In the Mundell–Fleming model, the central bank
shifts the LM* curve as required to keep e at its To keep fixed
Under e fromrates,
rising,
preannounced rate. the central bank musteffective
fiscal policy is very
sell domestic currency,
at changing output. e1
• This system fixes the nominal exchange rate. which increases M IS 2*
In the long run, when prices are flexible, the real and shifts LM* right.
IS 1*
exchange rate can move even if the nominal rate
Results:
is fixed. Y1 Y2 Y
e = 0, Y > 0
4
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Monetary policy under fixed exchange rates Trade policy under fixed exchange rates
An increase
Under in M
floating would
rates, e
Under floating rates,
A restriction on imports
import restrictions e
monetary
shift policy
LM* right andis reduce e. LM 1* LM 2* puts upward pressure on e.
do not affect Y or NX. LM 1* LM 2*
very
To effective
prevent at changing
the fall in e, the
To keep
Under e from
fixed rates,rising,
output.bank must buy
central
the central
import bank must
restrictions
domestic currency,
Under fixed rates,which
e1 sell domestic
increase Y and currency,
NX.
reduces M and
monetary policy shifts LM* be
cannot which increases
But, these gains come M
back
usedleft.
to affect output. e1
atand
theshifts LM*ofright.
expense other
Results: IS 1* countries:
Results: the policy merely IS 2*
e = 0, Y = 0 Y1 Y2 Y shiftse
demand from
= 0, Y > 0foreign to IS 1*
domestic goods. Y1 Y2 Y
Summary of policy effects in the Mundell-Fleming

Interest rate differentials
model
Type of exchange-rate regime: Two reasons why r may differ from r*
• country risk:
Floating: Floating: Floating: Fixed: Fixed: Fixed:
There is a risk that the country’s borrowers will
Policy Impact Impact Impact Impact Impact Impact default on their loan repayments because of
on: Y on: e on: NX on: Y on: e on: NX
political or economic turmoil.
Fiscal expansion 0 ↑ ↓ ↑ 0 0 Lenders require a higher interest rate to compensate them for
this risk.
Mon. expansion ↑ ↓ ↑ 0 0 0
• expected exchange rate changes:
Import restriction 0 ↑ 0 ↑ 0 ↑ If a country’s exchange rate is expected to fall,
then its borrowers must pay a higher interest
rate to compensate lenders for the expected
currency depreciation.
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Differentials in the Mundell-Fleming model Click to edit

The effects of anMaster title style
increase in 
r  r * 
IS* shifts left, because
where θ (Greek letter theta) is a risk premium,   r  I
assumed to be exogenous. e LM 1* LM 2*
LM* shifts right, because

Substitute the expression for r into the IS* and e1
  r  (M/P)d,
LM* equations:
so Y must rise to restore
Y  C (Y  T )  I (r *   )  G  NX (e ) money market eq’m.
e2
IS 1*
M P  L (r *   ,Y ) Results: IS 2*
e < 0, Y > 0 Y1 Y2 Y
The effects of an increase in θ, part 2 Why income may not rise
• The fall in e is intuitive: • The central bank may try to prevent the
An increase in country risk or an expected depreciation by reducing the money
depreciation makes holding the country’s supply.
currency less attractive.
Note: An expected depreciation is a self-
• The depreciation might boost the price of
fulfilling prophecy. imports enough to increase the price level
(which would reduce the real money
• The increase in Y occurs because supply).
• the boost in NX (from the depreciation) • Consumers might respond to the increased
• is greater than the fall in I (from the rise in risk by holding more money.
r).
Each of the above would shift LM* leftward.
6
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CASE STUDY: The Mexican peso crisis, part 1 CASE STUDY: The Mexican peso crisis, part 2
35
35
U.S. Cents per Mexican Peso
U.S. Cents per Mexican Peso

30
30
25
25
20
20
15
15
10
10
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
7/10/94 8/29/94 10/18/94 12/7/94 1/26/95 3/17/95 5/6/95
The Peso crisis didn’t hurt just Mexico Understanding the crisis, part 1
• U.S. goods became expensive to • In the early 1990s, Mexico was an attractive
Mexicans, so: place for foreign investment.
• U.S. firms lost revenue • During 1994, political developments caused an

increase in Mexico’s risk premium (θ):
• Hundreds of bankruptcies occurred • peasant uprising in Chiapas
along the U.S.–Mexico border
• assassination of leading presidential
• Mexican assets lost value (measured in candidate
dollars) • Another factor:
• Reduced wealth of millions of U.S. The Federal Reserve raised U.S. interest rates
citizens several times during 1994 to prevent U.S.
inflation. (Δr* > 0)
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Dollar reserves of Mexico’s central bank

Understanding the crisis, part 2
• These events put downward pressure on the December 1993 ……………… $28 billion
peso. August 17, 1994 ……………… $17 billion
• Mexico’s central bank had repeatedly promised December 1, 1994 …………… $ 9 billion
foreign investors it would not allow the peso’s December 15, 1994 ………… $ 7 billion
value to fall, so it bought pesos and sold dollars
to prop up the peso exchange rate.
• Such a move requires that the central bank have
adequate reserves of the foreign currency.
Did Mexico’s central bank have these adequate During 1994, Mexico’s central bank hid the fact that its
reserves of dollars? reserves were being depleted.
The disaster The rescue package
• Dec. 20: Mexico devalues the peso by 13% • 1995: The United States and the IMF set
(fixes e at 25 cents instead of 29 cents) up a $50 billion line of credit to provide
• Investors are SHOCKED! They had no idea loan guarantees to Mexico’s government.
Mexico was running out of reserves. • This helped restore confidence in Mexico
• θ, investors dump their Mexican assets and pull and reduced the risk premium.
their capital out of Mexico.
• After a hard recession in 1995, Mexico
• Dec. 22: The central bank’s reserves are nearly began a strong recovery from the crisis.
gone. It abandons the fixed rate and lets e float.
• In a week, e falls another 30%.
8
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Data on the SE Asian crisis

CASE STUDY: The Southeast Asian crisis, 1997-1998
Exchange Stock market Nominal
• Problems in the banking system eroded rate % % change GDP %
international confidence in SE Asian economies. change from from 7/97 – change 1997-
7/97 – 1/98 1/98 1998
• Risk premiums and interest rates rose.
Indonesia −59.4 −32.6 −16.2
• Stock prices fell as foreign investors sold assets Japan −12.0 −18.2 −4.3
and pulled out their capital. Malaysia −36.4 −43.8 −6.8
• Falling stock prices reduced the value of Singapore −15.6 −36.0 −0.1
collateral used for bank loans, increasing default S. Korea −47.5 −21.9 −7.3
rates, which exacerbated the crisis. Taiwan −14.6 −19.7 n.a.
• Capital outflows depressed exchange rates. Thailand −48.3 −25.6 −1.2
U.S. n.a. 2.7 2.3
Floating versus fixed exchange rates The impossible trinity
Argument for floating rates:

• allow monetary policy to be used to pursue
other goals (stable growth, low inflation)
Arguments for fixed rates:
• avoid uncertainty and volatility, making
international transactions easier
• discipline monetary policy to prevent
excessive money growth and hyperinflation
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The to
Click Impossible Trinity
edit Master title style CASE STUDY: The Chinese currency controversy
A nation cannot have free • 1995–2005: China fixed its exchange rate at 8.28
capital flows, independent Free capital yuan per dollar and restricted capital flows.
monetary policy, and a flows
fixed exchange rate • Many observers believed the yuan was
simultaneously. Option 1 Option 2 significantly undervalued. U.S. producers
A nation must choose (U.S.) (Hong Kong) complained the cheap yuan gave Chinese
one side of this producers an unfair advantage.
triangle and
give up the • President Bush called on China to let its currency
Independent Fixed float; others wanted tariffs on Chinese goods.
opposite monetary
Option 3 exchange
corner. (China) rate
policy • July 2005: China began to allow gradual changes
in the yuan/dollar rate. By June 2013, the yuan
had appreciated 35%.
Mundell-Fleming and the AD curve Deriving the AD curve
• So far in Mundell–Fleming model, P has been  LM*(P2) LM*(P1)

fixed. Why AD curve has
2
negative slope:
• Next, to derive the AD curve, consider the impact 1
of a change in P in the Mundell–Fleming model. P  (M/P)
IS*
• We now write the Mundell–Fleming equations as:  LM shifts left Y2 Y1 Y
(IS* ) Y  C (Y  T )  I (r *)  G  NX (ε ) P
 
P2
(LM* ) M P  L (r *,Y )  NX P1
 Y AD
(Earlier in this chapter, P was fixed, so we
could write NX as a function of e instead of ε.) Y2 Y1 Y
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From the short run to the long run Large: Between small and closed
 LM*(P1) LM*(P2) • Many countries—including the United States—

If Y1  Y ,
1 are neither closed nor small open economies.
then there is downward
pressure 2 • A large open economy is between the polar
on prices. IS* cases of closed and small open.
Over time, P will Y1 Y Y • Consider a monetary expansion:
P LRAS
move down, causing • As in a closed economy,
(M/P ) P1 SRAS1 M → r →I (though not as much)
 P2 SRAS2
• As in a small open economy,
NX  AD M → ε → NX (though not as much)
Y Y1 Y Y
CHAPTER SUMMARY, PART 1 CHAPTER SUMMARY PART 2

• Mundell–Fleming model: • Monetary policy:
 the IS–LM model for a small open  affects income under floating exchange rates.
economy.  Under fixed exchange rates, monetary policy is
not available to affect output.
 takes P as given.
• Interest rate differentials:
 can show how policies and shocks affect
 exist if investors require a risk premium to hold a
income and the exchange rate.
country’s assets.
• Fiscal policy:  An increase in this risk premium raises domestic
 affects income under fixed exchange rates interest rates and causes the country’s
but not under floating exchange rates. exchange rate to depreciate.
3 The
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Revisited 3 The
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• Fixed versus floating exchange rates • How the real exchange rate is determined
 Under floating rates, monetary policy is  NX depends negatively on the real exchange
available for purposes other than rate, other things equal
maintaining exchange rate stability.  The real exchange rate adjusts to equate NX
with net capital outflow
 Fixed exchange rates reduce some of the
uncertainty in international transactions.
3 The
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18 IN THIS CHAPTER, YOU WILL LEARN:
about two policy debates:

Stabilization Policy 1. Should policy be active or passive?
2. Should policy be by rule or discretion?
MACROECONOMICS
N. Gregory Mankiw
Fall 2014
PowerPoint ® Slides by Ron Cronovich
update
1
Growth rate of U.S. real GDP

Question 1: Chánh án-ghen.pptx
Percent 10
change
from 4 8
Should policy be active or quarters
earlier
6
passive?
Average 4
growth
rate
2
-2
-4
CHAPTER 18 Stabilization Policy 2 1970 1975 1980 1985 1990 1995 2000 2005 2010 2015
1
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Increase in unemployment during recessions

Arguments for active policy
increase in no. of
peak trough unemployed persons
(millions)  Recessions cause economic hardship for millions
July 1953 May 1954 2.11 of people.
Aug 1957 April 1958 2.27
April 1960 February 1961 1.21
 The Employment Act of 1946:
“It is the continuing policy and responsibility of the
December 1969 November 1970 2.01
Federal Government to…promote full employment
November 1973 March 1975 3.58
and production.”
January 1980 July 1980 1.68
July 1981 November 1982 4.08  The model of aggregate demand and supply
July 1990 March 1991 1.67 (Chaps. 10–14) shows how fiscal and monetary
March 2001 November 2001 1.50 policy can respond to shocks and stabilize the
December 2007 June 2009 6.14 economy.
CHAPTER 18 Stabilization Policy 5
Arguments against active policy Automatic stabilizers Automatic Stabilizers.pptx
Policies act with long & variable lags, including:  definition:

inside lag: Twain.pptx policies that stimulate or depress the economy
the time between the shock and the policy response. when necessary without any deliberate policy
 takes time to recognize shock change.
 takes time to implement policy,  Designed to reduce the lags associated with
especially fiscal policy stabilization policy.
outside lag:  Examples:
the time it takes for policy to affect economy.  income tax
If conditions change before policy’s impact is felt,  unemployment insurance
the policy may destabilize the economy.  welfare
CHAPTER 18 Stabilization Policy 6 CHAPTER 18 Stabilization Policy 7
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Forecasting the macroeconomy The LEI index and real GDP, 1960s
20
Because policies act with lags, policymakers must
annual percentage change

15
predict future conditions. Chuyên gia-khủng hoảng.pptx
10
Two ways economists generate forecasts:
5
 Leading economic indicators (LEI)
0
data series that fluctuate in advance of the
economy -5
 Macroeconometric models -10

Large-scale models with estimated parameters 1960 1962 1964 1966 1968 1970
that can be used to forecast the response of source of LEI data: Leading Economic Indicators
The Conference Board Real GDP
endogenous variables to shocks and policies
The LEI index and real GDP, 1970s The LEI index and real GDP, 1980s
20 20
15

15
10 10
5 5
0 0
-5 -5
-10 -10
-15 -15
-20 -20
1970 1972 1974 1976 1978 1980 1980 1982 1984 1986 1988 1990
source of LEI data: Leading Economic Indicators source of LEI data: Leading Economic Indicators
The Conference Board Real GDP The Conference Board Real GDP
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The LEI index and real GDP, 1990s Mistakes forecasting the 1982 recession
15
Unemployment rate
10
-5
-10
-15
1990 1992 1994 1996 1998 2000 2002
source of LEI data: Leading Economic Indicators
The Conference Board Real GDP
Forecasting the macroeconomy The Lucas critique
Because policies act with lags, policymakers must  Due to Robert Lucas who won Nobel Prize in
predict future conditions. 1995 for his work on rational expectations.
 Forecasting the effects of policy changes has
The preceding slides show that the often been done using models estimated with
forecasts are often wrong. historical data.
This is one reason why some  Lucas pointed out that such predictions would
economists oppose policy activism. not be valid if the policy change alters
expectations in a way that changes the
fundamental relationships between variables.
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An example of the Lucas critique The Jury’s out…

 Prediction (based on past experience):
An increase in the money growth rate will reduce Looking at recent history does not clearly answer
unemployment. Question 1:
 The Lucas critique points out that increasing the  It’s hard to identify shocks in the data.
money growth rate may raise expected inflation,  It’s hard to tell how outcomes would have been
in which case unemployment would not different had actual policies not been used.
necessarily fall.
Rules and discretion:

Question 2:
Basic concepts
 Policy conducted by rule:
Should policy be conducted by Policymakers announce in advance how
policy will respond in various situations
rule or discretion? and commit themselves to following through.
 Policy conducted by discretion:
As events occur and circumstances change,
policymakers use their judgment and apply
whatever policies seem appropriate at the time.
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Arguments for rules Arguments for rules

1. Distrust of policymakers and the political 2. The time inconsistency of discretionary
process policy
 misinformed politicians  def: A scenario in which policymakers
 politicians’ interests sometimes not the same have an incentive to renege on a
as the interests of societyNHTW độc lập.pptx previously announced policy once others
have acted on that announcement.
 Destroys policymakers’ credibility, thereby
reducing effectiveness of their policies.
Examples of time inconsistency Examples of time inconsistency

1. To encourage investment, 2. To reduce expected inflation,
govt announces it will not tax income from capital. the central bank announces it will tighten
monetary policy.
But once the factories are built,
govt reneges in order to raise more tax revenue. But faced with high unemployment,
the central bank may be tempted to cut interest
rates.
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Examples of time inconsistency Monetary policy rules

3. Aid is given to poor countries contingent on fiscal a. Constant money supply growth rate
reforms.
 Advocated by monetarists.
The reforms do not occur, but aid is given  Stabilizes aggregate demand only if velocity
anyway, because the donor countries do not want is stable.
the poor countries’ citizens to starve.
Monetary policy rules Monetary policy rules
a. Constant money supply growth rate a. Constant money supply growth rate
b. Target growth rate of nominal GDP b. Target growth rate of nominal GDP
 Automatically increase money growth c. Target the inflation rate
whenever nominal GDP grows slower than
 Automatically reduce money growth whenever
targeted; decrease money growth when
inflation rises above the target rate.
nominal GDP growth exceeds target.
 Many countries’ central banks now practice
inflation targeting but allow themselves a little
discretion.
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Central bank independence Inflation and central bank independence
 A policy rule announced by central bank will
average inflation
work only if the announcement is credible.
 Credibility depends in part on degree of
independence of central bank.
index of central bank independence

CHAPTER SUMMARY CHAPTER SUMMARY
1. Advocates of active policy believe: 3. Advocates of discretionary policy believe:

 frequent shocks lead to unnecessary fluctuations in  discretion gives more flexibility to policymakers in
output and employment. responding to the unexpected.
 fiscal and monetary policy can stabilize the 4. Advocates of policy rules believe:
economy.
 the political process cannot be trusted: Politicians
2. Advocates of passive policy believe: make policy mistakes or use policy for their own
 the long & variable lags associated with monetary interests.
and fiscal policy render them ineffective and  commitment to a fixed policy is necessary to avoid
possibly destabilizing. time inconsistency and maintain credibility.
 inept policy increases volatility in output,
employment.
30 31
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The economic statistic used to Which of the following is a flow

measure the level of prices is variable?
a. GDP. a. wealth
b. CPI. b. the number unemployed
c. GNP. c. government debt
d. real GDP. d. income
Trần Mạnh Kiên 1 Trần Mạnh Kiên 2
Which of the following is a stock All of the following are stocks

variable? variables except:
a. wealth a. a consumer's wealth.
b. consumption b. the government budget deficit.
c. investment c. the number of unemployed people.
d. income d. the amount of capital in the economy
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The amount of capital in an economy is When a firm sells a product out of

a(n), and the amount of investment is inventory, investment expenditures ……,
a(n) and consumption expenditures …….
a. flow; stock a. increase; decrease

b. stock; flow b. decrease; increase
c. final good; intermediate good c. decrease; remain unchanged
d. intermediate good; final good d. remain unchanged; increase
Assume that a firm buys all the parts that it puts into an
The value added of an item produced automobile for $10,000, pays its workers $10,000 to fabricate the
automobile, and sells the automobile for $22,000. In this case, the
refers to: value added by the automobile company is:
a. a firm's profits on the item sold. a. $10,000.

b. the value of the labor inputs in the b. $12,000.
production of an item. c. $20,000.
c. the value of a firm's output less the d. $22,000.
value of its costs.
d. the value of a firm's output less the
value of the intermediate goods that
the firm purchases.
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If nominal GDP in 2009 equals $14 trillion and If nominal GDP increased by 5 percent and the
real GDP in 2009 equals $11 trillion, what is the GDP deflator increased by 3 percent, then real
value of the GDP deflator? GDP …… by …… percent.
a. 0.79 a. increased; 2
b. 1.03 b. decreased; 2
c. 1.27 c. increased; 8
d. 3.2 d. decreased; 8
If GDP measured in billions of current dollars is $5,465,

consumption is $3,657, investment is $741, and If real GDP grew by 6 percent and population
government purchases are $1,098, then net exports grew by 2 percent, then real GDP per person
are: grew by approximately …… percent.
a. $131. a. 2
b. -$131. b. 3
c. $31. c. 4
d. -$31. d. 8
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In the national income accounts, all of the

following are classified as government
purchases except: The core inflation rate:
a. payments made to Social Security a. measures the change in producer
recipients. prices.
b. services provided by police officers. b. is measured using a Paasche index.
c. purchases of military hardware. c. excludes food and energy prices.
d. services provided by U.S. senators. d. includes the price of exports and
includes the price of imports
An increase in the price of imported

goods will show up in: The CPI is a:
a. the CPI but not in the GDP deflator. a. Laspeyres price index.
b. the GDP deflator but not in the CPI. b. Paasche price index.
c. both the CPI and the GDP deflator. c. Laspeyres quantity index.
d. neither the CPI nor the GDP deflator. d. Paasche quantity index.
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If the adult population equals 250 million, of

If 7 million workers are unemployed, 143 million
workers are employed, and the adult population equals which 145 million are employed and 5 million
200 million, then the unemployment rate equals are unemployed, the labor-force participation
approximately …… percent. rate equals …… percent
a. 3.5 a. 50
b. 4.7 b. 58
c. 4.9 c. 60
d. 7 d. 67
A woman marries her butler. Before they were married, she paid him Explain why the value of GDP in 2012 would or
$60,000 per year. He continues to wait on her as before (but as a husband would not change as a result of each
rather than as a wage earner). She earns $1,000,000 per year both before
and after her marriage. The marriage: transaction described below:
a. In 2012, the Smith family purchases a new house that was
a. does not change GDP. built in 2012.
b. decreases GDP by $60,000. b. In 2012, the Jones family purchases a house that was built in
2001.
c. increases GDP by $60,000. c. In 2012, a construction company purchases windows to put in
the Smith family home that was built in 2012.
d. increases GDP by more than $60,000.
d. In 2012, Mr. Jones paints all of the rooms of the Jones family
house purchased in 2009, using paint and supplies purchased
in 2012.
e. In 2012, Mr. Smith uses an online brokerage service to
purchases shares of stock in a construction company.
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A production function is a The production function feature called “constant

mathematical relationship between: returns to scale” means that if we:
a. factor prices and the marginal product a. multiply capital by z1 and labor by z2, we
of factors. multiply output by z3.
b. factors of production and factor prices. b. increase capital and labor by 10 percent
each, we increase output by 10 percent.
c. factors of production and the quantity c. increase capital and labor by 5 percent each,
of output produced. we increase output by 10 percent.
d. factor prices and the quantity of output d. increase capital by 10 percent and increase
produced. labor by 5 percent, we increase output by
7.5 percent.
If bread is produced using a constant returns to The assumption that the factor's supply is
scale production function, then if the: fixed will imply that the factor's
a. number of workers is doubled, twice as a. supply curve is horizontal.
much bread will be produced.
b. supply curve is vertical.
b. amount of equipment is doubled, twice as
much bread will be produced.
c. supply curve slopes up to the right.
c. amounts of equipment and workers are both d. demand curve slopes up to the right.
doubled, twice as much bread will be
produced.
d. amounts of equipment and workers are both
doubled, four times as much bread will be
produced.
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The marginal product of capital is: The real wage will increase if:
a. output divided by capital input. a. the supply of labor increases.
b. additional output produced when one b. the productivity of labor increases.
additional unit of capital is added. c. the price of output increases.
c. additional output produced when one d. the supply of capital decreases.
additional unit of capital and one
additional unit of labor are added.
d. the value of additional output when
one dollar's worth of additional capital
is added. Trần Mạnh Kiên 25 Trần Mạnh Kiên 26
According to the neoclassical theory of distribution, total

output is divided between payments to capital and If Y = AK0.5L0.5 and A, K, and L are all
payments to labor depending on their: 100, the marginal product of capital is:
a. supply. a. 50.
b. equilibrium growth rates. b. 100.
c. relative political power. c. 200.
d. marginal productivities. d. 1000.
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According to the neoclassical theory of distribution, in

If the production function describing an an economy described by a Cobb-Douglas production
economy is Y = 100 K.25L.75, then the share of function, workers should experience high rates of real
output going to labor: wage growth when:
a. is 25 percent. a. real interest rates are high.

b. is 75 percent. b. real interest rates are low.
c. depends on the quantities of labor and c. labor productivity is growing rapidly.
capital. d. capital's share of income is growing
d. depends on the state of technology. rapidly
If the consumption function is given by C = 500 If the consumption function is given by the equation C
+ 0.5(Y - T), and Y is 6,000 and T is given by T = 500 + 0.5Y, the production function is Y = 50K0.5L0.5,
= 200 + 0.2Y, then C equals: where K = 100 and L = 100, then C equals:
a. 2,500. a. 1,000.
b. 2,800. b. 2,500.
c. 3,500. c. 3,000.
d. 4,200. d. 5,000.
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Assume that the consumption function is given by C = 200 + 0.7(Y

- T), the tax function is given by T = 100 + t1Y, and Y = 50K0.5L0.5,
In the classical model with fixed income, if the interest
where K = 100 and L = 100. If t1 increases from 0.2 to 0.25, then rate is too low, then investment is too …… , and the
consumption decreases by: demand for output …… the supply.
a. 70 a. high; exceeds
b. 140 b. high; falls short of
c. 175 c. low; exceeds
d. 250 d. low; falls short of
If disposable income is 4,000, consumption is 3,500,

In a closed economy, Y- C - G government purchases is 1,000, and taxes minus
equals: transfers are 800, national saving is equal to:
a. national saving. a. 300.

b. private saving. b. 500.
c. public saving. c. 700.
d. financial saving. d. 1,000.
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The supply and demand for loanable When the demand for loanable funds exceeds the
supply of loanable funds, households want to save ……
funds determine the: than firms want to invest, and the interest rate ……
a. real wage. a. more; rises

b. real rental price of capital. b. more; falls
c. real interest rate. c. less; rises
d. nominal interest rate. d. less; falls
Assume that equilibrium GDP (Y) is 5,000. Consumption (C) is

given by the equation C = 500 + 0.6(Y - T). Taxes (T) are equal to
600. Government spending is equal to 1,000. Investment is given
In the neoclassical model with fixed income, if there is a
by the equation I = 2,160 - 100r, where r is the real interest rate, decrease in government spending with no change in
in percent. In this case, the equilibrium real interest rate is: taxes, then public saving …… and private saving ……
a. 5 percent. a. increases; increases

b. 8 percent. b. increases; does not change
c. 10 percent. c. decreases; increases
d. 13 percent. d. decreases; does not change
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In the classical model with fixed income,

a reduction in the government budget
deficit will lead to a:
a. higher real interest rate.

b. lower real interest rate.
c. higher level of output.
The economy begins in equilibrium at point E, representing the real
d. lower level of output. interest rate r1 at which saving S1 equals desired investment I1. What will
be the new equilibrium combination of real interest rate, saving, and
investment if there is a technological innovation that increases the demand
for investment goods?
a. point A
b. point B
c. point C
d. point D
The government raises lump-sum taxes on income by

$100 billion, and the neoclassical economy adjusts so In a neoclassical economy, if consumption
that output does not change. If the marginal propensity increases as the interest rate decreases, then a
to consume is 0.6, investment: $10 billion rise in government spending would:
a. rises by $100 billion. a. still crowd out exactly $10 billion of

b. rises by $60 billion. investment.
c. falls by $60 billion. b. crowd out between zero and $10
d. falls by $100 billion. billion of investment.
c. not crowd out any investment.
d. crowd out more than $10 billion of
investment.
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Assume that the production function is Cobb-Douglas

Assume that the production function is given by Y = AK0.5L0.5,
with parameter a = 0.3. If capital and labor are paid where Y is GDP, K is capital stock, and L is labor. The parameter A
their marginal products, they receive the shares of is equal to 10. Assume also that capital is 100, labor is 400, and
income: both capital and labor are paid for their marginal products.
a. 0.3 and 0.3. a. What is Y?

b. 0.7 and 0.7. b. What is the real wage of labor?
c. 0.3 and 0.7. c. What is the real rental price of capital
d. 0.7 and 0.3. (the amount of output paid per unit of
capital)?
Assume that GDP (Y) is 5,000. Consumption (C) is given by the

equation C = 1,200 + 0.3(Y - T) - 50r, where r is the real interest If there are 100 transactions in a year and the average value of
rate, in percent. Investment (I) is given by the equation I = 1,500 - each transaction is $10, then if there is $200 of money in the
50r. Taxes (T) are 1,000, and government spending (G) is 1,500. economy, transactions velocity is …… times per year.
a. What are the equilibrium values of C, I, and r? a. 0.2

b. What are the values of private saving, public saving,
and national saving? b. 2
c. Now assume there is a technological innovation that c. 5
makes business want to invest more. It raises the
investment equation to I = 2,000 - 50r. What are
d. 10
the new equilibrium values of C, I, and r?
d. What are the new values of private saving, public
saving, and national saving?
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If the average price of goods and services in the

Consider the money demand function that takes the form M / P =
economy equals $10 and the quantity of money in the kY. If the money supply is growing at a 10 percent rate, real output
economy equals $200,000, then real balances in the is growing at a 3 percent rate, and k is constant, what is the
economy equal: average inflation rate in this economy?
a. 10. a. 3 percent
b. 20,000. b. 7 percent
c. 200,000. c. 10 percent
d. 2,000,000. d. 13 percent
In the long run, according to the quantity theory of

If income velocity is assumed to be constant, money and classical macroeconomic theory, if velocity is
but no other assumptions are made, the level of constant, then …… determines real GDP and ……
…… is determined by M. determines nominal GDP.
a. prices a. the productive capability of the

b. real GDP economy; the money supply
c. transactions b. the money supply; the productive
d. nominal GDP capability of the economy
c. velocity; the money supply
d. the money supply; velocity
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If the money supply increases 12 percent, velocity The right of seigniorage is the right
decreases 4 percent, and the price level increases 5
percent, then the change in real GDP must be …… %. to:
a. 3 a. levy taxes on the public.
b. 4 b. borrow money from the public.
c. 9 c. draft citizens into the armed forces.
d. 11 d. print money.
Consider the money demand function that takes the form (M / P)d
= Y / (4i), where M is the quantity of money, P is the price level, Y
is real output, and i is the nominal interest rate. What is the
The inflation tax is paid: average velocity of money in this economy?
a. only by the central bank. a. i

b. by all holders of money. b. 4
c. only by government bond holders. c. 1 / (4i)
d. equally by every household. d. 0.25
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According to the classical theory of money, If inflation was 6 percent last year and a worker
inflation does not make workers poorer because received a 4 percent nominal wage increase last
wages increase: year, then the worker's real wage:
a. faster than the overall price level. a. increased 4 percent.

b. more slowly than the overall price b. increased 2 percent.
level. c. decreased 2 percent.
c. in proportion to the increase in the d. decreased 6 percent.
overall price level.
d. in real terms during periods of
inflation.
To end a hyperinflation, a government

trying to reduce its reliance on Variables expressed in terms of
seigniorage would: money are called …… variables.
a. print more money. a. real
b. raise taxes and cut spending. b. nominal
c. lower taxes and increase spending. c. endogenous
d. lower interest rates. d. exogenous
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According to the classical dichotomy, when the The value of net exports is also the
money supply decreases, …… will decrease. value of:
a. real GDP a. net investment.
b. consumption spending b. net saving.
c. the price level c. national saving.
d. investment spending d. the difference of national saving and
domestic investment.
If domestic saving exceeds domestic In a small open economy, if exports equal $20 billion,
investment, then net exports are …… and net imports equal $30 billion, and domestic national saving
capital outflows are …… equals $25 billion, then net capital outflow equals:
a. positive; positive a. -$25 billion.

b. positive; negative b. -$10 billion.
c. negative; negative c. $10 billion.
d. negative; positive d. $25 billion.
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In a small open economy, if domestic A small open economy with perfect capital
investment exceeds domestic saving, then the mobility is characterized by all of the following
extra investment will be financed by: except that:
a. borrowing from abroad. a. its domestic interest rate always

b. borrowing from domestic banks. exceeds the world interest rate.
c. the domestic government. b. it engages in international trade.
d. the World Bank. c. its net capital outflows always equal
the trade balance.
d. its government does not impede
international borrowing or lending.
In a small open economy, if the world real interest rate

is above the rate at which national saving equals
domestic investment, then there will be a trade …… and
…… net capital outflow.
a. surplus; negative
b. deficit; positive
c. surplus; positive
d. deficit; negative In a small open economy, if the world interest rate is
r1, then the economy has:
a. a trade surplus.
b. balanced trade.
c. a trade deficit.
Trần Mạnh Kiên 67 d. negative capital outflows. 68
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In a small open economy, starting from a position of

balanced trade, if the government increases domestic If the government of a small open economy
government purchases, this produces a tendency wishes to reduce a trade deficit, which policy
toward a trade …… and …… net capital outflow. action will be successful in achieving this goal?
a. deficit; negative a. increasing taxes

b. surplus; positive b. increasing government spending
c. deficit; positive c. increasing investment tax credits
d. surplus; negative d. imposing protectionist trade policies
The lower the real exchange rate is, the expensive

domestic goods are relative to …… foreign goods, and
When the real exchange rate rises: the …… the demand is for net exports.
a. exports will decrease but imports will a. more; greater

be unaffected. b. more; smaller
b. imports will decrease but exports will c. less; greater
be unaffected. d. less; smaller
c. exports will increase and imports will
decrease.
d. exports will decrease and imports will
increase.
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An appreciation of the real exchange rate

In a small open economy with perfect capital mobility, a
reduction in the government's budget deficit …… net in a small open economy could be the
exports, and the real exchange rate …… result of:
a. increases; appreciates a. an increase in government spending.

b. increases; depreciates b. an increase in taxes.
c. decreases; appreciates c. a decrease in the world interest rate.
d. decreases; depreciates d. the expiration of an investment tax-
credit provision.
Protectionist policies implemented in a small open

economy with a trade deficit have the effect of …… If a country has a high rate of inflation relative
the trade deficit and …… the quantity of imports and to the United States (holding the real exchange
exports rate fixed), the dollar will buy:
a. decreasing; decreasing a. less of the foreign currency over time.

b. not changing; decreasing b. more of the foreign currency over
c. decreasing; not changing time.
d. not changing; not changing c. the same amount of the foreign
currency over time.
d. an amount of foreign currency
determined by the real exchange rate.
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In a small open economy, if consumer

confidence falls and consumers decide to save
Purchasing-power parity theory: more, then the real exchange rate:
a. is a completely accurate description of the a. rises, and net exports fall.

real world.
b. and net exports both rise.
b. would be entirely accurate if only goods
were traded.
c. falls, and net exports rise.
c. would be entirely accurate if all consumers d. and net exports both fall.
had the same preferences.
d. provides a reason to expect that movements
in the real exchange rate will typically be
small or temporary.
Assume that in a small open economy with full The production function y = f (k)
employment, national saving is 300. means:
a. If domestic investment is given by I = 400 - a. labor is not a factor of production.
20r, where r is the real interest rate in
b. output per worker is a function of labor
percent, what would the equilibrium interest
rate be if the economy were closed? productivity.
b. If the economy is open and the world c. output per worker is a function of
interest rate is 10 percent, what will capital per worker.
investment be? d. the production function exhibits
c. What will the current account surplus or increasing returns to scale.
deficit be? What will net capital outflow be?
20
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Investment per worker (i) as a function of

In the Solow growth model the demand the saving ratio (s) and output per worker
for goods equals investment: (f (k)) may be expressed as:
a. minus depreciation. a. s + f (k).
b. plus saving. b. s - f (k).
c. plus consumption. c. sf (k).
d. plus depreciation. d. s / f (k).
If the capital stock equals 200 units in year 1 and the

depreciation rate is 5 percent per year, then in year 2,
assuming no new or replacement investment, the
capital stock would equal …… units.
a. 210
b. 200
c. 195
d. 190
In this graph, when the capital stock per worker is OA, AB represents:
a. investment per worker, and AC represents consumption per worker.
b. consumption per worker, and AC represents investment per worker.
c. investment per worker, and BC represents consumption per worker.
d. consumption per worker, and BC represents investment per worker.
83
Trần Mạnh Kiên 84
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In the Solow growth model, the economy ends

up with a steady-state level of capital:
a. only if it starts from a level of capital

below the steady-state level.
b. only if it starts from a level of capital
above the steady-state level.
In this graph, capital-labor ratio k2 is not the steady-state
c. only if it starts from a steady-state because:
level of capital. a. the saving rate is too high.
d. regardless of the starting level of b. the investment ratio is too high.
capital. c. gross investment is greater than depreciation.
d. depreciation is greater than gross investment. 86
If the per-worker production function is given by y =

k1/2, the saving ratio is 0.3, and the depreciation rate is
0.1, then the steady-state ratio of capital to labor is:
a. 1.
b. 2.
c. 4.
In this graph, starting from capital-labor ratio k1, the capital- d. 9.
labor ratio will:
a. decrease.
b. remain constant.
c. increase.
d. first decrease and then remain constant.
87
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In the Solow growth model, increases in capital

…… output and …… the amount of output used
A higher saving rate leads to a: to replace depreciating capital.
a. higher rate of economic growth in both a. increase; increase

the short run and the long run. b. increase; decrease
b. higher rate of economic growth only in c. decrease; increase
the long run. d. decrease; decrease
c. higher rate of economic growth in the
short run but a decline in the long run.
d. larger capital stock and a higher level
of output in the long run.
If an economy with no population growth or

technological change has a steady-state MPK of 0.125,
a depreciation rate of 0.1, and a saving rate of 0.225,
then the steady-state capital stock:
a. is greater than the Golden Rule level.

b. is less than the Golden Rule level.
c. equals the Golden Rule level.
The Golden Rule level of steady-state investment per worker
d. could be either above or below the
is: Golden Rule level.
a. AC
b. AB.
c. BC.
d. DE
91
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To determine whether an economy is operating at its A reduction in the saving rate starting from a steady
Golden Rule level of capital stock, a policymaker must state with more capital than the Golden Rule causes
determine the steady-state saving rate that produces investment to …… in the transition to the new steady
the: state.
a. largest MPK. a. increase

b. smallest depreciation rate. b. decrease
c. largest consumption per worker. c. first increase and then decrease
d. largest output per worker. d. first decrease and then increase
In the Solow growth model of an economy with population growth

but no technological change, if population grows at rate n, then
When an economy's capital is below the Golden capital in the steady state grows at rate …… , and output grows at
Rule level, reaching the Golden Rule level: rate …… in the steady state.
a. produces lower consumption at all times in a. n; n

the future.
b. n; 0
b. requires higher consumption levels at all
times.
c. 0; 0
c. requires initially reducing consumption to d. 0; n
increase consumption in the future.
d. requires initially increasing consumption to
decrease consumption in the future.
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In the Solow growth model with population growth but

no technological change, which of the following will
generate a higher steady-state growth rate of total An increase in the rate of population
output? growth with no change in the saving rate:
a. a higher saving rate a. increases the steady-state level of

b. a lower depreciation rate capital per worker.
c. a higher population growth rate b. decreases the steady-state level of
d. a higher capital per worker ratio capital per worker.
c. does not affect the steady-state level
of capital per worker.
d. decreases the rate of output growth in
the short run.
If y = k1/2, the country saves 10 percent of its output

each year, and the steady-state level of capital per
71. If Y = K0.3L0.7,
then the per- worker is 4, then the steady-state levels of output per
worker production function is: worker and consumption per worker are:
a. Y = F(K / L). a. 2 and 1.6, respectively.

b. Y / L = (K / L)0.3. b. 2 and 1.8, respectively.
c. Y / L = (K / L)0.5. c. 4 and 3.2, respectively.
d. Y / L = (K / L)0.7. d. 4 and 3.6, respectively.
25
5/1/2022
If an economy moves from a steady state with positive population

growth to a zero population growth rate, then in the new steady
Suppose that two countries are exactly alike in every
state, total output growth will be …… , and growth of output per respect except that the citizens of country A have a
person will be …… higher saving rate than the citizens of country B.
a. lower; lower a. Which country will have the higher

b. lower; the same as it was before level of output per worker in the
c. higher; higher than it was before steady state? Illustrate graphically.
d. higher; lower b. Which country will have the faster rate
of growth of output per worker in the
steady state?
The economy of Alpha can be described by the

Solow growth model. The following are some The assumption that technological progress
characteristics of the Alpha economy: increases the efficiency of labor is called:
saving rate (s) 0.20
a. endogenous technological progress.
depreciation rate (δ) 0.12
steady-state capital per worker (k) 4 b. the efficiency-wage model of economic
population growth rate (n) 0.02 growth.
steady-state output per worker 20,000
c. labor-augmenting technological
a. What is the steady-state growth rate of total output in Alpha? progress.
b. What is the level of steady-state consumption per worker in
Alpha?
d. the Golden Rule model of economic
c. What is the steady-state level of investment per worker in growth.
Alpha?
26
5/1/2022
In the Solow model with technological change, In the Solow model with technological progress,
the Golden Rule level of capital is the steady the steady-state growth rate of capital per
state that maximizes: effective worker is:
a. output per worker. a. 0.

b. output per effective worker. b. g.
c. consumption per worker. c. n.
d. consumption per effective worker. d. n + g.
In the Solow model with technological progress, The Solow model predicts that two economies
the steady-state growth rate of total output is: will converge if their economies have the same:
a. 0. a. capital stocks.
b. g. b. populations.
c. n. c. steady states.
d. n + g. d. production functions.
27
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Other things being equal, all of the Economic research shows that in
following government policies are likely to explaining international differences in
increase national saving except: living standards.
a. decreasing taxes on savings accounts. a. physical capital is more important than
b. running a budget deficit. human capital
c. running a budget surplus. b. human capital is at least as important
d. retiring part of the national debt. as physical capital
c. human capital is much more important
than physical capital
d. infrastructure is the most important
factor
The type of legal system and the level of

corruption in a country have been found In a steady state with population
to be: growth and technological progress:
a. unrelated to the rate of economic growth in a. the capital share of income increases.
a country.
b. the labor share of income increases.
b. significant determinants of the rate of
economic growth in a country.
c. the capital share of income, in some
c. important topics for political discussion, but
cases, increases, and sometimes the
not economic explanations of growth. labor share increases.
d. important variables explaining the Golden d. the capital and labor shares of income
Rule level of capital. are constant.
28
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In comparing two countries with different levels of If the production function is Y = AK2/3L1/3 in the land of
education but the same saving rate, population growth, Antegria, and the labor force increases by 5 percent
and rate of technological progress, one would expect while capital is constant, labor productivity, measured
the more highly educated country to have: by Y / L, will:
a. a higher growth rate of total income a. increase by 3.33 percent.

and a higher real wage. b. increase by 1.67 percent.
b. a higher growth rate of total income c. decrease by 1.67 percent.
and the same real wage. d. decrease by 3.33 percent.
c. the same growth rate of total income
and a higher real wage.
d. the same growth rate of total income
and the same real wage.
Assume that a country's production function is Y =

AK0.3L0.7. The ratio of capital to output is 3, the growth The IS curve plots the relationship between the
rate of output is 3 percent, and the depreciation rate is interest rate and …… that arises in the market
4 percent. Capital is paid its marginal product. for ……
a. What is the marginal product of capital in a. national income; goods and services
this situation?
b. the price level; goods and services
b. If the economy is in a steady state, what
must be the saving rate?
c. national income; money
c. What is the marginal product of capital if the d. the price level; money
economy reaches the Golden Rule level of
capital?
d. What must the saving rate be to achieve the
Golden Rule level of capital?
29
5/1/2022
The government-purchases multiplier indicates In the Keynesian-cross model with an MPC > 0,
how much …… change(s) in response …… to a if government purchases increase by 250, then
$1 change in government purchases. the equilibrium level of income:
a. the budget deficit a. increases by 250.

b. consumption b. increases by more than 250.
c. income c. decreases by 250.
d. real balances d. increases but by less than 250.
The theory of liquidity preference states that, The theory of liquidity preference states that
other things being equal, an increase in the real the quantity of real money balances demanded
money supply will: is:
a. lower the interest rate. a. negatively related to both the interest

b. raise the interest rate. rate and income.
c. have no effect on the interest rate. b. positively related to both the interest
d. first lower and then raise the interest rate and income.
rate. c. positively related to the interest rate
and negatively related to income.
d. negatively related to the interest rate
and positively related to income.
30
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The interest rate determines …… in the

An increase in income raises money …… goods market and money …… in the
and …… the equilibrium interest rate. money market.
a. demand; raises a. government spending; demand

b. demand; lowers b. government spending; supply
c. supply; raises c. investment spending; demand
d. supply; lowers d. investment spending; supply
Using the Keynesian-cross analysis, assume that the Assume that the money demand function is (M / P)d =
consumption function is given by C = 200 + 0.7 (Y - T). 2,200 - 200r, where r is the interest rate in percent. The
If planned investment is 100 and T is 100, then the money supply M is 2,000, and the price level P is 2. The
level of G needed to make equilibrium Y equal 1,000 is: equilibrium interest rate is percent.
a. 170. a. 2
b. 200. b. 4
c. 250. c. 6
d. 350 d. 8
31
5/1/2022
If MPC = 0.6 (and there are no income taxes)

when G increases by 200, then the IS curve for
any given interest rate shifts to the right by:
a. 200.
b. 300.
c. 400.
Based on the graph, starting from equilibrium at interest rate r1 and d. 500.
income Y1, an increase in government spending would generate the new
equilibrium combination of interest rate and income:
a. r2, Y2
b. r3, Y2
c. r2, Y3
d. r3, Y3
125
In the IS-LM model when M remains constant

but P rises, in short-run equilibrium, in the usual
case the interest rate …… and output ……
a. rises; falls
b. rises; rises
c. falls; rises
Based on the graph, starting from equilibrium at interest rate r3, income
d. falls; falls Y2, IS1, and LM1, if there is an increase in government spending that shifts
the IS curve to IS2, then in order to keep output constant, the Federal
Reserve should … the money supply, shifting to ….
a. increase; LM2
b. decrease; LM2
c. increase; LM3
d. decrease; LM3
128
32
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An increase in investment demand for any given level of

income and interest rates - due, for example, to more An increase in the money supply shifts the ……
optimistic “animal spirits” - will, within the IS-LM curve to the right, and the aggregate demand
framework, …… output and …… interest rates. curve ……
a. increase; lower a. IS; shifts to the right

b. increase; raise b. IS; does not shift
c. lower; lower c. LM; shifts to the right
d. lower; raise d. LM; does not shift
Starting from a short-run equilibrium greater If neither investment nor consumption depends
than the natural rate of output, as the economy on the interest rate, then the IS curve is ……,
returns to a long-run equilibrium: and …… policy has no effect on output.
a. both output and the price level will a. vertical; monetary

increase. b. horizontal; monetary
b. output will decrease, but the price c. vertical; fiscal
level will increase. d. horizontal; fiscal
c. output will increase, but the price level
will decrease.
d. both output and the price level will
decrease.
33
5/1/2022
According to the IS-LM model, when the If consumption is given by C = 200 + 0.75(Y-
government increases taxes and government T) and investment is given by I = 200 - 25r,
purchases by equal amounts: then the formula for the IS curve is:
a. income, the interest rate, consumption, and a. Y = 400 - 0.75T - 25r + G.

investment are unchanged.
b. Y = 1,600 - 3T - 100r + 4G.
b. income and the interest rate rise, whereas
consumption and investment fall.
c. Y = 400 + 0.75T - 25r - G.
c. income and the interest rate fall, whereas d. Y = 1,600 + 3T - 100r - 4G.
consumption and interest rise.
d. income, the interest rate, consumption, and
investment all rise.
Hãy xem xét các trường hợp sau đây ảnh

An increase in the money supply: hưởng tới GDP thực như thế nào?
a. increases income and lowers the interest rate in a. Một cơn bão đổ bộ vào Florida và làm
both the short run and in the long run.
Công viên Disney Land bị đóng cửa
b. increases income in both the short run and in the
long run but leaves the interest rate unchanged in nhiều ngày.
the long run. b. Việc phát hiện ra 1 giống lúa mới làm
c. lowers the interest rate in both the short run and in tăng sản lượng thóc của người nông
the long run but leaves income unchanged in the
long run. dân.
d. lowers the interest rate and increases income in the c. Mâu thuẫn giữa người lao động và chủ
short run but leaves both unchanged in the long doanh nghiệp tăng cao nên xảy ra đình
run.
công. Trần Mạnh Kiên 136
34
5/1/2022
Assume that an economy is characterized by the following equations:

The Mundell-Fleming model is a ……
C = 100 + (2/3) (Y - T)
T = 600
model for a …… open economy
G = 500
a. short-run; small
I = 800 - (50 / 3) r
Ms / P = Md / P = 0.5Y - 50r
b. short-run; large
a. Write the numerical IS curve for the economy, expressing Y as a numerical c. long-run; large
function of G, T, and r.
d. long-run; small
b. Write the numerical LM curve for this economy, expressing r as a function of
Y and M / P.
c. Solve for the equilibrium values of Y and r, assuming P = 1.0 and M = 1,200.
How do they change when P = 2.0? Check by computing C, I, and G.
d. Write the numerical aggregate demand curve for this economy, expressing Y
as a function of G, T, and M / P.
137
The intersection of the IS* and LM* curves shows the

In the Mundell-Fleming model, the domestic …… and the …… at which both the goods market and
interest rate is determined by the: the money market are in equilibrium.
a. intersection of the LM and IS curves. a. interest rate; price level

b. domestic rate of inflation. b. price level; exchange rate
c. world rate of inflation. c. level of output; exchange rate
d. world interest rate. d. level of output; price level
35
5/1/2022
In a small open economy with a floating

exchange rate, the exchange rate will
appreciate if:
a. the money supply is increased.

b. the money supply is decreased.
c. government spending is decreased.
A small open economy with a floating exchange rate is initially at
d. taxes are increased. equilibrium A with LM1*, equilibrium exchange rate e2, and equilibrium
output Y1. If there is a monetary expansion to the new equilibrium will be
at … , holding everything else constant.
a. A
b. B
c. C
d. D
142
In a small open economy with a floating exchange rate,

if the government imposes a tariff on foreign goods, Under a fixed-exchange-rate system, the central
then in the new short-run equilibrium: bank of a small open economy must:
a. imports will decrease while exports remain a. have a reserve of its own currency, which it must
constant, leading to a rise in net exports. have accumulated in past transactions.
b. have a reserve of foreign currency, which it can
b. imports will decrease and exports will
print.
increase, leading to a rise in net exports.
c. allow the money supply to adjust to whatever level
c. imports will decrease and exports will will ensure that the equilibrium exchange rate
decrease by an equal amount. equals the announced exchange rate.
d. both imports and exports will remain d. follow a rule specifying a constant growth rate for
unchanged. the money supply.
36
5/1/2022
In the Mundell-Fleming model with fixed exchange rates, attempts

by the central bank to increase the money supply lead the
exchange rate to fall, giving arbitrageurs the incentive to … the
central bank, which causes the money supply to ….
a. sell domestic currency to; increase

b. sell domestic currency to; decrease
c. buy domestic currency from; increase
A small open economy with a fixed exchange rate e2 is initially at
equilibrium A with IS1*, LM1*, and equilibrium output Y1. If there is an d. buy domestic currency from; decrease
increase in government spending to IS1* the new equilibrium will be at ,
holding everything else constant.
a. A
b. B
c. C
d. D
145
In a small open economy with a fixed exchange According to the Mundell-Fleming model, under fixed exchange
rates, expansionary fiscal policy causes income to …, and under
rate, if the government imposes an import flexible exchange rates expansionary fiscal policy causes income to
quota, then net exports: ……
a. decrease, but the money supply falls a. increase; increase

and income falls. b. increase; remain unchanged
b. increase, the money supply increases, c. remain unchanged; remain unchanged
and income increases. d. remain unchanged; increase
c. are unchanged, but the money supply
falls and income falls.
d. are unchanged, the money supply is
unchanged, and income is unchanged.
37
5/1/2022
Country risk included in the risk premium One argument favoring a floating-
in interest rates refers to the: exchange-rate system is that it:
a. additional costs incurred when loans are a. makes international trade less difficult.
made in currencies other than the domestic
b. minimizes destabilizing speculation by
currency.
international investors.
b. possibility that loans in some countries may
not be repaid because of political upheaval. c. allows monetary policy to be used for
c. expectation that the exchange rate may other purposes.
change in the future. d. helps prevent excessive growth in the
d. potential change in the terms of trade money supply.
between countries.
If a country chooses to have free capital flows Which of the following would be evidence that a
and to conduct an independent monetary country with a fixed exchange rate has an
policy, then it must: undervalued currency?
a. live with exchange-rate volatility. a. The government has a budget surplus.

b. restrict its citizens from participating in b. The government has a budget deficit.
world financial markets. c. The central bank's foreign-currency
c. give up the use of monetary policy for reserves are increasing.
purposes of domestic stabilization. d. The central bank's foreign-currency
d. have a fixed exchange rate. reserves are decreasing.
38
5/1/2022
In the Mundell-Fleming model with a floating

exchange rate, a rise in the world interest rate
will lead income:
a. and net exports both to fall.

b. to rise and net exports to fall.
c. to fall and net exports to rise.
d. and net exports both to rise.
39

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TRƯỜNG ĐẠI HỌC NGÂN HÀNG TP.

Important issues in macroeconomics Part 1

© 2019 Worth Publishers, all rights reserved

Macroeconomics - the study of the

U.S. Inflation Rate U.S. unemployment rate (% of labor force)

The demand for cars Digression: Functional notation

• Demand equation: Qd = D (P, Y ) • General functional notation

• A specific functional form shows the precise

Demand equation: Supply equation:

The demand curve The supply curve

The market for cars: Equilibrium The effects of an increase in income

The effects of a steel price increase Endogenous vs. exogenous variables

Supply equation: • The values of endogenous variables are

NOW YOU TRY

Prices: Flexible vs. sticky, part 2 Outline of this book (1 of 2)

• The economy’s behavior depends partly on Introductory material (Chapters 1, 2)

Outline of this book (2 of 2)

CHAPTER SUMMARY, PART 2

Gross domestic product: Expenditure and The circular flow

Expenditure equals income because

NOW YOU TRY

Consumption (C) U.S. consumption, 2016

Investment (I) U.S. investment, 2016

• Spending on capital, a physical asset used in

Government Spending (G) U.S. government spending, 2016

• G includes all government spending on

Net Exports (NX) U.S. net exports, 2016

NOW YOU TRY Why output = expenditure

Stocks vs. Flows Stocks vs. flows: examples

NOW YOU TRY

An important and versatile concept GNP vs. GDP

• total output • Gross Domestic Product (GDP):

• Examples of factor payments: wages, profits,

NOW YOU TRY

GNP and GDP in millions of current U.S. dollars.

NOW YOU TRY

NOW YOU TRY

U.S. nominal and real GDP, 1960–2014 GDP deflator

• Inflation rate: the percentage increase in

NOW YOU TRY NOW YOU TRY

• Use your previous answers to compute the GDP

• Use the GDP deflator to compute the inflation

Example with three goods

1. For any variables X and Y, 2. Percentage change in (X/Y )

Chain-weighted real GDP Consumer price index (CPI)

NOW YOU TRY

NOW YOU TRY The composition of the CPI’s “basket”

Example with three goods

Ci = amount of good i in the CPI’s basket

Et = cost of the CPI basket in month t

NOW YOU TRY

CPI vs. GDP deflator The PCE deflator

NOW YOU TRY

NOW YOU TRY NOW YOU TRY

Labor force • population increases by 1%

Unemployment rate • number of unemployed persons increases by

NOW YOU TRY

The measures of employment growth

IN THIS CHAPTER, YOU WILL LEARN:

What determines the

Outline of model (1 of 2) Factors of production

A closed economy, market-clearing model K = capital:

 determination of output/income L = labor:

The production function: Y = F (K,L) Returns to scale: A review