NATIONAL INCOME AND PRODUCT ACCOUNTS (NIPA) Life Cycle Hypothesis: To see where economy is today

Gross Domes8c Product (GDP) Impact of r on S

Measure of total economic ac8vity in a given year (NEWLY produced G&S) 1. Subs8tu8on effect (dominates) – Opp Cost of
1. Product Value added approach: ∑Mkt. value of FINAL goods and services NEWLY consumpDon today ­. That is, I will have more
produced in the market by domesDcally located capital & labor during the Yr. purchasing power tomorrow if I save today. Hence Sav­
• GDP = ∑ Value added by all G&S 2. Income effect: Since r­, can save less today & earn
• Value Added = Final Revenue - Cost of Intermediate Goods the same amt. tom., so Sav. ¯
• Avoids double coun8ng of intermediate goods
• Intermediate G&S: Used up in the producDon of other G&S in the same period Impact of G on S
that they themselves were produced. • ­ G à ¯S & ¯C ; (C declines < G)
• Capital Goods: itself produced & is used to produce other goods; but NOT USED • Temporary Inc. change, consumpDon no change
UP in the same period as produced. Eg. Lathe Machine, Roads, airports, telecom • Permanent changes, consumpDon changes
networks, factories, IPs, goods produced out of R&D, SoUware, IT, Banking Serv.
Investments: In eqm : MPL = W/P = w; MPK = R/P =r
2. Expenditure Approach: GDP as spending by ulDmate users of the final G&S during • Firm employs capital Dll the MPK equals real rental rate (r); r = cost of capital
the year. • Desired I = (Desired K – Current K) + Deprecia8on
Y = C + I + G + NX C = ∑ ConsumpDon; I = ∑ Investment in Capital Goods
As desired K ↑ à I ↑ ; Note: K is a stock variable, I is a flow
G = ∑ Govt Spending; NX = ∑ Net Exports
3. Income Approach: Accounts for GDP by how factors of producDon (L&K)are
compensated/ addiDon of income earned by firms, labour, govt. When r is less, investment is more;
i. Na8onal Inc. = Comp. + Proprietor’s Inc. + Rental Inc. + Corp. Profits + Net Int. firms can raise more capital at
lower cost of capital
ii. Net Na8onal Product = NI + Indirect taxes (excise, GST)
iii. GNP = NNP + Dep.; Dep = value of capital goods dep in the yr GNP is measured
iv. GDP = GNP - NFP; *Sta8s8cal Difference = Exp. Approach GDP – Income
Approach GDP Cost of Capital
Data for Exp Approach/ produc>on approach is combined from various sources • No Arbitrage condn: r = MPK – d
• MPK = r + d (Determines the desired capital stock)
Gross Na8onal Product (GDP) • Due to d, we will stop invesDng < in case there was no d
Value created by factors of producDon (K & L) owned by country’s ciDzens wherever
the factors are located Capital Market Equilibrium
* DisDncDon for GDP & GNP imp. for countries with many ciDzens working abroad • r has to ¯ for household savings to ¯ in eqm
e.g. Japanese cars made in US – US GDP not GNP • r is determined in eqm by household Supply of S & Firms Demand of I
US company makes road in Saudi – US GNP not GDP • Eqm can shift, if demand/supply curve shifts:
• GDP = GNP - NFP • S shifts with G (­ G à ¯S)
NFP = Net Inc. earned from Foreign Assets (NIFA) = Inc. from abroad – Inc. sent • I shifts with tech innovation (­ MPK)
abroad = Inc. paid to domes>c factors of prod. by rest of the world – paid to • Crowding out:
foreign by domes>c economy

Real GDP vs Nominal GDP

• Real GDP values O/P @base year prices. Picks up ­in GDP coming from higher Qty
If Govt borrowing ­, Pvt Sector
of G&S, rather than higher prices.
cannot borrow because cost of
borrowing ­
• Nominal GDP values O/P @current prices
ECONOMIC GROWTH
• Price index = e.g. GDP deflator (calc Qtrly) Production Function: Y = AK0.3L0.7; Diminishing returns: K or L doubled, O/P < doubles
• Infla8on: Y-o-Y growth rate on price level Productivity Shocks: Unexpected changes in A

Growth Accounting (process of acc. for economic growth)

• ΔY/Y = ΔA/A + 0.3(ΔK/K) + 0.7(ΔL/L) => ΔA/A =ΔY/Y -0.3(ΔK/K) -0.7(ΔL/L);
• A = Total Factor Prody; includes all activities that ­productivity e.g. R&D, tech, etc.
• ΔA/A is the TFP growth rate. Captures growth in output over and beyond what can
be accounted for by measurable inputs. Backed out as a residual

Labor Productivity: Al=Y/L, and its growth is: ΔAl/Al= ΔY/Y -ΔL/L
Given Y = AK0.3L0.7. => Al=Y/L = A(K/L)0.3
Real vs Nominal Interest Rates r = i - p = R - p; r = Real, R or i = Nominal • Al can increase due to increase in TFP (Pure Tech Growth) or in capital per labor
• Real interest rate measures by how much has the purchasing power of the asset ­
SOLOW MODEL
Limita8ons of GDP: a) Some underground and informal acDvity b) DepleDon of natural
resources, environmental degradaDon c) Homemakers contribuDon d) Human capital
formaDon e) UN agempts at reforms (HDI: Human Development Index)

SAVINGS & WEALTH

Use of Pvt Sav : To

fund I or CA Def or BD
• When CA > 0, NX +
NFP >0
Money Recd > Paid
Country has extra
savings that can be Steady State (SS):
• Long run position of the economy such that Δk=0 (i.e. i= δk)
used for lending or • Investment is sufficient to cover depreciation
investments abroad. Equilibrium depends on savings rate
• If BD is high, Pvt
Savings will fund • Growth Dynamics: No matter where an economy starts, it will end up at k*. If k <
Govt’s deficit. k*, i(=sy)>d, & capital stock (and output) ­ till you approach k*.
• If k > k*, i(sy) < d, & capital is wearing out faster than it is replaced, and CS ¯ till you
approach k*. Steady state never reached in finite time but useful for long run
• Why Save? – ConsumpDon Smoothing & PrecauDonary Measures • Sustained growth requires sustained tech. progress: A­, y­, sy­, Steady State­
Consump(on Smoothing: Savings (=Inv.) are more vola>le. GDP fluctuates, C will • Convergence: Solow Model predicts convergence in per capita GDP
also change but < GDP as some needs s>ll prevail. => Sav change by larger amount • LimitaDons: Diff countries have diff steady states, Convergence holds within subsets
x MONEY, INFLATION, BANKING SYSTEM, MONEY CREATION NEUTRALITY DEBATE & MONETARY POLCY
• Money – Any asset used as Medium of Exchange, unit of account & store of value
• Measures: CU, M1(CU + demand & checking depo), M2 (M1+ saving + time depo) Keynesians (Phillips )
• Central Banks create money - ↑Money supply – Buy govt. bonds with new
money; ↓ supply – Sell govt. bonds for currency-open market sale Money is Non-Neutral in short run (not long-run)
• Change in Nominal Qty (M or i) affects a Real Qty
(O/P, Inv., Consumption, economic activity)
• Quantity Theory: • M ↑ à Inf↑ à P↑ à Economic growth ↑
• Assumes labour doesn’t demand ↑ wages with
↑M (=> W is same)
• ↑M à Disposable Inc ↑, Demand of G&S ↑,
Sales ↑, P↑, with more P Co employs more L, L
↑, employment ↑, GDP↑
• Demand Govt. interventions: exploitation of
inflation-unemployment tradeoff. M↑ during
recessions & M↓ during booms
Classical Economists (Phelps, Lucas)
Money = Neutral in short run
• Change in Nominal Qty (M or i) affect Nominal
Prices only
• Instead of adaptive expectations, people have
rational expectations => demand ↑ wages
with ↑M (=> W↑)
• ↑M à Disposable Inc ↑, Demand of G&S ↑,
Sales ↑, P↑, W ↑, L does not increase
• Feel Govt. is not doing anything
• Relation between unanticipated inflation (π- πe
& cyclical unemployment (u – u)

PHILIPS CURVE
• -ve relation b/w inflation & unemployment

• Short run : Non-Neutral

• Long run : Neutral
• Neutrality of Money: Changes in M have no real effect on economy in long run • 1970s – Stagflation (Inflation inc, wages inc, no
change in u)
• Clear separation of M & real variables – O/P, Unemployment & Economic Growth CLASSICAL RESPONSE
SUMMARY
Interest And Money Demand: Md / P = L(i,Y). => Md/P = M/P = L(r + πe, Y) Clear evidence on long-run neutrality of money. All
economists agree on LR neutrality.
• Md depends on i (=Opp cost of holding 1$ cash) i ­à L↓ à Md ↓ Evidence on short-run non-neutrality is mixed.
• Y­ à L­ (more transactions require more money), • Keynesians believe in evidence, advocate
• Future M ­, πe ­, i ­, Md/P¯ but M is fixed, thus P ­ (What RBI does tomorrow exploitation of inflation-unemployment
tradeoff
affects prices today i.e. inflation) • Classical economists feel it is futile to try to
exploit non- neutrality even if it exists
Fractional Reserve Banking: Maximum Money Creation = (1 / res) x Dep
• A dollar injected becomes: 1 + (1-res) + (1-res)2 + (1-res)3+ ... = 1/res ; res = x%
Since 1/res > 1, Banking system creates money not wealth
Central Bank Commercial Banks

Assets Liabilities Assets Liabilities

Government Bonds Currency Res @ Central Bank Deposits

Res held by banks Loans

• m is a factor
of mkt forces
• Base is
controlled by
RBI

Money Supply is affected by:

• BASE: Directly controlled by the Fed. High BASE, High M
• res: Low res à high m. Fed policy & bank behaviour determine res
• cu: Low cu à high m. Determined by household & firm behaviour
Bank Failure / Run: cu ­ à res ­ (loans ¯ ) à m ¯ à M ¯
• As people withdraw deposits, cu ↑, Banks hold excess reserves, res
• As M¯, No Buyers, People are willing to sell for less, P ¯, CPI ¯ à Deflation
• Monetary Policy has a role in controlling wide-spread bank run: If Fed ­BASE, M­
even though m¯
Central Banking
Case for rules (Central bank follows a set of simple, pre-specified, & announced rules)
• Even if money non-neutral, long lags (~quarters) before policy takes effect (trickle-
down effect); will destabilize economy (it’s hard to judge what policy actions are
needed to hit the inflation target and hard for the public to tell if the central bank is
doing the right thing, so central banks may miss their targets, losing credibility)
• The Bank cannot be trusted to act prudently when it is under political pressure
• Forcing the Bank to keep its promises will increase credibility in monetary system

Hyperinflation:
More independent banks are, lower is the infla8on; India 4% ± 2%
• Very high level of inflation (>= 50% per month)
• Over reliance on printing money to cover operations Taylor rule
• Costs of high inflation: Allows the Fed to take economic conditions into account
• Huge costs involved with economizing on cash holdings
• Makes it hard for customers to shop around for best prices and distorts
efficient resource allocation (Prices change too fast)
• i = Nominal Fed funds rate,
• Redistributes wealth from creditors to debtors
• π= inflation rate over the last 4 quarters,
• y = % deviation of output from full-employment output

The Taylor rule

• The rule works by having the real Fed funds rate (i – π) respond to:
• y, the difference between output and full- employment output
• π – 0.02, the difference between inflation and its target of 2 percent
• If either y or π increase, the real Fed funds rate is increased, causing
monetary policy to tighten (and vice- versa)