Economics for Managers (EFM)

Subject Code: 4519905

Unit 3

Measuring a nation’s income

THE ECONOMY’S INCOME AND EXPENDITURE
•When judging whether the economy is doing well or poorly, it is natural to look at the total income that
everyone in the economy is earning.
•For an economy as a whole, income must equal expenditure because:
•Every transaction has a buyer and a seller.
•Every dollar of spending by some buyer is a dollar of income for some seller.

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT

•Gross domestic product (GDP) is a measure of the income and expenditures of an economy.
•It is the total market value of all final goods and services produced within a country in a given period of time.
•The equality of income and expenditure can be illustrated with the circular-flow diagram.

THE MEASUREMENT OF GROSS DOMESTIC PRODUCT

•GDP is the market value of all final goods and services produced within a country in a given period of time.
•“GDP is the Market Value . . .”
•Output is valued at market prices.
•“. . . Of All Final . . .”
•It records only the value of final goods, not intermediate goods (the value is counted only once).
•“. . . Goods and Services . . . “
•It includes both tangible goods (food, clothing, cars) and intangible services (haircuts, housecleaning, doctor
visits).
•“. . . Produced . . .”
•It includes goods and services currently produced, not transactions involving goods produced in the past.
•“ . . . Within a Country . . .”
•It measures the value of production within the geographic confines of a country.
•“. . . In a Given Period of Time.”
•It measures the value of production that takes place within a specific interval of time, usually a year or a
quarter (three months).

THE COMPONENTS OF GDP

•GDP includes all items produced in the economy and sold legally in markets.
•What Is Not Counted in GDP?
•GDP excludes most items that are produced and consumed at home and that never enter the marketplace.
•It excludes items produced and sold illicitly, such as illegal drugs.
•GDP (Y) is the sum of the following:
•Consumption (C)• Investment (I)• Government Purchases (G)• Net Exports
(NX)Y = C + I + G + NX
•Consumption (C):
•The spending by households on goods and services, with the exception of purchases of new housing.
•Investment (I):
•The spending on capital equipment, inventories, and structures, including new housing.
•Government Purchases (G):
•The spending on goods and services by local, state, and federal governments.
•Does not include transfer payments because they are not made in exchange for currently produced goods or
services.
•Net Exports (NX):
•Exports minus imports.

REAL VERSUS NOMINAL GDP

•Nominal GDP values the production of goods and services at current prices.
•Real GDP values the production of goods and services at constant prices.

The GDP Deflator

•The GDP deflator is a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100.
•It tells us the rise in nominal GDP that is attributable to a rise in prices rather than a rise in the quantities
produced.
•The GDP deflator is calculated as follows:

GDP deflator=(Nominal GDP/Real GDP)×100

•Converting Nominal GDP to Real GDP•Nominal GDP is converted to real GDP as follows:

Real GDP20XX= (Nominal GDP 20xx/GDP deflator20XX)×100

GDP AND ECONOMIC WELL-BEING

•GDP is the best single measure of the economic well-being of a society.
•GDP per person tells us the income and expenditure of the average person in the economy.
•Higher GDP per person indicates a higher standard of living.
3
•GDP is not a perfect measure of the happiness or quality of life, however.
•Some things that contribute to well-being are not included in GDP.
•The value of leisure.
•The value of a clean environment.
•The value of almost all activity that takes place outside of markets, such as the value of the time parents spend
with their children and the value of volunteer work.
Measuring the cost of living
Refer the attached PPT
Savings and investment
Savings
Saving means different things to different people. To some it means putting money in the bank. To others it
means buying stocks or contributing to a pension plan. But to economists, saving means only one thing—
consuming less in the present in order to consume more in the future.
An easy way to understand the economist’s view of saving—and its importance for economic growth—is to
consider an economy in which there is a single commodity, say, corn. The amount of corn on hand at any point
in time can either be consumed (literally gobbled up) or saved. Any corn that is saved is immediately planted
(invested), yielding more corn in the future. Hence, saving adds to the stock of corn in the ground, or in
economic jargon, the stock of capital. The greater the stock of capital, the greater the amount of future corn,
which can, in turn, either be consumed or saved….

Investments
Although in general parlance investment may connote many types of economic activity, economists normally
use the term to describe the purchase of durable goods by households, businesses, and governments. Private
(nongovernmental) investment is commonly divided into three broad categories: residential investment, which
accounts for about a quarter of all private investment (25.7 percent in 1990); nonresidential, or business, fixed
investment, which accounts for most of the remainder; and inventory investment, which is small but volatile.
Indeed, inventory investment is often negative (it was in 1990, and in three years during the eighties). Business
fixed investment, in turn, is composed of equipment and nonresidential structures. Equipment now makes up
over three-quarters of business investment….

https://www.economicsdiscussion.net/relationship/relationship-between-saving-and-investment-
economics/26032

When Keynes stated that saving was always equal to investment he was referred to actual or realised saving and
actual or realised investment.

The income obtained from the production of the national output is distributed to the various factors of
production employed in the production process and so national income and national output are always and
necessarily equal. They are merely the same thing looked at in two different ways.
The output produced will be either for current use or will be added to the country’s stock of investment goods.
The income earned will either be used for consumption purposes or saved. As aggregate output and income are
always equal and consumption is identical in both places, the rest of the equation must also be equal or Y = C +
I and Q = GNP = C + S and if Y = Q, C + S = C + I or S = I.
income = consumption + saving . . . (1)
With no government purchases or net exports, the components of aggregate expenditures that firms can produce
only two kinds of goods: consumer goods and investment goods.
Thus, output Y can be broken into two components:
Y = consumption + investment . . . (2)
These two identities can be combined to form a new one. Since the value of national output equals national
income
Y = income . . . (3)
We can use tire right-hand side of (1) and (2) to get:
Consumption + savings = Consumption + investment . . . (4)
By subtracting consumption from both sides of the equation, we get:

Saving = investment . . . (5)

In short, saving must equal investment. This is a simple matter of definition and is known as saving-investment
equality (identity).
The simplest way to understand this identity is to think of firms as producing a certain amount of goods, the
value of which is just equal to the income received by all individuals in the economy (here the entire sales
revenue of firms is paid out as income to factor-suppliers). That portion of national income which is not spend
on consumption goods is saved. On the output side, firms either sell the goods they produce or put them into
inventory, for future sale.
Some of the inventories business firms hold is planned (desired), because businesses require inventories to
survive (i.e., because production and sales do not coincide). Some of it is unplanned (undesired) — business
may be surprised by a brief recession that spoils their sales forecasts. Both intended and unintended inventory
build ups are considered investment.

The goods that are not demanded by consumers are, by definition, demanded by business firms, i.e., are
invested. (In fact, investment is the demand for capital goods). After all, inventory accumulation consists of
goods that are produced not for current consumption but presumably for future consumption.
The above identity (5) can now be transformed into an equation determining national income, once we
recognise that in equilibrium firms will cut back production if there is unintended inventory accumulation.
Since firms will reduce output, in equilibrium the amount companies invest in the amount they wish to invest
(including inventories), given current market conditions. (That is, in equilibrium, firms do not suffer unpleasant
surprises). The equilibrium condition theory is that
investment = desired investment . . . (6)
Now, let us switch over to the savings side of the identity (5). The Keynesian short-run consumption function
tells us how much people will wish to consume at each level of income. But since saving is a residue (i.e., what
is not consumed is automatically saved), the consumption function can easily be transformed into a saving
function, given the level of saving at each level of income.

Saving is just income minus consumption:

saving = income (Y) – consumption (c) . . . (7)

Fig. 1 shows the saving function. The slope of this curve, the amount by which saving increases as income rises,
is the MPS which is 1 – MPC.

Since saving must equal investment, and in equilibrium investment must equal desired investment, then in
equilibrium
saving = desired investment . . . (8)
The Fig. 2 shows a fixed level of desired investment (7). The desired investment function is horizontal because
in Keynes’ model all investment is autonomous, i.e., is assumed to be independent of national income. National
income equilibrium occurs at point E where the desired saving function intersects the desired investment
function.

Thus, in the words of Samuelson, “investment calls the tune and consumption dances to the music. Invest-
ment determines output, while saving responds precisely to income changes. Output rises or falls until
planned saving has adjusted to the level of planned investment”.
Therefore, we observe that actual (ex-post) saving is always equal to actual (ex-post) investment. But planned
or desired (ex-ante) saving is equal to planned or desired (ex-ante) investment only when national income is in
equilibrium.
When we talk of saving and investment being equal, we are referring to the observed behaviour of an economy;
a study of what has actually happened or what has been realised. But the Keynesian analysis of income
determination revolves around the intended nature of such variables as saving and investment. These plans to
save and invest lead to changes in the income flow, with different equilibrium levels being reached.
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Decisions to save and invest are constantly being made by different groups of people at different times and for
different reasons. So there is very little chance of these plans being equal to each other within the same time
period.
When any discrepancy between the plans to save and invest occurs a change in the level of income brings about
a state of disequilibrium, and as income continues to change so do these plans get readjusted until a level of
income is reached where planned saving and investment are once more equal to each other.
It is only then that equilibrium has been attained where there is no tendency for the level of income and
employment to alter. This process is facilitated by a multiplied change in income which operates both in an
upward and in a downward direction.
A simple numerical example may clarify the above:
The table gives a consumption function, from which saving plans can be obtained. Assuming that planned
investment is autonomous and that all household plans are realised, an equilibrium level of income can be
calculated.
When income is 500 the consumption schedule indicates that 400 will be consumed, leaving the remainder
(100) to be saved. At this level of income autonomous planned investment is 100, thereby bringing total
planned expenditure (consumption + investment) equal to the level of output (or income). With planned saving
and investment being equal, the economy is in a state of equilibrium — there are no forces at work changing the
level of output or income.
However, at the higher level of income (600) planned saving exceeds planned investment resulting in planned
expenditure failing below planned income. As the rate of production exceeds the rate of sales by 20 the level of
stock will rise thereby resulting in a rise in unplanned investment.
Any stock changes are regarded as changes in investment. At this stage, realised investment, made up of
planned and unplanned investment, will still be equal to realised saving, but the discrepancy between the
intentions of savers and investors will result in the level of income falling back until it reaches the equilibrium
level of 500.
An exactly opposite process will work itself out if actual income falls below its equilibrium value. If income
were 400 the consumption schedule would indicate that 320 would be consumed and 80 saved. With planned
investment exceeding planned saving, planned expenditure would exceed planned income resulting in a fall in
the value of stocks (inventories). The fall in stocks can be regarded as unplanned disinvestment, giving a
realised investment figure of (100 – 20) = 80 (which is the same as realised savings).

Production and growth, Concepts of GDP, GNP, PPP

Why Are the Factors of Production Important to Economic Growth?
Economic growth only comes from increasing the quality and quantity of the factors of production, which
consist of four broad types: land, labor, capital, and entrepreneurship. The factors of production are the
resources used in creating or manufacturing a good or service in an economy.
Understanding the Factors of Production
The factors of production are what's needed for a company to earn an economic profit. The four factors of
production are:
Land
Land is any natural resource that's needed or used in the production of a good or service. Land can also include
any resource that comes from the land such as oil, gas, and other commodities such as copper and silver.
Typically, land includes any natural resource that's used as raw materials in the production process.
Labor
Labor consists of the people that are responsible for the production of a good, including factory workers,
managers, salespeople, and the engineers that designed the machinery used in production.
Capital
Capital refers to capital goods such as manufacturing plants, machinery, tools, or any equipment used in the
production process. Capital might refer to a fleet of trucks or forklifts as well as heavy machinery.
Entrepreneurship
Entrepreneurship is the fourth factor and includes the visionaries and innovators behind the entire production
process. The entrepreneurs combine all the other factors of production to conceptualize, create, and produce the
product or service. They are the drivers behind any technical change in the economic system which has been
shown to be a major source of economic growth.
The Importance of the Factors of Production
According to the Federal Reserve Bank of St Louis, the factors of production are defined as
"Resources that are the building blocks of the economy; they are what people use to produce goods and
services."1
If businesses can improve the efficiency of the factors of production, it stands to reason that they can create
more goods at a higher quality and perhaps a lower price. Any increase in production leads to economic growth
as measured by Gross Domestic Product or GDP. GDP is merely a metric that represents the total production of
all goods and services in an economy. Improved economic growth raises the standard of living by lowering
costs and raising wages.
Capital goods include technological advances from iPhones, to cloud computing, to electric cars. For example,
in the last several years, the technology of fracking or horizontal drilling has led to improved extraction of oil
making the U.S. one of the world's largest oil producers. The innovation couldn't be done without the labor
behind the process, from conceptualization to the finished product.
However, as technology helps to increase the efficiency of the factors of production, it can also replace labor to
reduce costs. For example, artificial intelligence and robotic machines are used in manufacturing boosting
productivity, reducing costly errors from human beings, and ultimately reducing labor costs.
Of course, nothing gets started without the entrepreneurs who create a vision and the action steps needed to
design the production process. Entrepreneurs combine all the factors of production, including buying the land or
raw materials, hiring the labor, and investing in the capital goods necessary to bring a finished product to
market.
As Parmenides, a Greek philosopher, famously quipped, "Nothing comes from nothing." Economic growth
results from better factors of production. This process is clearly demonstrated when an economy
undergoes industrialization or other technological revolutions; each hour of labor can generate increasing
amounts of valuable goods.

GDP

GDP is the final value of the goods and services produced within the geographic boundaries of a country during
a specified period of time, normally a year. GDP growth rate is an important indicator of the economic
performance of a country.
It can be measured by three methods, namely,

1. Output Method: This measures the monetary or market value of all the goods and services produced within
the borders of the country. In order to avoid a distorted measure of GDP due to price level changes, GDP at
constant prices o real GDP is computed. GDP (as per output method) = Real GDP (GDP at constant prices) –
Taxes + Subsidies.

2. Expenditure Method: This measures the total expenditure incurred by all entities on goods and services
within the domestic boundaries of a country. GDP (as per expenditure method) = C + I + G + (X-IM) C:
Consumption expenditure, I: Investment expenditure, G: Government spending and (X-IM): Exports minus
imports, that is, net exports.

3. Income Method: It measures the total income earned by the factors of production, that is, labour and capital
within the domestic boundaries of a country. GDP (as per income method) = GDP at factor cost + Taxes –
Subsidies.

In India, contributions to GDP are mainly divided into 3 broad sectors – agriculture and allied services, industry
and service sector. In India, GDP is measured as market prices and the base year for computation is 2011-12.
GDP at market prices = GDP at factor cost + Indirect Taxes – Subsidies

GNP
Gross National Product (GNP) is the total value of all finished goods and services produced by a country’s
citizens in a given financial year, irrespective of their location. GNP also measures the output generated by a
country’s businesses located domestically or abroad. It can be defined as a piece of economic statistic that
comprises Gross Domestic Product (GDP), and income earned by the residents from investments made
overseas.

Simply put, GNP is a superset of the GDP. While GDP confines its analysis of the economy to the geographical
borders of the country, GNP extends it to also take account of the net overseas economic activities performed
by its residents.

Basically, GNP signifies how a country’s people contribute to its economy. It considers citizenship, regardless
of the location of the ownership. GNP does not include foreign residents’ income earned within the country.
GNP also does not count any income earned in India by foreign residents or businesses, and excludes products
manufactured in the country by foreign companies.

In calculation, GNP adds government expenditure, personal consumption expenditure, private domestic
investments, net exports, and income earned by nationals overseas, and eliminates the income of foreign
residents within the domestic economy. Moreover, GNP omits the value of intermediary goods to avoid double
counting, as these entries get included in the value of final products and services.
What is the difference between GDP and GNP?

The basic distinction between GDP and GNP is the difference in estimating the production output by foreigners
in a country and by nationals outside of a country.

How is GNP calculated?

The formula for GNP = GDP + Net factor income from abroad

or

GNP = C + I + G + X + Z

Where C is Consumption, I is investment, G is government, X is net exports, and Z is net income earned by
domestic residents from overseas investments minus net income earned by foreign residents from domestic
investments.
PPP

Purchase power parity (PPP) is an economic theory that allows for the comparison of the purchasing power of
various world currencies to one another. It is the theoretical exchange rate at which you can buy the same
amount of goods and services with another currency.

Learn why government agencies use PPP to compare national economies, and how you could use it to find out
where to get the cheapest hamburger in the world.

Definition and Examples of Purchase Power Parity

The purchasing power parity calculation tells you how much things would cost if all countries used the same
currency. In other words, it is the rate at which one currency would need to be exchanged to have the same
purchasing power as another currency.1 Purchasing power parity is based on an economic theory that states the
prices of goods and services should equalize among countries over time.

 Acronym: PPP

International trade allows people to shop around for the best price. Given enough time, this comparison
shopping allows everyone's purchasing power to reach "parity," or equalization.

Parity is tedious to compute. A U.S. dollar value must be assigned to everything. That includes items not widely
available in America. For example, there aren't too many ox carts in the United States. Also, it is doubtful that
the cart's U.S. price would accurately describe its value in rural Vietnam, where it's needed to grow rice.
The World Bank computes PPP for each country in the world. It provides a map that shows the PPP
ratio compared to the United States.

For many developing countries, the PPP is estimated using a multiple of the official exchange rate (OER)
measure. For developed countries, the OER and PPP measures are more similar because the standards of living
in developed countries are closer to those of the United States.

How Does Purchase Power Parity Work?

An economist will use the PPP to compare the economic output of different nations against one another. It
might be used to determine which country has the world's largest economy. Using PPP exchange rates in
addition to a country's gross domestic product (GDP) may help to provide a more detailed picture of a country's
economic health.

The theoretical value is also helpful to traders in foreign currency and investors holding foreign stocks or bonds
as it helps to predict fluctuations in international currency and indicate weakness.2

Although it doesn't happen often, PPP is also used to set the exchange rate for new countries and forecast future
real exchange rates.

Comparing a Country's Output

Purchasing power parity finds its greatest use in macroeconomic studies as you compare GDP. Since many
countries have their own currency, GDP values can be skewed. PPP recalculates a country's GDP as if it were
being priced in the United States.

The CIA World Factbook calculates PPP to compare output among countries.3 It is estimated that China's 2019
GDP was $22.5 trillion—much more than the U.S. GDP of $20.5 trillion. According to PPP, China has the
world's largest economy.

However, without PPP, this comparison yields a different result. If you were to measure China's GDP in yuan,
then simply convert that yuan to U.S. dollars at the market exchange rate, the country's 2019 GDP would only
total roughly $14.3 trillion.4

The difference between the two GDP measurements stems from the differences in the cost of living.

The Big Mac Index

You could also use PPP to find out where you could get a McDonald's Big Mac for less. In December 2020, the
U.S. Big Mac cost $5.66. In China, you can get the same thing for 22.4 yuan. At current market exchange rates,
that comes out to only $3.47. The Economist's Big Mac Index calculates these Big Mac comparisons for 55
countries.

The Big Mac Index is published each year by The Economist and was created in 1986.

Burgernomics—the study of the Big Mac index—can give an informal measure of the PPP. Like most other
sandwiches, the Big Mac doesn't travel well in its final form so it's not exported. Most of its price depends on
local labor and restaurant rental costs. Since labor in China is less expensive, it costs less to produce one Big
Mac than it does in the United States.
Thanks to McDonald's standards, a Big Mac is basically the same sandwich anywhere in the world. You aren't
getting a smaller sandwich in China, even though it's roughly $2 cheaper. Purchasing power parity solves this
problem. It recalculates the value of a country's goods and services as if they were being sold at U.S. prices.

The Big Mac Index will tell you a lot about a country's cost of living. If you want to live cheaply, and you can
move to any country in the world, use the Big Mac Index.

History

PPP was created after World War I. Before then, most countries relied on the gold standard. A country's
exchange rate told you how much gold the currency was worth. Most countries abandoned the gold standard to
pay for the war. They printed all the money they needed, creating inflation.

After the war, the Swedish economist Gustav Cassel suggested multiplying each currency's pre-war value by its
inflation rate to get the new parity. That formed the basis for today's PPP.5

Why We Don't Live in a PPP World

PPP depends on the law of one price. In theory, once the difference in exchange rates is accounted for, then
everything would cost the same.

This isn't the case in the real world for four reasons. First, there are differences in transportation costs, taxes,
and tariffs. These costs will raise prices in a country. Countries with many trade agreements will have lower
prices because they have fewer tariffs. Socialist countries will have higher costs because they have more taxes.

A second reason is that some things, like real estate and haircuts, can't be shipped. Only ultra-wealthy global
travelers can compare the prices of homes in New York to those in London.

A third reason is that not everyone has the same access to international trade. For example, someone in rural
China can't compare the prices of oxen sold throughout the world. But Amazon and other online retailers are
providing more real purchasing power parity to even rural dwellers.

A fourth reason is that import costs are subject to exchange rate fluctuations. For example, when the U.S. dollar
weakens, then Americans pay more for imports. The most significant driver of changing exchange rate values is
the foreign exchange market. It creates wide swings in exchange rate values.6 When traders decide to short a
country's currency, they effectively reduce costs throughout that country.

The monetary system, Money growth and inflation

Monetary System

The monetary system refers to a set of institutions that provides a supportive framework for the creation of
money in an economy by the government.
There are 3 types of monetary system:
1. Commodity money
2. Commodity-based money
3. Fiat money
The most common type of monetary system is Fiat money.

Types of Monetary system

The types of the monetary system are discussed below:
Commodity Money
Commodity money is the type of money that is made of precious metals or commodities that have intrinsic
value. It is not just a token or representative of monetary value like banknotes. Its worth remains intact even
after it is melted. Gold and silver coins are the perfect example of commodity money.
Commodity-based money
This type of monetary system can also be addressed as representative money. This type of currencies are mostly
like physical bank-notes with no financial value but can be exchanged with precious metals like gold and silver.
This is closely related to the term gold standard.
Fiat Money
This type of money is also termed as legal tender as notified by the Central Government and Central Bank. This
is unlike the commodity money; it might not have an intrinsic value. Paper currencies and metal coins are
examples of fiat money.
In modern economies or current phase, it mainly exists as data such as bank balances and records of credit or
debit card purchases.
Important terms related to Money
Money – Anything which has general acceptance as a means of payment.
Functions of Money
Medium of Exchange
 Common measure of value
 Standard for deferred payments
 Store of wealth
Barter System – A commodity is exchanged for other commodities.
 Problems of barter System are:-
 Double coincidence of what is required
 Valuation of commodities exchanged is a problem
 There won’t be a standard to serve as future monetary obligations
Gresham’s Law – Bad money drives out good money
Legal Tender Money – This money cannot be denied in the settlement of the monetary obligation
 Limited Legal Tender Money: It is compulsory to accept up to a certain limit
Example – A sum of 10 can be paid in denominations of 50 paisa coins and the recipient has to legally accept it.
 Unlimited Legal Tender Money: This money can be used to make any amount of payment
Non-Legal Tender Money – There is no legal compulsion to accept this money. It is also called optional money
or Fiduciary Money (on the basis of trust).
 E.g. – Nepalese currency at India – Nepal border may be used as but the recipient is not legally bound to
accept it.
Near Money – Highly liquid financial assets like shares and bonds

In India, monetary policy of the Reserve Bank of India is aimed at managing the quantity of money in order to
meet the requirements of different sectors of the economy and to increase the pace of economic growth.

The RBI implements the monetary policy through open market operations, bank rate policy, reserve system,
credit control policy, moral persuasion and through many other instruments. Using any of these instruments will
lead to changes in the interest rate, or the money supply in the economy. Monetary policy can be expansionary
and contractionary in nature. Increasing money supply and reducing interest rates indicate an expansionary
policy. The reverse of this is a contractionary monetary policy.

For instance, liquidity is important for an economy to spur growth. To maintain liquidity, the RBI is dependent
on the monetary policy. By purchasing bonds through open market operations, the RBI introduces money in the
system and reduces the interest rate.

Money Growth

The nobel prize winning economist Milton Friedman once said that “Inflation is always and everywhere a
monetary phenomenon.” The evidence to back his claim was pretty clear: whenever countries experience very
high inflation for a sustained period of time, those countries also experience a rapid increase in the rate of
growth of their money supply.
At the same time, increases in the money supply in those countries isn’t associated with sustained increases in
output that we would have predicted with monetary policy. It seems that in the short run, increases in the money
supply lead to increases in output, but in the long run increases in the money supply just cause inflation.
Key term definition
the number of times in a year that an “average” dollar gets spent on goods and services;
for example, if the velocity of money is 2, then every dollar in an economy gets used
Velocity twice in a year.
the concept that money only impacts nominal variables, not real variables, in the long
run; in other words, increasing the money supply might decrease the nominal interest
Money neutrality rate, but it won’t have an impact on the real interest rate.
a way of analyzing the impact of monetary and fiscal policy actions based on the
Monetarism equation of exchange
the equation of a mathematical identity that describes the relationship between the money supply and
exchange nominal GDP
a theoretical model that when the velocity of money is fixed and real output is limited to
the quantity full employment output, any increase in the money supply causes an increase in the price
theory of money level

Key equations

The equation of exchange

The equation of exchange states that the effective money supply is equal to nominal GDP:

M×V=P×Y

Where

M×V = the effective money supply is the money supply(M)multiplied by the velocity of money(V)
P×Y = is the price level (p) multiplied by real GDP (Y)

Note that P×Y the same as nominal GDP.

The equation of exchange of money is actually just saying that all of the nominal GDP that is bought (P×Y) has
to be bought with the effective amount of money available (M×V). Think of the quantity theory of money this
way: “you need $100 dollar to buy $100 worth of stuff.”

Equations (like the equation of exchange) become theories when we start describing attributes of the parts of
the equation. For example, if we assume that the velocity of money never changes, then any increase in the
money supply must also cause a change in one of the variables on the right-hand side of the equation.

The quantity theory of money

M×V=P×Y

Where V, the velocity of money, is constant.

The quantity theory of money has these important implications:

 If output (Y) is increasing and velocity is constant, the money supply will have to increase to
keep the price level from decreasing; and
 An increase in the money supply (M) without an increase in output (Y) causes the price level to
change by the same change in the money supply. In other words, output doesn’t change, but
when the money supply doubles, the price level also doubles.

For example, suppose we had a really simple economy that only produced mangoes. The velocity of money is 5
and there are 100 mangoes:
M×5=P×Y
What will the price be if there is $20 dollar in the money supply?
$20×5=P×100
$100 = P × $100
$1 = P
So, according to this theory, each mango will cost $1dollar. What if instead there is $40 dollar in the money
supply?
$40×5 = P×100
$200 = P×100
P=$2
Open-economy macroeconomics – Basic concepts
•Open and Closed Economies
•A closed economy is one that does not interact with other economies in the world.
•There are no exports, no imports, and no capital flows.
•An open economy is one that interacts freely with other economies around the world.
•An open economy interacts with other countries in two ways.
•It buys and sells goods and services in world product markets.
•It buys and sells capital assets in world financial markets.

THE INTERNATIONAL FLOW OF GOODS AND CAPITAL

•An Open Economy
•The United States is a very large and open economy—it imports and exports huge quantities of goods and
services.
•Over the past four decades, international trade and finance have become increasingly important.

The Flow of Goods: Exports, Imports, Net Exports

•Exports are goods and services that are produced domestically and sold abroad.
•Imports are goods and services that are produced abroad and sold domestically.
•Net exports (NX) are the value of a nation’s exports minus the value of its imports.
•Net exports are also called the trade balance.
•A trade deficit is a situation in which net exports (NX) are negative.
•Imports > Exports
•A trade surplus is a situation in which net exports (NX) are positive.
•Exports > Imports•Balanced trade refers to when net exports are zero—exports and imports are exactly equal.
•Factors That Affect Net Exports
•The tastes of consumers for domestic and foreign goods.
•The prices of goods at home and abroad.
•The exchange rates at which people can use domestic currency to buy foreign currencies.
The incomes of consumers at home and abroad.
•The costs of transporting goods from country to country.
•The policies of the government toward international trade.

The Flow of Financial Resources: Net Capital Outflow

•Net capital outflow refers to the purchase of foreign assets by domestic residents minus the purchase of
domestic assets by foreigners.
•A U.S. resident buys stock in the Toyota corporation and a Mexican buys stock in the Ford Motor corporation.
•When a U.S. resident buys stock in Telmex, the Mexican phone company, the purchase raises U.S. net capital
outflow.
•When a Japanese residents buys a bond issued by the U.S. government, the purchase reduces the U.S. net
capital outflow.
•Variables that Influence Net Capital Outflow
•The real interest rates being paid on foreign assets.
•The real interest rates being paid on domestic assets.
•The perceived economic and political risks of holding assets abroad.
•The government policies that affect foreign ownership of domestic assets.

The Equality of Net Exports and Net Capital Outflow

•Net exports (NX) and net capital outflow (NCO) are closely linked.
•For an economy as a whole, NX and NCO must balance each other so that:
NCO = NX
•This holds true because every transaction that affects one side must also affect the other
side by the same amount.
Saving, Investment, and Their Relationship to the International Flows
•Net exports is a component of GDP:
Y = C + I + G + NX
•National saving is the income of the nation that is left after paying for current
consumption and government purchases:
Y - C - G = I + NX
•National saving (S) equals Y - C - G so:
S = I + NX
or
Saving (S) = Domestic Investment (I) + Net Capital Outflow (NCO)

THE PRICES FOR INTERNATIONAL TRANSACTIONS: REAL AND NOMINAL

EXCHANGE RATES
•International transactions are influenced by international prices.
•The two most important international prices are the nominal exchange rate and the real
exchange rate.
Nominal Exchange Rates
•The nominal exchange rate is the rate at which a person can trade the currency of one
country for the currency of another.
•The nominal exchange rate is expressed in two ways:
•In units of foreign currency per one U.S. dollar.
•And in units of U.S. dollars per one unit of the foreign currency.
•Assume the exchange rate between the Japanese yen and U.S. dollar is 80 yen to one
dollar.
•One U.S. dollar trades for 80 yen.
•One yen trades for 1/80 (= 0.0125) of a dollar.
•Appreciation refers to an increase in the value of a currency as measured by the amount
of foreign currency it can buy.
•Depreciation refers to a decrease in the value of a currency as measured by the amount
of foreign currency it can buy.
•If a dollar buys more foreign currency, there is an appreciation of the dollar.
•If it buys less there is a depreciation of the dollar.

Real Exchange Rates

•The real exchange rate is the rate at which a person can trade the goods and services of
one country for the goods and services of another.
•The real exchange rate compares the prices of domestic goods and foreign goods in the
domestic economy.
•If a case of German beer is twice as expensive as American beer, the real exchange rate
is 1/2 case of German beer per case of American beer.
•The real exchange rate depends on the nominal exchange rate and the prices of goods in
the two countries measured in local currencies.
•The real exchange rate is a key determinant of how much a country exports and imports.
Real exchange rate = Nominal exchange rate Domestic price
Foreign price
×
•A depreciation (fall) in the U.S. real exchange rate means that U.S. goods have become
cheaper relative to foreign goods.
•This encourages consumers both at home and abroad to buy more U.S. goods and fewer
goods from other countries.
•As a result, U.S. exports rise, and U.S. imports fall, and both of these changes raise U.S.
net exports.
•Conversely, an appreciation in the U.S. real exchange rate means that U.S. goods have
become more expensive compared to foreign goods, so U.S. net exports fall.

A FIRST THEORY OF EXCHANGE-RATE DETERMINATION: PURCHASINGPOWER PARITY

•The purchasing-power parity theory is the simplest and most widely accepted theory
explaining the variation of currency exchange rates.
The Basic Logic of Purchasing-Power Parity
•Purchasing-power parity is a theory of exchange rates whereby a unit of any given
currency should be able to buy the same quantity of goods in all countries.
•According to the purchasing-power parity theory, a unit of any given currency should be
able to buy the same quantity of goods in all countries.
•The theory of purchasing-power parity is based on a principle called the law of one price.
•According to the law of one price, a good must sell for the same price in all locations.
•If the law of one price were not true, unexploited profit opportunities would exist.
•The process of taking advantage of differences in prices in different markets is called arbitrage.
•If arbitrage occurs, eventually prices that differed in two markets would necessarily converge.
•According to the theory of purchasing-power parity, a currency must have the same purchasing power in all
countries and exchange rates move to ensure that.

Implications of Purchasing-Power Parity

•If the purchasing power of the dollar is always the same at home and abroad, then the exchange rate cannot
change.
•The nominal exchange rate between the currencies of two countries must reflect the different price levels in
those countries.
•When the central bank prints large quantities of money, the money loses value both in terms of the goods and
services it can buy and in terms of the amount of other currencies it can buy.
Limitations of Purchasing-Power Parity
•Many goods are not easily traded or shipped from one country to another.
•Tradable goods are not always perfect substitutes when they are produced in different countries.