ECON1220 (Finals)

Intro Macro, Spring 23
Topic 6
Aggregate Production
Chapter 10 & 8
Supplementary material: Charles Jones, Macroeconomics
Introduction
• A model
– A mathematical representation of a hypothetical world
that we use to study economic phenomena
– Consists of equations and unknowns with real-world
interpretations
– Vast oversimplifications of the real world in a model can
still allow it to provide important insights.
• Macroeconomists
– Document facts
– Build a model to understand the facts
– Examine the model to see how effective it is
Production Model
Simplifying assumption:
• Production factors:
o Labor
o Capital
o Land
o Entrepreneurship
Aggregate production function: shows how much real
output of a country (Y) can be produced given the
number of labor inputs (H) and capital inputs (K).
Y = A× F(K,H) 𝐻 = 𝐿×ℎ = 𝐿
where
• Y is real output (RGDP)
• K is the physical capital stock
• H is the total efficiency units of labor
o 𝐻 = 𝐿×ℎ
o 𝑳: the number of workers used in production
o 𝒉: the efficiency of labor
o Assumed to be 1 in this intro class
• F() is a mathematical function
• A is an index of technology
– 𝐴 is the total factor productivity (TFP), which is largely associated with a country’s technology
level
Human capital, or Labor
• The stock of skills embodied in labor to produce output or
economic value.
• Total efficiency units of labor is the product of the total
number of workers in the economy and the average human
capital of workers.
o H=L×h
o L is total number of workers
o h is the average human capital or efficiency
o Assumed to be a constant in this intro class
Physical capital stock
• The stock of capital, which is manufactured goods
that are used to produce other goods and
services.
Technology
• A set of devices and practices that determine how
efficiently an economy uses its labor and capital.
– Superior knowledge in production or more efficient
production processes so that more output can be produced
with the same amount of labor and capital inputs.
Aggregate production function: shows how much real
output of a country (Y) can be produced given the
number of labor inputs (L) and capital inputs (K).
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
where
• Y is real output (RGDP)
• K is the physical capital stock
• 𝑳 is the number of workers used in production
• F() is a mathematical function
• A is an index of technology
– 𝐴 is the total factor productivity (TFP), which is largely associated with a
country’s technology level
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
• 𝐴 = 10
• 𝐾=1
• 𝐿=8
𝑭 𝑲, 𝑳 Aggregate production 𝒀
function
1 𝐹! 𝐾, 𝐿 = 𝐾 + 𝐿 𝑌! = 𝐴× 𝐾 + 𝐿
90
2 𝐹" 𝐾, 𝐿 = 𝐾×𝐿 𝑌" = 𝐴× 𝐾×𝐿

80
3 ! " ! "
𝐹# 𝐾, 𝐿 = 𝐾 #× 𝐿 # 𝑌# = 𝐴× 𝐾 #× 𝐿 #
40
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
The aggregate production function has the same

two properties as the production function of an
individual firm.
• “More is better”
o An increase in either physical capital or total
efficiency units of labor, holding the other factor
constant, leads to an increase in real output.
• Law of diminishing marginal product
YouTube video: The Law (or Principle) Of Diminishing Marginal Returns (or
Productivity) Explained in One Minute
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
The aggregate production function has the same two properties

as the production function of an individual firm.
o Diminishing marginal product of labor (MPL): holding
everything else (including A and K) constant, MPL will
decrease eventually as more labor inputs are used for
production.
o Diminishing marginal product of capital (MPK): holding
everything else (including A and H = h x L) constant, MPK
will decrease eventually as more capital inputs are used for
production.
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
The aggregate production function has the same

two properties as the production function of an
individual firm.
o An increase in either physical capital or total efficiency
units of labor, holding the other factor constant, leads
to an increase in real output.
o More is not necessarily better all the time
o due to diminishing marginal product
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
• 𝐴 = 10
• 𝐾=1
• 𝐿=8
Aggregate production More is better? Diminishing Valid?

function marginal
product?
1 𝑌! = 𝐴× 𝐾 + 𝐿
Yes No No
2 𝑌" = 𝐴× 𝐾×𝐿
Yes No No
3 ! "
𝑌# = 𝐴× 𝐾 #× 𝐿 #
Yes Yes Yes
Cobb-Douglas Production Function
𝑌 = 𝐹 𝐾, 𝐿 = 𝐴 𝐾 ! 𝐿"
Or 𝑌 = 𝐹 𝐾, 𝐻 = 𝐴 𝐾 $ 𝐻%
where
• 𝑌 is the production output
• 𝐹() represents the production function
• 𝐴 is an index of technology
• 𝐾 is the capital stock used in production
• 𝐿 is the number of workers used in production
– ℎ = 1 is the efficiency of labor
– 𝐻 = 𝐿×ℎ is the efficiency units of labor used in production
• α and β are the output elasticities of capital and labor, respectively.
– Data suggests 𝛼 = 1/3 and 𝛽 = 2/3
Cobb-Douglas Production Function
# %
𝑌 = 𝐹(𝐾, 𝐿) = 𝐴𝐾 $ 𝐿$
What do
firms do?
What do firms do?
A firm is an institution that hires factors of production and
organizes them to produce and sell goods and services.
A firm’s goal is to maximize economic profit, given the
constraints it faces.
To maximize economics profit, a firm must make decisions

including:
– What to produce and in what quantities
– How to organize and compensate its managers and workers
– How to market and price its products (if not in a perfectly
competitive market)
– What to produce itself and what to buy from other firms
– More
What do firms do?
This lecture focuses on:
– How much to produce (𝑌)
– How many units of capital and labor to hire (𝐾, 𝐿)
When (assume):
– Take the production function (technology) as given
– The firm only uses labor inputs and capital inputs for
production
– Firms, as demanders in perfect competition markets of
inputs, take input prices as given
– Firms, as suppliers in perfect competition markets of
output, take the output price as given
Production Model
• A firm decides (𝐾, 𝐿) and (𝑌) to maximize
economic profit, taking prices (𝑃, 𝑅, 𝑊) as given.
max 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑃×𝐹 𝐾, 𝐿 − 𝑅𝐾 − 𝑊𝐿

&,(
Revenue Production cost
where
§ 𝑃 is the money price of output products
§ 𝑅 is the money price of capital (money rent rate)
§ 𝑊 is the money price of labor (money wage rate)
Marginal Marginal
Costs Benefits
Production Model
• What is the MC of hiring one more unit of labor?

• What is the MB of hiring one more unit of labor?
• What is the MC of hiring one more unit of

capital?
• What is the MB of hiring one more unit of
capital?
Production Model
𝑌 = 𝐹 𝐾, 𝐿 = 𝐴 𝐾 $ 𝐿%
• The marginal product of capital (MPK) is the extra amount of

output that is produced when one unit of capital is added, holding
all the other inputs constant.
)*
– 𝑀𝑃𝐾 =
)+
),-+
– Diminishing MPK <0
)+
• The marginal product of labor (MPL) is the extra amount of
output that is produced when one unit of labor is added, holding
all the other inputs constant.
)*
– 𝑀𝑃𝐿 =
).
),-.
– Diminishing MPL <0
).
Production Model
• Assume labor supply and capital supply
o 𝐿B =1,000 people
o 𝐾B =100 units of capital
• Equilibrium condition:
𝑄/ = 𝑄0
• Equilibrium result:
o 𝐿∗ = 𝐿B = 1,000 people
o 𝐾 ∗ = 𝐾B = 100 units of capital
o 𝑌 ∗ = 𝐹(𝐾B , 𝐿B ) = 𝐴𝐾B D 𝐿B E
Production Model
• Equilibrium result:
$% ∗
o =𝛼
&' ∗
()∗
o =𝛽
&' ∗
• Data says
*
§ 𝛼= of production is paid to capital
+
,
§ 𝛽 = of production is paid to labor
+
§ Therefore:
𝑌 ∗ = 𝐹(𝐾B , 𝐿B ) = 𝐴𝐾B F/G 𝐿B H/G
Labor
income 𝑊 ∗ 𝐿∗ + 𝑅 ∗ 𝐾 ∗ = 𝑃∗ 𝑌 ∗ Real output
Capital income
Income = Production
• Real GDP per worker
∗ ∗ 2
𝑌 𝐾
𝑦 ∗ = ∗ = 𝐴 ( ∗ )3
𝐿 𝐿
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
The aggregate production function has the same two properties as the
production function of an individual firm.
o An increase in either physical capital or total efficiency units of labor,
holding the other factor constant, leads to an increase in real output.
o Diminishing marginal product of labor (MPL): holding
everything else (including A and K) constant, MPL will decrease
eventually as more labor inputs are used for production.
o Diminishing marginal product of capital (MPK): holding
everything else (including A and H = h x L) constant, MPK will
decrease eventually as more capital inputs are used for
production.
Exhibit 6.7 The Production Function with Physical Capital Stock
on the x-Axis (with the Total Efficiency Units of Labor Held
Constant)
Exhibit 6.8 The Production Function with the Efficiency Units of
Labor on the x-Axis (with Physical Capital Stock Held Constant)
Economic growth is the sustained expansion of
production possibilities measured as the
increase in real GDP over a given period.
• Economic growth is the outward shift of the PPC from
PPC0 to PPC1
Practice Question
Keeping everything else constant, can labor force growth alone

lead to:
• higher output
• better welfare for average people (assume the income is
evenly distributed for now)
• sustainable long-term economic growth?
YouTube video: Overpopulation - The Human Explosion Explained
(6:39)
"More" is not ALWAYS better

Practice Question
Keeping everything else constant, can population growth (labor

force growth) alone lead to:
• higher output Yes in general, but no after a certain point
• better welfare for average people (ignore how the income is
distributed for now) No in general
• sustainable long-term economic growth? No
• The labor
supply curve
shifts
rightward.
• The real wage
rate falls and
aggregate hours
increase.
• An increase in
labor supply
increases real
GDP.
Practice Question
Keeping everything else constant, can the growth of physical

capital stock alone lead to:
• higher output
distributed for now)
Practice Question
Keeping everything else constant, can the growth of physical capital

stock alone lead to:
• higher output Yes
distributed for now) Yes
• sustainable long-term economic growth? No due to diminishing
marginal product of capital
For a household
• Income = consumption + saving
For a simplified economy

• Production = income = consumption + saving
o Consumption: consumption goods
o Saving or investment: investment goods
Production Model
• A nation with a high saving rate will accumulate
physical capital rapidly and, by aggregate production
function, increase its real output.
IJIKL MKNOPQ
o 𝑠𝑎𝑣𝑖𝑛𝑔 𝑟𝑎𝑡𝑒 = RST
• National saving
o 𝑆 = 𝐼 + 𝑁𝑋 in an open economy
o 𝑆 + −𝑁𝑋 = 𝐼
o 𝑆 = 𝐼 in a closed economy
Practice Question
Keeping everything else constant, can a higher saving rate lead to:
– not necessarily
– No due to diminishing marginal product of capital
Practice Question
Keeping everything else constant, can technological innovation

alone lead to:
• higher output
Practice Question
Keeping everything else constant, can technological innovation

alone lead to:
• higher output Yes
distributed for now) Yes
• sustainable long-term economic growth? Yes
• With more advanced
y=Y/L
technology, more output
can be produced with the
same amount of physical
capital and total efficiency
units of labor.
• Therefore, technology will
shift the production
function upward.
K/L
Higher output Higher RGDP per Sustainable long-
worker term growth
Population growth
Yes No No
(unless initially)
Printing too much

money No No No
Better education
and research Yes Yes Yes
system (R&D)
A higher saving
rate Yes Yes No
not necessarily increase welfare for

average people
Productivity
Productivity differences are the ultimate drivers of income per
capita and income per worker differences across countries.
• Labor productivity or productivity is
𝑅𝑒𝑎𝑙 𝑜𝑢𝑡𝑝𝑢𝑡
𝑎𝑔𝑔𝑟𝑒𝑔𝑎𝑡𝑒 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 ℎ𝑜𝑢𝑟𝑠
• There are three reasons productivity differs across countries:

o Human capital (L)
o Physical capital (K)
o Technology (A)
𝑌 = 𝐴 ⋅ 𝐹(𝐾, 𝐿)
Productivity
• Definition 1: the quantity of goods and
services that can be produced by one worker
or by one hour of work.
• Definition 2: the value of goods and services
that a worker generates for each hour of work
• The unit of productivity is
𝑜𝑢𝑡𝑝𝑢𝑡/ℎ𝑜𝑢𝑟
Appendix
• *What is technology and knowledge

• Understanding TFP Differences
* Helpful but not required for the exam

Technology and Knowledge
What is technology?
Technology has two components:
1) Knowledge: as a direct result of scientific/technical
advancements, we know more about the physical processes
involved in production.
2) Efficiency in production: the ability of an economy to
produce the maximum amount of output from a given
quantity of factors of production.
Technology can be embodied or contained in H.

Workers today possess
(1) knowledge of how to produce new goods such as
smartphones.
(2) knowledge of how to perform certain tasks more
efficiently, like writing a term paper in the latest version
of Microsoft Word.
Technology can be embodied or contained in K.
Physical capital today contains
(1) knowledge of how to produce new goods such as

smartphones and
(2) knowledge of how to run certain software, like the latest

version of Microsoft Word.
Advances in technology result mostly from purposeful,

optimizing decisions by entrepreneurs and firms.
Firms and the government in the United States spent $430

billion (or 2.8% of GDP) in research and development (R&D) to
find new ways of applying science to production methods and to
develop new and improved goods and services.
Understanding TFP Differences
• Human capital
• Technology
• Institutions
• Misallocation
• Human capital
– Stock of skills that individuals accumulate to make
them more productive
– Education and training
• Returns to education
– Value of the increase in wages from additional
schooling
• Richer countries may use more modern and
efficient technologies than poor countries.
– Increases productivity parameter
• Even if human capital and technologies are better
in rich countries, why do they have these
advantages?
• Institutions are in place to foster human capital

and technological growth.
– Property rights
– The rule of law
– Government systems
– Contract enforcement
• Misallocation
– Resources not being put to their best use
– The role of entrepreneurs here is critical, in
pioneering new ways to bring together the factors
of production to produce better or lower cost
products.
• Examples
– Inefficiency of state-run resources
– Political interference
Topic 7
Aggregate Expenditure
Chapter 12
• For a household
o Take-home income = consumption + saving
• For all households

o 𝑌𝐷 = 𝐶 + 𝑆
• Disposable income 𝑌𝐷 = 𝑌 − 𝑇 is calculated using aggregate
income minus net taxes
Consumption
Consumption tends to follow a

relatively smooth, upward
trend; its growth declines
during periods of recession.
How strong is the relationship between income and consumption?
• A straight line describes this relationship very well, suggesting that
households spend a consistent fraction of each extra dollar of real
disposable income on consumption.
Consumption
• Marginal propensity to consume (MPC)
is the fraction of a change in disposable
income spent on consumption
– MPC is the slope of the consumption function.
Change in consumption ∆𝐶
𝑀𝑃𝐶 = =
Change in disposable income ∆𝑌𝐷
∆𝐶 $1,500 billion
𝑀𝑃𝐶 = = = 0.75
∆𝑌 $2,000 billion
Practice Questions
1. If people spend $0.6 out of each additional
dollar they earned after tax, how much they
save out of each additional dollar they
earned?
2. Then, what is the slope of the saving
function?
Consumption
• The marginal propensity to save (MPS) is the
fraction of a change in disposable income that
is saved.
o 𝑀𝑃𝐶 + 𝑀𝑃𝑆 = 1
Change in saving ∆𝑆
𝑀𝑃S = =
Change in disposable income ∆𝑌𝐷
The Multiplier
When autonomous expenditure changes, so does
equilibrium expenditure and real GDP.
• But the change in equilibrium expenditure is larger
than the change in autonomous expenditure
(investment, government spending, and exports).
• The multiplier is the amount by which a change in
autonomous expenditure is magnified or multiplied
to determine the change in equilibrium expenditure
and real GDP.
• Government purchases have generally, though not consistently,
increased over time; exceptions include the early 1990s (end of cold
war) and due to state and local cutbacks after 2009.
Simplifying Assumptions
• No leakage of the income
• Net taxes do not change as national income
changes
o any change in disposable income is the same as
the change in national income
In each “round”, the additional income prompts
households to consume some fraction (the marginal
propensity to consume).
The total change in equilibrium real GDP equals:
The initial increase in G $100 billion
Plus the first induced increase in MPC × $100 billion

consumption
Plus the second induced increase in MPC × (MPC × $100 billion)
consumption = MPC2 × $100 billion
Plus the third induced increase in MPC × (MPC2 × $100 billion)
Plus the fourth induced increase in MPC × (MPC3 × $100 billion)
And so on …
The MPC
determines the
magnitude of
the amount of
induced
expenditure at
each round as
aggregate
expenditure
moves toward
equilibrium
expenditure.
• The multiplier can work in reverse
too, like it did during the Great
Depression of the 1930s.
• Several events, including the stock
market crash of October 1929, led to
reductions in investments by firms.
• Real GDP fell, so consumers cut back
on spending, prompting firms to
reduce production more, so
consumers spent even less…
• Recovery from the Great Depression
took many years; unemployment
remained above 10% until the U.S.
entered World War II in 1941
Year Consumption Investment Exports Real GDP Unemployment Rate

1929 $781 billion $124 billion $40 billion $1,056 billion 2.9%
1933 $638 billion $27 billion $22 billion $778 billion 20.9%
Note: The values are in 2009 dollars.
The Paradox of Thrift
• Recall the savings identity: savings equals investment.
– This implied that savings were the key to long-term growth.
• But consider what happens in the short-term if people save more:
consumption decreases, and incomes decrease, so consumption
decreases more… potentially pushing the economy into recession.
• John Maynard Keynes referred to this as the paradox of thrift: what
appears to be favorable in the long-run may be counterproductive
in the short-run.
– Economists debate whether this paradox of thrift really exists;
increasing savings decreases the real interest rate; the consequent
increase in investment spending may offset the decrease in
consumption spending.
– This is a real-world data-driven debate, unable to be settled by our
simple model.
The Paradox of Thrift - 60 Second Adventures in Economics
• 1:21
Determinants of Consumption
What affects the level of consumption?
• Current disposable income
– Consumer expenditure is largely determined by how much money
consumers receive in a given year. We measure this by personal
income, minus personal income taxes, plus government transfer
payments such as Social Security.
– Income expands most years; hence so does consumption.
• Household wealth
– A household’s wealth can be thought of as its assets (like homes,
stocks and bonds, and bank accounts) minus its liabilities (mortgages,
student loans, etc.).
– Households with greater wealth will spend more on consumption,
even with similar incomes. Recent studies estimate that an extra
$1,000 in wealth will result in $40-$50 in extra annual consumption
spending, holding constant the effect of income.
Determinants of Consumption
• Expected future income
– Most people prefer to keep their consumption fairly stable from year
to year, a process known as consumption-smoothing.
– Example: Salespeople working on commission might have high
incomes in some years, and low incomes in others. In order to predict
their consumption, we would need to know what they believed their
income would be in the future.
• The price level
– As prices rise, household wealth may fall or rise. If you have $100,000
in the bank, that will buy fewer products at higher prices.
Consequently, higher prices result in lower consumption spending.
• The interest rate
– Higher real interest rates encourage saving rather than spending; so
they result in lower spending, especially on durable goods.
• More
• The rest of the Chapter 12 will be covered in
tutorials by Ulrich.
Topic 8
Short-run vs. Long-run

Supplementary Materials from Charles Jones
Short Run vs. Long Run
FRED link:
• https://fred.stlouisfed.org/graph/?g=CuXu
• Real GDP fluctuates around potential GDP.
• Potential GDP grows at a steady pace because the quantities of
the factors of production and/or their productivity grow at a
steady pace
Actual output is equal to the long-run trend plus
short-run fluctuations:
• Long-run trend: potential real output (𝑌($ )
o Potential Real GDP
• Short-run fluctuations: percentage deviations
from potential real output (𝑌($ )
Output gap
Short-run output fluctuations:
• Detrended output
• The difference in actual and potential real output,
expressed as a percentage of potential real
output
Where:
𝑌U* : detrended output
𝑌V* : potential real output, can be measured by potential real GDP
𝑌* : actual real output, can be measured by real GDP
Output gap Detrended output
Short term Long term Fluctuation
Actual output Potential output Detrended output

𝑌* − 𝑌*
𝑌* U
𝑌* =
𝑌* 𝑌*
https://fred.stlouisfed.org/ https://fred.stlouisfed.org/ https://fred.stlouisfed.org/

series/GDPC1 series/GDPPOT graph/?g=f1cZ
Actual unemployment Natural rate of Cyclical unemployment
unemployment
u* u+,+-.+/-,* = u* − u*
u*
series/UNRATE series/NROU graph/?g=lOu
Actual inflation Long-term inflation
Δ𝜋* = 𝜋* − 𝜋*
𝜋* 𝜋* = 𝑔0,* − 𝑔1,*

𝑌* − 𝑌*
𝑌* U
𝑌* =
𝑌* 𝑌*

unemployment
u* u+,+-.+/-,* = u* − u*
u*
Δ𝜋* = 𝜋* − 𝜋*
𝜋* 𝜋* = 𝑔0,* − 𝑔1,*

𝑌* − 𝑌*
𝑌* U
𝑌* =
𝑌* 𝑌*

unemployment
u* u+,+-.+/-,* = u* − u*
u*
Δ𝜋* = 𝜋* − 𝜋*
𝜋* 𝜋* = 𝑔0,* − 𝑔1,*
2
Growth rate of
potential output
The Quantity
theory of
Real
money Money
supply
Velocity Price
of money level GDP
(long run)
Velocity of money
• The average number of times per year that each piece of
paper currency is used in a transaction
• How fast each paper currency change hands
• V always assumed to be constant in the long run, so V=k
which k is a positive constant.
Express the quantity equation in terms of growth rates
The growth rate of a constant is ZERO
Conventionally, inflation rate is denoted by π

The fluctuations in the pace of expansion of real GDP the
business cycle. A business cycle is a periodic but irregular up-
and-down movement of total production and other measures of
economic activity.
[! \[!
W
1. If observe 𝑌I = > 0 and increasing, then expansion
[!
[! \[!
W
2. If observe 𝑌I = [ < 0 and decreasing, then recession
!
• NBER: “A recession is a significant decline in economic activity spread
across the economy, lasting more than a few months, normally visible in
real GDP, real income, employment, industrial production, and
wholesale-retail sales.”
– NBER National Bureau of Economic Research
U.S. Economic Fluctuations, 1970-2015
Short-Run Output in the United States
• Fluctuations in U.S. GDP:

– Difficult to see graphically over a long period of
time
– Have mostly been between + or – 4% since 1950
• The Great Depression:
– Negative gap during the 1930s
– Actual output was well below potential
• Without macroeconomic policy, in the short run
o the price level during the expansion would be likely to ____
o Δ𝜋! = 𝜋! − 𝜋! increase
o the price level during recession would be likely to ___
o Δ𝜋" = 𝜋" − 𝜋" decrease
• In the short run

• During the
expansion
o Demand ↑
o Price ↑
o Price level ↑
• The Phillips curve shows, in the short run:
o A boom increases inflation
o A recession decreases inflation
o A positive relationship between the change in
inflation and short-run output
• Empirically, the slope is about 1⁄3
o If real output exceeds potential by 3%, the
inflation rate increases one percentage point
• Without macroeconomic policy, in the short
run
o How do you expect the cyclical unemployment to
change during the expansion?
o u/0/12/31,5 = u5 − u5 decrease
o How do you expect the cyclical unemployment to

change during the recession?
o u/0/12/31,5 = u5 − u5 increase
Okun’s Law
Cyclical
unemployment
Current rate of
unemployment
Natural rate of Short-run
unemployment output
Short-run Phillips Curve
Long-run Phillips Curve
The short-run model is based on 3 premises:
1. The economy is constantly being hit by
shocks
o Shocks: factors that cause fluctuations
2. Monetary and fiscal policies affect output
o Policymakers can neutralize shocks to the
economy
3. There is generally a trade-off between
output and inflation in the short run
Topic 9
AS-AD Model
Chapter 13
AS-AD Model
• Aggregate demand and aggregate supply
model: A model that explains short-run
fluctuations in real GDP and the price level.
Aggregate Demand
Aggregate demand
• The quantity of real GDP demanded, Y, is the total
amount of final goods and services produced in the
United States that people, businesses, governments,
and foreigners plan to buy at a specific price level.
– This quantity is the sum of consumption expenditures,
investment, government purchases, and net exports.
– Y = C + I + G + X – M.
• Aggregate demand (AD) curve: A curve that shows the
relationship between the price level and the quantity
of real GDP demanded by households, firms, and the
government.
Aggregate demand
curve
• The relationship
between price
level and quantity
demanded by all
sectors of
economy, holding
everything else
constant
• A change in the
price level not
caused by a
component of
real GDP changing
results in a
movement along
the AD curve.
• A change in some
component of
aggregate
demand, on the
other hand, will
shift the AD
curve.
Buying plans depend
on many factors and
some of the main
ones are
• Expectations
• Fiscal policy and
monetary policy
• The world
economy
• And more shocks
Practice Questions
What would happen to the U.S. AD if:
1. Chinese households start purchasing less U.S. produced goods
• X↓è AD↓, shift AD left
2. A tax cut increases disposable income (assume government spending
stays unchanged)
• C↑& I ↑ è AD↑, shift AD right
3. The gloomy economic outlook harms the investment
• I↓è AD↓, shift AD left
4. Philadelphia is chosen to host the 2024 Olympics, and must build
infrastructure for it
• G↑è AD↑, shift AD right
5. Interest rate cuts
• C↑& I ↑ è AD↑, shift AD right
6. Prices level rise as most of the goods and services more expensive
• Move along the same AD
7. Workers become more productive
• AD curve stays constant. It changes AS
Aggregate Supply
Aggregate Supply
• The quantity of real GDP supplied is the total
quantity that firms plan to produce during a
given period at a specific price level.
• Aggregate supply is the relationship between
the quantity of real GDP supplied by firms and
the price level:
o Long-run aggregate supply (LRAS or LAS)
o Short-run aggregate supply (SRAS or SAS)
LRAS
• Long-run aggregate supply curve: A curve that
shows the relationship in the long run
between the price level and the quantity of
real GDP supplied.
– The quantity of real GDP supplied in the long run
doesn’t vary with price level
Fiat money, such as U.S.
dollar, has no intrinsic
value.
• U.S. dollar has “value”
only because a
government maintains its
value, or because parties
engaging in exchange
agree on its value.
LRAS
• If a government prints more money, then how
does it affect the LRAS?
– LRAS: the quantity of real GDP supplied is the total
quantity that firms plan to produce during a given
period. which might be different from what it is in the short run
– LRAS stays unchanged level of input stocks in the long run
• 𝐿𝑅𝐴𝑆 = 𝑟𝑒𝑎𝑙 𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝐺𝐷𝑃 = 𝐴×𝐹 𝐾, 𝐿

o In the long run, the quantity of real GDP supplied
is the potential real GDP, or the full-employment
real GDP
Long run aggregate supply (LRAS) curve is the
relationship between price level and quantity
supplied by all sectors of economy in long run
• In the short run,
the quantity of
real GDP supplied
increases if the
price level rises.
• The SRAS curve
slopes upward.
• A rise in the price
level with no (or
less) change in the
money wage rate
induces firms to
increase
production.
Short-Run Aggregate Supply Curve
•While the LRAS is vertical, the SRAS is upward sloping. Why?
• As prices of final goods and services rise, prices of inputs—such as the
wages of workers or the price of natural resources—rise more slowly.
•Economists tend to believe that some firms and workers fail to accurately
predict changes in the price level.
•Based on this, there are two potential explanations for why the SRAS curve
is upward-sloping:
• Contracts make some wages and prices “sticky”
• Prices and wages are said to be “sticky” when they do not respond quickly
to changes in demand or supply. Some firms and workers fail to predict price
level changes, and hence do not correctly build them into long-term
contracts.
• Firms are often slow to adjust wages
•Annual salary reviews are “normal”, for example. Also, firms dislike cutting
wages—it’s bad for morale.
118 of
© Pearson Education Limited 2015
Making
the How Sticky Are Wages?
Connection
•There is disagreement among economists about how sticky wages and
prices actually are.
• To examine this, it is best to look at individual worker-level data.
•Some recent studies have done this, finding firms are reluctant to cut
workers (nominal) wages. Instead, they:
• Offer lower salaries

to new hires
• Fire current workers
• Decreases raises or
freeze pay
The graph shows the
percentage of workers
with no wage change in
a given year.
119 of
Shifts of the SRAS Curve vs. Movements along It
•The short-run aggregate supply curve describes the relationship between
the price level and the quantity of goods and services firms are willing to
supply, holding constant all other variables that affect the willingness of
firms to supply goods and services.
•A change in the price level not caused by factors that would otherwise
affect short-run aggregate supply results in a movement along a stationary
SRAS curve.
•But some factors cause the SRAS curve to shift; we will consider them in
turn.
120 of
SRAS Shifts: Factors of Production and Technology
•An increase in the availability of the factors of production, like labor and
capital, allows more production at any price level.
•A decrease in the availability of these factors decreases SRAS.
•Improvements in technology allow productivity to improve, and hence the
level of production at any given price level.
shifts the short-run
An increase aggregate
in… supply curve… because…
• Table 13.2 •Variables that shift the short-run

aggregate supply curve 121 of
AD & AS
Changes in Short-run Aggregate Supply
• Aggregate supply changes if an influence on production
plans other than the price level changes.
• These influences include
o Changes in potential GDP
§ Permanent change in 𝐿
§ Permanent change in 𝐾
§ Permanent change in 𝐴
o Temporary change in 𝐿, 𝐾, or 𝐴
o Changes in money input prices
o Other
The effect of an
increase in potential
GDP
• The LRAS curve
shifts rightward
and the SRAS
curve shifts along
with the LRAS
curve.
The effect of a rise
in the money
wage rate
• Short-run
aggregate supply
decreases and
the SRAS curve
shifts leftward.
• Long-run
aggregate supply
does not change.
Short-Run
Macroeconomic
Equilibrium
• occurs when the quantity
of real GDP demanded
equals the quantity of
real GDP supplied at the
point of intersection of
the AD curve and the
SRAS curve.
• If real GDP is below
equilibrium GDP, firms
increase production and
raise prices…
• … and if real GDP is
above equilibrium GDP,
firms decrease
production and lower
prices.
• These changes bring
a movement along
the SAS curve
towards equilibrium.
• In short-run
equilibrium, real GDP
can be greater than
or less than potential
GDP.
Long-Run Macroeconomic
Equilibrium
• occurs when real GDP equals
real potential GDP
o when the economy is on
its LRAS curve.
• Long-run equilibrium occurs
at the intersection of the AD
and LRAS curves.
• If the quantity of labor
grows, capital is
accumulated, or technology
advances permanently,
then real potential GDP
increases.
• The LRAS curve shifts
rightward.
Practice Question
What would happen to the short-run and long-
run macroeconomic equilibrium when
1. A temporary natural disaster
2. A new minimum wage policy raises the
monetary wage
3. A new policy cuts interest rate
4. A technological innovation
In short-run equilibrium, real GDP can be greater
than or less than potential GDP.
è business cycle
Explaining Macroeconomic Trends
and Fluctuations
The business cycle occurs because aggregate demand

and the short-run aggregate supply fluctuate, but the
money wage does not change rapidly enough to keep
real GDP at potential GDP.
• An above full-employment equilibrium is an
equilibrium in which real GDP exceeds potential GDP.
• A full-employment equilibrium is an equilibrium in
which real GDP equals potential GDP.
• A below full-employment equilibrium is an
equilibrium in which potential GDP exceeds real GDP.
Above full-employment
equilibrium
• The amount by
which real GDP
exceeds potential
GDP is called an
inflationary gap
(𝑌! − 𝑌! ).
"! #"!
9
• 𝑌! = >0
"!
Below full-employment
equilibrium
• The amount by which
real GDP is less than
potential GDP is called a
recessionary gap (𝑌I −
𝑌I ).
[ \[
• 𝑌WI = ![ ! < 0
!
• Figure (d) shows how, as
the economy moves
from one type of short-
run equilibrium to
another, real GDP
fluctuates around
potential GDP in a
business cycle.
Fluctuations in
Aggregate Demand
– Figure (a) shows the
effects of an increase
in aggregate demand.
– Firms increase
production and the
price level rises in the
short run.
• At the short-run
equilibrium, 𝑌9! =
"! #"!
>0
"!
Illustrates inflation
• If the quantity of
money grows faster
than potential GDP,
aggregate demand
increases by more
than long-run
aggregate supply.
• The AD curve shifts
rightward faster
than the rightward
shift of the LAS
curve.
Fluctuations in
Aggregate Supply
– The effects of a rise in
the price of oil.
– The SAS curve shifts
leftward.
– Real GDP decreases
and the price level rises.
• At the short-run
equilibrium, 𝑌9! =
"! #"!
<0
"!
Making
the Does It Matter What Causes AD to Fall?
Connection
•GDP has four components; an decrease in any of the four could cause a
recession. Does it make any difference which component causes the
recession?
• Most post-WWII
recessions in the U.S.
have been preceded by
falls in residential
construction.
• Recent research
suggests that recessions
caused by financial
crises tend to be larger
and more long-lasting
than declines due to
other factors.
136 of
Supply Shock
•In the previous analyses, AD
moved suddenly. What if
instead SRAS moved
suddenly? We call this a
supply shock.
•For example, suppose a
sudden increase in oil prices
shifts SRAS to the left.
• This causes stagflation, a
combination of inflation
and recession, usually
resulting from a supply
shock.
•The short-run and long-run effects of a supply shock:
• Figure 13.7a (a) A recession with a rising price level—the short-run
effect of a supply shock
137 of
Adjustment back to Potential GDP from a Supply Shock
•With the lower level of

output, people are
unemployed and products
go unsold.
• Workers accept a lower
wage, and firms
decrease prices in order
to clear inventories.
•SRAS moves to the right,
restoring long-run
equilibrium.
•The short-run and long-run effects of a supply shock:

• Figure 13.7b (b) adjustment back to potential GDP—the long run effect
of a supply shock
138 of
How Long Does Adjustment to Long-Run Equilibrium Take?
•How long does it take to

restore full employment?
• It depends on the
severity of the supply
shock, but it is likely to
take several years.
•An alternative to waiting
this long is to use fiscal or
monetary policy to
increase aggregate
demand.
• This might result in
permanently higher • Figure 13.7b •The short-run and long-run effects of a supply shock:
(b) adjustment back to potential GDP—the long run effect
prices but may be of a supply shock
worth the cost.

139 of
Making
the Forecasts for Returning to Potential GDP
Connection
•After the 2007-2009 recession,

different groups estimated how
long it
would take to return to
potential GDP.
•In 2011, the White House and
the Congressional Budget
Office estimated that we would
return to full employment by
2016.
•The Federal Reserve disagreed,
believing it would take even
longer.
For comparison, the second worst post-Depression recession was in
1981-1982; recovery then took less than three years.
140 of
Making
the Forecasts for Returning to Potential GDP
Connection
•How accurate were these

forecasts? It turns out, they
were too optimistic.
•Economists still disagree about
why the U.S. economy was
taking so long to return to
potential GDP; we will discuss
this in later chapters.
2011 Estimates of 2013 Output Gap Actual Output Gap

White House CBO Federal Reserve
3.8% 2.7% 2.1% 5.4%
141 of
What Is the Usual Cause of Inflation?
•The usual cause of
inflation is total spending
increasing faster than
production.
• AD moves further right
than does LRAS.
• SRAS moves to the
right; but the
anticipated rise in the
price level causes it to
move less far than
LRAS.
• Long run equilibrium is
restored but with a
higher price level. • Figure 13.9 •Using dynamic aggregate demand and
aggregate supply to understand inflation
142 of
The Recession of 2007-2009
•Three main factors combined to cause the recession:
•The end of the housing bubble
•House prices rose in the early 2000s—initially due to low interest rates, but
then due to speculation. In 2006, the speculative bubble began to deflate,
and the spending on residential investment fell.
•The financial crisis
•As many people defaulted on their mortgages, many financial institutions
took heavy losses. This financial crisis led to a credit crunch, decreasing
consumption and investment spending.
•The rapid increase in oil prices during 2008
•Several factors combined to increase the price of oil from $34 per barrel in
2004 to $140 per barrel in mid-2008. This supply shock exacerbated the
ongoing recession.
143 of
The Recession of 2007-2009 in the Dynamic Model
•In 2007, the economy was

more or less in long-run
equilibrium.
•As usual, potential GDP
increased from 2007 to 2008.
• But aggregate demand did
not keep pace (housing
bubble, financial crisis).
•At the same time, increasing
oil prices shifted short-run
aggregate supply to the left.
• The result: higher prices
and below-potential real
GDP. • Figure 13.10 •The beginning of the
recession of 2007-2009
144 of
Topic 11
Economic Growth
Chapter 10, 11 and supplementary
materials
Measuring Economic Growth
Real GDP hold the prices constant:
• Eliminate price level change and focus on productions.
• Better for measuring economic growth
o A link to FRED: https://fred.stlouisfed.org/
To measure economic growth,

• Y = RGDP (or per worker RGDP)
• Annual growth rate from year t to year t+1
𝑌!%& − 𝑌!
𝑔!→!%& = ×100%
𝑌!
Practice Question
1. You have a saving account with a constant effective APY
(nominal interest rate) of 1%. If you deposit $100 in your
saving account, then how much is your balance after 10
years?
o $100× 1 + 1% 67 = $110.5
2. You have a saving account and you cannot recall its effective
APY. You deposited $100 in your account 10 years ago and
now you have a balance of $121.899. What is the average
effective APY of your saving account?
"# $696.;<<
o − 1 =2%
$677
Compounding: calculated using exponential functions

Practice Question
1. The U.S. real GDP per capita is $46,497 in year 2000 and
$58,055 in year 2019. What is the average annual growth
rate of U.S. real GDP per capita from year 2000 to year 2019?
#$ $^_,`^^
o $ab,acd
−1 = 1.175%
2. Assume this annual growth rate will remain the same for the
future. What is your prediction of the U.S. real GDP per
capita in year 2029?
o $58,055× 1 + 1.175% F` = $65,249
• Geometric annual growth rate

Measuring Economic Growth
• Per worker real GDP of 2003 = 𝑦H``G
• Per worker real GDP of 2023 = 𝑦H`HG
• Arithmetic annual growth rate

e%&%'( e%&&'
v e%&&'
÷ 20
vInaccurate
• Geometric annual growth rate
v
%& e%&%'
−1
Accurate
e%&&'
Economic Growth
• The rule of 72
• https://www.investopedia.com/terms/r/ruleof
72.asp
• Textbook: the rule of 70
Either one is fine

Catch-up Effect
• Catch-up effect: that the level of GDP per
capita (or income per capita) in poor countries
will grow faster than in rich countries.
– The effect of additional capital is greater for
countries with smaller initial capital stocks
– There are greater advances in technology
immediately available to poorer countries
• Examining high-income countries, we see strong
evidence of the catch-up hypothesis.
• Countries that were richer in 1960, like the U.S. and
Switzerland, experienced lower growth rates over the
next decades than countries that were initially poorer,
like Ireland, Singapore, and South Korea.
• However if we extend the set of countries to all countries for
which statistics are available, our catch-up model appears to
be worthless.
• We need to address the failures of the catch-up model.
Catch-up Effect
• Economists point to four key factors in explaining
why many low-income countries are growing so
slowly:
– Failure to enforce the rule of law
• For entrepreneurs in a market economy to succeed, the
government must guarantee property rights: the rights
individuals or firms have to the exclusive use of their
property, including the right to buy or sell it. Otherwise,
entrepreneurs will not risk starting a business.
– Wars and revolutions
– Poor public education and health
– Low rates of saving and investment
• Undeveloped and insecure financial systems
Appendix
• *Effect of Business Cycles on Firms
• *Economic Growth in the United States

Effect of Business Cycles on Firms
• Historically, recessions have generally been followed by
periods of strong economic growth.
• Some firms take advantage of the low real interest rates
that typically accompany a recession to make investments
by expanding productive capacity, effectively betting that
the growth will justify their investments.
• For example, VF Corporation (the largest apparel maker in
the world, including brands such as North Face,
Timberland, and Wrangler) decided to open 89 new stores
in 2008 and 70 in 2009.
• By 2013, the company’s sales and profits continued to
increase, making their decision look very smart.
Effect of Business Cycles on Firms
• When a recession hits, workers reduce spending due to
expectations about their current and future incomes decreasing.
• But this reduction in spending doesn’t affect all goods equally.
Consumers mostly continue to buy nondurables like food and
clothing. But purchases of durable goods, ones that (by definition)
are expected to last three or more years, are more strongly
affected.
• This includes goods like furniture, appliances, and automobiles—
goods that consumers can continue to use for a little longer when
their purchasing power decreases.
• Hence firms selling durable goods are more likely to be hit hard by a
recession.
The charts show that the entire The effect of the business cycle on
household appliance industry was Whirlpool. (a) Movements in real GDP,
particularly hard-hit by the (b) Movements in the real value of
recession of 2007-2009. manufacturers’ sales of household
appliances
Economic Growth in the United States
• Growth rates in the
United States were
relatively modest
prior to 1900.
• In the 20th century,
firms and the U.S.
government invested
heavily in research
and development,
resulting in
increasing growth
rates.
• Growth rates
remained high until
the mid-1970s, when
they fell
unexpectedly, before
picking up again in
the mid-1990s.
• Some economists argue that there was not really a slowdown in
economic growth—the appearance is a result of how we measure
growth.
• From the 1970s, most growth in output came in the form of
services rather than goods. Improvements in services come mostly
through quality differences, which are harder to measure for
services than for goods.
• An alternative argument is that America concentrated more on
quality-of-life issues, like health and safety, environmental
regulations, and a change in educational focus.
• Other high-income countries experienced similarly timed
slowdowns, suggesting that the United States was not doing
something uniquely counterproductive over this time.
• New technology has driven improvements in labor productivity
from 1996-2012.
• Examples: faster data processing (computers etc.); better
communication (cell phones, the internet)
• Some economists argue that changes in quality of services have

been particularly important over the last decade and a half.
• So GDP growth has understated the actual growth of the economy.
• But it may be that many of these gains are going toward improving
consumer products rather than improving labor productivity.
• This casts doubt on the future of economic growth in the U.S.
Intro Macro, Fall 22
U.S. Inflation and Bank
Collapse 2023
Supplementary Materials
• FRED: Consumer Price Index: Total All Items
for the United States
• https://fred.stlouisfed.org/series/CPALTT01US
M659N
US inflation nears record high
• 3:52
How a Cap on Russian Oil Prices Could
Affect U.S. Consumers | WSJ
Worker shortage closes Los Angeles
and Long Beach ports
How The Global Computer Chip
Shortage Happened
Here’s Where Inflation Is Hitting U.S. Households Hardest | WSJ
• 6:43
Inside Silicon Valley Bank's Collapse
What’s going to happen to Big Tech’s
laid off workers?
• Some helpful videos
Why High Inflation Has Lasted for So
Long | WSJ
How Silicon Valley Bank Collapsed in
36 Hours | What Went Wrong | WSJ
Why a 2022 Recession Would Be Unlike Any Other | WSJ
• 5:07
Topic 11-a
Countercyclical Policy
Chapter 14-16
FOMC Press Conference, March 22,
2023
8:48
Transcript of Chair Powell’s Press Conference
March 22, 2023
• https://www.federalreserve.gov/mediacenter/
files/FOMCpresconf20230322.pdf
The Federal Reserve System (the Fed) is the central bank of
the United States.
• A central bank is the public authority that regulates a
nation’s depository institutions and controls the quantity
of money.
The Fed’s goals are to

• Dual mandate
• price stability
• maximum sustainable employment
• contribute toward achieving long-term growth
• moderate the business cycle
o Countercyclical macroeconomic policy
2023
• Expansionary policy aims to reduce the
severity of an economic recession
– It is meant to “heat up” the economy and
economic activity.
• Contractionary policy is used to slow down
the economy when it grows too fast, or
“overheated.”
Question: Why would policymakers want to

slow down the economy?
• Moderate business cycle
• Ease inflation pressure
• A contractionary policy can reduce the risks of an
extreme contraction by trying to cool off the
economy before it overheats.
• “I’m the fellow who takes away the punch bowl
just when the party is getting good.”
– Former Fed Chairman William McChesney Martin, Jr.
2023
2023
• Fiscal policy
– In the United States, fiscal policy is directed
by both the executive and legislative branches of
the government. In the executive branch, the
President and the Secretary of the Treasury, often
with economic advisers' counsel, direct fiscal
policies.
• Monetary policy
– Managed by the central bank, the Fed
Fiscal Policy
Countercyclical fiscal policy is passed by the legislative

branch (i.e., Congress) and signed into law by the
executive branch (i.e., the president).
Fiscal Policy
The federal budget is the annual statement of the federal
government’s outlays and tax revenues.
• The federal budget has two purposes:
1. To finance federal government programs and activities
2. To achieve macroeconomic objectives
Fiscal policy is the use of the federal budget (setting and

changing taxes, making transfer payments, and purchasing
goods and services) to achieve macroeconomic objectives
• such as full employment, sustained economic growth,
and price level stability.
The federal government’s budget balance equals receipts minus
outlays.
federal government’s budget balance
= 𝑻 − (𝑻𝒓 + 𝑮)
• If receipts exceed outlays, the government has a budget

surplus.
• If outlays exceed receipts, the government has a budget
deficit.
• If receipts equal outlays, the government has a balanced
budget.
• Receipts come from personal income taxes, Social Security

taxes, corporate income taxes, and indirect taxes.
o Personal income taxes are the largest source of receipts.
• Outlays are transfer payments, expenditure on goods and
services, and debt interest.
o Transfer payments are the largest item of outlays.
U.S. Government Accounts, Combining Federal, State, and Local
Governments, 2007–2010 (Constant 2009 Dollars)
Practice Questions
If the government decides to increase the
government spending
• Is that expansionary or contractionary fiscal
policy?
• Use AS-AD model to illustrate the short-run
and long-run effect of this one-time policy
Practice Questions
• If the government
believes real GDP
is below potential
GDP, it can enact
expansionary
fiscal policy in an
attempt to
restore long-run
equilibrium:
decreasing
unemployment.
Practice Questions
2022 Russian invasion of Ukraine added extra
pressure on oil prices and inflation in the U.S..
• Use AS-AD model to illustrate how this shock
related to oil prices would impact the price
level in the U.S.
FOMC Press Conference, November 2,
2022
Where US gets its oil from and how strategic petroleum reserve is used | JUST THE FAQS
• 2:33
What Strategic Reserves oil release means for gas prices
• 1:24
Practice Questions
• If the
government
believes inflation
is a concern, it
can enact
contractionary
fiscal policy in an
attempt to
restore long-run
equilibrium:
decreasing
inflation.
FOMC Press Conference, November 2,
2022
Highlight
• We are taking forceful steps to moderate demand so
that it comes into better alignment with supply.
• Reducing inflation is likely to require a sustained period
of below-trend growth and some softening of labor
market.
• Restoring price stability is essential to set the stage for
achieving maximum employment and stable prices in
the longer run.
Fiscal Policy
• Expansionary fiscal policy uses higher government

expenditure and lower taxes to increase the growth
rate of real GDP.
• Contractionary fiscal policy uses lower government

expenditure and higher taxes to reduce the growth
rate of real GDP.
Fiscal Policy
Contractionary Expansionary
Fiscal policy 1 Increase tax rate 1 Cut tax rate
2 Decrease transfer payment 2 Increase transfer payment
3 Decrease government spending 3 Increase government spending
AD shifts: Changes in Fiscal Policy
2. Fiscal policy: Changes in federal taxes and purchases that are intended
to achieve macroeconomic policy objectives.
•Increasing or decreasing taxes affects disposable income, and hence
consumption. The government can also alter its level of government
purchases.
shifts the aggregate
An increase in… demand curve… because…
• Table 13.1 •Variables that shift the

aggregate demand curve
201 of
What Is Crowding Out?
• 2:59
Optional Materials
1. *A breakdown of the fiscal and monetary
responses to the pandemic
– https://www.investopedia.com/government-
stimulus-efforts-to-fight-the-covid-19-crisis-
4799723
2. *Recessions and the Components of AD

Making
the Recessions and the Components of AD—part 1
Connection
•We can understand the 2007-2009 recession better by examining what happened
to the components of real GDP.
•(The red bar indicates the period of the recession, per the NBER).
Consumption spending
fell, relative to
potential GDP during
the recession.
• This was unusual:
consumption
usually stays steady
during a recession.
Consumption also
stayed low in the four
post-recession years.
204 of
Making
Connection
•Residential investment had been falling before the recession, and
continued to fall during it.
Spending on residential
investment has
continued to be below
the pre-recession
boom levels.
205 of
Making
Connection
•Net exports increased (became less negative) just before and during the
recession.
• This was in part due to the falling value of the $US.
After the recession, net
exports started to
decrease once more,
but then have stayed
relatively steady.
• Loose monetary
policy has kept the
value of the $US
down.
206 of
Topic 11-b
Chapter 14-16
• Fiscal policy
– In the United States, fiscal policy is directed
by both the executive and legislative branches of
the government. In the executive branch, the
President and the Secretary of the Treasury, often
with economic advisers' counsel, direct fiscal
policies.
• Monetary policy
– Managed by the central bank, the Fed
Monetary System
The Federal Reserve System (the Fed) is the central bank of the
United States.
• A central bank is the public authority that regulates a
nation’s depository institutions and controls the quantity of
money.
The Fed’s goals are to

• Dual mandate
• price stability
• maximum sustainable employment
• contribute toward achieving long-term growth
• moderate the business cycle
o Countercyclical macroeconomic policy
Monetary System
A commercial bank puts the depositors’ funds
into three types of assets:
• Loans
– commitments of fixed amounts of money for
agreed-upon periods of time
• Reserves
• Securities
Monetary System
• Loans
• Reserves
o Notes and coins in its vault and in a deposit account at the
Federal Reserve.
o Why banks need reserves?
• To meet depositors’ currency withdrawals, and
• to make payments to other banks.
o A required reserve ratio is the fraction of deposits that the
Fed require a bank to hold in reserves and not loan out.
o Money multiplier=1/RR
• Securities
Reserve Ratio Video Investopedia
1:29
The Money Multiplier
6:55
Monetary System
• Loans
• Reserves
• Securities
o U.S. government Treasury bills and commercial bills
and longer-term U.S. government bonds and other
bonds such as mortgage-backed securities. Including:
– long-term assets
– liquid assets: the assets can be sold and instantly
converted into reserves with comparatively little risk
of loss.
• Such as overnight loans to other banks and U.S. government
Treasury bills.
2023
Monetary Policy
The monetary policy is conducted by the Federal
Reserve Bank.
• Monetary policy tools:
• Required reserve ratio
• *Last resort loan
• Open market operation (FFR)
• Quantitative easing (QE)
• *And more

Monetary Policy
Last resort loans
• Last resort: the last party that you can turn to
for help.
• A bank that finds itself short of reserves and
unable to borrow sufficient amounts in
financial markets may turn to the discount
window of the Fed. This is one way in which
the Fed functions as the lender of the last
resort.
The Fed as Lender of Last Resort
• 9:37
Monetary Policy
Reserve Bank.
• *And more

The primary tool of monetary policy is the Fed’s control of the
federal funds rate (FFR).
• A bank with excess cash or reserve, which is often referred
to as liquidity, will lend to another bank that needs to
quickly raise liquidity.
• FFR: the interest rate that banks charge each other on
overnight loans of reserves
o determined by the market
§ the rate that the borrowing institution pays to the lending institution
is determined between the two banks
o Influence by monetary policy conducted by Fed
• The federal funds rate is the central interest rate in the U.S.
financial market.
o It influences other interest rates such as the prime rate, which is
the rate banks charge their customers with higher credit ratings.
o Additionally, the federal funds rate indirectly influences longer-
term interest rates such as mortgages, loans, and savings, all of
which are very important to consumer wealth and confidence.
Open Market Operations
• Federal Reserve's Dual Mandate
1. maximum sustainable employment
2. Price stability: 2% inflation rate
• The Fed influences the federal funds rate through open market
operations: the purchase or sale of securities by the Fed.
– The Fed changes the quantity of bank reserves to influence short-term
interest rates via the federal funds rate.
– The monetary base is defined as the sum of currency in circulation
and reserve balances (deposits held by banks and other depository
institutions in their accounts at the Federal Reserve).
Simplified story:
• Equilibrium in the
market for reserves
determines the
actual federal funds
rate.
• By using open
market operations,
the Fed adjusts the
supply of reserves
to keep the federal
funds rate on target
Open Market Operations
The FOMC must observe the current state of the
economy to determine the best course of monetary
policy that will maximize economic growth while
adhering to the dual mandate set forth by Congress. In
making its monetary policy decisions, the FOMC
considers a wealth of economic data, such as: trends in
prices and wages, employment, consumer spending and
income, business investments, and foreign exchange
markets.
o FOMC: Federal Open Market Committee
• If the FOMC believes the economy is growing too fast
and inflation pressures are inconsistent with the dual
mandate of the Federal Reserve, then
Open Market Operation
Suppose Fed decides to reduce the monetary base by
$10M to arrive its federal funds target rate
• The open-market operations desk at the Federal
Reserves Bank of New York will announce that it is
selling $10M of government bonds (such as T-bills)
– Open Market Sale
• Some financial institutions will buy these bonds and pay
the Fed with currency or reserves
• Monetary base reduces
• federal funds rate increases because banks have less
liquidity to trade with other banks
• Supply of loanable funds / credit decreases
• Real interest rate increases in the short run
• The Federal Reserve influences the level of
economic activity in the short run.
o Real interest rate ↑ while everything else
constant
o è borrowing costs ↑
o è business investment and consumption ↓
o è business hire less people è consumption ↓
o è short-run price level and output ↓
2023
2023
How the Fed Steers Interest Rates to Guide the Entire Economy | WSJ
• 0:00-2:14; 2:46-5:18
Contractionary open market operation:
• Open Market Sale
• The Fed decreases reserves and liquidity by selling
government bonds, increasing federal funds rate because
banks have less liquidity to trade with other banks.
Expansionary open market operation:

• Open Market Purchase
• The Fed increases reserves and liquidity by buying
government bonds, decreasing the federal funds rate
because banks have excess liquidity for trade.
What are Open Market Operations?
2:28
Monetary Policy
Reserve Bank.
• *And more

Quantitative Easing (QE) and How the Fed Responds to Financial Crises
• 0:00-3:28
Policy
Contractionary Expansionary
Fiscal policy 1 Increase tax rate 1 Cut tax rate
2 Decrease transfer payment 2 Increase transfer payment
3 Decrease government spending 3 Increase government spending
Monetary Open market sale; Open market purchase;

policy ↑ FFR; ↓ FFR;
↓ monetary base; ↑ monetary base;
↑ RR; ↓ RR;
Many more QE;
Many more
• Assumption: the expectation about future

inflation stays constant.
AD shifts: Changes in Monetary Policy
•A government policy change could shift aggregate demand. There are two
categories of government policies here:
1. Monetary policy: The actions the Federal Reserve takes to manage the
money supply and interest rates to pursue macroeconomic policy
objectives.
•If the Federal Reserve causes interest rates to rise, investment spending will
fall; if it causes interest rates to fall, investment spending will rise.


237 of
AD shifts: Changes in Fiscal Policy
2. Fiscal policy: Changes in federal taxes and purchases that are intended
to achieve macroeconomic policy objectives.
•Increasing or decreasing taxes affects disposable income, and hence
consumption. The government can also alter its level of government
purchases.

238 of
AD Shifts: Changes in Expectations
•Households or firms could become more optimistic about the future,
increasing consumption or investment respectively.
•Of course, the opposite could also occur.


239 of
AD Shifts: Changes in Foreign Variables
•If foreign incomes rise more slowly than ours, their imports of our goods fall; if ours rise
more slowly, our imports fall.
•If our exchange rate (the value of the $US) rises, our exports become more expensive,
so foreigners buy less of them (and we buy more imports, also).


240 of
Consequences of Policies
• Lowering the inflation rate in the short run
o At the cost of a slumping economy in the short
run
o Higher unemployment and lost output in the short
run
o Contractionary monetary policy slows down
growth in bank reserves, raises interest rates,
reduces borrowing, slows growth in the money
supply, and reduces the rate of inflation.
Short-run Phillips Curve
2023
Appendix
• *What Does the Federal Reserve Do?
• *Interest Rate Control Is More Complicated Than You
Thought
• *IORB
• *ON RRP
• *The Discount Rate
• *Quantitative easing - how it works
• *The Disinflation over Time

What Does the Federal Reserve Do?
4:06
• Interest Rate Control Is More Complicated
Than You Thought
– https://www.stlouisfed.org/publications/regional-
economist/april-2016/interest-rate-control-is-
more-complicated-than-you-thought
• FRED data
– https://fred.stlouisfed.org/graph/?g=Olua
IORB
• IORB rate
– The interest rate on reserve balances
– https://www.federalreserve.gov/monetarypolicy/r
eserve-balances.htm
– IORR (interest on required reserves) rate & IOER
(interest on excess reserves) rate
• Discontinued on July 28, 2021
• https://www.federalreserve.gov/monetarypolicy/iorb-
faqs.htm
ON RRP
• The ON RRP provides a floor under overnight
interest rates by offering a broad range of
financial institutions that are ineligible to earn
IORB, an alternative risk-free investment option.
– https://www.newyorkfed.org/markets/domestic-
market-operations/monetary-policy-
implementation/repo-reverse-repo-
agreements#:~:text=The%20Overnight%20Reverse%2
0Repo%20Facility,reserve%20balances%20(IORB)%20r
ate.
– https://www.newyorkfed.org/markets/rrp_faq.html
Repurchase Agreements (Repo) & Reverse Repurchase Agreements
(Reverse Repo) Explained in One Minute
• 1:30
The Discount Rate
A bank that finds itself short of reserves and unable to
borrow sufficient amounts in financial markets may turn
to the discount window of the Fed. This is one way in
which the Fed functions as the lender of the last resort.
o The discount rate is the interest rate charged by the
Fed on loans that it makes to commercial banks and
other financial institutions.
o https://www.federalreserve.gov/regreform/discount-
window.htm
o https://www.federalreserve.gov/monetarypolicy/discountr
ate.htm
o During the period of 2008 financial crisis, Fed has created a
number of new lending facilities and initiatives to percent
banks from failing.
Quantitative easing - how it works
• 0:00-5:15
The Disinflation over Time

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Intro Macro, Spring 23

2 𝐹" 𝐾, 𝐿 = 𝐾×𝐿 𝑌" = 𝐴× 𝐾×𝐿

The aggregate production function has the same

The aggregate production function has the same two properties

The aggregate production function has the same

Aggregate production More is better? Diminishing Valid?

To maximize economics profit, a firm must make decisions

max 𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑃×𝐹 𝐾, 𝐿 − 𝑅𝐾 − 𝑊𝐿

Revenue Production cost

• What is the MC of hiring one more unit of labor?

• What is the MC of hiring one more unit of

• The marginal product of capital (MPK) is the extra amount of

• Real GDP per worker

Keeping everything else constant, can labor force growth alone

"More" is not ALWAYS better

Keeping everything else constant, can population growth (labor

Keeping everything else constant, can the growth of physical

Keeping everything else constant, can the growth of physical capital

For a simplified economy

Keeping everything else constant, can technological innovation

Keeping everything else constant, can technological innovation

Printing too much

not necessarily increase welfare for

• There are three reasons productivity differs across countries:

• *What is technology and knowledge

* Helpful but not required for the exam

Technology can be embodied or contained in H.

Technology can be embodied or contained in K.

Physical capital today contains

(1) knowledge of how to produce new goods such as

(2) knowledge of how to run certain software, like the latest

Advances in technology result mostly from purposeful,

Firms and the government in the United States spent $430

• Institutions are in place to foster human capital

• For all households

Consumption tends to follow a

The initial increase in G $100 billion

Plus the first induced increase in MPC × $100 billion

Year Consumption Investment Exports Real GDP Unemployment Rate

Short-run vs. Long-run

Actual output Potential output Detrended output

https://fred.stlouisfed.org/ https://fred.stlouisfed.org/ https://fred.stlouisfed.org/

Actual output Potential output Detrended output

https://fred.stlouisfed.org/ https://fred.stlouisfed.org/ https://fred.stlouisfed.org/

Actual output Potential output Detrended output

https://fred.stlouisfed.org/ https://fred.stlouisfed.org/ https://fred.stlouisfed.org/

The growth rate of a constant is ZERO

Conventionally, inflation rate is denoted by π

• Fluctuations in U.S. GDP:

• In the short run

o How do you expect the cyclical unemployment to

– LRAS stays unchanged level of input stocks in the long run

• 𝐿𝑅𝐴𝑆 = 𝑟𝑒𝑎𝑙 𝑝𝑜𝑡𝑒𝑛𝑡𝑖𝑎𝑙 𝐺𝐷𝑃 = 𝐴×𝐹 𝐾, 𝐿

• Offer lower salaries

• Table 13.2 •Variables that shift the short-run

The business cycle occurs because aggregate demand

•With the lower level of

•The short-run and long-run effects of a supply shock:

•How long does it take to

worth the cost.

•After the 2007-2009 recession,

•How accurate were these

2011 Estimates of 2013 Output Gap Actual Output Gap

•In 2007, the economy was