FOREIGN TRADE UNIVERSITY

Faculty of International Economics

Macroeconomics I

Hoang Xuan Binh,

MSc
A PowerPointTutorial
 CHAPTER I:
Introduction Lecture programme

I would like to express my deepest gratitude to Mannig J.

Simidian (Harvard University) and my Supervisor Prof. Witztum
(London University) for their invaluable comments.
 Introduction

Module title: Macroeconomics I

Semester: I
Year 2008-2009
Level: Undergraduate
Module Convenor: Hoang Xuan Binh
Time:15:05-17:30 on Monday
Room: D102- Foreign Trade University
(Hanoi Campus)
Tel: 844-8345801
Cellphone: 0912782608
 INTRODUCTION

Module Context:
The module is designed especially for
students taking Macroeconomics at FTU. It
is intended to provide students with an
understanding of important macroeconomic
factors and variables. The course analyses
how macroeconomic variables operate;and it
develops an understandings of the
international money and financial market, in
or outflows of capital. The course also draws
on the debates in real economy and tries to
use both old and new theories to understand
them.
 Introduction

Module aims and objectives:

1.To familiarise the students with some of the most
important macroeconomic variables in the
economy, for example GDP,GNP,CPI,PPI…
2.To introduce students to some important
macroeconomic policies including fiscal and
monetary policies.
3.To examine some different cases in term of using
macroeconomic policies to develop economy.
 Introduction
Learning outcomes
By the end of this module it is expected that students:
1.will have an understanding of how important
macroeconomic variables are interacting in the
economy.
2.will be able to interpret such variables and events as
GDP,GNP,CPI or inflation,unemployment… and relate
them to changes of other variables and events in the
economy.
3.will be ready to explain significant events in real
economy by using economic theories.
4.will be familiar with current debates on open-
economy and able to make a critical assessment of the
various arguments which are put forward.
Teaching and learning methods:
In class contact hours there will be lectures,
discussions and assistance with students’assignment
work,reading and using books. During the seminars the
students will be expected to discuss the provided
topics on the problems of real economy.
Assessment methods:
There is a written assignment and final examination.
It is worthy 30% and 60% respectively. Class
participation is 10% .
Suggested Supplementary
Reading
Mankiw, Principles of Economics
Mankiw, Macroeconomics 5th ed ,
 Lecture programme
Chapter: Introduction lecture programme

Chapter2:The Data of Macroeconomics

Chapter3:Aggregate Demand and Fiscal policy

Chapter4:Money and Monetary policy

Chapter5:Inflation and unemployment

Presentation assignment
Chapter6:Economic growth

Chapter 7: The Open economy

Revision
 I.Introduction
Everyone is concerned about macroeconomics
lately. We wonder why some countries are growing faster
than others and why inflation fluctuates. Why?
Because the state of the macroeconomy affects
everyone in many ways. It plays a significant
role in the political sphere while also affecting
public policy and social well-being.

There is much discussion of recessions-- periods

in which real GDP falls mildly-- and depressions,
concerns with issues such as inflation,
unemployment, monetary and fiscal policies.
Economists use models to understand what goes on in the economy.
Here are two important points about models: endogenous variables
and exogenous variables. Endogenous variables are those which the
model tries to explain. Exogenous variables are those variables that
a
model takes as given. In short, endogenous are variables within a
model, and exogenous are the variables outside the model.
Price Supply
This is the most famous
P* economic model. It describes
the ubiquitous relationship
Demand between buyers and sellers in
the market. The point of
Q* Quantity intersection is called an
equilibrium.
Economists typically assume that the market will go into
an equilibrium of supply and demand, which is called
the market clearing process. This assumption is central
to the Pho example on the previous slide. But, assuming
that markets clear continuously is not realistic. For
markets to clear continuously, prices would have to
adjust instantly to changes in supply and demand. But,
evidence suggests that prices and wages often adjust
slowly.

So, remember that although market clearing models

assume that wages and prices are flexible, in actuality,
some wages and prices are sticky.
 Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
marketplace. In microeconomics, a person chooses to
maximize his or her utility subject to his or her budget constraint.

Macroeconomic events arise from the interaction of many

people trying to maximize their own welfare. Therefore, when
we study macroeconomics, we must consider its
microeconomic foundations.
II. Research aims and research
methods:
1. Aims and objectives of
macroeconomics
Yield, Economic growth,
unemployment, inflation, budget,
Balance of Payments,
2. Research method

- Mathematics, general
equilibrium, Walras methods
(equilibrium in all market…
III. Macroeconomics system
1. Inputs
+ Exogenous variables:
weather, politics, population,
technology and patents or
know-how
+Endogenous variables: direct
impacts-fiscal policy,monetary
policy, external economic
2.policy
Black box: AS+AD
2.1. Aggregate Demand
*Related factors: Price, Income,
Expectation…

2.2.Aggregate Supply

* Related factors:
Price,production cost, potential
output (Y*)
Y*: maximization of output which
economy can produce, with full-
employment and no inflation.
Full-employment=population–
outof working age - invalids -
(pupils + students) – servant-
unwilling to work
3. Outputs

Yield, employment,
Average price,
Inflation,interest,budget,
Trade balance and balance of
International payment,
Economic Growth
Macroeconomics
Macroeconomics
Recession
Recession
Depression
Depression
Models
Models
Macroeconomic
Macroeconomicsystem
system
Inputs
Inputs
Outputs
Outputs
Endogenous
Endogenousvariables
variables
Exogenous
Exogenousvariables
variables
Market
Marketclearing
clearing
Flexible
Flexibleand
andsticky
stickyprices
prices
Microeconomics
Microeconomics
 CHAPTER II

Data of macroeconomics
I. Gross domestic products-GDP

Gross Domestic Product (GDP) is the

market value of all final goods and
services produced within an economy
in a given period of time.
 Income, Expenditure
And the Circular Flow
There are 2 ways Total income of everyone in the economy
of viewing GDP Total expenditure on the economy’s
output of goods and services
Income $
Labor
Households Firms
Goods

Expenditure $
For the economy as a whole, income must equal expenditure.
GDP measures the flow of dollars in this economy.
II.Computing GDP
1.Rules for
computing
1) GDP
To compute the total value of different goods and services,
the national income accounts use market prices.
Thus, if
$0.50 $1.00

GDP = (Price of apples  Quantity of apples)

+ (Price of oranges  Quantity of oranges)
= ($0.50  4) + ($1.00  3)
GDP = $5.00

2) Used goods are not included in the calculation of GDP.

3) The treatment of inventories
depends on if the goods are
stored or if they spoil. If the
goods are stored, their value is
included in GDP.

If they spoil, GDP remains

unchanged. When the goods are
finally sold out of inventory,
they are considered used goods
(and are not counted).
4) Intermediate goods are not
counted in GDP– only the value of
final goods. Reason: the value of
intermediate goods is already
included in the market price.

Value added of a firm equals the

value of the firm’s output less
the value of the intermediate
goods the firm purchases.
5) Some goods are not sold in the marketplace
and therefore don’t have market prices. We must
use their imputed value as an estimate of their
value. For example, home ownership and
government services.
The value of final goods and services measured at
current prices is called nominal GDP. It can change
over time either because there is a change in the
amount (real value) of goods and services or a change in
the prices of those goods and services.
Hence, nominal GDP Y = P  y, where P is the price
level and y is real output– and remember we use output
and GDP interchangeably.
Real GDP or, y = YP is the value of goods and services
measured using a constant set of prices.
 Let’s see how real GDP is computed in our apple and
orange economy.

For example, if we wanted to compare output in 2002 and

output in 2003, we would obtain base-year prices, such as 2002
prices.

Real GDP in 2002 would be:

(2002 Price of Apples  2002 Quantity of Apples) +
(2002 Price of Oranges  2002 Quantity of Oranges).
Real GDP in 2003 would be:
(2002 Price of Apples  2003 Quantity of Apples) +
(2002 Price of Oranges  2003 Quantity of Oranges).
Real GDP in 2004 would be:
(2002 Price of Apples  2004 Quantity of Apples) +
(2002 Price of Oranges  2004 Quantity of Oranges).
 GDP Deflator = Nominal GDP
Real GDP

Nominal GDP measures the current dollar value of the output

of the economy.

Real GDP measures output valued at constant prices.

The GDP deflator, also called the implicit price deflator for
GDP, measures the price of output relative to its price in the
base year. It reflects what’s happening to the overall level of
prices in the economy.
 In some cases, it is misleading to use base year prices that
prevailed 10 or 20 years ago (i.e. computers and
college). In 1995, the Bureau of Economic Analysis
decided to use chain-weighted measures of
real GDP. The base year changes continuously
over time. This new chain-weighted
Average prices in 2001 measure is better than the more
and 2002 are used to measure traditional measure because it
real growth from 2001 to 2002. ensures that prices will not be
Average prices in 2002 and 2003 too out of date.
are used to measure real growth from
2002 to 2003 and so on. These growth
rates are united to form a chain that is
used to compare output between any two
dates.
3. Methods of computing GDP

*Expenditure approach

GDP = C + I + G + (X-
M)
 Y
Y == C
C ++ II ++ G
G ++ NX
NX
Totaldemand
Total demand Investment
Investment
fordomestic
for domestic isiscomposed
composed spendingby
spending by
output(GDP)
output (GDP) of
of businessesand
businesses and
households
households Netexports
Net exports
ornet
or netforeign
foreign
Consumption Government demand
demand
Consumption Government
spendingby
spending by purchasesof
purchases ofgoods
goods
households
households andservices
and services

This is the called the national income accounts identity.

*The Factor Incomes Approach: it
measures GDP by adding together
all the incomes paid by firms to
households for the services of the
factors of production they hire.
According to this approach, GDP is
the sum of incomes in the economy
during a given period
W:
GDPwage,
=w r :rent
+r+ fixed
i +capital,
 + Di:+Te
interest,  profit, D: Depreciation,
Te: indirect tax
3. The output approach

Total Value added = Total

Revenues – Total Cost

GDP =  Value added in all

industries
=> GDP = VAT. 1/Value
added tax
Example:
One firm gains value added is 80, 1000
firms is 80,000. 80 = total revenues –
total cost (production cost)
II.Gross national products)-GNP

1. Definition:
GNP is the market value of all final
goods and services produced by
domestic residents in a given period of
time.

2. Computing methods:

GNP = GDP + Tn

Tn: net Income from Abroad

*3 cases :

+ GNP > GDP (Tn>0): domestic

economy has impacts in other
economies.

+ GNP < GDP (Tn<0): foreign

economies have impacts in
domestic economy.

+ GNP = GDP (Tn=0): no conclusion

4. Net Economic Welfare -NEW

GDP, GNP doesn’t compute some

goods and services which aren’t
sold, or illegal transactions or
activities of black market,
negative externality…
V1 + Value of Rest
+ Value of goods and services
which arent sold
+ Revenues from transactions in
black market
V2-negative externality for natural
resources,environment, such as noise traffic jam
…
NEW reflects welfare better than
GNPm but it is very difficult to have
enough data to compute
NEW,therefore, economists still use
GDP and GNP.
 NNP= GNP-D ; Y=NI=NNP-
Te=GNP-D-Te
Yd = NI - (Td-TR) = (C+S)
Tn
D D-Depreciation
C NNP-Net National
Te Product
I GNP Td- NI-National
NNP
NI TR Income
G
Yd-Disposal
(Y
Yd Income
)
NX TR (transfer)-
Td: Direct tax
Gross domestic product (GDP) National income accounts
Consumer Price Index (CPI) Consumption
Unemployment Rate Investment
Stocks and flows Government Purchases
Value added Net Exports
Nominal versus real Labor force
GDP GDP deflator
GNP
NEW
 CHAPTER III
Aggregate Demand
& Fiscal policy
of four lectures aimed at analysing
different (separate) markets in the
economy. This will then enable us to
bring the various markets together and
to analyse the behaviour of the whole
economy (this is also referred to as
general equilibrium analysis). Today
we will introduce an analysis of the
economy as originally described by the
economist John Maynard Keynes. His
theory of how the macroeconomy
works will help us explain how the
economy’s income (GDP) is
determined. Today we analyse the
model in its simplest form and we will
assume that the economy does not
have a government and that it does
not trade with the rest of the world.
We will relax these assumptions.
 The Keynesian Theory of Income Determination:
the theory that will be presented hereafter was
developed by the Cambridge economist John
Maynard Keynes in the wake of the 1920s Great
Depression. He argued that the cause of a low
level of income (GDP) in the economy was given
John
by Maynard
the lackKeynes
of AD.(right) and Harry Dexter White at the
Personal and marital life
Born at 6 Harvey Road, Cambridge, John
Maynard Keynes was the son of John Neville
Keynes, an economics lecturer at Cambridge
University, and Florence Ada Brown, a
successful author and a social reformist. His
younger brother Geoffrey Keynes (1887–1982)
was a surgeon and bibliophile and his younger
sister Margaret (1890–1974) married the
Nobel-prize-winning physiologist Archibald
Hill.
Keynes was very tall at 1.98 m (6 ft 6 in).

In 1918, Keynes met Lydia Lopokova, a well-

known Russian ballerina, and they married in
1925. By most accounts, the marriage was a
happy one. Before meeting Lopokova,
Keynes's love interests had been men,
 I. Aggregate Planned
Expenditure and Aggregate
Demand
1.Assumptions: a model nearly
always starts with the word
‘assume’ or ‘suppose’. This is
an indication that reality is
about to be simplified in order
to focus on the issue at hand
*Prices, Wages and Interest Rate
are Constant
*The Economy Operates at less
than full Employment: this
implies that firms are willing
to supply any amount of the
good at a given price P. In
other words, assume that the
supply of goods is completely
elastic at price P. This
assumption is generally valid
only in the short run
*Closed Economy and No
Government: we assume that the
economy does not trade with the
rest of the world so that both
exports and imports are equal to
zero (X=M=0). We also assume
that there is no government in the
economy so that government
expenditures and taxes are equal
to zero (G=T=0). This implies that
aggregate demand is therefore
reduced to the following
expression:
AD  C + I
1. Aggregate Planned Expenditure

APE reflects the total planned

expenditure at each income, with
assumption of given price.
*Households: Consumption 
C = f(Yd): the main determinant
of consumption is surely income,
or more precisely
C = f1(Y)
-Firms: to create the demand
through their investment
I = f2(Y)

APE = C + I = f1(Y) + f2(Y)

1.1. Consumption
*function
The relationship between consumption
expenditures and disposable income,
other things remaining the same, is
called consumption function. The
consumption function that we will use in
our model and that shows the positive
link between consumption and
C  f1 (Yincome
disposable )  C isMPC the .following
Yd
*Determinants of
Consumption:
+Autonomous Consumption (C):
this is the amount of consumption
expenditure that would take
place even if people had no
current disposable income

+Induced Consumption: this is

consumption expenditure that is
in excess of autonomous
consumption and that is induced
by an increase in disposable
income
+Marginal Propensity to
Consume (MPC): it is the
fraction of a change in
disposable income that is
consumed. It is calculated as
the change in consumption
expenditures (DC) divided by
the change in disposable
income (DYd) that brought it
about. It gives the effect of an
additional pound
C of disposable
income 
MPC on consumption. The
Y
MPC determines the slope of
the consumption function
0 < MPC< 1 :This reflects the
fact that people are likely to
consume only part of any
increase in income and to save
the rest
*Example. The following is an
example of a consumption
function:
C = 20 + 0.7xYd
Autonomous Consumption: 20
MPC = 0.7
 +NetPrivateSavings-S: savings
by
consumers is equal to their
disposable income minus their
consumption
=> S = Yd - C
and, by using the definition of
disposable income this identity
However, given that there is no
can be rewritten as:
government in our simple
S = Y – T – C (but T = 0, no
economy, T=0 and savings are
government)
equal to:Saving
1.2.The S = Y - CFunction: the
economy’s savings function can
be derived by using the private
savings expression and the
S Y C
S  Y  C  MPC.Y  C  (1  MPC ).Y
S  C  MPS .Y

+The Marginal Propensity to

Save (MPS): the propensity to
save tells us how much people
save out of an additional unit of
income. The assumption we
made earlier that MPC is
between zero and one implies
that the propensity to save is
given by
(1-MPC) and that it is also
1.3.Investment function (I): the
second expenditure in APE that
we will analyse today is
investment
*Determinants of Investment: we
can
distinguish four major
determinants of
investment

+Increased Consumer Demand:

investment is to provide extra
capacity. This will only be
necessary, therefore, if consumer
+Expectations: since investment
is made in order to produce
output for the future, investment
must depend on firms’
expectations about future market
conditions
+Cost and Efficiency of Capital
Equipment: if the cost of capital
equipment goes down or
machines become more efficient,
the return on investment will
increase and firms will invest
more
+Interest rate: the higher the
rate of interest, the more
expensive it will be for firms to
borrow the money to finance
their investment expenditures
and the less profitable will the
investment be
+Level of Investment in the
Economy: in this model we will
take investment as given or, in
other words, we will regard it as
an exogenous variable. The main
reason for taking investment as
given is to keep our model
simple. Thus we will assume that
investment is given by a
fixed/constant amount (a bar
over a variables indicates that
the variable is regarded as an
exogenous variable) that does
not changeI with
I the level of
income in the economy:
APE  C  I  C  I  MPC .Y

*The Determination of
Equilibrium Output: When P, w
is constant,the equilibrium in
the goods market requires that
the supply of goods (GDP=Y)
equals the demand for goods
(APE):
Y = APE =AD
This equation is called the
equilibrium condition. By
replacing the above expression
for aggregate planned
expenditure in the equilibrium
Y  APE
condition we get:
Y  C  I  MPC .Y

As you can see the above

expression is an equation in one
endogenous variable: Y. Thus we
can solve this equation for Y and
this will give us the equilibrium
level of output1 (Ye)produced in
Ye 
the economy (C  I )
1  MPC
I  200

*Example 1. Assume that in the

economy the level of autonomous
consumption c0=100, the
marginal propensity to consume
is MPC=0.5 and the investment
spending is I=200 . Determine the
equilibrium level of output
produced in the economy.
2. APE & Ye in closed economy with
a Government Sector

I  I
-Firms invest in economy
-Government sector expenditure: G

+G will increase APE and will shift

the APE curve upwards.
+Taxation reduces the level of
disposable income available for
consumption and will tend to
reduce APE. Such a reduction in
APE is reflected by a downward
rotation of the APE curve. Why?
 This is due to the fact that
taxation reduces the overall MPC
by the household so that for
each extra pound of income the
household will now consume less
since some of the extra income
must be paid
2.1.Fixed taxation T
inTtaxes

APE  C  I  G  C  I  G  MPC.(Y  T )
Y  APE
Y  C  I  G  MPC .(Y  T )
1 MPC
Y0  (C  I  G )  T
1  MPC 1  MPC
 MPC Multiplier Effect of
mt  
1  MPC taxation

Y0  m(C  I  G )  mt T

2.2. Taxation depends on income: T =

t.Y (t:tax rate)
C  C  MPC (Y  T )  C  MPC (1  t )Y

II G G
APE  C  I  G  C  I  G  MPC  (1  t )Y
=>Equilibrium point of economy:

Y  APE
Y  C  I  G  MPC (1  t )  Y
1
Y0  (C  I  G )
1  MPC (1  t )
 1
m  Multiplier of
1  MPC (1  t )
consumption in the
closed economy with
Government sector
1 1
m  m
1  MPC (1  t ) 1  MPC

This reflects that the income

based tax is less efficient than
fixed tax.
3. 2. APE & Ye in open-economy
with a Government Sector and
foreign trade
*Assuption: T = t.Y (t- taxrate)
Economy has 4 sector

*C = C + MPC.(Y-T) = C + MPC.
(1-t).Y
*I = I
*G = G
*NX=X-M: netexport
X doesn’t depend on domestic
income,therefore
X X
M derives from production inputs,
or consumptions of
households=>M increases when I
or Ye rises.

Ta cã: M = MPM.Y
*MPM (Marginal Propensity to
Import): it is the fraction of an
increase in GDP that is spent on
imports. It is calculated as the
change in imports (M) divided by
the change in GDP ( Y) that
brought it about, other things
remaining the same. The MPM is
a positive number smaller than
 APE  C  I  G  X  M
APE  C  I  G  X   MPC (1  t )  MPM   Y
*Equilibrium point of economy:
Y  APE
Y  C  I  G  X   MPC (1  t )  MPM   Y
1
Y0  (C  I  G  X )
1  MPC (1  t )  MPM
1
m   open-economy
1  MPC (1  t )  MPM
multiplier
m” < m’ < m. open-economy multiplier is
less efficient than closed economy
The Multiplier Spending Chain
I = £1 million - Marginal Propensity to Consume: mpc = 0.8
Spending in This Round Cumulative Total I
Round N.
1 £1,000,000 (G £1,000,000 (G1)
2 £ 800,000(C2=0.8*G) £ 1,800,000
3 £ 640,000(C3=0.8*C2) £ 2,440,000
4 £ 512,000(C4=0.8*C3) £ 2,952,000
5 £ 409,600(C5=0.8*C4) £ 3,361,600
6 £ 327,680(C6=0.8*C5) £ 3,689,280
7 £ 262,144(C7=0.8*C6) £ 3,951,424
8 £ 209,715(C8=0.8*C7) £ 4,161,139
9 £ 167,772(C9=0.8*C8) £ 4,328,911
10 £ 134218(C10=0.8*C9) £ 4,463,129
................... .............................................. .....................................
.
50 £ 18(C50=0.8*C49) £ 4,999,929
II.Fiscal policy:
1. Fiscal policy: Government use
taxation and consumption to
regulate aggregate demand.
2. Classification of fiscal policy
2.1. Expansionary fiscal policy

2.2. Contractionary fiscal policy

3. Fiscal policy and Budget decifit
*State Budget: total sum of
revenues and consumption of
Government in given time (one
year)
B=T-G
+ B = 0: Budget balance
+ B > 0: Budget surplus
+ B < 0: Budget deficit
*Classification:

- Real budget deficit: When

consumption > revenues

-Cyclic budget deficit: when

economy faces recession due to
cyclic business.
-Structural budget deficit: is
calculated in term of assumptions
with potential output.
where Btt = Bck + Bcc =>Bcc = Btt -
Bck
*Note: fiscal policy can reach
following objectives:

+Budget balance=>Y can

fluctuate.. .
+Y*=> Budget deficit can
happen. When there is recession
in economy, G increase or T
decrease or both to keep high
consumption => Y rises to Y*
but Budget deficit happens.
4. How to reduce budget
deficit
-Inreasing revenues and
decreasing consumption

-Public debt: Government bond

-Borrowings from foreign

countries or international
orgnizations
-Printing money or using
reserve from foreign currency
 CHAPTER IV

money and monetary policy

I. Money

1. The Meaning and functions of

Money
a.Definition of Money: money is
any commodity or token that is
generally acceptable as the means
of payment. A means of payment
is a method of settling a debt. In
general terms money can be
defined as the stock of assets that
can be readily used to make
transactions. Roughly speaking,
the coins and banknotes in the
 Stock of assets
Money Used for transactions
A type of wealth

Self-sufficiency
Without Money
Barter economy
b. Development of money
Cattle, iron, gold,silver,diamond
….and banknote today

Batter => commodity money=>

cash, cheque, credit card…

2. The Functions of Money:

money has three main purposes.
It is a medium of exchange, a
unit of account and a store of
value
2.1. Medium of Exchange: it is an
object that is generally accepted in
exchange for goods and services.
Money acts as such a medium
2.2. Unit of Account (A Means
of Evaluation): a unit of account
is an agreed measure for stating
the prices of goods and services. It
allows the value of one good to be
compared with another
2.3. Store of Value: any
commodity or token that can be
held and exchanged later for
goods and services is called a
store of value. Money acts as a
 Functions of Money

• Store of value
• Unit of account
• Medium of exchange
• International Money

The ease with which money is converted into other things--

goods and services-- is sometimes called money’s liquidity.
3.Types of Money
*Depend on the Liquidity:
M 0= Cash; (Wide Monetary
Base) =
Cash in circulation with the public
and held by banks and building
M1 =societies +Banks’(D: balances
Cash + Deposit Deposit is
with the Central Bank
unlimited time deposit). Liquidity of M1
is smaller than M0 but it is still good to
measure the cash in circulation in
M 2= M1 + limited time deposit:
economy.
Liquidity of M2 is very
low,therefore,there are some
developed economies such as US and
*Money can be divided into:

Fiat Money: money takes

different forms.
Money that has no intrinsic
value is called fiat money
because it is established as
money by government decree,
or fiat

In the UK economy we make

transactions with an items
whose sole function is to act as
money: pound coins and
banknotes. These pieces of
Commodity Money: although fiat
money is the norm in most
economies today, historically
most societies have used for
money a commodity with some
intrinsic value.
Money of this sort is called
commodity money and the most
widespread example of
commodity money is gold
II. Central Bank and creation
money of commercial bank
1.Banks are the Financial
Intermediaries. They are private
firms licensed by the Central Bank
under the Banking Act to take
deposits and make loans and
operate in the economy.
Retail Banks: they specialise in
providing branch banking
facilities to member of the general
public but they do also lend to
businesses albeit often on a short-
term basis. They are the most
important banks in the UK for the
2. The creation of Money by
commercial banks

The Creation of Money: banks

create money. However this
does not mean that they have
smoke-filled back rooms in
which counterfeiters are busily
working. Notice that most
money is deposits, not
currency. What banks create is
deposits and they do so by
making loans. But the amount
of deposits they can create is
limited by their reserves
Desired Reserver rate

Required Reserve Rate

Excessive Reserve Rate

 The Deposit Multiplier: this is
the amount by which an increase
in bank reserves is multiplied to
calculate the increase in bank
deposits. It is given by the
following formula:
Change in Deposit
Deposit Multiplier 
Change in Reserves

Alternatively, it can also be

defined as: 1
Deposit Multiplier 
Desired Reserve Ratio
if banks want to keep 10% of their
deposits as reserves, so that the
desired reserve ratio is 0,10 (ra), the
deposit multiplier is given by the
 Banking Desired
Deposits Lending
system reserve(ra)
NH1 1 1.ra (1-ra)
NH2 (1-ra) (1-ra).ra (1-ra)2
NH3 (1-ra)2 (1-ra)2 .ra (1-ra)3
... ... ... ...
NH(n+1) (1-ra)n (1-ra)n .ra (1-ra)n+1

n 1 n 1
1  (1  ra ) 1  (1  ra )
D  1  (1  ra )  (1  ra )  ...  (1  ra )  1
2 n
 1
1  (1  ra ) ra
1 0 1 1
0 < ra < 1 D=>
 1  1   10
ra ra 0,1
(tû.®)
Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000.

Firstbank Secondbank Thirdbank

Balance Sheet Balance Sheet Balance Sheet
Assets Liabilities Assets Liabilities Assets Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640
Loans $800 Loans $640 Loans $512

Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1000
Firstbank Lending = (1-rr)  $1000 TheTheprocess
processof oftransferring
transferringfunds
funds
Secondbank Lending = (1-rr)2  $1000 from savers to borrowers is called
from savers to borrowers is called
Thirdbank Lending = (1-rr)3  $1000
Fourthbank Lending
financial intermediation.
=. (1-rr)4  $1000 financial intermediation.
..
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …]  $1000
= (1/rr)  $1000
= (1/.2)  $1000
= $5000 Money
Moneyand andLiquidity
LiquidityCreation
Creation
III. Central Bank and money supply

1. Roles of Central Bank

*Supervision of Monetary System:

the central bank oversees the
whole monetary system and
ensures that banks and financial
institutions operate as stably and
as efficiently as possible
*Government’s Bank: the central
bank is the acts as the
government’s agent both as its
banker and in carrying out
2. Functions of Central Bank

*To Issue Notes: the Central

Bank is the sole issuer of
banknotes. The amount of
banknotes issued by Central
Bank depends largely on the
demand for notes from the
general public
For example, BOE issues
banknotes in England and Wales
(in Scotland and Northern
Ireland retail banks issue
banknotes).
*It Acts as a Bank
+To the Government: the
government deposits its revenues
from taxation in the central bank
and uses CB in order to borrow
money from the market
+To other Recognised Banks: all
banks licensed by CB hold
operational balances in the CB.
These are used for clearing
purposes between the banks and
to provide them with a source of
liquidity
+To Overseas Central Banks: these
are deposits in sterling held by
overseas authorities as part of
*It Manages the Government’s
Borrowing Programme: whenever
the government runs a budget
deficit (it spends more than what
it receives in taxes) it will have to
finance that deficit by borrowing.
It can borrow by using bonds
(gilts), National Savings
certificates or Treasury bills. The
*It organises
CB Supervises the Financial
this borrowing
System: it advises banks on
good banking practice. It
discusses government policy
with them and reports back to
the government. It requires
*It Provides Liquidity to Banks –
Lender of Last Resort: it ensures
that there is always an adequate
supply of liquidity to meet the
legitimate demands of
depositors in recognised banks
*It Operates the Government’s
Monetary and Exchange Rate
Policy
+Monetary Policy: the CB
manipulates the interest rate in
the economy and influence the
size of the money supply
+Exchange Rate Policy: the CB
manages the country’s gold and
3. The Supply of Money
*Definition of Money Supply: the
quantity of money available is
called the money supply. In an
economy that uses fiat money,
such as most economies today,
the government controls the
supply of money: legal restrictions
give the government a monopoly
on the printing
*Monetary of money
Policy: the control over
the money supply is called
monetary policy
4. Implement of money supply
a.Measures of Money Supply:
Recall that we can denote money
supply as the sum of currency
andMdeposits
 C  D
Money Currency Demand Deposits

Central Bank issues H0, (Basic

Money, High Powered Money), H0
< M0. Ho is divided into
U and R
 + Sectors keep a part of Ho,
denote as U. U can’t create other
means of payment and it can be
decrease due to damages..in the
circulation. Assuption, U is
constant.
+ The rest of Ho denote as R (Ho =
U +R). The banking system will use
R to create money as followings:
 1
D R
ra

Basic Money (H0)

U R

U D
Money supply : MS

Where: H0 = U + R and MS = U +
D
MS >Ho due to the creation of money
b.The Central Bank's Policy Tools:
there are three main tools that the
Central Bank can use to control money
supply and implement monetary policy

*Reserve Requirements: these are

regulations by the central bank
that impose on banks a minimum
reserve-deposit ratio. An increase
in reserve requirements raises the
reserve-deposit ratio and thus
lowers the money multiplier and
the money supply
*Discount Rate: it is the interest
rate that the central bank charges
when it makes loans to banks.
Banks borrow from the central
bank when they find themselves
with too few reserves to meet
reserve requirements. The lower
the discount rate, the cheaper are
borrowed reserves and the more
banks borrow at the central
bank’s discount window.

=> discount rate decreases =>the

monetary base and the money
supply go up.
*Open-Market Operations: they
are the purchases and sales of
government bonds by the central
bank.
When the central bank buys (sells)
bonds from (to) the public, the
pounds it pays (receives) for the
bonds increase (decrease) the
monetary base and thereby
The term (decrease)
increase 'Open Market'
therefers
moneyto
commercial
supply. banks and the general
CB conducts an open market
operation, it does a transaction
with a bank or some other business
but it does not transact with the
Example of US economy?
In the United States, monetary policy is
conducted in a partially independent
institution called the Federal Reserve,
or the Fed.
 • To expand the Money Supply:
ury B ond
USTh.e beTarrereofndathsise Uheniretebyd Stproplmeised
ates The Federal Reserve buys U.S. Treasury Bonds
and pays for them with new money.
y bo ci
the prin h it
Treasur
ment of hic
the repay the interest w ated
e pl us rm s st
valu e te
rough th
incurs th
ther eo f. y
stly repa
s will ju d
ted State an
The Uni in its entirety
er s y
its bear efault under an
d
will not
ances.
circumst
nt

• To reduce the Money Supply:

Preside
e of the
Signatur
______
_______
______

The Federal Reserve sells U.S. Treasury Bonds

and receives the existing dollars and then
destroys them.
 The Federal Reserve controls the
money supply in three ways.

1) Open Market Operations (buying and

selling U.S. Treasury bonds).
. T r e a s
ury b
utheryUniB on d
tates
ted S ised
US The bearer onofd is herebyrinciple
pr

the p
om

h it
2)  Reserve requirements (never really
Treas ayment of erest whic ed

used).
ep t t
the r lus the in terms sta
p e
value through th
r s
incu pay
thereo
f. ly re
l just
s wil rety and
t ed State enti
ni
The U rers in its nder any

3) Discount rate which member banks

ea u
its b t default
no
will ces.
rc umstan
ci
sident
e Pre

(not meeting the reserve requirements)

of th
ture
Signa
____
_____
_____
_____

pay to borrow from the Fed.

IV. Money market
1. Money Demand: the demand for
money refers to the desire to hold
money: to keep your wealth in the
form of money, rather than
spending it on goods and services
or using it to purchase financial
assets suchfor
2.Reasons asHolding
bond orMoney
shares

The Transactions Motive: since

money is a medium of exchange
it is required for conducting
transactions.
The Precautionary Motive:
unforeseen circumstances can
arise, such as a car breakdown.
Thus individuals often hold some
additional money as a
precaution
The Speculative Motive: certain
firms and individuals who wish
to purchase financial assets
such as bonds or shares may
prefer to wait if they feel that
their price is likely to fall. In the
meantime they will hold idle
money balances instead
3.The Demand for Money Function:
the relationship between the
demand for money and the interest
rate is described by the demand for
 
money function
M d
 f (Y , i )

This expression simply states that

the demand for money is a function
d
M of income Y and the interest rate
(f)
I
= denotes the nominal money
demand
Y = denotes nominal income (GDP)
and it captures the overall level of
transactions in the economy.
In fact, it is reasonable to assume
that the overall level of
transactions is roughly
proportional to nominal income.
The positive sign above Y denotes
that there is a positive
relationship between income and
demand for money: the higher the
level of income (transactions) the
higher the demand for money
i = is the interest rate and the
negative sign above it denotes the
negative relationship between the
interest rate and the demand for
money. The higher the interest
d. Determinant of money
demand
*Level of price:
MDn (nominal Money Demand
computing based on researched
price (usually higher than based
price)
MDr (real Money Demand,
computing 
 MD n  on based price
depend
P  
(constant  MDr  MD  const
price).


 MDn 
P  
 MDr  MD  const

*Interest rate (i)
i increases (decreases) => MD
decreases (increases)
*Income (Y)

Y increases (decreases) => MD

increases (decreases)
Money demand function can be
written:
MD = k.Y–h.i
k-income-elasticity of MD
h-interest rate –elasticity of MD.
 i
kY1
h

kY0
h

MD
MD 1
0 M
0 kY0
Note:
+ i change=>quantity demanded
move along MD, otherthings being
equal.
+ Y change=>MD shift rightwards
or leftwards. Depends on income-
elastricity of money demand (k).
+ Slope of MD depends on the
interest rate –elastricity of money
demand (h). kY 1
i  MD
h h
2. Money supply

* The Determinants of Money supply

-The level of price: nominal MS
doesn’t depend on P but real MS does
because: MS n
MS n  m  H 0 MS r 
P

-Central Bank: i can change but MS

maybe constant If CentralBank
doesn’t want to change MS.
i MS
o

io Eo

MDo

0 M
3. Equilibrium in the Money
Market: the equilibrium in the
money market requires that
money supply be equal to
s
 M that
M demand,
money
d
f (YMs=Md
, i)
This
equilibrium condition tells us
that the interest rate must be
such that people are willing to
hold and amount of money
equal to the existing supply.
This equilibrium relation is also
called LM and will be discussed
in more detail in the next
lecture
*Note:

+ If I # i0 =>imbalance between
supply and demand which puts
pressure to push I up or down to
equilibrium point i0. When MS,
MD changes =>quilibrium point
(E) changes which leads to
changes of i0.
V. Monetary policy:

1. Expansionary monetary policy

2.Contractionary monetary policy

 CHAPTER VI

Inflation and unemployment

I.unemployment:

Unemployment is the number

of people of working age who
are without work, but who are
available for work at current
wage rates. If the figure is to
be expressed as a percentage,
then it is a percentage of the
total labour force.
-The labour force is defined as:
those in employment (including
the self-employed, those in the
armed forces and those on
government training schemes)
plus those unemployed.
-The labour force doesn’t include
people who are out of working
age, students, pupils, invalids.
People who are at working age
but unwilling to work doen’t
belong to labour force
 Labour force

Labou employmen
r force t
In
unemploym
Workin
Popul g age ent
ation Out of
labour
force

Out
2. Computing
unemployment rate
u - Unemployment Rate): to be
expressed by fraction of
unemployment with the total
labour force. It can be expressed
by percentage as the formula
below:
U (Unemployed): L (Labour Force):
U
u   100%
L
Unemployment is a problem
for the economy because:

Output and incomes are lost.

Human capital depreciates.
Crime may increase.
Human dignity suffers.
3. Types and causes of
unemployment:
Frictional unemployment occurs
when people leave their jobs,
either voluntarily or because
they are sacked or made
redundant, and are then
unemployed for a period of time
while they are looking for a new
job. They may not get the first
job they apply for, despite a
vacancy existing. The employer
may continue searching, hoping
to find a better-qualified
person.
Likewise, unemployed people
may choose not to take the first
job they are offered. Instead,
they may continue searching,
hoping that a better job will turn
up. The problem is that
information is imperfect.
Employers are not fully informed
about what labour is available;
workers are not fully informed
about what jobs are available
and what they entail. Both
employers and workers,
therefore, have to search:
employers searching for the
Structural Unemployment refers
to unemployment arising because
there is a mismatch of skills and
job opportunities when the
pattern of demand and production
changes. Examples in the UK
include unemployment resulting
from a decline in the production of
textiles, shipbuilding, cars, coal
and steel. Those workers who
become structurally unemployed
are available for work but they
have either the wrong skills for
Demand-deficient Unemployment
is also referred to Keynesian
unemployment. Demand-deficient
unemployment occurs when
aggregate demand falls and
wages and prices have not yet
adjusted to restore full
employment. Aggregate demand
is deficient because it is lower
than full-employment aggregate
demand which implies that output
is less than full employment
output.
Classical Unemployment
describes the unemployment
created when the wage is
deliberately maintained above
the level at which the labour
market clears. It can be caused
either by the exercise of trade
union power or by minimum
wage legislation which enforces
a wage in excess of the
equilibrium wage rate.
II.Inflation
1. Definition

Inflation is a rise in the average

price of goods over time.
The term deflation is used to
describe a fall in the average price of
goods over time.

Deflation is very rare, but when it

occurs it can cause serious problems
in the economy. The inflation rate
is the percentage change in the price
level. The formula for the annual
2. Computing inflation
Gp:price growth Pt  Pt 1
rate gp  100%
Pt 1
t-time
Pt-1: at previous time
Pt: : at current time (research
time)
P is to be expressed as follows:

P1Q1  P2 Q2  ...  Pn Qn
P
Q1  Q2  ...  Qn
Actually, P is difficult to compute, we
can compute inflation as below:
k

 i i
P t
Q 0

CPI  i 1
k

 i i
P 0

i 1
Q 0

Where CPI is the consumer price

index and t is time. The consumer
price index measures how much
more a basket of goods that
represents goods purchased by the
average householder costs today
compared with some previous time
 Name CPI (I 2005/2004) %
A 1,2 30%
B 1,4 25%
C 0,9 15%
E 1,5 30%

CPI2005=1,2x30%+1,4x25%+0,9x15%
+1,5x30%=1,295
CPI t  CPI t 1 CPIt-1:
gp  100%
CPI t 1 CPIt:
Note: CPI doesnt reflect changes in
quality of goods and services or of
new goods and services.
+ GDP (D: Deflator)
n

GDPn  i i
P t
Q t

D  100%  i 1
n
 100%
GDPr
 i i
P 0

i 1
Q t

D-GDP reflects changes in prices of

total fianl goods and services
compare with based
price,therefore, this describes
D D
inflation rate.
gp  t t 1
100%
Dt 1
Why is inflation a problem?:
When inflation is present in the
economy, money is losing its
value. The higher the inflation
rate, the higher is the rate at
which money is losing value and
this fact is the source of the
inflation problem. Inflation is
said to be good for borrowers
and bad for lenders, and so
inflation can cause inequalities
in the economy. People on fixed
incomes (e.g. pensioners and
students) tend to suffer most
from inflation.
2. Types of inflation

*Moderate Inflation: inflation rate <

10%/n¨m, prices increases slowly..

Moderate inflation can spur

production because price
increases leading to highet profit
for enterprises,therefore, firms
will increases quantity.
*Galloping Inflation: inflation rate
is from 10% to 99% per year. This
type will destroy economy and curb
engines of economy.
*Hyper Inflation: is defined as
inflation that exceeds 100%
percent per year.
Costs such as shoe-leather and
menu costs are much worse with
hyperinflation– and tax systems
are grossly distorted. Eventually,
when costs become too great
with hyperinflation, the money
loses its role as store of value,
unit of account and medium of
exchange. Bartering or using
commodity money becomes
prevalent.
In 1920s (1922-12/1923) Weimar
*Expected inflation: depends on
expectation of individuals about gp
in the future. Its impacts is small
but help to adjust production cost.

+Unexpected inflation: derives

from exogenous shocks and
unexpected factors inside
economy.
The inconvenience of reducing money
holding is metaphorically called the
shoe-leather cost of inflation, because
walking to the bank more often induces
one’s shoes to wear out more quickly.

When changes in inflation require printing

and distributing new pricing information,
then, these costs are called menu costs.

Another cost is related to tax laws. Often

tax laws do not take into consideration
inflationary effects on income.
Unanticipated inflation is unfavorable because it arbitrarily
redistributes wealth among individuals.

For example, it hurts individuals on fixed pensions. Often these

contracts were not created in real terms by being indexed to a
particular measure of the price level.

There is a benefit of inflation– many economists say that some

inflation may make labor markets work better. They say it
“greases the wheels” of labor markets.
3. Causes of inflation

Demand-pull inflation P
is caused by
AS
continuing rises in AD
in the economy. The
increase in AD may be
caused by either P1
increases in the AD1
money supply or P0
increases in G-
expenditure when the AD0
economy is close to Y*
full employment. In 0 Y
general, demand-pull
* Cost-push inflation is associated
with continuing rises in costs. Rises
in costs may originate from a
number of different sources such as
wage increases and other higher
costs
P of production (e.g. raw
materials). AS
AS
1
0

P
P
1 AD
0
0 Y
Y1 Y0 Y*
*Structural (demand-shift)
inflation arises when the pattern
of demand (or supply) changes in
the economy which results I n
some industries experiencing
increased demand whilst others
experience decreased demand. If
prices and wage rates are
inflexible downwards in the
contracting industries, and prices
and wage rates rise in the
expanding industries, the overall
price and wage level will rise. The
problem will be made worse, the
*Expectations are crucial
determinants of inflation. Workers
and firms take account of the
expected rate of inflation when
making decisions. Generally, the
higher the expected rate of
inflation, the higher will be the
level of pay settlements and price
rises, and hence the higher will be
*Inflation and Money:
the resulting actual equilibrium
rate of
point of money market
inflation.
MS n
 MS r  MDr  kY  hi
P
 In other words, if Y is fixed (from Chapter 3) because it depends
on the growth in the factors of production and on technological
progress, and we just made the assumption that velocity is constant,

MV = PY
or in percentage change form:
%
%Change
Changein
inM
M++%
%Change
Changein
inVV==%
%Change
Changein
inPP++%
%Change
Changein
inYY
if V is fixed and Y is fixed, then it reveals that % Change in M is what
induces % Changes in P.
The quantity theory of money states that the central bank, which
controls the money supply, has the ultimate control over the inflation
rate. If the central bank keeps the money supply stable,the price level
will be stable. If the central bank increases the money supply rapidly,
the price level will rise rapidly.
 The
Therevenue
revenueraised
raisedthrough
throughthe
theprinting
printingofofmoney
moneyisiscalled
called
seigniorage.
seigniorage. When
Whenthethegovernment
governmentprints
printsmoney
moneyto tofinance
finance
expenditure,
expenditure,ititincreases
increasesthe
themoney
moneysupply.
supply. The
Theincrease
increasein in
the
themoney
moneysupply,
supply,in inturn,
turn,causes
causesinflation.
inflation.Printing
Printingmoney
moneyto to
raise
raiserevenue
revenueisislike
likeimposing
imposingananinflation
inflationtax.
tax.
* Inflation and interest rate

Economists call the interest rate

that the bank pays the nominal
interest rate and the increase in
your purchasing power the real
r=i–
interest rate.

This shows the relationship

between the nominal interest rate
and the rate of inflation, where r is
real interest rate, i is the nominal
interest rate and p is the rate of
The Fisher Equation illuminates the distinction between
the real and nominal rate of interest.

Fisher Equation: i = r + 
The one-to-one relationship
between the inflation rate and
the nominal interest rate is
the Fisher Effect.
Actual (Market)
Nominal rate of Real rate Inflation
interest of interest
It shows that the nominal interest can change for two reasons: because
the real interest rate changes or because the inflation rate changes.
+gp is high=>i is up to keep
equality of r.
+Economy has high i lead to high
gp or i can explains gp of
economy.

+If real gp > expected gp =>

borrowers get advantages
+If real gp < expected gp =>
lenders get advantages
4.Policies to deal with inflation:
4.1.Fiscal policy comprises
changes in government
expenditure and/or taxation. The
aim is to affect the level of AD
through a policy known as
demand management. In the
case of controlling inflation, this
involves reducing government
expenditure and/or increasing
taxation in what is called a
deflationary fiscal policy. Such
policies are likely to be effective
if inflation has been diagnosed
4.2.Monetary policy is concerned
with influencing the money
supply and the interest rate. In
terms of controlling inflation, the
government can aim to reduce
the money supply thus reducing
spending and, therefore, the
aggregate demand, or it can
increase the interest rate so as to
increase the cost of borrowing.
Both policies can be seen as
deflationary monetary policy.
Since monetarists view the
growth of the money supply as
being the main cause of inflation,
4.3.Prices and incomes policy aim
to limit and, in certain cases,
freeze wage and price increases.
In the past they have either been
statutory or voluntary. Statutory
prices and incomes policies have
to be enforced by government
legislation, such as the EU
minimum wage legislation. With a
voluntary prices and incomes
policy the government aims to
control prices and incomes
through voluntary restraint,
possibly by obtaining the support
4.4. Supply-side policy is
concerned with instituting
measures aimed at shifting the
aggregate supply curve to the
right. Supply-side economics is the
use of microeconomic incentives
to alter the level of full
employment and the level of
potential output in the economy. If
inflation is caused by cost-push
pressures, supply-side policy can
help to reduce these cost
pressures in two ways:
(1) by reducing the power of trade
unions and/or firms (e.g. by anti-
monopoly legislation) and thereby
encouraging more competition in
the supply of labour and/or goods,
(2) by encouraging increases in
productivity through the
retraining of labour, or by
investment grants to firms, or by
tax incentives, etc.
4.5.Learning to live with inflation
involves accepting the fact that
inflation is here to stay when
standard anti –inflationary policy
measures appear ineffective. In
such a situation we just have to
learn to live with inflation.
Learning to live with inflation
involves the government,
employers and workers taking
inflation into account in their
everyday transactions. For
example, the
government/employers may use
indexation in wage/pensions
contracts. Indexation is when
 CHAPTER VI

Economic growth
I. Definition

An increase on potential output

Economic growth or
developments?
II.Computing of economic growth
*Computed by % changes in real
GDP Yt  Yt 1
gt   100%
Yt 1
+gt: according to real GDP

*gpct : by GDP per capita ( Ýn

case population increases faster
than GDP)
y t  y t 1
g pct   100%
y t 1
II. Sources of economic growth

1.Human capital

2. Capital accumulation

3. Natural resource

4.Technological knowledge
III.Theories of economic growth:

1. Classical theory of Adam Smith vµ

Malthus
Land plays an important role for
economic growth.

+Adam Smith: gold age

+Malthus: dull age

 2. Economic growth theory of
Keynes
I increases => outputs and
income increase=> capital .acc
is up=> G should invest to push
AD, lead to ecnomic growth.
ICOR (Incremental Capital-Output Ratio )

K I
ICOR  ICOR 
Y Y
Y s
where S=I 
Y ICOR
Harrod- Domar model: explains the
role of capital accumulation for
economic growth.
s S
(s  )
g Y
ICOR
*If ICOR is constant, g increases at
the rate of savings rate.
*Debates: +ICOR is not constant
+Model ignores
technology and human resources
3. Neo-classical economic growth
theory
Solow model or Solow-Swan
Model

3.1. Introduction: paper of

economic growth were issued in
2/1956 and 11-1956 of two
economists are Solow and Swan
*Why it is neo-classical theory:
use the role of market and
government
The Solow Growth Model is designed to show how
growth in the capital stock, growth in the labor force,
and advances in technology interact in an economy,
and how they affect a nation’s total output of
goods and services.

Let’s now examine how the

model treats the accumulation
of capital.
 Let’s analyze the supply and demand for goods, and
see how much output is produced at any given time
and how this output is allocated among alternative uses.

The
The Production
Production Function
Function
The production function represents the
transformation of inputs (labor (L), capital (K),
production technology) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
zY = F (zK ,zL )

Income is some function of our given inputs

Key Assumption: The Production Function has constant returns to scale.
This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )

Output is some function of the amount of

Per worker capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )

Output is some function of the amount of

Per worker capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
 MPK = f (k + 1) – f (k)
The production function shows
y how the amount of capital per
worker k determines the amount
f(k)
of output per worker y=f(k).
MPK The slope of the production function
1 is the marginal product of capital:
if k increases by 1 unit, y increases
by MPK units.
k
 1) yy == cc ++ ii

2) (1-ss)y
cc == (1- )y consumption
Output per worker investment
per worker per worker

consumption depends
on savings
per worker
rate
3) (1-ss)y
yy == (1- )y ++ ii
(between 0 and 1)

Investment = savings. The rate of saving s

4) ii == ssyy is the fraction of output devoted to investment.
 Here are two forces that influence the capital stock:

• Investment: expenditure on plant and equipment.

• Depreciation: wearing out of old capital; causes capital stock to fall.

Recall investment per worker i = s y.

Let’s substitute the production function for y, we can express investment
per worker as a function of the capital stock per worker:

i = s f(k)
This equation relates the existing stock of capital k to the accumulation
of new capital i.
The saving rate s determines the allocation of output between
consumption and investment. For any level of k, output is f(k),
investment is s f(k), and consumption is f(k) – sf(k).

y
Output, f (k)
c (per worker)
Investment, s f(k)
y (per worker)
i (per worker)

k
Impact of investment and depreciation on the capital stock: k = i –k

Change in
Capital Stock
Investment Depreciation
Remember investment equals k k
savings so, it can be written:
k = s f(k)– k

Depreciation is therefore proportional

to the capital stock.
k
Investment
and Depreciation
Depreciation, k
At k*, investment equals depreciation and
capital will not change over time. Below k*,
investment
exceeds
Investment, s f(k) depreciation,
i* = k* so the capital
stock grows.
Above k*, depreciation
exceeds investment, so the
capital stock shrinks.
k1 k* k2 Capital
per worker, k
 The Solow Model shows that if the saving rate is high, the economy
will have a large capital stock and high level of output. If the saving
Investment
and
rate is low, the economy will have a small capital stock and a
Depreciation low level of output. Depreciation, k

Investment, s2f(k)
Investment, s1f(k)
i* = k*
An
Anincrease
increasein
in
the
thesaving
savingrate
rate
causes
causesthe
thecapital
capital
stock
stocktotogrow
growtoto
aanew
newsteady
steadystate.
state.
k1* k2* Capital
per worker, k
 c*= f (k*) -  k*.
According to this equation, steady-state consumption is what’s left
of steady-state output after paying for steady-state depreciation. It
further shows that an increase in steady-state capital has two opposing
effects on steady-state consumption. On the one hand, more capital
means more output. On the other hand, more capital also means that more
output must be used to replace capital that is wearing out.
The economy’s output is used for
consumption or investment. In the steady
state, investment equals depreciation.
k k Therefore, steady-state consumption is the
Output, f(k)difference between output f (k*) and
depreciation  k*. Steady-state
c *gold consumption is maximized at the Golden
Rule steady state. The Golden Rule capital
k*gold k stock is denoted k*gold, and the Golden Rule
consumption is c*gold.
3.2. Conclusions of Solow model

+The role of savings for

economics growth

+Capital accumulation is good

for short-run economic growth

+Techonology is the
determinant of long-run
economic growth
 4. Policies for economic
growth
4.1. Increasing domestic savings and
investment

4.2. Attracting FDI

4.3. Improving human

resources
4.4. R&D of new techonology
4.5. Stability of politics and
economy

4.6. The open-door policy

4.7. Curbing growth of

population
 CHAPTER IV

The Open Economy

 Y = C + I + G + NX

Total demand Investment

is composed spending by Net exports
for domestic
of businesses and or net foreign
output
households demand
Consumption Government
spending by purchases of goods
households and services
Notice we’ve added net exports, NX, defined as EX-IM. Also, note that
domestic spending on all goods and services is the sum of domestic
spending on domestics goods and services and on foreign goods and
services.
 Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:

NX = Y - (C + I + G)

NetExports
Net Exports Domestic
Domestic
Output
Output Spending
Spending
This equation shows that in an open economy, domestic spending need
not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
falls short of domestic spending, we import the difference: net exports
are negative.
Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.

Let’s call this S, national saving.

So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX

Trade Balance
Net Foreign Investment
 Net Capital Outflow = Trade
Balance

S-I=NX
S-I=NX
If S-I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing.

If S-I and NX are negative, we have a trade deficit. We would be net

borrowers in world financial markets, and we are importing more
goods than we are exporting.

If S-I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports.
 We are now going to develop a model of the
international flows of capital and goods. Then, we’ll
address issues such as how the trade balance responds to
changes in policy.
Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on saving
and investment. We’ll borrow a part of the model from Chapter 3, but
won’t assume that the real interest rate equilibrates saving and
investment. Instead, we’ll allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend
to other countries.

Consider a small open economy with perfect capital mobility in

which it takes the world interest rate r* as given, denoted r = r*.

Remember in a closed economy, what determines the interest rate is the

equilibrium of domestic saving and investment--and in a way, the world
is like a closed economy-- therefore the equilibrium of world saving and
world investment determines the world interest rate.
 Y = Y = F(K,L) The economy’s output Y is fixed by the
factors of production and the production
function.
C = C (Y-T) Consumption is positively related to
disposable income (Y-T).
I = I (r) Investment is negatively related to the
real interest rate.
NX = (Y-C-G) - I The national income accounts identity,
or NX = S - I expressed in terms of saving and investment.
Now substitute our three assumptions from Chapter 3 and the condition
that the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.
 Real
interest S In a closed economy, r adjusts to
rate, r* equilibrate saving and investment.
NX
In a small open economy, the
r* interest rate is set by world
financial markets. The difference
between saving and investment
rclosed determines the trade balance.
r*'
I(r)
NX
Investment, Saving, I, S
In this case, since r* is above rclosed and saving exceeds investment,
there is a trade surplus.
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.

Real
interest S' S
NX = (Y-C(Y-T) - G) - I (r*)
rate, r*
NX = S - I (r*)

The result is a reduction in national

saving which leads to a trade deficit,
r* where I > S.

NX I(r)
Investment, Saving, I, S
 A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
Real
interest S
rate, r*
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
r2*
where S > I.
r1* NX

I(r)
Investment, Saving, I, S
An outward shift in the investment schedule from I(r)1 to I(r)2 increases
the amount of investment at the world interest rate r*.
As a result, investment now
Real exceeds saving I > S, which
interest S means the economy is
rate, r* borrowing from abroad and
running a trade deficit.

r1*
I(r)2
NX I(r)1
Investment, Saving, I, S
In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!
Let’s think about when the US and Japan engage in trade. Each country
has different cultures, languages, and currencies, all of which could
hinder trade. But, because of the foreign exchange market, trade
transactions become more efficient. The foreign exchange market is a
global market in which banks are connected through high-tech
telecommunications systems in order to purchase currencies for their
customers.
The next slide is a graphical representation of the flow of the trade
between the U.S. and Japan, and how the mix of traded things might be
different, but is always balanced. Also, notice how the foreign exchange
market will play the middle-man in these transactions. For instance, the
foreign exchange market converts the supply of dollars from the U.S.
into the demand for yen, and conversely, the supply of yen into the
demand for dollars.
 In order for the U.S to pay for its imports of
goods and services and securities from Japan,
it must supply dollars which are then converted
into yen by the
V IC E S foreign
& SE R &
Securities
O O D S exchange
G
market.
DemandYEN Supply$
Foreign
Foreign
Exchange
Exchange
Market
Market
SupplyYEN Demand$
Goods and
Services ES
URI TI
& SEC

In order for Japan to pay for its imports of

goods and services and securities from the
U.S., it must supply yen which are then converted
into dollars by the foreign exchange market.
The exchange rate between two countries is the price at which
residents of those countries trade with each other.
 -relative price of the currency of two countries
-denoted as e

-relative price of the goods of two countries

-sometimes called the terms of trade
-denoted as 
The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.
Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?

e S$ D$ shifts rightward and increases

the nominal exchange rate, e.
e1 This is known as appreciation
B
A of the dollar.
e0
Events which decrease the
demand for the dollar, and thus
D  decrease e would be a
$

D$ depreciation of the dollar.

$
Dollar Value of Transactions
 
The real exchange rate is the relative price of the goods of two
countries. That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.

To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange 2
American cars for 1 Japanese car.
 
We can summarize our calculation as follows:
Real Exchange Rate = (120 yen/dollar)  (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 Japanese Car
American Car
At these prices, and this exchange rate, we obtain one-half of a Japanese
car per American car. More generally, we can write this calculation as
Real Exchange Rate =
Nominal Exchange Rate  Price of Domestic Good
Price of Foreign Good
The rate at which we exchange foreign and domestic goods depends on
the prices of the goods in the local currencies and on the rate at which
the currencies are exchanged.
 Nominal
Real Exchange Exchange Ratio of Price
Rate Rate Levels

 = e × (P/P*)
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).
 Real Exchange Nominal Exchange Ratio of Price
Rate Rate Levels

 = e × (P/P*)

The real exchange rate between two countries is computed from the
nominal exchange rate and the price levels in the two countries. If the
real exchange rate is high, foreign goods are relatively cheap, and
domestic goods are relatively expensive. If the real exchange rate is
low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.
How does the level of prices effect exchange rates? It doesn’t. All
changes in a nation’s price level will be fully incorporated into the
nominal exchange rate. It is the law of one price applied to the
international marketplace.
Purchasing Power Parity suggests that nominal exchange rate
movements primarily reflect differences in price levels of nations. It
states that if international arbitrage is possible, then a dollar must
have the same purchasing power in every country. Purchasing
Power Parity does not always hold because some goods are not
easily traded, and sometimes traded goods are not always perfect
substitutes– but it does give us reason to expect that fluctuations in
the real exchange rate will be small and short-lived.
Real The law of one price applied to the
exchange S-I international marketplace suggests that
rate,  net exports are highly sensitive to small
movements in the real exchange rate.
This high sensitivity is reflected here
with a very flat net-exports schedule.

NX()

Net Exports, NX
 The relationship between the real exchange rate
and net exports is negative: the lower the real
Real S-I exchange rate, the less expensive are domestic
exchange goods relative to foreign goods, and thus the
rate,  greater are our net exports.
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
Here the quantity of dollars
NX() supplied for net foreign
investment equals the
0 Net Exports, NX
quantity of dollars demanded
for the net exports of goods
and services.
Real S2-I S1-I Expansionary fiscal policy at home, such as an
exchange increase in government purchases G or a cut in
rate,  taxes, reduces national saving.
The fall in saving reduces the supply of dollars
to be exchanged into foreign currency, from
2 S1-I to S2-I. This shift raises the equilibrium real
exchange rate from 1 to 2.
1
NX() A reduction in saving reduces

NX2 NX1 Net Exports, NXthe supply of dollars which

causes the real exchange rate
to rise and causes net exports
to fall.
Real S-I(r1*) S-I (r2*) Expansionary fiscal policy abroad reduces
exchange world saving and raises the world interest
rate,  rate from r1* to r2*.
The increase in the world interest rate reduces
investment at home, which in turn raises the
supply of dollars to be exchanged into foreign
1
currencies.
2 As a result, the equilibrium
NX() real exchange rate falls from
1 to 2.
NX1 NX2 Net Exports, NX
Real S-I2 S-I1 An increase in investment demand raises
exchange the quantity of domestic investment from I1
rate,  to I2.
As a result, the supply of dollars to be
exchanged into foreign currencies falls
from S-I1 to S-I2.
2
This fall in supply raises the
1 equilibrium real exchange
NX() rate from 1 to 2.

NX2 NX1 Net Exports, NX