Introduction To Macroeconomics

What is Economics?
• Economics is the bridge between

Philosophy and Statistics.
Introduction to
Macroeconomics – Philosophy How the world works
– Statistics If I show this, I can say with
Brian Dempsey
certain probability this
Instructor – Economics I think the world works this way
with some probability.
Book Definition Two Branches of Economics

• Economics is the study of how a society • Microeconomics: The study of individual
uses it’s limited or scarce resources. economic agents (households, firms, etc.)
and their interactions
– Society: An economy is a group of people
– Uses: How do we decide • Macroeconomics: The study of an
– Limited or scarce resource: We all want Economy (or society) as a whole or the
everything, but we can’t produce it. aggregate (total)
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Two Types of Questions Scientist vs. Preacher
• Positive Analysis: A claim about how the • Economists answer questions
world is (descriptive).
• Normative Analysis: A claim about how the • Need question, so use philosophy
world should be (subjective).
• Positive statements can be proven given • Need answer, so use statistics
the data.
• Normative statements depends on our
values.
Problems with Statistics Microeconomic Foundations

• Cause vs. Effect Economic Models
Theory in the language of math
• Omitted variables Make assumption about economic agents
• Reverse Causality What is the objective of people

Be Happy – called utility
• Need theory as a guide What makes us happy – consuming goods
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Principle #2 The cost of something
Principle #1 People face tradeoffs
is what you gave up to get it
Consuming goods makes us happy.
The cost of something isn’t it’s price.
Can’t buy everything, so must decide what That’s 20 dollars?
to buy.
It’s what you can buy with it.
So how do you decide what to buy?
Opportunity Costs
Whatever makes you happiest Shown using budget constraints
Principle #3 Rational people think Principle #4 People respond to

on the margin incentives
Marginal means edge People’s objective is to be as happy.
Marginal changes are incremental or small
additional changes from where you are. People will alter their behavior when there is
Can show happiness or utility graphically a change in the marginal benefit or
using indifference curves, and thus marginal cost, to make themselves as
marginal benefit. happy as possible.
Together, indifference curves and budget
constraints show how a person makes Can show using budget constraints and
consumption decisions indifference curves.
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Principle #6 Markets are usually a
Principle #5 Trade can make
good way to organize economic
everybody better off
activity
People’s objective is to be as happy, so why Prices reflect relative cost and benefit.
trade? Because it makes us happier.
People react to prices to make them as happy as
Why do we trade with Peru? possible. When everybody is as happy as
possible, society is as happy as possible.
Comparative vs. Absolute

Would the Benevolent Social Planner want the
Advantage same outcome?
Principle #7 Government can Principle #8 Standard of living

improve market outcomes depends on ability to produce
Why would a free market outcome be different What does the ability to produce goods and
then what the Benevolent Social Planner would services have to do with standard of living?
want?
Market Failures In Macroeconomic models, output and income are
1) Externality the same thing.
2) Market Power
3) Asymmetric Information The more productive you are, the more you can
4) Public Goods produce, and thus the more income you earn.
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Principle #10 There is a tradeoff
Principle #9 Prices rise when the
between inflation and
government prints to much money
unemployment
Money is only good to purchase things with. If an economy expands to fast, prices rise. This is
called Inflation.
If the government prints more money, then
there is more money to purchase the If an economy expands to slowly, people lose their
jobs or can’t find jobs. This is called
same amount of goods, therefore people unemployment.
bid up the price of those goods.
Policy makers can speed up or slow down an
economy, therefore they can influence inflation
The rise in the overall price level is called and unemployment, but they can’t lower both at
inflation. the same time.
The Data of Macroeconomics

Economic Models
Measuring Economic Activity
• Circular Flow Economics is a philosophy, so what is the
big question?
• Production Possibility Frontier (PPF)
Are we happy?
Both models show the relationship between How are we doing?

goods and services and income
Is the economy healthy?
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GDP is the market value of all final goods
Measuring Economic Activity and services produced within a country in a
given time period
Economic activity is measured using a
variable called Gross Domestic Product. “GDP is the market Value”
We want to see how much stuff we have,
Gross Domestic Product (GDP) measures but how do you add apple and oranges.
the total expenditure on the economy’s
output of goods and services, it also “of all”
measures the total income of everybody in Try to incorporate all things produced, but
the economy. not everything is sold in a market.
GDP is the market value of all final goods GDP is the market value of all Final goods
and services produced within a country in a and services produced within a country in a
given time period given time period
“final” “produced”
Not all transactions are included in GDP. We want to measure economic activity in a
If we did, some goods and services would given time period, so the good must be
be counted more than once made in the present time period.
“goods and services” “within a country”

Includes tangible output (goods) and We want to try to measure economic
intangible actions (services) activity within a certain area.
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GDP is the market value of all Final goods
and services produced within a country in a A closer look at GDP
given time period
“in a given period of time” Y = P1Q1 + P2Q2 + P3Q3 + P4Q4 + …..
We want to measure the value of production in a
specific period of time. This can measure can increase for two
reasons, P↑ or Q↑.
Measures the flow of income or expenditures But if P↑, we don’t have more stuff, this is
during that time interval.
not a good measure of economic activity
or economic well-being.
Can compare how we are doing from year to
year. Call this Nominal GDP
A closer look at GDP A closer look at GDP

Real GDP: the measure of the production of goods Together Real GDP and Nominal GDP gives
and services at some base year prices us the GDP deflator
Ex. Base Year = 1998
1998 Real GDP = (Pe98*Qe98) + (Ps98*Qs98)
GDP Deflator = (Nominal GDP/Real GDP)*100
So in the base year, Real GDP and Nominal GDP
are the same, so the GDP Deflator equals 100
Since the same prices are used for each year,
Real GDP can only change with changes in Q.
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A closer look at GDP The components of GDP
(Real GDP)*(GDP Deflator) = Nominal GDP Consumption (C) – Goods and services
bought by households
Measures Measures
quantities prices
1) Nondurable goods – Goods that last
for only a short period of time.
2) Durable goods – Goods that last a
long period of time.
3) Services – Work done for consumers
The components of GDP The components of GDP

Investment (I) – Goods for future use to Government Purchases (G) – Goods and
produce more goods and services. services bought by the government.
Includes military equipment, highways,
1) Business Fixed Investment – New plant salaries for government workers.
and equipment
2) Residential Fixed Investment – New Does not include social security or welfare,
housing by households and landlords
because they are not paid for exchange in
3) Inventory Investment – Increase in firms goods or service.
inventory
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The components of GDP GDP Continued
Net Exports (NX) – Value of all of the goods Ways to calculate GDP
and services exported (EX) minus all of Income – Add up everybody’s income from wages, rents
the goods and services imported (IM) and profits
Final Goods – Add up all the expenditures on

Y = C + I + G +NX consumption, investment, government expenditures and
net exports
Value Added – Looks at each stage of production or at

intermediate goods.
GDP Continued GDP Continued

Value Added = Revenue – Cost of intermediate goods What does GDP actually tell us?
Let’s see how V.A. is related to the income.
Holding all else equal (ceteris paribus),
higher GDP leads to a better life
Revenue = wages + interest payments + indirect taxes
+ cost of intermediate goods + profits What should our goal for GDP be?
Revenue - cost of intermediate goods = wages + interest
payments + indirect taxes + profits Realistic Goal for Real GDP – To be as
Value Added = wages + interest payments + indirect taxes high as possible without accelerating
+ profits inflation (over stimulated economy)
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The Full Sustainable Level of Real
GDP Continued
GDP (YF)
The Full Sustainable Level of Real GDP YF is unobservable
The maximum level of real GDP the YF historically grows at 2.5% per year (U.S.)
economy can produce without bringing on
accelerating inflation. Unfortunately doesn’t grow at a steady 2.5%
Sometimes faster, sometimes slower
Also known as Potential GDP (Full GDP or YF) (recessions and depressions)
The Full Sustainable Level of Real

Measuring the Cost of Living
GDP (YF)
What affects the Full Sustainable level of You could actually buy something with a
real GDP nickel?
Labor Productivity
Calculate Consumer Price Index (CPI) to
Capital Stock measure the change in prices.
Labor Force The %Δ in the price level from one time

period to the next is called inflation.
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Measuring the Cost of Living Measuring the Cost of Living
Consumer Price Index (CPI) – A measure of the overall CPI ex. Step 2) Find the prices
cost of the goods and services bought by a typical Step 1) Fix the Basket
consumer. Quantity of Steaks (Qs) = 2 2000 2001 2002 2003
Quantity of Eggs (QE) = 4
Price of Steak $2.00 $2.00 $2.24 $2.28
The 5 steps in calculating the inflation rate. Quantity of Bacon (QB) = 8
1) Fix the basket Price of Eggs $0.50 $0.60 $0.74 $0.76

2) Find the prices
Price of Bacon $0.25 $0.20 $0.08 $0.15
3) Compute the basket’s cost
4) Choose the base year and compute index
5) Calculate the inflation rate

CPI example continued CPI example continued
Step 3) Compute the basket’s cost Step 4) Choose a base year (2000) and
QS PS + QE PE + QB PB = compute the CPI
2000 (2)(2.00) + (4)(0.5) + (8)(0.25) = 8 2000 (8.00/8.00)*100 = 100
2001 (2)(2.00) + (4)(0.6) + (8)(0.20) = 8 2001 (8.00/8.00)*100 = 100
2002 (2)(2.24) + (4)(0.74) + (8)(0.08) = 8.08 2002 (8.08/8.00)*100 = 101
2003 (2)(2.28) + (4)(0.76) + (8)(0.15) = 8.8 2003 (8.80/8.00)*100 = 110
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CPI example continued Other indexes besides CPI
Step 5) Calculate the inflation rate
Problems with CPI
2001 (100 – 100/100)*100 = 0% 1) substitution bias
2002 (101 – 100/100)*100 = 1% 2) new products
2003 (110 – 101/101)*100 ≈ 8.9% 3) change in quality
Measuring the Cost of Living Inflation

CPI vs. GDP Deflator So why do we care about inflation?
1) It erodes the purchasing power of money
1) All goods vs. Household goods Why hold money?
Why lend money?
2) Domestic goods vs. Imported goods 2) It erodes people’s standard of living

3) Costs to society as a whole
3) Fixed weights vs. changing weights
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Inflation Unemployment
What should the goal for inflation be? What is our most important resource? People
We care about labor markets because of

Idealistic Goal for inflation rate = 0%
Efficiency
Equity
Realistic Goal (US): |Inflation rate| < 3%
How do we identify or measure if our labor
resources are underutilized?
Unemployment Unemployment
Classify adult population (age 16 and over) Based on the previous definitions, several
into 3 categories variables to see how our labor resources
Employed: if you worked anytime in the are being used are calculated.
last week for a paid job
Unemployed: if you are on temporary The Labor Force = the number of employed
layoff or looking for a job people + the number of unemployed
Not in the Labor Force: if you do not fit in people
either category above
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Unemployment Variables Goal for Unemployment
Unemployment Rate (U)= Ideal Goal for Unemployment = 0
(# of people unemployed/Labor Force)
Realistic Goal for Unemployment = As low
Labor Force Participation Rate = as possible without accelerating inflation.
(Labor Force/Adult Population)
Natural Rate of Unemployment (UN) – The
Employment-Population Ratio = lowest unemployment rate the economy
Employed People/Adult Population can achieve without accelerating inflation
Interpreting the level of Interpreting the level of

unemployment unemployment
U = UN → Desired state of the economy What is the Natural Rate of Unemployment
in the United States?
U > UN → Sluggish economy
Historically = 5.5%
U < UN → Accelerating Inflation
(over-stimulated economy) Could it be 5%?
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Interpreting the level of
Labor Market Variables
unemployment
Real GDP and the Unemployment Rate Wages & Salary – Total amount of monetary
payment received by labor for their
U = UN ↔ Y = YF Desired Economy services over a given year
U > UN ↔ Y < YF Sluggish Economy Labor Compensation – Total wages, salaries

and benefits received by labor over a
given year
U < UN ↔ Y > YF Overstimulated Economy

An Application
Nominal Wage Rate (w) U.S. Labor Force Participation Rate
Overall Male Female
w = Total Labor Compensation / Total Labor Hours 1960 59.4% 83.3% 37.7%
1970 60.4% 79.7% 43.3%
Labor Productivity 1980 63.8% 77.4% 51.5%
1990 66.5% 76.4% 57.5%
Productivity = Total Output / Total Labor Hours 1999 67.1% 75.7% 60.0%
Source: Economic Report of the President Feb. 2000
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Problems with the Unemployment Problems with the Unemployment
Rate Rate
What does the unemployment rate actually Is Unemployment a short term or long term
measure? condition? Depends on how you look at it.
Misreporting Example: 10 people were unemployed in 1 year
Discouraged Workers 8 for 1 month and 2 for 12 months
Part-Time Workers 8/10 (80%) of people who were unemployed were

Multiple Jobs unemployed for 1 month – Short Term
24/32 (75%) months of unemployment is from people

who were unemployed all year – Long Term
Types of Unemployment AD-AS Model

Total Unemployment = Frictional + Macroeconomics is the study of a society or
Structural + Demand Deficit economy as a whole
Frictional – Sectoral Shifts The variables of interest are output/income,

Structural – Wage Rigidity the cost of output, and the efficient use of
Minimum Wage resources, especially labor
Unions Collective Bargaining
Efficiency Wage That is why we measure GDP, Inflation, and
Demand Deficit – Sluggish Economy unemployment
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AD-AS Model AD-AS Model
Now that we know what are the variables of interest and The purpose of the Aggregate Demand –
how we calculate them, we want to explain why they
occur and how to predict them in the future Aggregate Supply model:
To do this we build economic models. Models are theories

of how the world works in the language of math To predict and explain the behavior of Real
GDP (Y) and the Price Level (P).
One model used to explain the economy as a whole is the
Aggregate Demand-Aggregate Supply Model
Together we can use this information to
predict and explain Unemployment (U)

Prices – The higher the price level, the less we intend to purchase,
Defining the Terminology holding all else equal (ceteris paribus)
P↑ → AD↓
Aggregate Demand (AD) – The sum of all
Aggregate Expenditures (AE) – The desire to purchase quantities of
the newly produced U.S. final goods and newly produced final goods and services, apart from price
considerations.
services that Consumers, Businesses,
Government, and Foreigners intend to If your desire to purchase increases, how much you intend to purchase
increases, holding all else equal (ceteris paribus)
purchase (i.e. Real GDP Demanded)
AE↑ → AD↓
So what are the factors that determine AD?
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Formalizing the theory of Aggregate Demand Changes in Aggregate Expenditures is
shown by a shift in Aggregate Demand
Graph Aggregate Demand against one of it’s
causes – the price level (variable of interest)
Changes in Aggregate Expenditures is
different than changes in the price level is
Inverse relationship implies that AD is downward
because the price level is a variable on the
sloping on Price/Output Quadrant
graph
Changes in the Price level is a movement along
the curve and the curve is drawn assuming all
other causes are constant

Changes, other than the price level, that Modeling Aggregate Expenditures (AE)
make AD increase is shown by a rightward
shift of the AD curve, or an increase in AD AE = C + I +(G-T) + (EX – IM)
Close to the definition of Real GDP except it

Changes, other than the price level, that subtracts out taxes
make AD decrease is shown by a leftward Increases in C,I,G, or EX increases AE and thus
shift of the AD curve, or an decrease in AD increases AD
Increases in T or IM decreases AE and thus
decreases AD
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Modeling Aggregate Expenditures (AE) How Aggregate Supply is modeled depends
on what time frame is being used. Let’s
AE = C + I +(G-T) + (EX – IM) start in the short run
The causes of AE are the causes of C, I, Short Run Aggregate Supply (AS)
(G-T), (EX – IM) – Discuss later The sum of all newly produced domestic
final goods and services that firms wish to
produce (real GDP supplied) given
A change in any of them shifts the AD curve inflexible input prices.

Causes of Short Run Aggregate Supply Formalizing the theory of Short Run Aggregate Supply
Price Level P↑ → AS ↑ Graph AS against one of it’s causes – the price level
(variable of interest)
Nominal Wage Rate (w) w↑ → AS↓
Positive relationship implies that AS is upward sloping on
Price/Output Quadrant
Price of Energy (PE) PE↑ → AS↓
Changes in the Price level is a movement along the curve
Other production related causes like labor and the curve is drawn assuming all other causes are
productivity constant
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The shape of the AS curve describes different magnitudes Changes in w, PE, or any cause other than
of response to increases in the price level (P)
price is shown by a shift of the AS curve
The first segment, an increase in the price level generates
large output responses
Like with Aggregate Demand, changes in
The second segment, an increase in the price level the price level is because the price level is
generates moderate output responses
a variable on the graph
The last segment, an increase in the price level generates
small output responses

Changes, other than the price level, that Bringing AD and AS together
make AS increase is shown by a rightward By themselves, neither AD or AS can tell us what P or Y

shift of the AS curve, or an increase in AS will be. They just describe relationships (1 equation, 2
unknowns)
Changes, other than the price level, that Together they give us the equilibrium level of P and Y
(known as P* or Y*). At equilibrium is where real GDP
make AS decrease is shown by a leftward and the Price Level will settle, given that the strategies of
shift of the AS curve, or an decrease in AS demand and suppliers play out. There is no pressure for
P and Y to change.
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If the Price level isn’t at P*, natural market Examples of changes to Equilibrium
forces bring the Price level and real GDP
into equilibrium. P* and Y* are the actual War
Price level and real GDP predicted by
theory.
Firm’s views on the economy
Shifts in AD or AS curves will change the
equilibrium and thus change P* and Y* Change in energy Prices

In many economic models, there is the assumption When there is market failures in
about market efficiency macroeconomics, wages and the price of
energy do not change with changes in the
Assume that there is no market failures Price Level
(i.e. markets function smoothly and quickly to
coordinate choices)
This describes our upward sloping AS curve
When there are market failure, the nominal wage
rate and energy prices do not adjust to The main implication of this is that Y* does
macroeconomic conditions not have to equal YF
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Long Run Aggregate Supply (LAS) – The Long Run Aggregate Supply (LAS)
sum of all the newly produced domestic Characteristics
final goods and services that firms wish to
produce when all microeconomic
adjustments have been completed under Unaffected by the Price level – Why?
our assumptions (i.e. No market failures or
input prices have time to adjust to Affected by production oriented variables
macroeconomic conditions)

Formalizing Long Run Aggregate Supply
Putting the Model all together
The LAS curve is vertical when plotted against the
Price level (P)
The role of economic policy makers is to get
The LAS curve is vertical at the full sustainable Y* as close as possible to YF
level of real GDP (YF)
Keynesian vs. Classical Trying to push Y* to far causes the wage

price spiral
AS vs. LAS
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AD-AS Model Causes of Aggregate Demand
The short run goal is to get Y* as close as possible What are the causes that shift AD?
to YF
Aggregate Expenditures
The long run goal is to increase LAS or YF
AE = C + I +(G-T) + (EX – IM)
Some policies may be good for attaining one goal
but not the other
The causes of the components of AE,
Short run fluctuations causes Y* not to equal YF, causes AE to change and thus causes AD
therefore we concern ourselves with AD to change
Causes of Aggregate Demand Causes of Aggregate Demand

Causes of Consumption (C) Causes of Consumption (C)
Aggregate Income (Y)

Aggregate Income (Y), appears on the graph, Y →
Y↑ → C↑
C relationship affects the shape of the AD curve
Wealth
Wealth↑ → C↑ Changes in wealth and consumer confidence
make up autonomous consumption
Consumer Confidence (CC) (consumption due to causes other than Y) and
CC↑ → C↑ shift the AD curve
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Causes of Investment Causes of Investment
Investment is primarily made up of business

purchases of new plant and equipment and the How much Investment is a result from the
purchase of new housing behavior in the Capital Markets
These large expenditures create the need for long-

term borrowing. Borrowing is done through Capital Markets – The demand and supply
financial intermediaries such as banks or issuing for financial capital needed to finance
bonds and stocks in the Capital Markets purchases of plant and equipment (I)

Major causes for the Demand for Financial Capital (DI) Formalizing the Demand for Financial Capital (DI)
Nominal (long-term) interest rate (i) Graph against one of it’s major causes – the nominal
interest rate (i)
i↑ → DI↓
The inverse relationship implies that the curve is downward
Expected Inflation Rate (πe) sloping
π e ↑ → DI ↑
Changes in i are described as a movement along the curve
Business Confidence (BC)
BC↑ → DI ↑ The graph is drawn assuming that the other causes are
constant (ceteris paribus)
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Formalizing the Demand for Financial Capital (DI) Major causes for the Supply of Financial Capital (SI)
Nominal (long-term) interest rate (i)

Changes in causes other than i are shown as
i↑ → SI ↑
shifts of the DI curve
Expected Inflation Rate (πe)
Changes that increase the Demand for Financial π e ↑ → SI ↓
Capital shift the DI curve to the right
People’s willingness to Save (S)
Changes that decrease the Demand for Financial S↑ → SI ↑
Capital shift the DI curve to the left

Other causes for the Supply of Financial Capital Formalizing the Supply of Financial Capital (SI)
Graph against one of it’s major causes – the nominal

Monetary Policy – Affects banks ability to loan interest rate (i)
money
The positive relationship implies that the curve is upward
Foreigners willingness to buy US bonds and sloping
stock (Capital Flow)
Changes in i are described as a movement along the curve
The graph is drawn assuming that the other causes are

constant (ceteris paribus)
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Formalizing the Supply of Financial Capital (SI) Equilibrium in the Capital Markets
Investment (I*) occurs when the Demand for Financial

Changes in causes other than i are shown as Capital (DI) equals the Supply of Financial Capital (SI)
shifts of the SI curve
Shifts in the Demand or the Supply of Financial Capital
Changes that increase the Demand for Financial results in a change in Investment (I*)
Capital shift the SI curve to the right
Because they change Investment, they also change
Aggregate Demand, and P* and Y* as a result
Changes that decrease the Demand for Financial
Capital shift the SI curve to the left

The Government Budget Position (G-T) Federal Budget – Notation
The Federal Budget = Tax Revenues – T = Net Taxes = Tax Revenues – (Transfer
Government Expenditures Payments + Interest on National Debt)
The Federal Budget = Tax Revenues – G = Government Purchases of goods and services
(Government Purchases of goods and
services + Transfer Payments + Interest Federal Budget = (T – G)
on the National Debt)
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Describing the Federal Budget Government Budget Position (G – T) is the
opposite of the Federal Budget.
(T – G) < 0 – Budget Deficit An increase Government Purchases (G) increases

the demand for domestic goods and services
and thus increases AD.
(T – G) > 0 – Budget Surplus
An increase in Net Taxes (T) takes income away
(T – G) = 0 – Balanced Budget from households and thus lowers how much
they can purchase and thus decreases AD.

Government Budget Position (G – T) Government Budget Position (G – T)
Government Purchases (G) and Net Taxes (T) are

policy variables The Government Budget Position (G – T)
and the economy, an example, war
They are basically controlled by the government
But what happens when G↑ and T doesn’t
Government Purchases (G) and Net Taxes (T)
change for economic policy purposes (called
Fiscal Policy) and other reasons as well
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Net Exports (NX) Causes of Net Exports (NX)
World Output or Income (YW)

Net Exports (NX) = (EX – IM), therefore we YW↑ → EX↑ → NX↑
must consider the causes for both exports
and imports US Output or Income (Y)
Y↑ → IM↑ → NX↓
For simplicity, we will assume only two The Exchange Rate (e)
countries, the US and the rest of the world. e↑ → NX↓

Exchange Rate (e) – The amount of foreign Types of Exchange Rates
currency needed to be exchanged for one
(US) dollar. Bilateral Exchange Rates – exchange rate
between the US and an individual country
Also known as the “value of the dollar”.

Multilateral (trade weighted) Exchange rate –
weighted average of bilateral exchange rates
Conversion Ratio is expressed as an index (This is a
macroeconomic measure of exchange rate)
(Foreign currency)/(US dollar)
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Net Exports (NX) Net Exports (NX)
As e↑ → Price of American goods & services to foreigners↑ If e↑ (we have an appreciating dollar or a stronger dollar)
Price of foreign goods & services to Americans↓ → EX ↓, IM ↑ →(EX – IM) ↓
As e↓ → Price of American goods & services to foreigners↓ If e↓ (we have an depreciating dollar or a weaker dollar)
Price of foreign goods & services to Americans ↑ → EX ↓, IM ↑ →(EX – IM) ↓

Causes of Net Exports (NX) Net Capital Outflow
There are two things that Americans can do with S = I + NCO → NCO = S – I
their saving. Finance the purchase of domestic
capital or finance the purchase of an asset The ability to loan and borrow money from other countries
abroad allows Output and Domestic Spending to Differ
Net Capital Outflow – The purchase of foreign Y = C + I + G + NX

assets by domestic residents minus the
purchase of domestic assets by foreigners Y - (C + I + G) = NX
(Also called Net Foreign Investment) Output Domestic Spending Net Exports
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Causes of Aggregate Demand Aggregate Supply
Net Exports & Net Capital Outflow Causes of Short Run Aggregate Supply
The international flow of goods and services Price Level P↑ → AS ↑

is equal to the international flow of
financial capital
Nominal Wage Rate (w) w↑ → AS↓
This is because every time there is a
purchase of a good or service there is a Price of Energy (PE) PE↑ → AS↓
transfer of assets
Aggregate Supply Aggregate Supply

Causes of Short Run Aggregate Supply Upward sloping when plotted against P
Labor Productivity (Prod) Changes in a cause other than P is described as a

shift of the AS curve
PROD ↑ → AS ↑
Changes in variables that enhance production shift
Capital Stock (K) – All of the existing plant and the AS to the right
equipment used by firms to produce goods and
services Changes in variables that hinder production shift
K ↑ → AS ↑ AS to the left
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Supply effects on the economy Formalizing Long Run Aggregate Supply
Supply shock – Price of Energy (PE) ↑ The LAS curve is vertical when plotted
against the Price level (P)
The magic variable – Labor Productivity ↑
The LAS curve is vertical at the full
Wage Price Spiral – Labor market reaction sustainable level of real GDP (YF)
to aggressive policy

Causes of Long Run Aggregate Supply Causes of Long Run Aggregate Supply
Size of the Labor Force

Labor Productivity (Prod)
Labor Force ↑ → LAS ↑
PROD ↑ → LAS ↑
Attitudes Towards Work
Capital Stock (K) – All of the existing plant and Work ↑ → LAS ↑
equipment used by firms to produce goods and
services Transfer Payments (TP)
K ↑ → LAS ↑ TP ↑ → LAS ↓
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What makes LAS and YF grow What makes LAS and YF grow
Steady Growth in the following variables Example: Productivity Boom
Labor Force
Suppose an increase in technology (e.g.
Capital Stock Accumulation computerization) makes labor more productive
Labor Productivity
Productivity growth increases, shifts LAS curve to the
Historically in the US, the average growth rate of right more than usual
YF is 2.5%
Therefore YF grows more than 2.5%
This is good for a developed country but it is not This implies that actual Real GDP (Y*) can enjoy higher
the same for all countries in the world growth without accelerating inflation
Economic Policy Economic Policy

What is economic policy? Diagnosing the Economy (Review)
overt intervention taken to improve a economy
currently operating with problems Y* < YF – Sluggish Economy
Why have economic policy? Y* > YF – Economy with accelerating

Because the economy is not in the desired state. inflation
“Medicine” given to cure a “sick” economy Y* = YF – Economy with constant inflation

(desired state)
32
Strategies for Policy Economic Policy in more formal terms
Purpose – To move Y* closer to YF

Expansionary Policy – Policy designed to
address a sluggish economy (Y* < YF) Expansionary Policy – (policy for Y* < YF), seeks
to increase spending on goods and services, or
shift the AD curve to the right
Contractionary Policy – Policy designed to
Contractionary Policy – (policy for Y* > YF), seeks
address an overstimulated, or accelerated to decrease spending on goods and services, or
inflationary economy (Y* > YF) shift the AD curve to the left

Challenges to using economic policy Can the economy cure itself?
Short-Run Perspective
1) Can the economy cure itself instead? (equilibrium in AD-AS model): Y* does not
necessarily equal YF, economy needs policy
(interventionist position)
2) Avoiding excessive expansion and the
wage-price spiral. Long-Run Perspective
(equilibrium in AD-LAS model): Y* = YF economy
3) Reacting to adverse supply shocks. can cure itself, no need for policy
(non-interventionist position)
33
Movement to the Long-Run Supply of Labor (NS) – peoples desire to
offer their labor services based upon the
Consider the Labor Market – The demand wage rate and other causes.
and supply of labor employment W↑ → NS ↑
Demand for Labor (ND) – firms desire to hire Labor Market Equilibrium (N*) – where labor
workers based upon the wage rate and
other causes. demand equals labor supply. At N*, there
is no demand-deficit unemployment.
W↑ → ND ↓

The economy curing itself in the Long-Run The economy curing itself in the Long-Run
Example 1 – sluggishness (Y* < YF), and Example 2 – accelerating inflation (Y* > YF), and
correspondingly, having demand deficit correspondingly, having U < UN
unemployment
Problem – nominal wage rate (W) is too high Problem – nominal wage rate (W) is too low
Solution – allow W to decrease, until N = N*. Solution – allow W to increase, until N = N*. When
When that occurs, simultaneously Y* = YF that occurs, simultaneously Y* = YF
34
Why do we call for Policy? Avoiding the wage-price spiral
United States – Late 1960’s to Early 1970’s

Keynes famous quote – “In the Long-Run, We’re All Dead”.
Excessive demand policy – shifts the AD curve rightward too far, Y* >
YF, accelerates inflation, increases inflation expectations
The Great Depression and the Employment Act of 1946
Labor seeks above-normal increases in nominal wage rates (W) to
protect themselves, AS curve shifts to left
The 1992 election – Bush versus Clinton
As a result, Y* returns to previous level, call for further expansionary
Policy successes – Volker (1980s) and Greenspan (1991- policy
2000)
Process keeps repeating itself

Avoiding the wage-price spiral Reacting to Adverse Supply Shocks
Use policy judiciously, be careful of overshooting United States Experience – 1973 & 1978
where Y* exceeds YF, don’t arouse inflation
fears. Adverse supply shock – large increase in the price
of energy (PE), shifts AS curve to the left
Be watchful for nominal wage rate increases when
deciding to use policy. Refrain from As a result, Y* decreases and P* increases
expansionary policy if nominal wage increases
are larger than normal. Pressure for expansionary policy to “fix economy”
35
Expansionary policy shifts AD curve to the Reacting to Adverse Supply Shocks
right, creates further inflation, arousing Lessons learned
inflation fears as well
Labor seeks higher above-normal increases Don’t react – standard demand policy will
in the nominal wage rate (W) to protect not help the situation
themselves, shifting the AS curve leftward
Calls for alternative strategy – energy policy
The wage-price spiral again
Economic Policy Financial Institutions

Types of Policy From Chapter 13
Monetary Policy – The Federal Reserve changing the
supply of financial capital to promote investment (and Financial Markets – financial institutions
possibly durable goods consumption) through which savers can directly provide
funds to borrowers
Fiscal Policy – Changing the government budget position
(G-T)
Financial Intermediaries – financial
Trade Policy – Trying to manage the economy through institutions through which savers can
changing exports (EX) and imports (IM)
indirectly provide funds to borrowers
36
Financial Institutions Financial Institutions
Financial Markets Financial Intermediaries
Bond Market – A market where firms borrow Banks – An institution that take deposits from people who
money and promise to pay it back with some save and pool these deposits to make loans to people
interest as compensation who want to borrow. Banks charge a higher interest on
loans then deposits and use the difference between the
two to cover costs and give profits to the owners.
Stock Market – A market where firms are given
money for part ownership of the firm, and thus Mutual Funds – An institution that sells shares and use that
give a claim on future profits of the firm money to buy a selection or a portfolio of bonds, stocks
or both. The primary purpose of mutual funds is to
Debt vs. Equity financing diversify people’s savings.
Monetary Policy Monetary Policy

The role of money and Banking in the Economy Functions of Money
What is Money? – Money is assets that can be

1) Medium of Exchange
readily used to make transactions.
2) Unit of Account
Money vs. wealth 3) Store of Value
Liquidity
Why not hold all wealth as money? Liquidity vs. Store of value
37
Types of Money What is counted as money?
C – Currency – Paper money and coin held by

Commodity Money – Money that has consumers and firms
intrinsic value
M1 = Currency + Travelers Check + Checkable
Deposits
Fiat Money – Money with no intrinsic value
M2 = M1 + Savings Deposits + Small Time
Deposits + Money Market Mutual Funds

Liquidity vs. Interest Rate The Role of Financial Institutions
Medium of Exchange vs. Store of Value
Ranking (most to least) based on liquidity: (1) Lenders want to lend small, but borrowers
Currency, (2) Checkable Deposits, (3) Saving want to borrow large
Deposits, (4) Time Deposits
Pools small savers funds into large amount,

Ranking (most to least) based upon interest rate:
(1) Time Deposits, (2) Savings Deposits, (3) available for private borrowers
Checkable Deposits, (4) Currency
38
The Banks Balance Sheet Working with Assets, Liabilities, and Equity
Assets | Liabilities & Equity

Note: The definition of equity implies that:
Assets – Market value of items in your possession
Assets = Liabilities + Equity
Liabilities – Amounts owed to other parties
Equity = Assets - Liabilities Balance sheets must balance

A balance sheet example Bank’s Major Liabilities and Equity
What if you buy a house worth $120,000 1) Deposits (D) – Checking, Savings and
and you take out a mortgage of $100,000 Time deposits of bank customers
2) Borrowings (BORR) – Funds borrowed
Assets Liabilities + Equity by banks, usually for very short-term
House $120,000 Mortgage $100,000 adjustments
Equity $20,000 3) Equity (E) – Total Assets – Total
Liabilities
39
Bank’s Major Assets An Example: Customer Withdrawal
1) Reserves (R) – Vault cash of banks plus

Customer withdraws $200 from their savings
deposits at the Federal Reserve
1) Non-interest earning
deposit at chase
2) Purpose: to back up customer withdrawals from
deposits
Chase
Any customer withdrawal from any of their deposits ΔR - $200 ΔD - $200
must be met with an equal decrease in reserves

New Customer Deposits and the Acquisition Other Bank Assets
of Reserves
2) Holdings of Bonds (B) – source of revenue from
interest
Example: Customer deposits $300 in their
3) Loans (L) – revenue source, preferred to bonds
checkable deposit (D)
- Less liquid
- higher interest rate
Chase - more personal aspect
ΔR + $300 ΔD + $300
40
Inherent Instabilities in Banking Banking Regulation to deal with Instabilities
Loan Default – borrower fails to repay loan, Capital Requirements – minimum equity-
bank loses assets and equity asset ratio to absorb loan defaults
Profit vs. Safety – tradeoff between having

enough reserves to meet depositors Discount Window – Federal Reserve serves
withdrawal needs versus making sufficient as outlet for banks to borrow reserves for
profits from loaning the funds emergency withdrawal needs

Banking Regulation to deal with Instabilities Reserve Requirements: The “Minimum
Safety Level”
Deposit Insurance (provided by the Federal
Deposit Insurance Corporation, or FDIC) – The Federal Reserve issues a reserve ratio
guarantees reimbursement up to $100,000
per depositor if their bank fails on customer deposits (rD) with the
provision that at any time
Reserve Requirements – mandating a
“minimum safety level” or reserves R ≥ (rD)(D)
41
Decomposition of Reserves Bank Loaning – Balance Sheet Description
Required Reserves (RR) Consider the following example (rD = 0.10)

RR = (rD)(D)
Chase
Excess Reserves (ER)
ER = R - RR
R $4000 D $15000
Equivalent Ways to Express Reserve Requirement L $9000 E $1000
R ≥ RR, or ER ≥ 0 B $3000

Computing Required and Excess Reserves Chase makes loan of $2500
Chase Step #1 – Loan is Approved

R $4000 D $15000
L $9000 E $1000 Chase
R $4000 D $17500
B $3000 L $11500 E $1000
(rD = 0.10) B $3000
RR = (rD)(D) = (0.10)($15000) = $1500
Borrower signs loan contract, receives check from bank
ER = R – RR = $4000 - $1500 = $2500
42
Chase makes loan of $2500 Bank Loaning and the Money Supply
Step #2 – Loan is spent Consider from the previous example, Fleet gets new
deposits ($2500) while Chase has the same as before.
Chase
R $1500 D $15000 Therefore M2 changes by $2500, the amount of the loan.
L $11500 E $1000
B $3000 Result – banks loaning changes the money supply by the
amount of the loan
Seller deposits check in their bank
Fleet Now that Fleet has an increase in deposits, it now can
make loans. As funds from Fleet’s loan get deposited in
ΔR + $2500 ΔD +$2500 another bank, the process continues…..

Federal Reserve Structure of the Federal Reserve
Created in 1914 after a series of bank failures to ensure the Board of Governors
health of banking system 7 members that are appointed by the president with the
consent of Congress
Original Roles of the Federal Reserve
1) Provider of Discount Window Once approved, independent of the President
“Lender of last resort”, “The bank’s bank”
2) Regulate Banks (e.g. reserve ratios) Important Chairs of the BOG
Paul Volcker – 1979-1987
Manages the economy through monetary policy Alan Greenspan – 1987-Present
43
Structure of the Federal Reserve
Structure of the Federal Reserve
Federal Reserve District Banks
Each private bank exists within one of the 12 districts Federal Open Market Committee (FOMC)
within the U.S.
Each District has a Federal Reserve District Bank 12 voting members – 7 Board of Governors plus
located in a major city 5 District Bank Presidents
Each District Bank Meets 8 times per year (more if needed)
Conducts district loans with banks within the district Designs monetary policy by specifying Federal
Enforces reserve requirements for banks within the Funds rate target
district
Holds reserves of banks within district

Basic Strategy of Monetary Policy Monetary Policy Tools
Expansionary (Y* < YF) – Federal Reserve Instruments that initiate monetary policy
seeks to increase the supply of financial
capital by encouraging bank loaning.
1) The Discount Rate
Contractionary (Y* > YF) – Federal Reserve 2) Reserve Ratio
seeks to decrease the supply of financial 3) Open Market Operations
capital by discouraging bank loaning.
44
Changing the Discount Rate Changing the Reserve Ratio
The Discount Rate – The rate of interest charged Designed to change the amount of required
to banks that borrow from the Federal Reserve reserves
Expansionary Policy – Fed lowers discount rate Expansionary Policy – Fed lowers reserve ratio
Contractionary Policy – Fed raises discount rate Contractionary Policy – Fed raises reserve ratio

Open Market Operations Open Market Operations: An Example
Open Market Operations – The buying or selling of bonds Federal Reserve buys a $1000 bond from Chase
by the Federal Reserve in the open market (the Fed’s
predominant policy tool) Chase
ΔB -$1000
Expansionary Policy – Fed buys bonds ΔR +$1000
(gives banks new reserves)
Chase can make a new loan – start the loaning process
Contractionary Policy – Fed sells bonds (increasing the supply of financial capital)
(drains reserves from banks)
45
Obstacles to Monetary Policy The Volcker Recession: Ending the Wage-Price Spiral
1970s in the US experienced wage-price spiral

1) Banks don’t want to loan the added
reserves (pessimism about the prospects Started as overly expansionary government and monetary
of loan default or fears of inflation) policies of the 1960’s, with progressively higher wage
increases
2) Firms and consumers don’t want to Continued in late 1970s as expansionary monetary
borrow the funds (pessimism about the responses to increase in price of energy. Continued
high wage increases.
state of the economy)

Volcker Recession 1981-1983 Volcker Recession 1981-1983
Very contractionary monetary policy (federal funds

rate over 17%). Supply of financial capital Convinced of Federal Reserve’s intent to solve
decreases, I* falls, AD curve shifts leftward inflation problem, lower wage increases occur,
smaller leftward shifts in AS curve.
High nominal wage increases continue, big shift of
AS curve
Federal Reserve gradually practices cautious
expansionary monetary policy, shifts AD curve
Major recession, lower inflation eventually eases
inflation fears. rightward, Y* returns to YF
46
Greenspan Era Classical view of monetary policy
1990-1991 recession – Similar to Volcker, but on a Quantity Theory of Money

smaller scale The quantity of money is related to the number of dollars
exchanged in transactions
“Soft Landing” strategy in 1990s – small monetary
policy changes designed not to arouse inflation The Quantity Equation
fears and overly large wage increases
(Money) X (Velocity) = (Price) X (Transactions)
Contractionary in 2000 (Y* > YF), in 2001, had M*V=P*T
difficulty in expanding economy back to YF

The Quantity Equation The Quantity Equation
Ex. 60 loaves of Bread are sold in a year and price is $0.5 Replace transactions with output (Y)
per loaf
M*V = P*Y
P*T = ($0.5/loaf)*(60 loaves/year) = $30/year
V is now the income velocity of money
This is the dollar value of all transactions
Can now express money supply in quantity of goods and
If the quantity of money is $10 then velocity is services called real money balances (M/P)
V = P*T/M = ($30/year)/$10 = 3/year From previous example ($10)/($0.5/loaf) = 20 loaves
47
Using Quantity Theory of Money to explain inflation The Quantity Equation in %Δ form
First assume that velocity of money is constant %Δ M + %Δ V = %Δ P + %Δ Y
Theory for overall price level

%Δ M is controlled by the Federal Reserve
1) The level of output (Y) is determined by factors of production %Δ V is zero by assumption
%Δ P is inflation
2) Money supply determines nominal output
%Δ Y is determined by factors of production
3) Price level (P) is ratio of nominal output to level of output (PY/Y)
Because Real GDP (Y) is determined by factors of production, any

Since the Federal Reserve controls the money
changes in Nominal GDP due to changes in money supply (M), supply, it controls inflation
must be a change in the price level (P)

Seignorage the inflation tax Social Cost of Expected Inflation
1) Shoe leather cost

Monetary policy and interest rates, the 2) Menu cost
Fisher effect 3) Catalog cost
4) Tax laws
i=r+π 5) Inconvenience
Social Cost of Unexpected Inflation

Borrowers vs. Lenders
48
Monetary Policy Fiscal Policy
Classical vs. Keynesian Fiscal Policy – The Federal government
In classical model only real variables matter not nominal
changing its budget position (G-T) in order
(quantity terms not monetary) to stabilize the economy
Real Wage (W/P) not nominal wage (W)

Real interest rate (r) not nominal interest rate (i) Remember:
Real GDP (Y) not nominal GDP (PY) Budget = T – G
Since money only affects prices in the classical model, the Budget Position (or size of deficit)
model is said to have monetary neutrality
=G–T
Fiscal Policy Fiscal Policy

Recall variable definitions: Strategy for Fiscal Policy
T = Net Taxes
= Tax Revenues – (Transfer Payments Expansionary policies seek to induce more
+ interest on the national debt) purchasing of goods and services by
increasing (G – T) i.e. G↑ or T↓
G = Government Purchases of Contractionary policies seek to induce less

goods and services purchasing of goods and services by
decreasing (G – T) i.e. G↓ or T↑
49
Specific Types of Fiscal Policy Tax Policy as Fiscal Policy
Change Government Purchases of Goods and Change Marginal Tax Rate (t)
Services (G) 1) Expansionary: t ↓
1) Expansionary: G↑ 2) Contractionary: t ↑
2) Contractionary: G↓
Change Autonomous Net Taxes (T0) – Taxes that
Change Transfer Payments (TP) don’t depend upon income (e.g. sales taxes)
1) Expansionary: TP↑ 1) Expansionary: T0 ↓
2) Contractionary: TP↓ 2) Contractionary: T0 ↑

Fiscal Policy in the AD-AS Model Fiscal Policy in the AD-AS Model
Expansionary Fiscal Policy shifts the AD curve How much does the AD curve shift with
rightward, increases Y* and P*
fiscal policy?
Contractionary Fiscal Policy shifts the AD curve
leftward, decreases Y* and P* Multiplier Effect
Note: Like monetary policy, fiscal policy is justified Crowding out Effect
only from a short-run perspective
50
The Income Tax and Automatic Stabilization The Income Tax as an Automatic Stabilizer
Y*↑ (maybe > YF) → Tax Revenues ↑ and helps to

Automatic Stabilization – due to the income cool the economy
tax system, tax revenues change
directions that help to stabilize the Y*↓ (maybe < YF) → Tax Revenues ↓ and helps to
economy, without any change in the tax stimulate the economy
structure (i.e. no fiscal policy)
Note: This takes place without any change in the
tax structure, as prescribed by fiscal policy

The Income Tax and the Budget Obstacles to Fiscal Policy Effectiveness
Y*↑ → Tax Revenues ↑ → T ↑ Difficulties in getting the proper policy passed

→ (T – G) ↑ through Congress and the president
A strong and growing economy improves the
budget
A tax cut that isn’t used for spending. AD curve
does not shift rightward, no change in Y*
Y*↓ → Tax Revenues ↓ → T ↓
→ (T – G) ↓
A weak economy generates a lower budget Worries about the Federal Budget within a
sluggish economy
51
Economic Policy Debate Economic Policy Debate
Should the Government have discretion in Rule or Discretion
conducting Economic Policy
Active or Passive
Lags in implementation
Inside Lag → Fiscal Policy
Outside Lag → Monetary Policy Distrust of Policy Makers and the Political Process
Ways to cut down on lags Time Inconsistency

Use leading indicators
Automatic stabalizers
Economic Policy Debate

The Great Depression
Economic Policy could have soften the

Great Depression
Economic Policy made the Great

Depression worse
52

Introduction To Macroeconomics

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Introduction To Macroeconomics

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What is Economics?

• Economics is the bridge between

Book Definition Two Branches of Economics

Problems with Statistics Microeconomic Foundations

• Reverse Causality What is the objective of people

Principle #3 Rational people think Principle #4 People respond to

Comparative vs. Absolute

Principle #7 Government can Principle #8 Standard of living

The Data of Macroeconomics

Both models show the relationship between How are we doing?

“goods and services” “within a country”

A closer look at GDP A closer look at GDP

The components of GDP The components of GDP

Final Goods – Add up all the expenditures on

Value Added – Looks at each stage of production or at

GDP Continued GDP Continued

The Full Sustainable Level of Real

Labor Force The %Δ in the price level from one time

1) Fix the basket Price of Eggs $0.50 $0.60 $0.74 $0.76

Measuring the Cost of Living Measuring the Cost of Living

Measuring the Cost of Living Inflation

2) Domestic goods vs. Imported goods 2) It erodes people’s standard of living

We care about labor markets because of

Interpreting the level of Interpreting the level of

U > UN ↔ Y < YF Sluggish Economy Labor Compensation – Total wages, salaries

Labor Market Variables

Part-Time Workers 8/10 (80%) of people who were unemployed were

24/32 (75%) months of unemployment is from people

Types of Unemployment AD-AS Model

Frictional – Sectoral Shifts The variables of interest are output/income,

To do this we build economic models. Models are theories

AD-AS Model AD-AS Model

So what are the factors that determine AD?

AD-AS Model AD-AS Model

Close to the definition of Real GDP except it

AD-AS Model AD-AS Model

AD-AS Model AD-AS Model

make AS increase is shown by a rightward By themselves, neither AD or AS can tell us what P or Y

AD-AS Model AD-AS Model

AD-AS Model AD-AS Model

Keynesian vs. Classical Trying to push Y* to far causes the wage

Causes of Aggregate Demand Causes of Aggregate Demand

Aggregate Income (Y)

Investment is primarily made up of business

These large expenditures create the need for long-

Causes of Aggregate Demand Causes of Aggregate Demand

Nominal (long-term) interest rate (i)

Causes of Aggregate Demand Causes of Aggregate Demand

Graph against one of it’s major causes – the nominal

The graph is drawn assuming that the other causes are

Investment (I*) occurs when the Demand for Financial

Causes of Aggregate Demand Causes of Aggregate Demand

(T – G) < 0 – Budget Deficit An increase Government Purchases (G) increases

Causes of Aggregate Demand Causes of Aggregate Demand

Government Purchases (G) and Net Taxes (T) are

World Output or Income (YW)

Causes of Aggregate Demand Causes of Aggregate Demand

Also known as the “value of the dollar”.

Causes of Aggregate Demand Causes of Aggregate Demand