MONITORING MACROECONOMIC PERFORMANCE

Difference between Micro and Macro-

Microeconomics deals with the behaviour of individuals: firms and consumers.
Macroeconomics deals with the economy as a whole.

Macroeconomic problems- Growth, Inflation, Unemployment

Origins and Issues of Macroeconomics

Economists began to study economic growth, inflation and international
payments during the 1750s. Modern macroeconomics dates back towards The
Great Depression, a decade (1929-1939) of high unemployment and stagnant
production throughout the world economy.
John Meynard Keynes’ book, The General Theory of Employment, Interest and
Money, began the subject. In the book he discussed Short-Term vs Long-Term
goals. Keynes focused on the short-term issues of unemployment and lost
production. “In the long run, we are all dead”, said Keynes. During the 1970’s and
1980’s, macroeconomists became increasingly concerned with the long-term
issues of inflation and economic growth.
Economic growth-
Economic growth is the expansion of the economy’s production possibilities
which is an outward shifting PPF/PPC. We measure economic growth by the
increase in real GDP.
Real GDP (Gross Domestic Product) is the value of the total production of all
the nation’s farms, factories and offices, measured in the prices of a single year.

The Figure highlights the (smooth) growth of GDP

and fluctuations of real GDP around potential
GDP.

Real GDP fluctuates around potential GDP in a

business cycle- a periodic but irregular
up-and-down movement in production.

Every business cycle has two phases

1) A recession
2) An expansion
and two turning points-
1) A peak
2) A trough

Recession- It is a period during which real

GDP decreases for at least two consecutive
quarters.

Expansion- It is a period during which real

GDP increases
Benefits and Costs of Economic Growth
The main benefit of long-term economic growth is expanded consumption
possibilities, including more health care for the poor and elderly, more research
on cancer and AIDS, better roads, more and better housing and a cleaner
environment.
The costs of economic growth are foregone consumption in the present, more
rapid depletion of non-renewable natural resources and more frequent job
changes.
According to ONS, UK’s GDP fell by 20.4% in April 2020, following a fall of 5.8%
in March 2020.

This drop-off of GDP suggests unemployment.

Unemployment is a state in which a person does not have a job but is available
for work, willing to work and has made some effort to find work within the
previous four weeks.
The workforce/labour is the total amount of people who are employed and
unemployed.
The unemployment rate is the percentage of people in the workforce who are
unemployed.
A discouraged worker is a person who is available for work, willing to work but
has given up the effort to find work.
Labor-force participation rate is the percentage of adult population that is in
the labour force.
Why is unemployment a problem?
Unemployment is a serious economic, social and personal problem for two main
reasons-
1) Lost production and income- serious but temporary
2) Lost human capital- devastating and permanent

Inflation
Inflation is the process of rising price. We measure inflation rate as the
percentage change in the average level of prices or price level.

Here, the inflation rate since 1962 in the United

Kingdom is shown.
Inflation was low in the 1960’s, increased in the
1970’s and decreased during the 1980’s and
1990’s.

The inflation rate fluctuates, but it has been

consistently positive- the price level has not fallen during the years shown in the
figure.

A falling price level depicts a negative inflation rate, otherwise known as

deflation.
Inflation around the world is shown, as it compares
inflation rates in a number of countries. Industrial
countries tend to have similar inflation rates and has
lower inflation rates than developing countries.

Is inflation a problem?
- Unpredictable changes in the inflation rate are a
problem because they redistribute income in arbitrary
ways between employers and workers and between
borrowers and lenders.
A high inflation rate is a problem because it diverts
resources from productive activities to inflation
forecasting. Eradicating inflation is costly because it
brings a period of greater than average unemployment.

The impact of COVID-19

Surveys of business activity show the world economy continued to shrink at a
record pace in April 2020 when most major countries’ lockdown measures were
toughest. After imposing tight control on business and social life later than other
European countries, Britain’s economy appears to be underperforming many
other wealthy nations.
Official figures show just nine days of lockdown caused gross domestic product
(GDP), the broadest measure of the economy, to fall by 5.8% in March, and by
2% in the first three months of the year.
Surplus and deficits
Government budget-
If a government collect more taxes than it spends, then it has a government
budget surplus.
If a government spends more than it collects in taxes, it has a government
budget deficit.

Internationally-
If a nation imports more than it exports, it has an international deficit.
If a nation exports more than it imports, it has an international surplus.
The current account deficit or surplus is the balance of exports minus imports
plus net interest paid to and received from the rest of the world.

● Do surplus and deficits matter?

● What happens if the government can’t cover its expenditures using taxes?
- The government would need to borrow. This would increase the governments
debt. Interest on the debt must be paid until it is eventually paid off. So, future
taxes may have to go up or future public spending may have to go down.
International (current account) deficits have similar implications. Countries can’t
borrow to consume indefinitely.

Macroeconomic policy
Challenges and tools-
There are five widely agreed policy challenges for macroeconomics are to:
● Boost economic growth
● Stabilize the business cycle
● Lower unemployment
● Keep inflation low
● Reduce government and international deficit
Two broad groups of macroeconomic policy tools are:
● Fiscal policy- making changes in tax rates and government spending
● Monetary policy- changing interest rates and changing the amount of
money in the economy

GDP , Measuring GDP, and Economic growth

Gross Domestic Product (GDP)

GDP is the market value of all final goods and services produced in a country in
a given time period. The definition has four parts:
● Market value
GDP is a market value- goods and services are valued at their market
price. To add apples and oranges, we add the market values so we have a
total value of the output.
● Final goods and services
GDP is the value of the final goods and services produced. A final good (or
service) is an item bought by its final user. A final good contrasts with an
intermediate good used as a component of a final good and service e.g.
potatoes are an intermediate good for making potato chips as a final good.
● Produced within a country
GDP measures production within a county- domestic production.
● In a given period of time
GDP measures production during a specific time period- normally a year.
GDP and the Circular Flow of Expenditure and Income
GDP measures the value of production, which also equals total expenditure on
final goods and total income.

The circular flow shows the transactions among households, firms, governments
and the rest of the world.
Firms hire factors of production from households. The blue flow, Y, shows total
income paid by firms to households.
Households buy consumer goods and services.The red flow, C, shows
consumption expenditures.
Households save, S, and pay taxes, T. Firms borrow some of what households
save to finance their investment.
Firms buy capital goods from other firms. The red flow, I, represents this
investment expenditure by firms.
Governments buy goods and services, G, and borrow or repay debt if spending
exceeds or is less than taxes.
The rest of the world buys goods and services from us, X, and sells us goods
and services, M. Net exports are (X-M). The rest of the world borrows from us or
lends to us depending on whether net exports are positive or negative.
All of this can be written in a formula-
Y= AD= C+I+G+(X-M)

GDP equals expenditure which equals income.

Firms pay out all their receipts from the sale of final goods and services, so
aggregate income equals total expenditure.

It is vital that we measure the value of production with reasonable accuracy. For
such a measure is the basis of measurement of the standard of living, economic
welfare and making international comparisons.

Calculation- Assume a small nation has the following statistics

● Its consumption expenditure is $15 million
● Investment is $2 million
● Govt. expenditure on goods and services is $1 million
● Export of goods and services to foreigners is $1 million
● Import of goods and services from foreigners is $1.5 million

Calculate the nation’s GDP

GDP= C+I+G+(X-M)
= $15m+$2m+$1m+($1m-$1.5m)
= $17.5 million

Financial Flows
Financial markets finance deficits and investment. Household savings, S, is
household income minus net taxes and consumption expenditure
Y= C+S+T
S= Y-T-C
Household’s savings flows from households to financial markets.
Now, if government expenditure exceeds net taxes, the deficit (G-T) is borrowed
from the financial markets (if T exceeds G, the government surplus flows to the
financial markets).

If imports exceed exports, the deficit with the rest of the world (M-X) is borrowing
from the rest of the world.

Finally, we have firms borrowing from financial markets. We can use the circular
flow diagram above to help us understand how such investment is financed.
There are three sources of firms borrowing-
● Private (household) saving, S
● Government budget surplus (T-G)
● Borrowing from the rest of the world (M-X)

Gross and Net Domestic Product

“Gross” means before accounting the depreciation of capital. The opposite of
gross is net. To understand the distinction, we need to distinguish between flows
and stocks.

Flows and Stocks in Macroeconomics

A flow is a quantity per unit of time; a stock is the quantity that exists at a point
of time.
On the other hand, wealth is the value of all the things that people own, is a
stock. Saving is the flow that changes the stock of wealth.

Capital and Investment

Capital is the plant, equipment and inventories of raw and semi-finished
materials that are used to produce other goods and services. It is a stock.
Investment is the flow that changes the stock of capital.
Depreciation- It is the decrease in the stock of capital that results from wear and
tear and obsolescence.

Gross investment- It is the amount spent on purchases of new capital and on

replacing depreciated capital.

Net investment- It is the change in the stock of capital.

Net investment= Gross investment- Depreciation

Calculating GDP
To calculate the GDP or the total market value of all the goods and services
produced within a year, we need to know the price and quantities of the particular
goods and services for the current year as well as the base year.
A base year is used for comparison in the measure of a business activity or
economic index. For example- to find the inflation rate between 2013 and 2018,
2013 is the base year or the first year in the time set. The base year can also
describe the starting point from a point of growth. Thus, two different types of
GDP is introduced, nominal and real.

Nominal and Real GDP

Nominal GDP is the value of all the final goods and services that an economy
produced within a given year. Nominal GDP measures the value of the goods
and services produced in a country at current prices, providing a snapshot at a
country’s current output in the current moment. It is calculated by using the prices
that are in the current year in which the output is produced. In economics, a
nominal value is expressed in monetary terms.
To calculate the real GDP, given the prices and quantities of goods and services
we can use the formula below-

Base year / Reference year prices will be mentioned for your calculation.

Nominal GDP measures output using current prices, but real GDP measures
output using constant prices, keep in mind the quantity is in the current year.

Real GDP, is the inflation-adjusted total economic output of a nation's goods and
services in a given period of time. Also known as "constant price GDP,"
"inflation-corrected GDP," or real GDP is derived by isolating and removing
inflation thus making GDP a more accurate reflection of a nation's economic
output.

Measuring Real GDP

Let us assume Country X only produces Books and Magazines. The table below
gives data on the production and prices. Using 2017 as the base year, we can
calculate the real GDP in 2017 and 2018-

The table gives data on the production and prices in a Country X. Use 2017 as
the base year. What is the Nominal GDP and real GDP in 2017 and 2018?
Ans- In 2017, nominal GDP calculated using 2017 prices
= (18 X 20)+(5 X 15)
= 360+75
=435

Because 2017 is the base year, real GDP equals nominal GDP, so real
GDP in 2017 was 435.

In 2018, nominal GDP calculated using 2018 prices

= (20 X 30)+(7 X 20)
= 600 + 140
= 740

To calculate real GDP in 2018, we need to value the production in 2018

using 2017 prices. Real GDP in 2018 using 2017 prices is
= (18*30)+(5*20)
= 640
If price index is given
Real GDP of Current year = Nominal GDP of Current Year x (100/Price index of
current year)
Uses and limitations of GDP
Uses-
We use estimates of real GDP for two main purposes. They are:
● To compare the standard of living over time
● To compare the standard of living across countries

The growth of potential GDP- Potential GDP is the value of production when all
the economy's labor, capital, land, and entrepreneurial ability are fully employed.
Comparing standard of living across countries
Two problems arise in using real GDP to compare living standards across
countries-
1) The real GDP of one country must be converted into the same currency
units as the real GDP of the other country.
2) The goods and services in both countries must be valued at the same
prices.

Comparing the US and China provides a striking example of these two problems-

The prices of some goods are higher in the US than in China, so these items get
a smaller weight in China's real GDP than they get in the US real GDP. Some
prices in China are higher than in the US but more prices are lower, so Chinese
prices put a lower value on China's production than do US prices.

Limitations
Real GDP measures the value of goods and services that are bought in markets.
Some of the factors that influence the standard of living and which are not part of
GDP are:
● Household production
● Underground economic activity
● Leisure time
● Environmental quality

GDP and Economic Growth

Economic growth is a sustained expansion of production possibilities measured
as the increase in real GDP over a given period.
GDP growth rate is measured as:

Economic growth or real GDP growth is the rate at which a nation's GDP
changes/grows from one year to another.

Above, GDP growth rate from 2017 to 2018 is =

 Employment and Unemployment
Aims of this chapter-
- Define the workforce, the unemployment rate, the economic activity rate
- Describe the sources of unemployment, its duration, the groups most
affected by it, and how it fluctuates over a business cycle
- Explain how we measure the price level and the inflation rate using the RPI
and CPI

How will COVID-19 affect the world of work?

- COVID-19 will have far-reaching impacts on labour market outcomes. Beyond
the urgent concerns about the health of workers and their families, the virus and
the subsequent economic shocks will impact the world of work across three key
dimensions, as per ILO:
● The number of jobs (both unemployment and underemployment)
● The quality of work (e.g. wages and access to social protection)
● Effects on specific groups who are more vulnerable to adverse labour
market outcomes.
An ILO report of growth of unemployment is shown in the graph below:
There is more of a time lag on the
UK's official unemployment data
than some other nations. Its main
statistics office shows employment
at a record high and unemployment
at around 4%. However, KPMG
forecasts this will rise to just under
9% during the lockdown period.
The unemployment rate in Canada in April was 13% up 5.2 percentage points in
March, according to data from the country’s official statistics bureau. So far in the
covid-19 crisis, more than 7.2 million people have applied for emergency
unemployment assistance.

How do we measure unemployment and what other data do we use to monitor

the labour market?
- Having a good job that pays a decent wage is important. But the cost of living
also matters
How do we measure the cost of living and its rate of change?

Labour force survey

The Office for National Statistics conducts a continuous survey to determine the
changing state of the UK labour market.
The survey divides the population into two groups:
 ● The working-age population i.e. the number of people aged between 16
years and retirement who are not in jail, hospital, or some other form of
institutional care.
● Others

The working-age population is in turn divided into two groups:

● The economically active or workforce
● The economically inactive

Workforce- It is the sum of employed and unemployed workers.

To be considered unemployed (according to the LFS), a person must be:

1) Without work but having made specific efforts to find a job within the past
four weeks
2) Waiting to be called back to a job from which he or she has been laid off
3) Waiting to start a new job within 30 days.

Figure 21.1 shows the population categories

used by the ONS and the relationships among
them.

Note that "workforce" and "economically active"

are two names for the same group of people.
Three Labour Market Indicators
Three labour market indicators are calculated using the data from the Labour
Force Survey. They are:
● The unemployment rate
The unemployment rate is the percentage of the workforce that is
unemployed. The unemployment rate is-
UR = (Number of people unemployed/Workforce) x 100.
The unemployment rate reaches its peaks during recessions.
● The economic activity rate
The economic activity rate is the percentage of the working-age population
that is in the workforce. The economic activity rate is-
(Workforce/Working-age population) x 100.
The economic activity rate has hovered just under 80 per cent for the last
30 years, sometimes higher, sometimes lower, but not by much. The
economic activity rate falls during recessions as discouraged workers i.e.
people available and willing to work but who have not made an effort to
find work within the last four weeks and thus leaves the workforce.
● The employment rate
The employment rate is the percentage of working-age people who have
jobs. The employment rate is-
(Number of people employed/Working-age population) x 100
The employment rate was around 75 per cent in 1971 and was still around
75 per cent in 2007. But during that time the employment rate has risen
and fallen with the cycle (lower in recessions)
Exercise

Based on the information in the above table, what is the unemployment rate?
What is the economic activity rate?

- The unemployment rate=

(6 million unemployed) + (139 million workforce)x100 = 4.3%
The economic activity rate=
(139 million workforce) + (207 million working-age population)x100 = 67.1%
Figure 22.3 shows the changing face of the
UK labour market. The female economic
activity rate has risen and the male economic
activity rate has fallen. The female
employment rate has risen and the male
employment rate has fallen.

Aggregate hours- These are the total number of hours worked by all workers
during a year. Aggregate hours have fluctuated with the business cycle but have
no clear trend. But as the number of workers
has increased, the average workweek has
shortened. The graph shows aggregate hours
in UK from 193 to 2003.

Real wage rate- It is the number of goods and services that an hour's work will
buy. The real wage rate equals the money wage rate divided by the price level
(the GDP deflator). Three measures of the real wage rate are-
● Average hourly earnings of adult manual workers
● Total wages and salaries per hour
● Total labour compensation per hour
 Unemployment, Full Employment and Price Level
The Anatomy of Unemployment
People become unemployed if they:
1) Lose their jobs
2) Leave their jobs
3) Enter or re-enter the workforce.

People end a spell of unemployment if they:

1) Are hired or recalled
2) Withdraw from the workforce

The figure shows labour market flows between different states.

● This graph shows UK unemployment by

reason in the 1980’s and 1990’s. Job leavers
are the smallest group while job losers are
the largest group.

● The duration of unemployment increases

during a recession. This figure shows
unemployment by duration close to a
business cycle trough in 1992 and close to a
peak in 1989.
Types of Unemployment
Classification of unemployment helps us to understand what causes
unemployment. Unemployment can be classified into three types-
● Frictional unemployment
Frictional unemployment is unemployment that arises from normal labour
market turnover. The creation and destruction of jobs require that
unemployed workers search for new jobs. Increases in the number of
young people entering the workforce and increases in unemployment
benefit payments raise frictional unemployment.
● Structural unemployment
Structural unemployment is unemployment created by changes in
technology and foreign competition that change the skills and location
match between jobs and workers. This is mainly caused by skills mismatch
and/or spatial mismatch.
● Cyclical unemployment
Cyclical unemployment is the fluctuation in unemployment caused by the
business cycle.
Full employment- Full employment occurs when there is no cyclical
unemployment or, equivalently, when all unemployment is frictional and/or
structural. The unemployment rate at full employment is called the natural rate of
unemployment. The natural rate of unemployment cannot be measured
accurately and estimates of its size vary.

Real GDP and Unemployment Over the Cycle

Reflecting back at the definition of potential GDP, we can restate it as the
quantity of real GDP produced at full employment. It corresponds to the
capacity of the economy to produce output on a sustained basis; actual GDP
fluctuates around potential GOP with the business cycle.
 ● The figures show real GDP and the
unemployment rate and estimates of potential
GDP and the natural unemployment rate from
1980-2010

The Output Gap and Unemployment Rate

The quantity of real GDP at full employment is
potential GDP Over the business cycle, real GDP
fluctuates around potential GDP. The gap between
real GDP and potential GDP is called the output gap.
As the output gap fluctuates over the business cycle,
the unemployment rate fluctuates around the natural
unemployment rate. The 3rd figure shows us the
output gap in the US. 2nd figure shows the
unemployment and natural unemployment rate in the
US.

When the economy is at full employment, the unemployment rate equals the
natural unemployment rate and real GDP equals potential GDP, so the output
gap is zero.
When the unemployment rate is less than the natural unemployment rate, real
GDP is greater than potential GDP and the output gap is positive.

And when the unemployment rate exceeds the natural unemployment rate, real
GOP is less than potential GDP and the output gap is negative.

Price Level, Inflation and Deflation

What will it really cost you to pay off your student loan? What will your parents'
life savings buy when they retire?
The answers depend on what happens to the price level, the average level of
prices and the value of money. A persistently rising price level is called inflation;
a persistently falling price level is called deflation.

Low, steady and anticipated inflation or deflation is not a problem, but an

unexpected burst of inflation or a period of deflation brings four big problems and
costs. It:
● Redistributes income
● Redistributes wealth
● Lowers real GDP and employment
● Diverts resources from production
Price Indices
The price level is the "average" level of prices and is measured by using a price
index. The Office for National Statistics calculates two indexes every month.
They are: The Retail Prices Index, or RPI and The Consumer Prices Index or
CPI
Reading the RPI and CPI numbers
The RPI is defined to equal 100 for the reference base period. Currently, the
reference base period is July 2015. That is, the CPI/RPI is defined to have a
value of 100 in July 2015. In July 2016, the CPI was 100.63, which means that
the prices measured by the CPI were 0.63 per cent higher in July 2016 than in
July 2015.
The CPI & RPI work in a similar way

Constructing the RPI and CPI

Constructing the RPI and CPI involves three stages:
● Selecting and updating the basket
● Conducting a monthly price survey
● Calculating the price index
The different indices have slightly different 'baskets'.

Selecting and updating the basket

The figure represents the CPI basket. The basket
is selected to cover all expenditure on consumer
goods and services in the United States by
households, residents of institutions and tourists.
Conducting a Monthly Price Survey
Each month, ONS employees check 180,000 prices of more than 7000 types of
goods and services in 150 places throughout the United Kingdom. The RPI and
CPI are calculated using the prices and the contents of the baskets.

Calculation
We calculate the RPI (or CPI) for an economy that consumes only oranges and
haircuts. The RPI (or CPI) basket is 10 oranges and 5 haircuts. This table shows
us the prices of the base period. The cost of RPI/CPI basket in the base period
was £50.

This table shows us the prices in the current period. The cost of the RPI/CPI
basket in the current period was £70.
We use- (2x10)+(10x5)= 70

The RPI is calculated using the formula:

RPI= (Cost of basket in current period/Cost of basket in base period)x100
Using the numbers for this example the RPI is:
RPI= (£70/£50)x100= 140
The RPI is 40% higher in the current period than in the base period.
Measuring Inflation
The main purpose of the RPI is to measure inflation. The inflation rate is the
percentage change in the price level from one year to the next. The inflation
formula is:
Inflation rate = [(RPI this year — RPI last year)/RPI last year] x 100.

Figures in the side show us the CPI and Inflation

rate of the United States from 1970 to 2010.

Biased Price Indices

The main sources of bias in a price index are:
● New goods bias
New goods that were not available in the
base year appear and, if they are more
expensive than the goods they replace, the
price level may actually be higher than that
suggested by the RPI. Similarly, if the new
goods are Cheaper than the goods they
replace, but not yet in the RPI basket, they
bias the RPI upwards (the price level may
actually be lower).
● Quality change bias
Quality improvements generally are neglected, so quality improvements
that lead to price increases are considered purely inflationary.
 ● Substitution bias
The basket used to calculate the RPI is fixed and does not take into
account consumers' substitutions away from goods whose relative prices
increase.

Some Consequences of Bias in the RPI and CPI

Pensions and other government outlays are linked to the RPI so bias upwards
could end up swelling government spending. The Bank of England uses the CPI
as the target of monetary policy and biases in the index could lead to
inappropriate monetary policy decisions.

CPI and GDP deflator

The CPI is an index of the prices of consumption goods and services. For some
purposes, we need a price index that has broader coverage. One such price
index is the GDP deflator, which is an index of the prices of all the items in GDP.
So the GDP deflator is an index of the prices not only of the items in consumption
expenditure but also the prices of items in investment, government expenditure
and net exports.
The CPI measures only the prices of consumption goods and services, so it
covers a narrower range of items than does the GDP deflator.
The GDP deflator is calculated using two numbers that we have already met:
Nominal GDP and real GDP. The formula for the GDP deflator is:

GDP deflator = (Nominal GDP/Real GDP)x100

 ECONOMIC GROWTH

Economic growth is the persistent rise in the level of potential GDP of a country.

The table below shows us the growth rate of 4 countries. In 2020, all four
countries experienced a decline in growth due to the pandemic, with India and
the US experiencing negative growth rates.

GDP and Potential GDP

Potential GDP is the level of production that can be sustained over a period of
time by a country (look back at PPF in ECO101).

Here, moving from A to B does not mean

there is economic growth. However, as PPF
extends, a move from B to C would be
considered as economic growth.
Calculating Economic Growth
● Via GDP growth
It is calculated as- [(GDP of current year - GDP of previous year)/GDP of
previous year]x100

Suppose Country A has a GDP of 10 billion in 2019 and 15 billion in 2020.

Therefore,

Between 2019 and 2020, the GDP of Country A increased 50%. Thus, the
country has experienced 50% growth rate.

GDP growth rate does not tell us anything about what we can buy with this
amount.

● Real GDP growth

However, this does not tell us anything about standard of living.

● Real GDP per capita growth

It is calculated as- [(Real GDP of current year - Real GDP of previous
year)/Real GDP of previous year]x100
Here, Real GDP of China is 45x of Bangladesh, which is not a real estimate of
growth. However, Real GDP per capita of China is 6x of Bangladesh, which can
be used as a much more accurate estimate for calculating growth.

The first panel shows the growth rate from 1960-2010 of the US, Canada, Japan,
and the big 4 European countries. We see countries grow at different rates at
different times. For example- From 1960 to 195, Japan experienced very rapid
growth. However, now Japan economic growth from 1990 has stagnated
compared to its past.
In the second column, we see growth rate from different countries and different
regions. If we look at Eastern Europe, Eastern Europe went through a contraction
(GDP fell) around 1990 but recovered. Africa is considerably below other regions
especially the US, and never closed the gap.
Where does growth come from?
Economic growth depends on potential GDP. Two factors belong to potential
GDP:
● Aggregate production function
Here, PF is increasing at a decreasing
rate. As Labour hours is increasing, Real
GDP is increasing but lowering in rate.
Suppose a company needs 3 people,
and 5 people applies. So these 5 people
are ranked, and would hire the 3 best
candidates according to their qualification. Now, if the company wants to
expand and take in another worker late on, they will take the 4th best.
Thus, 1st candidate would produce the most output, 2nd will produce
slightly less and so on. In an economy, the best resources will be used
first.

● Aggregate labour market

Labour is demanded by companies,
factories etc in exchange for wage. Labour
is supplied by households in order to
receive wage. As suppliers of labour, we
care about real wages. i.e. if a persons
wage increases from $100 to $120, but
there is an inflation of 30%, real wage falls.
Thus, purchasing power falls. Demanders of labour care about how many
goods they would need to sell to make up the money they are paying in
wages. i.e. if there is inflation of 20% in the economy, their revenue
increases by 20%, thus they can afford to pay their workers more.
How does economic growth occur?
There are two main ways economic growth takes place-

● A rise in the labour supply

1) Labour supply may increase due to an
increase in population, however, it is a slow
process. Immigrants may increase the
population too.
2) If the average hours worked by the
population goes up, labour output may
increase, however it is rare. More likely to
occur in the short run.
3) If the labour participation rate increases, i.e. if more people are interested
to look for job, or the retirement age is increases then the labour supply
curve would shift to the right thus increased labour supply. Factors like
more female participation in the job market have led to a significant rise in
Bangladesh’s labour supply in recent years.

All three of these factors lead to shift in labour supply curve to the right, thus
leading to increased potential GDP.

According to the diagram, some concerns of rising labour supply are a fall in
standard of living due to real wage rate falls due to rising labour supply.
Average productivity falls too as described by the aggregate product function
explanation. As labour increases, productivity falls.
 ● Rise in labour productivity
A rise in labour productivity implies that the same worker can now give us
more/better output. Economic growth would occur if the labour force’s
productivity increases. This may be due to-
1) More educated/ experienced/trained workforce
2) Workforce with better health condition
3) Advances in technology
From the increase in productivity, for the same
input (labour), we get more output (potential
GDP). Labour demand also increases, as
employers would want to hire more productive
workers. Thus, real wage of workers increases.
Potential GDP increases again.
 AGGREGATE DEMAND AND AGGREGATE SUPPLY
Aggregate demand
The quantity of real GDP demanded is the total amount of final goods and
services produced in a country that people, businesses, governments, and
foreigners plan to buy in a given period of time and at a given price level.
Quantity of Real GDP demanded is:Y(output)= C+I+G+(X-M)
Buying plans depend on-
● The price level
● Expectations
● Fiscal and monetary policy
● The world economy

The relationship between the quantity of real GDP and

the price level is aggregate demand.
Price level and real GDP has an inverse relationship.

Reasons for downward sloping AD-

● Wealth Effect
Other things remaining the same, the higher the price level the lower the
real wealth. This is because money and other assets buy less thus the
quantity of real GDP demanded decreases as the price level rises.

● Substitution Effect
When today's Bangladeshi price level changes, other things remaining the
same, the expected future price level does not change and the price level
in the rest of the world does not change. A rise in Price Level also
 Increases the Interest Rate— as with smaller amount of Real Money
around, banks can charge higher interest rates on loans.

Changes in AD Curve
A change in any influence on buying plans other than the price level changes
the aggregate demand (AD). These influences can be-
● Expectations
Expectations about three factors have a big influence on spending plans
and affect aggregate demand. They are-
● Expectations about jobs and (disposable) incomes
● Expectations about future inflation
● Expectations about future profit
● Fiscal and monetary policy
Fiscal policy is the governments attempt to influence the economy by
setting and changing hanging taxes, making transfer payments and
purchasing goods and services.

AD increases if:
Taxes decreases
Transfer payments increases
Expenditures on goods and services increases

Monetary policy is the Central Bank’s attempt to influence the economy

by setting and changing interest rates (i) and quantity of money (Ms)
 AD increases if:
Interest rates decreases
The quantity of money increases
● The world economy
Changes in the world economy also influences the domestic economy
mainly through three channels:
AD rises when:
Foreign prices rise (rest of world price level falls)
Foreign income rises (rest of world Real GDP)
The foreign exchange rate decreases

AGGREGATE SUPPLY
The quantity of real GDP supplied is the total quantity of goods and services that
a firm plans to produce during a given period.
The quantity depends on the:
● Quantity of Labour (L)
● Quantity of human and physical capital (K)
● Technology (T)
At any given time Capital (K) and Technology (T) is fixed. But quantity of
labour (L) is variable.

The labour market can be in anyone of the three states:

● At full employment (where Real GDP supplied = Potential GDP)
● Above full employment (RGDP>PGDP)
● Below full employment (RGDP<PGDP)
In a business cycle: Employment fluctuates around full employment and RGDP
around PGDP.

Aggregate supply shows us the relationship between the quantity of Real GDP
supplied and the price level in two different time frames:
Long-run aggregate supply (LRAS)
It is the relationship between the quantity of real GDP supplied and the price
level when the money wage rate changes accordingly with the price level to
maintain full employment (RGDP=PGDP).
Along the LAS, as the price level changes the
money wage rate also changes, so the real wage
rate remains at the full-employment equilibrium
and Real GDP remains at Potential GDP.

If both Price Level and Money wage rate change

by the same percentage, the real wage rate
remains unchanged at its full employment level.
AND so Real GDP remains constant at Potential GDP.
Short-run aggregate supply
It is the relationship between the quantity of Real GDP supplied and the price
level when the money wage rate, the prices of factors of production and Potential
GDP remain constant.
In the short-run, a rise in the price level brings an
increase in the quantity of Real GDP supplied
As the SAS curve intersects the LAS curve, Real
GDP supplied equals Potential GDP.
If Price Level Rises and money wage rate and
other factor prices don't change. Then firms
increase production and real GDP supplied
increases.

Changes in Aggregate Supply

Aggregate supply changes when there is any influence on production plans other
than the price level changes and these influences are:
● Changes in potential GDP
Changes in Potential GDP increases both Long-run and Short-run
aggregate supply. Potential GDP can increase for
the following reasons:

1. An increase in the full employment quantity of

Labour
2. Increase in the Quantity of Capital
3. Advancement in Technology

● Changes in money wage rate and other resource prices

A rise in the money wage rate decreases SAS and shifts SAS to the left
 The money wage rate and other resource prices affect SAS as they
influence firms' costs. (higher money wage rate highest cost of production
and hence less quantity supplied)
A change in the money wage rate does not
change LAS, because for the LAS the a
change in Money wage rate must be
accompanied by an equal percentage change
in the Price level.

Why money wage rate changes?

- Two reasons
● Departure and full employment
Unemployment above natural rate puts downward pressure on
money wage rate
Unemployment below natural rate puts upward pressure
● Expected increase in the inflation rate increases money wage rate
and vice versa

Short-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs when the quantity of real GDP
demanded equals to the short-run quantity of real GDP supplied at the point of
intersection of the AD curve and the SRAS curve.
If real GDP is above equilibrium GDP, firms will
decrease production and lower prices. If real GDP is
below the equilibrium GDP, firms increase production
and raise prices.
Long-run macroeconomic equilibrium
Long-run macroeconomic equilibrium occurs when real GDP equals potential
GDP. Long-run equilibrium occurs because the money
wage rate adjusts.

In the long-run equilibrium, the money wage rate adjusts

to put the (pink) short-run aggregate supply curve
through the long-run equilibrium point.

Economic growth- It is when the quantity of labour

grows (L), capital is accumulated (K) and technology
advances (T). These changes increase potential
GDP and shift the long-run aggregate supply curve
rightward.
Inflation- It occurs when aggregate demand
increases by more than long-run aggregate supply,
or if the aggregate demand curve shifts rightward by
more than the rightward shift in the long-run aggregate supply curve.
The Business Cycle
Fluctuations in AD

Suppose government follows expansionary monetary policy. Thus, as interest

rates are cut, investments in the country rise (loans are cheaper to get). Thus AD
rises causing an increase in price level and inflationary gap in the shor-run.
Higher price levels mean companies earn more money, so they would raise the
wage rate of workers. Workers would be motivated due to increased wages and
thus would produce more amounts of goods causing SRAS to shift to the left in
the long-run as shown in the diagram.

Fluctuations in AS

Suppose oil prices start to fall in a country.

The firm would now have a higher operating
cost compared to its revenue. So, they would
lower their production of oil causing the
SRAS curve shift to the left.
AD-AS School Of Thoughts (5 min vid)
 Finance, Savings and Investment
In economics, we use the term finance to describe the activity of providing the
funds that finance expenditures on capital.
Money is what we use to pay for goods, services, factors of production and to
make financial transactions.
Physical and Financial Capital
Economists distinguish between physical capital and financial capital. Physical
capital is the tools, instruments, machines, buildings, and other items that have
been produced in the past and that are used today to produce goods and
services. (Ex: Inventories of raw materials, semi finished goods.)
The funds that firms use to buy physical capital are called financial capital.

Financial Capital Market

Saving is the source of the funds that are used to finance investment. These
funds are supplied and demanded in three types of financial markets:
● Loan market
Businesses often want short-term finance to buy inventories or to expand
their business, Households often want finance to purchase big ticket items,
such as automobiles or household furnishings and appliances Or to buy
new homes. They get this finance as bank loans, often in the form of
outstanding credit card balances. These funds are usually obtained as a
loan that is secured by a mortgage. All of these types of financing take
place in loan markets.
● Bond market
It is where bonds are bought and sold. A bond is a promise to make
specified payments on specified dates until maturity when the final
payment is made. Can be issued by both private corporations and the
government.
 For example, you can buy a Wal-Mart bond for $100 that promises to pay
$5.00 every year until 2024 and then to make a final payment of $100 in
2025. The buyer of a bond from Wal-Mart makes a loan to the company
and is entitled to the payments promised by the bond (given by the issuer).
When a person buys a newly issued bond, he or she may hold the bond
until the borrower has repaid the amount borrowed or sell it to someone
else.
Bonds issued by firms and governments are traded in the Bond market.
● Stock market
A stock is a certificate of ownership and claim to the firm's profits. It gives
partial ownership of a company. Thus don't have maturity.
Example: When Boeing wants finance to expand its aeroplane building
business, it issues stock. Boeing has issued about 900 shares of its stock.
So if you owned 90 Boeing shares, you would own 10% of Boeing and be
entitled to receive 10% of its profits.
Unlike a stockholder, a bondholder does not own part of the firm that
issued the bond. Thus, a stock market is a financial market in which
shares of stocks of corporations are traded. Ex: The New York Stock
Exchange(NSE), the London Stock Exchange (LSE). In Bangladesh we
have two stock exchanges- Dhaka Stock Exchange (DSE) and Chittagong
Stock Exchange (CSE).
Financial Institutions
A financial institution is a firm that operates on both sides of the market for
financial capital. The financial institution is a borrower in one market and a lender
in another. The key financial institutions are-
● Commercial Banks
● Government-sponsored mortgage lenders
● Pension funds
● Insurance companies
What finances Investment?
The loanable funds market is the aggregate of all the individual financial markets.
Funds that Finance Investment come from three sources:
● Household saving
● Government budget surplus
● Borrowing from the rest of the world
Households' income, Y, is spent on consumption goods and services, C, saved,
S, or paid in net taxes, T. So,
Income(Y) = C+ S +T
Y also equals the sum of the items of aggregate expenditure: consumption
expenditure, C, investment, I, government expenditure, G, and exports, X, minus
imports, M. Thus,
Y =C+I+G+(X-M)
By using these two equations, you can see that
I +G +X = M +S +T.
Subtract G and X from both sides of the last equation to obtain-
I = S+ (T- G) +(M -X)
This equation tells us that investment, I, is financed by household saving, S, the
government budget surplus, (T-G), and borrowing from the rest of the world,
(M-X)
A government budget surplus (T > G) contributes funds to finance investment,
but a government budget deficit (T < G) competes with investment for funds.

If we export less than we import, we borrow (M-X) from the rest of the world to
finance some of our investment.
If we export more than we import, we lend (X-M) to the rest of the world and part
of saving finances investment in other countries.
The sum of private saving, S, and government saving, (T-G), is called national
saving. National saving and foreign borrowing finance investment.
Real Vs Nominal Interest Rate
The nominal interest rate is the number of dollars(or other currency) that a
borrower pays and a lender receives in interest in a year expressed as a
percentage of the number of dollars borrowed and lent.
For example, if the annual interest paid on a $500 loan is $25, the nominal
interest rate is 5 per cent per year ($25 ÷ $500 x 100 or 5%)
The real interest rate is the nominal interest rate adjusted to remove the effects of
inflation on the buying power of money. The real interest rate is approximately
equal to the nominal interest rate - the inflation rate.
For example: Suppose that the inflation rate is 2% per year—during the year, in
the above example (i.e. all prices increased by 2 %), then the real interest rate is
370(5%-2%)
The Demand For Loanable Funds
The quantity of loanable funds demanded is the total
quantity of funds demanded to finance investment, the
government budget deficit, and international investment or
lending during a given period.
Many details influence this decision, but we can summarize
them in two factors:
● The real interest rate
● Expected profit
The demand for loanable funds is the relationship between the quantity of
loanable funds demanded and the real interest rate, when all other influences on
borrowing plans remain the same.
Changes in the Demand for Loanable Funds(due to
change in non-price factors)
Demand for Loanable Funds also changes due to change
in expectations.
Other things remaining the same, the greater the
expected profit from new capital, the greater is the
amount of investment and the greater the demand for
loanable funds. Expected profit also rises during a
business cycle expansion and falls during a recession;
Profit is expected to rise rises when technological change creates profitable new
products
Additionally, it rises as a growing population brings increasec demand for goods
and services.
These non-price factors causes a shift in the Demand curve

The Supply For Loanable Funds

The quantity of loanable funds supplied is the total
funds available from private saving, the government
budget surplus, and international borrowing during a
given period. Factors commonly determining the supply
decisions are:
● The real interest rate
● Disposable income
● Expected future income
● Wealth
● Default risk
The supply of loanable funds is the relationship between the quantity of loanable
funds supplied and the real interest rate when all other influences on lending
plans remain the same.
Changes in the Supply of Loanable Funds due to change in other non-price
factors
Disposable Income (income earned-taxes):
When disposable income increases, other things
remaining the same some of the increase in income is
saved. So the greater a household's disposable
income, the greater is its saving.
Expected Future Income:
The higher a household's expected future income,
other things remaining the same, the smaller is its
saving today.
Wealth:
The higher a household's wealth, other things remaining the same, the smaller is
its saving.
Default Risk(the risk that a loan will not be repaid):
The greater the default risk, the smaller is the supply of loanable funds.
These non-price factors cause a shift in the supply curve.
Equilibrium in the Loanable Fund Market
There is one real interest rate at which the quantities
of loanable funds demanded and supplied are equal,
That interest rate is the equilibrium real interest rate.

Changes in Demand and Supply bring fluctuations in

the equilibrium real interest rate and in the
equilibrium quantity of funds lent and borrowed.
An Increase in Demand-
If the profits that firms expect to earn increase, they
increase their planned investment and increase their
demand for loanable funds to finance that investment.
With an increase in the demand for loanable funds, but
no change in the supply of loanable funds, there is a
shortage of funds.
As borrowers compete for funds, the interest rate
rises, and lenders increase the quantity of funds
supplied.
Thus both equilibrium interest rate and quantity of loanable funds rise

An Increase in Supply-
If one of the influences on saving plans changes and
increases saving, the supply of loanable funds
increases.
With no change in the demand for loanable funds, the
market is flush with loanable funds.
Borrowers find bargains and lenders find themselves
accepting a lower interest rate.
At the lower interest rate, borrowers increase the
quantity of loanable funds that they borrow.
Thus the equilibrium interest rate will fall and the quantity of loanable funds will
rise.
Government in the Loanable Fund Market
Government enters the loanable funds market when it has a budget surplus or
budget deficit.
A government budget surplus increases the supply of loanable funds.
A government budget deficit increases the demand for loanable funds and
competes with businesses for funds.
A Government Budget Surplus:
A government budget surplus increases the supply of
loanable funds.
The real interest rate falls which decreases household
savings and decreases the quantity of private funds
supplied.
The lower real interest rate increases the quantity of
loanable funds demanded and increases investment.
A Government Budget Deficit:
A government budget deficit increases the demand for
loanable funds.
The real interest rate rises, which increases
household saving and increases the quantity of
private funds supplied.
But the higher real interest rate decreases investment
and the quantity of loanable funds demanded by firms
to finance investment.
The tendency for a government budget deficit to raise the real interest rate and
decrease investment is called the crowding-out effect.
The budget deficit crowds out investment by competing with businesses for
scarce financial capital.
The Ricardo-Barro Effect
First suggested by the English economist David
Ricardo in the eighteenth century and refined by
Robert J. Barro the Ricardo-Barro effect holds that
neither government surplus nor the deficit,
has any effect on either the real interest rate
or investment.
Barro says that, taxpayers are rational.
They can see that a budget deficit today means
that future taxes will be higher and future disposable incomes will be smaller.

With smaller expected future disposable incomes, saving increases today.

Private saving and the private supply of loanable funds rises to match the
quantity of loanable funds demanded by the government.
So the budget deficit has no effect on either the real interest rate or investment.

The Global Loanable Funds Market

The loanable funds market is global, not national. Lenders on the supply side of
the market want to earn the highest possible real interest rate and they will seek
it by looking everywhere in the world. Borrowers on the demand side of the
market want to pay the lowest possible real interest rate and they will seek it by
looking everywhere in the world.
This means, financial capital is mobile: It moves to the best advantage of lenders
and borrowers.
When funds leave the country with the lowest interest rate, a shortage of funds
raises the real interest rate. When funds move into the country with the highest
interest rate, a surplus of funds lowers the real interest rate.
The free international mobility of financial capital pulls real interest rates around
the world toward equality.
A country's loanable funds market connects with the global market through net
exports. [Exports(X)-Imports(M)]
If a country's net exports are negative (X<M), the rest of the world supplies funds
to that country and the quantity of loanable funds in that country is greater than
national savings.
If a country's net exports are positive (X>M ), the country is a net supplier of
funds to the rest of the world and the quantity of loanable funds in that country is
less than national savings.

Demand And Supply In The Global And National Markets

The demand for and supply of funds in the global loanable
funds market determines the world equilibrium real
interest rate.
This interest rate makes the quantity of loanable funds
demanded equal to the quantity supplied in the world
economy. But it does not make the quantity of funds
demanded and supplied equal in each national economy.

The demand for and supply of funds in a national economy determine whether
the country is a lender to or a borrower from the rest of the world.
International Borrowing and Lending

An International Borrower-
The country's demand for loanable funds, DLF, and supply of loanable funds,
SLFD, is part of the world supply.
If this country were isolated from the global market, the real interest rate would
be 6 per cent a year (where the DLF and SLFD curves intersect). But if the
country is integrated into the global economy, with an interest rate of 6 per cent a
year, funds would flood into it.
With a real interest rate of 5 percent a year in the rest of the world, suppliers of
loanable funds would seek higher return in this country.
At the new interest rate, the country borrows from the rest of the world.
An International Lender: The country's demand for loanable funds, DLF, and
supply of loanable funds, SLFD, is part of the world demand and supply If this
country were isolated from the global economy, the real interest rate would be 4
per cent a year (where the DLF and SLFD curves intersect). But if this country is
integrated into the global economy, with an interest rate of 4 per cent a year,
funds would quickly flow out of it. With a real interest rate of 5 per cent a year in
the rest of the world, domestic suppliers of loanable funds would seek the high
returns in other countries.
Again, the country faces the supply of loanable funds curve SLF, which is
horizontal at the world equilibrium interest rate.
At the new interest rate the country lends to the rest of the world
Changes in Demand and Supply
A change in the demand or supply in the global loanable funds market changes
the real interest rate.
The effect of a change in demand or supply in a national market depends on the
size of the country.
A change in demand or supply in a small country has no significant effect on
global demand or supply, so it leaves the world real interest rate unchanged and
changes only the country's net exports and international borrowing or lending.
A change in demand or supply in a large country has a significant effect on global
demand or supply, so it changes the world real interest rate as well as the
country's net exports and international borrowing or lending.

Money, The Price Level and Inflation

Money is defined as any commodity or token that is generally accepted as
means for payment.
Means of payment means a method of settling a debt. When a payment has
been made, there is no remaining obligation between the parties to a transaction.
Money serves three functions-
● Medium of exchange
● Store of value
● Unit of account
A depository institution is a financial firm that takes deposits from households
and firms. These deposits help generate money in the economy.
What do depository institutions do?
Depository institutions earn most of their income by using the funds they receive
from depositors to make loans and to buy securities that earn a higher interest
rate than that paid to depositors. In this activity, a depository institution must
perform a balancing act weighing return against risk.
A commercial bank puts the funds it receives into four types of assets :
● Reserves
● Liquid assets
● Securities
● Loans

Depository institutions provide four benefits

● Create liquidity
● Pool risk
● Lower the cost of borrowing
● Lower the cost of monitoring borrowing
Important concepts

Required Reserve Ratio- The required reserve ratio is the minimum percentage
of deposits that depository institutions are required to hold as reserves, which is
set by the central bank.
The Monetary Base- The monetary base is the sum of notes, coins, and banks'
deposits at the central bank. The size of the monetary base limits the total
quantity of money that the banking system can create.
Desired Reserves- A bank's desired reserves are the reserves that it plans to
hold. The quantity of desired reserves depends on the desired reserve ratio i.e.
the ratio of reserves to deposits that the banks plan to hold.
Desired Currency Holding- The proportions of money held as currency and
bank deposits, which is the ratio of currency to deposits. It depends on how
households and firms choose to make payments. When banks make loans that
increase deposits, some currency leaves the banks. Thus, the banking system
leaks reserves, known as currency drain, and we call the ratio of this currency to
deposits the currency drain ratio.
How the bank creates money by taking loans

Money market equilibrium

Money market equilibrium occurs when the quantity
of money demanded equals to the quantity of money
supplied. The adjustments that occur to bring money
market equilibrium are fundamentally different in the
short run and long run.

Demand for money

The demand for money is the relationship between
the quantity of real money demanded and the
nominal interest rate, ceteris paribus.
When the interest rate rises, other things remain the same, the opportunity cost
of holding money rises and the quantity of real money demanded decreases.
This negative relation is shown by the money demand curve (movement along
the same curve).
Change in Money Demand: When any influence on money holding other than
the interest rate changes, there is a change in the demand for money and the
demand for money curve shifts. Any factor other than the interest rate, if it
changes people's buying plans will shift the money demand curve either to the
left or right. Such factors can be Real GDP, Price level, Financial innovation etc.

Influences on money holding

The Price Level- The quantity of money measured in currency(dollars, BDT) is
nominal money. The quantity of nominal money demanded is proportional to the
price level, other things remaining the same.
If the price level rises by 10 percent, people hold 10 percent more nominal
money than before, other things remaining the same (However real money
balance remains constant).
The Nominal Interest Rate- The interest rate that you earn on currency and
checking deposits is zero.
So the opportunity cost of holding these items is the nominal interest rate on
other assets such as a savings bond or Treasury bill.
Other things remaining the same, the higher the expected inflation rate, the
higher is the nominal interest rate. (nominal interest rate= real interest rate+
inflation), the less is money holding.
Real GDP- The quantity of money demanded in the economy as a whole
depends on aggregate expenditure which is measured by the real GDP. Higher
the quantity goods and services in an economy, the higher the demand for
money.
Now, suppose that the prices of all goods remain constant but that your income
increases. As a consequence, you now buy more goods and services. So, you
also keep a larger amount of money on hand to finance your higher volume of
expenditure.
Financial Innovation- Technological change and the arrival of new financial
products influence the quantity of money held.
Financial innovations include Automatic transfers between checking and saving
deposits, Automatic teller machines, Credit cards and debit cards, Internet
banking and bill paying etc. These innovations have occurred because of the
development of computing power that has lowered the cost of calculations and
record keeping. As a result, they change the amount of money that people holds.

The Supply Of Money

The quantity of money supplied in the economy for a
fiscal year is fixed by the policy of the Central Bank.
Thus, the money supply is fixed and does not vary
with interest. The money supply curve is a vertical
line, at a fixed quantity of money.
The role of the central bank includes influencing the
quantity of money and interest rates by using the
following tools:
● Open market operations
● Last resort loans
● Required reserve ratio
Short-Run Equilibrium
In the diagram shown, the Central bank fixes the quantity
of real money supplied to $3.0 trillion and the supply of
money curve MS.
With demand for money curve MD, the equilibrium
interest rate is 5 percent a year. If the interest rate were
4 percent a year, people would want to hold more money
than is available. They would sell bonds and the interest
rate would rise. The opposite occurs if the interest rate
were 6 percent a year.

The Short-Run Effect Of A Change In The Supply Of Money

Starting from a short-run equilibrium, if the central bank
increases the quantity of money, people find themselves
holding more money than the quantity demanded.
With a surplus of money holding (MS0 to MS1), people
enter the loanable funds market and buy bonds. The
increase in demand for bonds raises the price of a bond
and lowers the interest rate. The new equilibrium occurs
at a lower interest rate and higher quantity of money.

Long-Run Equilibrium
The nominal interest rate is determined in the money market at the levels that
makes the quantity of money demanded equal the quantity supplied by the
central bank. The real interest rate (nominal interest rate- inflation) is determined
in the loanable funds market at the level that makes the quantity of loanable
funds demanded equal the quantity of loanable funds supplied. When the
inflation rate equals to the expected inflation rate and when real GDP equals
potential GDP, the money market, the loanable funds market, the goods market,
and the labour market are in long-run equilibrium. Thus, the economy is in
long-run equilibrium.
If in long-run equilibrium, the central bank increases the quantity of money,
eventually a new long-run equilibrium is reached in which nothing real has
changed. Real GDP, employment, the real quantity of money, and the real
interest rate all return to their original levels. But something does change: the
price level. The price level rises by the same percentage as the rise in the
quantity of money. So when the Central bank changes the nominal quantity of
money, in the long run the price level changes by a percentage equal to the
percentage change in the quantity of nominal money.

If we take reference from the diagram above, initially the long-run equilibrium
occurs where the nominal interest rate is 5% and Money supply is $3 trillion. Now
if the central bank increases the quantity of money by 10%, here are the steps in
what happens next:
First, the nominal interest rate falls. The real interest rate falls too, as people try
to get rid of their excess money holdings and buy bonds. With a lower real
interest rate, people want to borrow and spend more. Firms want to borrow to
invest and households want to borrow to invest in bigger homes or ot buy more
consumer goods.
The increase in the demand for all goods cannot be met by an increase in supply
because the economy is already at full employment. So, there is a general
shortage of all kinds of goods and services. The shortage of goods and services
forces the price levels to rise. As the price level rises, the real quantity of money
decreases. The decrease in the quantity of real money raises the nominal
interest rate and real interest rate. As the interest rates rises, spending plans are
cut back and eventually the original full-employment equilibrium is restored. At
the new long-run equilibrium, the price level has risen by 10% and nothing real
has changed.
 INFLATION
Inflation And The Price Level
Inflation is a process in which the price level rises and
money loses value. Inflation is fundamentally a monetary
phenomenon. We have average prices rising in the
economy. Inflation is not high prices, it is also not a jump
in prices.
First diagram shows inflation where the inflation rate is
the percentage change in price level during a given
period. The second diagram shows a one-time jump in
price level.

Demand-Pull Inflation
Demand pull inflation is inflation that results from an initial
increase in aggregate demand. A demand pull inflation can
result from any influence that increases aggregate
demand.
In demand-pull inflation, initially aggregate demand increases. Thus, real GDP
increases above potential GDP and the price level rises. At the same time,
money wages rise and the price level rises further so real GDP decreases
towards potential GDP.
A one-time increase in aggregate demand raises the price level but does not
always start a demand-pull inflation. For demand-pull inflation to occur,
aggregate demand must persistently increase. The money supply must
persistently grow at a rate that exceeds the growth rate of potential GDP.
The figures show a demand-pull inflation. Initially, aggregate demand increases.
Real GDP increases and the price level rises. Now, real GDP exceeds potential
GDP as seen in the first diagram.
There is an inflationary gap created from the first diagram. Thus, when we take
into account that money wages start to rise and the SAS curve shifts leftwards,
real GDP decreases back towards the potential GDP.
However, price level has ultimately increases from 110 to
113 to finally 121.
This process repeats in an un-ending price wage spiral.
Inflationary Gap
If real GDP > Potential GDP (full employment GDP), then
an inflationary gap exist. At the same time,
unemployment rate < natural rate of unemployment.
Since job seekers are less than job openings in the
market, employers are forced to raise the wage to attract
more workers. High wages will decrease the AS, and
raise the price. Higher price will lower consumption. This
process will repeat until the long-run equilibrium is
reached.
Recessionary Gap
If real GDP < Potential GDP (full employment GDP),
then a recessionary gap exists. Ar the same time,
Unemployment Rate > Natural Rate Of
Unemployment. Since job seekers are high, they tend
to settle for lower wages. Lower wage will lower the
AS curve causing the price to decrease. Lower price
will increase consumption. This process will continue
until the economy reaches long-run equilibrium
(potential GDP).

Cost-push inflation
Cost-push inflation is an inflation that results from an initial increase in costs. The
two main sources of cost-push inflation are:
● An increase in the money wage rate
● An increase in the money prices of raw materials
In a cost push inflation, initially short-run aggregate supply decreases. Thus, real
GDP decrease below potential GDP and the price level rises. Here the economy
could become stuck in this stagflation situation for sometime.
Stagflation- The combination of a rising price level and falling real GDP

A one-time decrease in aggregate supply raises the price level but does not
always start a cost-push inflation. For cost-push inflation to occur, aggregate
demand must increase in response to this cost-push.

The following figures show cost-push inflation. Initially, a factor price rises.
Short-run aggregate supply decrease and the SAS curve shifts leftward. Real
GDP falls and the price level rises in stagflation.
With no subsequent change in demand, prices are bound to fall. Thus, no
inflation would occur. For cost-push inflation to occur,
aggregate demand must increase.
If there is an increase in money supply, it increases AD
and the AD curve shifts to the right. Real GDP goes back
to its original level and ultimately price level rises from
110 to 117 to 121. This process repeats to create an
unending cost-price inflation spiral.
Hyperinflation
It is when inflation is more than 50% per month. Although rare, some examples
of hyperinflation are there in the 1980’s when Bolivia, Argentina and Nicaragua
experienced hyperinflation.
During hyperinflation, money no longer works very well in facilitating exchange.
Since prices are changing so fast and unpredictable, there is typically massive
confusion about the true value of commodities. Different stores may be raising
prices at different rates so the same commodities may sell for radically different
prices. Everyone spends all their time hunting for bargains and finding the lowest
price. Governments are forced to put an end to hyperinflation before it destroys
their economies.
Hyperinflation typically occurs in countries with large deficits, cannot borrow
money and thus are forced to print more. It can only be stopped by eliminating
the deficit which is the basic cause. The government would need to raise taxes
and cut on spending. Once the deficit is cut and the government stops printing
money, the hyperinflation would end.

Effects of Inflation
Whether it is demand-pulled or cost-pushed, inflation imposes costs. The costs
depend on whether the inflation is expected or non-expected.

Expected Inflation-
If inflation is expected, the fluctuations in real GDP that accompany demand-pull
and cost-push inflation discussed doesn’t occur. Instead, inflation proceeds as it
does in the long-run, with real GDP equal to potential GDP
and unemployment at its natural rate.
In the figure shown, it is supposed that aggregate demand
curve was AD0, the aggregate supply curve was SAS0 and
the long run aggregate supply curve was LAS.
This figure shows how anticipating inflation avoids the cost of deviations from
potential GDP.
Anticipating inflation also avoids
● The redistribution of income and wealth
● Errors in investment and savings decision
Still anticipated inflation has some costs-
● “Bootleather” costs (walking around to look for a job)
● Other transaction costs
● Potential GDP decreasing
● Fall in long-term growth rate
The costs are estimated to be very high, even for a modest inflation. The main
problem is that taxes on capital income is seriously distorted by inflation.

Non-Expected Inflation-
The following problems may occur due to unexpected inflation:
● Redistribute income within firms and workers
● Move real GDP away from potential GDP
● Redistribute wealth between borrowers and lenders
● Result in too much or too little savings and investment

As unexpected inflation is costly, people try to anticipate it. To make the best
possible forecast of inflation, people use all the information they can about the
source of inflation and likely trends in those sources. Such a forecast is called a
rational expectation. An anticipated inflation avoids some of the costs of
inflation.
Deflation
An economy experiences deflation when it has a persistent fall in the general
price level in the economy. Equivalently, during deflation the inflation rate is
negative.
In most economies and for most of the time, the inflation rate is positive and the
price level is rising. Deflation is very rare, but it does happen.
A one time fall in price level can occur because AD decreases or SAS increases.
However, it is not deflation. Deflation is a persistent fall which may occur if AD
increases at a persistently slower rate than AS.
The trend rate of increase in aggregate supply is determined by the forces that
make , potential GDP grow. These forces are the growth rates of the workforce
and capital stock and the growth rate of productivity that results from
technological change. All these variables are real, not monetary, and they have
trends that change slowly.

Consequences of Deflation
The consequence depends on whether the deflation was expected or
unexpected. However, as inflation is normal and deflation is rare, it is usually
unexpected.
Unanticipated deflation redistributes income and wealth, lowers real GDP and
employment, and diverts resources from production. Workers with long-term
wage contracts find their real wages rising. But on the other side of the labour
market, employers respond to a higher and rising real wage by hiring fewer
workers. So the level of employment and output falls.
With lower output and profits, firms re-evaluate their investment plans and cut
back on projects that they now see as unprofitable. The fall in investment slows
the pace of capital accumulation and slows the growth rate of potential GDP.
Another consequence of deflation is a low nominal interest rate, which, in turn,
brings an increase in the quantity of money that people plan to hold and a
decrease in the velocity of circulation.
To end deflation, we need an increase in the growth rate of the money stock, not
a one-time increase in the quantity of money, that is required. Central banks
sometimes increase the quantity of money and fail to increase its growth rate. An
increase in the level with no change in the growth rate brings a temporary
inflation as the price level adjusts but not ongoing inflation, so it does not end
deflation.

GOVERNMENT POLICIES
Fiscal Policy
Fiscal policy is a government’s use of its budget to achieve some
macroeconomic objectives. Some objectives of government include-
● Low Unemployment
● Price Stability (not volatile inflation)
● Economic growth

Budget- Suppose a person’s income is $100 weekly. They spend $80 in that
week. Thus, they have a $20 budget surplus. However, if the same person spent
$130, they would have a $30 budget deficit. (This extra $30 may come from
loans for the person)
Governments also have a budget. Their income is known as receipts i.e. how
government raises money, and their expenditure is known as outlays i.e. how
government plans to spend.

Receipts- This is how government raises money. A common example is taxation

which include income tax, corporate tax, VAT etc. Incomes may also be gotten
from our payment of water and electricity to government
Outlays- This is how government spends money. Examples include spending on
goods and services, interest payments for loans, transfer payments (relief fund).

Receipts - Outlays = Budget Balance

In 2020 Bangladesh, 5.68 trillion taka was planned to be spent as outlays, while
1.90 trillion taka was assumed to be the budget deficit. Thus, revenue of
government was 5.68-1.90= 3.78 trillion taka.
There are two types of fiscal policy-
● Expansionary Fiscal Policy
It is when the government lowers taxation and increases government
spending
● Contractionary Fiscal Policy
It is when the government increases taxation and decreases
government spending

Expansionary Fiscal Policy has two distinctions-

● Automatic Fiscal Stimulus
● Discretionary Fiscal Stimulus
Here, we see that real GDP is lower at 1500 than the potential GDP of 1600.
Thus, there is a recessionary gap. To combat this, government raises spending
to increase AD. As AD increases, real GDP also gets closer to the potential GDP
and recessionary gap reduces. As increasing government spending is creating a
stimulus in the economy, consumption C also goes up.
However, government mostly operates on debts. Thus, as
debt increases, demand for loanable funds increases, thus
interest rates increases. Thus, investments may reduce
leading to a lowering of AD. If change in consumption is more
than change in investment, then monetary policy is effective.

Summary of fiscal policy example

If an economy is operating below potential GDP, then expansionary fiscal policy
is undertaken to increase GDP. Government will either increase expenditure or
lower tax. AD = C+I+G+(X-M). As G increases, AD curve shifts to the right and
GDP increases. Also, as G increases, C increases, however I may fall.

At the end of the day, the effect which is greater is what matter. If change in
consumption is greater than the change in investment, AD increases and vice
versa.
Monetary Policy
Monetary policy is the use of interest rates or money supply to meet some
macroeconomic objectives which include:
● Low Unemployment
● Price Stability
● Economic growth (Y increases)
There are two types of monetary policy-
● Expansionary Monetary Policy
● Contractionary Monetary Policy

The goal of the government is to increase Y to Y*.

Government can use expansionary monetary policy to
increase it.

Here, as money supply is increased, we can see than quantity of money in the
economy increases, which also corresponds to a decrease in the interest rates.
Now, if we take a look at the loanable funds market, as money supply increases,
banks can give out more loans so supply of loans shifts rightwards, which also
indicates the lowering of interest rates.
As interest rates fall, consumers will consume more as people will take more
loans and save less. Investors will also invest more.
Exchange rates of local currency also falls, thus exports
rise and imports fall. Thus, net exports will increase.
Thus as a whole, C, I and net exports rise leading to
increased AD.

If contractionary monetary policy is imposed, interest rates rise. Thus,

consumption, investments and net exports would fall. Thus, AD falls.