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CHAPTER 23: Measuring a Nation’s Income

- Microeconomics: The study of how individual households and firms make decisions, interact with
one another in markets.
- Macroeconomics: The study of the economy as a whole.
1. Gross Domestic Product (GDP)
- Measures:Total income of everyone in the economy equal and total expenditure on the economy’s
output of goods and services

Notes: Omit The government, The financial system,

The foreign sector

- Definition: Gross Domestic Product (GDP) is the market value of all final goods & services produced
within a country in a given period of time.
- Components of GDP:
Y = C + I + G + NX
+ Consumption (C): is total spending by households on g&s.
+ Investment(I): is total spending on goods that will be used in the future to produce more goods
(capital equipment, structures), - does not mean the purchase of financial assets like stocks and bonds.
+Government Purchases(G):is all spending on the g&s purchased by govt
at the federal, state, and local levels. - excludes transfer payments. They do not purchase goods and
service.
+ Net Exports (NX)= Export- Import
2. Nominal GDP, Real GDP, and GDP deflator

- Nominal GDP values output using current prices. It is not corrected for inflation.
- Real GDP values output using the prices of a base year. Real GDP is corrected for inflation
- GDP deflator is a measure of the overall level of prices.
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CHAPTER 24: Measuring the Cost of Living

1. Consumer Price Index (CPI):
Measures ? measures the typical consumer’s cost of living (foods, service of health, service of
education,…)
- CPI is Calculated by 5 steps:
Step 1: Fix the “basket. - what’s in the typical consumer’s “shopping basket

Step 2: Find the prices.- the prices of all the goods in the basket.
Step 3: Compute the basket’s cost. - Use the prices to compute the total cost of the basket.
Step 4: Choose a base year and compute the index.
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Step 5: Compute the inflation rate: The percentage change in the CPI from the preceding period

Problems with the CPI:

-Substitution Bias Over time, some prices rise faster than others. Consumers substitute toward
goods that become relatively cheaper
Introduction of New Goods: The introduction of new goods increases variety, allows consumers to
find products that more closely meet their needs. In effect, dollars become more valuable.

Unmeasured Quality Change: Improvements in the quality of goods in the basket increase the
value of each dollar
⇨ The CPI misses these because it uses a fixed basket of goods. CPI overstates increases in the
cost of living.
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2. Comparing Dollar Figures from Different Times

▪ Example: the minimum wage

▪ $1.15 in Dec 1964
▪ $5.85 in Dec 2007
▪ In our example,
211.7
▪ year T = 12/1964,
“today” = 12/2007
$7.78 = $1.15 x
▪ Min wage = $1.15 in year
31.3
T

▪ CPI = 31.3 in year T, CPI = 211.7 today

3. The nominal interest rate vs The real interest rate

The nominal interest rate: the interest rate not corrected for inflation; the rate of growth in the dollar
value of a deposit or debt

The real interest rate: corrected for inflation; the rate of growth in the purchasing power of a deposit
or debt

CHAPTER 25: Production and growth

1. Productivity.
Why Productivity Is So Important: A country's standard of living depends on its ability to produce goods
and services.
PRODUCTIVITY: the average quantity of goods and service produced per unit of labor input.

-Productivity = Y/L (output per worker) (Y: real GDP, L: quantity of labor)
=>When a nation’s workers are very productive, real GDP is large and incomes are high and in contrast.
How Productivity Is Determined
-Physical Capital per worker

+ The stock of equipment and structures used to produce g&s is called [physical] capital, denoted K.
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+ K/L = capital per worker.

+ Productivity is higher when the average worker has more capital (machines, equipment, etc.).
-Human capital (H): the knowledge and skills workers acquire through education, training, and experience

+ H/L = the average worker’s human capital

+ Productivity is higher when the average worker has more human capital (education, skills, etc.). An
increase in H/L causes an increase in Y/L
-Natural resources (N): the inputs into production that nature provides, e.g., land, mineral deposits

+ Other things equal, more N allows a country to produce more Y. An increase in N/L causes an
increase in Y/L.
+ Some countries are rich because they have abundant natural resources
+ But countries need not have much N to be rich (e.g., Japan imports the N it needs).

-Technological knowledge: society’s understanding of the best ways to produce g&s

+Technological progress does not only mean a faster computer, a higher-definition TV, or a
smartphone.
+ It means any advance in knowledge that boosts productivity (allows society to get more output from
its resources).

⇨ Technological knowledge refers to society’s understanding of how to produce g&s. Human capital
results from the effort people expend to acquire this knowledge. Both are important for
productivity.
The Production Function: is a graph or equation showing the relation between output and inputs:

Y = A F(L, K, H, N)
F– a function that shows how inputs are combined to produce output
“A” – the level of technology
“A” multiplies the function F( ), so improvements in technology (increases in “A”) allow more output (Y) to
be produced from any given combination of inputs.
2. Economic Growth and Public policy
-The ways public policy can affect long-run growth in productivity and living standards.
* Saving and Investment

* Diminishing Returns and the Catch-Up Effect

+ Diminishing Returns: If workers have little K, giving them more increases their productivity a lot
and in contrast
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+ Catch-Up Effect: The property whereby poor countries tend to grow more rapidly than rich ones
* Investment from Abroad
▪ Foreign direct investment: a capital investment (e.g., factory) that is owned & operated by
a foreign entity
▪ Foreign portfolio investment: a capital investment financed with foreign money but
operated by domestic residents
Free Trade
● Inward-oriented policies :aim to raise living standards by avoiding interaction with other
countries.

● Outward-oriented policies: promote integration with the world economy

Education, Health and Nutrition, Property Rights and Political Stability, Research and Development,
Population Growth

CHAPTER 26: Saving, Investment, and the Financial System

1. The Financial system:
The group of institutions that helps match the saving of one person with the investment of another.
Financial markets: institutions through which savers can directly provide funds to borrowers.
Examples:

▪ The Bond Market: A bond is a certificate of indebtedness.

▪ The Stock Market: A stock is a claim to partial ownership in a firm.
Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers.
Examples:
▪ Banks
▪ Mutual funds – institutions that sell shares to the public and use the proceeds to buy
portfolios of stocks and bonds
2. Kinds of saving
▪ Private saving: The portion of households’ income that is not used for consumption or paying taxes
=Y – T – C. It is the income remaining after households pay their taxes and pay for consumption
▪ Public saving: Tax revenue less government spending = T – G
⇨ Saving = investment in a closed economy
▪ National saving (=private saving + public saving =Y – C – G) is the portion of national income that
is not used for consumption or government purchases
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▪ Budget surplus: an excess of tax revenue over govt spending =T – G =public saving
▪ Budget deficit: a shortfall of tax revenue from govt spending =G – T = – (public saving)
- Investment is the purchase of new capital. In economics, investment is NOT the purchase of stocks
and bonds!
3. The Market for Loanable Funds
The supply of loanable funds comes from saving:
▪ Households with extra income can loan it out and earn interest.

▪ Public saving, if positive, adds to national saving and the supply of loanable funds. If
negative, it reduces national saving and the supply of loanable funds.
The demand for loanable funds comes from investment:
▪ Firms borrow the funds they need to pay for new equipment, factories, etc.

▪ Households borrow the funds they need to purchase new houses.

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-
-
- Increase in budget deficit causes fall in investment.The govt borrows to finance its deficit,
leaving less funds available for investment -> Crowding out.
- Investment is important for long-run economic growth. Hence, budget deficits reduce the
economy's growth rate and future standard of living.

CHAPTER 28: UNEMPLOYMENT

1. Identifying unemployment

3 groups:
▪ Employed: paid employees, self-employed, and unpaid workers in a family business
▪ Unemployed: people not working who have looked for work during previous 4 weeks
▪ Not in the labor force: everyone else

- Labor force is the total number of workers, including the employed and unemployed.

- Unemployment rate (“u-rate”): % of the labor force that is unemployed

- Labor force participation rate: % of the adult population that is in the labor force
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*The u-rate is not a perfect indicator of joblessness or the health of the labor market:
▪ It excludes discouraged workers (would like to work but have given up looking for jobs;
classified as “not in the labor force” rather than “unemployed”)
▪ It does not distinguish between full-time and part-time work, or people working part time
because full-time jobs are not available.
▪ Some people misreport their work status in the BLS survey.
Natural rate of unemployment: the normal rate of unemployment around which the actual unemployment
rate fluctuates
Cyclical unemployment the deviation of unemployment from its natural rate. It associated with business
cycles
Frictional unemployment: occurs when workers spend time searching for the jobs that best suit their skills
and tastes.
Structural unemployment: occurs when there are fewer jobs than workers. (Longer -term)

2. Reasons for unemployment

2.1. Job Search: is the process of matching workers with appropriate jobs
The economy is always changing (Sectoral shifts) -> changes in the composition of demand across industries
or regions of the country-> Displace some workers, who must search for new jobs appropriate for their skills
& tastes-> Frictional unemployment is inevitable
Public Policy
-Govt employment agencies: provide information about job vacancies to speed up the matching of workers
with jobs.

-Public training programs: aim to equip workers displaced from declining industries with the skills needed
in growing industries.
-Unemployment insurance (UI): a government program that partially protects workers’ incomes when they
become unemployed.
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+Increases frictional unemployment. : UI benefits end when a worker takes a job, so workers have
less incentive to search or take jobs while eligible to receive benefits.
+ However, it has some benefits: reduces uncertainty over incomes, gives the unemployed more time
to search, resulting in better job matches and thus higher productivity
2.2 Minimum-Wage Laws
The wage is above the equilibrium level-> The quantity of labor supplied exceeds the quantity of labor
demanded-> Surplus -> workers are unemployed because they are waiting for jobs to open up.

2.3. Unions
- A worker association that bargains with employers over wages, benefits, and working conditions
- When unions raise the wage above eq’m, the quantity of labor demanded falls and unemployment results.
2.4. Efficiency Wages:Firms operate more efficiently if wages are above the equilibrium level

- Worker health: Paying higher wages allows workers to eat better, makes them healthier, more productive.
-Worker turnover: Hiring & training new workers is costly.
Paying high wages gives workers more incentive to stay, reduces turnover
- Worker quality: Offering higher wages attracts better job applicants, increases quality of the firm’s
workforce

- Worker effort: so workers have more incentive to work, not shirk.

CHAPTER 29: The Monetary System

1. The Meaning of Money
- Money: the set of assets that people regularly use to buy g&s from other people.

Function:
- Medium of exchange: an item buyers give to sellers when they want to purchase g&s
- Unit of account: the yardstick people use to post prices and record debts
- Store of value: an item people can use to transfer purchasing power from the present to the future

2 Kinds of Money
- Commodity money: takes the form of a commodity with intrinsic value
- Fiat money: money without intrinsic value, used as money because of govt decree
2. Banks and the Money Supply
- Money supply: the quantity of money available in the economy (Currency, and Demand deposits)
- Federal Reserve (Fed) :the central bank of the United States
- Central bank: an institution designed to oversee the banking system and regulate the quantity of
money in the economy
- Monetary policy: the setting of the money supply by policymakers in the central bank
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*How banks influence the money supply

Ex: Suppose $100 of currency is in circulation.
1. No banking system
Public holds the $100 as currency.
Money supply = $100.
⇨ Banks do not affect the size of money supply.
2. 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans
Public deposits the $100 at First National Bank (FNB). FNB holds
100% of deposit as reserves (reserves: deposits that banks have received but have not loaned out)

Money supply = currency + deposits = $0 + $100 = $100

⇨ Banks do not affect the size of money supply.
3. Fractional reserve banking system:
- Fractional-reserve banking: a banking system in which banks hold only a fraction of deposits as
reserves
- Reserve ratio (R): the fraction of deposits that banks hold as reserve

Money supply = currency (Loan) + deposits = $90+ $100 = $190

⇨ A fractional reserve banking system creates money, but not wealth
● Money multiplier(1/R): the amount of money the banking system generates with each dollar of
reserves
In our example,
R = 10% -> 1/R = 10
⇨ $100 of reserves creates $1000 of money
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Thus, the higher the reserve ratio, the less of each deposit banks loan out, and the smaller the
money multiplier.

Other assets ( securities - bond,stock,...)

The leverage ratio: is the ratio of the bank’s total assets to bank capital.
-> the leverage ratio is $1,000/$50, or 20.
(for every dollar of capital that the bank owners have contributed, the bank has
$20 of assets)
3. The Fed’s 3 Tools of Monetary Control
How the Fed Influences the Quantity of Reserves (buying or selling bonds in open-market
operations or by making loans to banks)
Open-Market Operations (OMOs): the purchase and sale of U.S. government bonds by the Fed
▪ To increase money supply, Fed buys govt bonds, paying with new dollars-> increase the number of
dollars in the economy
…which are deposited in banks, increasing reserves
…which banks use to make loans, causing the money supply to expand.
▪ To reduce money supply, Fed sells govt bonds, public pays for these bonds
with its holdings of currency and bank deposits, make withdrawals from banks -> taking dollars out
of circulation, and the process works in reverse.
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Fed Lending to Bank

When banks are running low on reserves, they may borrow reserves from the Fed.
▪ To increase money supply,
The Fed can lower the discount rate, which encourages banks to borrow more reserves from the
Fed.
Banks can then make more loans, which increases the money supply.
▪ To reduce money supply, the Fed can raise the discount rate.
How the Fed Influences the Reserve Ratio
Reserve Requirements - , the regulations that set the minimum amount of reserves that banks
must hold against their deposits.
▪ To increase money supply, the Fed reduces RR.
Banks make more loans from each dollar of reserves, which increases money multiplier and
money supply.
▪ To reduce money supply, the Fed raises RR, and the process works in reverse.