Economics: Macroeconomic Analysis Flashcards
Aggregate Output: GDP
Market value of all final goods and services produced in a country/economy.
- Produced during the period
- Only goods that are valued in the market
- Final goods and services only (not intermediate)
- Rental value for owner occupied housing (estimated)
- Government services (at cost)-not transfers
Aggregate Output: Calculating GDP - Income Approach
Earnings of all households + businesses + government
Expenditures Approach
Sum the market values of all final goods and services produced in the economy
OR
Sum all the increases in value at each stage of the production process.
Aggregate Output: GDP - Expenditures Approach
GDP = C + I + G + (X - M)
C = consuption spending
I = business investment )capital equipment + change in inventories_
G= goverment purchases
X = exports
M = imports
Aggregate Output: Final Values and Value Added
Aggregate Output: Nominal vs. Real GDP
Aggregate Output: GDP Deflator
Aggregate Output: National Income
GDP = national income
- +capital consumption allowance
- +statistical discrepancy
Capital consumption allowance is the output that goes to replace capital stock wearing out, depreciation
National income =
- employees’ wages and benefits
- +corporate and governmen tprofits pre-tax
- +interest income
- +unincorporated business owners’ income
- +rent
- +indirect business taxes - subsidies
(taxes and subsidies included in final prices)
Aggregate Output: Personal Income
Personal income=
national income
+ transfer of payments to households
- indirect business taxes
- corporate income taxes
- undistributed corporate profits
Aggregate Output: Personal Disposable Income
Personal disposable income
= personal income - personal taxes
= after-tax income
Each period, individuals decide whethr to consume or save disposable income
Aggregate Output: Deriving the Fundamental Relationship
GDP = C + 1 +G + (X - M) Total Expenditures
GDP = C + S +T Total Income
¢ + S + T = ¢ + I + G + (X - M)
S + T = I + G + (X - M)
S = I + (G - T) + (X - M)
Aggregate Output: Fundamental Relationship
S = I + (G - T) + (X - M)
Savings = Investment + Fiscal Balance + Trade Balance
Saving are either invested, used to finance government deficit, or used to fund a trade surplus, when both exist.
Aggregate Output: Income = Savings (IS) Curve
**When income = planned expenditure: **
(S - I) = (G - T) + (X - M)
Increase in income increases savings more than investment → (S - I) is an increasing function of income
Increase in income decreases fiscal deficit, increases imports → (G - T) + (X - M) is a decreasing function of income.
Aggregate Output: Deriving the IS Curve
Aggregate Output: IS Curve: Increase in real interest rate
When income = planned expenditure
(S- I) = (G - T) + (X - M)
Increase in real interest rate, holding (G - T) + (X - M) and (S - I) constant:
- Investment decreases
- Savings must also decrease
- Decrease in savings must result from decrease in income
Aggregate Output: The IS Curve
Aggregate Output: Equilibrium in the Money Market
Real money supply (M/P)
Money demand = f (real rates, income)
M/P = MD (r,Y)
Real rates up → quantity demanded down
Income up → quantity demanded up
Higher real interest rates → higher income
Aggregate Output: The LM Curve
Aggregate Output: The Aggregate Demand Curve
Aggregate Output: Aggregate Supply
In the very short run: Aggregate supply does not change (input quantities are fixed)
In the short run: input prices are fixed so businesses expand real output when (output) price increase
In the long run: Aggregate supply is fixed at full-employment or potential real GDP
Aggregate Output: Aggregate Supply Chart
Aggregate Output: Aggregate Demand
- The aggregate demand curve (AD) shows the relation between price level and real quantity of final goods and servies (real GDP) demanded
- Components of aggregate demand
- Consumption (C)
- Investment (I)
- Government spending (G)
- Net exports (X), exports minus imports
Aggregate demand = C + I + G + netX
Aggregate Output: Shifts in Aggregate Demand
C + I + G + netX
- Increase in wealth increase C
- Increase in expectations for economic growth increase C, I
- Capacity utilization > - 85% increase I
- Increase in tax rates decrease disposable income and C
- I_ncreases in government spending_, G
- Increases in money supply reduce real rates and increase I, C
- Depreciation of currency increases netX - imports prices up, export prices down
- Growth of foreign GDP increases netX
Aggregate Output: Shifts in SR Aggregate Supply
Factors that Increase SRAS
- Descrease in input prices
- Improved expectation about future
- Decreases in business taxes
- Increases in business subsidies
- Currency appreciation that reduces the cost of imported inputs
Aggregate Output: Shifts in LR Aggregate Supply
Factors the Increase LRAS
- Increase in labor supply
- Increased availability of natural resources
- Increase stock of physical capital
- Increased human capital (labor quality)
- Advances in technology/labor productivity
Aggregate Output: Short-Run Disequilibrium
Aggregate Output: Increase in Aggregate Demand
Aggregate Output: Decrease in Aggregate Demand
Aggregate Output: Stagflation
- A supply shock decreases SRAS
- Prices rise to P1 and output declines to GDP1
- Government can address inflation or recession, not both
- It can take a long, difficult time for wages and input prices to fall
Aggregate Output: Sources of Economic Growth
Same as factors that increase LRAS
- Increase in labor supply
- Increased availabilit of natural resources
- Increased stock of physical capital
- Increased human capital (labor quality)
- Advances in technology/labor productivity
Aggregate Output: Sustainable Growth
**Potential GDP = **
Aggregate hours worked x labor productivity
Growth **in Potential GDP = **
growth in labor force +
growth in labor productivity
Long-term equity returns are dependent on sustainable growth
Aggregate Output: Production Function Approach
Y = A x f(L, K)
where:
Y = aggregate economic output
L = size of labor force
K = amount of capital available
A = total factor productivity, the increase in output not from increases in labor and capital, closely related to advances in technology
Aggregate Output: Output per worker
One measure of eocnomic progress is output per worker
Because of the diminishing marginal productivity of capital, progress in developed countries relies on technology.
Aggregate Output: Components of Economic Growth
Growth in potential GDP =
growth in total factor productivity +
WC (growth in capital) +
WL (growth in labor)
Where the weights are each factor’s share of national income
Aggregate Output: Per Capita Growth
**Growth in per-capital potential GDP = **
growth in technology +
WC(growth in capital-to-labor ratio)
In developed countries, K/L is high and growth in per capital GDP must come from technolical advancement
Aggregate Output: Example: Total Productivity
Aggregate Output: Problem
Business Cycles: Chart
Business Cycles: Inventory/Sales Ratios
- Eariy in a contraction, sales slow unexpectedly, casusing unplanned increase in inventories to above-normal levels
- Early in an expansion, sales increase unexpectedly, causing unplanned decrease in inventories; inventory/sales ratios decrease to below-normal levels
Business Cycles: Labor and Capital Utilization
- Firms are slow to hire/lay off employess or increase/decrease physical capital because frequent adustments are costly
- At the beginning of a contraction, sales fall and both labor and capital are used less intensively
- At the beginning of an expansion, sales increase and both labor and captital are used more intensively
- When sales trends persist, firms adust labor and physical capital over time
Business Cycles: Housing Sector
- Highly cyclical sector of the economy
- Activity determined by:
- Mortgage Rates: Rates Increase, as housing decreases
- Income / housing costs: When income rises, housing rises
- Speculation: Home purchases based on expected price increase
- Demographics: Household formations, geographic shifts in population density.
Business Cycles: External Trade Sector
- Imports determined by domestic incomes - depend on domestic business cycle
- Exports determed by foreign incomes- independent of domestic business cycle
- Both imports and exports influenced by currency exchange rates
- Domestic currency appreaciates: Imports Rise, Exports Fall
- Domestic currency depreciates: Imports Fall, Exports Rise
Business Cycles: Neoclassical, New/Keynesian
Business Cycles: Monetarist, Austrian, and New Classical
Business Cycles: Types of Unemployment
- Frictional unemployment results from time it takes employers and employees to find each other
- Structural emloyment results from long-term changes in the economy that require workers to gain new skills to fill new jobs
- Cyclical unemployment results from changes in economic growth; = 0 at full employment.
Business Cycles: Unemployment Rate
To be counted as unemployed, a person ust be available for work and actively looking for work
Labor force consists of those who are employed and those who are unemployed
Business Cycles: Unemployment Measures
- Discouraged Workers and Participation Ratio
- Discouraged workers are those who are avaiable for work but not emplyed or seeking employment; considered not in labor force and not counted as unemolued.
Business Cycles: Inflation, Disinflation, and Deflation
- Inflation: Persistent increase in price level over time
- Inflation rate: Percent increase in price level over a period (usually one year)
- Disinflation: Decreae in positive inflation rate over time
- Deflation: Persistent decrease in price level over time; negative inflation rate
- Hyperinflation: Out-of-control high inflation
Business Cycles: Inflation Indexes
- A price index is a weighted average of goods and services prices compared to a base period used as a proxy for the overall or average price level
- The consumer price index (CPI) measures the cost of a fixed “basket” of goods and services compared to the cost in a base period
Business Cycles: Calculating the CPI
- Find the cost of the CPI basket in the base period
- Find the cost of the CPI basket in the current period
Business Cycles: Other Inflation Indexes
- Price index for personal consumption expenditures: Surveys businesses instead of consumers
- GDP Deflator
- Producer price index: Crude materials, intermediate goods, finished goods price
Business Cycles: Headline and Core Inflation
- Price indexes that include all goods and services measure headline inflation
- Core inflation refers to prices of all goods excluding food and energy
- Food and energy prices are subject to large short-term fluctuations that can magnify or mask the true inflation rate.
Business Cycles: Limitations of Inflation Measures
- The CPI is widely believed to overstate the true rate of inflation
- The most significant biases in the CPI data includeL
- Consumer substitution of lower-priced products for higher-priced products
- New goods replace older, lower-priced products
- Price increases due to quality improvments.
Business Cycles: Adjustment for CPI Bias
CPI is calculated using basket weights from base period (laspeyres index)
A Paasche index uses basket eweights from current period and compares cost to base period
Chained price index reduces bias from substitution (e.g. Fisher index = geometric mean of Laspeyres and Paasche indexes)
Business Cycles: Factors that Affect Price Levels
- Cost-push (or wage-push) inflation: increases in wages or other producer input prices decrease short-run aggregate supply, increase price level
- Demand-pull inflation: Increase in aggregate demand above full employent increases price level
Business Cycles: Cost-Push Inflation (SRAS down)
Business Cycles: Demand-Pull Inflation (AD up)
Business Cycles: Non-Accelerating Inflation Rate of Unemployment (NAIRU)
- NAIRU is the lowest unemployment rate that will not induce wage-push inflation; also called natural rate of unemployment
- Likely varies over time and across countries
- Not necessarily the same as “full employment” or cyclical unemployment = 0 because wage pressure may be in economic segments
Business Cycles: Leading Indicators
Turning points in these tend to precede business cycle peaks and troughs
Business Cycles: Coincident Indicators
- Turning points in these tend to coincide with business cycle peaks and troughs
Business Cycles: Lagging Indicators
- Turning points in these tend to follow business cycle peaks and troughs
- Unemployment rate is a lagging indicator
Business Cycles: Examples: Phases of Business Cycle
Monetary/Fiscal Policy: Monetary Policy
- Management of the supply of money and credit
- Expasionary: increase the money supply, decrease interest rates, increase aggregate demand
- Contractionary: Decrease the money supply, increase interest rates, slow economic growth and inflation
Monetary/Fiscal Policy: Fiscal Policy
- Government decisions on taxing and spending
- Expansionary: Increase spending and/or decrease taxes; increase the budget deficit, increase aggregate demand
- Contractionary: Decrease spending and/or increase taxes; decrease the budget deficit, reduce aggregate demand
Monetary/Fiscal Policy: Functions of Money
- Medium of exchange
- Unit of account
- Store of value
Much more efficient than barter economy
Monetary/Fiscal Policy: Definitions of Money
Narrow Money (M1 in U.S. and Eurozone)
- Currency in circulation
- Checkable deposits
- Travelers checks
Broad Money (M2 in U.S. and M3 in Eurozone)
- Savings deposits
- Time deposits < $100,000
- Money market mutual funds
Monetary/Fiscal Policy: How Banks Create Money
In a fractional reserve banking system, a bank is required to hold a fraction of its deposits in reserve; this fraction is the required reserve ratio
Example: Bank 1 receives $1,000 in new reserves- can loan out $800 in RR of 20%
$800 in loans deposited, $640 in new loands…
$640 deposited, 0.8 x 640 = $512 new loands…
- Potential increase in the money supply is
- 1/.2 or 5 x $1,000 = $5,000
- **Maximum deposit expanision multiplier = 5 **
Monetary/Fiscal Policy: Demand for Money
Transactions demand: Increases with GDP
Precautionary demand: Money held for unforeseen future needs, increases with GDP
Speculative demand: Money held to take advantage of future investment opportunities, smaller when current returns are high, greater when risk is perceived to be high
Supply of money is set by the monetary authority, central bank
Monetary/Fiscal Policy: Equilibrium in the Money Market
Monetary/Fiscal Policy: Fisher Effect
Riskless nominal interest rate = real interest rate + expected inflation
There is also uncertainty about future inflation rates and other economic variables, and a risk premium that increases with uncertainty
Riskless nominal interest rate = real riskless rate + expected inflation + risk premium for uncertainty
Monetary/Fiscal Policy: Roles of Central Banks
- Issue currency
- Banker to bansk and governmet
- Regulate banking and payment systems
- Lender of last resort
- Hold gold and foreign currency reserves
- Conduct monetary policy
Monetary/Fiscal Policy: Objectives of Central Banks
All central banks have price stability (low inflation rates) as an obective. Many (except U.S. and Japan) have explicit target rates, usually 2% to 3%
Some central banks also attempt to:
- Maintain full employment
- Promote economic growth
- Keep exchange rates stable
- Keep long-term interest rates moderate
Monetary/Fiscal Policy: Expected and Unexpected Inflation
- Expected inflation increases cost of holding money, adds cost of frequently changing advertised prices
- Additional costs of unexpected inflation:
- Shifts wealth from lenders to borrowers
- Less reliable supply/demand information in price changes
- Incorrect production decisions by firms
- Less stable business cycle
Monetary/Fiscal Policy: Monetary Policy Tools: Policy Rate
Policy rate: Interest rate central banks charge for borrowed reserves
- By raising the policy rate, Fed discourages banks from borrowing reserves; thus, they reduce their lending
- Decreasing the discount rate tends to increase the amount of lending and the money supply
- The U.S. Fed sets a target for the fed funds rate, the rate at which banks lend short-term to each other
Monetary/Fiscal Policy: Monetary Policy Tools: Open market operations and required reserve ratio
Open market operations: Most often used
- Central bank buys government securities for cash, reserves increase, money supply increases
- Selling securities decreases money supply
Required reserve ratio: Seldom changed
- Reducing required reserve percentage increases excess reserves and increases the money supply
- Increasing required reserve ratio decreases the money supply
Monetary/Fiscal Policy: Central Bank Characteristics
To be effective, central banks should be:
-
Independent- free from political interference
- Operation independence: Free to set policy rate
- Target independence (ECB): Sets inflation target, measures inflations, determines horizon to meet target
- Not absolute; viewed as degree of independence.
- Credible: Banks follow through on states intentions and policies
- Transparent: Bank discloses inflation reports, indicators they use, and how often they use them
A central bank that is independent, credible, and transparent can influence expectationsl policy changes are anticiplated and easier to implement.
Monetary/Fiscal Policy: Monetary Policy Transmissions: CB buys securities
When a central bank buys securities:
- Bank reserves increase
- Interbank lending rates decrease
- Short-term and long-term lending rates decrease
- Businesses increase investment
- Concumers increase house, auto, and durable goods purchases
- Domestic currency depreciates, exports increase
Overall, aggregate demand increases, increasing real GDP, employment, and inflation
Monetary/Fiscal Policy: Monetary Policy Transmissions: Expansionary Policy
Expansionary monetary policy affects four things:
- Market interest rates fall, less incentive to save
- Asset price increase, wealth effect, consumption spending increases
- Expectations for economic growth increase, may expect further decreases in interest rates
- Domestic currency depreciates, import prices increase, export prices decrease
Overall, aggregate demand increases, increasing real GDP, employment, and inflation
Monetary/Fiscal Policy: Central Bank Targets: Interest and Inflation
- Interest rate targeting: Increase money supply growth when interest rates are above targets, decrease money supply growth when interest rates are below target
-
Inflation targeting: Target band for inflation rate (typically 1% to 3%)
- Increase money suppy growth when inflation is below target band, decrease money supply growth when inflation is above target band
- Target inflatinn band >0 to prevent deflation
Monetary/Fiscal Policy: Central Bank Targets: Exchange Rate
-
Exchange rate targeting: Target band for currency exchange rate with developed country
- Sell domestic currency when above target
- Buy domestic currency when below target (limited by available foreign reserves)
- Central bank does not react to domestic economic conditions
- Result of successful exchange rate targeting is same inflation rate in domestic economy as in targeted developed country.
Monetary/Fiscal Policy: The Neutral Interest Rate
Neutral interest rate = trend growth rate of real GDP + target inflation rate
Policy rate > neutral rate: Contractionary
Policy rate < neutral rate: Expansionary
Monetary/Fiscal Policy: Limitations of Monetary Policy
- Long-term rate may move oppositely to short term rates because inflation expectations change
- If monetary tightening is etreme, expectations of recession may make long-term bonds more attractive, decreasing long-term rates
- If demand for money is very elastic, people will hold currency even as money supply increases, referred to as a liquidity trap
- Banks may desire to increase capital and not increase lending in response to expansionary monetary policy
- Short-term rates cannot be below zero–limits a central bank’s ability to act against deflation
Recently, central banks have employed quantitative easing (QE), buying longer-dated government securities, mortgage securities, and risky bonds
Monetary/Fiscal Policy: Fiscal Policy Types
Expansionary Fiscal Policy
Increase government spending, decrease taxes, or both–increasing aggregate demand and the budget deficit
Contractionary Fiscal Policy
Decrease government spending, increase taxes, or both–decreasing aggregate demand and budget deficit
Monetary/Fiscal Policy: Fiscal Policy perspectives
- Keynesian economists believe discretionary fiscal policy can stabilize the economy, increasing aggregate demand to combat recession and decreasing aggregate demand to combat inflation
- Monetarists believe that such effects are temporay and that appropriate monetary policy dampen economic cycle
- Automatic stabilizers (taxes and transfer payment) tend to increase deficitis during recessions and decrease deficits during expansions
Monetary/Fiscal Policy: Fiscal Policy Objectives
Governments use fiscal policy to:
- Influence aggregate demand and economic growth
- Redistribute wealth
- Affect the allocation of resources to different sectors of the economy
Monetary/Fiscal Policy: Fiscal Tools: Spending
- Transfer payments: Cash payments by government to redistribute wealth
- Current spending: Purchases of goods and services
- Capital spending: To increase future productivity; on infrastructure, or to support research on and development of new technologies
Monetary/Fiscal Policy: Fiscal Tools: Revenue
Direct taxes--levied on income or wealth
Takes time to implement
Indirect taxes–levied on goods and services
Quick to implement to raise revenue or promote social goals (e.g. tobacco tax)
Monetary/Fiscal Policy: Fiscal Multiplier
Note: MPC is Marginal Capacity to consume and is calculated by change in consumption divided by change in income or ^C/^I
Monetary/Fiscal Policy: Tax Multiplier
- With MPC = .8, a tax increase of $100 billion will reduce consumption by .8 x 100 = $80 billion
- The fiscal multiplier effect will, over time, lead to a decrease in consumption spending of 2.27 x $80 billion = $182 billion
The balanced budget multiplier is positive
A $100B increase in spending + a $100 billion increase in taxes ca, over time, increase consumption spending by $227 - $182 = $45B
Monetary/Fiscal Policy: Ricardian Equivalence
- If a tax decrease causes taxpayers to increase savings in anticipation of higher future taxes, the resulting descrease in spending will reduce the expansionary impact of a tax cut
- If the increase in saving (decrease in consumption) just offsets the tax decrease, it is termed Ricardian equivalence
- An increase in spending funded by issuing debt will have no impact on aggregate demand
Monetary/Fiscal Policy: Government Debt
If the real interest rate on government dbt is less (greater) than the real rate of growth, debt ratio will decrease (increase) over time
Monetary/Fiscal Policy: Budget Deficits - Con
Reasons to be concerned about deficits
- Higher future taxes will decrease GDP growth
- Government borrowing can drive up interest rates and reduce (crowd out) private investment
- At some point, debt can become risky, interest rate rises, country may default or expand money supply and cause inflation
Monetary/Fiscal Policy: Budget Deficits - Pro
Arguments that deficits are not concerning
- If the deficit is to finance capital investment, future GDP will be higher
- Deficits don’t matter if Ricardian equivalence holds
- If the economy is operating below capacity, government borrowing will not displace capital investment
Monetary/Fiscal Policy: Fiscal Policy Lags
- Recognition lag: To identify the need for fiscal policy change
- Action lag: To enact legislation
- Impact lag: For the policy change to have the intended effect
Lags can cause fiscal policy changes to be destabilizing rather than stabilizing
Monetary/Fiscal Policy: Fiscal Policy Limitations
- If the economy is at full employment, fiscal stimulus will result in higher inflation
- If the economy is below full employment, due to supply shortages, fiscal stimulus will lead to inflation rather than GDP growth
- If the economy has high unemployment and high inflation (stagflation), fiscal policy cannot address both
Monetary/Fiscal Policy: Analysis of Fiscal Policy
- Whether fiscal policy is expansionary or contractionary depends on the business cycle stage
- An adjusted, or full-employment, deficit amount can be used to adjust for the business cycle stage
In general:
Spending increases, tax decreases – expansionary
Spending decreases, tax increases – contractionary
Monetary/Fiscal Policy: Policy Interaction
Monetary/Fiscal Policy: Fiscal Policy - Problem
