Principles of Macroeconomics

Key issues

1. Unemployment: a. Concepts: unemployment, labor force, labor force participation rate, full employment

and natural rate of unemployment b. Major types of unemployment (frictional, structural, cyclical, seasonal)

2. Inflation:

a. Difference between inflation, disinflation and deflation. b. Difference between nominal value and real value. c. Price index: it represents the cost of a basket of goods expressed as a percentage of its

cost in the base year. We use the price index to calculate the rate of inflation:

× 100

d. Price Indexes: CPI, PPI, GDP deflator. e. Real interest rate: nominal interest rate – expected inflation.

3. Measuring the economy’s performance:

a. The circular flow: the main idea is to understand that GDP can be calculated in different ways (as total spending, as total income…)

b. What is GDP? c. Value added is not the value of all sales (we would be double counting). d. GDP as total spending (expenditure approach): C + I + G + NX e. Difference between nominal GDP and real GDP. f. GDP deflator: Nominal GDP/Real GDP.

4. Keynesian Equilibrium

a. Consumption: spending on new goods and services by households out of disposable income. Saving: whatever is not consumed out of disposable income (Yd).

i. Consumption function: autonomous consumption (independent of Yd) + marginal propensity to consume x Yd. Marginal propensity to consume: change in real consumption when there is a change in Yd.

ii. Any change in wealth, population, interest rate will affect consumption (C*), and this will shift AD.

b. Investment: does not depend on income (is autonomous). Affected by interest rate, expectations, technology, business taxes, etc. When these variables change, Investment will change and AD will shift.

c. Government spending: G (is autonomous). Taxes (T) are taxes on income, so Yd = Y –T. d. Net exports = Exports – Imports. e. Equilibrium: Y = C + I + G + NX = C* + mpcx (Y-T) + I + G+ NX

i. If C + I + G + NX > Y, unplanned decrease in inventories -> businesses raise output and Y = C + I + G + NX.

ii. If C + I + G + NX < Y, unplanned increase in inventories -> businesses reduce output and Y = C + I + G + NX

f. Multiplier: change in the equilibrium level of Y when there is a change in autonomous expenditures (C*, I, G, NX). Multiplier = 1/ (1-mpc) -> the larger mpc, the larger the multiplier. If multiplier is equal to 2, for every unit increase in autonomous expenditure, equilibrium output will increase by 2 units.

5. Aggregate supply and aggregate demand.

a. Long run: when all necessary adjustments have taken place. b. Aggregate supply (AS): total planned production of the economy c. Long run AS: real output that the economy can produce when all resources are

employed. d. LRAS curve will shift: changes in population growth, labor force and labor force

participation; changes in capital stock, changes in technology. e. SRAS will shift whenever LRAS shifts. It will also shift with changes in input prices (oil

price, etc.), generally temporary. f. Aggregate Demand (AD): total planned expenditures (C, I, G, NX).

i. AD has negative relation with the price level (negative slope) because of the real balance effect, the interest rate effect and the open economy effect. In other words, these effects explain movements along the AD curve.

ii. AD will shift when there are changes in aggregate spending (anything that changes C, I, G or NX).

iii. Effect of appreciation and depreciation of the currency on NX and on AD. g. Long run equilibrium: when AD = LRAS. h. Short run equilibrium: SRAS = AD. It may be below, equal or above full employment GDP

(indicated by LRAS). i. Work the effects of shifts in SRAS on the price level and real GDP. j. Work the effects of shifts in AD on the price level and real GDP. Notice that in the long

run, any change in AD will only have an effect on the price level, as the real GDP will be determined by the LRAS.

k. In the short run the economy can be below or above full employment. l. AD shock: event that shifts AD curve inward/left (negative shock) or outward/right

(positive shock). m. AS shock: event that shits AS curve inward/left (negative shock) or outward/right

(positive shock). n. You should be able to determine what happens with the price level and real GDP if there

is an AD positive shock, etc. o. Recessionary gap, Inflationary gap.

6. Discretionary fiscal policy (FP): the government changes G or T in order to achieve national economic goals (high employment, economic growth, price stability).

a. Expansionary FP: AD shifts right through higher G or lower T. Contractionary FP is the opposite.

b. Problems: i. Crowding-out effect: an expansionary FP lowers I (and C). This happens when

borrowing by the government (to finance the extra spending) increases interest rates.

ii. Direct expenditure offsets (when government spending is a substitute for private spending).

iii. Long and variable lags (recognition, action time and effect time)

7. Government budget: balanced, deficit or surplus. How can the deficit be reduced?

8. Money: what is money? What is M1? And M2?

9. What is financial intermediation?

10. What is the lender of last resort?

11. What does “fractional reserve banking” mean? What is the reserve ratio?

12. Monetary policy. What is an open market operation (sale and purchase)? How does the money

multiplier work?

13. What are the effects of an increase in the money supply on GDP, the price level and

unemployment?

Note that we have seen two macroeconomic policies in this course: fiscal policy and monetary

policy.