MACROECONOMICS NOTES

CHAPTER 4 1

CHAPTER 5 1

GENERAL NOTES

Factors of production – (capital and labour) and production technology (know how) as the sources of the economy’s output and therefore its total income

GDP is what the economy produces (so doesn’t include expenditure on used items) Real GDP is the best measure of economic satisfaction – it can be used to measure

exactly how much is being produced To find GDP, we must add up all of the different goods and services and multiply

them by their market price Gross domestic product measures total income produced within a country’s borders,

and Gross national product measures total income produced by a country’s nationals. GNP is therefore GDP minus income earned domestically by foreigners plus income that nationals earn abroad. The correct answer is C.

A Laspeyres index is a price index with a fixed basket of goods. A Paasche index is a price index with a changing basket. CPI measures the price level of a basket of the same fixed basket of goods relative to some base year. Therefore, CPI is a Laspeyres prices index.

Because GDP measures the value of output produced within a country’s borders, the GDP deflator does not take into account goods imported from other countries. The CPI does take into account goods produced in other countries that are consumed domestically.

One measure of the change in price levels is called core inflation. Energy and food prices tend to be substantially volatile in the short run, causing a lot of variation in the CPI. Core inflation cuts out this short run volatility by ignoring food and energy products in order to get a better gauge of the on-going inflation trends.

Money supply: in a barter economy with 10,000 commodities, how many prices are there. Price is relative to 1 commodity – so for 1 commodity it has 9999 prices – each of the 10,000 commodities have 9999 prices – so there are 999900000 different prices – but this is over counting – so we half (if I know how much a chicken costs in goats I know how much a goat costs in chickens). If there was money – there would be 10,000 prices (much easier)

CHAPTER 4

Fractional reserve banking creates money but does not create wealth. Borrowers undertake a debt obligation to the bank when they borrow, the loan does not make them wealthier.

o Therefore creation of money by the banking system increases the economies liquidity, not its wealth

M = money supply Cr = currency deposit ratio = C/D Err = reserve deposit ratio = R/D D = demand deposits

Money multiplier = cr+1cr+rr

= m (money multiplier is little m money supply is caps M)

Money supply: M = m x B Each dollar of the monetary base produces m dollars of money. Because the

monetary base has a multiplied effect on the money supply, the monetary base is sometimes called high powered money

The money supply is proportional to the monetary base. An increase in the monetary base increases the money supply by the same percentage

The discount rate is the interest the Fed charges when it makes loans to banks. Banks can borrow from the Fed’s if they are left with too few reserves. If the discount rate is low – borrowed reserves are cheap so banks will loan out more and therefore increase money supply

After the 1930’s Great Depression, policies have been put into place to prevent the same happening again. System of federal deposit insurance protects depositors when a bank fails – this has increased public confidence and therefore the c/d ratio will not go down as much as it did during the Great Depression. Bank runs are one of the key causes of situations like the great depression and this policy has tried to limit the chance of bank runs.

On a real banks balance sheet

Assets Liabilities and owners equitiesReserves $200 Deposits $750Loans $500 Debt $200Securities (such as government bonds) $300 Capital (owners equity) $50

CHAPTER 5

Because the factors of production and the production function have already determined real GDP, nominal GDP can adjust only if the price level changes. This quantity theory implies that the price level is proportional to the money supply

Quantity theory of money – assumes that velocity is constant The quantity theory of money states that the central bank, which controls money

supply, has ultimate control over the rate of inflation. If the central bank keeps the money supply stable, the price level will be stable. If the central bank increases the money supply rapidly, the price level will rise rapidly.

Quantity theory of money: money supply and money demanded determines equilibrium price level (change in price level is by definition inflation)

The theory of inflation works best in the long run. (If measured monthly, the correlation is not clear between money growth and inflation, so better yearly etc.)

Seigniorage: when government prints money to finance it’s spending (increase its revenue). This raises money supply and therefore raises inflation. Who pays? Money holders (the real value in their wallet falls). Bringing in idea of inflation tax.

1775-1779: During the American Revolution the US suffered inflation because the Continental Congress needed to finance the revolution and did so by printing fiat money

According to the quantity theory, an increase in the rate of money growth of 1% causes a 1% increase in the rate of inflation. According to the Fisher equation, a 1% increase in the rate of inflation in turn causes a 1% increase in the nominal interest rate. This 1-1 relation between inflation rate and nominal interest rate is called the Fisher Effect

The Fisher Equation is re-written to take into account ex ante and ex post real interest rates: i = r + Eπ (where E π represents the expectation of future inflation

o Ex ante real interest rate is determined by equilibrium in the market for goods and services

o Nominal interest rate moves 1for1 with expected inflation Eπ The Fisher effect relies on ability to reasonably predict future inflation rates. 19th

Century it was difficult to predict, and therefore Fisher Effect is not seen. The cost of holding money (opportunity cost) equals the nominal interest rate

(which could have been earned through Gov. bonds etc.) The cost of holding money:

o When money is put into bonds etc. they earn real return ro Held money earns an expected real return of – E π (because its real value

declines at the rate of inflation)o So when you hold money, you give up the difference between these two

returns (r – (-E )), which is the same as nominal interest rateπ The quantity of money demanded depends on the price of holding money

o Therefore the demand for real money balances depends on both level of income and nominal interest rate (M/P)=L (i, Y) (L represents money demand because money is the economies most liquid asset)

o The higher the level of income, the greater the demand for real money balances. The higher the nominal interest rate, the lower the demand for real money balances.

How are price levels affected by money supply?o Price level depends on an average of the current money supply (and

monetary policy) and future money supply (and monetary policy) If the FED keeps money supply the same now but announces they will be increasing

money supply in the future:o People will expected higher inflation (because of higher money growth)o Fisher effect: this inflation will lead to higher nominal interest rateo This higher nominal interest rate will increase the cost of holding money and

therefore reduces the demand for real money balanceso Because the FED hasn’t changed the money supply today – the reduced

demand for real money balances leads to a higher price level (because of M/P = key equation (k increases so P decreases)

What causes hyperinflation?o Excessive money growth due to the central bank printing too much money,

therefore to reduce the rate of inflation the central bank must reduce the rate of money growth

o But why do the banks print money if they know the consequence is hyperinflation?

o Inadequate tax revenue to pay for it’s spending – the government is not earning enough in tax to pay for it’s spending. It deals with this budget deficit by issuing debt. However sometimes governments have bad credit histories and therefore wont be leant money

o The government needs to print money to cover the deficit

o Once inflation begins there is a delay in collecting tax payments so real tax revenue falls as inflation rises – which means the government needs to rely on seigniorage again – this is self-reinforcing inflation

o This then leads to hyperinflation

CHAPTER 7 – GROWTH 1

For the production function Y = F (K, L) we firstly assume it has constant returns to scale.

Secondly, for the Solow model we look at output per worker – this gives a better indication of growth (as overall GDP can significantly increase with out the quality of life increasing at all). So we divide the whole equation by L to find output per worker

K/L = k Y/L = y

o So the new production function is: y=f (k) i = sy – this shows that investment equals saving. Thus the rate of saving s is also the

fraction of output devoted investment Investment – is expenditure on new plant and equipment – it causes the capital

stock to rise Depreciation – is wearing out of old capital and causes capital stock to fall The steady state represents the long-run equilibrium of the economy Solow explanation for high economic growth in Japan and Germany post WWII – this

is because their capital stock suddenly fell (much was destroyed) but their savings rate (the amount saved and invested) remained the same – this meant that despite much lower output – growth was high as the economy moved back towards the steady

Saving and investment around the world:o There is a positive relationship between the fraction of output devoted to

investment and the level of income per person. o US and Japan have high rates of investment and also high incomeso Ethiopia and Burundi have low rates of investment and also low incomeso Why do countries have different savings rates?

Many reasons: tax policy, development of financial markets, unstable political institutions, reverse causation (countries with high incomes therefore have high savings rates)

o Always true? No – US and Peru both have similar savings rates by US output per person is more than 8 times higher Peru – there are other factors

Steady state consumption is the gap in the graph between output and depreciation – there is one level of the capital stock, which maximises consumption. The golden rule level.

Remember when finding the optimum steady state that higher levels of capital affect not just output but depreciation also

Remember that an economy does not necessarily gravitate towards a ‘golden’ steady state – but can achieve it with a particular savings rate

NB remember the depreciation line is σk NOT σf (k) Transition between steady states what happens when countries try to transition

from steady states to golden rule stead state

o From starting with too much capital: - the decrease in savings rate causes consumption to immediately go up – consumption will stay up – therefore an overall positive change

o From starting with too little capital: - the increase in savings rate means there will be an initial drop in consumption, which eventually will lead to more consumption that the original – but this process takes time. Therefore policymakers are sometimes reluctant to chose it – toss up questions between looking out for this generations of for future generations. The golden rule is the idea of ‘doing unto others as you would have them do unto you’

Remember that when population is also taken into account when measuring the steady state that the positive effect of investment will now equal both the negative effects of depreciation and population growth (when in steady state)

Population growth can explain total growth of a country (as n increased so does output) but can not explain growth in standard of living (this is growth in output per worker)

Remember steady state represents the LONG RUN equilibrium of the economy Germany and Japans growth after WWII can be explained by Solow – they had very

high savings rates and because their capital stock was cut so much – their economy grew quickly to return to the steady state levels

Conclusion: o High savings rates (to an extent) = high growtho High rates of population growth tend towards poorer countrieso What the model cannot explain is the persistent growth in living standard of

most countries – for this we need to bring in technological progress Malthusian model:

o Increasing population will eventually cause worldwide povertyo This theory was not proved to be true – Malthus failed to see technological

advancements which means farmers can produce far more food in less time etc. – now in US only 2% of the population are farmers

o His idea of ‘passion between the sexes’ being out of control was destroyed when modern birth control was invented

Kremerian modelo Population growth is necessary for advancing economic prosperityo The more people there are the more inventors engineers scientists etc.

there are o After the melting of the polar ice caps and end of the ice age 10,000 BC the

most populated countries were the ones which did best

CHAPTER 8 – GROWTH II

Making Solow more realistic – we need to now look at technological process (looking at it exogenously – Solow does not explain it)

Technical progress causes the efficiency of labor to grow at a constant rate g. e.g. if g = 0.02 then each unit of labor would become 2% more efficient each year and output increases as if the labour force had increased by 2% more than it really did – this technological progress is called labour augmenting

In the Solow growth model in steady state – output per worker increases at growth rate g (technological progress) and total output increases at rate g + n (with more population output will rise but pop growth does not affect growth rate)

Balanced growth is that technological progress causes the values of many variables to rise together in the steady state – this describes the long run data for the US economy

o Data shows that capital stock per workers and output per worker growth at the same rate due to technological progress

o Real wage grows at the rate of technological progresso Real rental prices of capital remain constant with technical progress

These two acts go against Marx’s theory of capitalist economies and supports Solow’s theory

In the Solow growth model, the steady-state growth rate of output per effective worker is zero, and the steady-state growth rate of output per actual worker is the rate of technological progress.

Convergence: o It has been shown that countries with different outputs/capital stocks will

eventually converge IF they have the same steady states e.g. Germany and Japan

o Political and cultural similarities mean similar steady stateso If they don’t have the same steady states the will noto When steady states are ignored there is convergence at the rate of 2% per

year (this is conditional convergence) In the early 1970’s growth per income fell substantially. It is believed that the

growth in the 1990’s was caused by advances in IT Policy makers believe that they should encourage public saving and capital

accumulation (by doing tax incentives etc.). They should also have the right financial and legal institutions to efficiently allocate resources and provide incentives to enough technological progress

Adam smith – wealth of nations – if a country can make it cheaper use them (advocating free trade)

o Open economies have been proven to grow more per year than closed economies (remember though that correlation does not prove causation)

Endogenous growth theory – this tries to incorporate explaining technological growth and rejects solows assumption of exogenous technological change

o This assumes that as long as savings is bigger than depreciation – an economies income grows forever

o Difference from Solow is that Solow predicts diminishing returns to capital – so an increase in savings will not increase growth forever

When European settlers colonized much of the world, they avoided tropical climates because there was a higher risk of disease. Europeans brought their institutions with them where they settled. As such, strong institutions were not created in many tropical countries.

Recall that the number of effective workers is equal to L * E. If L grows at a rate of n and E grows at a rate of g, the number of effective workers will grow at a rate of n + g. If we plug in the numbers from the question, we see that the number of effective workers is growing at a rate of 2% + 3% = 5%.

Economists have found that the US has a capital stock, which is below the Golden Rule level. This was discovered by showing that MPK – δ is greater than n + g. If

the United States wishes to reach the consumption maximising level of capital, it should increase its savings rate in order to accumulate more capital.

A great deal of empirical evidence supports the claim that economies that are open to trade (countries with few barriers that prevent buying and selling from other countries) grow faster. One study, for example, showed that open economies grew at 2.3% a year while closed economies grew at .7% a year.

In the Solow model, capital exhibits diminishing marginal returns (which can be seen from the concave production function). In this context, a change in the savings rate will not lead to growth forever because diminishing returns to capital will force the economy to approach a steady state. In the basic endogenous growth model, however, there are no diminishing marginal returns to capital. As a result, the economy is not forced towards a steady state and persistent growth can be achieved.

In the two-sector endogenous growth model, labour can be used in university production, which increases the growth rate of the stock of knowledge. When the growth rate of knowledge is higher, the growth rate of income will also be higher. The correct answer is D.

CHAPTER 6 – UNEMPLOYMENT

L = E + U (labour force equals number of employed workers and the number of unemployed workers

The rate of unemployment is U/L fU = sE (in the steady state people are finding jobs at the same rate as losing them fU = s(L-U) – sub in equation before the higher the rates of job separation the higher the unemployment rate

the steady state rate of unemployment U/L = SS+F

o This model assumes that job finding is not instantaneous Frictional unemployment – the time it takes for unemployed people to get a job

o Government policies such as unemployment insurance alter the amount of frictional unemployment

o Sometimes people will take longer because they are fussy about the job they get – wages and/or skills

The two reasons for unemployment are structural unemployment and frictional unemployment

o Wage rigidity is a form of structural unemployment – it is the failure of wages to adjust to a level at which labour supply equals labour demand

Essay: minimum wageo Some jobs are exempt from minimum wage (newspaper delivery etc.)o Women are more likely to have wage below minimum wage (3% is US)o Tend to be young o Tend to be less educatedo More likely to work part time o Most common industry leisure and hospitality

Sectoral shift: a change in the composition of demand among industries or regions Structural unemployment: unemployment resulting from wage rigidity and job

rationing

Wage rigidity: the failure of wages to adjust to equilibrate supply of labour and labour demand – this can be caused by minimum wage legislation and unions.

o Efficiency wage theories suggest that firms may find it profitable to keep wages high despite an excess supply of labour – to make people worker harder (get more out of the workers)

Unemployment tends to be short term Difference in unemployment between the young and the old tends to be to do with

job separation Individuals who have recently entered the workforce make up about 1/3 of the

unemployed – these transitions in and out of the workforce make data hard to interpret

Europeans work less hours than Americano This could be because of higher unemployment rates, shorter workweeks,

more holidays and earlier retirement Unemployment represent wasted resources – they could be contributing to national

income Insiders: workers who are already employed and therefore have an influence on

wage bargaining Outsiders: workers who are not employed and therefore have no influence on wage

bargaining Unemployment insurance: a program in which unemployed workers can collect

benefits for a certain period of time after losing their jobs – as long as they are still looking for jobs

CHAPTER 19

Each $1 deposited in a bank generates 1/rr of money Monetary base – is the total number of dollars held by the public (as currency and

reserves) Reserve deposit ratio err is the fraction of deposits that banks hold in reserve Currency deposit ratio – cr is the amount of currency C that people want to hold A bank is insolvent if its leverage falls to zero Remember cr and rr are ratios – if people hold the same amount of demand deposits

as currency cr = 1

CHAPTER 20

Economic crisis – because of decline in housing prices – things could not go up for ever

When wall street sneezes, main street catches a cold Financial system: the institutions in the economy that facilitate the flow of funds

between savers and investors. Financial markets – one piece of the financial system though which households can

directly provide resources for investmento E.g. market for stocks and bonds

A bond represents a loan from the bondholder to the firm – a bondholder is a creditor

A share of sock represents an ownership claim by the shareholder in the firm – a shareholder is a part owner

Raising investment by issuing bonds is called debt finance Raising funds by issuing stock is called equity finance Financial intermediaries are a piece of the financial system though which households

can indirectly procide resources for investment – banks are the best known type – they take deposits from savers and use these deposits to make loans to those who have investment projects the need to finance

Some investors may be risk averse and therefore would like to share investment – so that if they lose money they will lose less

o Reducing risk by holding many imperfectly correlated assets (spreading wealth around) is called diversification

Mutual funds are financial intermediaries that sell shares to savers and use their funds to buy diversified pools of assets – so that a small saver could become a part owner of thousands of businesses – it is a far less risky strategy than using it to buy stock in one single company

o This risk is called systematic risk and is a form of diversification Asymmetric information is a situation in which one party to an economic transition

has more information about the transaction than the other – e.g. hidden knowledge or there could be the problem of adverse selection – think market for lemons

Moral hazard – the risk that an imperfectly monitored agent will act in a dishonest or other wise inappropriate way – entrepreneurs will not look after investors money as well as they would look after their own

It is harder to find financial backing in poorer countries such as Bangladesh because the institutions are not in place to provide it

o Microfinance is a proven tool for fighting poverty – it is giving small loans to poor people (mostly women) who can use it to start their own businesses (they don’t need to provide their own capital either

o These repayment rates are better than that of the student loan and credit card debts – showing it is a good venture!

A financial crisis is a major disruption in the financial system that impedes the economies ability to intermediate between those who want to save and those who want to borrow and invest

The speculative bubble – a period of optimism leading to a large increase of prices usually precedes a financial crisis – when this optimism turns to pessimism the speculative bubble bursts

Banks rely on leverage – the use of borrowed funds for the purposes of investment Fire sale – is why risky assets suddenly lose their value during a financial crisis and

banks try and sell them off quickly so they are not burdened with them Victory has a thousand fathers, but defeat is an orphan J F Kennedy – nobody wants

responsibility for the financial crisis. Who is to blame?o The FED – kept interest rates too low which contributed to the housing

bubble – which eventually bursto Home buyers – people were reckless with borrowingo Mortgage brokers- some offered loans such as NINJA loans – no income no

job no assets – hugely risky loans

o Investment banks- sold risky mortgages etc. on to buyers who were not aware of the risk they were taking on

o Rating agencies – rated high risk mortgage back securities badlyo Regulators – failed to appreciate the substantial decline in housing priceso Government policymakers – encouraged mortgage lending – when renting

could have been bettero Layer irresponsibility

Liquidity crisis – a situation in which a solvent bank does not have enough funds to satisfy its depositors withdrawals

o a central bank might become a ‘lender of last resort’ in this situation how to stop a financial crisis

o central banks should act as lenders of last resorts during liquidity crisis’so financial crisis’s main enemy is a lack of confidence in banks – leading to

bank runs o during the economic crisis banks dealt with this lack of confidence much

better than they did during the great depression a function of the financial system is to allocate risk amount market participants – it

can also allow individuals to reduce risk though diversification financial institutions such as banks are meant to mitigate the problems that arise

from asymmetric information crisis’s

o begin with a decline in asset prices – after a speculative bubble o this causes insolvencyo this leads to a fall in confidence in the systemo which means depositors try and withdraw – bank runso this leads to reduced lending by bankso this means a credit crunch will happeno this leads to a recession – which is a vicious circle which exacerbates the

problem of rising insolvencies and falling confidence how policy makers respond

o first they can use conventional monetary and fiscal policy to expand aggregate demand

o they can also provide liquidity by acting as a lender of last resorto policymakers can use public funds to prop up the functional systemo Financial crisis’s can be avoided by regulating shadow banks – reducing the

size of financial firms and trying to reduce risk taking and reforming regulatory agencies which oversee the financial system