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CHAPTER 14: THE NATIONAL ECONOMY
The Scope of Macroeconomics
Macroeconomics studies the economy on a national scale
...
Four main concepts, each of which we will study in
detail later, are central in macroeconomics
...

-

Economic Growth: Refers to an increase in national output
...

Reducing Unemployment: Should be as low as possible
...

Balance of Payments and Exchange Rates: A surplus on the balance of payments account
...


The Circular Flow of Income (book page 405)
One way in which the macroeconomic objectives can be related to one another is through aggregate
demand and aggregate supply
...
Let’s look at demand first
...
The first is the total consumer expenditure C
minus consumer spending on imports M, written as Cd
...
The next elements are investment spending by firms I, the
government spending G and the expenditure of residents abroad on exports X
...


Otherwise written as:
AD = C + I + G + X – M
-

AD = Aggregate Demand
I = Investment spending
G = Government spending
X = expenditure of residents abroad on the country’s exports
M = expenditure on imports

We recognize two major players in the economy: the households and the producers (the firms)
...
The firms are the producers of goods and
services, the employers of labor and other factors of production
...
The circular flow of income shows
how all actors and elements that make up the economy are related
...
In return, the households
provide factors of production
...
On the right hand side we can see that the households
pay the firms for goods and services
...

The red arrows represent the withdrawals (W): the money from the households that does not
directly go to the firms
...
Therefore:
W = S + T + IM
The green arrows represent the injections (J): the money received by the firms but that does not
directly come from the households
...
Therefore
J=I+G+X
In the circular flow W = J: withdrawals equal injections
...

We will first try to calculate the nominal GDP: the value for the GDP unadjusted for changing prices
...

How can we calculate the nominal GDP? There are several methods
...
With this method the problem of double counting arises
...
We only add the values of
finished goods!
Y = P1Q1 + P2Q2 + … + PnQn
The same results will be obtained if we add together all the added values during each stage of the
production process
...

The Expenditure Method
This method focusses on summing all expenditures on final output
...
The GNY is linked not only to territory,
like the GDP, but also to nationality
...
This way we can find out the income within the country, regardless of where that
income came from in the first place
...
Depreciation is the decline in value of capital due to age
and wear
...
Since we multiply the amount
of good produced with the price of the good, we can intuitively see that if prices were too double, the GDP
would double too without any increase in output
...
If we want to find a better
‘version’ of GDP to illustrate living standards, we have to start taking several other factors into account
...
If over the course of one year prices on average
rise by 1%, then inflation is 1%
...
Two indexes are particularly important
...
Imported goods are included in this
...
It is the average price level in the economy
...
This is the GDP calculated with the prices of a base
year
...

How do we turn this into a number that shows us inflation? We look at how much the GDP deflator
or the CPI changes over the course of time
...
The multiplication
by one hundred at the end is there to get an outcome in percentages
...
We
also need to know how many people share the GDP: the less people, the greater the income per
person
...
This will yield the GDP per
capita and can be done for the nominal or the real GDP
...
This means that the currency of one country will not buy the same goods in the
other country even if it was exchanged according to actual exchange rate
...
To use this, we need to know the PPP exchange
rate, or EPPP
...
The
underground economy is not included, as well as homework and other unpriced or unpaid services
...
For one thing
production does not per se equal consumption
...
It sometimes comes with negative externalities
...
The index of sustainable economic welfare (ISEW) tries to paint a more accurate
picture
...
Actual economic growth is the
percentage annual increase in output and therefore GDP
...
Accordingly, potential output is the output of the economy if it operates at normal capacity
...
The difference between the actual output and the potential output is known as
the output gap
...


The potential output is given by the production possibility curve
...


The Business Cycle
The economy does not grow at a steady pace:
there are fluctuations over time
...
There are
four different phasis through which the
economy goes: the upturn (a stagnant
economy begins to recover), the expansion
(rapid economic growth), peaking out (growth
slows down or ceases) and the slowdown (little
or no growth, or even a decline in output)
...

In reality, the length of the different phases can vary from a few months to a few years
...

In the short run, the variations in the rate of actual growth are caused by changes in aggregate
demand
...
) In the long run, actual growth is determined by the
growth in aggregate demand and the growth in potential output (the last of which is itself determined
by an increase in and more efficient use of production factors)
...

-

-

Increases in the quantity of production factors (inputs)
...
Therefore, unless all factors of production are increased, the rate of growth
will slow down
...
New machines, for example, yield higher rates of return than old
ones
...


-

Investment is also extremely important: one the one hand it is a component of economic growth
and helps determine the level of actual output
...
This means that investment increases both supply and demand, even though the
demand is generally influenced faster than supply
...
In other words, the
government will try to increase aggregate demand or aggregate supply
...

Economic growth has several advantages: firstly, consumption will increase
...
And thirdly, since the pie is bigger, there is more to be
redistributed among population: the poor will be better off
...
It comes at opportunity costs in the present: sacrifices have
to be made in order to increase output in the future
...
It can lead to a more materialistic society and can come at environmental costs
...


CHAPTER 15: MACROECONOMIC ISSUES
Unemployment (book page 431)
The standard economic definition of unemployment goes as follows: those persons of working age that have
no job, but that are actively seeking and can accept a job at current wage rates
...
Logically the
unemployment rate is expressed by the following formula:
𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑚𝑒𝑛𝑡 𝑅𝑎𝑡𝑒 =

𝑁𝑢𝑚𝑏𝑒𝑟 𝑜𝑓 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑
𝑆𝑖𝑧𝑒 𝑜𝑓 𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒

Another important variable is the participation ratio: the part of the population aged between 16 and 64 that
is in the labor force
...

-

The number of unemployed (the stock): the larger the unemployment rate, the longer on average a
person will be unemployed
...

The phase of the business cycle: at the onset of the recession the unemployment will on average be
relatively short, but as the recession drags on, the average time unemployed will go up
...
First of all the unemployed themselves lose financially as
well as socially, a burden often share by family and friends
...

Okun’s Law (actually more of a rule of thumb) shows the empirically observed relationship between the
unemployment rate and the national output
...


Unemployment and the Labor Market (book page 436)
There are two types of unemployment: equilibrium unemployment and disequilibrium unemployment
...
Like all markets,
there is a supply and a demand: the aggregate demand for labor and the aggregate supply of labor
...


The supply curve (the number of workers willing
to work at each wage rate) is relatively inelastic,
since in the short run the supply can’t
significantly change
...
The
market equilibrium is easily visible at the
intersection point between the two curves
...
But the curves can
shift too
...
The demand curve
can shift due to the MPL (marginal product of
labor): if a worker is more efficient, firms might
be willing to hire more for the same wage
...
This
is not true however: the supply curve
shows the workers willing to accept
work at a current wage
...
Even if there is an equilibrium on
the macroeconomic level, there will on
the microeconomic level be unemployment: in some markets there will be excess demand and in
some markets there will be excess supply
...

There are several causes of equilibrium unemployment
...
Then there is also frictional unemployment: unemployment that occurs even if the
demand is high enough
...
There might be a perfect job
opening, but the unemployed person cannot apply for the job if he does not know the opening
exists
...
After a while
the unemployed person will be more eager for a job and accept a lower wage
...

This can happen because certain markets undergo a declining demand for their goods (change in
demand patterns), because new production methods make employees redundant (technological
unemployment), or because a geographically concentrated industry collapsed (geographical
unemployment)
...
This is especially important in the tourist sector, when extra
employees are needed during the holiday seasons
...

There are three different types of disequilibrium
unemployment
...
There is a positive economic
effect, however
...
This in turn will
shift the demand for labor to the right, since the firms need
more employees to meet the additional demand
...
This is
associated with economic recessions
...
Once the economy
starts growing again the demand will rise and the output
will increase, which will make the cyclical unemployment
drop
...
The problem lies in the stickiness of
wages: if there is a new equilibrium with a lower wage rate,
then people won’t be willing to accept this new wage and
will, at least initially, prefer to be unemployed
...
Thus, wages are sticky in a
downward direction (not upward, of course, since anyone is
immediately willing to accept a higher wage)
...
This will
cause the wages to fall
...


The government can initiate certain policies to reduce unemployment
...
Also, some policies can actively or passively influence the unemployment rate
...
Passive policies can include unemployment benefits
...
This means that the unemployment rate refuses
to go down to previous levels
...
Hysteresis refers to a recession that increases natural employment
...
In turn the people that have a job (the insiders) manage to secure
wage increases for themselves and prevent the unemployed from competing the wages down
...
On the vertical axis we plot the GDP inflator, or the
average price level in the economy, and on the horizontal axis we plot the total volume of national output
(or GDP), also referred to as national income
...

Two effects can be identified that determine the negative slope of the demand curve: the income effect
and the substitution effect
...
The
wages of the workers do not immediately rise
...
This is one reason why the demand has a negative slope
...
The first is the international substitution effect: if prices go
up, people will start buying more foreign goods and imports will rise
...
The second effect is the
inter-temporal substitution effect
...
This means that aggregate demand will fall
...
They may
save more to compensate and thus drive demand down
...
If it shifts to the right, then there is an increase in
demand
...
Shifts are caused by a change in one
of the four above-mentioned components of aggregate demand
...
This curve has a positive slope
...
A positive change in technology, the labor force and the stock of capital will shift the supply

curve to the right
...
The same goes for taxes
...
If one of the curves shifts (or both), a new
equilibrium will be created
...
In the EU, we
use the HICP, the harmonized index of consumer prices, which covers virtually 100% of consumer spending
...
The GDP deflator measures the prices of domestically produced goods
...

Most countries have set the inflation target rate to 2% as a macroeconomic objective
...
Seigniorage is the profit made
from the minting of coins (or the printing of banknotes)
...

Inflation comes at a cost
...
Shoe-leather costs refer to the costs associated with the actions of people
that try to anticipate inflation
...
Inflation redistributes income away from those
with fixed incomes to those with economic bargaining power such as landlords
...
The balance of payments is likely to worsen due to the inflation
...
This will mess up the
balance of payments
...
For example,
additional personnel (like financial experts) may have to be hired
...

Demand Pull Inflation
Demand-pull inflation is caused by continued rising of the demand
...
However, if the shift
of the demand curve is one-time only, then the inflation will fall back to zero
...
If the inflation goes
up, then these shifts occur faster after one another
...
Such a shift occurs
when production costs rise independently of demand
...

Interaction of Demand Pull and Cost Push Inflation
This occurs when the above inflations occur at the same time
...
If in some
industries in the economy demand increases, and in other industries demand decreases, then in the
first industries the wages will go up, but in the other (due to the stickiness of wages) the wages will
not go up
...

Again, the government can impose demand- and supply-side policies
...
The supply
side policies have to do with restricting the costs of production
...


The Relationship between Unemployment and Inflation (book page 450)
The relationship between unemployment and
inflation is given by the Phillips curve
...
This is because when
economy
booms,
prices
rise
and
unemployment is low
...
This curve held
more or less true until the seventies, when its
shape became highly uneven
...


The Open Economy: the Balance of Payments and Exchange Rates (book page 453)
An open economy is an economy that trades and has financial dealings with other countries
...
Important variables determining these flows are
the balance of payments (BoB), exchange rates (E), purchasing power parities (PPP), and interest rate parities
...

The current account records payments for imports and exports, incomes flowing in and out of the
country, and net transfers of money into and out of the country
...
The first two together make up the trade account
...
Also included are the transfer of funds from immigrants
and payments and debt forgiveness of the government to another country
...

When evaluating the BoB, it is considered undesirable if the combined accounts are in deficit, since
the deficit would have to be covered by borrowing from abroad (which often means high rates of
interest)
...
If we drain the reserves
(R), then we can’t buy any more imports (IM)
...
Borrowing money domestically drives interest rates up and borrowing
internationally is very expensive
...

In other words, the exchange rate of the dollar against the euro is the amount of euros one would
pay to buy one dollar
...
e
...
To best know the value of a currency it is best to
look at the exchange rate index: the weighted average exchange rate for a currency
...

In an open economy, the rate of
exchange is determined by
demand and supply without
government intervention
...
Like the price of any other
good, the price of a currency is
determined by the graph: if the
price is too low or too high, then
the market will move to
equilibrium
...
If the exchange rate of a given currency falls, then
we say that that currency has depreciated
...

A shift to the right of the supply curve will result in depreciation (lower equilibrium price)
...
This
can happen because of an increased demand for domestic goods and services, an increase in the
amount of tourists from abroad in the economy, a greater export toward the country…
If the BoB is in deficit, and if the exchange rate (E) is flexible (it can change), then the following chain
of events happens
...

If the BoB is in deficit and if the exchange rate (E) is fixed (it cannot change), then the following
happens
...
Often the central bank will drive up the discount rate to prevent capital outflows, which makes
the interest rate go up and can lead to bankruptcy
...
Notably, it will attempt to
eliminate short term fluctuations
...

Maintaining a fixed exchange rate over the longer term can be achieved by raising the interest rates
and achieving deflation (this reduces consumer spending)
...
Finally, restriction on
inflows and outflows of money influence the exchange rate
...
In the recession, the inflation is low and there is a
current account surplus, but output is low too and unemployment is high
...

Purchasing Power Parity Theory and the Open Economy (book page 757)
The purchasing power parity theory states that the exchange rate of a currency will adjust so as to offset
differences different countries’ inflation rates
...
Put simpler, if because of inflation prices in
one country go up, the exchange rate will automatically adjust in such a way that the same amount of foreign
currency still buys the same goods as before the inflation
...
This is given by the formula:
𝑃𝑃𝑃 𝐸 =

𝑃
𝑃∗

P is the price of the good in country A and P* is the price of the good in country B, against the same
currency!
If the Big Mac costs 25SEK in Sweden and 3$ in the USA, and if the PPP E is 8
...
However, if the PPPE is equal to, say, 9, then the Big Mac will be undervalued in SEK
...
33, then the Big Mac is overvalued in SEK
...
If the inflation
rate in Sweden is 2% and the inflation rate in the US is 5%, then the Swedish Krona will depreciate by 3%
...
Three major areas of
disagreement are the flexibility of wages and prices, the flexibility of aggregate supply, and the role of
expectations in the workings of the market
...

The Flexibility of Prices and Wages
Economists of the right believe that wages and prices are flexible, while economists on the left
believe that prices and wages are rigid (they do not adjust quickly to changes in the market)
...
Prices
too are flexible, and any long term employment must be equilibrium (natural) unemployment
...
Wages will not adjust quickly because they are sticky, and
also because there is a lot of resistance from unions
...
Logically the two are linked: if wages are inflexible downward, then the cost for the firm
can’t drop much and the prices will stay high
...
A rise in
aggregate demand simply results in a rise in prices
...
Therefore, if the government wants to stimulate
economic growth, it is useless to focus on the demand curve
...
This is called supply-side economics
...

There is some consensus now
over the short-run aggregate
supply curve: it is sloping
upwards and steeper the higher
the output
...
The consequence is that workers will refuse to work more for a higher wage, because they
know that the subsequent increase in demand will lead to an increase in price, which will eat up
their additional wage
...
This result in a zero-sum
game, because the additional income the firms gets is needed to cover the increase in wage costs
...

Those on the left argue that expectations of prices depend on expectations of output and
employment
...
This will not result in inflation but in an expansion
of the market
...

There is a strong link between the last two issues: the right argues that a boost to demand does not increase
supply (output) and therefore just fuels inflation
...


Classical Macroeconomics (book page 468)
The first school of macroeconomics that we will discuss is the classical one
...
They also
assume that markets clear: they automatically move towards equilibrium price
...

The gold standard was a fixed exchange rate system for a currency: a single unit of a currency had the
same value of a certain amount of gold
...

Say’s Law states that supply creates its own demand
...
Because of the circular flow of the economy, any
expenditures that firms make in the production of goods,
ultimately comes back to the firms
...
Note that this applies to the macroeconomic level,
not the microeconomic one
...

The market for loanable funds clears too: if the supply of
funds is too high, then the interest rate will fall so that it
gets cheaper to take a loan
...
e
...
The
graph shows investment as the demand curve and savings
as the supply curve
...

The Quantity Theory of Money
With regard to prices and inflation, the classical economists will use the quantity theory of money,
abbreviated as QTM
...
The basic assumption is that the greater the quantity of
money, the higher the prices will be
...

In order to better understand the reasoning behind this, we have to look at the relationship
between national income and national expenditure
...
This is the number of
times a year a single unit of currency is spent on buying goods and services
...
P is the general price level (the price index of a certain year where the index in
the base year is assumed to be 1), and Y is the real value of national income
...

Classical economists argue that both V and Y are determined independently of the money supply (if
the money supply changes, neither V nor Y has to change)
...
This means that P, the price level, is a
function of M and that, thus, if M increases, P will increase
...


M + V = P + Y
V & Y are zero (because V and Y are constant, they can’t change)
M = P
M = 

Then if only the velocity of money is constant and the GDP (Y) grows over time, Y is not zero
anymore and:

 = M - Y
This has implications for the monetary policy: if the money supply rises (through, for example,
printing more), then the inflation rate will rise and the exchange rate E will be depreciated in
terms of purchasing power parity PPP
...
Because the ratio between wages and prices
(W/P) was far too high (prices were too low and wages too high), there was unemployment: the firms, with
their limited revenue from the low prices could not afford to hire more workers
...
Printing money was not an option
...

The other option was for the government to start borrowing money, but this would drive the interest
rates up and private borrowing would go down: again no difference would be made
...

Furthermore, the general assumption in classical economics is that unemployment is caused by above
equilibrium wages, and inflation is caused by an expansion in the money supply
...
He identified
two key markets in which disequilibrium could persist (whereas classical economists assume that all
markets move toward equilibrium automatically)
...
In a recession,
when the demand for labor decreases, wages do not fall quickly enough to reach a new
equilibrium
...

Therefore cutting wages would result in a leftward shift of the ADL curve and disequilibrium would
worsen
...

The market for loanable funds is another market in which disequilibrium would persist
...
He argued
that interest rates have very little effect on investment because an increase in savings reduce
consumption spending
...


In addition, Keynes rejected the very simple quantity
theory of money
...
The argument is that if there is a lot of slack in
the economy and much present capital is unused (like
unused factories), an increase in money would lead to
an increase in production (Y) rather than an increase in
prices (inflation)
...
The central point made is that an
unregulated economy sufficient demand is not
ensured, and that the government must intervene to keep demand at a sufficiently high level
...
If injections (J) do not equal
withdrawals (W), there is a state of disequilibrium
...
This will lead firms
to produce more, which will then lead the households to consumer more
...
The government spends more, then firms hire more workers, then household
consumption rises, then firms will produce even more, hire even more workers and households will
consume even more, leading to even larger production and even more people hired and even more
household consumption: there is a multiplier effect that diminishes with every round of increased
demand
...
Let’s look at the formulas:
Y = C + I + G + NX
C = c (Y – T)

GDP and components
...


Now if government spending G goes up then the national income Y will go up too, leading household
consumption c to rise to, which will then again lead to a rise in national income Y
...
(*) is used for
multiplication
...


Y = G*(1+MPC)
Y = G*(1+MPC)*(1+MPC2)= = G*(1+MPC+MPC2)
Y = G*(1+MPC)*(1+MPC2)*(1+MPC3)
Y = G*(1+MPC+MPC2+MPC3
...


In addition to the multiplier for consumption there are also multipliers for Tax and Government spending:
𝐺 − 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

𝑌
1
=
 𝐺 1 − 𝑀𝑃𝐶

𝑇 − 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 =

𝑌
−𝑀𝑃𝐶
=
 𝑇 1 − 𝑀𝑃𝐶

Keynes recommended demandmanagement policies
...
Basically, if the economy
grew too fast, the government adopted
contractionary (deflationary) policies,
while it adopted expansionary
(reflationary) policies if the economy was
slacking and a recession was looming
(demand deficit generates unemployment and must therefore be avoided)
...

There was a lot of criticism focused on these policies, however
...
Also, an overconcentration on short-term policies and a neglect for long-term policies and
structural changes in the economy prevented strong economic growth
...
This meant that both
unemployment and inflation could rise at the same time
...


The Monetarists (books page 477)
As a reaction on Keynesianism, the monetarists returned to the old classical theory
...

Whereas previously it was assumed that the national income Y was independent of the money supply at
all times, it monetarists believe that this is only the case in the long run: in the short run the national
income can change if the money supply changes
...

This new version of the QTM led monetarists to make two conclusion:
-

Inflation happens because in the long run growth in the money supply outpaces growth of output
...
However, with the increased national income people will
expect higher wages, and prices will go up accordingly
...
It will lead to some unemployment in the short run, because demand
falls
...
The unemployment can then only persist if workers continue to demand excessive wages
or firms and workers continue to expect high inflation rates
...
Contrary to Keynesian methods of government spending, monetarists therefore argue
that monetary policy to control the inflation rate is essential
...
This means that at different inflation levels,
the unemployment level will be the same
...
This is because in the short run the increase in demand is a real
increase in demand
...
If we want
to understand this, we need to introduce the concept of adaptive expectations: the theory that people base
their expectations of inflation on past inflation rates
...
The effect is that prices and wages will rise
...
If the prices then rise more quickly than the wages, then the real wages fall and the firms
will hire more labor
...
Gradually
workers that their real wages are lower and they will start demanding higher ones (adaptive expectations)
and the unemployment will go back to the natural level
...
This can only be achieved by a reduction of the natural unemployment equilibrium, and not by an
increase in demand
...


The Current Position (book page 484)
The following is a list of areas of general agreement between modern-day economists
...

In the short run a change in aggregate demand can have a major effect on output and
unemployment
...
Many economists even say that the entire effect will be on prices
...

Expectations have an important effect on the economy, though it is still unclear how exactly
...


-

-

-

It is difficult to control inflation through the control of the money supply
...
Therefore economists argue that interest rates must be changed, since
they directly affect aggregate demand
...
Long term growth depends primarily on changes
in supply (in potential output)
...


CHAPTER 17: Short-Run Macroeconomic Equilibrium
This chapter will explain what determines the level of national income (GDP) in the short run
...

Background to the Theory: The Keynesian Model (book page 495)
Put simply, the level of output in the economy is dependent on the level of aggregate demand
...
If people want to buy more, firms will increase their output, providing they
have a spare capacity
...
But how
much does national income change if demand changes? Remember that we are in the short run: up to
two years!
Back to the circular flow of income
...
Withdrawals are savings, taxes and spending on imports
...

In this chapter we will refer to aggregate demand as aggregate expenditure, as is the normal case in the
Keynesian model
...
(In math the three dots before a formula  means ‘therefore’
...
How can we, in the short run, create a new equilibrium? If aggregate
expenditure (Cd + J) exceeds national income (Cd + W), then firms will increase output as a response to the
greater demand
...
If national
income rises, savings, imports and the amount paid in taxes will rise too until they are once again equal: a
new, greater equilibrium has been reached
...
But how much will the
national income rise if we do this? If we want to know this we have to examine the three elements of the
circular flow of income: withdrawals (W), injections (J) and consumption (Cd)
...

The Keynesian 45 Line Diagram
For this model we assume that levels of consumption and withdrawal are determined by the national income
and since national income is part of the model we say that they are endogenous
...
For now we can assume all this
...


Cd , W , J

Y =Cd + W
Cd

W

Y

On the horizontal axis we plot the real national income Y
...
Since Y = C d + W, the line must be 45 degrees: at every point
they are equal
...
The slope of the function is determined by the marginal propensity to
consume: for every bit of additional income, how much of this will be used to consume?
𝑐 = 𝑚𝑝𝑐 =

𝐶
𝑌

But consumption is not only determined by income
...
If the marginal propensity to consume
where 1, then the consumption function would have the same slope as the national income
function
...
If consumption changes as the result of a change in national income,
then this will be shown as a movement along the consumption curve
...

Then there is also long run and short run consumption
...
But after a while they will be more
comfortable with their new income and spend more: the mpc will be higher
...
This means that the steeper the one curve is, the less steep the other
...


Injections
Injections are exogenous and thus independent of the level of national income
...

Furthermore, investment is influenced by real interest rates: the higher the interest rate, the more
expensive it is to finance investment (but remember that for Keynes, confidence in the economy is
a more important factor in determining investment than the interest rates)
...
If the national income is
in equilibrium, then withdrawals must equal injections: W = J
...

Since injections are independent of the level of income, we must draw it as a horizontal line: if the Y
changes, the value of the injections on the vertical axis won’t change
...
Above we stated that in

equilibrium injections equal withdrawals
...

We also stated that in equilibrium expenditure E (aggregate demand) equals income Y
...

If the curves are correctly drawn both intersection points must lie on the same vertical line: they both
represent the value of the national income and must show the same value on the horizontal Y-axis
...
If it is the other way around, the national
income will rise
...
We need to introduce the multiplier (k)
...

𝑘=

𝑌
𝐽

A more specific formula for the multiplier depends on which part of the injections is changed
...
In this case there are two different options: both taxes and imports are
fixed, or they are not and change with the G
...

𝐺 − 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑘 =

𝑌
𝐽

=

𝐺 − 𝑚𝑢𝑙𝑡𝑖𝑝𝑙𝑖𝑒𝑟 = 𝑘 =

𝑌
𝐽

=

1

Fixed

1−𝑚𝑝𝑐
1
1−[𝑚𝑝𝑐(1−𝑡)−𝑚𝑝𝑚]

Not Fixed

A fall in withdrawals will also result in a multiplier
...


If we shift the injections curve (for example because of a change in government spending), then we see
that we find a new equilibrium value for the national income (remember that the intersection between W
and J gives us the value of Y, even if the Y-curve is not drawn)
...


If we
shift the expenditure curve then logically a new
equilibrium will be found too
...


The Simple Keynesian Analysis of Unemployment and Inflation (book 513)
The simple theory assumes that there is a maximum level of
national output (and therefore real income)
...
This is referred
to as the full-employment level of national income
...
There will be what is known as a
deflationary gap
...
The
problem is that it is impossible to reach this equilibrium since
the full-employment level of output is lower (it can be
reached in the long term)
...

Both of these situations can be resolved by changes in
injections: if we shift the injections curve (for example by
increasing government spending) then we can reach a new
equilibrium since there will be a new intersection point with the withdrawals curve
...
They argue that private sector spending is volatile: investment is instable
...

The Accelerator Theory
The accelerator theory states that the level of investment depends on the rate of change in national
income
...
Investment rises dramatically when the economy
booms, but falls just as drastically if it slows down and can entirely disappear in a recession
...

When income and consumption remain unchanged only very little investment is needed:
replacement investment that serves only to keep production capacity at the same level
...
Once the capacity is back on par with consumption, investment will
fall back to replacement investment
...

Ii = Y
Here,  is the amount by which induced investment depends on changes in national income
...

Booms and recessions persist for a variety of reasons
...
Actors in the economy also need to adapt to new situations
...
If people expect the economy to boom, even if it is growing
only very slowly, they will start consuming and investing
...


-

Interactions between the accelerator and the multiplier
...


Booms and recessions and for several reasons:
-

-

Ceilings and floors: the economy can only grow fast if there is slack in it
...
At the other extreme,
there is a basic minimum level of consumption that people strive to maintain
...

Keynesians argue that governments should pursue policies that limit the fluctuations of the
business cycle
...
However, this is a lot more than notes and
coins: these make up only a very small portion of a country’s money supply
...

Why the need for money? Because if we relied solely on bartering, then the price of every good would
have to be known in terms of other goods: a single good would have many prices expressed in other
goods
...
A single accepted means of payment and a single price make trading
much easier
...

Money serves three main purposes:
-

-

It is a medium of exchange: because bartering is impractical in the modern economy, a medium of
exchange is needed to make trade easier
...
Money is such a medium and can come in various
forms
...
Money is such a mean
...

Money is also a unit of account, since countries’ GDPs are expressed in it
...
Goods money is
money with an inherent value: a gold coin will have the value of the gold it is made from
...

What counts as money? This depends on which definition we choose
...
In the broader sense bank accounts and various financial assets count as well
...


The Supply of Money (book page 543)
If we want to measure the money supply in the economy, we should first wonder what to include (what
should count as money)
...

The Monetary Base
The monetary base, or ‘high-powered money’ (denoted as M0), consists of cash and notes in
circulation outside the central bank
...


Broad Money
The monetary base M0 is however a poor indicator of the effective money supply in the economy
...
This is quite complicated though, and we distinguish different kinds of broad money
...
The differences
between M1, M2 and M3 (=M4) are determined by which deposits are counted
...

To explain the creation of credit, we will use the simplest possible case
...
The
bank has a liquidity ratio of 10%
...
Essentially this means that ten percent of the
total assets is quickly available if people want to get their money
...
Assume that the bank’s total balance is 100 billion: 90 billion lend out and 10
billion in the central bank
...
The
bank will send this to the central bank
...
The liquidity ratio is not about 18%
...
Now the bank has a total balance of 110 billion
...

This means that the customers have an additional 9 billion to spend
...
The shopkeepers then deposit this 9 billion in the bank: the banks total balance is now 119
billion
...
9 billion with the central bank and lend out
the remaining 108
...
This process goes on and on until almost no new money is created
...
The total increase in the money supply is thus
100 billion
...
The number is the inverse of the liquidity ratio
...

𝐵𝐷𝑀 =

1
𝐿𝑖𝑞𝑢𝑖𝑑𝑖𝑡𝑦 𝑅𝑎𝑡𝑖𝑜

We can interpret this number as follows: if the deposits increase by 10 billion, and the multiplier is 10,
then the total increase in deposits will be 10 x 10billion = 100 billion
...
We need to introduce the money multiplier
...
It is
given by the following formula:
∆𝑀 𝑆 = 𝑚 𝑥 ∆𝑀 𝑏
If we want to know how much broad money will increase if the monetary base increases by 1%, we use
the following formula
...
Assume on the horizontal axis the quantity of money and on the vertical axis the rate of
interest
...
Thus the money supply is determined independently of the demand for money and the
interest rates (the money supply is exogenous: determined by factors outside the model)
...

The money supply is thus at least partly dependent on the demand for money and the interest rates (since
variables within the model influence the money supply, it is endogenous)
...

There are three motives for this:
Precautionary and Transactions Motive: L1
If an unforeseen circumstance arises, people might need money (like a car breaking down)
...
Since money is received in intervals (weekly or monthly),
people hold on to it
...
Money balances held for these purposes are called active balances
...
The greater a household’s
income, the greater its expenditure and therefore the greater its demand for active balances
...
But if money is received every day, then the active balance can be much smaller: it needs to
cover only a single day’s expenses
...
Lastly, other
determinants may be the seasons of the year or financial developments
...

The Speculative or Assets Motive: L2
Firms and individuals might want to keep money because they
expect the price of financial assets to fall
...

The balances held for these purposes are called idle balances
...
Also, the

expectations of the changes in prices and other security assets influences the size of L2
...

The total demand for money is thus L1 + L2 = L
...
The interest, national income
and price level between brackets merely serve to signify that they determine the L
...

In the graph we see that on the vertical axis we have the rate of interest and that on the horizontal axis we
find the quantity of money
...
In equilibrium, we find the
equilibrium rate of interest re
...
This shows the relationship
between the inflation , the real interest rate r and the nominal
interest rate i
...

i = r + e
Consequentially:

𝑀
𝑃

= 𝐿(𝑟 +  𝑒 , 𝑌)

More simply, this means that the real supply of money is
determined by the national income Y and the real interest rate
r
...

Finally, there is a connection between money, prices
and interest rates
...
Then, via
the quantity theory of money QTM we know that a
growth of money in the economy will result in inflation
...


CHAPTER 19: The Relationship between the Money and the Goods Market
The Effects of Monetary Changes on National Income (book page 561)
First, let’s go back to the quantity theory of money QTM
...
MV is the total spending on national output and thus the aggregate demand
...
PY is the money value of the national output: the GDP
measured at current prices (the nominal GDP)
...
If V is
constant, then a change in M will directly influence nominal aggregate demand and thus nominal GDP
...
For this chapter we will assume that V
is fixed
...
So, since the central bank can influence the money supply M, it can
affect the Y
...

The Interest Rate Transmission
Mechanism
This is a three stage process
...
The MS-curve will shift
to the right and a new equilibrium with the
L-curve will be reached
...
Since it is less profitable to
keep money in the bank, people will rather spend it
...

In the third stage aggregate demand goes up
because of increased investment and the multiplier
effect is applied
...
This means that by increasing the money
supply the equilibrium can change
...
They
argue that there are problems with the first step,
because the money supply is effected only very little
by the interest rate if the demand curve for money L
is very flat or unstable (due to expectations)
...
This is called the liquidity trap
...
e
...
Fluctuations
in the money demand can result in fluctuations in
the interest rate
...


There can also be problems with stage two of the
interest rate transmission mechanism
...

In the first case investment demand curve (the
investment curve on the investment/rate of interest
diagram) is very steep and therefore quite inelastic
...


In the second case the investment-curve can shift unexpectedly
...
Similarly, investment
will down up if the fall in interest rates is accompanied by a decrease in business confidence
...

The Exchange Rate Transmission Mechanism
The exchange rate transmission mechanism
backs up the interest rate transmission
mechanism
...
The mechanism consists of four
stages
...
The strength of
this stage is largely dependent on the openness of the economy
...
Note
that the graph shows the foreign exchange
market
...
This
stage can be quite strong, especially since
financial markets are extremely open and a
small change in the exchange rate can
cause large financial flows
...
Stage three can be very
strong in the long run
...
The
precise magnitude of this stage is highly
unpredictable
...
If the
money supply in the economy goes up, people will have more money than they require to hold
...
Much of this spending will go to goods and services, thereby directly
increasing aggregate demand
...
As
people get more money through a rise in supply, they may want to diversify their portfolio; i
...

they don’t want too many liquid assets
...
As more of these assets are being bought, they drive up their price and reduce
their yield
...

Goods and services will have a higher price/marginal utility ratio
...
By that time aggregate demand has increased through a rise in
consumption
...
The increase in investment should push
the macroeconomic equilibrium upward, as we have seen before (new intersection point between
withdrawals and injections)
...
This will reduce the rise in injections
...
However, if the central bank had increased the
money supply, then the interest rates would not have gone up and the negative effects would have been
avoided
...
Crowding out is the
phenomenon where an increase in government
borrowing diverts money away from the private sector (in
other words, in increase in public sector spending will
decrease spending in the private sector)
...
This will result in
less consumer spending
...

Even more, the currency appreciates and imports rise, while exports will go down
...

The extent of crowding out depends on the responsiveness of demand for money (L) to a change
in interest rates (i)
...

It also depends on the responsiveness of investment I to an interest rate
...
Monetarists, who
believe in an elastic investment function, believe that
there will be a large change in investment
...

Case 2: The Central Bank Allows the M to Change
In this case, if the government increases spending, the national income will go up, the demand for
money L will go up, the money supply M will rise too and there will be no change in interest rates
...
Inflation will increase
...

The IS curve shows the combination of interest rate and the national income Y needed to attain an
equilibrium in the goods market
...
It is negative because when
interest falls, investment goes up and Y and S go up (until S=I)
...
The elasticity of the IS curve (its responsiveness to changes in interest) depends
on the responsiveness of S and I to i, and the size of the multiplier
...

The LM curve shows the combination of interest rate and Y
needed to attain equilibrium in the money market
...

M=L(P, i, Y)
...
The LM curve’s
elasticity depends on the elasticity of Y and L with respect
to the interest rates
...

The curve shifts if any other determinants of M and L
change
...
Imagine that the
markets are not both in equilibrium and that Y is bigger
than Ye
...
This would cause
inflation to fall
...

If the government starts an expansionary fiscal policy, then the IS curve will shift to the right
...
If the government conducts and expansionary monetary policy, then the LM curve will shift to the
right and the interest rate will fall
...


The Keynesian Version of ISLM
For the Keynesians, the LM curve is very flat and
thus very inelastic with respect to the interest rate
...
However, they argue that
an expansionary monetary policy, due to the very
steep IS curve, will have a minor change on the Y
...

This means that a monetary expansionist policy is
highly effective, again with a small change in
interest, while a fiscal expansionary policy is
relatively ineffective, with a big change in interest
rate but only a small change in Y
...
The goal is usually around 2%
...

The model shows graphically the relationship between
national income and the inflation rate
...
This in turn will influence
investment and shift the ADI curve
...
By
shifting the ADI curve it can attempt to create an equilibrium
located somewhere on this line
...
But as the firms respond to the higher
demand by raising prices, inflation goes up and Y goes down
until a new equilibrium is reached
...


At this point the central bank can do two things
...
If it does this, however, the
higher prices will translate into higher wages and the ASI
curve will shift to the left
...
The second option is to
reduce aggregate demand back to the original level
...


CHAPTER 20: Aggregate Supply, Unemployment and Inflation
Aggregate Supply (book page 594)
We know by now that in macroeconomics, every action
has a tradeoff: we can’t reach all goals simultaneously
and therefore we need to prioritize
...
To know this we look at the
microeconomic level and look at what firms do
when demand increases
...

However, if the firm is already at full capacity, an
increase in demand will largely result in an
increase in price
...
Therefore the AS curve will be
relatively flat at low output and steep at high
output
...
This is the
moderate consensus
...
The
extreme Keynesians argue that the short run
supply curve is horizontal up too full employment
and vertical at full employment
...
The new classical economists
believe that the supply curve is vertical
...
Whichever of these factors is stronger will determine the shape of the LRAS
...
But this will
in the long run make the production inputs of
other firms more expensive, thereby shifting the
supply curve upward
...
The supply curve will shift to the right:
higher output for lower prices
...
For monetarists, real
wage rates are flexible
...
The conclusion is that the LRAS of
labor curve is vertical
...

They argue that wages are not as flexible as
monetarists believe (for example because
negotiations with unions have fixed the wages
for at least a year)
...
Also, workers suffer from long run money illusion: they believe that
changes in wages or prices represent a real change
...

Therefore the LRAS of labor curve is not vertical
...
If the aggregate demand curve shifts to the right, then the national income Y will go up, but so
will the price level
...
If for some reason there is an exogenous increase in costs
(like a rise of oil prices), then the supply curve will shift upward and drive prices up
...
In this case again
price will increase
...


The Expectations Augmented Phillips Curve (book page 602)
We will incorporate expectations into the Phillips curve
...
An
example
...

Assume that the government wants to reduce
unemployment to six percent and thus expand
aggregate demand
...

In year 2 the government expands aggregate demand
in order to reduce unemployment
...
The
economy has moved along the curve and inflation is
now 4%
...
Therefore the Phillips curve
has not shifted yet
...
The Phillips curve shifts upward by four percentage
points
...
There is no
demand-pull inflation but inflation due to
expectations
...

Because there is inflation, the nominal aggregate
demand has to be increased more than in year 2
...

In year 5 the expected inflation is 8%: the level of
actual inflation in year 4
...

The government, trying to stay at 6% unemployment,
has to increase aggregate demand by more than inflation: there is a move along the curve up to 12%
inflation
...
In order to keep the unemployment below the initial equilibrium
rate, the government must constantly surpass inflation
...
This is why it is
called the accelerationist theory
...
So long as there is demand pull
pressure, inflation will rise as the expected rate of inflation rises
...
The quick way is to severely
contract the economy
...
However, the economy falls into a deep recession and unemployment will be
very high
...

The slow way involves a mild contraction
...
Inflation falls slightly in the first year, leading expectations of less inflation to be small
...

There is also the phenomenon of stagflation: a
simultaneous rise in inflation and unemployment
...
Consider a 10-year cycle
...
This, as we have seen, will push up
inflation
...
The inflation rate still rises
because people’s expectations are based on the
previous year
...
Inflation
starts going down
...
From points d to f both inflation and
unemployment are rising: this is where the stagflation is
...

In addition, the Phillips-curve can shift to the right because frictional and structural unemployment rises
...

What are the consequences of this? It is clear now that monetary and fiscal policies have no long term
effect on unemployment, and the Phillips curve can only be used to control inflation
...
Examples of this are
market oriented policies (removing restrictions on competition: drives prices down), or interventionist
policies (providing better education or transport)
...

Rational Expectations and the Phillips Curve: The New Classical Position (book page 609)

Short-Run
Long-Run

Shape of AS
Adaptive
SRAS positive
LRAS vertical

Rational
SRAS vertical
LRAS vertical

Phillips curve
Adaptive
Negative
Vertical

Rational
Vertical
Vertical

Economists from the new classical school argue that even the short run Phillips curve is vertical
...
Rational expectations here are opposed to the

adaptive expectations we discussed earlier
...
Therefore the rate of the expected inflation is dependent on the current state
of the economy, current policy and future policy
...

Correct Expectations
Let’s take a P/Y graph and assume that
expectations are adaptive
...
Prices and
national income rise as a consequence
...
This will cause the supply
curve to shift upwards
...

Therefore in the short term the national
income has gone up, but in the long term
only the prices
...
They believe that people will correctly anticipate a
rise in price level and will immediately start asking for higher wages (rational expectations)
...

Incorrect Expectations
On the goods market, firms may incorrectly expect the real wages to rise too much if the
government stimulates the demand
...
In this case firms have underpredicted
inflation
...

On the labor market workers can underpredict the inflation rate, leading them to think that they
are better paid
...
The
opposite can happen too: workers may overpredict the inflation, leading them to believe that they
will earn less than they actually do
...

Rational expectations have important policy implications
...
Therefore the
money supply must be used to control inflation
...
Therefore inflation and unemployment are separate problems
...


CHAPTER 21: Fiscal and Monetary Policy
Fiscal Policy (book page 626)
Fiscal policy seeks to control aggregate demand AD by change the balance between government spending G
and taxation T
...

The public sector net cash requirement is the amount that the public sector must borrow if it is in deficit
...
The national debt
is composed of the accumulated government budget deficits over the years: it is the government’s debt
...

The government takes a fiscal stance: this can be either contractionary or expansionary, depending on the
state of the economy
...

There are automatic fiscal stabilizers that even out the business cycle: if national income rises taxes
increase and benefits go down
...
The higher the tax rate (MPT = marginal
propensity to tax), and the higher the G, the higher the automatic fiscal stabilizer
...
The disadvantage is that they do not eliminate
fluctuations entirely
...
Also,
equilibrium unemployment may be increased if the benefits are too high: people might lose income by
getting a job
...

Discretionary fiscal policy refers to the government’s ability to choose its own policy
...
If the G is increased, then the Y will go up with a
multiplier
...
The main advantage of discretionary fiscal policy is that
it can correct severe macroeconomic
disequilibria
...

Also, the phenomenon of crowding out
can occur: money is diverted from the
private to the public sector
...
If the
timing is wrong, fiscal policy can actually
destabilize the economy and worsen the
fluctuations in the business cycle
...
Inflation can occur
...

There are in practice several techniques to reduce the money supply M
...
These operations involve selling government bonds to get money out of the economy
...
If banks obtain less money from
the central banks, they have to cut back on lending
...

The third method is to change the way national debt is financed
...


Problems of Monetary Policy (book page 645)
The central banks have difficulties controlling the money supply in the long term because it has little control
over the velocity of money
...

In the short run there are problems controlling the M too
...
Changing the interest rate is also not guaranteed
to work: sometimes the demand for loans is very inelastic
...
And if banks can’t create as much credit as they want, they will prefer bigger firms as customers
rather than small ones
...
Also, stability will create confidence in
growth and investment, and lastly, there will be less sudden contractionary or expansionary policies
...
Also, choosing a rule can be
difficult and rules can become obsolete
...
It is also
more flexible and thus better suited to deal with a specific situations
...


CHAPTER 22: Long-Term Economic Growth
What are the causes of economic growth in the long run, and why are there poor and rich countries?
These two questions we will answer
...


Long-run Economic Growth in Industrialized Countries (book page 670)
The main causes of economic growth are an increase in production factors K and L (capital and labor)
...

The production function is determined by K (real capital stock), L (labor force measured in working hours)
and A (the productivity of the production factors K and L)
...


The Solow Model: A New Classical Model of Economic Growth (book page 673)
Without Technological Progress
We can use more capital compared to labor, which will generally increase the productivity per
worker
...
This means that there is an opportunity cost attached to
investment
...
This is increased
by increasing the K per L: increasing capital will
increase productivity per worker (per capita)
...
Then the K can be increased by
investment I
...
Logically, economic growth is determined by ‘y’
...
Depreciation refers to worn out capital, like machines
that needs to be replaced
...

We assume that in our model, an increase in savings will increase investment (just assume this)
...
Note that this equilibrium is

only in the short run, because when the new capital
starts wearing out the depreciation curve will move
upward too!
I comes from savings
...
This means that if savings go up, investments
go up
...
So saving increases output
(through investment) but directly decreases demand
...
Logically, there must be a rate of saving where consumption is highest
...

So we know what happens if we increase capital
...
This
means that there can be no long term economic growth if only the labor force increases
...
However, if the
GDP increases because of a rise in population, then the GDP per capita will go down
...
Technological progress
actually has two effects
...
The
second effect is that the rate of technological progress
determines the slope of the output curve over time: the faster
the progress, the steeper the curve, the greater the rate of
growth
...


Endogenous Growth Theory (book page 679)
What do we have to do to increase innovation, renewal and invention? After all, technological progress
does not come from nothing
...


Institutional Growth Theory (book page?)
Institutional growth theory assumes that even while new technologies are available to all countries, not all
countries have the same abilities to incorporate new technology in order to create production
...


CHAPTER 23: Supply-Side Policies
Y = C + I + G + NX

L, K, Technology

Supply-Side Policies and the Macro Economy (book page 685)
Supply-side policies are designed to increase potential output
...

Supply-side policies serve several macroeconomic objectives
...
Also,
labor mobility across regions can be improved
...

How should supply-side policies be approached? Through the market or intervention?

Approaches to Supply-Side Policy (book page 686)
Market-Oriented Supply-Side Policies
In general, market-oriented supply-side policies ask for reducing government expenditure: reducing
the size of the public sector and maximizing resource efficiency
...
This will have a positive effect on the supply of labor: people may
wish to work longer hours (remember the income and substitution effects from micro), more
people may wish to work, and people may work with greater enthusiasm
...

Tax cuts are best given to businesses because they tend to invest in output
...

Also, policies should focus on increasing competition (since this drives down prices)
...

Thatcher and Reagan in the ‘80s pursued these kinds of policies
...

Union power (especially under Thatcher) was eroded
...

Interventionist Supply-Side Policies
There is a case to be made against the market
...
Also, the market has imperfections of its own:
sometimes there is a lack of investment, and investment itself is cyclical in nature
...

On a large scale the government can even plan the economy by improving coordination between
firms
...
On a smaller scale,
governments may try to intervene selectively by, for example, helping certain small firms
...
Subsidies may support inefficient production,
investment grants may be more likely to go to high-profile project (rather than the most beneficial ones),
and reducing the tax burden may result in a higher return on investment than increasing the taxes and
intervening

---