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Principles of Macroeconomics Notes
January 16th Lecture: Chapter Eight – GDP Accounting
• Nominal GDP
• When did national accounting begin? It began right after the great depression started
...
Prior we had no data collection for unemployment rates,
inflation, etc
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In 1971
he received the Nobel Prize in economics for his work
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• A precise definition of GDP: gross domestic product – a measure of the market value of all
newly produced final goods and services in a country during some period of time
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g
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Things that don’t have a market value are excluded, e
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housework
you do for yourself
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GDP does not look at the resale market, so no used goods are included like
used textbooks
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For GDP, we only look at final goods
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o GDP counts goods that are produced within the borders of said country
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If US companies outsource their
manufacturing, then our GDP decreases because the good is no longer produced within
our territory
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§ Goods produced by foreigners within US borders are included in US GDP
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GDP data is reported quarterly and
annually
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10 million $30,000 new cars + 20
million $1000 computers = $320 billion for GDP
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The actual purchase of a stock is not included, but the commission is included
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Wealth includes things like infrastructure, which is
necessary for economic growth
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o The income or factor payments approach: measures the total income earned by all
factors of production that produce goods and services in the United States
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§ The total value added in the economy from the sale of one ream of paper is $5,
where does this money go? Look at PowerPoint slides
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The expenditure approach: GDP (Y) = C + I + G + NX (where Y refers to income)
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Department of Commerce – Bureau of Economic Analysis
collects information on GDP for the US (bea
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o C = consumption: purchases of final goods and services by individuals
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No
financial transactions are included
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4) + G (3
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39-2
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25 trillion = $11
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48 + $3
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55 (GDP = C + I + G + NX)
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62% + 15
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51% - 3
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For the US, economists believe the number for investment should be higher
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o In the last forty years, the net exports have been negative in the United States
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• Nominal GDP (current dollar GDP): values output using current prices
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The change in nominal GDP reflects both prices and quantities
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Real GDP
is corrected for inflation
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Leave price constant according to its base year, and use this price to calculate
GDP in later years to get rid of the effect of inflation on GDP
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e
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• The GDP Deflator or GDP Price Index: the GDP deflator is a measure of the overall level
of prices – a price index
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o Equation: GDP deflator = 100 x [(nominal GDP) / (real GDP)]
o There are no units for a GDP price index
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00
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6,
showing that prices increased from 2005 to 2006 by 14
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o The understanding with comparing inflation is that it is a one-year comparison, ex:
between 2005 and 2006
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Nominal GDP Q3: $16
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84 trillion
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o Nominal and Real GDP are the same during the base year, so in this graph the base year
occurs in 2009
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o Shaded areas on the map: recessions in the United States (around 2001, and the Great
Recession from 2007-2009)
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GNP is the market value of all final
goods and services produced by a country’s permanent residents anywhere in the world
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Take notes on rest of PowerPoint it will be on the quiz
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February 4th Lecture: The Open Economy – The Balance of Payments (Chapter 18)
• Midterm is on February 27th in class in Elliott room 113
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o Now on a monthly basis, you can expect this amount to be tapered down by 10 billion
dollars, unless something shitty happens
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Now this money is going back into the US, because the
interest rates are increasing
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It is a record of a country’s trade with other countries in
goods and services, cash, and assets
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§ The current account is the most important part of the balance of payments
accounts
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• US Balance of Payments, 2012: balance on current account is $-440
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It has been
negative (a deficit) for many years
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Both
of these accounts balance each other out, so the numbers must be similar and must have
opposite signs (positive or negative) to balance each other
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o Balance of payments is always zero, or it should always be equal to zero
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o The biggest portion of the current account is net exports
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§ Trade deficit refers to the balance of trade aspect of the net exports
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)
o Net Transfers = (transfers received by domestic residents) – (transfers made to
foreign residents
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How does the US current account rank? We are in last place (#193) in 2012 with $-440 billion
dollars in our current account
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What do countries with current account surpluses do with those funds? Since the
US has a current account deficit with Japan, Japan could use the funds for:
o Foreign direct investment: Japanese residents purchase or build factories in the US
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o Bank reserves/holdings of US currency
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This is part of the financial account (capital inflow)
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o Foreign portfolio investment: US residents purchase Canadian stocks or bonds
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o These transactions show up as a decrease (capital outflow) under US holdings of assets
in foreign countries
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o Capital Inflows: funds flowing into the country (for foreign purchases of domestic
assets)
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§ What influences Net Capital Flows? Real interest rates paid on assets,
perceived risks, and government policies
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Net
Foreign Investment (NFI) is the negative of the balance on the financial account or net
capital flows
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Recall NX is the largest part of the current account balance
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o The US pays foreign countries with US dollars; the other countries use the dollars to
acquire US assets, causing the balance on the US financial account (NCF) to rise by the
same amount, and NFI to fall by that amount
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o Foreign countries pay the US with their currency; the US uses the currency to acquire
foreign assets, causing the balance on the US financial account (NCF) to fall by the same
amount, and NFI to rise by that amount
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o Foreigners who want to buy domestic goods, services, and assets, as well as currency
traders who expect the currency to appreciate demand domestic currency
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The physical location where the exchange of currencies takes place doesn’t matter – whether
you trade dollars for yen in London in Mexico City, you are a trader in the same dollar-yen
market
...

o We can think of any exchange rate from two perspectives – domestic (number of units of
foreign currency per dollar) or foreign (number of dollars per unit of foreign currency)
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o Exchange rates are generally expressed as foreign currency per unit of domestic
currency
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61 British pounds = $1 US
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64 = 1 British pound
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o If the price of a British pound falls from $1
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60 per pound, then the
dollar has become more valuable
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Appreciation: (strengthening/rising) is an increase in the value of a currency as measured by
the larger amount of foreign currency it can buy
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o Example: the exchange rate changes from 0
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This shows
the dollar is up, it has appreciated, and conversely the British pound has depreciated
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The
demand curve represents foreigners demand for US goods, and currency traders
demand for the currency
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61 pounds = $1, $150 million worth of microchips from Intel will cost 91
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61)
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o When the $ appreciates, the British company will buy fewer microchips as they have just
become more expensive, therefore, the quantity of dollars demanded decreases, and vice
versa
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It’s a movement along the
demand curve
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o When 0
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If the
exchange rate changes to $1 for 1 pound, then the 200,000 pounds worth of sweaters
will cost $200,000
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The
appreciation of the dollar helps US importers
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So when a currency appreciates, exports will fall and imports will rise which will reduce NX,
and therefore reduce GDP
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Shifts in Demand and Supply
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• Boom or expansion overseas (real GDP rises)
• Relative price levels (higher inflation overseas)
• British taste for American goods grows
§ Increase in demand for US assets
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§ Speculators and currency traders’ expectation that the value of the dollar will rise
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o An increase in the supply of US dollars
§ Increase in demand for British goods
• Boom or expansion in the US (real GDP rises)
• Relative price levels (lower inflation overseas)
• American taste for British goods grows
§ Increase in Demand for British Assets
• Higher interest rates and rates of return in the UK
§ Speculators and currency traders’ expectation the value of the dollar is going to
fall
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February 18th Lecture: The Real Exchange Rate
• Midterm review session on February 24th from 6-8pm
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• The real exchange rate is an index number that tracks changes in the relative prices which
the goods and services of a country trade for the goods and services of another
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o The real exchange rate (RER) = [(e x P) / P*] – per dollar exchange rate
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P is the
price of a good (domestic price level), and e is the exchange rate between the two
currencies (nominal market exchange rate, ie
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o Imagine a basket of goods that costs $500 in the US and 500 pounds in Britain
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00 pound
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00
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Let the
nominal exchange rate be 0
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§ RER = [(e x P) / P*] = (0
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61
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o Imagine a basket of goods that costs $750 in the US and 500 pounds in Britain
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61 pounds
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61 pounds x $750) / 500 pounds] = 457
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92
• Therefore the prices of US goods and services are 8% lower relative to
British goods and services
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If the RER is
greater than 1, the goods are more expensive in the domestic country
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Ex: Canadian dollar, US dollar, Japanese yen, and
British pound
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Canada for instance is one of the countries that interferes
least with their currency market
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For example: buying its own currency to prevent depreciations, or selling its
own currency to prevent appreciations
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Worth is
determined by:
o A fixed weight of gold ex
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You can only issue
as much paper currency as you have gold
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o A fixed amount of another currency ex
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Gold exchanged for $35 per ounce by central
banks
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• A country will peg below the market rate to protect export-oriented industries
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o A country will peg if the exchange rate is too volatile and makes doing business and
trading too risky
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Example: Venezuelan Bolivar
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Repegged at 1920 bolivars per
US dollar in 2004 and 2150 bolivars in 2005
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o Repegged in 2010 at 2
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39 per bolivar) (for goods being imported –
necessities) and 4
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23 per bolivar) (for anyone who wanted to purchase
foreign goods)
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• Revaluation is an increase in the value of a currency that previously had a fixed exchange
rate
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12 per Yuan (well below equilibrium)
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It is now about $0
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• Foreign investment in the US shows up as positive entry in the US financial account
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• What happens in the foreign exchange market affects the economy and what happens in the
economy affects the foreign exchange market
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o Short run: Real GDP – all else equal, if real GDP rises the domestic currency will
depreciate, if real GDP falls the domestic currency will appreciate
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Remember that only in the very short run do interest rates and investor’s expectations shift
both the supply and the demand curve for a currency
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Now the demand curve for the
dollar will shift left because the demand is decreasing
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61 pounds, and new
equilibrium exchange rate is 0
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Exchange rates in the short run: if incomes are rising in the US or US GDP is rising then
the supply of US $ will shift to the right
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o This shows why US $ depreciates when the US GDP increases
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This is a fake exchange rate, it is not a
real exchange rate – it’s implied, this is what it should be, what we are striving for or what we
think the market will get to
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§ The currency of a country with a higher inflation rate will depreciate against the
currency of a country whose inflation rate is lower
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§ It tells you how much more you can buy in a certain country, hence why GDP is
important
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P = price of lunch in India in
rupees = Rs
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o Eppp = implied long-term PPP exchange rate, per Rs
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05 euros (50 euros / 1000
rupees)
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01 euros for every rupee, so
notice how these numbers are similar to the PPP
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Finish notes with PowerPoint on blackboard
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Increases
in inflation determine: cost of living index (COLA) – the COLA in many multi-year labor
contracts
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• Different types of price indexes: GDP deflator (1) = prices of all final goods counted in GDP
...

o Producer Price Index (3) = prices received by firms at all stages of production –
inflation at early stages of the production process
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Also called CPI-U, measures the typical consumer’s cost of living – all urban
consumers (87% of population) – inflation experienced by consumers in day-today living expenses
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o “Core” Inflation Rate (5) = basket minus food and energy prices – used by Fed to
determine interest rates
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o Capital goods: excluded from CPI, but included in GDP deflator (if produced
domestically)
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This
matters if different prices are changing by different amounts
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o Another 7000 families keep diaries on food and personal care items for a 2-week period
to determine frequency of purchase
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Base year it will equal
100 (duh) find the inflation rate difference between each year by using the percentage change
equation
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o The fixed basket overstates inflation because of substitution bias, new products/outlets,
and unmeasured quality change
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5% per year
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Inflation
makes it harder to compare dollar amounts from different times
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15) or
2013 ($7
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]
o In our example, federal minimum wage = $1
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CPI = 31 in 1964, CPI=233 in
2013
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15 x 233/31 = $8
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So hourly real wage in 1964 = 1
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037
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25/233 = 0
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March 25th Lecture: Solow Economic Growth Model
• The Solow economic growth model: when a nation’s workers are very productive, real GDP is
large and incomes are high
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o The economic growth model focuses on the causes of long-run increases in labor
productivity
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o Y = Real GDP = quantity of output produced
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• What determines productivity and its growth rate: 1
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Productivity is higher when the average
worker has more capital (machines, equipment, etc
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o But, what determines how fast the capital stock increases?
§ Investment: private (I) and government (G)
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So, private and public investment
must be greater than depreciation for the capital stock to increase
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However, after a point, increases in capital result in smaller and smaller increases in
labor productivity
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Positive technological change
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o Better machinery and equipment (a steam-powered tractor replaces a horse-drawn
plow), better ways of organizing production (Henry Ford and single piece vs
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§ An improvement in technology causes a rise in labor productivity
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o At the firm level, it is subject to diminishing returns; at the economy level it results in
increasing returns
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Subsidize research and development, and subsidize education
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o The convergence or catch-up effect: the property whereby poor countries tend to grow
more rapidly than rich ones
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• Do poor countries grow the same way as already rich countries?
o Much of the institutional infrastructure that is taken for granted in rich countries does
not exist in poor countries
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The government’s role is
key providing infrastructure, subsidies and tax cuts for:
§ Addition of capital and infrastructure (South Korea)
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Encouraging investment
from abroad – foreign direct investment and foreign portfolio investment
(Singapore)
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wars, revolutions, and corruption; an open
economy; access to education’ access to public health
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Examples of investment: General Motors spends
$250 million to build a new factory in Michigan, or your parents spend $300,00 to have a new
house built
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Where do the funds come from? Savers!
o For growth to take place we need investment, but for investment to take place we need
saving to occur in the economy
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o A bond is a certificate of indebtedness that specifies a date of maturity and a rate of
interest (coupon rate)
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Prices
reflect comparative returns
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A stock is a claim to partial ownership in a firm,
and prices reflect expected profitability
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Financial intermediaries: institutions through which savers can indirectly provide funds to
borrowers
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o Financial institutions play a key role in the market: they allow risk-sharing through
diversification, they facilitate liquidity though smoothly functioning securities markets,
it provides market information by way of price indices, ratings, etc
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1
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If it’s a closed economy, the GDP equation
will look like this: Y = C + I + G (because there are no imports or exports)
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Different kinds of saving: private saving and public saving
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S (private) = Y + TR – C – T
§ TR = transfer payments; S = savings; C = consumption expenditures; T = taxes
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o Public saving is the tax revenue less government spending
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o Budget surplus is an excess of tax revenue over government spending
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o Budget deficit is a shortfall of tax revenue from government spending
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National saving (S) = S (private) + S (public): (Y + TR – C – T) + (T – G – TR) = Y + TR – C
– T + T – G – TR … therefore: Y – C – G
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The market for loanable funds: assume there’s only one financial market in the economy
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There is one long-run real interest rate r, which is both the return to saving and the cost of
borrowing
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Public saving, if positive, adds to national saving and the supply
of loanable funds
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Supply curve: an increase in the real interest rate ® makes saving more
attractive, which increases the quantity of loanable funds supplied
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households borrow the funds they
need to purchase new houses (only looking at investment, not consumption)
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o Equilibrium: the interest rate adjusts to equate supply and demand
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A consumption tax is put in place by
the government to encourage households to save money and not spend it on consumption
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An investment tax credit increases the demand for
loanable funds, which raises the equilibrium interest rate and increases the equilibrium
quantity of loanable funds
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Budget deficits shown on the supply
curve as well
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Tax incentives for saving increase the supply of loanable
funds, which reduces the equilibrium interest rate and increases the equilibrium quantity of
loanable funds
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• Saving and investment in an open economy: Y (GDP) = C + I + G + NX, or I = Y – C – G
– NX
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§ So, you can rewrite the investment equation as: I = Y – C – G – NX à I = S –
NX
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o Net Foreign Investment (NFI) = domestic purchases of foreign assets minus foreign
purchases of domestic assets
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Domestic
purchases of foreign assets will exceed foreign purchases of domestic assets, causing NFI to be
positive b the same amount
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We know from
the balance of payments: NX = NFI, therefore S = I + NFI
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• Consumption spending is beneficial for the economy in the short-term
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• Trade deficit (-NX) results in negative net foreign investment (-NFI): ie
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We haven’t had a trade deficit since the
1970s
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§ Causes the dollar to appreciate against foreign countries
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This is because of favorable investment climate, political stability, and protection of individual
property rights
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April 8th Lecture: Aggregate Demand and Aggregate Supply – The Short Run
• Aggregate demand and aggregate supply model: over the long run, real GDP grows
about 3% per year on average
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o These short-run economic fluctuations are often called business cycles
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But the aggregate demand
and aggregate supply model also shows how the economy works in the short run
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The word aggregate simply means “total”
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o The aggregate demand curve is real GDP
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The supply curve is called SRAS – short run aggregate supply
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Y-axis = P (price level); and X-axis = Y (Real
GDP)
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§ The equilibrium price is the equilibrium price level so it is an index
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• The aggregate demand curve is equal to Y (AD = Y)
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o Y = C + I + G + NX
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So, to understand the slope of AD,
we must determine how a change in P affects C, NX and I
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§ Suppose P (price level) rises
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People therefore feel poorer
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The opposite would hold when the price level falls
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§ If the price level in an economy rises, then buying goods and services requires
more dollars
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• To get the dollars you need to start using up your savings or borrowing
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As a
result, investment falls (because interest rates have risen, making
investors do less investing than before)
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As US interest rates rise, foreign
investors now desire more US bonds and assets, so this causes a higher demand
for $ in foreign exchange market
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US exports become more
expensive to people abroad, imports cheaper to us residents, and as a
result, NX falls
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Suppose price levels rise,
then US prices rise relative to prices in foreign countries
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US export more expensive to people abroad, imports cheaper to US
residents
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§ So exports fall for two reasons: interest rates, and the fact that US exports are
more expensive
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Changes in the price level cause movements along the AD curve,
but changes in C, G, NX, or I cause shifts in the demand curve
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Preferences: consumption/saving tradeoff
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Tax hikes/cuts
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Expectations of
future of firms; optimism/pessimism
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Tax incentives,
fiscal policy
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Defense
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Roads,
schools
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other
countries
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§ Basically any change to C, I, G, or NX will cause a shift in the AD curve, unless it
deals with the price level à then it causes a movement along the curve
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Leftward
shift – negative demand shock (like people are pessimistic about the future, or the
government raises taxes)
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AS is upward-sloping in the short run (SR) – an
increase in P causes an increase in the quantity of goods and services supplied
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§ Sticky nominal wages: if actual price level in the economy is higher than
expected (P > PE) but some wages are stuck in the SR, firms are more profitable
and increase output (Y)
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In the long run, all economists believe that wages rise to the price level
of inflation (they catch up to price levels)
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§ Sticky prices due to menu costs: if actual price level in the economy is
higher (P > PE), but some prices are stuck in the SR, their sales increase and so,
they increase output (Y)
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Misperceptions are corrected
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§ Price level has no effect on behavior in the long run
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§ YN = determined by L (labor), K (capital), N (natural resources) and technology
– the long-run economic growth model
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April 10th Lecture:
• What does affect LRAS? An increase in P does not affect YN
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o LRAS: the natural rate of output (YN) is the amount of output the economy produces
when unemployment is at its natural rate
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• Red line is potential GDP, and blue line is the actual GDP in the graph of US Actual and
Potential Output
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o Changes in labor or natural rate of unemployment: immigrations, babyboomers retire, government policies reduce natural unemployment rate
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Factories destroyed by a
hurricane, just natural disasters really
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Changing weather patterns that affect agricultural production
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Productivity improvements
from technological progress
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• The only other thing that also shifts the SRAS is price expectations
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o Which curve shifts? AD or SRAS?
o What is the direction of this shift?
o Will the unemployment rate increase or decrease? What about the price level?

April 15th Lecture: Aggregate Supply and Demand Curves Worksheet
• Wages rise in the long run, cost of production increases for firms, and then the short run
aggregate supply curve shifts left
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• Middeast revolution disrupts world oil supply
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The SRAS curve shifts left = recession
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April 17th Lecture: Monetary Policy
• Monetary policy refers to actions taken by the central bank of a country to manage the money
supply and interest rates to achieve certain macroeconomic policy goals
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Board
of governors (7 members), located in DC
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Federal open market committee
(FOMC), includes the board of governors and 4 regional fed presidents plus the
president of the NY Fed
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o The challenge for the Fed is that: tensions among the goals can arise in the short run,
and information about the economy becomes available only with a lag and may be
imperfect
...

o Open market operations (OMOs): the purchase and sale of US treasury bills (T bills) by
the Fed
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Causes
increase in reserves of the banks; their securities will go down
...

• Which are deposited in banks, increasing reserves, which banks use to
make loans, causing the money supply to expand
...

§ The FOMC uses Open Market Operations to target the Federal Funds rate
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This is a quick and easy way to do monetary policy
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The Taylor rule: a rule developed by John Taylor that links the fed’s target for the federal funds
rate to economic variables
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o Where: inflation gap = current inflation rate – target rate
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May 1st Lecture: The Rise and Fall of Government Debt
• Government debt stays pretty level until the 1970’s, then it begins to rise at a fast rate
...

• Us government has all of these trust funds that it is in charge of, and then it borrows from itself
from the things like the social security trust fund, or the Medicare trust funds, etc
...

o 2/3 of gross debt is debt owed to the public
...

• The debt ceiling has been changed many times
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• Prelude to the US Financial Crisis
...

o The house price bubble bursts: declining demand for houses led to a drop in house
prices beginning in early 2006
...

• As housing pries fell, borrowers especially those who had made little or no down payment,
increasing went underwater (owed more on their mortgages than their houses were worth)
...

• Vulnerabilities in the private sector: Fannie Mae and Freddie Mac pioneered mortgagebacked securities (MBS), packages of mortgages, which they guarantee against loss
...
Invested in their own securities and sold
them as MBSs or Collateralized Debt Obligations (CDOs) with AAA ratings to other
financial institutions here and around the world
...

o Commercial paper is funded by money market accounts, AIG offers credit default swaps,
(CDSs) as insurance against default
...
AIG
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• 2008-2009: the perfect storm, most intense period of financial collapse
...

o Financial firms that invested in these securities would suffer heavy losses, and this even
led to bank runs, such as in California
...
Fannie and
Freddie taken over by the treasury which guaranteed its obligations, September 2008
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Investors and households pull money out of money market
funds

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