Macro – Review II

1. Macro – Review II GDP = C + I + G + NX MV = P Q (= $GDP)

2. Aggregate Expenditures = AE = GDP Y = AE = C + I + G + NX • Disposable income = Yd =Y-T = after tax income. Yd = Y - T = C + S Consumption is related to disposable income (Y-T). C = Ca +cYd where c = Marginal Propensity to Consume = mpc Ca = Autonomous consumption • Additional income not consumed is saved mpc + mps =1

3. Imports and Exports The demand for imports depends on current economic activity, YIM = IMa + mpi Y • “mpi” is the marginal propensity to import • Exports are exogenously determined • they depend on conditions in foreign economies, not our economy • Net exports is NX = EX – (IMa + mpi Y) orNX = NXa – mpi Y • Net expects decrease as the economy expands

4. Demand-Side Equilibrium and the MultiplierAt equilibrium: Y = C + I + G + NX = AEIncrease in Y = Spending Multiplier x {Increase in Autonomous Spending}Multiplier = 1/(mps + mpi)

5. From Aggregate Expenditure toAggregate Demand:As price level rises, real money balances decrease and consumption function shifts owing toi) wealth effectii) interest rate effectiii) international competition

6. Demand-Side Policy: Greater Spending Means Higher Prices (c) Aggregate Demand and Supply in the classical range of AS curve. (Prices rise without significant improvements in output and employment.) Price Level AD1 AD Y? Real GDP

7. Fiscal Policy: Some Definitions • Fiscal policy: government spending and taxing • Demand-side policies • Supply-side policies: • Discretionary Fiscal Policy: aimed at achieving a policy goal. • Automatic Stabilizer: fiscal policy that changes automatically and countercyclically as income changes. • Progressive taxes • Unemployment insurance • Welfare payments / other transfer payments

8. Functions of Money • Medium of exchange • Unit of account • Standard of Deferred Payment • Store of value

11. Multiple Creation of Bank Deposits  M1Fractional Reserve Banking System: r = .1Deposit expansion multiplier = 1/r(when banks lend all excess reserves andpublic redeposits proceeds of loans into the banking system  no leakages)

12. The Fed’s Policy Tools 1) Reserve Requirements 2) Discount rate “primary credit rate” 3) Open market operations • Manage the public’s expectations Inflation Targeting?

13. Fed Policy LinkagesTools – Intermediate Targets – Goals

14. Equation of Exchange: relates quantity of money to nominal GDP • M = money supply (some aggregate) • V = velocity of money (of the aggregate) • P = price level • Q = real GDP • PQ = nominal GDP MV = PQ (Note: V = PQ/M) Money Demand • Transactions demand • Precautionary demand • Speculative demand … fear decline in the value of other assets, so hold money as a safeguard.

15. How Money Supply Changes Affect GDP

16. Aggregate Demand and Supply Phillips Curve

17. Starting at (1): 5% unemployment and 3% inflation. People believe inflation will continue at 3%  Curve I. • Then Fed hypes inflation to 6%  unemployment falls to 3% (Point 2 on Curve I). • Expectations adjust to 6% inflation  Wage demands up  Economy moves to point (3) Unemployment returns to 5%. • If expectations adjust instantly, e.g., anticipating Fed’s policy, economy moves directly from (1) to (3). Expectations and the Phillips Curve

18. Expectations Formation • Adaptive Expectations: expectations of the future based on history • The public acts on its expectations The present depends on the past • Rational Expectations: expectation based on all available relevant information. • The public understands how the economy works. • The public knows the structure and linkages between variables in the economy. • The public anticipates policy actions and their consequence • The public acts now on its expectations The present depends on the future

19. New Classical Economics:Rational Expectations  Policy Ineffectiveness{Expansionary policy  movement from 1 to 3}

20. Macroeconomic ViewpointsLaissez - FaireClassical Monetarist New ClassicalActivist/InterventionistKeynesian New Keynesian

21. The Modern Keynesian Model:Sticky Prices Demand Management Policies Can Stabilize an Unstable Economy

22. Long and Variable Policy Lags • 1. Recognition Lag: policymakers need time to realize that there is a problem. • 2. Reaction Lag: they need time to formulate an appropriate policy response. • 3. Effect Lag: policy takes time to implement and work through the economy. • Countercyclical policies can become procyclical policies, worsening fluctuations

23. Economic Growth • Economic growth: an increase in Real GDP. • Small changes in rates of growth  Big changes over many years • Per Capita Real GDP: real GDP divided by population. Determinants of Economic Growth • Size and quality of the labor force • Capital • Land/Natural Resources … are not a necessary condition for economic growth … they can be acquired through trade. • Technology

24. Determinants of Growth • Size and quality of the labor force • Capital • Land/Natural Resources … are not a necessary condition for economic growth … they can be acquired through trade. • Technology