Principles of Macroeconomics

July 16, 2016

Macroeconomics Notes

1. Absolute Advantage: when an individual/nation can produce more of a

good or service than the competitor in the same amount of time
2. Comparative Advantage: when an individual/nation can produce a
good/service at a lower opportunity cost than the competitor
a. Three most common barriers to trade:
i. Tariffs: tax on trade (foreign made products)
ii. Quotas: limit on trade (max amount of foreign made products
that can be sold)
iii. Embargos: ban on trade
3. Tariff on foreign cars:
a. GM (US automobile): happy; increase sales
b. BMW (foreign automobile): unhappy
c. US consumers: unhappy
d. US government: happy
4. Arguments against trade:
a. Protecting domestic jobs
b. Human rights/environmental
c. National security/defense
d. Infant industry argument: small industries need protection by
government from foreign competition in order to figure out how to
make things cheaper and compete globally; then trade barriers can be
removed
e. Dumping: a kind of predatory pricing, especially in the context of
international trade. It occurs when manufacturers export a product to
another country at a price either below the price charged in its home
market or below its cost of production.
GDP = C + Ig + G + Xn
C: Consumption (largest component of GDP; 60-70%)
Ig: Gross Private Investment (businesses spending money on capital goods)
G: Government spending

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Xn: Net Exports (X-M) (exports imports)
GDP: the market value of all final goods and services produced within a nation in a
year; measures aggregate spending, income, and output.
-unsold inventory = investment spending
^ WHATS NOT INCLUDED:

Non-market transactions
Illegal activity
Intermediate goods: a good or service that is used in the eventual production
of a final good, or finished product

Transfer payments/financial transactions

Used products (ex: 1950 Toyota Thunderbird)

Nominal GDP = GDP unadjusted for inflation

Real GDP = GDP adjusted for inflation
Real GDP per capita = Real GDP/population

Phases of Business Cycle

Expansion/recovery
Peak
Contraction/recession: the GDP per capita has decreased for 6 consecutive

months; over once GDP has increased for 6 consecutive months

Trough: last month of recession

Limitations of GDP

Changes in quality & inclusion of new goods

Leisure/human costs
Underground economy
Harmful side effects
Non-market production of goods and services

Alternative Measures

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Human Development Index

Economic Freedom and Transparency
Internationals Corruption Perception Index
Green GDP
Genuine Progress Indicator
Happy Planet Index
United Kingdom Measures of National Well Being

Hidden Unemployment

Discouraged workers
Underemployed

Inflation: increase in the average general price level

Causes

Demand-pull inflation
Cost-push inflation
Too much money in circulation
Political instability
Weak dollar in FX

HOW TO CALCULATE:
Price of basket (currently X 100)
Price of basket (in the base year) =PRICE INDEX

Deflation: decrease in the average general price level

Disinflation: a decrease in the rate of inflation
INFLATION EXAMPLES
1. If banks lend out billions of dollars in fixed-rate home mortgages to
consumers. Unexpected inflation will cause: the lender is hurt and the
borrower is helped
2. You borrow $15,000 for a new car and agree to a variable interest rate loan.
Inflation will cause: the lender is helped and the borrower is hurt
3. You decide to save $5000 in a savings account. Unexpected inflation will
cause: the value of the savings to decrease

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4. You sign a three year lease at an apartment complex for $900 per month for
the length of the lease. Unexpected inflation will cause: the leaser will be hurt
and the renter will be helped because the rate is fixed while it costs the
leaser more to house the renter
5. You loan $10,000 to your cousin at 7% so that she can start a small business.
If inflation jumps from 2% a year to 4% a year, then: it would hurt you and
benefit your cousin; only 3% return on your investment & money returned is
worth less
6. You earn $15.00 per hour and work 40 hours a week for a year with two
weeks unpaid leave. In the same year, inflation increases from 2% a year to
5% a year: it would hurt you because you can buy 3% less
Healthy Indicators

Target: 2% inflation rate

Natural rate of U% = 5% (occurs at full employment) [includes frictional and
structural U%]

Aggregate Demand

Shows the real amount of GDP that the private, public, and foreign sector
collectively desire to purchase and each possible price level

Aggregate Supply

The level of real GDP that firms will produce at each price level
o LONG RUN: period of time where input prices are fully adjustable; no
o

relationship between price level and how much businesses produce

SHORT RUN: period of time where input prices are sticky and do not
change; level of Real GDP supplied is directly related to price level.

Employee wages do not change; prices go up and supplies decrease

An increase in SRAS is seen as a shift to the right
A decrease is SRAS is seen as a shift to the left
The key to understanding shifts in SRAS is per unit cost of production

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Full Employment Production

Fixed inflation rate = 2%

Natural rate of unemployment = 5%

Classical Perspective
Focus on supply
Aggregate market = sum of parts
Assumptions

Says Law
Flexible wages and prices
Savings = Investment Spending because of flexible interest rates

Self correcting economy: the economy fixes itself

Keynes Perspective

Focus on demand

Assumptions

Keynes Law
Flexible wages and prices downward
Savings are not equal to investment spending because of expectations
o The multiplier effect refers to the increase in final income arising
from any new injection of spending. The size of
the multiplier depends upon household's marginal decisions to spend,
called the marginal propensity to consume (mpc), or to save,
called the marginal propensity to save (mps).
o MPS: change in savings because of a change in income
o MPC: change in consumption because of change in income

Offsets to Fiscal Policy

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Crowding-Out effect: deficit spending (debt); increasing DLF. Interest rates
increase. Investment spending decreases. Dollar value increases, price of
goods increase, net exports decrease.
Direct fiscal offsets: the government competes with the private sector.
Ricardian Equivalence Theorem: rational expectations; an economic
hypothesis holding that consumers are forward looking and so internalize the
government's budget constraint when making their consumption decisions.
Inflation
o Example:
MPC= .9
MPS= .1
Gov spending = $100 billion
1/.1 = 10
Change in AD = 10 X 100 B = $1 trillion
Marginal tax rate: tax on the last dollar you earned
Average tax rate: taxed owed divided by total taxable income X 100
o EXAMPLE
Currently the federal income tax rate is:
10% for any income earned between 0 and $10,000
20% for any income earned between $10,000 and $20,000
If you currently earn $10,000 and you boss offers you a $1,000 raise, should
you take it?
o Yes, you will only be taxed 20% on the additional $1000
Automatic Stabilizers
Unemployment insurance
Medicaid
Progressive tax system
o Discretionary vs automatic
o Expansionary vs contractionary

Deductions
Child care
Mortgage interest
Student loan interest
Total Income=
Deductions=
Taxable Income=
3 Deficits
Federal budget deficit

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Trade deficit
Savings deficit

Trade Deficit
Deficit: r% INCREASE, $ INCREASE, Xn INCREASE
Foreign capital finances G + C Debt
Savings Deficit
Easy credit
Stagnating real wages
DECREASE in savings, INCREASE in r%, DECREASE in Ig
Consequences of Debt
Government spending today is paid by taxes tomorrow
Income redistribution
Crowding out effect (slows growth)
o r% INCREASE, Ig DECREASE, K DECREASE, Productivity DECREASE,
wealth DECREASE
Foreign held debt payments Capital outflows
Reducing Deficit/Debt
DECREASE government spending
INCREASE tax revenue
Economic growth
o Deficit
GDP
Tools of Monetary Policy
Reserve ratio
OMO (open market operations)
Discount rate
o Raising the discount rate will make things more expensive
1. Prime rate = best customer
2. Discount rate = federal to Bank
3. Federal Fund rate = bank to bank
What goal might the Federal Reserve try to attain by decreasing the money supply?
-fight recession
Monetarism
Neo-classical
Assumes flexible wages & prices
Macroeconomic stability
MV=PQ
M=Money Supply
V=Velocity of $
P=Price
Q=Quantity
Monetary Policy

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Tools

Federal Reserve
Goal = Full employment & stable prices

Open market operations

Reserve ratio
Discount rate
o Raise discount rate = lower supply of money
o Lower discount rate = increased supply of money
2 Policies
Easy money/Expansionary (increase money supply)
Tight money/Contractionary (decrease money supply)
Quantitative Easing
Goal:
o inject cash
o lower yield on long term debt
buy non-traditional bonds
o corporate bonds
o mortgage backed securities (loans that are not returned)
Pros
Free political process
Quick/efficient
Liquidity/solvency of financial markets
Cons
Incentivizes inefficient behavior
Monetary policy less effective
Distorts investment spending