MS 201/401 - Principles of Macroeconomics

Lecture 8

Recommended books:
1 . Macroeconomics by N. G Mankiw
1

2. Mac .by M Swann

Lecture plan
concepts:
calculating GDP
Unemployment
Inflation
Interest rate
Money Market
Relation between money and interest rate.

Two Main Methods

of Measuring GDP

Presenting the expenditure approach

Where

= consumption expenditures

= investment expenditures

= government expenditures

= exports

imports

GDP(Y) = C + I + G + X-M
3

Figure 8-3 Gross Domestic Product and Gross

Domestic Income, 2009 (in billions of 2009 dollars per
year)

Gross Domestic Product and Gross Domestic

Income, 2009 (in billions of 2009 dollars per year)

Business Cycle
Definition: alternating increases and decreases in
the level of business activity of varying amplitude
and length
How do we measure increases and decreases in
business activity?

Percent change in real GDP!

The Phases of the Business

Cycle

Total Output

Expansion

Recession

Expansion

Peak

Trough

Secula
r
growt
h
trend

Jan.- Apr.- July- Oct.- Jan.- Apr.- July- Oct.- Jan.- Apr.Mar June Sept. Dec. Mar June Sept. Dec. Mar June

Long-Run Economic Growth

Secular long-run growth, or long-run growth, is the
sustained upward trend in aggregate output per person
over several decades.
A country can achieve a permanent increase in the
standard of living of its citizens only through long-run
growth. So a central concern of macroeconomics is what
determines long-run growth.

Recession

What is a recession?

Generally, 2 or more quarters of declining

real GDP
Implication: its not officially a called a
recession until the economy has already
been declining for 6 months!

Unemployment
the inability of labor force participants
to find jobs.
Unemployment implies that we are
producing inside the PPF , rather than on it.
If the output of economy does not grows
with the pace so that it could absorb the
new labor force enters into the market than
unemployment increases.
Depends on the phases of Business Cycles
10

How is Unemployment Measured?

The unemployment rate is
calculated as the percentage of
the labor force that is
unemployed.
Number unemployed
Unemployme nt rate =
100
Labor force

Kinds of Unemployment

1. Seasonal Unemployment
2. Frictional Unemployment
3. Structural Unemployment
4. Cyclical Unemployment

12

Inflation
Inflation is an increase in the overall level of prices.
The quantity theory of money is used to explain the
long-run determinants of the price level and the
inflation rate.
Inflation is an economy-wide phenomenon that
concerns the value of the economys medium of
exchange.
When the overall price level rises, the value of
money falls

13

The Quantity Theory of Money

How

the price level is determined and why it might

change over time is called the quantity theory of
money.
The

quantity of money available in the

economy determines the value of money.
The primary cause of inflation is the growth
in the quantity of money.

Velocity and the Quantity Equation

The velocity of money refers to the
speed at which the typical dollar bill
travels around the economy from
wallet to wallet.

V = (P x Y)/M
Where:

V = velocity

P = the price level

Y = the quantity of output
M = the quantity of money

Velocity and the Quantity Equation

The

quantity equation shows that an increase

in the quantity of money in an economy must
be reflected in one of three other variables:
the

price level must rise,

the quantity of output must rise, or
the velocity of money must fall.

Interest Rate
Interest is a rental amount charged by
financial institutions for the use of money.
Called also the rate of capital growth, it is the
rate of gain received from an investment.
It is expressed on an annual basis.
For the lender, it consists, for convenience, of
(1) risk of loss, (2) administrative expenses,
and (3) profit or pure gain.
For the borrower, it is the cost of using a
capital for immediately meeting his or her
needs.

17

TIME VALUE OF MONEY

The

time-value of money is the relationship

between interest and time. i.e.
Money has time-value because the
purchasing power of money changes with
time.

18

EARNING POWER OF MONEY

The

earning power of money represents

funds borrowed for the prospect of gain.
Often these funds will be exchanges for
goods, services, or production tools, which
in turn can be employed to generate and
economic gain.

19

PURCHASING POWER OF
MONEY
The prices of goods and services can go upward or
downward, and therefore, the purchasing power of
money can change with time.
Price Reductions : Caused by increases in
productivity and availability of goods.
Price Increases : Caused by government policies,
price support schemes, and deficit financing.

20

Demand Curve for Money

If

interest rates are

high, more wealth
will be held in bonds

If

interest rates are

low, more wealth will
be held as liquid
money, because the
opportunity cost, i.e.,
the income foregone,
is low.

Supply Curve for Money

Supply of Money is
Unilaterally fixed by
the Central Bank.
For USA, it is the
Federal
Reserve
System.

At

equilibrium,
money demand =
money supply

Shifts in Demand for Money

Income effect: Increase in income
increases the amount of money
individuals want to hold. Therefore, an
increase in GNP/Income shifts the money
demand curve to the right.
Price Level Effect: Increases in price
levels reduce the real value of money.
Therefore, more money is held by
individuals, thus shifting the money
demand curve to the right.

Changes in Equilibrium Interest Rates

Changes

in Income

Money
demand
curve moves to the
right
Money supply curve
remains at previous
level
Interest
rate
increases

Income Effect: Increase in money supply

increases demand for money and thus shifts the
demand curve to the right, thereby increasing
interest rates.
Price-level Effect
Expected Inflation Effect

These 3 effects work against the liquidity effect on

the direction of interest rate movements. In reality,
the final outcome depends upon which effect is
stronger and which one comes into play earlier.

The supply of money curve:

Rate of interest

MS

Quantity of money

The Demand for Money

The motives for holding money

transactions and precautionary motive

assets or speculative motive

the total demand for money

Determinants of demand for money

money national income

frequency with which people are paid

financial innovations

speculation about future return on assets

rate of interest

Rate of interest

The demand for money (liquidity preference) curve

Md
O
Money

Monetary Equilibrium
Equilibrium

in the money market

equilibrium interest rate where D and S of

money are equal

Equilibrium in the money market

Rate of interest

MS

re

Md
O

Me

Money

Monetary Equilibrium
Effects

of changes in money supply on

national income

effect on interest rates

Ms r

The demand for and supply of money

Rate of interest

MS

r1

Md
O

Q1
Money

The demand for and supply of money

Rate of interest

M S'

MS

r2

r1

Md
O

Q2

Q1
Money

Monetary Equilibrium

Effects of changes in money supply on national

income

effect on interest rates

effects of changes in interest rates on

investment

r (opp cost /cost of borrowing) I

effects of changes in interest rates on the

exchange rate, and imports and exports

Ms price level demand $ er r

r $d (capital outflow) er X, M

effects of changes in investment, imports

and exports on national income

I, X, M Y

Money Supply, Money Demand, and the

Equilibrium Price Level
Value of
Money (1/P)
(High) 1

Price
Level (P)
1 (Low)

Money supply

1.33

1/2

1/4

(Low) 0

Money
demand

Quantity fixed
by the Fed

Quantity of
Money

Equilibri
um price
level

Equilibrium
value of
money

3/4

(High)

The Effects of Monetary Injection

Value of
Money (1/P)
(High) 1

MS1

MS
2

1. An
increase in
the money
supply...

3/4
1/2

(Low) 0

Money
demand
M1

1.33
2

1/4

Price
Level (P)
1 (Low)

M2

Quantity of
Money

(High)

The Short-Run
Tradeoff between
Inflation and
Unemployment

Unemployment and Inflation

The

natural rate of unemployment depends on

various features of the labor market.
Examples include minimum-wage laws, the market
power of unions, the role of efficiency wages, and
the effectiveness of job search.
The inflation rate depends primarily on growth in
the quantity of money, controlled by the central
Bank.
The misery index, one measure of the health of
the economy, adds together the inflation rate and
unemployment rate.

Unemployment and Inflation

Society

faces a short-run tradeoff between

unemployment and inflation.
If policymakers expand aggregate demand, they can
lower unemployment, but only at the cost of higher
inflation.
If they contract aggregate demand, they can lower
inflation, but at the cost of temporarily higher
unemployment.

The Phillips Curve

The Phillips curve illustrates the short-run
relationship between inflation and
unemployment.

The Phillips Curve...

Inflation
Rate
(percent
per year)
B

Phillips curve
0

Unemployment
Rate (percent)

Aggregate Demand, Aggregate

Supply, and the Phillips Curve

The

Phillips curve shows the short-run combinations

of unemployment and inflation that arise as shifts in
the aggregate demand curve move the economy
along the short-run aggregate supply curve.

Aggregate Demand, Aggregate

Supply, and the Phillips Curve
The

greater the aggregate demand for goods and

services, the greater is the economys output, and the
higher is the overall price level.
A higher level of output results in a lower level of
unemployment.

How the Phillips Curve is Related to the Model

of Aggregate Demand and Aggregate Supply...
(a) The Model of AD and AS
Price Level

Short-run
AS

102

Inflation Rate
(percent per
year)

106
A

High AD
Low AD

(b) The Phillips Curve

8,000
7,500
(unemployment
(unemployment
is 7%)
is 7%)

6
2
0

B
A
Phillips curve
7
4
(output is (output is
8,000)
7,500)

Unemployment
Rate (percent)

An Adverse Shock to Aggregate

Supply...
(a) The Model of Aggregate
Demand and Aggregate Supply
Price
Level

3. and raises the

price level

(b) The Phillips Curve

Inflation
Rate

AS2 Aggregate
supply, AS1
P2

P1

1. An adverse
shift in aggregate
supply

A
PC2

Aggregate
demand
0

Y2

Y1

2. lowers output

Quantity of
Output

4. giving policymakers
a less favorable tradeoff
between unemployment
and inflation.

Phillips curve, PC1

Unemployment Rate

Effectiveness of Monetary Policy

Effectiveness of controlling interest rates

inelastic demand for loans

problem of possibly high interest rates

Monetary Policy

The significance of monetary policy

The policy setting

relationship between the government and the central

bank

degree of central bank independence

Medium- and long-term policy

control of banks liquidity ratio

restricting size of PSNCR

Monetary Policy

Short-term monetary control

techniques to control money supply

open-market operations

reduced central bank lending to the banks

funding

variable minimum reserve ratios

techniques to control interest rates

announcing changes in interest rates

backing up announcements

operations in the discount and repo markets

credit rationing

Effectiveness of Monetary Policy

Medium and long-term control over the money

supply: reducing PSNCR
automatic fiscal stabilisers
the desire to cut taxes

difficulty in cutting government expenditure

Short-term control of the money supply

use of money supply targets

ways in which banks resist attempts to restrict the

growth in the money supply
demand-determined money supply

An inelastic demand for loans

Rate of interest

Assume that the authorities

want to reduce the
demand for money to Q2

r1
Demand for loans
O

Q2

Q1

Loans

Rate of interest

An inelastic demand for loans

A large rise in the

rate of interest (to r2)
will be necessary

r2

r1
Demand for loans
O

Q2

Q1

Loans

Effectiveness of Monetary Policy

Effectiveness of controlling interest rates

inelastic demand for loans

problem of possibly high interest rates

reasons for an inelastic demand for loans

unstable demand for money

problem of changing expectations

speculation

possible conflict between domestic goals and exchangerate goals

Using monetary policy

use of interest rates to meet inflation target