Macroeconomics Outline

Date of Last Update: December 13, 2011

Measuring Economic Performance Output

Expenditure Approach: GDP = C + I + G + NX Personal Consumption Expenditure (C) by households. Gross (Private) Domestic Investment (I) by businesses and households includes: o Purchases of machinery and equipment. o Construction of buildings such as factories, warehouses and stores including residential construction because they could be rented out to yield an income. o Changes in inventories. Inventories are goods which have been produced but are still unsold. Changes in inventories are counted as investment because an increase in inventories is, in effect, "unconsumed output" and that is what investment is. o Net Investment = Gross Investment - Depreciation o When gross investment is more than depreciation, the economy's capital stock rise and its production capacity expands. o When gross investment is less than depreciation, the economy's capital stock falls and its production capacity declines. Government Purchases (G) of Goods and Services Net Exports (NX) = Exports (X) - Imports (M) o Exports (X) are Foreign Expenditures on our Goods and Services. o Imports (M) are our Expenditures on Foreign Goods and Services. o Net Exports or the balance of trade measures the difference between exports and imports of goods and services. We have a trade surplus if X > M, and a trade deficit if X < M. Income Approach: GDP = Wages + Rents + Interest + Profits Nominal vs. Real GDP Nominal GDP = Current Prices * Current Quantities Real GDP = Base-Year Prices * Current Quantities

Unemployment
Frictional Unemployment because of temporary layoffs, search for jobs or wait to take jobs. Structural Unemployment because of mismatches of job skills or job locations. Cyclical Unemployment because of business cycle downturn. "Full Employment" occurs at the "Natural" Rate of Unemployment which is equal to frictional and structural unemployment (when cyclical unemployment is zero). Measurement of Unemployment o Labour Force = Total Population - Under 16 and/or Institutionalized - Not in Labour Force (Not Seeking Work) o Individuals who wanted and were available to work and had looked for a job sometime in the prior 12 months are considered marginally attached to the labour force. They, however, are not counted as unemployed because they had not

actively searched for work in the 4 weeks preceding the household (employment) survey. Discouraged workers are those marginally attached who are not currently looking for work specifically because they believe no jobs are available for them. o Labour Force = Employed + Unemployed (Actively Seeking Work) o Unemployment Rate = Unemployed/Labour Force

Inflation
GDP Deflator = Nominal GDP/Real GDP Consumer Price Index (CPI) = Current Value of Market Basket/Base-Year Value of Market Basket Measurement of Inflation o (Current) Rate of Inflation = (Current GDP Deflator/Previous GDP) - 1 o (Current) Rate of Inflation = (Current CPI - Previous CPI) - 1 Demand-Pull Inflation occurs when aggregate expenditures exceed potential GDP (full-employment GDP); aggregate expenditures pull the price level upward. Cost-Push Inflation occurs when higher factor prices such as labour and raw materials drive up production costs; higher costs push the price level upward.

The AD-AS Model

Explores how the output level and the price level are determined. Provides an understanding of how fiscal and monetary policies can affect the economy.

Aggregate Demand (AD)

AD is the quantity demanded for all goods and services in the economy at different price levels. It is the sum of expenditures by households (consumption), business (investment), government and foreigners (net exports) on new goods and services. AD = C + I + G + NX AD is downward sloping because an increase in the price level will reduce the purchasing power of households and consequently reduce consumption spending, lowering the amount of spending in the economy. Changes in Aggregate Demand: o Change in Consumption Spending: Consumer Confidence Wealth Effect Income Taxes: Higher income taxes reduce disposable income, lower consumption spending and shift the aggregate demand curve to the left. Interest Rates o Change in Investment Spending: In contrast to consumption spending, investment spending is unstable. Interest Rates Business Confidence o Change in Government Spending o Change in Net Foreign Spending: Economic Growth Abroad Exchange Rates

Long-Run Aggregate Supply (LRAS)

LRAS is vertical because nominal wages eventually change by the same amount as the price level. Changes in LRAS (Economic Growth): o Labour Force o Capital Stock o Technology (Productivity)

Short-Run Aggregate Supply (SRAS)

SRAS has a positive slope (rising output is accompanied by higher prices) because nominal wages remain constant as the price level changes. Changes in SRAS (Business Cycle): o Factor Prices (Nominal) Wages Price of Oil o Corporate Taxes o Government Regulations o Also Labour Force, Capital Stock, and Technology (Productivity)

Equilibrium in the AD-AS Model

Long-run equilibrium at the intersection of the AD and LRAS. Short-run equilibrium at the intersection of the AD and SRAS. Actual GDP vs. Potential GDP (Full-Employment Output) Recessionary Gap when actual GDP is less than potential GDP. Inflationary Gap when actual GDP is larger than potential GDP.

Applications of the AD-AS Model

Demand-Pull Inflation Cost-Push Inflation Recession

Fiscal Policy
Fiscal policy involves changes in government spending, taxes and/or transfer payments to influence the economy. Discretionary fiscal policy involves changes in government spending and/or taxes to influence output, prices and employment. Contractionary fiscal policy shifts the aggregate demand curve to the left to contract output. It involves decrease in government spending and/or increase in taxes. Expansionary fiscal policy shifts the aggregate demand curve to the right to expand output. It involves increase in government spending and/or decrease in taxes. When government spending exceeds tax revenues, there is government budget deficit. Non-Discretionary Fiscal Policy (Built-in Stabilizers): Tax revenues automatically increase in economic expansions and decrease in recessions, and transfer payments automatically decrease in economic expansions and increase in recessions to add a degree of built-in stability to the economy. Problems with Fiscal Policy:

o Policy Lag: The lag time between when a fiscal policy measure is agreed upon and when it is actually implemented is considerable. o Political Problems: Political Business Cycle o Crowding-out Effect: An expansionary fiscal policy financed by government borrowing increases the interest rate. Because investment spending varies inversely with the interest rate, private investment (and some interest-sensitive consumption spending such purchases of homes and automobiles) will be crowded out. The crowding-out effect weakens expansionary fiscal policy. o Inflation: An expansionary fiscal policy financed by government borrowing increases the interest rate. The higher domestic interest rate will attract capital from abroad. The demand for dollars will increase and its value in terms of foreign currencies will rise. The dollar appreciation makes exports more expensive and imports cheaper, thus net exports will decline. The net export effect weakens expansionary fiscal policy.

Monetary Policy
What is Money? The Functions of Money The Demand for Money Monetary policy involves changes in the money supply and interest rates to influence the economy. Contractionary monetary policy shifts the aggregate demand curve to the left to contract output. Expansionary monetary policy shifts the aggregate demand curve to the right to expand output. Problems with Monetary Policy: o Policy Lag o The Term Structure of Interest Rates (the Yield Curve): The relationship between short-term and long-term interest rates is becoming increasingly unstable. o Higher Inflationary Expectations may lead to higher not lower interest rates, thus weakening the effects of expansionary monetary policy.