Monetary Macroeconomic Modeling Setting the stage

 Key indicators of Macroeconomic Performance - Definition - Measurement - Stylized Facts  Macroeconomic Policy Objectives - Stabilization - Long-run Growth  Monetary Macroeconomic Framework

 Gross Domestic product (GDP): a measure of all currently produced final goods and services in a given period.  Unemployment: the number of unemployed persons expressed as a percentage of the labor force.  Inflation: a rise in the general level of price. These are three key economic variables that policy makers try to influence….

Nominal VS Real Nominal: valued at current market price. Real: valued at constant price (i.e. relative to the base year) RGDP = NGDP/Price Measurements Expenditure Approach: summation of all expenditures made on goods and services. This is represented by C + I + G + NX Production approach Income approach GDP is NOT Measuring non- market productive activities Measuring the underground economy Measuring a welfare (However, it is used a measure of development).

Potential Output The level of output that would be reached if productive resources are fully utilized Cyclical Variation in Output This is referred as Business Cycle It is the deviation of actual output from the potential output.

BUSINESS CYCLE Business Cycle captures cyclical variations of actual output around potential output. These cyclical variations are costly. Expansion is normally related to inflation while contraction is related to unemployment. The worst scenario is when contraction is accompanied by inflation, termed as STAGFLATION. Stabilization policies aim at dampening the magnitudes of cyclical variations Growth policies aim at increasing the trend in output over long periods of time.

 Consumer price index: the retail prices of a fixed market baskets of several thousand goods and services purchased by households  Producer price index: the wholesale prices of approximately 3000 items  GDP Deflator: the prices of all goods and services currently produced. The rates of changes in these prices are measures of inflation

 Unemployment: Unemployed persons as a percentage of the labor forces  Types of unemployment: - Frictional: in-between jobs - Structural: changes in economic structure - Cyclical: due to cyclical downturns  What matters is cyclical unemployment  Full employment: when unemployment equals frictional + structural unemployment

 Fluctuations are costly. But all economies have ridden through the cycles.  It seems that cyclical fluctuations are inevitable but they can be dampened.  Inflation-unemployment trade-offs  Highly fluctuating cycles may dampen long-term growth  Issues: - How to dampen the cycles? - How to accelerate long-term growth?  Requirement: - A need to understand theories of fluctuations and long-term growth.

 Goods Market: Market for the production (supply) and the aggregate demand for those goods.  Money Market: Market for Money Demand and Money Supply.  Factor Markets: markets for the factor inputs in the production of goods and services.  OPEN-ECONOMY: markets that link the sales and purchases of goods and services between nations (Exports and Imports).

Goods Market (IS Function) Factor Inputs Markets (AS Function) Money Market (LM Function)

SR AS

 IS Function Y = C(Y-T) + I(r) + G C Y-T > 0; I r < 0; Both G and T assumed exogenous and NX = 0  LM Function M/P = L(Y, r); L y > 0; L r < 0  AS Function Y = f(P); f p > 0 These are basic functions with no elements of uncertainty and expectations

 IS: a graph of all combinations of Y and r that result in goods market equilibrium.  Equilibrium in Goods Market Output (Y) = Aggregate Expenditure (E)  Components of Aggregate Expenditure - Household Expenditure (C) - Firm Expenditure (I) - Government Expenditure (G) - International Sector (X – M)  Y = C + I + G + (X-M)

IS FUNCTION The IS function is negatively sloped… Justification: A fall in interest rate motivates investment and, thus, planned expenditure. To restore equilibrium, output (Y) must increase. Slope: depends on marginal propensity to consume and Interest sensitivity of Investment. Intercept: containing the factors that shift the curve.  Goods Market Equilibrium  Total Differentiation  Express dr as a function of the remaining expressions Slope Intercept Term

 A graph of all combinations of Y and r that equate the supply and supply for real money balances  Assuming that the stock of money supply is a policy variable (i.e. influenced by monetary instruments), we state this equilibrium as:

LM FUNCTION LM Curve is positively sloped. An increase in income raises money demand. With money supply fixed, interest rate must increase to restore equilibrium in the money market. The SLOPE of the LM curve depends on the income and interest rate sensitivities of money demand. Intercept: Changes in money appears in the intercept. It leads to shift in LM function.  Market Equilibrium  Total Differentiation  Express dr as a function of the remaining terms

 Function Y = f(P)  Total Differentiation dY = f P dP f P = 0 (Classical) f P > 0 (Keynesian) The foundation of AS function is the assumption of wage stickiness or imperfect information in the labor market.