BASIC MACROECONOMICS IMBA Managerial Economics Lecturer: Jack Wu

Major Macroeconomic Problems  National Income: Low Economic Growth Rate  Employment Opportunity: High Unemployment Rate  Cost of Living: High Inflation Rate

How to Measure National Income?  Gross Domestic Product (GDP)  Gross National Product (GNP)  GDP (Purchasing Power Parity)

Gross Domestic Product  Gross domestic product (GDP) is a measure of the income and expenditures of an economy.  It is the total “Market value” of “all final” “goods and services” “produced” “within a country” in a “given period of time”.

Formula of GDP  GDP (Y) is the sum of the following:  Consumption (C)  Investment (I)  Government Purchases (G)  Net Exports (NX) Y = C + I + G + NX

GDP(PPP)  Gross Domestic Product (GDP) at Purchasing Power Parity (PPP)

Gross National Product  GNP is the total income earned by a nation’s permanent residents. It differs from GDP by including income that citizens earn abroad and excluding income that foreigners earn here.

Unemployment Rate

Consumer Price Index  The consumer price index (CPI) is a measure of the overall cost of the goods and services bought by a typical consumer.

Calculating Inflation Rate  Compute the inflation rate: The inflation rate is the percentage change in the price index from the preceding period.

HOW CAN GDP INCREASE?  Consumption increases  Investment increases  Government purchase increases  Net export increases

Consumption  Autonomous consumption spending  Derived consumption spending =c*(disposable income) C: marginal propensity to consume Disposable income= income - tax

Investment  Domestic or Foreign Direct investment  Investment is affected by real interest rate (nominal interest rate – inflation)  Portfolio investment (ex: buying shares) is considered as Saving  National Saving = Private Saving +Public Saving

The Market for Loanable Funds Copyright©2003 Southwestern/Thomson Learning Quantity of Loanable Funds Real Interest Rate Supply of loanable funds (from national saving) Demand for loanable funds (for domestic investment and net capital outflow) Equilibrium quantity Equilibrium real interest rate

Nominal Interest rate and Money Market  Money supply  Money demand

Fiat Money in the Economy  Currency is the paper bills and coins in the hands of the public.  Demand deposits are balances in bank accounts that depositors can access on demand by writing a check.

Money Supply  M1:Narrowly defined money supply _ M1A _ M1B  M2: Broadly defined money supply

Open-Market Operations  Open-Market Operations  The money supply is the quantity of money available in the economy.  The primary way in which the Fed changes the money supply is through open-market operations. The Fed purchases and sells U.S. government bonds.

Money Creation through the bank  When one bank loans money, that money is generally deposited into another bank.  This creates more deposits and more reserves to be lent out.  When a bank makes a loan from its reserves, the money supply increases.

Money Multiplier  The money multiplier is the reciprocal of the reserve ratio: M = 1/R  With a reserve requirement, R = 20% or 1/5,  The multiplier is 5.

Tools of Money Control  The Fed has three tools in its monetary toolbox:  Open-market operations  Changing the reserve requirement  Changing the discount rate **The discount rate is the interest rate the Fed charges banks for loans.

Motives of Money Demand  Transaction motive (Price, income)  Precautionary motive (Price, income)  Speculative motive (interest rate)

Money Market Equilibrium The interest rate and quantity demanded of money are negatively related. Therefore, the money demand curve is downward sloping. The quantity supplied of money is controlled by Fed. Therefore, the money supply curve is vertical. As money demand increases, the interest rate is higher. As money supply increases, the interest rate is lower.

Figure M3M3 M2M2 M1M1 r 2 =r 3 r1r1 MS3MS3 MS1MS1 MS2MS2 Money Quantity Interest Rate

Liquidity Trap  When the money demand is perfectly elastic at a low interest rate, the increase in money supply would not have any impact on the interest rate.

International Trade and Exchange Rate  Net Export is affected by exchange rate.

Nominal Exchange Rate  The nominal exchange rate is the rate at which a person can trade the currency of one country for the currency of another.  The nominal exchange rate is expressed in two ways:  In units of foreign currency per one U.S. dollar.  And in units of U.S. dollars per one unit of the foreign currency.

Figure 30 E ** E*E* D Q ** Q*Q* 29 S S1S1 US Dollar Nominal Exchange Rate (NT$/US$)

Real Exchange Rate  The real exchange rate is the rate at which a person can trade the goods and services of one country for the goods and services of another.  The real exchange rate compares the prices of domestic goods and foreign goods in the domestic economy.  If a case of German beer is twice as expensive as American beer, the real exchange rate is 1/2 case of German beer per case of American beer.

Formula

The Market for Foreign-Currency Exchange Copyright©2003 Southwestern/Thomson Learning Quantity of Dollars Exchanged into Foreign Currency Real Exchange Rate Supply of dollars (from net capital outflow) Demand for dollars (for net exports) Equilibrium quantity Equilibrium real exchange rate

Short-Run Economic Fluctuation Economic activity fluctuates from year to year. A recession is a period of declining real incomes, and rising unemployment. A depression is a severe recession. Fluctuations in the economy are often called the business cycle.

The Aggregate-Demand Curve... Quantity of Output Price Level 0 Aggregate demand P Y Y2Y2 P2P2 1. A decrease in the price level increases the quantity of goods and services demanded. Copyright © 2004 South-Western

Shifts  Shifts arising from  Consumption  Investment  Government Purchases  Net Exports

 Demand Curve Shifts Quantity of Output Price Level 0 Aggregate demand, D 1 P1P1 Y1Y1 D2D2 Y2Y2

The Long-Run Aggregate-Supply Curve Quantity of Output Natural rate of output Price Level 0 Long-run aggregate supply P2P2 1. A change in the price level does not affect the quantity of goods and services supplied in the long run. P Copyright © 2004 South-Western

Long-Run Aggregate Supply Curve  The Long-Run Aggregate-Supply Curve  The long-run aggregate-supply curve is vertical at the natural rate of output.  This level of production is also referred to as potential output or full-employment output.  Any change in the economy that alters the natural rate of output shifts the long-run aggregate-supply curve.  The shifts may be categorized according to the various factors in the classical model that affect output.

Long-Run Growth and Inflation Quantity of Output Y 1980 AD 1980 AD 1990 Aggregate Demand,AD 2000 Price Level 0 Long-run aggregate supply, LRAS 1980 Y 1990 LRAS 1990 Y 2000 LRAS 2000 P In the long run, technological progress shifts long-run aggregate supply and ongoing inflation leading to growth in output... P 1990 P and growth in the money supply shifts aggregate demand... Copyright © 2004 South-Western

Short-Run Aggregate Supply Curve  Short-run fluctuations in output and price level should be viewed as deviations from the continuing long-run trends.  In the short run, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied.  A decrease in the level of prices tends to reduce the quantity of goods and services supplied.

The Short-Run Aggregate-Supply Curve Quantity of Output Price Level 0 Short-run aggregate supply 1. A decrease in the price level reduces the quantity of goods and services supplied in the short run. Y P Y2Y2 P2P2 Copyright © 2004 South-Western

The Long-Run Equilibrium Natural rate of output Quantity of Output Price Level 0 Short-run aggregate supply Long-run aggregate supply Aggregate demand A Equilibrium price Copyright © 2004 South-Western

Two Causes of Economic Fluctuation  Shifts in Aggregate Demand  In the short run, shifts in aggregate demand cause fluctuations in the economy ’ s output of goods and services.  In the long run, shifts in aggregate demand affect the overall price level but do not affect output.  An Adverse Shift in Aggregate Supply  A decrease in one of the determinants of aggregate supply shifts the curve to the left: Output falls below the natural rate of employment. Unemployment rises. The price level rises

A Contraction in Aggregate Demand Quantity of Output Price Level 0 Short-run aggregate supply,AS Long-run aggregate supply Aggregate demand,AD A P Y AD 2 AS 2 1. A decrease in aggregate demand causes output to fall in the short run but over time, the short-run aggregate-supply curve shifts and output returns to its natural rate. CP3P3 B P2P2 Y2Y2 Copyright © 2004 South-Western

An Adverse Shift in Aggregate Supply Quantity of Output Price Level 0 Aggregate demand and the price level to rise causes output to fall An adverse shift in the short- run aggregate-supply curve... Short-run aggregate supply,AS Long-run aggregate supply Y A P AS 2 B Y2Y2 P2P2 Copyright © 2004 South-Western

Policy Responses to Recession  Policy Responses to Recession  Policymakers may respond to a recession in one of the following ways: Do nothing and wait for prices and wages to adjust. Take action to increase aggregate demand by using monetary and fiscal policy.

Fed’s Monetary Injection  The Fed can shift the aggregate demand curve when it changes monetary policy.  An increase in the money supply shifts the money supply curve to the right.  Without a change in the money demand curve, the interest rate falls.  Falling interest rates increase the quantity of goods and services demanded.

A Monetary Injection MS 2 Money supply, MS Aggregate demand,AD Y Y P Money demand at price levelP AD 2 Quantity of Money 0 Interest Rate r r2r2 (a) The Money Market (b) The Aggregate-Demand Curve Quantity of Output 0 Price Level which increases the quantity of goods and services demanded at a given price level the equilibrium interest rate falls When the Fed increases the money supply... Copyright © 2004 South-Western

Fiscal Policy  When policymakers change the taxes, the effect on aggregate demand is indirect — through the spending decisions of firms or households.  When the government alters its own purchases of goods or services, it shifts the aggregate-demand curve directly.

Two Macroeconomic Effects  There are two macroeconomic effects from the change in government purchases:  The multiplier effect  The crowding-out effect