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Macroeconomics I: Introduction
1. FOREIGN TRADE UNIVERSITY
Faculty of International Economics
Macroeconomics I
Hoang Xuan Binh, PhD
A PowerPoint™Tutorial
to Accompany m a c ro e c o no m ic s , 5th ed.
N. Gregory Mankiw
3. Introduction
Module title: Macroeconomics I
Semester: I
Year 2011-2012
Level: Undergraduate
Module Convenor: Hoang Xuan Binh
Office hours: 15 -17 on Monday
Room: A703- Foreign Trade University
(Hanoi Campus)
Tel: 844-8345801 ext 506
Cellphone: 0912782608
4. INTRODUCTION
Module Context:
The module is designed especially for
students taking Macroeconomics at FTU. It
is intended to provide students with an
understanding of important macroeconomic
factors and variables. The course analyses
how macroeconomic variables operate;and it
develops an understandings of the
international money and financial market, in
or outflows of capital. The course also draws
on the debates in real economy and tries to
use both old and new theories to understand
them.
5. Introduction
Module aims and objectives:
1.To familiarise the students with some of the most
important macroeconomic variables in the
economy, for example GDP,GNP,CPI,PPI…
2.To introduce students to some important
macroeconomic policies including fiscal and
monetary policies.
3.To examine some different cases in term of using
macroeconomic policies to develop economy.
6. Introduction
Learning outcomes
By the end of this module it is expected that students:
1.will have an understanding of how important
macroeconomic variables are interacting in the
economy.
2.will be able to interpret such variables and events as
GDP,GNP,CPI or inflation,unemployment… and relate
them to changes of other variables and events in the
economy.
3.will be ready to explain significant events in real
economy by using economic theories.
4.will be familiar with current debates on open-
economy and able to make a critical assessment of the
various arguments which are put forward.
7. Teaching and learning methods:
In class contact hours there will be lectures,
discussions and assistance with students’assignment
work,reading and using books. During the seminars the
students will be expected to discuss the provided
topics on the problems of real economy.
Assessment methods:
There is a written assignment and final examination.
It is worthy 30% and 60% respectively. Class
participation is 10% .
Suggested Supplementary Reading
Mankiw, Principles of Economics
Mankiw, Macroeconomics 5th ed ,
Sloman J., (2003), Ec o no m ic s , 5th ed
8. Lecture programme
Chapter: Introduction lecture programme
Chapter2:The Data of Macroeconomics
Chapter3:Aggregate Demand and Fiscal policy
Chapter4:Money and Monetary policy
Chapter5:Inflation and unemployment
Presentation assignment
Chapter6:Economic growth
Chapter 7: The Open economy
Revision
9. I.Introduction
Everyone is concerned about macroeconomics
lately. We wonder why some countries are growing faster
than others and why inflation fluctuates. Why?
Because the state of the macroeconomy affects
everyone in many ways. It plays a significant
role in the political sphere while also affecting
public policy and social well-being.
There is much discussion of recessions-- periods in which real
GDP falls mildly-- and depressions, concerns with issues such
as inflation, unemployment, monetary and fiscal policies.
10. Economists use models to understand what goes on in the economy.
Here are two important points about models: endogenous variables
and exogenous variables. Endogenous variables are those which the
model tries to explain. Exogenous variables are those variables that
a
model takes as given. In short, endogenous are variables within a
model, and exogenous are the variables outside the model.
Price Supply
This is the most famous
P* economic model. It describes
the ubiquitous relationship
Demand between buyers and sellers in
the market. The point of
Q* Quantity intersection is called an
equilibrium.
11. Economists typically assume that the market will go into
an equilibrium of supply and demand, which is called
the market clearing process. This assumption is central
to the Pho example on the previous slide. But, assuming
that markets clear continuously is not realistic. For
markets to clear continuously, prices would have to
adjust instantly to changes in supply and demand. But,
evidence suggests that prices and wages often adjust
slowly.
So, remember that although market clearing models
assume that wages and prices are flexible, in actuality,
some wages and prices are sticky.
12. Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
marketplace. In microeconomics, a person chooses to
maximize his or her utility subject to his or her budget constraint.
Macroeconomic events arise from the interaction of many
people trying to maximize their own welfare. Therefore, when
we study macroeconomics, we must consider its
microeconomic foundations.
13. II. Research aims and research methods:
1. Aims and objectives of macroeconomics
Yield, Economic growth, unemployment,
inflation, budget, Balance of Payments,
2. Research method
- Mathematics, general equilibrium W
, alras
methods (equilibrium in all market…
14. III. Macroeconomics system
1. Inputs
+ Exogenous variables: weather,
politics, population, technology and
patents or know-how
+Endogenous variables: direct impacts-
fiscal policy,monetary policy, external
economic policy
2. Black box: AS+AD
2.1. Aggregate Demand
15. * Related factors: Price, Income,
Expectation…
2.2.Aggregate Supply
* Related factors: Price,production cost,
potential output (Y* )
Y* : maximization of output which
economy can produce, with full-
employment and no inflation.
Full-employm ent=population–outof
working age - invalids -(pupils + students)
– servant-unwilling to work
16. 3. Outputs
Yield, employment,
Average price,
Inflation,interest,budget,
Trade balance and balance of
International payment,
Economic Growth
17. Macroeconomics
Macroeconomics
Recession
Recession
Depression
Depression
Models
Models
Macroeconomic system
Macroeconomic system
Inputs
Inputs
Outputs
Outputs
Endogenous variables
Endogenous variables
Exogenous variables
Exogenous variables
Market clearing
Market clearing
Flexible and sticky prices
Flexible and sticky prices
Microeconomics
Microeconomics
19. I. Gross domestic products-GDP
Gross Domestic Product (GDP) is the
market value of all final goods and
services produced within an economy
in a given period of time.
20. Income, Expenditure
And the Circular Flow
There are 2 ways Total income of everyone in the economy
of viewing GDP Total expenditure on the economy’s
output of goods and services
Income $
Labor
Households Firms
Goods
Expenditure $
For the economy as a whole, income must equal expenditure.
GDP measures the flow of dollars in this economy.
21. II.Computing GDP
1.Rules for computing GDP
1) To compute the total value of different goods and services,
the national income accounts use market prices.
Thus, if
$0.50 $1.00
GDP = (Price of apples × Quantity of apples)
+ (Price of oranges × Quantity of oranges)
= ($0.50 × 4) + ($1.00 × 3)
GDP = $5.00
2) Used goods are not included in the calculation of GDP.
22. 3) The treatment of inventories depends
on if the goods are stored or if they
spoil. If the goods are stored, their
value is included in GDP.
If they spoil, GDP remains unchanged.
W hen the goods are finally sold out of
inventory, they are considered used
goods (and are not counted).
23. 4) Intermediate goods are not counted in
GDP– only the value of final goods.
Reason: the value of intermediate goods is
already included in the market price.
Value added of a firm equals the value of
the firm’s output less the value of the
intermediate goods the firm purchases.
5) Some goods are not sold in the marketplace
and therefore don’t have market prices. We must
use their imputed value as an estimate of their
value. For example, home ownership and
government services.
24. The value of final goods and services measured at
current prices is called nominal GDP. It can change
over time either because there is a change in the
amount (real value) of goods and services or a change in
the prices of those goods and services.
Hence, nominal GDP Y = P × y, where P is the price
level and y is real output– and remember we use output
and GDP interchangeably.
Real GDP or, y = Y÷P is the value of goods and services
measured using a constant set of prices.
25. Let’s see how real GDP is computed in our apple and
orange economy.
For example, if we wanted to compare output in 2002 and
output in 2003, we would obtain base-year prices, such as 2002
prices.
Real GDP in 2002 would be:
(2002 Price of Apples × 2002 Quantity of Apples) +
(2002 Price of Oranges × 2002 Quantity of Oranges).
Real GDP in 2003 would be:
(2002 Price of Apples × 2003 Quantity of Apples) +
(2002 Price of Oranges × 2003 Quantity of Oranges).
Real GDP in 2004 would be:
(2002 Price of Apples × 2004 Quantity of Apples) +
(2002 Price of Oranges × 2004 Quantity of Oranges).
26. GDP Deflator = Nominal GDP
Real GDP
Nominal GDP measures the current dollar value of the output
of the economy.
Real GDP measures output valued at constant prices.
The GDP deflator, also called the implicit price deflator for
GDP, measures the price of output relative to its price in the
base year. It reflects what’s happening to the overall level of
prices in the economy.
27. In some cases, it is misleading to use base year prices that
prevailed 10 or 20 years ago (i.e. computers and
college). In 1995, the Bureau of Economic Analysis
decided to use chain-weighted measures of
real GDP. The base year changes continuously
over time. This new chain-weighted
Average prices in 2001 measure is better than the more
and 2002 are used to measure traditional measure because it
real growth from 2001 to 2002. ensures that prices will not be
Average prices in 2002 and 2003 too out of date.
are used to measure real growth from
2002 to 2003 and so on. These growth
rates are united to form a chain that is
used to compare output between any two
dates.
28. 3. Methods of computing GDP
* Expenditure approach
GDP = C + I + G + (X-M)
29. Y = C + II + G + NX
Y = C + + G + NX
Total demand
Total demand Investment
Investment
for domestic
for domestic is composed
is composed spending by
spending by
output (GDP)
output (GDP) of
of businesses and
businesses and
households
households Net exports
Net exports
or net foreign
or net foreign
Consumption Government demand
demand
Consumption Government
spending by
spending by purchases of goods
purchases of goods
households
households and services
and services
This is the called the national income accounts identity.
30. * The Factor Incomes Approach: it measures
GDP by adding together all the incomes paid
by firms to households for the services of the
factors of production they hire. According to
this approach, GDP is the sum of incomes in
the economy during a given period
GDP = w + r + i + Π + D +Te
W wage, r :rent fixed capital, i: interest, Π
:
profit, D: Depreciation, Te: indirect tax
31. 3. The output approach
Total Value added = Total Revenues –
Total Cost
GDP = ∑ Value added in all
industries
=> GDP = ∑VAT. 1/
Value added tax
Example:
One firm gains value added is 80, 1000 firms is
80,000. 80 = total revenues – total cost
(production cost)
32. II.Gross national products)-GNP
1. Definition:
GNP is the market value of all final goods
and services produced by domestic residents
in a given period of time.
2. Computing methods:
GNP = GDP + Tn
Tn: net Income from Abroad
33. * 3 cases :
+ GNP > GDP (Tn>0): domestic economy has
impacts in other economies.
+ GNP < GDP (Tn<0): foreign economies have
impacts in domestic economy.
+ GNP = GDP (Tn=0): no conclusion
34. 4. Net Economic Welfare -NEW
GDP, GNP doesn’t compute some goods
and services which aren’t sold, or illegal
transactions or activities of black market,
negative externality…
35. V1 + Value of Rest
+ Value of goods and services which arent sold
+Revenues from transactions in black market
V2-negative externality for natural
resources,environment, such as noise traffic jam
…
NE reflects welfare better than GNP but it is
W m
very difficult to have enough data to com pute
NE ,therefore, econom
W ists still use GDP and
GNP .
36. NNP= GNP-D ; Y=NI=NNP-Te=GNP-D-Te
Yd = NI - (Td-TR) = (C+S)
Tn
D D-Depreciation
C NNP-Net National
Te Product
I GNP Td-TRNI-National Income
NNP
NI Yd-Disposal Income
G
(Y TR (transfer)-
Yd
) Td: Direct tax
NX
37. Gross domestic product (GDP) National income accounts
Consumer Price Index (CPI) Consumption
Unemployment Rate Investment
Stocks and flows Government Purchases
Value added Net Exports
Nominal versus real Labor force
GDP GDP deflator
GNP
NEW
39. Today’s lecture is the first in a series of four
lectures aimed at analysing different (separate)
markets in the economy. This will then enable us
to bring the various markets together and to
analyse the behaviour of the whole economy (this
is also referred to as general equilibrium analysis).
Today we will introduce an analysis of the
economy as originally described by the economist
John Maynard Keynes. His theory of how the
macroeconomy works will help us explain how the
economy’s income (GDP) is determined. Today we
analyse the model in its simplest form and we will
assume that the economy does not have a
government and that it does not trade with the
rest of the world. W will relax these
e
assumptions.
40. The Keynesian Theory of Income Determination: the theory
that will be presented hereafter was developed by the
Cambridge economist John Maynard Keynes in the wake of
the 1920s Great Depression. He argued that the cause of a
low level of income (GDP) in the economy was given by the
lack of AD.
J
ohn Maynard Keynes (right) and Harry Dexter White at the Bretton Woods
41. Personal and marital life
Born at 6 Harvey Road, Cambridge, John Maynard Keynes
was the son of John Neville Keynes, an economics lecturer
at Cambridge University, and Florence Ada Brown, a
successful author and a social reformist. His younger
brother Geoffrey Keynes (1887–1982) was a surgeon and
bibliophile and his younger sister Margaret (1890–1974)
married the Nobel-prize-winning physiologist Archibald
Hill.
Keynes was very tall at 1.98 m (6 ft 6 in).
In 1918, Keynes met Lydia Lopokova, a well-known
Russian ballerina, and they married in 1925. By most
accounts, the marriage was a happy one. Before meeting
Lopokova, Keynes's love interests had been men, including
a relationship with the artist Duncan Grant and with the
writer Lytton Strachey. For medical reasons, Keynes and
Lopokova were unable to have children, though both his
42. I. Aggregate Planned Expenditure and
Aggregate Demand
1.Assum ptions: a m odel nearly always
starts with the word ‘assum or ‘suppose’.
e’
This is an indication that reality is about
to be sim plified in order to focus on the
issue at hand
*Prices, Wages and Interest R are
ate
Constant
43. * The E conom Operates at less than full
y
E ploym
m ent: this implies that firm are
s
willing to supply any am ount of the good
at a given price P In other words,
.
assum that the supply of goods is
e
com pletely elastic at price P This.
assum ption is generally valid only in the
short run
44. * Closed E conom and No Governm
y ent: we
assum that the econom does not trade with
e y
the rest of the world so that both exports and
im ports are equal to zero (X =0). W also
=M e
assum that there is no governm
e ent in the
econom so that governm
y ent expenditures
and taxes are equal to zero (G=T=0). This
im plies that aggregate dem and is therefore
reduced to the following expression:
AD ≡ C + I
45. 1. Aggregate Planned Expenditure
APE reflects the total planned expenditure
at each income, with assumption of given
price.
*H ouseholds: Consumption C =
f(Yd): the main determinant of
consumption is surely income, or more
precisely
C = f1(Y)
46. -F s: to create the demand through their
irm
investment
I = f2(Y)
APE = C + I = f1(Y) + f2(Y)
1.1. Consumption function
* The relationship between consumption
expenditures and disposable income, other things
remaining the same, is called consumption
function. The consumption function that we will
use in our model and that shows the positive link
between consumption and disposable income is the
following (figure 1):
C = f1 (Y ) = +
C MPC.Yd
47. * Determinants of Consumption:
+Autonomous Consumption (C): this is the
amount of consumption expenditure that
would take place even if people had no
current disposable income
+Induced Consumption: this is
consumption expenditure that is in excess
of autonomous consumption and that is
induced by an increase in disposable
income
48. +Marginal Propensity to Consume
(MPC): it is the fraction of a change in
disposable income that is consumed. It
is calculated as the change in
consumption expenditures (DC) divided
by the change in disposable income
(DYd) that brought it about. It gives the
effect of an additional pound of
disposable income on consumption. The
MPC determines the slope of the
consumption ∆Cfunction
MPC =
∆Y
49. 0 < M C< 1 :This reflects the fact that
P
people are likely to consume only part of
any increase in income and to save the
rest
* Example. The following is an example
of a consumption function:
C = 20 + 0.7xYd
Autonomous Consumption: 20
MPC = 0.7
50. +NetPrivateSavings-S: savings by
consumers is equal to their disposable
income minus their consumption
=> S = Yd - C
and, by using the definition of disposable
income this identity can be rewritten as:
S = Y – T – C (but T = 0, no government)
However, given that there is no
government in our simple economy, T=0
and savings are equal to: S = Y - C
1.2.The Saving Function: the economy’s
savings function can be derived by using
the private savings expression and the
consumption function:
51. S = Y −C
S = Y − C − MPC.Y = −C + (1 − MPC ).Y
S = −C + MPS .Y
+The Marginal Propensity to Save (MPS):
the propensity to save tells us how much
people save out of an additional unit of
income. The assumption we made earlier
that MPC is between zero and one implies
that the propensity to save is given by
(1-M C) and that it is also between 0 and
P
1.
The Saving Curve: it traces the
relationship between the level of net
52. 1.3.Investment function (I): the second
expenditure in APE that we will analyse
today is investment
* Determinants of Investment: we can
distinguish four major determinants of
investment
+Increased Consumer Demand: investment
is to provide extra capacity. This will only
be necessary, therefore, if consumer
demand increases
53. +Expectations: since investment is made in
order to produce output for the future,
investment must depend on firms’
expectations about future market
conditions
+Cost and Efficiency of Capital
Equipment: if the cost of capital
equipment goes down or machines become
more efficient, the return on investment
will increase and firms will invest more
54. +Interest rate: the higher the rate of
interest, the more expensive it will be for
firms to borrow the money to finance
their investment expenditures and the
less profitable will the investment be
55. +Level of Investment in the Economy: in
this model we will take investment as
given or, in other words, we will regard it
as an exogenous variable. The main
reason for taking investment as given is
to keep our model simple. Thus we will
assume that investment is given by a
fixed/constant amount (a bar over a
variables indicates that the variable is
regarded as an exogenous variable) that
does not change with the level of income
in the economy:
I =I
56. APE = C + I = C + I + MPC .Y
* The Determination of Equilibrium
Output: W hen P, w is constant,the
equilibrium in the goods market
requires that the supply of goods
(GDP =Y) equals the demand for goods
(APE):
Y = APE =AD
57. This equation is called the equilibrium
condition. By replacing the above
expression for aggregate planned
expenditure in the equilibrium condition
we get:
Y = APE
Y = + +
C I MPC .Y
As you can see the above expression is an
equation in one endogenous variable: Y.
Thus we can solve this equation for Y and
this will give us the equilibrium level of
output (Ye)produced in the economy
1
Ye = (C + I )
1 − MPC
58. I = 200
* Example 1. Assume that in the economy
the level of autonomous consumption
c0=100, the marginal propensity to
consume is M C=0.5 and the investment
P
spending is I=200 . Determine the
equilibrium level of output produced in the
economy.
59. 2. APE & Ye in closed economy with a
Government Sector
-Firms invest in economyI = I
-Government sector expenditure: G
+G will increase APE and will shift the APE
curve upwards.
+Taxation reduces the level of disposable
income available for consumption and will
tend to reduce APE. Such a reduction in
APE is reflected by a downward rotation of
the APE curve. W hy?
60. This is due to the fact that taxation
reduces the overall MPC by the household
so that for each extra pound of income
the household will now consume less since
some of the extra income must be paid in
taxes
2.1.Fixed taxation T =T
APE = C + I + G = C + I + G + MPC .(Y − T )
Y =APE
Y = +I + +
C G MPC .(Y − )
T
1 MPC
Y0 = (C +I + ) −
G T
1−MPC 1− MPC
61. MPC Multiplier Effect of taxation
mt = −
1 − MPC
Y0 = m(C + I + G ) + mt T
2.2. Taxation depends on incom T = t.Y (t:tax
e:
rate)
C = C + MPC (Y − T ) = C + MPC (1 − t )Y
I=I G =G
62. APE = C + I + G = C + I + G + MPC × (1 − t )Y
=>Equilibrium point of economy:
Y = APE
Y = C + I + G + MPC (1 − t ) ×Y
1
Y0 = (C + I + G )
1 − MPC (1 − t )
63. 1
m′ = Multiplier of consumption
1 − MPC (1 − t )
in the closed economy with
Government sector
1 1
m′ = <m =
1 − MPC (1 − t ) 1 − MPC
This reflects that the income based tax is
less efficient than fixed tax.
64. 3. 2. APE & Ye in open-economy with a
Government Sector and foreign trade
* Assuption: T = t.Y (t- taxrate)
Economy has 4 sector
* C = C + MPC.(Y-T) = C + MPC.(1-t).Y
*I=I
*G= G
* NX=X-M: netexport
X doesn’t depend on domestic
income,therefore
X =X
65. M derives from production inputs, or
consumptions of households=>M increases
when I or Ye rises.
Ta cã: M = MPM.Y
* MPM (Marginal Propensity to Import): it
is the fraction of an increase in GDP that is
spent on imports. It is calculated as the
change in imports ( ∆ M divided by the
)
change in GDP ( ∆ Y) that brought it about,
other things remaining the same. The M M P
is a positive number smaller than one
MPM = ∆ M ∆ Y and 0<M M<1
/ P
66. APE = C + I + G + X − M
APE = C + I + G + X + [ MPC (1 − t ) − MPM ] × Y
* Equilibrium point of economy:
Y = APE
Y = C + I + G + X + [ MPC (1 − t ) − MPM ] × Y
1
Y0 = (C + I + G + X )
1 − MPC (1 − t ) + MPM
1
m′′ = open-econom m
y ultiplier
1 − MPC (1 − t ) + MPM
m” < m’ < m. open-econom m
y ultiplier is less efficient
than closed econom m
y ultiplier.
68. II.Fiscal policy:
1. Fiscal policy: Government use taxation
and consumption to regulate aggregate
demand.
2. Classification of fiscal policy
2.1. Expansionary fiscal policy
2.2. Contractionary fiscal policy
69. 3. Fiscal policy and Budget decifit
*State Budget: total sum of revenues and
consum ption of Governm in given tim
ent e
(one year)
B= T - G
+ B = 0: Budget balance
+ B > 0: Budget surplus
+ B < 0: Budget deficit
70. * Classification:
- R budget deficit: W
eal hen consumption >
revenues
-Cyclic budget deficit: when econom faces
y
recession due to cyclic business.
-Structural budget deficit: is calculated in
term of assum ptions with potential output.
where Btt = Bck + Bcc =>Bcc = Btt - Bck
71. * Note: fiscal policy can reach following
objectives:
+Budget balance=>Y can fluctuate.. .
+Y* => B udget deficit can happen. When
there is recession in econom G increase or
y,
T decrease or both to keep high
consum ption => Y rises to Y* but Budget
deficit happens.
72. 4. How to reduce budget deficit
-Inreasing revenues and decreasing
consumption
-Public debt: Government bond
-Borrowings from foreign countries or
international orgnizations
-Printing money or using reserve from
foreign currency
74. I. Money
1. The Meaning and functions of Money
a.Definition of Money: money is any
commodity or token that is generally
acceptable as the means of payment. A
means of payment is a method of settling a
debt. In general terms money can be
defined as the stock of assets that can be
readily used to make transactions. Roughly
speaking, the coins and banknotes in the
hands of the public make up the nation’s
stock of money
75. Stock of assets
Money Used for transactions
A type of wealth
Self-sufficiency
Without Money
Barter economy
76. b. Development of money
Cattle, iron, gold,silver,diamond ….and
banknote today
Batter => commodity money=> cash,
cheque, credit card…
2. The Functions of Money: money has
three main purposes. It is a medium of
exchange, a unit of account and a store of
value
77. 2.1. Medium of Exchange: it is an object
that is generally accepted in exchange for
goods and services. Money acts as such
a medium
2.2. Unit of Account (A Means of
Evaluation): a unit of account is an
agreed measure for stating the prices of
goods and services. It allows the value
of one good to be compared with
another
2.3. Store of Value: any commodity or
token that can be held and exchanged
later for goods and services is called a
s to re o f va lue . Money acts as a store of
value.
78. Functions of Money
• Store of value
• Unit of account
• Medium of exchange
• International Money
The ease with which money is converted into other things--
goods and services-- is sometimes called money’s liquidity.
79. 3.Types of Money
* Depend on the Liquidity:
M 0= Cash; (W Monetary Base) =
ide
Cash in circulation with the public and
held by banks and building societies
+Banks’ balances with the Central
M = Bank + Deposit (D: Deposit is unlimited
1 Cash
time deposit). Liquidity of M1 is smaller than
M0 but it is still good to measure the cash in
circulation in economy.
M = M + lim
2 1 ited tim deposit: Liquidity of M2
e
is very low,therefore,there are some
developed economies such as US and UK
where use to measure the cash in
80. * Money can be divided into:
Fiat Money: money takes different
forms.
Money that has no intrinsic value is
called fiat money because it is established
as money by government decree, or fiat
In the UK economy we make
transactions with an items whose sole
function is to act as money: pound coins
and banknotes. These pieces of paper
with the portrait of the queen would
have little value if they were not widely
accepted as money.
81. Commodity Money: although fiat money
is the norm in most economies today,
historically most societies have used for
money a commodity with some intrinsic
value.
Money of this sort is called commodity
money and the most widespread example
of commodity money is gold
82. II. Central Bank and creation money of
commercial bank
1.Banks are the Financial Intermediaries.
They are private firms licensed by the
Central Bank under the Banking Act to take
deposits and make loans and operate in the
economy.
Retail Banks: they specialise in providing
branch banking facilities to member of the
general public but they do also lend to
businesses albeit often on a short-term
basis. They are the most important banks in
the UK for the functioning of the economy
and for the implementation of monetary
83. 2. The creation of Money by commercial banks
The Creation of Money: banks create
money. However this does not mean
that they have smoke-filled back rooms
in which counterfeiters are busily
working. Notice that most money is
deposits, not currency. W hat banks
create is deposits and they do so by
making loans. But the amount of
deposits they can create is limited by
their reserves
85. The Deposit Multiplier: this is the amount
by which an increase in bank reserves is
multiplied to calculate the increase in
bank deposits. It is given by the following
formula:
Change in Deposit
Deposit Multiplier =
Change in Reserves
Alternatively, it can also be defined
as: 1
Deposit Multiplier =
Desired Reserve Ratio
if banks want to keep 10% of their deposits as
reserves, so that the desired reserve ratio is 0,10
(ra), the deposit multiplier is given by the following
expression:1/ =10. See example
ra
86. Banking Desired
Deposits Lending
system reserve (ra)
NH 1 1 1.ra (1-ra)
NH 2 (1-ra) (1-ra).ra (1-ra)2
NH 3 (1-ra)2 (1-ra)2 .ra (1-ra)3
... ... ... ...
NH (n+1) (1-ra)n (1-ra)n .ra (1-ra)n+1
n+ 1 n+ 1
1 − (1 − ra ) 1 − (1 − ra )
D = 1 + (1 − ra ) + (1 − ra ) + ... + (1 − ra ) = 1×
2 n
= 1×
1 − (1 − ra ) ra
1− 0 1 1
0 < ra < 1 => = 1×
D = 1× = = 10 (tû.®)
ra ra 0,1
87. Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000.
Firstbank Secondbank Thirdbank
Balance Sheet Balance Sheet Balance Sheet
Assets Liabilities Assets Liabilities Assets Liabilities
Reserves $200 Deposits $1,000 Reserves $160 Deposits $800 Reserves $128 Deposits $640
Loans $800 Loans $640 Loans $512
Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1000
Firstbank Lending = (1-rr) × $1000 The process of transferring funds
The process of transferring funds
Secondbank Lending = (1-rr)2 × $1000 from savers to borrowers is called
from savers to borrowers is called
Thirdbank Lending = (1-rr)3 × $1000
Fourthbank Lending
financial intermediation.
= (1-rr)4 × $1000 financial intermediation.
. .
.
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …] × $1000
= (1/rr) × $1000
= (1/.2) × $1000
= $5000 Money and Liquidity Creation
Money and Liquidity Creation
88. III. Central Bank and money supply
1. Roles of Central Bank
* Supervision of Monetary System: the
central bank oversees the whole monetary
system and ensures that banks and
financial institutions operate as stably and
as efficiently as possible
* Government’s Bank: the central bank is
the acts as the government’s agent both as
its banker and in carrying out monetary
policy
89. 2. Functions of Central Bank
* To Issue Notes: the Central Bank is the
sole issuer of banknotes. The amount of
banknotes issued by Central Bank
depends largely on the demand for notes
from the general public
F exam
or ple, BOE issues banknotes in
England and W ales (in Scotland and
Northern Ireland retail banks issue
banknotes).
90. * It Acts as a Bank
+To the Government: the government
deposits its revenues from taxation in the
central bank and uses CB in order to borrow
money from the market
+To other Recognised Banks: all banks
licensed by CB hold operational balances in
the CB. These are used for clearing purposes
between the banks and to provide them with
a source of liquidity
+To Overseas Central Banks: these are
deposits in sterling held by overseas
authorities as part of their official reserves
and/ purposes of intervening in the foreign
or
exchange market in order to influence the
exchange rate of their currency.
91. * It Manages the Government’s Borrowing
Programme: whenever the government
runs a budget deficit (it spends more than
what it receives in taxes) it will have to
finance that deficit by borrowing. It can
borrow by using bonds (gilts), National
Savings certificates or Treasury bills. The
CB organises this borrowing
* It Supervises the Financial System: it
advises banks on good banking practice.
It discusses government policy with them
and reports back to the government. It
requires banks to maintain adequate
liquidity: this is called prudential control.
92. * It Provides Liquidity to Banks – Lender
of Last Resort: it ensures that there is
always an adequate supply of liquidity to
meet the legitimate demands of
depositors in recognised banks
* It Operates the Government’s Monetary
and Exchange Rate Policy
+Monetary Policy: the CB manipulates
the interest rate in the economy and
influence the size of the money supply
+Exchange Rate Policy: the CB manages
the country’s gold and foreign currency
reserves
93. 3. The Supply of Money
* Definition of Money Supply: the quantity
of money available is called the m oney
supply. In an economy that uses fiat money,
such as most economies today, the
government controls the supply of money:
legal restrictions give the government a
monopoly on the printing of money
* Monetary Policy: the control over the
money supply is called monetary policy
94. 4. Implement of money supply
a.Measures of Money Supply:
Recall that we can denote money supply as
the sum of currency and deposits
M = C + D
Money Currency Demand Deposits
Central Bank issues H0, (Basic M oney, H igh
Powered M oney), H0 < M0. Ho is divided into
U and R
95. + Sectors keep a part of Ho, denote as U. U
can’t create other means of payment and it
can be decrease due to damages..in the
circulation. Assuption, U is constant.
+ The rest of Ho denote as R (Ho = U +R).
The banking system will use R to create
money as followings:
96. 1
D= ×R
ra
Basic Money (H0)
U R
U D
Money supply : MS
Where: H0 = U + R and MS = U + D
MS >Ho due to the creation of money from
commercial banks.
97. b.The Central Bank's Policy Tools: there are
three main tools that the Central Bank can
use to control money supply and implement
monetary policy
* Reserve Requirements: these are
regulations by the central bank that impose
on banks a minimum reserve-deposit ratio.
An increase in reserve requirements raises
the reserve-deposit ratio and thus lowers the
money multiplier and the money supply
98. * Discount Rate: it is the interest rate that
the central bank charges when it makes
loans to banks. Banks borrow from the
central bank when they find themselves
with too few reserves to meet reserve
requirements. The lower the discount rate,
the cheaper are borrowed reserves and the
more banks borrow at the central bank’s
discount window.
=> discount rate decreases =>the monetary
base and the money supply go up.
99. * Open-Market Operations: they are the
purchases and sales of government bonds
by the central bank.
W hen the central bank buys (sells) bonds
from (to) the public, the pounds it pays
(receives) for the bonds increase (decrease)
the monetary base and thereby increase
(decrease) the money supply.
The term 'Open Market' refers to commercial
banks and the general CB conducts an open
market operation, it does a transaction with
a bank or some other business but it does
not transact with the government
100. Example of US economy?
In the United States, monetary policy is
conducted in a partially independent institution
called the Federal Reserve, or the Fed.
101. • To expand the Money Supply:
re
Bond
ansituySrptaymilseed
tes The Federal Reserve buys U.S. Treasury Bonds
US. T f the U ereb incip it
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eb
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ay
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• To reduce the Money Supply:
ci
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of ___
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nat ___
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___
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The Federal Reserve sells U.S. Treasury Bonds
and receives the existing dollars and then
destroys them.
102. The Federal Reserve controls the
money supply in three ways.
1) Open Market Operations (buying and
selling U.S. Treasury bonds).
es d
at n d
U
riyedBroise it
asun t y p ipl
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2) ∆ Reserve requirements (never really
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(not meeting the reserve requirements)
rc th
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pay to borrow from the Fed.
__
103. IV. Money market
1. Money Demand: the dem and for m oney
refers to the desire to hold money: to keep your
wealth in the form of m oney, rather than
spending it on goods and services or using it to
purchase financial assets such as bond or
shares
2.Reasons for Holding Money
The Transactions Motive: since money is a
medium of exchange it is required for
conducting transactions.
104. The Precautionary Motive: unforeseen
circumstances can arise, such as a car
breakdown. Thus individuals often hold
some additional money as a precaution
The Speculative Motive: certain firms
and individuals who wish to purchase
financial assets such as bonds or shares
may prefer to wait if they feel that their
price is likely to fall. In the meantime
they will hold idle money balances
instead
105. 3.The Demand for Money Function: the
relationship between the demand for money
and the interest rate is described by the
demand for money function
+ −
M d
= (Y , i )
f
This expression simply states that the
demand for money is a function (f) of income
Y and the interest rate I
d
M = denotes the nominal money demand
Y = denotes nominal income (GDP) and it
captures the overall level of transactions in
the economy.
106. In fact, it is reasonable to assume that the
overall level of transactions is roughly
proportional to nominal income. The
positive sign above Y denotes that there is a
positive relationship between income and
demand for money: the higher the level of
income (transactions) the higher the
demand for money
i = is the interest rate and the negative sign
above it denotes the negative relationship
between the interest rate and the demand
for money. The higher the interest rate, the
sm aller the demand for money since
individuals prefer to hold their wealth in
bonds
107. d. Determinant of money demand
*Level of price:
M n (nom
D inal M oney Demand com puting
based on researched price (usually higher
than based price)
M r (real M
D oney Dem and, com puting depend
on based price (constant price).
MDn ↑
P↑ →
MDr = MD = const
MDn ↓
P↓
→
MDr =MD =const
108. * Interest rate (i)
i increases (decreases) => MD decreases
(increases)
* Income (Y)
Y increases (decreases) => MD increases
(decreases)
Money demand function can be written:
MD = k.Y–h.i
k-income-elasticity of MD
h-interest rate –elasticity of MD.
110. Note:
+ i change=>quantity demanded move along
MD, otherthings being equal.
+ Y change=>MD shift rightwards or
leftwards. Depends on income-elastricity of
money demand (k).
+ Slope of MD depends on the interest rate –
elastricity of money demand (h).
kY 1
i= − MD
h h
111. 2. Money supply
* The Determinants of Money supply
-The level of price: no m ina l M d o e s n’t
S
d e p e nd o n P but re a l M d o e s be c a us e :
S
MS n
MS n = m × H 0 MS r =
P
-Central Bank: i can change but MS maybe
constant If CentralBank doesn’t want to
change MS.
113. 3. Equilibrium in the Money Market: the
equilibrium in the money market
requires that money supply be equal to
money demand, that M d s=M
M = M = f (Y , i ) This
s d
equilibrium condition tells us that the
interest rate must be such that people
are willing to hold and amount of money
equal to the existing supply. This
equilibrium relation is also called LM
and will be discussed in more detail in
the next lecture
114. * Note:
+ If I # i0 =>imbalance between supply
and demand which puts pressure to push
I up or down to equilibrium point i0.
W hen MS, MD changes =>quilibrium
point (E) changes which leads to changes
of i0.
117. I.unemployment:
Unemployment is the number of people
of working age who are without work,
but who are available for work at
current wage rates. If the figure is to be
expressed as a percentage, then it is a
percentage of the total labour force.
118. -The labour force is defined as: those in
em ploym ent (including the self-employed,
those in the arm forces and those on
ed
governm ent training schemes) plus those
unem ployed.
-The labour force doesn’t include people
who are out of working age, students,
pupils, invalids. People who are at
working age but unwilling to work doen’t
belong to labour force
119. Labour force
Labour employment
force
In
unemploymen
W orking
Populat age t
ion Out of
labour
force
Out
120. 2. Computing unemployment rate
u - Unem ploym R
ent ate): to be expressed by
fraction of unemployment with the total
labour force. It can be expressed by
percentage as the formula below:
U (Unemployed): L (Labour Force):
U
u = ×100%
L
121. Unemployment is a problem for the
economy because:
Output and incomes are lost.
Human capital depreciates.
Crime may increase.
Human dignity suffers.
122. 3. Types and causes of unemployment:
Frictional unem ploym ent occurs when
people leave their jobs, either voluntarily
or because they are sacked or m ade
redundant, and are then unem ployed for a
period of tim while they are looking for a
e
new job. They m not get the first job
ay
they apply for, despite a vacancy existing.
The em ployer m ay continue searching,
hoping to find a better-qualified person.
123. Likewise, unem ployed people m choose
ay
not to take the first job they are offered.
Instead, they m ay continue searching,
hoping that a better job will turn up. The
problem is that inform ation is im perfect.
E ployers are not fully inform about
m ed
what labour is available; workers are not
fully inform ed about what jobs are
available and what they entail. B oth
em ployers and workers, therefore, have to
search: em ployers searching for the right
labour and workers searching for the right
jobs.
124. Structural Unemployment refers to
unemployment arising because there is a
mismatch of skills and job opportunities
when the pattern of demand and
production changes. Examples in the UK
include unemployment resulting from a
decline in the production of textiles,
shipbuilding, cars, coal and steel. Those
workers who become structurally
unemployed are available for work but they
have either the wrong skills for the jobs
available or they are in the wrong location.
125. Demand-deficient Unemployment is also
referred to Keynesian unemployment.
Demand-deficient unemployment occurs
when aggregate demand falls and wages
and prices have not yet adjusted to restore
full employment. Aggregate demand is
deficient because it is lower than full-
employment aggregate demand which
implies that output is less than full
employment output.
126. Classical Unemployment describes the
unemployment created when the wage is
deliberately maintained above the level
at which the labour market clears. It can
be caused either by the exercise of trade
union power or by minimum wage
legislation which enforces a wage in
excess of the equilibrium wage rate.
127. II.Inflation
1. Definition
Inflation is a rise in the average price of
goods over time.
The term deflation is used to describe a
fall in the average price of goods over
time.
Deflation is very rare, but when it occurs it
can cause serious problems in the
economy. The inflation rate is the
percentage change in the price level. The
formula for the annual inflation rate is:
128. 2. Computing inflation
Gp:price growth rate Pt − Pt −1
gp = × 100%
Pt −1
t-tim e
P : at previous tim
t-1 e
P: : at current tim (research time)
t e
P is to be expressed as follows:
P Q1 + P2 Q2 +... + Pn Qn
P= 1
Q1 +Q2 +... +Qn
129. Actually, P is difficult to compute, we can
compute inflation as below:
k
∑i
P t Qi0
CPI = i =1
k
∑i
P 0Qi0
i =1
W here CPI is the consumer price index and t
is time. The consumer price index measures
how much more a basket of goods that
represents goods purchased by the average
householder costs today compared with some
previous time period.
130. Name CPI (I 2005/2004) %
A 1,2 30%
B 1,4 25%
C 0,9 15%
E 1,5 30%
CPI2005=1,2x30%+1,4x25%+0,9x15%
+1,5x30%=1,295
CPI t − CPI t −1 CPIt-1:
gp = × 100%
CPI t −1 CPIt:
Note: CP doesnt reflect changes in quality of
I
goods and services or of new goods and services.
131. + GDP (D: Deflator)
n
GDP ∑i
P t Qit
D= n
×100% = i=
n
1
×100%
GDPr
∑i
P 0Qit
i=1
D-GDP reflects changes in prices of total
fianl goods and services compare with based
price,therefore, this describes inflation rate.
Dt − Dt −1
gp = × 100%
Dt −1
132. W hy is inflation a problem?: W hen
inflation is present in the economy,
money is losing its value. The higher the
inflation rate, the higher is the rate at
which money is losing value and this fact
is the source of the inflation problem.
Inflation is said to be good for borrowers
and bad for lenders, and so inflation can
cause inequalities in the economy. People
on fixed incomes (e.g. pensioners and
students) tend to suffer most from
inflation.
133. 2. Types of inflation
*M oderate Inflation: inflation rate < 10%/ m
n¨ ,
prices increases slowly..
M oderate inflation can spur production
because price increases leading to highet
profit for enterprises,therefore, firm will
s
increases quantity.
* Galloping Inflation: inflation rate is from 10%
to 99% per year. This type will destroy
econom and curb engines of econom
y y.
134. *Hyper Inflation: is defined as inflation
that exceeds 100% percent per year.
Costs such as shoe-leather and menu costs
are much worse with hyperinflation– and
tax systems are grossly distorted.
Eventually, when costs become too great
with hyperinflation, the money loses its
role as store of value, unit of account and
medium of exchange. Bartering or using
commodity money becomes prevalent.
In 1920s (1922-12/ 1923) W eimar
Germany, CPI increased from 1 to 10
millions
135. * Expected inflation: depends on expectation
of individuals about gp in the future. Its
im pacts is sm but help to adjust production
all
cost.
+Unexpected inflation: derives from
exogenous shocks and unexpected factors
inside economy.
136. The inconvenience of reducing money
holding is metaphorically called the
shoe-leather cost of inflation, because
walking to the bank more often induces
one’s shoes to wear out more quickly.
When changes in inflation require printing
and distributing new pricing information,
then, these costs are called menu costs.
Another cost is related to tax laws. Often
tax laws do not take into consideration
inflationary effects on income.
137. Unanticipated inflation is unfavorable because it arbitrarily
redistributes wealth among individuals.
For example, it hurts individuals on fixed pensions. Often these
contracts were not created in real terms by being indexed to a
particular measure of the price level.
There is a benefit of inflation– many economists say that some
inflation may make labor markets work better. They say it
“greases the wheels” of labor markets.
138. 3. Causes of inflation
•Dem and-pull inflation is P
caused by continuing rises in
AS
AD in the econom y. The
increase in AD m be caused
ay
by either increases in the
m oney supply or increases in P1
G-expenditure when the AD1
econom is close to full
y P0
em ploym ent. In general,
dem and-pull inflation is AD0
typically associated with a Y*
boom econom
ing y. 0 Y
139. * Cost-push inflation is associated with
continuing rises in costs. Rises in costs may
originate from a number of different sources
such as wage increases and other higher
costs of production (e.g. raw materials).
P AS1
AS0
P1
P0 AD
0 Y
Y1 Y0 Y*
140. * Structural (demand-shift) inflation arises
when the pattern of demand (or supply)
changes in the economy which results I n
some industries experiencing increased
demand whilst others experience decreased
demand. If prices and wage rates are
inflexible downwards in the contracting
industries, and prices and wage rates rise
in the expanding industries, the overall
price and wage level will rise. The problem
will be made worse, the less elastic is
supply to these shifts.
141. * Expectations are crucial determinants of
inflation. W orkers and firms take account
of the expected rate of inflation when
making decisions. Generally, the higher the
expected rate of inflation, the higher will be
the level of pay settlements and price rises,
and hence the higher will be the resulting
actual rate of inflation.
* Inflation and Money: equilibrium point of
money market
MS n
= MS r = MDr = kY − hi
P
142. In other words, if Y is fixed (from Chapter 3) because it depends
on the growth in the factors of production and on technological
progress, and we just made the assumption that velocity is constant,
MV = PY
or in percentage change form:
% Change in M + % Change in V = % Change in P + % Change in Y
% Change in M + % Change in V = % Change in P + % Change in Y
if V is fixed and Y is fixed, then it reveals that % Change in M is what
induces % Changes in P.
The quantity theory of money states that the central bank, which
controls the money supply, has the ultimate control over the inflation
rate. If the central bank keeps the money supply stable,the price level
will be stable. If the central bank increases the money supply rapidly,
the price level will rise rapidly.
143. The revenue raised through the printing of money is called
The revenue raised through the printing of money is called
seigniorage. When the government prints money to finance
seigniorage. When the government prints money to finance
expenditure, it increases the money supply. The increase in
expenditure, it increases the money supply. The increase in
the money supply, in turn, causes inflation. Printing money to
the money supply, in turn, causes inflation. Printing money to
raise revenue is like imposing an inflation tax.
raise revenue is like imposing an inflation tax.
144. * Inflation and interest rate
Economists call the interest rate that the
bank pays the nom inal interest rate and the
increase in your purchasing power the real
interest rate.
r=i–π
This shows the relationship between the
nominal interest rate and the rate of
inflation, where r is real interest rate, i is the
nominal interest rate and p is the rate of
inflation, and remember that p is simply the
percentage change of the price level P.
145. The Fisher Equation illuminates the distinction between
the real and nominal rate of interest.
Fisher Equation: i = r + π
The one-to-one relationship
between the inflation rate and
the nominal interest rate is
the Fisher Effect.
Actual (Market)
Nominal rate of Real rate Inflation
interest of interest
It shows that the nominal interest can change for two reasons: because
the real interest rate changes or because the inflation rate changes.
146. +gp is high=>i is up to keep equality of r.
+Economy has high i lead to high gp or i can
explains gp of economy.
+If real gp > expected gp => borrowers get
advantages
+If real gp < expected gp => lenders get
advantages
147. 4.Policies to deal with inflation:
4.1.Fiscal policy comprises changes in
government expenditure and/ taxation.
or
The aim is to affect the level of AD
through a policy known as demand
management. In the case of controlling
inflation, this involves reducing
government expenditure and/ increasing
or
taxation in what is called a deflationary
fiscal policy. Such policies are likely to be
effective if inflation has been diagnosed
as dem and-pull since a reduction in
governm ent expenditure or an increase in
incom tax will reduce aggregate dem
e and in
148. 4.2.Monetary policy is concerned with
influencing the money supply and the
interest rate. In terms of controlling
inflation, the government can aim to
reduce the money supply thus reducing
spending and, therefore, the aggregate
demand, or it can increase the interest
rate so as to increase the cost of
borrowing. Both policies can be seen as
deflationary monetary policy. Since
monetarists view the growth of the money
supply as being the main cause of
inflation, any control of inflation from a
monetarist viewpoint must involve control
of the money supply.
149. 4.3.Prices and incomes policy aim to limit
and, in certain cases, freeze wage and price
increases. In the past they have either been
statutory or voluntary. Statutory prices and
incomes policies have to be enforced by
government legislation, such as the EU
minimum wage legislation. W a voluntary
ith
prices and incomes policy the government
aims to control prices and incomes through
voluntary restraint, possibly by obtaining
the support of the unions and employers.
150. 4.4. Supply-side policy is concerned with
instituting measures aimed at shifting the
aggregate supply curve to the right. Supply-
side economics is the use of microeconomic
incentives to alter the level of full
employment and the level of potential
output in the economy. If inflation is caused
by cost-push pressures, supply-side policy
can help to reduce these cost pressures in
two ways:
151. (1) by reducing the power of trade unions
and/ or firms (e.g. by anti-monopoly
legislation) and thereby encouraging more
competition in the supply of labour and/ or
goods, (2) by encouraging increases in
productivity through the retraining of
labour, or by investment grants to firms, or
by tax incentives, etc.
152. 4.5.Learning to live with inflation involves
accepting the fact that inflation is here to
stay when standard anti –inflationary
policy measures appear ineffective. In
such a situation we just have to learn to
live with inflation. Learning to live with
inflation involves the government,
employers and workers taking inflation
into account in their everyday
transactions. For example, the
government/ employers may use
indexation in wage/ pensions contracts.
Indexation is when wages or pensions are
increased in line with the current rate of
inflation. Indexation is aimed at nullifying
the effects of inflation.
155. II.Computing of economic growth
* Computed by % changes in real GDP
Yt − Yt −1
gt = × 100%
Yt −1
+gt: according to real GDP
* gpct : by GDP per capita ( Ýn case
population increases faster than GDP)
y t − y t −1
g pct = ×100%
y t −1
156. II. Sources of economic growth
1.Human capital
2. Capital accumulation
3. Natural resource
4.Technological knowledge
157. III.Theories of economic growth:
1. Classical theory of Adam Smith vµ Malthus
Land plays an important role for
economic growth.
+Adam Smith: gold age
+Malthus: dull age
158. 2. Economic growth theory of Keynes
I increases => outputs and income
increase=> capital .acc is up=> G should
invest to push AD, lead to ecnomic
growth.
ICOR (Incremental Capital-Output Ratio )
∆K I
ICOR = ICOR =
∆Y ∆Y
∆Y s
where S=I =
Y ICOR
159. Harrod- Domar model: explains the role of
capital accumulation for economic growth.
s S
(s = )
g= Y
ICOR
* If ICOR is constant, g increases at the rate
of savings rate.
* Debates: +ICOR is not constant
+Model ignores technology and
human resources
160. 3. Neo-classical economic growth theory
Solow model or Solow-Swan Model
3.1. Introduction: paper of economic
growth were issued in 2/1956 and 11-
1956 of two economists are Solow and
Swan
* W it is neo-classical theory: use the
hy
role of market and government
161. The Solow Growth Model is designed to show how
growth in the capital stock, growth in the labor force,
and advances in technology interact in an economy,
and how they affect a nation’s total output of
goods and services.
Let’s now examine how the
model treats the accumulation
of capital.
162.
163. Let’s analyze the supply and demand for goods, and
see how much output is produced at any given time
and how this output is allocated among alternative uses.
The Production Function
The Production Function
The production function represents the
transformation of inputs (labor (L), capital (K),
production technology) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
zY = F (zK ,zL )
Income is some function of our given inputs
Key Assumption: The Production Function has constant returns to scale.
164. This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )
Output is some function of the amount of
Per worker capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
165. This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )
Output is some function of the amount of
Per worker capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: y = f ( k ) , where f(k)=F(k,1).
166. MPK = f (k + 1) – f (k)
The production function shows
y how the amount of capital per
worker k determines the amount
f(k)
of output per worker y=f(k).
MPK The slope of the production function
1 is the marginal product of capital:
if k increases by 1 unit, y increases
by MPK units.
k
167. 1) y = c + ii
y=c+
2) c = (1- )y
c = (1-ss)y consumption
Output per worker investment
per worker per worker
consumption depends
on savings
per worker
rate 3) y = (1-ss)y + ii
y = (1- )y +
(between 0 and 1)
Investment = savings. The rate of saving s
4) ii = ssy
= y is the fraction of output devoted to investment.
168. Here are two forces that influence the capital stock:
• Investment: expenditure on plant and equipment.
• Depreciation: wearing out of old capital; causes capital stock to fall.
Recall investment per worker i = s y.
Let’s substitute the production function for y, we can express investment
per worker as a function of the capital stock per worker:
i = s f(k)
This equation relates the existing stock of capital k to the accumulation
of new capital i.
169. The saving rate s determines the allocation of output between
consumption and investment. For any level of k, output is f(k),
investment is s f(k), and consumption is f(k) – sf(k).
y
Output, f (k)
c (per worker)
Investment, s f(k)
y (per worker)
i (per worker)
k
170. Impact of investment and depreciation on the capital stock: ∆k = i –δk
Change in
Capital Stock
Investment Depreciation
Remember investment equals δk δk
savings so, it can be written:
∆k = s f(k)– δk
Depreciation is therefore proportional
to the capital stock.
k
171. Investment
and Depreciation
Depreciation, δ k
At k*, investment equals depreciation and
capital will not change over time. Below k*,
investment
exceeds
Investment, s f(k) depreciation,
i* = δk* so the capital
stock grows.
Above k*, depreciation
exceeds investment, so the
capital stock shrinks.
k1 k* k2 Capital
per worker, k
172. The Solow Model shows that if the saving rate is high, the economy
will have a large capital stock and high level of output. If the saving
Investment
and
rate is low, the economy will have a small capital stock and a
Depreciation low level of output. Depreciation, δ k
Investment, s 2f(k)
Investment, s 1 f(k)
i* = δk*
An increase in
An increase in
the saving rate
the saving rate
causes the capital
causes the capital
stock to grow to
stock to grow to
aanew steady state.
new steady state.
k 1* k 2* Capital
per worker, k
173. c*= f (k*) - δ k*.
According to this equation, steady-state consumption is what’s left
of steady-state output after paying for steady-state depreciation. It
further shows that an increase in steady-state capital has two opposing
effects on steady-state consumption. On the one hand, more capital
means more output. On the other hand, more capital also means that more
output must be used to replace capital that is wearing out.
The economy’s output is used for
consumption or investment. In the steady
state, investment equals depreciation.
δk δk Therefore, steady-state consumption is the
Output, f(k)difference between output f (k*) and
depreciation δ k*. Steady-state consumption
c *gold is maximized at the Golden Rule steady
state. The Golden Rule capital stock is
k*gold k denoted k*gold, and the Golden Rule
consumption is c*gold.
174. 3.2. Conclusions of Solow model
+The role of savings for economics
growth
+Capital accumulation is good for short-
run economic growth
+Techonology is the determinant of
long-run economic growth
175. 4. Policies for economic growth
4.1. Increasing domestic savings and
investment
4.2. Attracting FDI
4.3. Improving human resources
4.4. R&D of new techonology
176. 4.5. Stability of politics and economy
4.6. The open-door policy
4.7. Curbing growth of population
178. Y = C + I + G + NX
Total demand Investment
is composed spending by Net exports
for domestic
of businesses and or net foreign
output
households demand
Consumption Government
spending by purchases of goods
households and services
Notice we’ve added net exports, NX, defined as EX-IM. Also, note that
domestic spending on all goods and services is the sum of domestic
spending on domestics goods and services and on foreign goods and
services.
179. Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:
NX = Y - (C + I + G)
Domestic
Spending
Domestic
Spending
Net Exports
Net Exports Output
Output
This equation shows that in an open economy, domestic spending need
not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
falls short of domestic spending, we import the difference: net exports
are negative.
180. Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.
Let’s call this S, national saving.
So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX
Trade Balance
Net Foreign Investment
181. Net Capital
Outflow = Trade
S-I=NX
Balance
If S-I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing.
If S-I and NX are negative, we have a trade deficit. We would be net
borrowers in world financial markets, and we are importing more
goods than we are exporting.
If S-I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports.
182. We are now going to develop a model of the
international flows of capital and goods. Then, we’ll
address issues such as how the trade balance responds to
changes in policy.
183. Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on saving
and investment. We’ll borrow a part of the model from Chapter 3, but
won’t assume that the real interest rate equilibrates saving and
investment. Instead, we’ll allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend
to other countries.
Consider a small open economy with perfect capital mobility in
which it takes the world interest rate r* as given, denoted r = r*.
Remember in a closed economy, what determines the interest rate is the
equilibrium of domestic saving and investment--and in a way, the world
is like a closed economy-- therefore the equilibrium of world saving and
world investment determines the world interest rate.
184. Y = Y = F(K,L) The economy’s output Y is fixed by the
factors of production and the production
function.
C = C (Y-T) Consumption is positively related to
disposable income (Y-T).
I = I (r) Investment is negatively related to the
real interest rate.
NX = (Y-C-G) - I The national income accounts identity,
or NX = S - I expressed in terms of saving and investment.
Now substitute our three assumptions from Chapter 3 and the condition
that the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.
185. Real
interest S In a closed economy, r adjusts to
rate, r* equilibrate saving and investment.
NX
In a small open economy, the
r* interest rate is set by world
financial markets. The difference
between saving and investment
rclosed determines the trade balance.
r*' I(r)
NX
Investment, Saving, I, S
In this case, since r* is above rclosed and saving exceeds investment,
there is a trade surplus.
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.
186. An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.
Real
interest S' S
NX = (Y-C(Y-T) - G) - I (r*)
rate, r*
NX = S - I (r*)
The result is a reduction in national
saving which leads to a trade deficit,
r* where I > S.
NX I(r)
Investment, Saving, I, S
187. A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
Real
interest S
rate, r*
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
r2*
where S > I.
r1 * NX
I(r)
Investment, Saving, I, S
188. An outward shift in the investment schedule from I(r)1 to I(r)2 increases
the amount of investment at the world interest rate r*.
As a result, investment now
Real exceeds saving I > S, which
interest S means the economy is
rate, r* borrowing from abroad and
running a trade deficit.
r1 *
I(r)2
NX I(r)1
Investment, Saving, I, S
189. In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!
190. Let’s think about when the US and Japan engage in trade. Each country
has different cultures, languages, and currencies, all of which could
hinder trade. But, because of the foreign exchange market, trade
transactions become more efficient. The foreign exchange market is a
global market in which banks are connected through high-tech
telecommunications systems in order to purchase currencies for their
customers.
The next slide is a graphical representation of the flow of the trade
between the U.S. and Japan, and how the mix of traded things might be
different, but is always balanced. Also, notice how the foreign exchange
market will play the middle-man in these transactions. For instance, the
foreign exchange market converts the supply of dollars from the U.S.
into the demand for yen, and conversely, the supply of yen into the
demand for dollars.
191. In order for the U.S to pay for its imports of
goods and services and securities from Japan,
it must supply dollars which are then converted
into yen by the
VICES foreign
& SER
&
Securities
OOD S exchange
G
market.
DemandYEN Supply$
Foreign
Foreign
Exchange
Exchange
Market
Market
SupplyYEN Demand$
Goods and
Services S
& SECURITIE
In order for Japan to pay for its imports of
goods and services and securities from the
U.S., it must supply yen which are then converted
into dollars by the foreign exchange market.
192. The exchange rate between two countries is the price at which
residents of those countries trade with each other.
193. -relative price of the currency of two countries
-denoted as e
-relative price of the goods of two countries
-sometimes called the terms of trade
-denoted as ε
194. The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.
195. Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?
e S$ D$ shifts rightward and increases
the nominal exchange rate, e.
e1 This is known as appreciation
B
A of the dollar.
e0
Events which decrease the
demand for the dollar, and thus
D ′ decrease e would be a
$
D$ depreciation of the dollar.
$
Dollar Value of Transactions
196. ε
The real exchange rate is the relative price of the goods of two
countries. That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.
To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange 2
American cars for 1 Japanese car.
197. ε
We can summarize our calculation as follows:
Real Exchange Rate = (120 yen/dollar) × (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 Japanese Car
American Car
At these prices, and this exchange rate, we obtain one-half of a Japanese
car per American car. More generally, we can write this calculation as
Real Exchange Rate =
Nominal Exchange Rate × Price of Domestic Good
Price of Foreign Good
The rate at which we exchange foreign and domestic goods depends on
the prices of the goods in the local currencies and on the rate at which
the currencies are exchanged.
198. Nominal
Real Exchange Exchange Ratio of Price
Rate Rate Levels
ε = e × (P/P*)
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).
199. Real Exchange Nominal Exchange Ratio of Price
Rate Rate Levels
ε = e × (P/P*)
The real exchange rate between two countries is computed from the
nominal exchange rate and the price levels in the two countries. If the
real exchange rate is high, foreign goods are relatively cheap, and
domestic goods are relatively expensive. If the real exchange rate is
low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.
200. How does the level of prices effect exchange rates? It doesn’t. All
changes in a nation’s price level will be fully incorporated into the
nominal exchange rate. It is the law of one price applied to the
international marketplace.
Purchasing Power Parity suggests that nominal exchange rate
movements primarily reflect differences in price levels of nations. It
states that if international arbitrage is possible, then a dollar must
have the same purchasing power in every country. Purchasing
Power Parity does not always hold because some goods are not
easily traded, and sometimes traded goods are not always perfect
substitutes– but it does give us reason to expect that fluctuations in
the real exchange rate will be small and short-lived.
201. Real The law of one price applied to the
exchange S-I international marketplace suggests that
rate, ε net exports are highly sensitive to small
movements in the real exchange rate.
This high sensitivity is reflected here
with a very flat net-exports schedule.
NX(ε)
Net Exports, NX
202. The relationship between the real exchange rate
and net exports is negative: the lower the real
Real S-I exchange rate, the less expensive are domestic
exchange goods relative to foreign goods, and thus the
rate, ε greater are our net exports.
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
Here the quantity of dollars
NX(ε) supplied for net foreign
investment equals the
0 Net Exports, NX
quantity of dollars demanded
for the net exports of goods
and services.
