Lectures Macroeconomics PDF

**[LECTURES MACROECONOMICS]** ========================================= [[LECTURES MACROECONOMICS] 1](#lectures-macroeconomics) [[CHAPTER 1- THE SCIENCE OF MACROECONOMICS] 2](#section) [[CHAPTER 2] 5](#section-4) [[CHAPTER 3- THE NATIONAL INCOME] 8](#chapter-3--the-national-income) [[CHAPTER 4-...

**[LECTURES MACROECONOMICS]** ========================================= [[LECTURES MACROECONOMICS] 1](#lectures-macroeconomics) [[CHAPTER 1- THE SCIENCE OF MACROECONOMICS] 2](#section) [[CHAPTER 2] 5](#section-4) [[CHAPTER 3- THE NATIONAL INCOME] 8](#chapter-3--the-national-income) [[CHAPTER 4- THE MONETARY SYSTEM] 21](#chapter-4--the-monetary-system) [[CHAPTER 5- INFLATION-causes, effects and social costs] 27](#section-5) [[CHAPTER 6- THE OPEN ECONOMY] 38](#chapter-6--the-open-economy) [[CHAPTER 7- UNEMPLOYMENT + AGGREGATE SUPPLY] 53](#section-6) [[CHAPTER 8- ECONOMIC GROWTH I] 55](#chapter-8--economic-growth-i) [[CHAPTER 9 AND 10- ECONOMIC GROWTH II] 66](#chapter-9-and-10--economic-growth-ii) [[CHAPTER 9-POPULATION GROWTH AND TECHNOLOGICAL PROGRESS] 66](#chapter-9-population-growth-and-technological-progress) [[CHAPTER 10-GROWTH EMPIRICS AND POLICY] 71](#section-8) [[CHAPTER 11- INTRODUCTION TO ECONOMIC FLUCTUATIONS] 74](#chapter-11--introduction-to-economic-fluctuations) [[CHAPTER 12- AGGREGATE DEMAND I:BUILDING THE IS-LM MODEL] 77](#section-10) [[CHAPTER 13- AGGREGATE DEMAND II:APPLYING THE IS-LM MODEL] 91](#section-13) [[CHAPTER 14- THE OPEN ECONOMY REVISITED: The Mundell-Fleming Model and the Exchange-Rate Regime] 100](#section-14) [[CHAPTER 15- AGGREGATE SUPPLY and the short run trade-off between inflation and unemployment] 118](#section-16) [[CHAPTER 17- STABILIZATION POLICY] 135](#chapter-17--stabilization-policy) [[CHAPTER 18- GOVERNMENT DEBT AND BUDGET DEFICITS] 140](#section-18) [CHAPTER 1- THE SCIENCE OF MACROECONOMICS] ------------------------------------------------------ **ECONOMIC MODELS** -...are simplified versions of a complex,economic reality - irrelevant details are stripped away **MACROECONOMICS** is the study of the economy as a whole, including - growth in incomes - changes in the overall level of prices - the unemployment rate **EXAMPLE OF A MODEL: THE SUPPLY & DEMAND FOR NEW CARS** - explains the factors that determine the price of cars and the quantity sold. - assumes the market is **competitive**: each buyer and seller is too **small** to affect the market price - Variables: ***Q^d^*** = quantity of cars that buyers demand ***Q^s^*** = quantity that producers supply ***P*** = price of new cars ***Y*** = aggregate income ***P~s~*** = price of steel (an input) **THE MARKET FOR CARS: DEMAND** Demand equation: ***Q^d^* = D (P,Y)** Demand curve: shows the relationship between quantity demanded and price, other things equal. Diagrama Descripción generada automáticamente con confianza media **THE MARKET FOR CARS: SUPPLY** Supply equation: ***Q^s^* =S (P, *P~s~*)** Supply curve: shows the relationship between quantity supplied and price, other things equal.  **MARKET FOR CARS: EQUILIBRIUM** Diagrama Descripción generada automáticamente **THE EFFECTS OF AN INCREASE IN INCOME**  **THE EFFECTS OF A STEEL PRICE INCREASE** Diagrama Descripción generada automáticamente **ENDOGENOUS VS EXOGENOUS VARIABLES** - The values of **endogenous** **variables** are determined in the model. - The values of **exogenous** **variables** are determined outside the model: The model takes their values and behaviors as given. In the model of supply and demand for cars, - endogenous variables: ***P***, ***Q^d^***, ***Q^s^*** - exogenous variables: ***Y***, ***P~s~***  **THE USE OF MULTIPLE MODELS I** - No one model can address all the issues we care about. Different models explain different aspects of the economy. Diagrama, Dibujo de ingeniería Descripción generada automáticamente **PRICES: FLEXIBLE VS STICKY** - *Market clearing*: an assumption that [prices are flexible] and adjust to equate supply and demand. - [Flexible Prices:] Adjust quickly to equate supply and demand (long-run behavior). - [Sticky Prices]: fixed however they adjust only slowly in response to supply/demand imbalances (ex. Contract for your fitness club). Then demand won't always equal supply (short-run behavior). This helps explain unemployment (excess supply of labour). [CHAPTER 2] ----------------------- **GROSS DOMESTIC PRODUCT(GDP)** - Two definitions: - Total expenditure on domestically-produced final goods and services - Total income earned by domestically-located factors of production EXAMPLE: GDP only includes goods and services **produced domestically**. So, when you buy a product in the USA, produced in the USA, it adds to the **US GDP**. If you purchased the laptop in Germany and it was produced in the USA. This means the **sale of the laptop increases the US GDP** through exports, while it **does not increase Germany\'s GDP** because the product was imported into Germany. [THE CIRCULAR FLOW] - GDP represents total: - Income earned. - Expenditure made. - Value added.  **[FINAL GOODS, VALUE ADDED, AND GDP ]** GDP = value of final goods and services produced within a country (already includes the value of the intermediate goods) = sum of value added at all stages of production Value Added= Value of Output -Value of Inputs (Cost of Purchases from other firms) **EXAMPLE: Work on this problem!** - A farmer grows a kilo of wheat and sells it to a miller for €1.00. - The miller turns the wheat into flour and sells it to a baker for €3.00. - The baker uses the flour to make a loaf of bread and sells it to an engineer for €6.00. - The engineer eats the bread. ANSWER: Tabla Descripción generada automáticamente Total GDP = sum of value added= €6 (final good price). **[THE EXPENDITURE COMPONENTS OF GDP ]** C: Consumption (e.g., durable goods, non-durable goods, services). I: Investment (e.g., business, residential, inventory investment). G: Government spending NX: Net exports (Exports - Imports). Important identity: Y=C+I+G+NX Y: value of total output C+I+G+NX: aggregate expenditure **Trade Surplus/Deficit**: Net exports (NX) \> 0 = Surplus; NX \< 0 = Deficit. **EXPENDITURE OUTPUT PUZZLE** Suppose a firm - produces €10 million worth of final goods - but only sells €9 million worth. Does this violate the **expenditure = output** identity? The identity is **Y = C + I + G + NX**, where **Y** is the value of total output and [the right-hand side is the total expenditure.] No, this does **not** violate the expenditure = output identity. - **Y (output)** =\>€10 million (total value of the goods produced). - The €9 million in goods sold =\> **C (Consumption)** - The **€1 million** worth of goods that are unsold is still part of the firm's output =\> **I ([Inventory Investment)]**[.] - **Expenditure (C + I + G + NX)** equals €10 million, because €9 million is sold and €1 million goes into [**inventory investment**.] [Conclusion:] The identity **Y = C + I + G + NX** holds true.(10=9+1) Both output and expenditure still match. **GNP VS GDP** Gross **National** Product (GNP):\ is the total income earned by a country\'s **nationals** (factors of production owned by its citizens) **[regardless of where they are located]** in the world. **Example**: If you are a citizen of France but working in the United States, your income would count toward **France's GNP** (because you are French) but not toward France\'s GDP (since you are not working within France) Gross **Domestic** Product (GDP):\ is the total income earned by all **factors of production within the country\'s borders**, **regardless of nationality**. This means GDP measures all the production within a country, whether by citizens or foreign workers. **Example**: If a French citizen is working in the USA, their income contributes to **US GDP** (since they are working in the USA), but it doesn\'t count towards **US GNP** (since they are not a US national). (GNP -- GDP) = (factor payments from abroad) -- (factor payments to abroad) Examples of factor payments: wages, profits, rent, interest & dividends on assets **REAL VS NOMINAL GDP** - GDP is the [value] of all final goods and services produced. - **Nominal GDP** measures these values using current prices. - **Real GDP** measure these values using the [prices of a base year.] **GDP DEFLATOR** One measure of the price level is the **GDP Deflator**, defined as  shows how much of GDP growth is due to changes in prices rather than output. It is used to measure inflation and track price changes over time **HARMONIZED INDICES OF CONSUMER PRICES (HICPs)** a measure of the overall level of prices across different goods and services in the Eurozone **How HICPs Are Computed:** 1. **Survey Consumers:** Identify the typical basket of goods and services. 2. **Monthly Data Collection:** Record prices of items in the basket. 3. **Calculate CPI in any month:** Imagen que contiene Texto Descripción generada automáticamente **CPI vs. GDP Deflator** - **CPI** focuses on the **average consumer\'s** perspective by tracking the cost of living. - **GDP Deflator** gives a broader measure of **overall inflation** for all goods and services produced domestically, relevant to the entire economy. **CPI:** - Fixed basket of goods (consumer focus). - Includes imported goods. - Excludes capital goods. **GDP Deflator**: - All domestically-produced goods. - Excludes imports. - Basket changes annually. **UNEMPLOYMENT RATE** **Categories of the population** - **employed** - working at a paid job - **unemployed** - not employed but looking for a job - **labour force** - the amount of labour available for producing goods and services; all employed + unemployed persons - **not in the labour force** - not employed, not looking for work. **Two important labour force concepts** - ***unemployment rate -*** % of the labour force that is unemployed - ***labour force participation rate -*** % of the adult population that 'participates' in the labour force [CHAPTER 3- THE NATIONAL INCOME] -------------------------------------------- **OUTLINE OF THE MODEL** - *A closed economy, market-clearing model* Supply side - factor markets (supply, demand, price) - determination of output/income Demand side - determinants of ***C***, ***I***, and ***G*** Equilibrium - goods market - loanable funds market **[SUPPLY SIDE ]** **THE PRODUCTION FUNCTION-** denoted ***Y*** = ***F*** (***K***, ***L***) - shows how much output (***Y*** ) the economy can produce from ***K*** units of capital and ***L*** units of labour. - reflects the economy's level of technology- how effectively capital and labor can be combined to produce output. - exhibits ***constant returns to scale*** (by assumption): doubling inputs doubles output **RETURNS TO SCALE** **Returns to scale** to describe [what happens to the amount of output in response to a proportional increase or decrease in all of the inputs. ] **Constant Returns to Scale**: If you double (or triple) both inputs (capital K and labor L), the output also doubles (or triples). The output grows **proportionally** to the inputs. **Increasing Returns to Scale**: If you double the inputs, the output more than doubles. The output grows **more** than the inputs. **Decreasing Returns to Scale**: If you double the inputs, the output increases, but by **less** than double. The output grows **less** than the inputs. **RETURNS TO SCALE: A REVIEW** - Initially ***Y~1~*** = ***F*** (***K~1~*** , ***L~1~*** ) - Scale all inputs by the same factor ***z**:* - ***K~2~*** = ***zK~1~*** and ***L~2~*** = ***zL~1~*** - (If ***z*** = 2, then all inputs are doubled, i.e., increased by 100%) - What happens to output, ***Y~2~*** = ***F*** (***K~2~*** , ***L~2~*** ) ? - If *constant returns to scale*, ***Y~2~*** = ***zY~1~*** - If *increasing returns to scale*, ***Y~2~*** \> ***zY~1~*** - If *decreasing returns to scale*, ***Y~2~*** \< ***zY~1~***  ### **F(K,L)=KL​** **Step 1:** Let's scale K and L by a factor of z, which means we multiply both K and L by z. So, we calculate F(zK,zL)=[\$\\sqrt{(zK)(zL)}\$]{.math.inline} **Step 2:** Multiply the inputs inside the square root: F(zK,zL)=​[\$\\sqrt{z\^{2}\\text{KL}}\$]{.math.inline} **Step 3:** The square root of [*z*^2^]{.math.inline} is just z. So, F(zK,zL)= ​z[\$\\sqrt{\\text{KL}}\$]{.math.inline} This is the same as z×F(K,L) **Conclusion:** The output scales exactly like the inputs. So, this function has **constant returns to scale**. **F(K,L)=**[**K**^**2**^]{.math.inline}**+**[**L**^**2**^]{.math.inline} **Step 1:** Scale K and L by z, meaning we multiply both K and L by z. So, we calculate F(zK,zL)= [(*zK*)^2^ + (*zL*)^2^]{.math.inline} **Step 2:** Square the inputs: F(zK,zL)= [(*z*^2^*K*)^2^ + (*z*^2^*L*)^2^]{.math.inline} **Step 3:** Factor out the z\^2: F(zK,zL)= [*z*^2^(*K*^2^ + *L*^2^)]{.math.inline} F(zK,zL)= [*z*^2^*F*]{.math.inline}*(K,L)* **Conclusion:** The output grows by z\^2, which is **more** than z. So, this function has **increasing returns to scale**. ### **. F(K,L)=**[\$\\frac{\\mathbf{K}\^{\\mathbf{2}}}{\\mathbf{L}}\$]{.math.inline} **Step 1:** Scale K and L by z, so we multiply both K and L by z. So, we calculate F(zK,zL)=[\$\\frac{{(zK)}\^{2}}{\\text{zL}}\$]{.math.inline} **Step 2:** Square the zK in the numerator: F(zK,zL)= [\$\\frac{{z\^{2}K}\^{2}}{\\text{zL}}\$]{.math.inline} **Step 3:** Simplify the fraction by canceling one z: F(zK,zL)=z×[\$\\frac{K\^{2}}{L}\$]{.math.inline} F(zK,zL)=zF(K,L) **Conclusion:** The output scales exactly like the inputs, meaning **constant returns to scale**. **ASSUMPTIONS OF THE MODEL** - Technology is fixed- no technological progress in the model - Constant returns to scale. - The economy's supplies of [capital and labour are fixed] at: **DETERMINING GDP** - Aggregate supply (GDP) is determined by the fixed factor supplies and the fixed state of technology(A):  - e.g. with [\$\\overline{K}\$]{.math.inline}=2500, [\$\\overline{L}\$]{.math.inline}=300 and Y=[*K*^0.6^*L*^0.4^]{.math.inline} we have [\$\\overline{Y} \\approx 1070.56\$]{.math.inline} - \- e.g. with A=1.8, [\$\\overline{K}\$]{.math.inline}=2500, [\$\\overline{L}\$]{.math.inline}=300 and Y=[AK^0.6^*L*^0.4^]{.math.inline} we have [\$\\overline{Y} \\approx 1927\$]{.math.inline} **THE DISTRIBUTION OF NATIONAL INCOME** - determined by **factor prices**- the prices per unit that firms pay for the factors of production. - The **wage** (**W**) is the price of ***L*** and the **rental rate** (**R**) is the price of ***K*** - Remark: - W/P denotes the real wage rate (also called: real wage) - R/P denotes the real rental rate (also called: real rental price of capital, real rental wage) - [Both measured in units of output] **DEMAND FOR LABOUR** - Assume markets are competitive: each firm takes ***W***, ***R***, and ***P*** as given - Basic idea:\ A firm hires each unit of labour if [the cost does not exceed the benefit.] - cost = real wage that is paid - benefit = ***marginal product of labour (MPL)*** Note: [Given the assumptions, MPL declines in L] MPL refers to the additional output produced by one more unit of labor, and it often declines as the number of laborers (L) increases due to the **law of diminishing marginal returns**. As labor inputs increase, each additional worker typically contributes less to total output, assuming other inputs (like capital) are fixed. Gráfico, Gráfico de líneas Descripción generada automáticamente EXERCISE: - Which of these production functions have diminishing marginal returns to labor?- **NOTAS ADICIONALES-important** **THE EQUILIBRIUM REAL WAGE** is the [wage rate adjusted for inflation that equates the supply and demand for labor in the economy]. It represents the wage workers receive in terms of the goods and services they can purchase, rather than the nominal wage, which is just the monetary amount paid without adjusting for the price level. The equilibrium real wage occurs where the [**demand for labor** equals the **supply of labor**]: **LD=LS** **Labor Demand Curve (LD)**: This is typically derived from the **marginal product of labor (MPL)**  **DEMAND FOR LABOUR:** - Profits ([*π*]{.math.inline}) of a firm hiring labour and capital: - [*π* = *P* \* *Y* − *W* \* *L* − *R* \* *K*]{.math.inline} - [*P* \* *Y*:]{.math.inline} revenues - [*W* \* *L*]{.math.inline}: (nominal) labour costs - [*R* \* *K*]{.math.inline}: (nominal) capital costs - The optimal demand for labor is given where the partial derivative with respect to labor is equal to zero: - [\$\\frac{\\partial\\pi}{\\partial L} = 0\\ \\ \\leftrightarrow \\ P\*\\frac{\\partial Y}{\\partial L} - W = 0\$]{.math.inline} - [\$\\frac{\\partial Y}{\\partial L}:\$]{.math.inline} MPL, additional output from hiring additional worker - [*W***P*** - The same logic shows that ***MPK*** = ***R****P***. (That is, compute the partial derivative of the profit function with respect to K.) SUMMARY: For **labor**, the benefit is **MPL** and the cost is the **real wage (W/P)**. For **capital**, the benefit is **MPK** and the cost is the **real rental rate (R/P)**. They keep hiring or renting until the **benefit = the cost**. **THE EQUILIBRIUM REAL RENTAL WAGE** The **equilibrium real rental wage** (or **equilibrium real rental rate**) is the price that firms pay to use capital, such as machinery or buildings, when markets are in equilibrium. In general, the equilibrium real rental rate of capital is equal to the **marginal product of capital (MPK)**. Gráfico Descripción generada automáticamente con confianza media Here\'s a breakdown of how to determine the **equilibrium real rental rate** in economic models, often using the **Cobb-Douglas production function**. ### 1. **Cobb-Douglas Production Function**: A common production function used in economics to represent output (Y) as a function of capital (K) and labor (L) is the **Cobb-Douglas production function**:  - where ***A*** represents the level of technology. - The Cobb-Douglas production function has constant factor shares: - ***α*** = capital's share of total income: - capital income = ***MPK*** × ***K*** = ***α*** ***Y*** - labor income = ***MPL*** × ***L*** = (1 -- ***α*** )***Y*** Texto, Carta Descripción generada automáticamente *Note: derivas con respecto a L en la primera y con respecto a K en la segunda.* **Exercise - the real wage and the real rental price of capital-Notas Adicionales** **[SUMMARY:]** Real wage(W/P)= MPL Real rental wage(R/P)=MPK **↑**labor=\> MPL **↓** so real wage **↓** With cobb douglas production= ↑labor=\> MPK ↑ and real rental wage ↑ ↓labor=\> MPL ↑ and real wage ↑ With cobb douglas production= ↓labor= MPK ↓ so real rental wage ↓ **↑**capital=\> MPK **↓** so real rental wage **↓** With cobb douglas production= ↑capital=\> MPL ↑ and real wage ↑ ↓capital=\> MPK ↑ and real rental wage ↑ With cobb douglas production= ↓capital= MPL ↓ so real wage ↓ If something improves production function, like technological improvements= =likely MPK ↑ and MPL ↑ and real wage ↑ and real rental wage ↑ When example (high inflation)= Doubling prices and nominal wages/rentals = **no effect on real wages or real rental rates** **[DEMAND SIDE: ]** DEMANDS FOR GOODS AND SERVICES: - Components of **aggregate demand:** - ***C*** = consumer demand for goods and services consumption items like food, clothing, and housing. - ***I*** = demand for investment goods such as machinery, buildings, and equipment. - ***G*** = government demand for goods and services. It includes all government expenditures on public services, infrastructure, defense, etc. - (**in closed economy**: there are no international transactions, so **net exports (NX)** are excluded: no ***NX***) **Aggregate demand equation** in a [closed economy] is: - AD=C+I+G **[CONSUMPTION (C)]** def: **disposable income** is total income - total taxes: ***Y*** -- ***T*** it represents the income available to households after paying taxes, which they can either spend (consume) or save. - Consumption function: ***C*** = ***C*** (***Y*** -- ***T*** ) [how much people consume depends on how much disposable income they have.] Assume that ↑(***Y*** -- ***T*** ) ⇒ ↑***C*** - if disposable income **increases**, consumption C will also **increase**. def: The **marginal propensity to consume** is the increase in ***C*** caused by a one-unit increase in disposable income. Formula: **ΔC=MPC×Δ(Y−T)** Example: - If a household receives an additional unit of income, the MPC tells us how much of that extra income will be spent on consumption. The rest would typically be saved. - For example, if the MPC is 0.8, this means that for every extra dollar of income, 80 cents will be spent on consumption  **High MPC**=close to 1: people spend most of their income (high consumption) **Low MPC**=close to 0: people save more of their income (low consumption) Reality, **MPC somewhere between 0 and 1** **[INVESTMENT (I)]** - The investment function is ***I*** = ***I*** (***r*** ), where [***r*** denotes the real interest rate] that is the **nominal interest rate** adjusted for **inflation**. This rate reflects the **true cost** of borrowing money or the **true return** on savings after accounting for inflation. - The real interest rate is:\ - the cost of borrowing\ - the opportunity cost of using one's own funds to finance investment spending rather than saving it to earn interest elsewhere When the **real interest rate (r) rises**, the **cost of borrowing increases** or the opportunity cost of using one\'s own funds becomes higher. As a result, **investment decreases** because borrowing becomes more expensive or firms prefer to save rather than spend on capital projects So, **↑*r*** **⇒ ↓*I*** Imagen que contiene Diagrama de Venn Descripción generada automáticamente **[GOVERNMENT SPENDING (G)]** - ***G*** includes government spending on goods and services. - ***G*** [excludes *transfer payments*] (like pensions, unemployment benefits, and social security payments)= included in **T** **[TOTAL TAXES (T)=]** taxes - transfer payments. This is the amount of revenue the government [collects after distributing transfer payments] (such as welfare benefits or social security) Assume government spending and total taxes are exogenous: meaning they are **determined outside the model** and **not influenced by other variables** in the economy, such as income or interest rates Since they're exogenous, **G and T are not influenced by changes in income, output, or interest rates**. Instead, they are based on policy decisions by the government.  **[EQUILIBRIUM ]** **THE MARKET FOR GOODS AND SERVICES** Texto, Carta Descripción generada automáticamente **THE LOANABLE FUNDS MARKET** - A simple supply-demand model of the financial system. - One asset: "loanable funds" - demand for funds: investment - supply of funds: saving - "price" of funds: real interest rate - The demand for loanable funds: - [comes from investment]:\ Firms borrow to finance spending on plant and equipment, new office buildings, etc. Consumers borrow to buy new houses. - [depends negatively on ***r (real interest rate)***]:\ ***r*** is the "price" of loanable funds (cost of borrowing). - The supply(dar) of loanable funds comes from saving: - Households use their saving to make bank deposits and purchase bonds and other assets. These funds become available to firms to borrow and finance investment spending. - The government may also contribute to saving if it does not spend all the tax revenue it receives. **TYPES OF SAVING** - **private saving**= (***Y*** --***T*** ) -- ***C*** - **public saving** = ***T*** -- ***G*** - **national saving**=**S** NATIONAL SAVING= private saving + public saving S = (***Y*** --***T*** ) -- ***C*** + ***T*** -- ***G*** S = ***Y*** -- ***C*** -- ***G*** **Budget surpluses and deficits** ** ** When T \> G , budget surplus = (T -- G ) = public saving When T \< G , budget deficit = (G --T ) and public saving is negative When T = G , budget is balanced and public saving = 0 **LOANABLE FUNDS SUPPLY CURVE** [National saving does not depend on **r (real interest rate)**] so the supply curve is vertical  **LOANABLE FUNDS MARKET EQUILIBRIUM** Diagrama Descripción generada automáticamente **THE SPECIAL ROLE OF r** - In the **loanable funds market**, the **supply of funds** comes from **savings (S)**, and the **demand for funds** comes from **investment (I(r)**. - **Equilibrium in the loanable funds market** is when the amount of funds saved = the amount of funds borrowed for investment: Savings=Investment - **Equilibrium in the good market**= supply=demand - The **real interest rate** (r) is the \"price\" of borrowing money. If [r increases], borrowing costs go up, so [**investment** (I) decreases]. Conversely, if r decreases, investment increases. - *r* adjusts to equilibrate the goods market [and] the loanable funds market simultaneously. - Add (*C* +*G* ) to both sides to get - *Y* = *C* + *I* + *G* *(goods market eq'm)* - **Savings (S)**: Total saving in this model is given by S=Y−C−G, where it's assumed that saving is **not affected by r**. So, S is based on income, consumption, and government spending. - **Investment (I)**: Investment **depends negatively on r**. A higher r decreases investment (since borrowing is more costly), while a lower r increases investment. Since **investment** I depends negatively on r, as investment is a component of the total demand, then any changes in the real interest rate affect both the loanable funds market and the goods market simultaneously. **[Equilibrium Connection:] If the loanable funds market is in equilibrium (where S=I), then the goods market will also be in equilibrium because the demand for goods (which includes I) matches the supply. Both at the same real interest rate**  ***Remark: Mastering models*** - *To learn a model well, be sure to know:* - *Which of its variables are endogenous and which are exogenous.* - *For each curve in the diagram, know* - *definition* - *intuition for slope* - *all the things that can shift the curve* - *Use the model to analyse the effects of changes in exogenous variables on endogenous variables.* **MASTERING THE LOANABLE FUNDS MODEL** - Things that shift the **saving** curve a. [public saving ] i. **fiscal policy:** changes in *G* or *T* b. [private saving] ii. preferences iii. tax laws that affect saving - e.g. replace income tax with consumption tax **THE EFFECTS OF FISCAL POLICY (G VS T)** - Equilibrium loanable market: Y= C(Y-T) + I(r) + G. - An **increase in Government spending (G)** (which reduces Savings) must **reduce I** such that Eq is still valid. Remember that Y (total output) is exogenous! **Crowding out** occurs when [increased government spending (**G**) leads to a reduction in private investment (**I**)] because it\'s now more costly for businesses to take out loans for new investments. Diagrama Descripción generada automáticamente **A Reduction in Saving** A reduction in saving, possibly the result of a change in **fiscal policy**, shifts the saving schedule to the left. The new equilibrium is the point at which the new saving schedule crosses the investment schedule. A reduction in saving lowers the amount of investment and raises the interest rate. Fiscal-policy actions that reduce saving are said to **crowd out investment**. **IMPACT OF AN INCREASE IN** [\$\\overline{\\mathbf{L}}\$]{.math.inline}**?**  **MASTERING THE LOANABLE FUNDS MARKET:** - Things that shift the **investment** curve: a. certain technological innovations - to take advantage of the innovation, firms must buy new investment goods b. tax laws that affect investment - investment tax credit **INCREASE IN INVESTMENT DEMAND** Gráfico, Gráfico de líneas Descripción generada automáticamente An increase in the demand for investment goods shifts the investment schedule to the right. At any given interest rate, the amount of investment is greater. The equilibrium moves from point A to point B. Because the amount of [saving is fixed,] the increase in investment demand raises the interest rate while leaving the equilibrium amount of investment unchanged. **[KEY MODIFICATION=\> allowing consumption and saving to depend on the interest rate:]** **[INCREASE IN INVESTMENT DEMAND] WHEN SAVING DEPENDS ON THE INTEREST RATE**  When [saving is positively related to the interest rate,] **Higher interest rates** lead to both an **increase in saving** (because saving is more rewarding) and a **decrease in consumption** (because the cost of consuming today increases). **The increased saving** leads to a [higher equilibrium interest rate and a higher level of investment. (rightward shift)] Now, different from before, the [**saving curve** would be upward sloping], meaning that as the interest rate rises, saving increases. [CHAPTER 4- THE MONETARY SYSTEM] -------------------------------------------- **MONEY**: stock of assets that can be readily used to make transactions MONEY FUNCTIONS 1. **medium of exchange**\ *we use it to buy stuff* 2. **store of value**\ *transfers purchasing power from the present to the future* 3. **unit of account**\ *the common unit by which everyone measures prices and values* MONEY TYPES 1. **Fiat money** - *[has no intrinsic(essential) value ]* - *established as money by the government* - *example: the paper currency we use* - its value doesn\'t come from the material it\'s made from, but from the trust and authority of the government that issues it. 2. **Commodity money** - *has intrinsic value* - *examples: gold coins, cigarettes in P.O.W. camps (see the case study in the book on page 99f.)* - intrinsic value because they are valuable in themselves **Bitcoin** is a type of money that exists only in electronic form. Created in 2009 by anonymous computer experts, [bitcoin is not commodity money], since it has no intrinsic value, [nor fiat money,] since it is not issued by government action. It is a [medium of exchange] that relies on people's accepting it in exchange. Although bitcoin is a medium of exchange, the volatility in its dollar price makes it a poor store of value and an inconvenient unit of account. Hence, whether it becomes the money of the future or a short-lived speculative fad remains to be seen. **MONEY SUPPLY AND MENTARY POLICY** - The **money supply** is the quantity of money available in the economy. - **Monetary policy** is the [control over the money supply]. **CENTRAL BANK** - Monetary policy is [conducted by a country's central bank.] - The primary way in which a central bank controls the supply of money is through open-market operations. **MONEY SUPPLY MEASURES IN THE EURZONE** Gráfico, Gráfico de líneas Descripción generada automáticamente M1: sum of currency in circulation and overnight deposits M2: sum of M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months M3:the sum of M2, repurchase agreements, money market fund shares/units and dept securities with a maturity of up to two years. **BANKS ROLE IN THE MONETARY SYSTEM** - The **money supply** equals currency plus demand deposits: ***M*** = ***C*** + ***D*** - Since the money supply includes demand deposits, the banking system plays an important role. **Currency**: - This refers to the physical money that circulates in an economy, including **coins** and **paper bills** (cash). It\'s the form of money that people use for everyday transactions, such as buying goods or services. - Currency is usually issued by a country\'s central bank (like the Federal Reserve in the U.S.) and is considered **legal tender**. Legal tender=moneda de curso legal (dinero que tiene respaldo legal) **Demand Deposits**: - These are funds held in **bank accounts** that can be withdrawn at any time, such as **checking accounts**. The term \"demand\" means that these deposits are available \"on demand\" for account holders, without any restrictions. - Demand deposits [do not earn interest], or earn very little interest, [but they offer high liquidity], meaning the account holder can access them whenever needed (e.g., using a debit card, writing a check, or making a bank transfer). *Checking accounts= type of bank account designed for everyday financial transactions. It allows you to deposit money, withdraw cash, and make payments easily using various methods, such as checks, debit cards, or electronic transfers.* **FEW PRELIMINARIES** - **Reserves** (***R*** ): the deposits that banks have not lent out. They keep rather than loaning them out or investing them. - A bank's liabilities include deposits; assets include reserves and outstanding loans. - **100-percent-reserve banking**: a system in which banks hold all deposits as reserves. - **Fractional-reserve banking**: a system in which banks hold a fraction of their deposits as reserves. **BANKS ROLE IN THE MONETARY SYSTEM** - To understand the role of banks, we will consider three scenarios: **1.** No banks **2.** 100-percent-reserve banking\ (banks hold [all deposits as reserves]) **3.** Fractional-reserve banking\ (banks hold a fraction of deposits as reserves, [use the rest to make loans)] - In each scenario, we assume ***C*** = €1,000. SCENARIO 1: - With no banks,\ ***D*** = 0 and ***M*** = ***C*** = \$1,000. SCENARIO 2: *The only difference from scenario 1: Instead of having it as currency we put it in the bank account.* - Now suppose households deposit the 1,000 at "First European Bank." - After the deposit:\ ***C*** = 0,\ ***D*** = 1,000,\ ***M*** = 1,000 - ***LESSON**:\ *100%-reserve banking has no impact on size of money supply.  SCENARIO 3: - Suppose banks hold 20% of deposits in reserve, making loans with the rest 80% - First European Bank will make 800 in loans (80%\*1000) The money supply now equals 1,800: - Depositor has 1,000 in demand deposits. - Borrower holds 800 in currency. Tabla Descripción generada automáticamente  - Suppose the borrower deposits the 800 in Second European Bank. - Initially, Second European Bank's balance sheet is: Tabla Descripción generada automáticamente - If this 640 is eventually deposited in Third European bank, - then Third European Bank will keep 20% of it in reserve and loan the rest out:  FINDING THE TOTAL AMOUNT OF MONEY: - Original deposit = 1000 - \+ First European bank lending = 800 - \+ Second European bank lending = 640 - \+ Third European bank lending = 512 - \+ other lending... - Total money supply = (1***D*** *depends on regulations & bank policies* - **Currency-deposit ratio**, ***cr*** = ***C****Y*** depends on growth in the factors of production and on technological progress (all of which we take as given, for now). - Hence, the Quantity Theory of Money predicts a one-for-one relation between changes in the money growth rate and changes in the inflation rate. Note: The theory [doesn't predict] that the [inflation rate will equal the money growth rate]. It [\*does\* predict] that a [change in the money growth rate will cause an equal change in the inflation rate] **MONEY DEMAND FUNCTION AND QUANTITY EQUATION** **[Real money balances]** tell us the **purchasing power** of the money you hold. It's the amount of goods and services you can buy with your cash after accounting for inflation. **Formula:** Real Money Balances=M/P - M: The amount of money you have (nominal money). - P: The price level (how much goods cost). **Example:** - If you have \$100 (M) and prices (P) double, your real money balances drop to \$50 because your \$100 now buys only half as much as before. [MONEY DEMAND FUNCTION] [\${(\\frac{M}{P})}\^{d} = kY\$]{.math.inline} - [*k* is a constant] that tells us how much money people want to hold for every dollar of income. (liquidity preference) This money demand function offers another way to view the quantity equation. [*M***P*** )^d^ = real money demand, depends - negatively on ***i*** - positively on ***Y*** (***L*** is used for the to denote money demand because money is the most liquid asset.) - The higher the level of income *Y=\>* the greater the demand for real money - The higher the nominal interest rate *i*=\> the lower the demand for real money NOW: we use the fisher equation to write the nominal interest rate as the sum of the real interest rate and expected inflation:  **EQUILIBRIUM** Diagrama Descripción generada automáticamente con confianza baja  - it is very important [to learn the logical order in which variables are determined.] - I.e., we do not need to know P in order to determine Y. We do need to know Y in order to determine L, and we need to know L and M in order to determine P. **HOW P RESPONDS TO** [*Δ***M**]{.math.inline} Diagrama Descripción generada automáticamente con confianza media - For given values of ***r***, ***Y***, and π^e^, a change in ***M*** (money supply) causes ***P (price level)*** to change by the same percentage --- just like in the Quantity Theory of Money. **WHAT ABOUT EXPECTED INFLATION?** - [Over the long run], people don't consistently over- or under-forecast inflation, so [π^e^ = π] on average. Example: If inflation has been consistently 2%, people will expect it to stay around 2% - In the [short run, π^e^ may change] when people get new information. Inflation expectations (πe) are based on what people think will happen in the future. - Example: Suppose ECB announces it will increase ***M*** next year. People will expect next year's ***P*** to be higher, so π^e^ will rise. This increase in exp inflation raises nominal rate. Lenders will raise nominal rate now to protect themselves from the expected loss of money value. (Formula: i=r+πe) - So expectations of higher money growth (M) in the future lead to higher price level (P) TODAY Why today? People try to spend more money now because they know money will lose value in the future. This increased demand for goods/services rises prices. **HOW P RESPONDS TO ∆π^e^**  **DOES INFLATION MAKE WORKERS POORER?** *Nominal wages-definition=\> (nota)* *Real Wages-definition=\>(nota)* depends on the time frame: **Short Run (Yes, it can temporarily make workers poorer=\> *[inflation reduces real wages]*):** - Why? In the short run, many workers are paid based on contracts that **fix their nominal wages** (the amount of money they earn, not adjusted for prices). - If prices go up (inflation), but wages stay the same (because of the fixed contract), workers can buy less with their money. Real Wage=Nominal Wage (fixed)/Higher Price Level (P) So your **real wage goes down** because you can buy less with the same nominal wage. - **Long Run (No, inflation does not make workers poorer[=\> *inflation does not reduce real wages*]):** In the long run, wages are **not fixed**. Workers, employers, and markets adjust to the new price levels over time. Real wages (your purchasing power) are determined by: - **Labor supply:** How many people are willing to work. - **Marginal Product of Labor (MPL):** The value of what each worker produces. - NOT by inflation or price levels. **Example:** - If prices go up by 10%, in the long run, wages will also rise by about the same amount because workers demand higher wages to match inflation. **THE CLASSICAL VIEW OF INFLATION** *The classical view:\ *sees changes in prices (inflation) as simply a change in the unit of measurement---like switching from feet to meters. They argue that inflation doesn\'t affect the real economy much because everything (wages, prices, etc.) adjusts over time. However, inflation can still be a **social problem** because it affects people differently: - **Losers**: Rich, older households often hold bonds and savings. Inflation [reduces the value of those fixed returns,] so they lose purchasing power. - **Winners**: Young, middle-class families with fixed-rate mortgages [benefit because inflation reduces the real value of their debt over time], making it easier to pay off....fall into [two categories]: - 1\. costs when inflation is [expected] - 2\. additional costs when inflation is [unexpected] **THE COSTS OF EXPECTED INFLATION: 1.SHOE-LEATHER COST** refers to the effort and inconvenience of making extra trips to the bank (or ATM) because you keep less cash on hand. You're essentially "[wearing out your shoes" from walking to the bank more often]! Even though your real income and spending don't change-you still buy the same amount of goods, so extra trips to the bank because less money holding. The costs of having to [keep less cash on hand to avoid losing money] due to inflation. - ↑π ⇒ ↑***i*** ⇒ ↓ real money balances - In the long run, **money is \"neutral.\"** This means that changes in the money supply (or inflation) only affect **nominal variables** like prices and wages, but not **real variables** like real income, real wages, or real spending. Inflation just increases the price level, but it doesn't change how much the economy can actually produce or consume. **THE COSTS OF EXPECTED INFLATION: 2.MENU COSTS** - def: The [costs of changing prices.] - **Example**: Businesses have to print new menus, labels, or catalogs frequently as prices change. - The higher is inflation, the more frequently firms must change their prices and incur these costs. **THE COSTS OF EXPECTED INFLATION: 3.RELATIVE PRICE DISTORTIONS** Relative price distortions happen [when prices of goods and services don't change at the same rate during inflation. ] For example, if a company updates its prices only once a year, its prices may become outdated compared to competitors who adjust more frequently. This creates confusion in the market, making some products seem cheaper than they really are. As a result, people and businesses might make bad decisions, like buying more of something that seems cheaper but isn't. This causes inefficiencies in how resources are used, meaning that money, time, and labor might not be spent in the best way possible, [leading to waste and economic problems]. **THE COSTS OF EXPECTED INFLATION: 4.UNFAIR TAX TREATMENT** - Some taxes are not adjusted to account for inflation, such as the [capital gains tax]. This means you could be taxed on money you didn't really \"gain\" after considering inflation. **Example:** - **January 1, 2016**: You buy stocks for **100,000 kr**. - **December 31, 2016**: You sell the stocks for **110,000 kr**, making a **nominal gain of 10,000 kr**. - But, if **inflation is 10%**, your **real gain is 0 kr** because prices went up, and your money isn't worth as much as before. - Still, the government will **tax you on the 10,000 kr profit**, even though you didn't really make any extra money in real terms. **Another Issue: Tax Drag** - Some people get a **raise** at work, but because of inflation, their **real pay** (what they can actually buy) [stays the same or even goes down.] - Even though they earn more on paper, they might [end up paying more taxes and not feel better off] (*higher salary doesn't make them richer).* **THE COSTS OF EXPECTED INFLATION: 5. GENERAL INCONVENIENCE** - Inflation makes it harder to compare nominal values from different time periods. It [makes it difficult to plan for the future] because it changes how we value money. - This complicates long-range financial planning. **Example**: Parents saving for their child\'s education find it hard to predict how much to save due to rising costs. **ADDITIONAL COST OF UNEXPECTED INFLATION:ARBITRARY REDISTRIBUTIONS OF PURCHASING POWER** **What it is**: When actual inflation differs from what people expected, it can unfairly benefit one group over another. - Many long-term contracts are not indexed, but based on expected inflation rate π^e^. - If π turns out different from π^e^, then there is some gain at others' expense. Example**: borrowers & lenders** - If π \> π^e^, then (**i** **−** π) \< (**i** **−** π^e^)\ and [purchasing power] is transferred from lenders to [borrowers]. - If π \< π^e^, then [purchasing power] is transferred from borrowers to [lenders]. **Example:** If you borrow \$1,000 and inflation turns out to be higher than expected, the \$1,000 you repay is worth less in real terms than when you borrowed it (pay back loans with \"cheaper\" money), making it easier for you to pay off the loan. **Example**: If you borrow \$1,000 and inflation turns out to be lower than expected, the \$1,000 you repay is worth more than you anticipated, making it harder to pay back the loan. **ADDITIONAL COST OF HIGH INFLATION: INCREASED UNCERTAINTY** - When [inflation is high, it's more variable and unpredictable], making it hard for people and businesses to plan, which can slow overall economic progress. - This leads to **random changes** in who gains or loses money, which is called **arbitrary redistribution of wealth**. When inflation is unpredictable, it can cause people to unexpectedly **gain** or **lose money**, even if they didn\'t plan for it. - **More uncertainty**: People can't predict prices, so it's harder to make decisions about spending, saving, or investing. - **Businesses suffer**: Companies might avoid investing or hiring new workers because they can't predict their future costs, slowing down the economy. **ONE BENEFIT OF INFLATION** **Wage Flexibility**: Inflation allows companies to adjust **real wages** (what workers can buy) by simply increasing prices, [without having to cut workers\' paychecks (nominal wages]). This helps keep the labor market balanced. **CLASSICAL DICHOTOMY** - Note: Real variables were explained in Chap 3, nominal ones in Chap 5. - **Classical Dichotomy**: the theoretical separation of real and nominal variables in the classical model, which implies that in the long run, money is neutral: [nominal variables do not affect real variables]. This means that changes in the money supply don't affect real variables. - **Real variables** are measured in physical units: quantities and relative prices, e.g. - quantity of output produced - real wage: output earned per hour of work - real interest rate: output earned in the future by lending one unit of output today - **Nominal variables**: measured in money units, e.g. - nominal wage: euros / hour of work - nominal interest rate: euros earned in future by lending one euro today - the price level: the amount of euros needed to buy a representative basket of goods **REVIEW:** Texto, Carta Descripción generada automáticamente [CHAPTER 6- THE OPEN ECONOMY] ----------------------------------------- **CLOSED VS OPEN ECONOMY** - Closed economy (chapter 3): - Output =spending: **Y = C + I + G** - National savings = investment: **S -- I = 0** - Open economy (today): - Output [need not equal] spending: **Y = C + I + G + NX** - National savings [need not equal] investment: **S -- I = NX** - *"Spending need not equal output"* - *Residents of an open economy [can spend more than the country's output] simply by importing foreign goods. Residents [can spend less than output], and the extra output will be exported.* - *"Saving need not equal investment"* - *If [individuals in an open economy want to save more than domestic firms want to borrow,] no problem. The savers simply send their extra funds abroad to buy foreign assets. Similarly, [if domestic firms want to borrow more than individuals are willing to save], then the firms simply borrow from abroad (i.e. sell bonds to foreigners).* **PRELIMINARIES** **[OPEN ECONOMY]- NATIONAL INCOME ACCOUNTS IDENTITY:** Y=C+I+G+EX-IX Net exports=exports-imports : NX=EX-IM So, Y=C+I+G+NX  - **EX** = exports =\ foreign spending on domestic goods, on other words, the value of goods exported to other countries. - **IM** = imports = **C** ^f^ + **I** ^f^ + **G** ^f^\ = spending on foreign goods - [Total consumption expenditure] is the sum of consumer spending on domestically produced goods and foreign produced goods. **GDP=expenditure on domestically produced good and services** Texto, Carta Descripción generada automáticamente **THE NATIONAL INCOME IDENTITY IN AN [OPEN ECONOMY]**  - Solving this identity for NX yields the second equation, which says: - A country's **net exports**\-\--its net [outflow of goods]\-\--equals the difference between its output and its expenditure. - Example: If we produce €100b worth of goods, and only buy €80b worth, then we export the remainder. Of course, [NX can be a negative number,] which would occur if our spending exceeds our income/output **INTERNATIONAL CAPITAL FLOWS** - In an [open economy, savings need not equal investment] - Net capital outflows (net foreign investment)-measures the difference between savings and investment - ***S*** -- ***I*** - When ***S*** \> ***I***, the country is saving more than it is investing, so it lends the extra savings to other countries. The country is a **net lender**. - When ***S*** \< ***I***, The country is investing more than it is saving, so it has to borrow money from other countries. The country is a **net borrower** RECALL: S=Y-C-G from national savings in closed economy Texto Descripción generada automáticamente - Trade surplus implies [**net lending** from the country] to the rest of the world. When S-I and NX are positive. exports\> imports - Trade deficit implies [**net borrowing** by the country] from the rest of the world. When S-I is negative because S\ exports - Balance trade: imports=exports  This equation says that:\ Net exports (the net outflow of goods) = net capital outflows (the net outflow of loanable funds) - We learn a very important lesson from it: - A country (such as the U.S.) with persistent, large trade deficits (NX \< 0) also [has low saving, relative to its investment, and is a net borrower of assets. ] **SAVING AND INVESTMENT IN A SMALL OPEN ECONOMY** - An open-economy version of the loanable funds model from chapter 3. - [Includes many of the same elements]: Texto Descripción generada automáticamente con confianza baja NX=(Y-C-G)-I NX=S-I Substituting the chapter 3 assumptions with the assumption that the interest rate (r) = world interest rate (r\*): \ [\$\$NX = \\left\\lbrack \\overline{Y} - C\\left( \\overline{Y} - \\overline{T} \\right) - \\overline{G} \\right\\rbrack - I(r\^{\*})\$\$]{.math.display}\ \ [\$\$= \\overline{S} - I(r\^{\*})\$\$]{.math.display}\ **NATIONAL SAVING: THE SUPPLY OF LOANABLE FUNDS** National saving doesn't depend on the interest rate  **IN A CLOSED ECONOMY** CLOSED economy=real interest rate adjust to equate saving and investment. So the real interest rate is found where the saving and investment curves cross. **OPEN ECONOMY**  OPEN ECONOMY=interest rate is [determined in world financial markets]. (world interest rate=r\*) The [difference between saving and investment] determines the **trade balance**. Here=there is a [trade surplus] because at the world interest rate, saving\>investment. **ASSUMPTIONS ABOUT CAPITAL FLOWS** a. domestic & foreign bonds are **perfect substitutes** (same risk, maturity, etc.). In equilibrium, domestic and foreign bonds must [offer the same interest rate]. (r=r\*) because if one bond offers a higher interest rate than the other, **investors will move their money** to the bond with the higher return. b. **perfect capital mobility**: **no restrictions** or barriers stopping people from moving money across borders (e.g., buying foreign bonds or assets). Because of this, the [domestic interest rate r= global interest rate r\*]. Otherwise, capital would flow in or out until they equalize. a. economy is **small**: means the economy is [too small to influence global financial markets or to change the world interest rate], denoted ***r**\*.* r\* is determined by external influences and is [fixed for the domestic/small economy] (exogenous-comes from outside) **a & b imply *r* = *r\**** **c implies *r\** is exogenous** **[POLICIES THAT INFLUENCE THE TRADE BALANCE ]** - 1.Fiscal policy at home - 2.Fiscal policy abroad - 3.An increase in investment demand **1.FISCAL POLICY AT HOME** **THIS IS FOR NX=0** At world interest rate: I=S NX=0 **When NX=0 (Balanced Trade):** - **What happens?** - The government **spending increases** or **taxes decrease**, so people save less, national saving (Y-C-G) decreases*. increases private consumption C (C(Y-T))(reduction in taxes) or public consumption G (government purchases)* - Therefore, shifts the vertical line that represents saving from to S1 to S2. - With less saving, there's not enough money to cover investment (I), and the country starts borrowing from abroad. - **Result:** Because *NX* is the distance between the saving schedule and the investment schedule at the world interest rate, this shift reduces *NX*. (NX\0, savings are already greater than investment (S\>I): trade surplus. A reduction in savings makes the trade surplus becomes **smaller** but can still remain **positive** as long as S\>I.  **2.FISCAL POLICY ABROAD** **THIS IS FOR NX=0** What happens when foreign governments increase their government purchases? If these are big countries (big open economy), their increase in government purchases **reduces** world saving=\> **increase** in world interest rate =\> **increases** cost of borrowing=\> in your country, investment (I) **decreases** As investment decrease and **no change** in domestic saving= now [S\> I] and some of the country savings go abroad. This means there is extra saving that isn't being used for domestic investment. The [extra savings flow out of the country,] financing investments or loans abroad. As NX=S-I, decrease in I=\> increase in NX. This results in a **trade surplus at home** (exports are greater than imports) because your country is effectively lending money to the rest of the world. Imagen que contiene Interfaz de usuario gráfica Descripción generada automáticamente **THIS IS FOR NX\>0** - Expansionary fiscal policy abroad=\> higher world interest rate (r\*)=\>less global savings but domestic savings not affected=\> as r=r\*=\> reduces domestic investment in our small open economy. Since NX=S−I, if I falls and S is unchanged, **NX increases**, meaning your **trade surplus becomes larger**.  **3.SHIFTS IN INVESTMENT DEMAND** **When NX=0 (Balanced Trade):** - **What happens?** - If businesses want to invest more (I increases), but savings (S) stay the same, your country must borrow from abroad to finance the extra investment.([more imports)] - Since NX=S−I, a rise in I causes NX\ exports) From balance trade, outward shift=\> t**rade deficit** Diagrama Descripción generada automáticamente **WHEN NX\>0 (trade surplus)**  **What happens?** - More money is used for businesses and projects in the country (investment increases). - **This does not change the total amount of savings.** Savings stay the same, but more of that savings is now used for investment instead of being saved to lend abroad. **(net outflows (savings going abroad/foreign investment)** decrease) - **As** reduces **net capital outflows (S-I)**, it also reduces net exports (NX). - **Result:** The trade surplus becomes smaller. (less exports) **[NOMINAL AND REAL EXCHANGE RATES ]** **NOMINAL EXCHANGE RATE** **e** = nominal exchange rate, the [relative price of domestic currency] in terms of foreign currency (e.g. 1 Euro per 7 Kroner). In other words, the relative price of the currencies of two countries. **REAL EXCHANGE RATE** - **ε** = real exchange rate, the [relative price of domestic goods] in terms of foreign goods (e.g. relative price of a Tuborg beer in Copenhagen in terms of Tuborg beer in Frankfurt). In other words, the relative price of the goods of two countries. Texto Descripción generada automáticamente con confianza media *P\*=is the country that we are considering foreign.* *EXERCISE:* - one good: Tuborg beer - price in Frankfurt: **P\*** = 3 Euros - price in Copenhagen: **P** = 60 DKK - nominal exchange rate **e** = 0.134 EUR/DKK - [How many beers in Frankfurt can you buy if you sell one beer in Copenhagen?]  Answer: One beer sold in Copenhagen can buy you 2.68 beers in Frankfurt! **HOW NX DEPENDS ON *ε*** - ↑***ε* ⇒** home goods become more expensive relative to foreign goods - (as e or P increases relative to P\*) - **⇒** ↓***EX***, ↑***IM*** - **⇒** ↓***NX (trade deficit)*** **REAL EXCHANGE RATE AND THE TRADE BALANCE** We write this relationship between real exchange rate and net exports (trade balance) as: NX=NX (***ε)*** This equation states that [net exports are a function of the real exchange rate]. - higher real exchange rate =\>the lower NX(imports\> exports) - lower real exchange rate =\> less expensive are domestic goods relative to foreign goods =\> the higher NX(exports\>imports) Gráfico Descripción generada automáticamente con confianza baja Note that a portion of the horizontal axis measures negative values of *NX:* Because imports can exceed exports[, net exports can be less than zero. ] Diagrama Descripción generada automáticamente HERE: S and I DON'T depend on the real exchange rate so the capital outflow curve (S-I) is vertical. - The accounting identity says ***NX*** = ***S*** - ***I*** - We saw earlier how ***S*** - ***I*** is determined: - ***S*** depends on domestic factors (output, fiscal policy variables, etc) - ***I*** is determined by the world interest rate ***r*** \* - So, ***ε*** must adjust to ensure equilibrium:  [**ε**]{.math.inline}**1**: equilibrium real exchange rate A diagram of a graph Description automatically generated **[POLICIES THAT INFLUENCE THE REAL EXCHANGE RATE]** - 1\. Fiscal policy at home - 2.Fiscal policy abroad - 3\. An increase in investment demand - 4\. Effect of trade policies [1.FISCAL POLICY AT HOME ] - [ ↑ *G* *or*  ↓ *T* = \> ]{.math.inline}reduce savings=\> **means less money available** to lend or invest abroad, **lower supply of the domestic currency** (since people are saving less and sending less money abroad) =\> rise the equilibrium real exchange rate, so the dollar becomes more valuable. Due to this dollar appreciation, domestic goods become more expensive relative to foreign goods, causing reduction in NX (imports\>exports) Diagrama Descripción generada automáticamente [2.FISCAL POLICY ABROAD] If these are big countries (big open economy), their [ ↑ *G* *or*  ↓ *T*]{.math.inline} **reduces** world saving=\> **increase** in world interest rate (**less money available to lend**) =\> **increases** cost of borrowing=\> in your country, investment (I) **decreases** This **reduced investment** means they are less likely to need money (domestic currency) in your country. Instead, they might send money (currency) abroad or exchange it for foreign currencies. **So, the supply of your currency in the foreign exchange market increases**, because more people are exchanging your currency for other currencies, or sending money abroad to invest elsewhere. When **more of your country\'s currency is available** in the foreign exchange market (because people are exchanging it for foreign currency), the **value of your currency falls**. As the value of your currency falls, your goods and services become **cheaper for people in other countries** to buy (currency is weaker=\> real exchange rate decreases). This makes **exports increase**, so **net exports increase**.  [3.INCREASE IN INVESTMENT DEMAND ] - An increase in investment =\> [reduces the supply] of domestic currency=\> raises the exchange rate and reduces net exports. Diagrama Descripción generada automáticamente 1. [TRADE POLICY TO RESTRICT IMPORTS ] Trade policy - Affects the real exchange rate - [Does not affect net exports] Example: a protectionist trade policy, makes government prohibited the import of foreign cars. So imports go down, which would shift the net-exports curve outward, raising demand for exports. However, even with this shift, the actual level of net exports (S-I) stays the same because the policy doesn\'t change savings or investment. The only thing that changes is that the real exchange rate becomes higher. Texto, Chat o mensaje de texto Descripción generada automáticamente **[PURCHASING-POWER PARITY (PPP)]** - PPP implies that the cost of a basket of goods (even a basket with just one good, like a Big Mac or a latte) should be the same across countries.  - Solve for ***e***: ***e*** = ***P**\*/ **P*** - PPP implies that the nominal exchange rate between two countries =the ratio of the countries' price levels. In other words, one unit of currency should have the same purchasing power in both countries when you account for their prices. **[DETERMINANTS OF NOMINAL EXCHANGE RATE ]** Solve the expression of real exchange rate for the nominal exchange rate: Diagrama Descripción generada automáticamente con confianza baja  So e (nominal exchange rate) depends on the real exchange rate and the price levels in two countries. Diagrama Descripción generada automáticamente - We can rewrite the nominal exchange rate equation in terms of growth rates (*see* "*arithmetic tricks for working with percentage changes,*" *Chap 2* ):  - For a given value of ***ε***,\ the [growth rate of ***e*** equals the difference between foreign and domestic inflation rates. ] *This shows the **Classical Dichotomy** in action: real factors(demand and supply) determine the real exchange rate, while nominal factors (like inflation rates) only affect nominal variables* [CHAPTER 7- UNEMPLOYMENT + AGGREGATE SUPPLY] -------------------------------------------------------- The causes of unemployment can be broken down into long-run and short-run. [This chapter focuses on the long-run,] particularly the causes of the so-called **"natural rate of unemployment."** Unemployment represents [wasted resources]: the higher the unemployment rate, the less labour is involved in the production of goods and services, implying a lower level of output and income in the economy. **NATURAL RATE OF UNEMPLOYMENT** - The natural rate of unemployment is the "normal" unemployment rate the economy experiences when it is neither in a recession nor a boom. In a recession, the actual unemployment rate rises above the natural rate. Recession=Actual\>natural In a boom, the actual unemployment rate falls below the natural rate. Boom=Actual\ supply labor exceeds demand, and so=\> unemployment **Workers wanting jobs \> jobs available**: There are more people looking for work than there are jobs. (real wage above equilibrium level) If wages don't easily go down (rigid), businesses can't hire as many workers as they need. And so if wages stay high (and don't decrease), businesses can't afford to hire everyone who wants a job, and some people remain unemployed for longer, because companies are unwilling or unable to lower wages to meet the demand for labor, **LONG RUN AGGREGATE SUPPLY CURVE** Gráfico Descripción generada automáticamente con confianza baja IN long run, **output** is [determined by the amounts of capital and labor and by the available technology]; **it does not depend on the price level**. Therefore, the long-run aggregate supply (*LRAS*) curve is vertical. The LRAS curve is vertical at the full-employment level of output. [Full employment]=meaning that almost everyone who wants a job can find one. The economy producing at its **maximum sustainable output**, which is called the **natural level of output**=meaning that the economy is using all its available resources, like labor and capital, efficiently (full capacity) [CHAPTER 8- ECONOMIC GROWTH I] ------------------------------------------ [Time horizon: Long run (*Y* fixed; *P* adjusts to bring supply and demand into balance)] Models: - Closed economy - Open economy [Time horizon: Very long run (*A,K,L* grow and change, affecting output Y)] Models: - Solow model (closed economy) [Time horizon: Short run (*P* sticky (don't adjust quickly), so output Y adjusts instead)] Models: - IS-LM model (closed economy) - Mundell-Fleming model (open economy) - extends the IS-LM model to include international trade and capital flows. **[CENTRAL MACRO MODELS ]** - In the **short run** (e.g., a few years), year-to-year movements in output are primarily driven by movements in demand. - In the **medium run** (e.g., a decade), the economy tends to return to the level of output determined by supply factors, such as the capital stock, the level of technology, and the size of the labor force. - In the **long run** (e.g., a few decades or more), the economy depends on its ability to innovate and introduce new technologies, and how much people save, the quality of the country's education system, the quality of the government, and so on.. **[WHY GROWTH THEORY?]** (this is not very important) To measure economic growth, economics use GDP, which measures the total income of everyone in a nation's economy. Our goal in this part of the book is to understand [what causes these differences in income over time and across countries.] Differences in income across time and nations must then come from differences in capital, labor, and technology. [Importance of long run growth: ] - Anything that effects the long-run rate of economic growth -- even by a tiny amount -- [will have huge effects on living standards] in the long run. [Lessons from growth theory:] - understand why poor countries are poor - design policies that can help them grow - learn how our own growth rate is affected by shocks and government's policies **[VERY LONG RUN- SOLOW MODEL ]** SOLOW MODEL: The Solow model explains how **capital stock**, the **labor force**, and **technology** work together to influence an **economy\'s total output** of goods and services. **The Supply of Goods and the Production Function** [Key Concepts:] 1. **Production Function**: - The production function represents how output (Y) is determined by the amount of **capital (K)** and **labor (L)**: Y=F(K,L) - The model assumes **[constant returns to scale]**, meaning if both capital and labor increase by the same proportion, output increases by that same proportion. Mathematically, if we scale K and L by a factor z, output also scales by : zY=F(zK,zL)for any z\>0 2. **Output Per Worker**: - By setting z=1/L we express [output per worker as a function] of **capital per worker**: The assumption of constant returns to scale implies 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. ] We can then write the production function as: y=f(k) where we define f(k)=F(k,1) 3. **Capital and Labor Effects**: - **More Capital Per Worker (machines, tools, etc.)** : - If the amount of [capital per worker k increases] (through investment and savings), then [**output per worker** y also increases.] - **Higher savings** lead to more capital accumulation, which in turn raises **GDP per capita** (Y/L). - **More Workers (Labor Force Growth)**: - If the [labor force grows] but capital remains fixed, **capital per worker** k decreases, leading to a [decrease in **output per worker**.] - A **higher population growth rate** can reduce **GDP per capita**.  The [slope of the production function] is the marginal product of capital (MPK): If *k* increases by 1 unit, *y* increases by *MPK* units. The **extra output** you get when you add one more unit of capital. The production function becomes flatter as *k* increases, indicating diminishing marginal product of capital. **Diminishing Returns**: As k increases, the increase in y becomes smaller and smaller. Why does MPK decrease? Because each additional tool or machine has less impact: - If a worker has no machines, giving them one greatly increases productivity. - If a worker already has 10 machines, adding one more doesn't help as much. - At low k, adding capital has a big impact on productivity. - At high k, adding capital has a smaller impact. **The Demand for Goods and the Consumption Function** The demand for goods in the Solow model comes from consumption and investment. y=c+i where ***c*** = ***C****L*** - This equation is the per-worker version of the economyʼs national **income accounts identity**. It [omits government purchases] (which for present purposes we can ignore) and net exports (because we are assuming a closed economy). (for simplicity ***G = T = 0***) The Solow model assumes that each year people [save a fraction *s*] of their income and [consume a fraction (1-s)]. the consumption function: c= (1-s)y s= saving rate- number between 0-1 To see what this consumption function implies for **investment**, [substitute (1-s)y for *c* in the national income accounts identity: ] y=(1-s)y+i Rearrange the terms: i=sy This equation shows that investment =saving, as we first saw in Chapter 3. Thus, [the rate of saving *s* is also the fraction of output devoted to investment]. **GROWTH IN THE CAPITAL STOCK AND THE STEADY STATE** the capital stock determines the economyʼs output, so changes in the capital stock can lead to economic growth. Two forces influence the capital stock: **investment and depreciation**. ***Investment*** is expenditure on new plant and equipment, and it causes the capital stock to rise. ***Depreciation*** is the wearing out of old capital due to aging and use, and it causes the capital stock to fall. Investment per worker *i* = *sy*. By [substituting the production function for *y*,] we can express investment per worker as a function of the capital stock per worker: i=sf(k) This equation [relates the existing stock of capital *k* to the accumulation of new capital *i*.] Figure 8-2 shows this relationship. Diagrama Descripción generada automáticamente **Output, Consumption, and Investment** The saving rate *s* determines the allocation of output between consumption and investment. For any level of capital *k*, output is *f*(*k*), investment is *sf*(*k*), and consumption is f(k)-sf(k) To incorporate depreciation into the model, we assume that a certain fraction of [δ ]{.math.inline}the capital stock wears out each year. Here, [*δ*]{.math.inline}= is called the *depreciation rate*. For example, if capital lasts an average of 20 years, the depreciation rate is 5 percent per year. The amount of capital that depreciates each year is [δk]{.math.inline}  **Depreciation** A constant fraction of the capital stock wears out every year. Depreciation is therefore proportional to the capital stock. Shows how much amount of depreciation depends on capital stock. **[CAPITAL ACCUMULATION]** **[Impact of Investment and Depreciation on Capital Stock (Δk):]** Texto Descripción generada automáticamente con confianza media \ [*Δk* = *sf*(*k*) − *δk*]{.math.display}\ - Δk: Change in capital stock per worker between one year and the next. - sf(k): Investment per worker (saving rate multiplied by output). - δk: Depreciation per worker (depreciation rate multiplied by capital stock). **STEADY STATE CAPITAL PER WORKER (k\*)** **Definition**: The steady-state level of capital per worker where **investment =depreciation**: \[*sf(k)* = *δk* \] - At k\*, capital per worker remains constant(steady state): ∆*k* = 0. - Below k\*, investment\>depreciation=capital stock per worker (k) [↑]{.math.inline}. As long as **k** \< **k^\*^** (below the steady state)=\> investment \> depreciation, and **k** will continue to grow toward **k^\*^**. - Above k\*, investment \< depreciation=capital stock per worker (k) [↓]{.math.inline} **SO:** *Investment makes the capital stock bigger,* *depreciation makes it smaller.*  **[THE GOLDEN RULE ]** Diagrama, Dibujo de ingeniería Descripción generada automáticamente **GOLDEN RULE LEVEL OF CAPITAL(k\*gold)**=The steady-state capital per worker (k\*) that maximizes steady-state consumption (c\*) **Why are they different?** - **k\*gold​:** This is about how many tools/machines (capital) are needed to maximize consumption. - **c\*gold​:** This is about [how much people can actually consume] when we have those tools. - It happens at k\*gold the Golden Rule level of capital per worker. - If the economy is **not at k\*gold** steady-state consumption (c\*) will be **less than c\*gold** How can we tell whether an economy is at the Golden Rule level? 1. determine steady-state consumption per worker(c\*). 2. see which steady state provides the most consumption. To find steady-state consumption per worker, we begin with the national income accounts identity: **y=c+i** and rearrange it as c=y-i *(Consumption=output -- investment)* Because we want to find steady-state consumption, we [substitute steady-state values] for output (y) and investment(i). Steady-state output per worker(y)=f(k\*) As the [capital stock is not changing in the steady state], investment =depreciation=\> sf(k\*) =*δk\** So i substitutes by *δk\** *THAT IS WHY IN THE GRAPH, THE LINE INCLUDED INVESTMENT IN THE PARENTHESIS* Substituting for *y* and for *i*, we can write steady-state consumption per worker as: c\*=f(k\*)-*δk\** This equation shows that: an increase in steady-state capital(k\*) has [two opposing effects on steady-state consumption(c\*):] 1. more capital means more output. 2. more capital, means more output is needed to cover the cost of replacing the depreciating capital.  Diagrama Descripción generada automáticamente - Below k\*gold, [↑]{.math.inline}steady state capital (k\*) [↑ ]{.math.inline}steady state consumption (c\*gold) - Above k\*gold, [↑]{.math.inline}steady state capital (k\*) [↓ ]{.math.inline}steady state consumption (c\*gold) **Below the Golden Rule level k** \< **k^\*^**gold: [↑]{.math.inline} capital =\>[↑]{.math.inline} consumption because the [↑]{.math.inline} in output is **bigger** than the [↑]{.math.inline} in depreciation. the [production function is steeper than the *δk\** line,] so the gap between these two curves --- which equals consumption --- grows as rises. **Above the Golden Rule level**: [↑]{.math.inline} capital =\> [↓ ]{.math.inline}consumption since the [↑]{.math.inline} in output is **smaller** than the [↑]{.math.inline} in depreciation. the [production function is flatter than the *δk\** line], so the [gap between the curves] --- consumption --- [shrinks] as rises. **At the Golden Rule level(k\*gold)**: Consumption is maximized because the MPK(slope of the production function) = depreciation rate δ (slope of the line δk\*). the production function and the *δk\** line have the same slope. [these two slopes are equal at k\*gold. ]  At the Golden Rule level of capital (k\*gold), the marginal product of capital net of depreciation = zero. As we will see, a [policymaker can use this condition to find the Golden Rule capital stock for an economy. ] MPK-δ=0 - If MPK-δ\>0 , increases in capital increase consumption, so [k\* must be below] the Golden Rule level. - If ,MPK-δ\