Chapter 20
GDP: market value of all the final goods and services produced
within a country
in a given time period (usually a year)
4 parts:
o Market value: the prices at which items are traded in
markets
o Final goods & services
Final good: item bought by final user during a
specified time period
Intermediate good: item that is produced by one firm,
bought by another firm and used as a component of a
final good or service
o Produced within a country
o Given time period
Also measures total income and total expenditure
Circular flow of income
Households & firms
o Households:
sell labour to firms
o Firms:
Buy labour, capital, land in factor markets
Pay income to households (wages), interest for use of
capital, rent for use of land
Entrepreneurship receive profit
Retained earnings (not distributed to households) are
part of household income income that households
save & lend back to firms
o Governments
Buy goods & services from firms
o Rest of the world (net exports)
+ net export flow of goods and services is from
country of origin to the rest of the world, vice versa
Aggregate income & expenditure
Aggregate income:
o Wages + interest + rent + profit
Aggregate expenditure:
o C + I + G + (X – M)
*** subsidies lower market prices aggregate expenditure valued at
market prices: indirect taxes – subsidies
*** aggregate expenditure = aggregate income + indirect taxes –
subisides
Gross & Net
Depreciation: decrease in the value of a firm’s capital that results
from wear and tear and obsolescence
Gross investment: total amount spent on purchasing new capital
& replacing depreciated capital
Net investment: amount by which the value of the firm’s capital
increases
Net investment= Gross investment- Depreciation
Expenditure approach
GDP = C+I+G+(X-M)
o Don’t include purchase of new houses (I)
Income approach
Incomes paid by firms to households for services of factors of
production (wages, interest for capital, rent, profit)
o Compensation of employees: total payments for labour
services
o Gross operating surplus: total profit made by companies &
surpluses made by publicly owned businesses
Some profit paid to households as dividends
Some profit retained by companies
o Mixed income: combination of rental income, income from
self-employment
Nominal VS Real
Real GDP: value of final goods & services produced in a given year
when valued at the prices of a base year
o Same prices can see change in production
o If it rises, economy actually grew (cuz more production)
Nominal GDP: value of final goods & services produced in a given
year when valued at the prices of that year
o Grow as prices rise even when country don’t produce more
*GDP deflator = (nominal GDP/real GDP) *100
measure of price calculated as the ratio of nominal GDP to real GDP
times 100
rise in nominal GDP that is attributable to a rise in prices rather than
rise in quantities produced
Standard of living over time
Real GDP per person:
o tells us the value of goods & services that the average person
can enjoy
o real GDP remove any influence that rising prices & cost of
living might have had on our comparison.
The Business Cycle
periodic up-and-down movement of total production and other
measures of economic activity
1. Expansion: real GDP rises
o Real GDP potential GDP
o As expansion progresses, real GDP exceeds potential GDP
2. Peak: highest value that real GDP has attained up to that time
3. Recession: real GDP drops, negative growth rate for at least 2
consecutive quarters
o Occur after peak
o Ends at a trough
4. Trough: real GDP reaches a temporary low point and from which
the next expansion begins
Limitations of real GDP
Household production
o Productive activities not traded in markets, hence not
included in GDP
Underground economic activity
o Part of the economy hidden to avoid taxes & regulations
(illegal goods)
Leisure time
o Economic good that adds to our standard of living
o More leisure time than working time economic well-being
not reflected in GDP
Environmental quality
o Cost of pollution not subtracted from GDP
Data concepts:
Procyclical: does the behavior of a variable GDP move along with
GDP?
Countercyclical: doesn’t move along with GDP
Chapter 22
Economic growth: sustained expansion of production possibilities
measured as the increase in real GDP over a given period
Economic growth rate: annual % change of real GDP show how
rapidly economy is growing
Real GDP current year−Real GDP previous year
Real GDP growth rate= ∗100
Real GDP previous year
RealGDP per capita:
o Only grow if real GDP grows faster than population grows
o Standard of living depends on this
o Formula: same as Real GDP growth rate or Real GDP growth
rate – population growth rate
Potential GDP: level of real GDP with full employment
o Aggregate production function
relationship that tells us how real GDP changes as the
quantity of labour changes when all other influences on
production remain the same
o Aggregate labour market
Demand for labour: relationship between quantity of
labour demanded & real wage rate
Supply for labour: relationship between quantity of
labour supplied & real wage rate
Labour market equilibrium: price of labour = real wage
rate
Determinants of growth
Supply factors
o Increase in quality & quantity of natural resources
o Increase in quality & quantity of human resources
o Increase in supply of capital goods (industrialization)
o Improvements in technology (R&D)
Demand factors
o Households, businesses, government purchase economy’s
expanding output of goods & services
Efficiency factor
o To reach full potential: economy must achieve economic
efficiency & full employment
*Labour productivity grows because of…
- physical capital growth
- human capital growth (workers’ skill & knowledge)
- technological advances
- allocative efficiency
* Real GDP = hrs of work * labour productivity
Chapter 21
Unemployment
Social, personal, economic problem
Lost income
o Lower consumption & savings
o Cost for government / society (unemployment benefit)
Lost production
o Lower investments lower standard of living
Lost human capital
o Damage one’s job prospects
unemployment benefits from safety net & give some compensation &
don’t replace lost earnings
spread unequally, important cause of poverty & social deprivation
Labour market
Age 16 – 64 not in prison, hospital or other institutional care
Those that don’t want a job (full-time students, retired) not included
Labour force: employed people + unemployed that are willing &
able to work
o Employed: working labour force
o Unemployed: not working, willing & able to work
Labour market indicators
Unemployment rate
Number of people unemployed
∗100
Workforce
Employment rate
Number of people employed
∗100
W orking−age population
Economic activity rate
Workforce
∗100
Working−age population
Types of unemployment
Frictional
o Arise from people entering & leaving workforce, ongoing job
creation & job destruction
Structural
o Created by changes in technology & foreign competition that
change needed skills to perform jobs / location of jobs
o Last longer
Cyclical
o Depend on business cycles & expansion & recessions
Higher than unemployment at trough
Lower than unemployment at peak
0 = natural unemployment rate
o Actual unemployment – natural unemployment rate
Natural
o No cyclical unemployment, all unemployment is frictional &
structural
o Influenced by….
Age distribution of population
Scale of structural change
Real wage rate
Unemployment benefits
Full employment
o Unemployment rate = natural unemployment rate
Natural rate of unemployment:
the normal rate of unemployment around which the unemployment
rate fluctuates
frictional + structural unemployment rate
Measuring cost of living
Price level: avg level of prices & value of money
Inflation: persistently rising price level
Deflation: persistently falling price level
*unexpected bursts of inflation/deflation are a problem
redistributes income
redistributes wealth
lowers real GDP & employment
diverts resources from production
Consumer price index (CPI)
measure of the average of the prices paid by consumers for a fixed
‘basket’ of goods and services
major purpose is to measure inflation
1. Define basket of goods (Q)
2. Calculate value CPI basket (P * Q) in base year
3. Calculate value CPI basket (P * Q) in current year
Value CPI basket at current prices
∗100
ValueCPI basket at base year prices
Inflation & Income
Redistribution of income (price go up, wages don’t follow
immediately)
Nominal income: unadjusted for inflation
Real income: nominal income adjusted for inflation
o Nominal income / Price index
**% change in real income = % change in nominal income - % change in
price level
Measuring inflation
Inflation rate: % change in price level from one year to the next
CPI this year−CPI base year
∗100 %
CPI base year
Who is affected? (deflation is vice versa)
o Receivers of fixed income
o Savers (savings are worth less)
o Creditors/lenders
Money borrowers repay later will worth less
Inflation is favourable when you have debts
Chapter 26
Aggregate supply (AS)
relationship between the quantity of real GDP supplied and the price
level
Quantity supplied: total quantity of goods and services that
companies plan to produce during a given period (valued in
constant base year)
o Depends on…
Q of labour employed
Q of physical capital (fixed)
State of technology (fixed)
Long-run AS
LAS = vertical independent of price level
o Movement along LAS curve means change of price level &
change in factors of production
o All adjustments made to have full employment (real GDP =
potential GDP)
o Shift determinants:
Land, labour, capital, entrepreneurship
Short-run AS
relationships between Q of real GDP supplied & price level when
money wage rate, prices of other resources, potential GDP remain
constant
o Wage is sticky (don’t change along with prices in short run)
o Prices can be sticky (price level fall unexpectedly, prices don’t
change fast)
o Shift determinants:
Wage rates, resource costs, energy & transportation
costs, government regulation, business taxes/subsidies,
exchange rates
*increase in potential GDP shift both LAS and SAS
Aggregate demand (AD)
relationship between the quantity of real GDP demanded and the price
level
Wealth effect: price level rises, purchasing power of consumers
decline decrease consumption
Substitution effect
o Interest rate: price level rise, decrease in real value of
money, people want more loan, bank raises interest rates,
decrease in AD
o Exchange rate: price level fall relative to foreign market,
increase spending on domestic products, decrease import
spending increase AD
Change in AD-AS model (demand-pull inflation)
1. AD shifts right due to rise in demand
2. Price goes up
3. New short run AS-AD equilibrium, in the long-run the current state is
not sustainable, real GDP goes up
4. Only inflation left
Change in AD-AS model (cost-push inflation)
1. Prices go up, suppliers supply less, AS shifts to the left
2. Results in inflation, stagnation, real GDP goes down
Long-run Macroeconomic Equilibrium
SAS1 = money wage rate
too high, fall in money
wage rate shifts SAS1 to
SAS* for full employment
SAS2 = money wage rate
too low, rise in money
wage rate shifts SAS2 to
SAS* for full employment
Long-run, potential GDP
determine real GDP,
potential GDP & AD
determine price level
Economic growth & inflation
LAS increase due to
growth
Inflation occur when
AD increase more
than LAS & intersect
at higher price level
% increase = growth
in real GDP without
inflation
Business cycle in AS-AD model
Chapter 24
Money Market
Bank decrease Q of money, interest rate rise (vice versa)
quantity of money that people plan to hold depends on four main
factors:
Price level
Nominal interest rate
o Adjusts to bring money supply and demand into balance
o Opportunity cost of holding money
Real GDP
Financial innovation
AD & Money demand
Money demand: relationship between the quantity of real money
demanded and the interest rate
o Price level goes up money demand rises higher interest
rate (money supply is fixed) reduces Q of goods & services
demanded
Supply of money & equilibrium
Vertical graph independent of interest rate
Monetary authorities & financial institutions provide particular
stock/supply of money depending on political preferences
Short-run Long-run
Bank increase Q of money Nominal Q of money change,
People buy more bonds, price level changes by %
raising prices of bonds & equal to % change in Q of
lowering interest rates (vice nominal money
versa) Change in price level =
change in Q of money
AD & Money supply
Monetary policy:
o Money supply rise money demand stays the same
reduces interest rate Q of goods & services rise AD shifts
to the right
Expansionary VS Contractionary
Expansionary (in recession)
o Lower taxes
o Higher government spending
o Increase AD & GDP
Budget deficit created because G > T get economy out of
recession
Contractionary (in expansion)
o Increase taxes
o Lower government spending
o Decrease AD & GDP
budget surplus created because G < T slow down economic
growth & prevent inflation
Chapter 29
Government budgets
annual statement of projected outlays and receipts during the next
financial year together with the laws and regulations that will support
those outlays and receipts
Purposes:
Plan & finance government’s activities
Stabilize economy
Encourage economy’s long-term growth & balance regional
development
Fiscal policy
government’s use of its budget to achieve macroeconomic objectives
(full employment, sustained economic growth, price-level stability)
1. Expansionary ( tax goes down, government expenditure goes up)
2. Contractionary (tax goes up, government expenditure goes down)
Receipts
o Taxes (income, wealth, business, expenditure)
o National insurance contributions
Outlays
o Expenditure on goods & services
o Transfer payments
o Debt interest
Budget balance
o Receipts – outlays
o Budget surplus: receipts > outlays
o Budget deficit: receipts < outlays
o Balanced budget: receipts = outlays
Monetary policy
controlled by central bank
1. Expansionary (increase economic activity)
Money supply rise
Interest rate fall
Methods:
o Lower interest rate
o Central bank buy bonds
o Required reserve ratio fall
2. Contractionary (decrease economic activity)
Money supply fall
Interest rate rise
Methods:
o Interest rate rise
o Sells bonds (reduce money supply)
o Required reserves ratio
Government debt
past deficits – past surpluses + payments to buy assets – receipts from
sale of assets
Chapter 23
Financial capital: funds firm use to buy physical capital, households
use to buy a home
Gross investment: total amount spent on new capital
Net investment: change in value of capital
Wealth: value of all things people own
Saving: amount of income not paid in taxes / spent on consumption
goods & services
Financial Capital Markets
Loan markets
o Mortgage: legal contract giving ownership of home to the
lender in case borrower fails to meet agreed loan payments
Bond markets
o Bond: promise to make specified payments on specified dates
o Bond identifies date of maturity & rate of interest paid
periodically until loan matures
o Mortgage-backed security:
entitles its holder to the income from a package of
mortgages
mortgage lenders create mortgage-backed securities
o Price of bond depends on term & credit risk
Length of time until bond matures
Probability borrower fail to pay some interest
o Government VS Corporate bonds
Low credit risk low interest
High credit risk high interest
Stock markets
o Stock: certificate of ownership & claim firm’s profits
o Stock market: financial market where shares of stocks of
corporations are traded
Financial Institutions
firm that operates on both sides of the markets for financial capital
Commercial banks
o Accept deposits, provide payment services, make loans to
firms & households
Mortgage companies
o Specialize in making loans for property purchases
o Loan for house purchase: packed into mortgage-backed
securities & sold to banks
Pensions funds
o Use pension contributions of firms & workers to buy bonds &
stocks
o Also hold mortgage-backed securities
Insurance companies
o Allow coping with risks (accident, theft, fire, ill-health, other
misfortunes)
o Use funds received to buy bonds & stocks (interest income)
Bank of England
o Regulate bank & money
Insolvency & Illiquidity
Net worth: market value of assets – market value of liabilities
Illiquid: long-term loans with borrowed funds & faced with sudden
demand to repay more loan than available cash
Interest rates & Asset prices
interest rate = % of price of asset
asset price rise = interest rate falls
Loanable Funds Market
aggregate of all the individual financial markets
Funds that finance investment
o Household saving (S)
o Government budget surplus (T – G)
o Borrowing from rest of the world (M – X)
Net taxes: taxes paid to governments - cash transfers received from
governments
Y=C+S+T
Y=C+I+G+X–M
I + G + X = M + S + T I = S + (T – G) + (M – X)
I is financed by household saving, government budget balance,
borrowing from foreign countries
National saving
private saving + public saving
Demand for loanable funds
Relationship between Q of loanable funds demanded & interest rate
Funds required by companies & households wanting to borrow
money to finance investments
Depends on:
o Real interest rate: additional goods & services lender buy
with interest received
o Expected profits
Cause change in loanable funds
Supply for loanable funds
Relationship between Q of loanable funds supplied & real interest
rate
Supply from private & public saving
Government deficit affects supply negatively, depends on:
o Disposable income
Income – net taxes
Saving & consumption expenditure increase if this rises
o Expected future income
The higher, the smaller saving is
o Wealth
The higher, the smaller the saving
o Risk of default
Risk that loan won’t be paid
Supply rise when:
o Rise in disposable income
o Decrease in expected future income
o Decrease in wealth
o Fall in default risk
increases saving
Government in Loanable Funds Market
Budget surplus
o Increase supply of loanable funds
o Real interest rate falls decreases household saving &
decreases Q of private funds supplied
Budget deficit
o Increase demand for loanable funds
o Real interest rate rises increases household saving &
increases Q of private funds supplied
o Higher real interest rate decreases investment & Q of
loanable funds demanded by firms
Crowding out effect
decrease in investment from government budget deficit
budget deficit crowds out investment by competing businesses for
scarce financial capital
Investment decreases by less than government budget deficit because
higher real interest rate cause increase in private saving contributing to
financing the deficit