Macroeconomics Final Cheat Sheet

● The Aggregate Expenditure model is a simple mathematical model that shows the short-run relationship between total spending in the economy and real GDP, assuming that the price level is constant. It is a model of output determination in the short run. ● The 4 components of AE are: Consumption (C), planned investment (I), government purchases (G) and net exports A (NX). AE = C + I + G + NX. The difference from GDP is planned investment (I) vs. actual investment (I ). Planned investment is the desired level of investment that firms wish to make. Actual investment is the level of investment firms A actually make due to inventory build ups or shortages. I = I + unplanned investment. When demand is too high, there will be an unplanned decrease in inventory investment, and vice-versa. ● Macroeconomic equilibrium: Y = AE. If AE < Y, inventories rise (unplanned increase in inventories) and GDP employment decrease (firms respond by producing less), and vice-versa. ● The level of AE in the economy is determined by determinants of each of the 4 components. Determinants of C: Disposable income, wealth, interest rate and expected future income. Determinants of I: interest rate, expected future profits, cash flows, corporate taxes and investment tax credit. Determinants of G: social programs, need of citizens (transfer payments are not a part of G). Determinants of NX: Depreciation/Appreciation of currency, relative price level (price level in the US vs. price level in other countries), relative growth of income (US Growth rate vs. growth rate in other countries), relative income (domestic income relative to foreign income). Note: Domestic income affects imports but not exports. Foreign income affects exports but not imports. Thus, real GDP affects imports but not exports. EX is a bar constant, not a function of GDP. IM is a function of GDP: IM + (MPM . Y), where MPM is the marginal propensity bar bar to import. So NX is a function of GDP: NX = NX - (MPM . Y). MPM is the slope of the import function: ΔIM / ΔY. ● Disposable income: Y - T (Y - TX + TR, where Y can be National Income). Most important determinant of C, as C if a function of DI (C = f (Y - T)). Linear function of Y - T: C = Co + MPC (Y - T) . MPC = ΔC / Δ(Y - T) . Note: Y - T = C + Spersonal . Solving for S: S = - Co + (1 - MPC) . (Y - T) ➝ S = So + MPS . (Y - T) . So MPS = 1 - MPC, and So = - bar bar bar bar Co . To summarize: AE = [Co - MPC . T + I +G + NX ] + MPC (Y) , where inside the [] we have our intercept, and MPC is AE's slope. ● Equilibrium: Algebraically: YE = [1/(1-MPC)] . [Co - MPC . Tbar + Ibar +Gbar + NXbar] ● Multipliers: Autonomous expenditure is spending unrelated to real GDP (income). If C = 250 + 0.75 (Y - T) , 250 is an autonomous consumption. I is always autonomous, because it's unrelated to real GDP or income. Induced expenditure is spending sensitive to real GDP (income). It is the 0.75 (Y - T). ● An increase in autonomous (planned) aggregate expenditure leads to an increase in equilibrium real GDP by more than the increase in autonomous (planned) aggregate expenditure. The multiple by which real GDP changes as a result of an increase in autonomous aggregate expenditure is called spending multiplier (Mspending). Mspending = ΔYE / ΔAE . So, ΔYE = Mspending . ΔAE . In terms of its value, Mspending = 1/(1 - MPC) . Thus, ΔYE = Mspending . [ΔCo - MPC . ΔTbar + ΔIbar + ΔGbar + ΔNXbar]. So a change in any of these components will lead to a change in Y by the multiplier times the component change. ● Tax Multiplier (Mnet tax): Mnet tax = ΔYE / ΔTax . ΔYE = Mnet tax . ΔT . Mnet tax = - MPC / (1 - MPC) ● Why does the multiplier process occur? If G goes up, firms respond by increasing Y (income), and as a result C goes up. Recall C = Co + MPC (Y - T) . So the tax multiplier is different because it has a negative sign.So C goes up by a factor of MPC. Thus, C goes up by less than Y. When C goes up, Y goes up, C goes up again, and so on… So ΔYE = multiple x ΔG or ΔAE . Conclusion: ΔCo , ΔI , ΔG , ΔNX ➝ Mspending , while ΔT ➝ Mnet tax . ● If we increase TR by 100 and our Mnet tax is -3: Because T = TX - TR: ΔT = - 100 . ΔYE = - 100 x - 3 = 300 . Thus, an increase in TR is expansionary (increases real GDP), while an increase in Taxes is contractionary (decreases real GDP). If TR are financed by an increase in TX: ΔT = 0 . MΔTR = ΔTX = 0 . Balanced budget multiplier happens when: MΔG = ΔT = 1. So if Mspending = 4 and Mnet tax is -3, Mspending + Mnet tax = 1. Or when MΔTR = ΔTX = 0 . Note: The larger the value of the MPC, the larger the multiplier. ● The Paradox of Thrift: Over the Long Run (LR), we saw that Saving = Investment (an increase in saving leads to an increase in investment). However, on the SR, saving could be counter-productive, because if we increase private saving, we are reducing consumption, which reduces real GDP, and this continues so on. This is the paradox. But some economists believe that the paradox may not exist after all. Why? Because an increase in saving will cause the reduction in the real interest rate, which leads to an increase in investment. If an increase in investment is at least the decrease in consumption, there is no paradox. ● The Aggregate Demand Curve: It is a curve that shows the relationship between Price Level and real GDP demanded (P vs Y). What happens when Price Level changes? 3 effects: (1) Wealth effect: If P increases, real wealth (W / P) will decrease (real wealth is wealth in terms of what you can buy), C will decrease and real GDP will decrease. Inverse relationship. (2) International trade effect: If P increases, domestic prices increase, exports are going to be more expensive, net exports decrease and real GDP will decrease. Inverse relationship. (3) Interest rate effect: If P increases, people need to hold more money to buy goods and services, so they hold fewer bonds, the interest rate increases (because there is an inverse relationship between interest rates and prices in financial products, and the price of the bond decreases due to less demand), investment decreases, and real GDP will decrease. Inverse relationship. ○ They will all lead to the downward slope of the aggregate demand (AD) curve ● Chapter 13 ● ● ● ● The aggregate demand and aggregate supply model explains short-run fluctuations in real GDP and the price level (could be the GDP Deflator, CPI, PPI...) Aggregate demand is the relationship between price level (P) and real GDP (Y) demanded. The aggregate demand curve is downward sloping because of the wealth effect, the international trade effect, the interest rate effect (all seen above) and the exchange rate effect. Exchange rate effect: If P increases, money demand will increase, causing the interest rate to increase, creating a capital inflow (people want to invest in the US), which increases the demand for domestic currency and consequently its value (domestic currency appreciation), which will make exports less attractive (as foreign prices are lower), and will decrease net exports, making real GDP decrease. Inverse relationship. ● Shifting the AD curve: Changes in P and Y do not shift the AD curve. Instead, they lead to movements along the curve. In order for the curve to shift, we have to change an exogenous factor. Rule: any exogenous change to aggregate expenditure will shift the AD curve (autonomous aggregate expenditure - unrelated to P and Y). ● ○ Any exogenous change in AE that increases Y at every P shifts the AD curve right. ○ Any exogenous change in AE that decreases Y at every P shifts the AD curve left. Factors that change AE components: CO : wealth, interest rate, expected future income, expectations, tastes/preferences. Tbar : expected future profit, cash flows, corporate taxes, investment tax credit, technology, interest rate, expectations. Gbar : pacing of government programs. NXbar : relative growth in income, exchange rate (appreciation, depreciation). ● ΔT and ΔG refer to fiscal policy, while ΔM refers to monetary policy. ○ Example 1: Firms are optimistic about the future → I increases → AE increases → Y increases (at any P level) → AD curve shifts right. ○ Example 2: Expansionary monetary policy: M (money supply) increases → r decreases → I increases → C increases → NX increases → AE increases → Y increases (at any P level) → AD shifts right. ○ Example 3: Expansionary fiscal policy: Government spending increases → G increases → AE increases → Y increases (at any P level) → AD curve shifts right. ● ● ● ● ● ● Aggregate supply is the relationship between price level (P) and real GDP (Y) supplied. This relationship depends on the time horizon, so there are 2 aggregate supply curves: LRAS and SRAS. The long-run aggregate supply (LRAS) shows the relationship between P and Y supplied in the long-run. The short-run aggregate supply (SRAS) shows the relationship between P and Y supplied in the short-run. The LRAS curve: In the LR, real GDP depends on (1) factor supplies (labor and capital) and (2) technology. With fixed factor supplies and technologies in the LR, the LRAS is vertical at potential real GDP (Ybar). Potential real GDP = full employment real GDP or nature rate of real GDP. Factors that shift LRAS: Changes in factor supplies and technology. This is called a permanent supply shock. Changes in AD do not affect output, but prices on way (prices are flexible in the long run). The SRAS curve: It is upward-sloping because prices (and wages) are sticky (slow to adjust). Why? Due to the sticky price theory, the sticky wage theory and the misinformation/misconception price theory. Equation for the SRAS curve: P = Pe + � (Y - Y bar) + temporary supply shock. Where Pe is the expected price level, alpha is a slope that measures sensitivity of P to changes in the output gap, Y - Ybar is the output gap, Ybar is potential real GDP and the temporary supply shock is an event that affects production or the cost of production. ● Factors that shift SRAS: Changes in (1) Pe (expected price level), (2) output gap (what affects Ybar : technology, factor supplies, productivity, and natural rate of employment), (3) temporary supply shock. ● Macroeconomic equilibrium in SR and LR: Occurs when AD, LRAS and SRAS curves intersect with each other. The SRAS and AD intersect at the LRAS level. Assumptions: the economy has not been experiencing any inflation, and the economy is not experiencing any long run growth. ● Adjusting to shocks (adjustment from SR to LR): adjustment occurs through changes in the expected price level (Pe), which shift the SRAS. There are 3 cases: ○ 1. Output is too low (Y < Ybar): people will expect that prices will fall due to wage cuts (there is unemployment happening). As the price level falls, SRAS will increase until we get to Y bar (potential real GDP). ○ 2. Output is too high (Y > Ybar): people will expect the price level increase, making the SRAS decrease and ○ 3. Y = Ybar: No adjustment is needed. We are already at full employment. return to potential real GDP. ● Positive (favorable) demand shock: Consider an increase in wealth (stock market boom): Initially we assume that the economy started at its LR equilibrium. The increase in wealth causes Co to rise, and therefore AD increases. This will make Y increase and P increase. The LR response: As now Y > Ybar , the price level will rise and SRAS will shift left or up. We will return to Ybar but with a higher price level. ● Negative (adverse) demand shock: Suppose that firms expect profits to decrease (pessimistic about future profits): Assume that the economy is at LR equilibrium initially. If expected future profitability decreases, I bar decreases, AD shifts left, decreasing P and Y. The SR response: Y and P decrease. The LR response: Because Y < Y bar , the economy might have gone into a recession with high unemployment, Pe will decrease, and SRAS will increase until it hits Ybar again, setting a new equilibrium with a lower P. ● Temporary negative (adverse) supply shock: Suppose there is an increase in oil prices: Initially, the economy starts at LR equilibrium. As oil prices go up, SRAS decreases. The SR response: Y falls and P increases. This is called stagflation (combination of falling output and rising price level). The LR response: As Y < Ybar, Pe will decrease, making SRAS decrease until it returns to Ybar, where we have started. ○ Fiscal and/or monetary policy might have to be used to restore full employment, and it can be lengthy (take many years). The average is 6 quarters. ● The Dynamic Aggregate Demand and Aggregate Supply Model: In our previous model, we assumed no inflation, no growth, and no population growth. Movements were caused only by shocks and adjustments. Nothing else was going on. But in reality that's not true. There are several other dynamic aspects: ○ Continually increasing real GDP, shifting LRAS to the right; ○ AD also ordinarily shifting to the right; ○ SRAS also shifting to the right except when workers and firms expect high rates of inflation. In this case, LRAS increases and SRAS does not shift as much, and it even might decrease. ● Suppose that firms become more optimistic so that AD is expected to grow faster than production(AD grows too fast). LRAS shifts to the right as usual, but demand will increase much more (shifting more to the right ) so that SRAS will have to decrease due to increases in price level (P), in order to restore equilibrium between LRAS, SRAS and AD. This is called self-adjustment. A contractionary policy could reduce AD and make SRAS not need to shift left (decrease). This way the price level won't increase so much as it would without the policy. A contractionary policy is usually used when output Y is too high and the economy is expanding quickly, what could lead to inflation. ● Chapter 14 ● Money is a liquid asset that people are willing to accept in exchange for goods/services and repayment of debt. Importance of money: In absence of a money economy, we have a barter economy (straight exchange of goods/services). Problems with barter economy (that make it inefficient): (1) Time consuming; (2) Double coincidence of wants (I must produce what another person wants). Money removes those requirements and makes trade much more efficient. ● Functions/Properties of money: ○ i. Defining property of money: medium of exchange (anything that is used in exchange for goods/services). ○ ii. Unit of account (a way to quote prices or measure value in a standard or consistent manner). In the U.S., ○ iii. Store of value (a way to store wealth, which can transfer purchasing power into the future). With inflation, ○ iv. Standard of deferred payment (money facilitates exchanges across time when we anticipate that its value the dollar is the unit of account. money is not a good store of value. Liquidity of money makes it an attractive store of value. (purchasing power) in the future will be predictable). ● ● What can serve as money? The good must have the following characteristics: ○ i. Must be acceptable to most people; ○ ii. Should be of standardized equality so any two units are alike; ○ iii. Should be durable so that value is not lost by wearing out; ○ iv. Should be valuable relative to its weight, so that it can easily be transported even in large quantities; ○ v. Should be divisible enough to be used for purchases of both low-priced and high-priced goods. Types of money: ○ i. Commodity money: Money that has intrinsic value. For example, gold and cigarettes in prison camps. ○ ii. Fiat money: Money authorized by a government or Central bank. For example, dollar bills. Advantage: Governments do not have to be willing to exchange it for gold or some other commodity on demand. Disadvantage: People must have faith in that money. If people stop "believing" in fiat money, it will cease to be useful. ■ Note: Credit cards are not money, even though they exchange for goods/services. ● Money, Income, Wealth: ○ a. Wealth:; Value of all assets that an individual or firm owns. It includes money. It is a stock variable: ○ b. Money: Liquid asset used in exchange for goods/services. It is also a stock variable. ○ c. Income: Earnings over a period of time. It is a flow variable: something whose value is determined in something whose value is determined at one point in time. reference with 2 points in time (over time). A flow leads to a change in a stock. ● How is money measured in the United States today? ○ M1: Is the narrow definition of the money supply: the sum of currency in circulation, checking account deposits in banks, and holdings of traveler's checks. M1 = C + D + TC. This is the simplest measure, more about transaction money. ○ M2: Is a broader definition of the money supply that includes M1, plus savings account deposits, smalldenomination time deposits, balances in money market deposit accounts, and non-institutional money market fund shares. M2 = M1 + saving accounts + small denomination time deposits + money market deposit accounts + money market fund shares. Money market characteristics: ○ ● ■ Short term; ■ Liquid; ■ Safe. If not specified, money supply refers to M1. How do banks create money? ○ i. Balance sheets of key players: ■ Central bank, Fed: On the assets side, they have securities, foreign reserves, and loans (to banks: discount loans). On the liabilities side, they issue currency and reserves. ■ Banks: On the assets side, they have reserves, loans and securities. On the liabilities side, they have deposits and loans from the Central bank and other banks. ■ Nonbank public: On the assets side, they have cash, deposits, bonds, etc. On the liabilities side, they have personal loans. ○ ii. Key definitions: ■ ■ 1. Reserves (R): Portion of total deposits that banks keep. ● Reserves = cash in banks vaults + deposits at Fed; ● Reserves = Required reserves (RR) + excess reserves (ER); ● Reserves = Borrowed reserves (BR) + non borrowed reserves (NBR). 2. Required reserves (RR): Amount (portion) of total deposits that banks are required to keep. They represent 10% of total deposits. ■ 3. Excess reserves (ER): Amount (portion) of total deposits that banks keep but are not required to. ■ 4. Borrowed reserves (BR): Come from banks borrowing from the Fed. ■ 5. Non borrowed reserves (NBR): Created mostly through open market operations. ■ 6. Reserve requirement (rr) (required reserve ratio): RR / Total deposits. If not specified, use 10%. ■ 7. Open market operations (OMO): Buying and selling of government securities by the Fed to influence the money supply. ■ 8. 100% reserve banking system: System in which banks keep all deposits as reserves. Reserves / Total Deposits = 1. ■ 9. Fractional reserve banking system: Banks keep a fraction of deposits as reserves. ○ iii. How do banks really create money? ■ Recall that M = C + D; ■ Banks create deposits, therefore play an important role in creation of money. ■ Banks create deposits up to the point allowed by the reserve requirement (rr). rr = RR / total deposits. ■ Example: Assume fractional banking system (rr = 10%). Currency = $100. Currency is deposited in a bank. Bank receives $100 and keeps 10% as reserves, and lends the rest (90%). The borrower receives $90, and deposits in a 2nd bank. Bank 2 receives $90 deposit, keeps 10% as reserves ($9) and lends the rest (90% - $81). The rest is deposited into a 3rd bank, and the process goes on and on. There is a multiplier process. ■ Summary: This process leads to total deposits of $1000. The multiple by which deposits change is called the deposit multiplier. In this example, the value of the deposit multiplier is 10, because the currency is $100, and total deposits is $1000. Deposit multiplier = total deposits / reserves (initial deposits) = Δ total deposits / Δ reserves. ● Simple deposit multiplier = maximum value of deposit multiplier. ● The value of dm can be (1 / rr) under 4 assumptions: ● ○ i. No one wants to hold currency (pocket money); ○ ii. Banks are fully load up (hold no excess reserves); ○ iii. There are no thrift accounts (savings accounts); ○ iv. No leakages to foreign banking system. Money multiplier = money supply / reserves = Δ money supply / Δ reserves. Under 4 assumptions, dm = mm: ● ○ i. Currency to deposit ratio (cr) = 0; ○ ii. Excess reserve to deposit ratio (er) = 0. ○ If both > 0, dm = 1 / (rr + er + cr), and mm = (1 + cr) / (rr + er + cr). Values of dm and mm are much lower than 1 / rr in the real world. This is because people do hold currency and banks do hold excess reserve. ● IV. Federal Reserve System ○ 1. Creation: The Fed was created in 1914 by Act of Congress to have the role of lender as a last resort. Around 1914, bank runs and panics were happening, so the Central Bank was needed to act as a lender of last resort. ○ 2. Structure of Fed: ■ Elements: ● 1. Board of Governors (D.C.) ● 2. Federal Open Market Committee (FOMC); ● 3. 12 Federal Reserve Banks across the nation; ● 4. Member banks; ● 5. Federal Advisory Board; ○ The Fed makes decisions on monetary policy. ○ 3. Tools of monetary policy: ■ How Fed affects reserves and money (and interest rate): ● 1. Open market operations (OMO); ○ To increase the money supply, open market purchase (OMP), and the interest ○ To decrease the money supply, open market sale (OMS), and the interest rate rate falls. rises. ● ● 2. Discount rate (dr): ○ Rate that Fed charges banks when they borrow from the Fed - discount loans. ○ If dr increases, the money supply decreases, increasing the interest rate. ○ If dr decreases, the money supply increases, decreasing the interest rate. 3. Reserve requirement (rr): ○ If rr increases, the excess reserve will fall and the money supply will decrease, ○ If rr decreases, the excess reserve will rise and the money supply will increase, increasing the interest rate. decreasing the interest rate. ● 4. Interest rate paid on reserves (ir): ○ If ir increases, the excess reserve will rise, the money supply will fall and the ○ If ir decreases, the excess reserve decreases, the money supply will increase interest rate will rise. and the interest rate will fall. ● The Shadow Banking System is non-bank financial firms that started to loan money. ● V. Quantity Theory of Money (QTM) ○ 1. Definition: QTM is a classical theory of inflation. It links money and the price level or the growth of money and the inflation rate. ■ ○ ΔM / M (growth of money) would lead to ΔP / P (growth of price). 2. Velocity and Quantity Equation (equation of exchange): ■ Quantity equation: M x V = P x Y, where M is the money supply and V is the velocity of money. P x Y (output) is nominal income, or nominal GDP. Velocity is the average number of times that money changes hands in the economy (average number of times that a $1 bill is used in transactions). ■ V = (P x Y) / M . ■ Quantity equation in growth rate terms: ● If ΔM / M > ΔY / Y, we have inflation; ● If ΔM / M < ΔY / Y, we have deflation; ● If ΔM / M = ΔY / Y, we have stable prices. ● So according to the QTM, when money grows too fast, it will result in inflation. When money grows way too fast, it will result in hyperinflation. ● When the government prints money to raise revenue, it's called seigniorage. That leads to inflation and even hyperinflation. ● Final Considerations: ○ Mspending + Mtax = Mspending - Mtransfer = 1 ○ Mtransfer + Mtax = 1