Study Guide Macroeconomics

Chapter 1. Measuring a Nation´s Income

Definition of Macroeconomics: the study of economy-wide phenomena, including inflation,
unemployment and economic growth.

Gross Domestic Product (GDP)

Measures the total income of everyone in the economy and the total expenditure on the
economy’s output of goods and services.
 For an economy as a whole, the income must be equal to the expenditure.

Circular-flow diagram
Markets
• Goods and services
• Factors of production
Households
• Spend all of their income
• Buy all goods and services
Firms
• Pay wages, rent, profit to resource owners

Households buy goods and services from firms

Firms use their revenue from sales to paywages to workers, rent to landowners, and profit to
firm owners.
GDP = total amountspent by households in the market for goods and services.
It also equals the total wages, rent, and profit paid by firms in the markets for the factors of
production.

GDP: is the market value of all final goods and services produced within a country in a given period.

“Market prices”--- reflect the value of the goods.

“Of all…” ---- all items produced and sold legally in markets, and excludes the one produced and
consumed at home.
 “… final…” --- Value of intermediate goods is already included in the prices of the final goods

“… goods and services…” --- Tangible goods & intangible services

“… Produced…” -- Goods and services currently produced

“… Within a country…” -- Goods and services produced domestically (Regardless of the nationality of
the producer)

“… In a given period of time” -- A year or a quarter

Y = C + I + G + NX
Y (Income $) = GDP
C = consumption – spending by households (families) on goods and services.
I = investment – Purchase of (capital) goods that will be used to produce other goods and services
in the future.
G = government purchases – Government consumption expenditure and gross investment.Spending
on goods and services. By local, state, and federal governments.
NX = net exports (Exports-Imports) – Exports(X): Spending on domestically produced goods by
foreigners. Imports (N): Spending on foreign goods by domestic residents.

Real and Nominal GDP

• Total spending rises from one year to the next
– Economy — producing a larger output of goods and services
– And/or goods and services are being sold at higher prices
• Nominal GDP
– Production of goods and services
– Valued at current prices
• Real GDP
– Production of goods and services
– Valued at constant prices
– Designate one year as base year
– Not affected by changes in prices
• For the base year
– Nominal GDP = Real GDP

PIB Nominal: (quantity 1 x price 1) + (quantity 2 x price 2)

PIB Real: (quantity 1 x price 1 of the base year) + (quantity 2 x price 2 of the base year
GDP DEFLATOR
Nominal GDP divided by Real GDP times 100

𝐷𝑒𝑓𝑙𝑎𝑡𝑖𝑜𝑛PIB
Nominal
= × 100
PIB REAL

INFLATION
Inflation in year 2 =
Deflation current yea -Deflation previous year
= × 100
Deflation previous year

GDP – “the single best measure of the economic well-being of a society”

 Economy’s total income
 Economy’s total expenditure
 Larger GDP
 Good life, better healthcare
 Better educational systems
 Measure our ability to obtain many of the inputs into a worthwhile life

International differences: GDP & quality of life

Rich countries — higher GDP per person
Better:
 Life expectancy
 Literacy
 Internet usage
Poor countries — lower GDP per person
Worse:
 Life expectancy
 Literacy
 Internet usage

Low GDP per person

 More infants with low birth weight
 Higher rates of infant mortality
 Higher rates of maternal mortality
 Higher rates of child malnutrition
 Less common access to safe drinking water
 Fewer school-age children are actually in school
 Fewer teachers per student
 Fewer televisions
 Fewer telephones
 Fewer paved roads
 Fewer households with electricity

Chapter 2. Aggregate Demand

Economic Fluctuations
Economic activity
 Fluctuates from year to year
Recession
 Economic contraction
 Period of declining real incomes and rising unemployment
Depression
 Severe recession

Three key facts about economic fluctuations

1. Economic fluctuations are irregular and unpredictable
• The business cycle
2. Most macroeconomic quantities fluctuate together
• Recessions: economy-wide phenomena
3. As output falls, unemployment rises

Aggregate-Demand curve
 Shows the quantity of goods and services
 That households, firms, the government, and customers abroad
 Want to buy at each price level
 Downward sloping

Aggregate-supply curve
 Shows the quantity of goods and services
 That firms choose to produce and sell
 At each price level
 Upward sloping

Aggregate-Demand Curve
Y = C + I + G + NX
Three effects explain why AD curve slopes downward:
 Wealth effect (C )
 Interest-rate effect (I)
 Exchange-rate effect (NX)

Assumption: government spending (G)

 Fixed by policy
Price level and consumption (C): the wealth effect
 Decrease in price level
 Increase in the real value of money
 Consumers are wealthier
 Increase in consumer spending
 Increase in quantity demanded of goods and services
Price level and consumption (C): the interest-rate effect
 Decrease in price level
 Decrease in the interest rate
 Increase spending on investment goods
 Increase in quantity demanded of goods and services
Price level and net exports (NX): the exchange-rate effect
 Decrease in U.S. price level
 Decrease in the interest rate
 U.S. dollar depreciates
 Stimulates U.S. net exports
 Increase in quantity demanded of goods and services
Summary: a fall in price level
 Increases quantity of goods and services demanded, because:
1) Consumers are wealthier: stimulates the demand for consumption goods
2) Interest rates fall: stimulates the demand for investment goods
3) Currency depreciates: stimulates the demand for net exports
Summary: a rise in price level
 Decreases the quantity of goods and services demanded, because:
1)Consumers are poorer: depress consumer spending
2)Higher interest rates fall: depress investment spending
3)Currency appreciates: depress net exports

The AD curve might shift:

 Changes in consumption, C
 Changes in investment, I
 Changes in government purchases, G
 Changes in net exports, NX

Changes in consumption, C
 Events that change how much people want to consume at a given price level
Changes in taxes, wealth
 Increase in consumer spending
Aggregate-Demand curve: shift right
Changes in investment, I
 Events that change how much firms want to invest at a given price level
Better technology
Tax policy
Money supply
 Increase in investment
Aggregate-Demand curve: shift right

Changes in government purchases, G

 Policy makers – change government spending at a given price level
Build new roads
 Increase in government purchases
Aggregate-Demand curve: shift right

Changes in net exports, NX

 Events that change net exports for a given price level
Recession in Europe
International speculators – change in exchange rate
 Increase in net exports
Aggregate-Demand curve: shift right

Why Does the Aggregate-Demand Curve Slope Downward?

1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on
consumption.
2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates
spending on investment.
3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate,
which stimulates spending on net exports.

Aggregate-Supply Curve
Natural level of output
 Production of goods and services
 That an economy achieves in the long run
 When unemployment is at its normal rate
 Potential output
 Full-employment output

The LRAS (long run aggregate supply) curve might shift:

 Any change in natural level of output
 Changes in labor
 Changes in capital
 Changes in natural resources
 Changes in technological knowledge
Changes in labor
– Quantity of labor – increases
• Aggregate-supply curve: shifts right
– Natural rate of unemployment – increases
• Aggregate-supply curve: shifts left
Changes in capital
– Capital stock – increase
• Aggregate-supply curve: shifts right
– Physical and human capital
Changes in natural resources
– New discovery of natural resource
• Aggregate-supply curve: shifts right
– Weather
– Availability of natural resources
Changes in technology
– New technology, for given labor, capital and natural resources
• Aggregate-supply curve: shifts right
– International trade
– Government regulation
Aggregate supply curve slopes upward in the short-run:
– Price level affects the economy’s output
– Increase in overall level of prices in economy
• Tends to raise the quantity of goods and services supplied
– Decrease in level of prices
• Tends to reduce quantity of goods and services supplied

Four Steps for Analyzing Macroeconomic Fluctuations

1. Decide whether the event shifts the Aggregate-Demand curve or the aggregate-supply curve
(or perhaps both).
2. Decide the direction in which the curve shifts.
3. Use the diagram of aggregate demand and aggregate supply to determine the impact on
output and the price level in the short run.
4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy
moves from its new short-run equilibrium to its new long-run equilibrium.
Questions
1. The aggregate demand and aggregate supply graph has the: Quantity of output on the
horizontal axis. Output is best measured by real GDP.
2. The Aggregate-Demand curve: Shows an inverse relation between the price level and the
quantity of all goods and services demanded.
3. When the price level falls the quantity of: consumption goods demanded and the quantity
of net exports demanded both rise.
4. Other things the same, a fall in an economy's overall level of prices tends to: raise the
quantity demanded of goods and services, but lower the quantity supplied.
5. The wealth effect, interest-rate effect, and exchange-rate effect are all explanations for:
the slope of the Aggregate-Demand curve.
6. Which effects helps to explain the slope of the Aggregate-Demand curve: the exchange-rate
effect, the wealth effect and the interest-rate effect
7. Changes in the price level affect which components of aggregate demand: Consumption,
investment and net exports.
8. Other things the same, a decrease in the price level makes consumers feel: Wealthier, so
the quantity of goods and services demanded rises.
9. Which of the following decreases in response to the interest-rate effect from an increase
in the price level? Investment and consumption.
10. The quantity of aggregate goods and services demanded rises when the: price level falls,
because the interest rate falls.
11. When the dollar depreciates, U.S.: Exports increase and imports decrease.
12. When the dollar appreciates, U.S.: Exports decrease and imports increase.
13. From 2006 to 2008, there was a dramatic fall in the price of houses. If this fall made people
feel less wealthy, then it would have shifted: Aggregate demand right.
14. Other things the same, when the government spends more, the initial effect is that:
Aggregate demand shifts right.
15. Tax cuts shift aggregate demand: Right as do increases in government spending.

Chapter 3. The Influence of Monetary and Fiscal Policy on Aggregate Demand

Aggregate Demand
Aggregate-Demand (AD) curve slopes downward:
– Simultaneously:
• The wealth effect
• The interest-rate effect
• The exchange-rate effect
– When price level falls - quantity of goods and services demanded increases
• When price level rises - quantity of goods and services demanded decreases
For the U.S. economy
– The wealth effect - least important
• Money holdings – a small part of household wealth
– The exchange-rate effect - not large
• Exports and imports – small fraction of GDP
– The interest-rate effect
• The most important
The theory of liquidity preference
– Keynes’s theory
– Interest rate adjusts:
• To bring money supply and money demand into balance
– Nominal interest rate
– Real interest rate
– Assumption: expected rate of inflation is constant

Demand and Supply of Money

Money supply
– Controlled by the Fed
– Quantity of money supplied
• Fixed by Fed policy
• Doesn’t vary with interest rate
– Fed alters the money supply
• Changing the quantity of reserves in the banking system
– Purchase and sale of government bonds in open-market operations
Money demand
– Money: most liquid asset --- Can be used to buy goods and services
– Interest rate: opportunity cost of holding money
– Money demand curve – downward sloping
• Increase in the interest rate
 Raises the cost of holding money
 Reduces the quantity of money demanded
Equilibrium in the money market
– Interest rate – adjusts to balance the supply and demand for money
– Equilibrium interest rate
– Quantity of money demanded exactly balances the quantity of money supplied
If interest rate > equilibrium
– Quantity of money people want to hold
• Less than quantity supplied
– People holding the surplus
• Buy interest-bearing assets
– Lowers the interest rate
– People - more willing to hold money
– Until: equilibrium
If interest rate < equilibrium
– Quantity of money people want to hold
• More than quantity supplied
– People - increase their holdings of money
• Sell - interest-bearing assets
– Increase interest rates
– Until: equilibrium
 Aggregate Demand
The downward slope of the AD curve
1. A higher price level ------- Raises money demand
2. Higher money demand ---------- Leads to a higher interest rate
3. A higher interest rate ----------Reduces the quantity of goods and services demanded.

Monetary Policy Influences AD

Aggregate-Demand curve shifts

– Quantity of goods and services demanded changes
– For a given price level
Monetary policy
– Increase in money supply
– Decrease in money supply
– Shifts Aggregate-Demand curve
The Fed increases the money supply
– Money-supply curve shifts right
– Interest rate falls
– At any given price level
• Increase in quantity demanded of goods and services
– Aggregate-Demand curve shifts right

The Fed decreases the money supply

– Money-supply curve shifts left
– Interest rate increases
– At any given price level
• Decrease in quantity demanded of goods and services
– Aggregate-Demand curve shifts left
Federal funds rate
– Interest rate
– Banks charge one another
 – For short-term loans
The Fed: targets the federal funds rate
– The FOMC – open-market operations
• Adjust money supply
Changes in monetary policy aimed at expanding aggregate demand
– Increasing the money supply
– Lowering the interest rate
Changes in monetary policy aimed at contracting aggregate demand
– Decreasing the money supply
– Raising the interest rate
Liquidity trap
– If interest rates have already fallen to around zero, monetary policy may no longer be effective.
– Aggregate demand, production, and employment may be "trapped" at low levels
Zero lower bound (interest rate)
– A central bank continues to have tools to expand the economy:
• Raise inflation expectations by committing to keep interest rates low
• Buy a larger variety of financial instruments (mortgages, corporate debt, and longer-term
government bonds)
Hitting the zero lower bound for interest rates
– Justifies setting the target rate of inflation well above zero
– Moderate inflation gives monetary policymakers more room to stimulate theeconomy

Fiscal Policy Influences AD

Fiscal policy
– Government policymakers
– Set the level of government spending and taxation
• Shift the aggregate demand
 Multiplier effect
 Crowding-out effect
The multiplier effect
– Additional shifts in aggregate demand
• Result when expansionary fiscal policy increases income and it increases consumer spending
The multiplier effect of an increase in government purchases by $20 billion
– Aggregate-Demand curve
• Shifts right by exactly $20 billion
– Consumers respond
• Increase spending
– Aggregate-Demand curve
• Shifts right again

Multiplier effect
– Response of consumer spending
– Response of investment
 Investment accelerator
– Higher government demand
• Higher demand for investment goods
– Positive feedback from demand to investment
Spending multiplier
– Marginal propensity to consume, MPC
• Fraction of extra income that consumers spend
– Size of the multiplier
• Depends on the MPC
– A larger MPC
• Larger multiplier
Spending multiplier = 1/(1 – MPC)

Because of multiplier effect

– $1 of government purchases
• Can generate > $1 of aggregate demand
– $1 of consumption, investment, or net exports
• Can generate > $1 of aggregate demand
The crowding-out effect
– Offset in aggregate demand
– Results when expansionary fiscal policy raises the interest rate
– Thereby reduces investment spending
The crowding-out effect of an increase in government spending
– Aggregate-Demand curve – shifts right
• Increase in income
• Money demand – increases
• Interest rate – increases
• Aggregate-Demand curve – shifts left

A decrease in personal income taxes

– Households income – increases
– Multiplier effect
• Aggregate demand – increases
– Crowding-out effect
• Aggregate demand – decreases
– Permanent tax cut – large impact on AD
– Temporary tax cut – small impact on AD
Chapter 4. The Balance of payments and exchange rates
Closed economy: Economy that does not interact with other economies in the world
Open economy: Economy that interacts freely with other economies around the world

Open Economy
• Interacts with other economies:
– It buys and sells goods and services in world product markets
– It buys and sells capital assets such as stocks and bonds in world financial markets
Flow of Goods
• Exports
– Goods and services that are produced domestically and sold abroad
• Imports
– Goods and services that are produced abroad and sold domestically
• Net exports(Trade balance)
– Value of a nation’s exports minus the value of its imports
• Trade surplus (Positive net exports)
– Exports are greater than imports: sells (+) goods and services abroad than it buys.
• Trade deficit (Negative net exports)
– Imports are greater than exports: sells (-) goods and services abroad than it buys.
• Balanced trade: Exports = Imports
• Factors that might influence a country’s exports, imports, and net exports:
– Tastes of consumers for domestic &foreign goods
– Prices of goods at home and abroad
– Exchange rates at which people can use domestic currency to buy foreign currencies
– Incomes of consumers at home and abroad
– Cost of transporting goods from country to country
– Government policies toward international trade
The increasing openness of the U.S. economy
• Increasing importance of international trade and finance
– 1950s, imports and exports: 4-5% of GDP
– Recent years – about three times that level
• Largest trading partner, 2015 (imports and exports combined)
– China
– Followed by Canada, Mexico, Japan, Germany, South Korea, the United Kingdom
• Increase in international trade
– Improvements in transportation
 Cargo ships, long-distance jets, wide-body jet
– Advances in telecommunications
 Telephone, e-mail
– Technological progress
 Light and easy to transport goods
– Government’s trade policies
 NAFTA, GATT
The Flow of Financial Resources
• Net capital outflow (net foreign investment)
– Purchase of foreign assets by domestic residents
 Foreign direct investment
 Foreign portfolio investment
– Minus the purchase of domestic assets by foreigners
• Variables that influence net capital outflow
– Real interest rates paid on foreign assets
– Real interest rates paid on domestic assets
– Perceived economic and political risks of holding assets abroad
– Government policies that affect foreign ownership of domestic assets
Net Exports = Net Capital Outflow
• Net exports (NX)
– Imbalance between a country’s exports and its imports
• Net capital outflow (NCO)
– Imbalance between
 Amount of foreign assets bought by domestic residents
 And the amount of domestic assets bought by foreigners
• Identity: NCO = NX
• When NX > 0 (trade surplus)
– Selling more goods and services to foreigners
 Than it is buying from them
– From net sale of goods and services
 Receives foreign currency
 Buy foreign assets
 Capital is flowing out of the country: NCO > 0
• When NX < 0 (trade deficit)
– Buying more goods and services from foreigners
 Than it is selling to them
– The net purchase of goods and services
 Needs financed
 Selling assets abroad
 Capital is flowing into the country: NCO < 0
Saving and Investment
• Open economy: Y = C + I + G + NX
• National saving: S = Y – C – G
– Y – C – G = I + NX
– S = I + NX
• NX = NCO
– S = I + NCO
– Saving = Domestic investment + Net capital outflow

International Flows
• Trade surplus: Exports > Imports
• Net exports > 0
• Y > Domestic spending (C+I+G)
• S>I
• NCO > 0
• Trade deficit: Exports < Imports
• Net exports < 0
• Y < Domestic spending (C+I+G)
• S<I
• NCO < 0
• Balanced trade: Exports = Imports
• Net exports = 0
• Y = Domestic spending (C+I+G)
• S=I
• NCO = 0
International Flows of Goods and Capital: Summary
 This table shows the three possible outcomes for an open economy.

Is the U.S. trade deficit a national problem?

• The United States
– “The world’s largest debtor”
– Borrowing heavily in world financial markets during the past three decades
 To finance large trade deficits
• Before 1980
– National saving and domestic investment were close
– Small net capital outflow (between – 1 and 1 % of GDP)

• After 1980
– National saving – often falling below domestic investment
– Sizable trade deficits
– Substantial inflows of capital
– Net capital outflow is often a large negative number
• Unbalanced fiscal policy: 1980 to 1987
– Flow of capital into the U.S. declines
 From 0.5 to 3.1% of GDP (2.6 percentage point change)
– Due to a fall in national saving of 3.2 percentage points
 Due to decline in public saving
 Increase in the government budget deficit
 President Ronald Reagan cut taxes and increased defense spending
• An investment boom: 1991 to 2000
– Increase flow of capital (from 0.5 to 3.9% of GDP)
– Saving increased
– Government budget surplus
– Investment increased from 13.4 to 17.8% of GDP
• An economic downturn and recovery: 2000 to 2015
– 2000-2009, saving and investment fell by about 6 percentage points.
 Investment: tough economic times made capital accumulation less profitable
 Saving: government began running extraordinarily large budget deficits
– 2009-2015, as the economy recovered, saving and investment increased by about 3 percentage
points
• Are these trade deficits and international capital flows a problem for the U.S. economy?
– No easy answer to this question
• Trade deficit induced by a fall in saving (1980s)
– The nation is putting away less of its income to provide for its future
– No reason to deplore the resulting trade deficits
 Better to have foreigners invest in the U.S. economy than no one at all
• Trade deficit induced by an investment boom (1990s)
– Economy is borrowing from abroad to finance the purchase of new capital goods
 For good return on investment - the economy should be able to handle the debts that are
being accumulated
 For lower return on investment - debts will look less desirable
Prices for International Transactions
• Nominal exchange rate
– Rate at which a person can trade currency of one country for currency of another
• Example
– Exchange rate = 80 yen per dollar
• Appreciation (strengthen)
– Increase in the value of a currency as measured by the amount of foreign currency it can buy
 Buy more foreign currency
 • Example: dollar appreciation
– Exchange rate (old) = 80 yen per dollar
– Exchange rate (new) = 90 yen per dollar
– (Yen depreciation)
• Depreciation (weaken)
– Decrease in the value of a currency
– As measured by the amount of foreign currency it can buy
 Buy less foreign currency
• Example: dollar depreciation
– Exchange rate (old) = 80 yen per dollar
– Exchange rate (new) = 70 yen per dollar
– (Yen appreciation)
• Real exchange rate
– Rate at which a person can trade goods and services of one country
– For goods and services of another
Real exchange rate 
Nominal exchange rate  Domestic price

Foreign price
• Real exchange rate = (e ˣ P) / P*
– Using price indexes
– e: nominal exchange rate between the U.S. dollar and foreign currencies
– P: price index for U.S. basket
– P*: price index for foreign basket
• Depreciation (fall) in the U.S. real exchange rate
– U.S. goods: cheaper relative to foreign goods
– Consumers at home and abroad buy more U.S. goods and fewer goods from other countries
 Higher exports, Lower imports
 Higher net exports
• An appreciation (rise) in the U.S. real exchange rate
– U.S. goods - more expensive compared to foreign goods
– Consumers at home and abroad - buy fewer U.S. goods and more goods from other countries
 Lower exports, Higher imports
 Lower net exports
Purchasing-Power Parity
• Purchasing-power parity, PPP
– Theory of exchange rates
– A unit of any given currency should be able to buy the same quantity of goods in all countries
• Basic logic of purchasing-power parity
– Based on the law of one price
– A good must sell for the same price in all locations
• Arbitrage
– Take advantage of price differences for the same item in different markets
– Result: the law of one price
• PPP
– Parity: Equality
– Purchasing-power: Value of money in terms of quantity of goods it can buy
Implications of PPP
• If purchasing power of the dollar is always the same at home and abroad
– Then the real exchange rate cannot change
• Theory of purchasing-power parity
– Nominal exchange rate between the currencies of two countries
– Must reflect the price levels in those countries
• Implications:
 – Nominal exchange rates change when price levels change
– When a central bank in any country increases the money supply
 And causes the price level to rise
 It also causes that country’s currency to depreciate relative to other currencies in the world
Nominal exchange rate during a hyperinflation
• Natural experiment, hyperinflation
– High inflation
– Arises when a government prints money to pay for large amounts of government spending
• German hyperinflation, early 1920s
– Money supply, price level, nominal exchange rate
 Move closely together
• German hyperinflation, early 1920s
– Money supply - starts growing quickly
 Price level – starts growing; Depreciation
– Money supply - stabilizes
 Price level and exchange rate – stabilize
• Quantity theory of money
– Explains how the money supply affects price level
• Purchasing power parity
– Explains how price level affects nominal exchange rate
Limitations of PPP
• Theory of purchasing-power parity does not always hold in practice
1. Many goods are not easily traded
2. Even tradable goods are not always perfect substitutes
 When they are produced in different countries
 No opportunity for profitable arbitrage
• Purchasing-power parity
– Not a perfect theory of exchange-rate determination
– Real exchange rates fluctuate over time
• Large and persistent movements in nominal exchange rates
– Typically reflect changes in price levels at home and abroad

Predicted exchange rate = Price in foreign country (in foreign currency) divided by price in U.S.
Chapter 5. Unemployment and Inflation
Inflation and Unemployment
• Inflation and unemployment
– Closely watched indicators of economic performance
• Commentators: misery index
– Inflation + unemployment
– Used to gauge the health of the economy
Origins of the Phillips Curve
• Phillips curve
– Shows the short-run trade-off
– Between inflation and unemployment
• 1958, A. W. Phillips
– “The relationship between unemployment and the rate of change of money wages in the United
Kingdom, 1861–1957”
 Negative correlation between the rate of unemployment and the rate of inflation
• 1960, Paul Samuelson and Robert Solow
– “Analytics of anti-inflation policy”
 Negative correlation between the rate of unemployment and the rate of inflation
• Policymakers: Monetary and fiscal policy
– To influence aggregate demand
 Choose any point on Phillips curve
 Trade-off: High unemployment & low inflation
 Or low unemployment and high inflation

AD, AS, and the Phillips Curve

• Phillips curve
– Combinations of inflation and unemployment
– That arise in the short run
– As shifts in the aggregate-demand curve
– Move the economy along the short-run aggregate-supply curve
• An increase in aggregate demand, in the short run
– Higher output
 – Higher price level
– Lower unemployment
– Higher inflation
• Lower aggregate-demand
– Lower output & Lower price level
– Higher unemployment & Lower inflation
The Long-Run Phillips Curve
• The long-run Phillips curve
– Is vertical
– Unemployment rate tends toward its normal level
 Natural rate of unemployment
– Unemployment does not depend on money growth and inflation in the long run
• If the Fed increases the money supply slowly
– Inflation rate is low
– Unemployment – natural rate
• If the Fed increases the money supply quickly
– Inflation rate is high
– Unemployment – natural rate

• The long-run Phillips curve

– Expression of the classical idea of monetary neutrality
• Increase in money supply
– Aggregate-demand curve – shifts right
 Price level – increases
 Output – natural level
– Inflation rate – increases
 Unemployment – natural rate

Chapter 6. Economic Growth and Development

Economic Growth around the World
• Real GDP per person
– Living standard
– Vary widely from country to country
• Growth rate
– How rapidly real GDP per person grew in the
typical year
• Because of differences in growth rates
– Ranking of countries by income changes
substantially over time
Productivity
• Productivity
– Quantity of goods and services
– Produced from each unit of labor input
• Why productivity is so important
– Key determinant of living standards
– Growth in productivity is the key determinant of growth in
living standards
– An economy’s income is the economy’s output
• Determinants of productivity
– Physical capital per worker
– Human capital per worker
– Natural resources per worker
– Technological knowledge
• Physical capital
– Stock of equipment and structures
– Used to produce goods and services
• Human capital
– Knowledge and skills that workers acquire through
education, training, and experience
• Natural resources
– Inputs into the production of goods and services
– Provided by nature, such as land, rivers, and mineral deposits
• Technological knowledge
– Society’s understanding of the best ways to produce goods and services
Saving and Investment
• Raise future productivity
– Invest more current resources in the production of
capital
– Trade-off
 Devote fewer resources to produce goods
and services for current consumption

Diminishing Returns
• Higher savings rate
– Fewer resources – used to make
consumption goods
– More resources – to make capital
goods
– Capital stock increases
– Rising productivity
– More rapid growth in GDP
• Diminishing returns
– Benefit from an extra unit of an
input
– Declines as the quantity of the input increases
• In the long run, higher savings rate
– Higher level of productivity
– Higher level of income
– Not higher growth in productivity or income
• Catch-up effect
– Countries that start off poor
– Tend to grow more rapidly than countries that start off rich
• Poor countries
– Low productivity
– Even small amounts of capital investment
 Increase workers’ productivity substantially
 • Rich countries
– High productivity
– Additional capital investment
 Small effect on productivity
• Poor countries
– Tend to grow faster than rich countries
Investment from Abroad
• Investment from abroad
– Another way for a country to invest in new capital
– Foreign direct investment
 Capital investment that is owned and operated by a
foreign entity
– Foreign portfolio investment
 Investment financed with foreign money but
operated by domestic residents
• Benefits from investment
– Some flow back to the foreign capital owners
– Increase the economy’s stock of capital
– Higher productivity
– Higher wages
– State-of-the-art technologies
• World Bank
– Encourages flow of capital to poor countries
– Funds from world’s advanced countries
– Makes loans to less developed countries
 Roads, sewer systems, schools, other types of capital
– Advice about how the funds might best be used
• World Bank and the International Monetary Fund
– Set up after World War II
– Economic distress leads to:
 Political turmoil, international tensions, and military conflict
– Every country has an interest in promoting economic prosperity around the world
Education
• Education
– Investment in human capital
– Gap between wages of educated and uneducated
workers
– Opportunity cost: wages forgone
– Conveys positive externalities
– Public education – large subsidies to human-capital
investment
• Problem for poor countries: Brain drain
Health and Nutrition
• Human capital
– Education
– Expenditures that lead to a healthier population
• Healthier workers
– More productive
• Wages
– Reflect a worker’s productivity
• Right investments in the health of the population
– Increase productivity
– Raise living standards
• Historical trends: long-run economic growth
– Improved health – from better nutrition
– Taller workers – higher wages – better productivity
• Vicious circle in poor countries
 – Poor countries are poor
 Because their populations are not healthy
– Populations are not healthy
 Because they are poor and cannot afford better healthcare and nutrition
• Virtuous circle
– Policies that lead to more rapid economic growth
– Would naturally improve health outcomes
– Which in turn would further promote economic growth
Property Rights, Political Stability
• To foster economic growth
– Protect property rights
 Ability of people to exercise authority over the
resources they own
 Courts – enforce property rights
– Promote political stability
• Property rights
– Prerequisite for the price system to work
• Lack of property rights
– Major problem
– Contracts are hard to enforce
– Fraud goes unpunished
– Corruption
 Impedes the coordinating power of markets
 Discourages domestic saving
 Discourages investment from abroad
• Political instability
– A threat to property rights
– Revolutions and coups
– Revolutionary government might confiscate the capital of some businesses
– Domestic residents – less incentive to save, invest, and start new businesses
– Foreigners – less incentive to invest
Free Trade
• Inward-oriented policies
– Avoid interaction with the rest of the world
– Infant-industry argument
 Tariffs
 Other trade restrictions
– Adverse effect on economic growth
• Outward-oriented policies
– Integrate into the world economy
– International trade in goods and services
– Economic growth
• Amount of trade – determined by
– Government policy
– Geography
 Easier to trade for countries with natural seaports
Population Growth
• Large population
– More workers to produce goods and services
 Larger total output of goods and services
– More consumers
• Stretching natural resources
– Malthus: an ever-increasing population
 Strain society’s ability to provide for itself
 Mankind – doomed to forever live in poverty
• Diluting the capital stock
– High population growth
  Spread the capital stock more thinly
 Lower productivity per worker
 Lower GDP per worker
• Reducing the rate of population growth
– Government regulation
– Increased awareness of birth control
– Equal opportunities for women
• Promoting technological progress
– World population growth
 Engine for technological progress and economic prosperity
 More people = More scientists, more inventors, more engineers