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MACROECONOMICS

Prof. João Amador

Carolina Romão Correia

2021/2022
 ÍNDICE
MICRO vs MACRO ..................................................................................................................... 3
(SIMPLE) CIRCULAR INCOME FLOW ......................................................................................... 3
CIRCULAR INCOME FLOW ......................................................................................................... 4
BASIC NATIONAL ACCOUNTS ................................................................................................... 5
FUNDAMENTAL IDENTITY OF MACROECONOMICS................................................................. 6
NOMINAL vs REAL VARIABLES ................................................................................................. 7
SIMPLE KEYNESIAN MODEL...................................................................................................... 8
Keynesian Cross (graph) ........................................................................................................... 9
Keynesian thinking ................................................................................................................. 10
MONEY .................................................................................................................................... 10
Money demand....................................................................................................................... 11
Money supply ......................................................................................................................... 11
Money Market ........................................................................................................................ 11
Money Creation ...................................................................................................................... 12
Role of the Central Bank......................................................................................................... 14
IS-LM MODEL .......................................................................................................................... 15
POLICY MIX ............................................................................................................................. 16
EXTERNAL LINKAGES .............................................................................................................. 16
Mundell Fleming Model ......................................................................................................... 16
Exchange Rates Regimes ........................................................................................................ 17
AD/AS MODEL......................................................................................................................... 20
 MICRO vs MACRO
 Macroeconomics complements microeconomics
 But the scale of the analysis is different  micro looks at the individuals; macro
is not only “the aggregation of micro”, we want all the components of the
economy in one (like the companies and consumers, the international relations
of the agents, the banks and money, etc), using a conceptual model that puts
all of this together – aggregates and what links them
 These are the most reported and discussed things when talking about
economics (so we might read some news concerning these topics)

 In micro – output comes from the relationship between producers and

consumers (how individual households and firms make decisions and how they
interact with one another in markets)
 In macro – relationship between firms and consumers  studies the economy
as a whole (people are both consumers AND workers at the firm)

(SIMPLE) CIRCULAR INCOME FLOW

Consumption

Goods and services

HOUSEHOLDS FIRMS
(“consumers”) (“producers”)
Public goods

Labor (they work at the firms)

Taxes

Labor

Wages

Wages

GENERAL Taxes
GOVERNMENT
Public goods

Goods and services

Public consumption

 There are other agents interacting with these elements, like the government,
banks, the rest of the world, etc
  (even when we own a house, the house is considered a “firm” because I own it
and it is providing a service to me – shelter services)

 If there is a shock, for example people are pessimistic about the economy, and
households are saving more, firms will sell less and need less labor  if there is
no labor, households will consume less

RECESSION (so everything is circular)

 If there is a recession, what can the government do?
 They can lower taxes, pay unemployment rates, go directly to the firms
and spend more money there (creating more demand for firms), etc
 But the government can also become the source of the problem itself… for
example trying to boost the economy when there was nothing wrong  this
has problems in the long run

CIRCULAR INCOME FLOW

 Households
 Firms (non-financial corporations)
 Banks (financial corporation) INSTITUTIONAL
 General government SECTORS
 Rest of the world
 (central bank – monetary authority)

Exports
Consumption REST OF THE Comentado [CC1]: Consumption - spending by households
Goods and services on goods and services, with the exception of purchases of
Goods and services WORLD
new housing
Investment - spending on business capital, residential
HOUSEHOLDS FIRMS capital, and inventories
Public goods

Labor
Labor

Credit (investment)
Taxes

Wages

Credit

Wage

Taxes
GENERAL
Public goods
GOVERNMENT
Public consumption
BANKS
Goods and services

Imports
Goods and services

Savings

Credit
(Note: taxes = tax – subsidies)

Public goods - you can’t exclude someone from using them (to charge), even though
they don’t pay for them (ex: public lighting, the army, etc); everyone benefits (there is
no rivalry)  so only the government produces them

BASIC NATIONAL ACCOUNTS

Gross Domestic Product – the market value of all final goods and services produced
within a country in a given period of time
GDP measures two thing at once: 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, income must equal expenditure.

How do we obtain the GDP (gross domestic product)?

1. EXPENDITURE APPROACH (summing up all the destinations we have for what
we’ve produced – where do we use it?)

GDP (Y) = private consumption (C) + public consumption (G) +

investment (I) + exports (X) – imports (M)

 investment (I) = gross fixed capital formation (GFCF) + change in inventories

 public consumption (G) = wages paid to civil servants + goods and services
bought by the government  hard to measure
 we subtract the imports because inside every one of these aspects, there are
components which are imported, so we need to eliminate the imported
content from the calculations

2. PRODUCTION APPROACH (adding all the value that each firm created 
looking at the economy from the firm level)

GDP = GVA (gross value added) = ∑ GVA in all sectors =

∑ (value of production – intermediate consumption)
Things I have to buy in order to
produce my product (which doesn’t
include the wages paid to the workers)
Example:
PRODUCING BREAD

Farm Mill Baker GDP = 10 + 10 + 20 = 40

10 sales 10 + 10 20 + 20
(wheat) Intermediate GVA = (10+20+40) – (20+10)
Intermediate
consumption = 70 – 30 = 40
consumption

3. INCOME APPROACH (looking at who and how much is being paid  this
method is not very good because some things aren’t reflected by this, for
example self-employed people)

GDP = national income = wages (W) + rents + interest payments + profits

FUNDAMENTAL IDENTITY OF MACROECONOMICS

Public savings

Y = C + I + G + X – M + T – T ↔ Y – T – C – I + T – G = X – M ↔ (S – I) + (T – G) = (X – M)

Disposable income Private Fiscal balance Foreign balance

Taxation sector (government) (country vs world)
Savings (S = Y – T - C)

(S – I) + (T – G) = (X – M)

Example – Portugal:

(S – I) + (T – G) = (X – M)

Twin deficits (they are close)

 So we have to get money somewhere (typically investment from the outside)

 One day there is a sudden stop in international investment because we are too
risky of a country  so there are two options:
 We don’t pay (bankruptcy) – no one lends us money again and no more
international transactions with us
  TROIKA – they give us money but we have to do some things that they
demand in order to improve (increase taxation and decrease public
consumption; increase investment and increase savings)

NOMINAL vs REAL VARIABLES

Inside the nominal variable, there are quantities and prices. As economists, we prefer
to consider these two aspects separately, so we focus more on the real variables.

 Nominal GDP – the production of goods and services valued at current prices Comentado [CC2]: Reflects both the quantities and prices
(of the goods and services produced)
(of a certain year)
 Real GDP - the production of goods and services valued at constant prices of a Comentado [CC3]: Reflects only the quantities produced
(by holding prices constant at base-year levels)
reference base year (used to obtain a measure of the amount produced that is
not affected by changes in prices)  not affected by changes in prices

Price Level
In practice, it’s measured as index – HCPI (harmonized consumer price index) Comentado [CC4]: a measure of the overall cost of the
goods and services bought by a typical consumer
Inflation rates = the growth rate of the HCPI
There are some items inside the HCPI that are very volatile (like food items and energy)
 that way we obtain CORE INFLATION
Inflation - situation where the prices of most things increase continuously

 Nominal (not real) = prices * quantity

Nominal GDPT = price levelT * quantitiesT = PT * QT

Certain period
They publish these two numbers
of time

GDPT = PT-1 * QT with prices of the previous year

The growth rate between these two

numbers is comparing the quantities
GDPT-1 = PT-1 * QT-1 in T versus in T-1

Real growth rate (PT-1 * QT) QT Real growth rate (PT * QT) PT
= = of the deflator = =
for the quantity (PT-1 * QT) PT-1
(PT-1 * QT-1) QT-1

deflator of GDP (≈ inflation)

Nominal ≈ real + deflator

GDP deflator = (nominal GDP / real GDP) * 100 Comentado [CC5]: GDP deflator - a measure of the price
level calculated as the ratio of nominal GDP to real GDP
times 100

SIMPLE KEYNESIAN MODEL

Models are abstract and not realistic, so we have to look at them keeping that in mind,
never losing track of the rationality behind things
The Keynesian model shows the relationship between households and firms  it tells
us when to stop, when things stabilize
Each economic agent has an objective/desired expenditure – how much to spend,
consume, invest, etc (there are three equations)

(here they are ignored like

it is a closed economy)

1. desired expenditure = C + I + G + X – M

Desired Desired public

consumption Desired
investment consumption
(fixed profit)

2. Y = AD = desired expenditure in the equilibrium (in the long run)

(the equilibrium/steady-state is when the desired expenditure equals the GDP)

3. C = C + c*Y Comentado [CC6]: Desired consumption

Autonomous
consumption
Marginal
propensity
to consume
1<c<0
(income they spend
on consumption )
how much of their

(1 – c) = s  marginal propensity to save

If all three of these things are true, my world is stable and we are in the
equilibrium/steady-state

In the equilibrium Desired expenditure = Y = C + c*Y + I + G + X - M

Now we need to see what the “number” of the GDP that makes all three of these Comentado [CC7]: GDP in the equilibrium
equations true is:

Y – c*Y = C + I + G + X - M ↔ Y (1 – c) = C + I + G + X - M ↔

Y=C+I+G+X-M Y* = 1 * (C + I + G + X – M)
↔ ↔
(1 – c) (1 – c)
Keynesian
multiplier

(>1 because c>0)

If G is higher, the output increases (higher GDP)

This is true for all the variables,
Because 1 is higher than 1, then: but the others are harder to
ΔY* = 1 * ΔG change, whereas this one can be
(1 – c) (1 – c) changed by policy makers

 Recession (negative output gap – recessionary gap, between the GDP and the
potential GDP) – expansionary fiscal policy (G going up)
 Boom (positive output gap – inflationary gap) – contractionary fiscal policy (G
going down)

The GDP can’t increase to infinity, it starts fast but then gradually slows down and
loses strength  c is responsible for this, because it is smaller than 1 which means that
we always save something along the way
(If the c = 1, the multiplier is infinity; If the c = 0, the multiplier is 1 so it “doesn’t exist”
 this means that it’s not good to save everything nor to spend everything)

Keynesian Cross (graph)

Desired expenditure
= output
Desired
expenditure

Increase in G
ΔY*
C + I + G’ + X - M Impact of the
multiplier
ΔG
C+I+G+X-M c (<1)

Desired
= C + c*Y + I + G + X – M + c*Y
expenditure

Slope
45º = 1 (“declive”)

Y* Y’* Y

Increase in income
 If c = 0 (save a lot) If c = 0,99 (spend a lot)

ΔG
0,99
ΔG (<1)~~
~~

45º

ΔY*

So the more a country loves to spend, the more powerful the fiscal policy is.

Keynesian thinking
Keynesians  if we increase the G, output will be higher, which means that increasing
the GDP is to increase public expenditure

In 1929, there was the Great Depression in the USA, so the government had to try to
improve things in the economy and society. President Roosevelt hired Keynes to advise
on the economy, and came up with the “New Deal” (included major investments in
public things and fiscal policies), which started this path to recovery that got them out
of the recession.
This model Keynes developed works when facing a deep recession  fiscal policy can
be a useful tool in a moment of crisis, and it works (however, the model is missing
something…)

MONEY
1. Unit of account – you can express prices in these units
2. Store of value – it has to be able to store value that can be transferred into the
future This is the one condition
3. Medium of exchange - widely accepted as a means of payment that GOLD does not fulfill

Legal tender – what is defined, by law and by the government, as something that has to be
accepted by everyone (in Portugal, it’s euros)
In a country with hyperinflation, the currency starts to lose the “store of value”
condition, so it eventually stops being money  in this situation, you change the
currency, ignoring the old one (this is known as “dollarization”)

Money demand
There is a demand for money. Why do people want money?
 Transaction motives - to finance transactions (buy and sell)
 Speculative motives - to be part of our portfolio of assets (it’s good to have
money because it is liquid and you can immediately use it, instead of having to
trade it  but we should not only have money, because it’s more susceptible
to inflation)
 Cautionary motives (“rainy-day” money, to use in unexpected situations)

There is a money demand function MD = α*Y – β*i

P
Structural
parameters

So, an interest rate is the opportunity cost of having money (the higher the interest rates,
the less the demand for money is  if they are high, the alternative is better, so it’s better not
to have money; the banks have a high opportunity cost for holding the money, it’s better to
lend it)

Money supply

There is a money supply function MS

P Monetary policy

Money Market

M S = α*Y – β*i
P
 i

The central bank can “move”

this line in order to decide
where the interest rates are
(this can be difficult to achieve
and they may fail)

Here, if they want to increase the

i* MD
interest rates, they destroy money
Excess demand
(Y) (decrease money supply), so there is an
for money
P
excess demand for money created. If we
M intersect, we see that the interest rates
MS ‘ MS
P are now higher.
P P

(Higher Y  money demand curve contracts)

Side by side with this, there is the bond market (Wall Street):
 When the ECB wants to increase the interest rates, it destroys money, and
there is an excess demand for money
 When there is an excess demand for money, we want to sell our bonds  so
then there is an excess supply of bonds in Wall Street, and the prices of bonds
(index) go down, which means Wall Street loses
 So, when the prices of bonds go down, the interest rates increase
VS
 When there is excess supply of money, there is excess demand for bonds
 When there is excess demand for bonds, the prices in Wall Street go up (so
Wall Street likes an expansionary monetary policy)
 If the prices of bonds go up, the interest rates decrease

Money Creation
Banks

 It started with a person who stored people’s money in a safe at home; he

noticed that the money stayed there for a long time without being used, and
there were other people out there looking to have money temporarily; so he
saw a business opportunity, to lend money to those who needed it, using the
people’s savings; and then, one day, they will pay the money back, and he
would gain the interest rates from being this “intermediary”  taking this a
step further, we have the logic of banks
 This means that it is a risky business (built on trust), because the people can
come back wanting their money and you might not have it because you haven’t
been paid back
  Without banks, there would be too little investment in society and the output
would be smaller
 Banks end up actually creating money (giving money to someone to use,
without destroying the deposits)  credit originates deposits that lead to
further credit (leakages in this process are reserves and circulation)

Money = M = deposits + what is in circulation

Balance sheet of the bank:

ASSETS (ativo) LIABILITIES (passivo)

 Reserves (they keep some money  Deposits
aside for safety)
 Credit (capital/equity) Capital is not truly a liability
assets = liabilities + capital
 Bonds (portfolio)

If the capital < 0, then the bank is insolvent (there are more liabilities than assets)

 Mandatory reserves
 Deposit insurance (fundo de garantia dos depósitos) - commitment of a
number that they always pay you back; it’s aimed to be established on a
European level, which hasn’t been achieved yet because some countries don’t
“trust” the others’ banks for being too risky (but you need to diversify risk to
decrease risk…)
 Minimum capital requirements – the banks can’t have a capital which is too
small (legislated)
 Supervision – there are supervisory authorities that check if the banks are
complying with the mandatory reserves and minimum capital requirements, if
there is fraud, if there is too much risk (force the bank to save some money),
etc; they can, for example, say that the banks need do create some
provisioning for “bad credits” (like non-performing loans)  nowadays this is a
EUROPEAN SUPERVISION (supervised by Frankfurt and not by the Bank of
Portugal)
 “Lender of last resort” – if everything else fails, this is the ultimate layer of
safety; someone with the ability to come to the bank with all the money
necessary to save it  this is the Central Bank of the country (because they can
create money – however they don’t have the capacity to create all the money
they want, they have to borrow from other countries; it can’t be the ECB)
  Resolution mechanism - Europe has also established a procedure if a bank
really goes wrong (like BES – we were the first to use this)  you split the bank
in two (a good bank and a bad bank) and then support the good bank and try to
save it and hope it goes well, and you let the bad bank die

(BAD) BANK GOOD BANK

ASSETS LIABILITIES ASSETS LIABILITIES
 Reserves  Deposits  Some of the  Deposits
“good” credit
 Credit (capital/equity)  Some of the New capital
“good” bonds injected  public
money coming
 Bonds
from a resolution
fund

Now the bad bank only has bad assets.

Ideally the resolution fund would be European (but it isn’t yet)  however, it’s Europe
that decides that this procedure must happen (even if then the money for the
resolution fund is ours…)

Role of the Central Bank

Balance Sheet of the CENTRAL BANK
 Reserves of foreign  Banknotes
currency

 Gold  Deposits from banks

 Bonds

When the Central Bank wants to affect the money supply: Comentado [CC8]: Usually the CB has 2 objectives: keep
inflation stable; stability of the banking system (it’s a
1. In a direct way (unconventional), the CB can go to the market, buy bonds, and regulator and the “bank of banks”)
therefore puts money in the hands of sellers, with “fresh money” that they
have created – we already brought interest rates to 0, and inject liquidity by
buying bonds from the not usual places (not just the banks, but secondary
markets)
 The CB has been doing this in a massive way lately
 This is bad because the CB is not supposed to be an investor and
interfere in the market “just because it can”
 Is is risky for the CB to do this, because it can be insolvent…
  The argument has been that it keeps people calm and not scared

2. The CB can play with the bonds, and these operations change the money
supply – “conventional monetary policy”/open market operations
 Example: we want to lower interest rates, so we increase money supply
 so the CB sets an auction to buy bonds from the banks  the CB now
has more bonds and more deposits from banks  the banks have less
bonds and more reserves  so this causes the banks to decrease their
reserves and increase their credit  once banks give credit, it means
that there is money put in someone’s hands that goes into circulation,
and some of it will come back to the bank as deposits (so the deposits
will be increasing)  if the deposits increase, the reserves will be
increased, and so on (it’s a “circle”)
Note: this process has to stop somewhere, because not all the money goes
to credit and not all the credit goes to deposit and circulation (ex: 1 euro of
credit does not reflect 1 euro of deposit, so there are “leakages” along the
way, which will make all of this stop somewhere)

Circulation = c * deposits
Money = reserves + deposits
Coefficient for preference for liquidity
(1>c>0)
Money base = reserves + circulation Reserves = r * deposits

Mandatory reserve rate

M = c*deposits + deposits (1>r>0)

MB = r*deposits + c*deposits M c+1 c+1

= ↔ M= *MB
MB r+c r+c

c + 1 *MB
MS =  If the r=1 the banks can’t create money
r+c
 If the r=0 and c=0, there is an “explosion”
Money multiplier (>1) because there are no “leakages” in the process

IS-LM MODEL
Y = C + c*Y + I – h*i + G + X – M
i
S
Y= 1 * (C + I + G + X – M) IS curve LM M
(goods and P
(1 – c)
services market)
Equilibrium

I = I – h*i
i*
M S = α*Y – β*i LM curve
P (money market)
MD
P
IS (G)

Y* Y
i = -1 * M S + α * Y
β P β
 Contractionary MS
i monetary LM’’ P

LM Y goes down
MS G goes down
LM’
P
Higher i means I goes up
lower output
i* X=

i *’ M=

C goes down
IS’’ (G) i goes down
IS’ (G) IS
Contractionary
fiscal
Y *’ Y* Y

POLICY MIX

Cooperation CB with a contractionary monetary policy

i i LM’
LM LM
LM’

BP = 0

IS’
IS IS

Y Higher Y
Y
means lower i

EXTERNAL LINKAGES
Mundell Fleming Model Comentado [CC9]: Portrays the short run relationship
 BP = balance of payments between real income and interest rates (the balance of
payments is at equilibrium)
 NX = nex exports (X-M)
Comentado [CC10]: Net Exports - spending on
 CF = capital flows  CF (i – i*F) domestically produced goods by foreigners (exports) minus
 NX + CF = 0 spending on foreign goods by domestic residents (imports)
Foreign interest rates

BP = NX + CF = 0 If i > i*F CAPITAL INFLOW

If i < i*F CAPITAL OUTFLOW
Current account Financial account
nominal exchange rate (how
many euros it takes to buy 1
unit of foreign currency)
Foreign prices (prices in dollars)
Exports Imports

e * PF = R X (R; YF) M (R; Y)

P Real exchange rate

Domestic prices

The higher the R, the more competitive we

The lower the e, the more valuable is the are because our products are cheaper than
euro; you need less euros to buy 1 dollar  foreign (we export more and import less –
nominal appreciation NX increases)  real depreciation

Exchange Rates (e) Regimes

a) Flexible – they let the exchange rates change
b) Fixed – Central Bank is committed to keep them fixed (ex: Portugal)

In a perfect capital mobility world, i = iF and capital flow is very powerful (your i is Comentado [CC11]: When i and foreign i are the same
lower than abroad – people want our currency and invest here  excess demand for (and the BP is 0 - line is horizontal)

your currency  e goes down – nominal appreciation  we are less competitive, our Comentado [CC12]: Monetary policy
NX goes down)
(Ponto de partida é sempre i = iF)

CONTRACTIONARY MONETARY POLICY (MS )

Fixed exchange rate regime Flexible exchange rate regime (CB doesn’t intervene)
i LM’ i LM’
Capital inflow LM Capital inflow LM

i F BP = 0 i F 0 BP = 0
2

IS NX IS’ IS

Y Y
So monetary policy doesn’t work on
Only monetary policy works
fixed exchange rates; only fiscal
(both IS and LM change)
policy works (both IS and LM change)
Capital inflow  now the e will actually decrease 
There is an excess demand for currency  there is more
appreciation of the currency  shortage of demand
valuable currency  pressure to descrease e  money
supply goes up, CB creates more euros  LM expands again Exports go down  imports go up  NX goes down
 IS curve contracts
  Fixed exchange rates are good for your credibility, but it makes you a risk for
speculators
 SPECULATIVE ATTACKS – speculators focus on a country with fixed
exchange rates, go to them and say they want to invest in the country
and they have collateral; they want a loan (a big loan, expressed in the
domestic currency) from the banks, saying they use it for investment 
then they go to the CB and convert it into dollars (they go to the
reserves for this); the speculators continue to do it, so the exchange
rates don’t change  the CB is running out of reserves in dollars, and
one day you have to let go of the fixed exchange rate regime, and
currency depreciates  now the speculators take some dollars you
gave him and pays you back, converted into the currency, because the
currency has been depreciated

AD/AS MODEL

Technology
AD – aggregate demand Comentado [CC13]: AD – inverse relationship between
inflation and output
AS – aggregate supply Production function Y = A * f (K, L)
Capital stock (machinery, Labor/employment
transportation etc)  tends
to be stable
ΔK = I - depreciation

If you are at full

employment, you are at
your potential output

 There is “normal” unemployment rate (excess supply of labor), which is pretty

much the people who are in between jobs
 If unemployment rate = natural/frictional unemployment rate, then L = full
employment
  So the potential output is when Y = f (K, L in full employment)

Expansionary policies - G goes

Contractionary policies - G goes down, or M S
up, or M S goes up, or C goes
goes down, or C goes down, or I goes down
up, or I goes up  then AD
 then AD curve contracts
curve expands

So these policies are useless in the long run because you

end up in the same place, but they can be really useful
in the short run (to soften short run adjustments and
avoid price variations)

Inflation (higher prices and lower output) and deflation

are a consequence of the change in potential Y

In the long run, what matters for the economy is the

supply side (inputs + technologies), and not policies,
because those matter only in the short run
 The world nowadays (war in Ukraine)
2 This is very bad because we are below potential output
(recession – inflation)  so there are very risky moves by
1 the government, but they are trying to “buy time” and
keep the economy where it was, taking supply to normal
0 Step 1 – levels – point 0 (higher than now). They hope the supply
3 expansionary comes back to where it was, but there is a risk of inflation
going even higher; the ECB can increase interest rates
(contractionary monetary policy); they are waiting to see
Step 2 –
contractionary if this is solved on its own.

Governments are discussing how to smooth this, trying to

get the aggregate supply back to where it was –
expansionary policies.

Program
- From Microeconomics to Macroeconomics (1 class)
- Circular income flow (1 class)
- Principles of National Accounts (2 classes)
- Simple Keynesian Model (3 classes)
- Output and interest rates (4 classes)
- External linkages: Balance of Payments and exchange rates (3 classes)
- Output and Inflation in the long run (3 classes)
- Money and the Banking System (2 classes)
- Cyclical fluctuations (1 class)
- Economic growth in the very long run (2 classes)