Output

National income and product accounts were developed at the end of World War II as measures of aggregate
output, it is called gross domestic product (GDP).
How to calculate GDP:
 GDP is the value of final goods and services produced in the economy during a given period. We want to count only
final goods, not intermediate goods.
 GDP is the sum of value added in the economy during a given period. The value added by a firm is the value of its
production minus the value of the intermediate goods used in production.
 GDP is the sum of incomes in the economy during a given period. It is equal to the sum of labor income and capital
or profit income.
Nominal GDP is the sum of the quantities of final goods produced times their current price.
Nominal GDP increases for two reasons:
– The production of most goods increases .
– The price of most goods increases. (inflation)
Real GDP is the sum of quantities of final goods times constant prices.
Real GDP= Nominal GDP x price of yearX

GDP growth in year t is (Yt − Yt-1)/Yt-1.

The UNEMPLOYMENT RATE

Employment is the number of people who have a job.

Unemployment is the number of people who do not have a job but are looking for one.

The labor force is the sum of employment and unemployment.

The unemployment rate is the ratio of the number of people who are unemployed to the number of people in the
labor force.
Discourage workers are those who give up looking for a job and so no longer counted as unemployed.
The participation rate is the ratio of the labor force to the total population of working age.

INFLATION
Inflation is a sustained rise in the general level of prices—the price level.

The inflation rate is the rate at which the price level increases.

Deflation is a sustained decline in the price level (negative inflation rate).

The GDP deflator in year t (Pt) is the ratio of nominal GDP to real GDP in year t:
 The rate of change: The rate of inflation: πt = (Pt − Pt-1)/Pt-1 (+ inflation, - deflation)

• The rate of growth of nominal GDP is equal to the rate of inflation plus the rate of growth of real GDP.
$Yt = PtYt
The Consumer Price Index (CPI) is a measure of the cost of living.

• GDP- only domestic products.

• CPI- domestic + imported products

Pure inflation is proportional increase in all prices and wages.

Okun’s law:
• Output growth that is higher↑ than usual is associated
with a reduction ↓ in the unemployment rate.

• Output growth that is lower ↓ than usual is associated

with an increase ↑in the unemployment rate.

The Phillips curve :

• A low unemployment rate leads to an increase in
the inflation rate.

• A high unemployment rate leads to a decrease in

the inflation rate.

The Goods Market

Consumption (C): goods and services purchased by consumers

Investment (I) or fixed investment: the sum of nonresidential investment and residential investment

Government spending (G): purchases of goods and services by the federal, state, and local governments; excluding
government transfers

Exports (X): purchases of U.S. goods and services by foreigners

Imports (IM): purchases of foreign goods and services by U.S. consumers, U.S. firms and the U.S. government

Net exports or trade balance: X − IM

• Exports > Imports → trade surplus

• Imports > Exports → trade deficit

Inventory investment: difference between production and sales

Z ≡ C + I + G + X − IM

The above identity defines the total demand for goods (Z) as consumption, plus investment, plus government, plus
export, minus imports.

In a closed economy (X = IM = 0): Z≡C+I+G

Consumption function (C) is a function of disposable income (YD), which is the income that remains once
consumers have received government transfers and paid their taxes.

• c1 is the propensity to consume.

• c0 is what people would consume if their disposable income equals zero.

Consumption increases with disposable income but less

than one for one. A lower value of c0 will shift the entire
line down.

Disposable income is:

YD ≡ Y − T

where Y is income and T is taxes minus government

transfers.

Endogenous variables: variables depend on other

variables in the model

Exogenous variables: variables not explained within the model but are instead taken as given.(I, T,G)

Z≡C+I+G Y=Z

• In equilibrium, production (Y) is equal to demand, which in turn depends on income (Y),
which is itself equal to production

Autonomous spending: [c0 + + G – c1T] is always positive

• The term 1/(1-c1) is the multiplier, which is larger when c1 is closer to 1.

 Equilibrium output is determined by the condition that
production is equal to demand.
• To summarize our findings using words:
– Production depends on demand, which depends on
income, which is itself equal to production.
– An increase in demand leads to an increase in
production and income, which in turn leads to a future
increase in demand.
– The increase in output that is larger than the initial
shift in demand, by a factor equal to the multiplier

Private saving (S) is S ≡ YD − C S≡Y−T−C

By definition, public saving = T −G .

• Public saving > 0 Budget surplus

• Public saving < 0 Budget deficit

In equilibrium: Y=C+I+G
Subtract T from both sides and move C to the left side: Y − T − C = I + G –T
,
The left side of the equation is simply S so S = I + G −T
Or equivalently

This is the IS relation, which stands for “Investment equals Saving”.

Two equivalent ways of stating the condition for equilibrium in the goods market:

• Production = Demand
• Investment = Saving
Because consumption behavior implies that:
S = Y − T − C = Y − T − c0 − c1(Y − T )
Rearranging terms, so
• (1−c1) is called the propensity to save, which is between zero and one.
I = −c0 + (1 − c1)(Y − T ) + (T – G)
Financial Markets
• Two types of money: currency and checkable deposits.
• Bonds pay a positive interest rate, i (the rate of interest), but cannot be used for
transaction.
Money is what can be used to pay for transactions.

Income is what you earn, and it is a flow.

Saving is the part of after-tax income that you do not spend, and it is also a flow.

Savings is the value of what you have accumulated over time.

Financial wealth, or wealth, is the value of all your financial assets minus all your financial liabilities,
and it is a stock variable

Investment is what economists refer to as the purchase of new capital goods.

Financial investment is the purchase of shares or other financial assets.

Demand for money (Md) is equal to nominal income $Y (a measure of level of transactions
in the economy) times a decreasing function of the interest rate i:

An increase in the interest rate decreases the demand for money, as people put more of
their wealth into bonds.

Ms=Md=M
 Central banks typically change the supply of money by buying or selling bonds in the bond
market— open market operations.

• Expansionary open market operation: the central bank expands the supply of
money by buying bonds.
• Contractionary open market operation: the central bank contracts the supply of
money by selling bonds.
If the price of the bond today is $PB, then the interest rate on the bond is: Treasury bill, or T-
bill, promises to pay $100 a year from now.

• The higher the price of the bond, the lower the interest rate.
• The higher the interest rate, the lower the price today.
• Choosing the interest rate, instead of the money supply, is what modern central banks, typically do.
• Financial intermediaries: Institutions that receive funds from people and firms and use these funds to
buy financial assets or to make loans to other people and firms.
• Banks are financial intermediaries that have money, in the form of checkable deposits, as their
liabilities.
• Banks keep as reserves some of the funds they receive.
• The liabilities of the central bank are the money it has issued, called central bank money.
 The equilibrium
interest rate is
such that the
supply of central
bank money is
equal to the
demand for
central bank
money.

The supply of central bank money is equal to the demand for central bank money// overall demand for
money.
 When the interest rate is equal to zero, and
once people have enough money for transaction
purposes, they become indifferent between
holding money and holding bonds.
The demand for money becomes horizontal.
This implies that, when the interest rate is equal
to zero, further increases in the money supply
have no effect on the interest rate, which
remains equal to zero.
• Zero lower bound: The interest rate
cannot go below zero.
• The economy is in a liquidity trap when
the interest rate is down to zero, monetary
policy cannot decrease it further.

The IS-LM Model

Investment depends on production Y (or sales) and the interest rate i.

equilibrium in the goods market becomes:

, which is the IS
relation.

For a given value of i, the demand for goods

is an increasing function of output.
Equilibrium requires that the demand for
goods be equal to output.
• ZZ is upward-sloping because, for a
given value of the interest rate, an increase
in output leads to an increase in the
demand for goods through its effects on
consumption and investment.
• ZZ is flatter than the 45-degree line
because we have assumed that an increase
in output leads to a less than one-for-one
increase in demand.
 An increase in the interest rate decreases the
demand for goods at any level of output, leading
to a decrease in the equilibrium level of output.

Equilibrium in the goods market implies that an

increase in the interest rate leads to a decrease
in output.

An increase in taxes shifts the IS curve to

the left.

• Downward-sloping IS curve: Equilibrium in

the goods market implies that an increase in the
interest rate leads to a decrease in output.

• Shifting the IS curve: Changes in factors that

decrease (increase) the demand for goods given
the interest rate shift the IS curve to the left
(right).

LM relation:

In equilibrium, real money supply

equals the real money demand,
which depends on real income Y,
and the interest rate i.

The central bank chooses the interest rate (and adjusts

the money supply so as to achieve it).

IS relation: Y = C(Y−T) + I(Y,i) + G

LM relation: i = i
• The IS and LM relations together determine output.

• Any point on the downward sloping IS curve corresponds to equilibrium in the goods market.

• Any point on the horizontal LM curve corresponds to equilibrium in financial markets.

• Only at their intersection (point A) are both equilibrium relations satisfied.

Equilibrium in the goods market

implies that an increase in the interest
rate leads to a decrease in output.
This is represented by the IS curve.
Equilibrium in financial markets is
represented by the horizontal LM
curve. Only at point A, which is on
both curves, are both goods and
financial markets in equilibrium.

• Fiscal Policy:

Decrease in G–T → fiscal contraction//fiscal consolidation

Increase in G–T → fiscal expansion

FISCAL POLICY:
An increase in taxes
shifts the IS curve to the
left. This leads to a
decrease in the
equilibrium level of
output.
• Monetary Policy:

Decrease in i increase in M → monetary expansion

Increase in i decrease in M → monetary contraction//monetary tightening

A monetary expansion shifts the LM

curve down, and leads to higher
output.

Using a Policy Mix

• Monetary-fiscal policy mix is the combination of monetary and fiscal policies.

• Suppose that the economy is in a recession and output is too low.

• Both fiscal and monetary policies can be used to increase output.

The fiscal expansion shifts the IS curve to the right.

A monetary expansion shifts the LM curve down.

Both lead to higher output.

The fiscal consolidation shifts the IS curve

to the left.

A monetary expansion shifts the LM curve

down.

This allows for the reduction in the deficit

without a recession.
The Labor Market

employment rate—the ratio of employment to the population.

When unemployment is high, workers are worse off in two ways:

• Employed workers face a higher probability of losing their job.

• Unemployed workers face a lower probability of finding a job; or they can expect to
remain unemployed for a longer time.

Wages are set by collective bargaining—a bargaining between unions and firms.

Workers are typically paid a wage exceeding their reservation wage—the wage that would make
them indifferent between working or being unemployed.

Efficiency wage theories link the productivity or the efficiency of workers to the wage they are paid.

• Firms may want to pay a wage above the reservation wage in order to decrease workers’
turnover and increase productivity.
• Firms that see employee morale and commitment as essential to the quality of workers’
work will pay more than those whose activities are routine.
• When unemployment is low, firms that want to avoid an increase in quits will increase
wages to induce workers to stay with the firms.

Both workers and firms care about real wages (W/P), not nominal wages.

•The nominal wage depends on the expected price level (rather than the actual price level) because
when nominal wages are set, the relevant price levels are not yet known.

The prices set by firms depends on their costs, which in turn depends on the nature of the
production function: where Y is output, N is
Y = AN employment and A is labor
productivity (output per worker).
The WAGE-
SETTING RELATION

price-setting relation:

Price-setting decisions determine the real wage paid by firms.

An increase in unemployment benefits
leads to an increase in the natural rate
of unemployment.

An increase in the markup leads to an increase in

the natural rate of unemployment.
The AS-AD model

An increase in output leads

to an increase in the price
level.

An increase in the expected

price level leads, one for
one, to an increase in the
actual price level.

Given the expected price level, an increase in output

leads to an increase in the price level.

If output is equal to the natural level of output, the price

level is equal to the expected price level.
The aggregate demand relation captures the effectof the price level on output.

Changes in monetary or fiscal policy—or more

generally in any variable, other than the price level,
that shift the IS or the LM curves—shift the
aggregate demand curve.
 Equilibrium depends on the value of Pe. The
value of Pe determines the position of the
aggregate supply curve, and the position of the
AS curve affects the equilibrium.

In words:

1.So long as output exceeds the natural

level of output, the price level turns out
to be higher than expected.

2.This leads wage setters to revise their expectations of the price level upward, leading to an
increase in the price level.
3.The increase in the price level leads to a decrease in the real money stock, which leads to
an increase in the interest rate, which leads to a decrease in output.
4.The adjustment stops when output is equal to the natural level of output. At that point,
the price level is equal to the expected price level, expectations no longer change, and,
output remains at the natural level of output.

In the medium run output returns to the natural level of output

Key facts:

In the short run: Y≠Yn.

Output can be above or below the natural level of output. Changes in any of the variables
that enter either the aggregate supply relation or the aggregate demand relation lead to changes in
output and to changes in the price level.

In the medium run: Y=Yn.

Output eventually returns to the natural level of output. The adjustment works through
changes in the price level. When output is above the natural level of output, the price level
increases. The higher price level decreases demand and output. When output is below the natural
level of output, the price level decreases, increasing demand and output.
 In the aggregate demand equation, we can see that an
increase in nominal money, M, leads to an increase in the real
money stock, M/P, leading to an increase in output. The aggregate
demand curve shifts to the right.

The increase in the nominal money stock

causes the aggregate demand curve to shift to the
right. In the short run, output and the price level
increase. The difference between Y and Yn sets in
motion the adjustment of price expectations.

In the medium run, the AS curve shifts to

AS’’ and the economy returns to equilibrium at Yn.
The increase in prices is proportional to the
increase in the nominal money stock (10%
increase in M leads to 10% increase in P).
A monetary expansion leads to an increase in output in the
short run, but has no effect on output in the medium run.

The impact of a monetary expansion on the interest rate

can be illustrated by the IS-LM model.

The short-run effect of the monetary expansion is to

shift the LM curve down. The interest rate is lower,
output is higher.

If the price level did not increase, the shift in the LM

curve would be larger—to LM’’.

Over time, the price level increases, the real money stock
decreases and the LM curve returns to where it was
before the increase in nominal money.

In the medium run, the real money stock and the

interest rate remain unchanged.
The increase in nominal money initially shifts the LM curve
down, decreasing the interest rate and increasing output.
Over time, the price level increases, shifting the LM curve back
up until output is back at the natural level of output.

Over time, the price level increases, and the effects of a

monetary expansion on output and on the interest rate
disappear.

•The neutrality of money refers to the fact that an increase in the nominal money stock has no
effect on output or the interest rate in the medium run. The increase in the nominal money stock is
completely absorbed by an increase in the price level.
 A decrease in the budget deficit leads initially to a
decrease in output. Over time, output returns to the
natural level of output.

Since the price level declines in response to

the decrease in output, the real money stock
increases. This causes a shift of the LM curve
to LM’. Both output and the interest rate are
lower than before the fiscal contraction.

The LM curve continues to shift down until

output is back to the natural level of output.

The interest rate is lower than it was before

deficit reduction.

Deficit reduction leads in the short run to a

decrease in output and to a decrease in the
interest rate.

In the medium run, output returns to its

natural level, while the interest rate declines further.