Flashcards in Macroeconomics Deck (103):
What is real GDP?
Real GDP = nominal GDP / GDP deflator
Real GDP uses the prices of a base year and enables measuring the effect of the change in quantities of goods and services sold in comparison to the base year.
What is nominal GDP?
Nominal GDP = Real GDP x GDP Deflator
Nominal GDP measures today's quantities x today's prices.
What is the GDP deflator?
GDP deflator = Nominal GDP / Real GDP
What are chain-weighted measures of real GDP?
The base year changes continuously over time, with the base year being the previous year.
The various year to year growth rates then form a chain that can be used to compare the output of goods and services between any two dates.
Arithmetic tricks for comparing percentage changes in two goods.
Percentage change in (P x Y) ~ Percentage change (P) + Percentage change Y
Percentage change in (P/Y) ~ Percentage change (P) - Percentage change (Y)
What is investment
The economy's investment does not include purchases that merely reallocate existing assets among individuals (investment and disinvestment)
Example investments: build a house, build a new factory.
Investment categories: residential fixed investment (purchase of new housing), business fixed investment (new plant and equipment), inventory investment (increase in inventory)
What does government expenditure include?
Includes goods and services bought by government, e.g highways, military equipment, services provided by government workers.
Does not include transfer of payments to individuals (this is reallocation of income)
What is gross national product (GNP)?
GNP = GDP + factor payments from abroad - factor payments to abroad
Factor income = wages, profit and rent
GDP measures total income produced domestically. GNP measures total income produced by nationals (residents of a nation).
E.g. Japanese national owns apartment in USA => the rent he receives is a factor payment to abroad.
What is Net National Product (NNP)?
NNP = GNP - Depreciation
GNP = gross national product
Depreciation = consumption of fixed capital = depreciation of plants and equipment, residential structures
What is National Income?
National income = NNP - indirect business taxes
Indirect business taxes = GST.
National income measures how much everyone in the economy has earned.
What are the five categories of national income accounts?
Compensation of employees: wages and fringe benefits earned by workers
Proprietors' income: income of non-corporate businesses, e.g. Mum and dad businesses, small farms, law firms (partnerships)
Rental income: rent, including imputed rent that landowners pay themselves, less expenses (e.g. depreciation)
Corporate profits: income of corporations after payments to their workers and creditors = corporate taxes, dividends and retained earnings
Net interest: interest domestic businesses pay minus the interest they receive, plus interest earned from foreigners
What is personal income?
Personal income =
- corporate profits + dividends
- social insurance contributions to govt + government transfers to individuals
- net interest + personal interest income (diff is in part from interest on government debt)
What is disposable personal income?
Disposable personal income = personal income - personal tax and non-tax payments (to the govt)
Non tax payments = non tax payments to the govt, e.g. Parking tickets
Disposable personal income shows the amount households and non corporate businesses have available to spend after satisfying their obligations to govt.
What is the Consumer Price Index (CPI)?
It measures the price change of a fixed basket of goods and services purchased by a typical consumer compared to a base year. It measures the overall level of prices.
Laspeyres Index (fixed basket of goods index)
Weighted - takes into account the number of each good bought, and sometimes the increased quality of the good.
What is the producer price index?
Producer price index is similar to the consumer price index, but it monitors a basket of good bought by firms rather than consumers.
GDP deflator and CPI differences
1. GDP measures price of all goods and services produced. CPI measures price of goods and services bought consumers (not goods bought by firms or the govt)
2. GDP measures goods and services produced domestically. CPI includes imported goods that consumers buy.
3. CPI assigns fixed weights to the prices of different goods and services. GDP inflators assigns changing weights.
What is the difference between a Laspeyres Index and a Paasche Index?
Both are price indexes.
Laspeyres Index measures a fixed basket of goods
Paasche Index a changing basket of goods.
What kind of index (Laspeyres or Paasche) is a better measure of the cost of living?
Neither is clearly superior
When prices of goods are changing by different amounts:
Laspeyres index (fixed basket) overstates the increase in the cost of living - consumers can consume substitutes.
Paasche index (changing basket) understates the increase in the cost of living - doesn't reflect reduced consumer welfare by using substitutes.
What kind of indexes are CPI and GDP?
CPI - Laspeyres Index (fixed basket)
GDP - Paasche Index (changing basket)
What is CPI the main measure of?
Does CPI overstate inflation?
Yes - by slightly less than 1 percent.
Does not reflect ability of consumers to substitute goods for those whose relative prices have fallen
Does not consider introduction of new goods, which increase the value of the currency and makes consumers better off.
Does not consider all changes in quality. Increased quality results in higher consumer benefit.
What is the unemployment rate?
The percentage of people who want to work who do not have jobs.
Employed = spent some of the previous week working in a page job
Unemployed = not employed and has been looking for a job or is on temporary layoff.
Not in the labor force = does not fit into the previous categories, or is a person that wants work but has given up looking (a discouraged worker)
Labor force = number of employed + number of unemployed
Unemployment rate = number of unemployed / labor force x 100
What is the labor force participation rate?
Labor force participation rate =
Labor force / adult population x 100
What is Okun's Law?
When the unemployment rate rises, real GDP typically grows more slowly than it's normal rate (3 percent) and may even fall.
Percentage change in real GDP = 3 percent - 2 x change in the unemployment rate.
If unemployment stays the same, GDP rises by approx 3 percent due to growth in labor force, capital accumulation and technological progress.
Why the negative relationship between unemployment and real GDP?
Because workers help to produce goods and services and unemployed workers do not.
What does GDP measure?
1. The income of everyone in the economy and
2. The total expenditure on the economy' output of goods and services.
What are the determinants of the GDP and national income?
1. Quantity of factors of production (inputs)
2. Production function (represents ability to turn inputs into outputs)
What are factors of production?
Inputs used to produce goods and services.
Most important factors of production = capital (K) and labor (L)
What determines how much output is produced for given capital and labor?
Available production technology
What is the production function?
Y = F(K,L)
Output is a function of the amount of capital and the amount of labor.
Y is real GDP
What does constant returns to scale mean?
Increase in an equal percentage in all factors of production results in an increase in output of the same percentage.
zY = F(zK,zL)
For any positive number z
What determines the distribution of national income?
Factor prices: the amount paid for the factors of production (labor and capital), being wages and rent of capital.
What are the assumptions that go with a firm being competitive?
Wages, rent and price is fixed
What is the profit function of a competitive firm?
Profit = pY - WL - RK
Y = F(K,L)
Profit = PF(K,L) - WL - RK
Profit depends on price, factor prices (wages and rent) and number of production factors (labor and capital)
What is the profit maximising quantity of labor and capital?
Marginal product of capital = marginal product of labor
MPK = MPL
What is GDP made up of?
Y = C +I + G + NX
Y is real GDP
C = Consumption: durable goods, non durable goods, services
I = Investment: business fixed investment, residential fixed investment, inventory investment
G = Government expenditure: federal defence, federal non defence, state and local
NX = net exports: exports minus imports
What is the change in profit for a competitive firm when they hire 1 more unit of labor?
Change in profit = change in revenue - change in costs
Change in profit = p x MPL - W
What is a profit-maximising, competitive firm's demand for labor?
P x MPL = W
MPL = W/P
What is the real wage?
The payment for labor measured in units of output rather than dollars.
What is the real rental price of capital?
Real rental price of capital = R/P
The price of capital measured in units of output rather than dollars.
What is the change in profit for a competitive firm when they hire 1 more unit of capital
Change in profit = change in revenue - change in costs
Change in profit = P x MPK - R
What is a profit-maximising, competitive firm's demand for capital?
MPK = R/P
P x MPK = R
What are the total real wages paid to labor in a competitive market?
Total real wages paid to labor = MPL x L
What is the total real rent paid to capital in a competitive market?
Total real rent paid to capital = MPK x K
What is the economic profit of the owners of competitive firms?
Economic profit =
Y - MPL x L - MPK x K
Y = national income
Under what conditions is economic profit zero?
Constant returns to scale
How is national income distributed?
Y = MPL x L + MPK x K + economic profit
Economic profit = 0, so:
Total output is divided between the payments to capital and the payments to labor, depending on their marginal productivity.
What is Euler's theorem?
If the production function has constant returns to scale,
F(K,L) = MPK x K + MPL x L
If economic profit is 0, how is there any profit?
Income is divided into wages and rent of capital. The firm owners own the capital and so don't pay rent.
Accounting profit = economic profit + MPK x K
Assuming competition, constant returns to scale and profit maximisation so economic profit = 0:
Accounting profit = MPK x K
What is the consumption function?
C = C(Y-T)
Consumption is a function of disposable income, Y-T
Disposable income is income (Y) less taxes (T)
Upwards sloping, because as disposable income rises, more is consumed
What is the Marginal Propensity to Consume (MPC)?
Marginal Propensity to Consume (MPC) = the amount consumption changes when disposable income increases by 1 dollar.
It is between 0 and 1.
What does the quantity of investment goods depend on?
The interest rate (financing costs) and the profit the investment yields.
What is the nominal interest rate and the real interest rate?
Nominal interest rate = the reported interest rate.
Real interest rate = nominal interest rate corrected for (minus the rate of) inflation .
What is the investment function?
I = I(r)
Investment is a function of the real interest rate.
Define balanced govt budget, budget surplus and budget deficit.
Balanced govt budget: G (govt expenditure) = T (taxes)
Budget surplus: G is smaller than T
Budget deficit: G is bigger than T
How do different interest rates differ from each other?
Term: longer term => higher rate
Credit risk: likelihood of being repaid.
Tax treatment of different types of bonds
What variables are fixed under Neo-classical macroeconomics theory?
Y, L, K
What is the GDP equation under neoclassical theory using neoclassical assumption?
Y = C(Y-T) + I(r) + G
All are fixed except for I(r).
The interest rate must adjust so that demand = supply.
How does the interest rate work to balance demand and supply?
The interest rate must adjust to ensure that demand (C + I + G) equals supply (Y).
The higher the interest rate, the lower the investment and the lower the demand, C + I + G. If the interest rate is too high, demand falls short of supply.
Assuming a close economy (so net exports are 0):
Y = C + I + G
Y = C(Y-T) + I(r) + G
T and G are fixed by policy makers.
Profit maximisation so K and L are fixed, making Y fixed.
As T and Y are fixed, C is also fixed.
The real interest rate is the only variable that isn't fixed.
What is the equation for private savings?
Private savings = Y - T - C
This is disposable income minus consumption.
What is the equation for public savings?
Public savings = T - G
Government revenue minus Government spending
What is the equation for national savings (S)?
National Savings (S) = Y - C - G
National savings = private savings + public savings
S = (Y - T - C) + (T - G)
How does the interest rate bring financial markets into equilibrium?
Y - C(Y-T) - G = I(r)
National savings = Investments
National savings is fixed. Investments depend on the real interest rate.
How to graph the equilibrium real interest rate?
X axis: investment, savings
y axis: real interest rate
Savings curve is a vertical straight line (it is fixed). Nb this is like supply of loanable funds
Desired investment curve I(r): downwards sloping. Nb this is like demand for loanable funds
Equilibrium real interest rate: point of intersection. Households's desire to save equals firms' desire to invest..
What is the impact of an increase in government purchases (without increasing the tax rate)? How is this represented on a graph?
Government purchases increase => immediately increases demand for goods and services so demand exceeds supply.
BUT output is fixed, so it must be balanced by a decrease in investment, which means an increase in the interest rate. Government purchases crowd out investment.
Graph: national savings shift to the left, increasing the real interest rate.
Increase in government purchases reduces public savings. Private savings remain unchanged. Therefore, national savings is reduced and so shifts to the left.
What is the impact of a decrease in taxes? How to graph it?
Tax decreases => Disposable income increases, so consumption increases by: change in tax times MPC (Marginal Propensity to Consume).
The greater the MPC, the higher the impact of the tax cut on consumption.
Government expenditure is fixed, so investment must decrease to meet supply of goods and services, which is fixed by the factors of production => interest rate goes up.
Decrease in tax rate, like an increase in govt spending, crowds out investment by raising the interest rate.
National savings (Y-C-G) shifts to the left - it decreases by the amount consumption increases (change in tax times MPC)
What can increase demand for investment (people wanting to invest)?
Technological innovation (promising)
Government tax breaks on investment
What is the effect of an increase of investment demand (by firms)?
Investment curve shifts to the right.
Assuming national savings is fixed, this raises the real interest rate while the investment quantity stays the same.
Assuming national savings depend on the interest rate: Savings, S(r), is upwards sloping- the higher the interest rate, the more returns from saving => less consumption, more saving.
An increase in demand for investment raises the interest rate and the investment quantity too.
What are the functions of money?
1. Store of value - transfer purchasing power from the present to the future.
2. Unit of account - the terms in which prices are quoted and debts are recorded.
3. Medium of exchange - what we use to buy goods and services - it enables indirect trade, unlike the barter economy.
What types of money are there?
Commodity money - money that has intrinsic value and that everyone accepts e.g. gold (hence the gold standard)
Fiat money - money that has no intrinsic value, e.g. Dollars, Euros
When is the economy said to be on a gold standard?
When the people use gold as money, or paper money that is redeemable for gold.
What is money?
The stock of assets that can be readily used to make transactions.
Roughly speaking, the dollars in the hands of the public make up the nation's stock of money.
What is money supply?
The quantity of money available.
What is monetary policy?
The control of the supply of money.
With fiat money, controlling the supply of money is usually a government policy instrument due to legal restrictions giving government a monopoly on printing money.
With commodity money, it's determined by the production of the commodity.
Who determines monetary policy?
Monetary policy is usually delegated to a partially independent institution called the central bank.
How does the central bank control the supply of money?
Through open market operations: the purchase and sale of government bonds.
Central bank purchases govt bonds from the public => increases money supply (money goes into public hands)
Central bank sells govt bonds => decreases money supply (less money in public hands)
How is the quantity of money measure?
Currency- the sum of the outstanding paper money and coins
M1 - currency plus demand deposits, traveller's cheques and other checkable deposits
M2 - M1 plus retail money market mutual fund balances, saving deposits (money in savings accounts), and small time deposits.
M3 - M2 plus large time deposits, repurchase agreements, Eurodollars, and institution only money market mutual fund balances
The most common measures are M1 and M2.
What are demand deposits?
The funds people hold in their checking accounts (everyday transaction accounts).
Describe the quantity equation.
Money x Velocity = Price x Transactions
M x V = P x T
M = money in the economy
V is the transactions velocity of money = number of times per period (e.g. year) the money is exchanged.
P = average price of a transaction
T = number of transactions per period (e.g year)
What is the quantity equation using Y for real GDP?
Money x Velocity = Price x Output
M x V = P x Y
V is called the income velocity of money - the number of times a dollar bill enters someone's income in a given period of time.
P is the GDP Deflator, Y is real GDP, or total income.
PY is nominal GDP.
Transactions is similar to but not the same as GDP - transactions includes the sale of a used car.
What are the real money balances?
= the quantity of money in terms of the amount of goods and services it can buy. It measures the purchasing power of the stock of money.
What is the money demand function?
It shows what determines the amount of money people wish to hold.
E.g. (M/P)^d = kY
k is how much money people wish to hold for every dollar of income.
The quantity of real money balances demanded is proportional to real income. Higher income => higher demand for real money balances (and so the convenience of making more transactions)
What does the money demand function tell about the income velocity of money?
If demand for real money balances (M/P) must equal supply:
M/P = KY
MV = PY where V = 1/k
If people want to hold more money (k gets bigger), the income velocity of money decreases (money changes hands more slowly)
Why might income velocity of money change?
Introduction of ATMs, credit cards = people can reduce the amount of money they carry.
What is the quantity theory of money?
Assume income velocity of income remains constant.
M x V = P x Y
Assume V is constant (generally true).
Therefore the quantity of money determines the nominal GDP (PY). It determines the dollar value of the economy's output.
As Y is determined by the factors of production and the production function, the quantity of money determines P, the GDP Deflator, or the price level.
The money supply determines the rate of inflation. The central bank therefore controls the level of inflation through controlling the money supply.
This theory works best in the short run.
What is seigniorage?
Government printing money to pay for its expenditure.
This can be seen as an inflation tax, because it decreases the value of money that money holders have. It is a tax on money holding.
In countries experiencing hyperinflation, seigniorage is often the government's chief source of revenue.
What is the difference between an ex ante real interest rate and an ex post real interest rate?
Ex ante real interest rate = expected real interest rate when the loan is taken out = i - Pi^e
Ex post real interest rate = actual real interest rate once the loan has been taken out = i - Pi
i = nominal interest rate
Pi = actual future inflation
Pi^e = expected future inflation
What is the Fisher Effect?
i = r + Pi^e
The nominal interest rate is the real interest rate determined by equilibrium in the market for goods and services, plus the expected future rate of inflation.
Nb it is more accurate to say that (1+i) = (1+r)/(1+Pi), but if r, i and Pi are relatively small it doesn't matter.
What is the cost of holding money?
The nominal interest rate.
By holding another asset, you earn the real interest rate r.
Money loses value by the rate of inflation, Pi.
Together, this is the nominal interest rate.
What does the quantity of real money balances demanded depend on?
(M/P)^d = L(i,Y)
The quantity of real money balances demanded is a function of the nominal interest rate and income.
L for liquid asset.
What does the supply of real money balances depend on?
M/P = L(r + pi^e, Y)
The supply of real money balances depends on the expected inflation rate and amount of income.
This assumes supply of real money balances equals the demand for real money balances.
What effect does a higher expected inflation rate have on the impact of prices?
Higher expected inflation raises the nominal interest rate.
This reduces demand for real money balances.
As the quantity of money doesn't change, reduced demand leads to higher prices.
Therefore, higher expected inflation leads to higher prices.
What does the price level depend upon?
A weighted average of the current money supply and the money supply expected to prevail in the future.
Does inflation make people poorer by reducing their buying power?
No - this assumes their nominal wage would have increased by the same amount as without inflation.
Their real wage will still increase by the same amount, as will their savings.
What social costs does expected inflation have?
Distortion of the inflation tax on the amount of money people hold:
1. Shoe leather costs of inflation - people withdraw smaller amounts of money more often
2. Menu costs of inflation - the costs of shops and restaurants changing their prices more often
3. The costs of relative price variability - when firms face menu costs, they change their prices more significantly but less often, leading to changing relative prices => less is bought after the price change, more once inflation catches up and relative prices fall => this leads to microeconomic inefficiencies in the allocation of resources.
4. Tax distortion - inflation distorts how taxes are levied, e.g. CGT, which considers nominal gains, not real gains.
5. Inconvenience of making inflation corrections - inconvenience of living with a constantly changing price level - e.g. Trying to figure out how much to save for retirement - must take inflation into account.
What are the social costs of unexpected inflation?
It arbitrarily redistributes income between debtors and creditors. Solutions? predictable inflation, or index contracts to inflation, e.g. By using CPI.
E.g. Loan agreements with a fixed nominal interest rate - if higher than expected inflation, the debtor wins. If lower than expected inflation, the creditor wins.
E.g. Fixed pensions - worker benefits from low inflation, employer benefits from high inflation.
High inflation is variable inflation - countries with high inflation tend to have inflation rates that change greatly from year to year.
What is one benefit of inflation?
It improves the functioning of the labour market by allowing real wages to reach equilibrium levels without cuts in nominal wages.
Firms are reluctant to cut nominal wages, and workers are reluctant to accept them => nominal wages rarely fall.
With zero inflation and decreasing demand for a type of labor (e.g. Mining), wages rise above the equilibrium rate and unemployment rises.
Inflation enables cuts in the real wage without requiring cuts to the nominal wage, leading to the equilibrium and lower unemployment.
What are the effects of hyperinflation?
1. Shoe leather costs: The economy runs less efficiently, as resources are diverted from production and investment to cash management
2. Menu costs: normal business practices such as printing menus and catalogues become impossible.
3. Relative prices don't reflect the true scarcity of the goods - consumers don't have time to shop around before their buying power decreases.
4. Real tax collected decreases due inflation in the time between earning the money and paying taxes.
5. Inconvenience of carrying so much money around
Result => the money loses its role as a store of value, unit of account and means of exchange => barter economy or use a more stable foreign currency,
How does hyperinflation start and end?
Government has higher expenditure than tax revenue, and may be unable to borrow because it is viewed as a high credit risk => print more money => hyperinflation
Hyperinflation is self-reinforcing, as the real tax revenue decreases due to the delay before tax is collected => higher budget deficit => more seigniorage.
Governments see the magnitude of the problem, undertake fiscal reform (reduce spending and increase taxes), reducing the need for seigniorage.
What is capital stock?
The quantity of machines and structures available at a given time.
What are real variables?
All variables measured in physical units, such as quantities and relative prices.
E.g. Real GDP, capital stock, real wage, real interest rate
What are nominal variables?
Variables expressed in terms of money.
E.g. Price level, inflation rate, the dollar wage someone earns
What is the classical dichotomy?
The theoretical split between real and nominal variables.