Chapter 2
A flow variable is an economic variable measured over a period of time
A stock variable is an economic variable that depends on an instant
There are three formal definitions of GDP
The sum of final sales within The sum of value added The sum of factor incomes
a geographic location during occurring within a given earned from economic
a period of time (only final geographical location during activities over a period of
sales and not intermediate a period of time time
because those create
value-added)
Nominal GDP measures prices, whilst Real G
DP measures quantities, prices are set
nominal GDP
GDP Deflator =
real GDP
CPI is the Consumer Price Index
GDP does not take into account domestic activities, public services (which are entered as
government costs), and the underground economy
Each individual expenditure necessarily contributes to some other individual’s income →
circular flow diagram (Y-T = private income).
Absorption is the total domestic spending (C + I + G)
Y GDP / Output / Income
C Consumption
S Savings of the private sector
I Investment
T Net Taxes (Taxes - transfers)
G Government purchases
X Exports
Z Imports
NX Net Exports (X-Z)
GDP = C + S + T = C + I + G + X - Z
GDP - Depreciation = NDP (net domestic product)
GDP + Income earned abroad by residents - Income generated by non-residents in the
country = GNI (gross national product)
GDP ± taxes abroad, gifts = GDNI (gross disposable national income)
GNI / GDNI - depreciation = NNI / NDNI
The balance of payments accounts record all economic transactions between a
geographic entity and the rest of the world. They are the following:
- Current Account
- Goods and Services (X, Z) → Balance of goods and services
- Income account ± primary / secondary income → Balance of international
income.
- Capital Account
Captures commercial transactions that involve intangible, non-product
assets (e.g. right to use the land, goodwill).
- Financial Account
Net lending (positive. money flows out of the country to purchase foreign
assets) or Net borrowing (deficit. domestic assets are sold to foreigners). It is made
up of:
- Direct investments
- Portfolio investments
- Other investments
- Reserve assets (performed by authorities through foreign exchange market
interventions). CA + KA = NOFA + ΔR
CA + FA + OFF = 0
Net Lending = CA = FA
- Errors and Omissions
E&O = FA - CA
Chapter 3
There are three ways in which we have economic growth
Growth of capital stock Growth of the Labour Technological progress,
through investments, which Force, which increases the which causes workers and
enables workers to produce number of workers available machines to become more
more productive
The production function relates the output of an economy (real GDP) to its inputs (labour
and capital). y = f (K + , L+ )
There are two assumptions upon which our theories of economic growth rely:
- Returns to scale are held constant
Δy
- The marginal productivity of capital ( Δk ) is decreasing in the long run
The intensive form of the production function is the following:
y = f (k)
y = f (k α ) (Cobb-Douglas. 0 < α < 1 is the elasticity of output y with respect to capital k)
Kaldor drew five stylized facts (empirical regularities found in the data)
- Both output per capita and c apital intensity keep increasing
- The capital-output ratio exhibits little or no trend over time
- Hourly wages keep rising
- The rate of profit is trendless
- The relative income shares of GDP paid to labour and capital are trendless
The steady state is a situation in which certain features (GDP growth, ratios growth) are
kept steady. It is the long run average behaviour that we never reach but fluctuate about.
In the steady state: I = S + (T-G) + (Z-X), (S-I) = (T-G) + (X-Z)
Solow’s growth model
The proportion of the total stock lost in the period δ is called the depreciation rate. δ
equals the slope of the depreciation line.
Gross investment is the amount of money spent on new capital.
Net investment is the increase in capital stock ( Δk = sy − δk ).
The golden rule is a way to achieve the highest consumption per capita given existing
technological capabilities. MPK = δ
Dynamic efficiency is a condition in which it is not possible to do better without paying the
price for it
Dynamic inefficiency is a condition in which there are too many savings and investments
but little consumption as a result.
Capital widening refers to the addition of n to the capital accumulation condition, stating
that Gross Domestic Investment must also provide new workers’ equipment. For instance:
Δk = sy − (δ + n)k
The aggregate production function takes into account technological progress (A); it is
called total factor productivity. This causes the production function to become:
Δk = sy − (δ + n + a)k
The convergence hypothesis states that countries with lower GDP will grow faster than
those which have a higher one. Hence, at some point, they converge. The hypothesis does
well among richer nations however it doesn’t work in the world as a whole because of
growth traps.
Conditional convergence means that convergence occurs but to steady states that depend
on the individual attributes of an economy or a nation. This implies that countries have
different production functions because of a series of possibilities, such as:
- Human Capital (H)
- Health
- Public Infrastructure
- Social Infrastructure
Chapter 4
Labour supply is the trade-off between consumption and leisure.
Utility (consumer satisfaction) is expressed through indifference curves. The MRS is the
rate a which a household is willing to give up consumption for leisure.
The real (consumption) wage is the price of leisure for a household.
The budget constraint is the following: lw = lw + c
When wages rise, consumption increases, while leisure time decreases → Substitution
effect. However, if the amount of money dedicated to consumption is held constant, there is
less working time for a household, hence more working time → Income effect.
There is the household labour supply curve, which relates to an individual decision,
The aggregate labour supply curve reflects the sum of many individual decisions. It is
measured in person-hours (total amount of hours supplied by all workers during that
period). It is more elastic.
The marginal productivity of labour is the quantity of additional output which results from
one or more units of labour input. Graphically, it is the slope of the production function, as
well as being the labour demand curve. When there are increases in capital stock (k) the
curve shift upwards, making labour more productive at any level. The equilibrium demand
and supply curves intersect.
The labour force is given by the employment summed to the unemployment: LS = L + U
There is a distinction between voluntary unemployment (the decision not to work) and
involuntary unemployment (labour is willing and able to work at a wage w but cannot find
employment).
Real wage rigidity can be caused by two factors:
- involuntary unemployed workers must be unable to supply services at wages below
w
- firms must be unwilling or not allowed to pay wages below w
There are two main labour market institutions:
- Employers’ association
- Labour / trade unions:
- they offer employees a better bargaining position (united)
- they vary from the country in terms of functioning, power and membership
- their two priorities are higher real wages and more jobs
- hence, their optimal choice is the tangency point of the highest indifference curve
with demands for labour.
- they represent the employed (insiders), which tend to ask for higher wages, even if
this might decrease the unemployed (outsiders) quantity.
Minimum wage causes higher salaries but higher unemployment
An efficiency wage is a wage higher than w but that helps the employer select employees.
There are three ways to become unemployed:
(1) new entrants in the labour market are initially unsuccessful
(2) voluntary separation of workers from jobs
(3) involuntary separation of workers from jobs
Change in employment is given by the inflows into unemployment (sep. rate x labour) and
the outflows from (find. rate x l). → Δu = sL − f U
There are two types of unemployment:
- frictional (unavoidable)
- structural (given by inappropriate wage levels)
The equilibrium unemployment is given by frictional + structural unemployment.
The equilibrium unemployment rate is given by the following formula:
s
u = s+f
Chapter 5
The principle of monetary neutrality states that the supply of money does not matter for
the real aspects of the economy. “Prices and the nominal exchange rate should grow at the
same level as money”.
Money is just a medium of exchange, it only affects price levels, not the real economy
which influences (a) employment (b) standards of living (c)long-run economic growth.
Real GDP: Y Price levels: P → Nominal GDP: PY
Total demand for money (M): M = kPY (C ambridge equation).
Real demand for money: M
P = kY P
Inflation ( π ) is the growth rate of price levels. It is called hyperinflation if higher than 50%
per month.
According to the principle of monetary neutrality: infl. = money growth - GDP growth
ΔM ΔY
π= M − Y
The dichotomy principle states that nominal variables do not affect real ones in the long
run.
The real interest rate (r) is given by the nominal int. rate - inflation rate
r = i − π
The exchange rate can be expressed in two different terms:
- British terms: number of foreign currency units per domestic unit
- European terms: number of domestic currency units needed to buy a foreign one
The real exchange rate generally compares broad price levels rather than individual goods
(e.g. CPI, GDP deflator). It is given by the following equation:
SP P
σ = P* = P * /S
( σ = both prices in foreign currency = both prices in domestic currency)
The rate of change of the real exchange rate is given by the following equation
Δσ ΔS
σ = S + π − π*
(rate of ch. = rate of ch. of the nominal exchange rate + domestic infl. - foreign infl.)
Effective exchange rates are average exchange rates that include each partner country
weighted on their respective importance.
External terms of trade indicate how many imports are received in return for exports →
ratio of domestically-produced exports to foreign-produced imports prices.
Internal terms of trade measure the prices of goods which are not traded internationally
relative to the goods that are. → the ratio of non-traded to traded goods prices.
The real exchange rate is constant in the long run, hence there is purchasing power parity.
Relative purchasing power parity exists because, in the long run, a country must retain its
competitiveness.
Absolute purchasing power parity → law of one price: the same good should trade
everywhere at the same price if prices are in the same currency.
Arbitrage is created and continues until there are profit opportunities, hence at some point
prices are equalized around the world.
Chapter 6
Borrowing → an action by which future income is spent today
Lending → an action by which income is deferred to a later date
Intertemporal trade can be seen as a metaphor for shifting of spending over time.
The interest rate can be seen as the price of time.
An intertemporal budget constraint requires that liabilities will be repaid someday and that
accumulated assets will be spent.
Intertemporal choices involve present and future goods
Intratemporal choices involve different goods at a point in time.
The rational expectation hypothesis is an assumption that economic agents’ forecasts are
right on average.
Perfect foresight means that people anticipate the future correctly.
The endowment of resources can be present or future.
Operating in autarky means not to trade or consume the endowment
1
1+r is the intertemporal price - what an asset from the future is worth today
Discounting means valuing future goods in terms of goods today.
The budget line is a representation of the budget constraint, with − (1 + r) as a slope.
Investment or fixed capital formation is the use of valuable resources to produce more
goods later.
The real interest rate measures the opportunity cost of the resources used in the
investment.
In a solvent government, initial debt is financed by the present value of current and future
primary budget surpluses → the government budget balance from which interest
receipts/payments have been removed.
A government which is borrowing has a deficit, made up of:
- primary deficit: the amount by which non-interest related expenses exceed
revenues
- interest payments and debt repayments
The Ricardian equivalence proposition is a hypothesis that states that the private sector
fully internalizes the public sector’s budget constraint. That is, both the public and the private
sector lend and borrow at a rate r=rg.
There are three interpretations of the Ricardian equivalence proposition:
1) Total national spending (public + private) cannot exceed a country’s wealth
2) Private sector wealth = PV of production income - public purchases of goods and
services → implies that taxation over time has no effect on wealth
3) Citizens do not treat the government’s debt as wealth
However, there are also some issues concerning the model:
1) The hypothesis states that r=rg, however most of the times rg < r
2) There is mortality and now people are born (for what concerns tax incidence)
3) There are restrictions on borrowing
4) Taxes are distortionary (they alter people’s behaviour). Moreover, taxes have an
effect on unemployment
5) Evidence proves it works ! → households save about 50% of tax cuts.
The current account is divided into two parts:
- Primary current account
- Net investment income
CA = PCA +rF
There are also global imbalances in the net asset positions of countries (F).
International borrowing is operated by private entities, whilst sovereign borrowing is
operated by national governments from foreigners.
Chapter 8
There are three main implications of the intertemporal choice model
1) A temporary increase in income is accompanied by a permanent, but smaller,
increase in consumption
2) A permanent increase in income is absorbed in a permanent increase in consumption
3) If there is known to be an increase in future income, borrowing against that future
income increases.
The random walk theory of consumption states that only new, non-predetermined
information about the future should alter consumption.
Consumption smoothing is a process caused by the fact that people dislike variable
consumption patterns. When faced with a temporary change in income, rational consumers
borrow or save to spread consumption over time. Consumption is the most stable
component of aggregate demand.
Life-cycle consumption is a theory saying that to maintain a constant flow of consumption,
individuals should spend each year an amount corresponding to their permanent income.
When interest rates increase, they make the intertemporal budget constraint steeper.
This makes the cost of good today higher compared to goods in the future. This is an
advantage for lenders and a disadvantage for borrowers.
Consumers are credit rationed if they cannot obtain credit in spite of future earnings
potential. This will cause disposable income to be the dominating influence when it comes to
consumption of credit rationed households.
Consumption is primarily based on wealth, which is based on current and future income of
households. This can be seen in the consumption function.
Gross domestic capital formation, also called investment, is an intertemporal decision.
This because investment goods are not made for consumption.
If investment is financed by:
- resources that could be invested in financial assets, (1 + r) is the opportunity cost of
the investment.
- borrowing, (1 + r) is the marginal cost of capital
Profit equals production - its costs: = F(K) - K(1+r)
The optimal level of capital stock is to be found when MPK = 1 + r. It depends positively on
the expected effectiveness of the available technology, captured by the MPK. It depends
negatively on the real interest rate. This can be seen in the investment function I=I(r)
The accelerator principle makes two points:
- In order for investment to remain constant, output must continually increase
- Investment today depends on the expected growth of output tomorrow.
market value of installed capital
Tobin’s q = replacemet cost of installed capital . The numerator can be thought of as the stock
price of the firm.
According to Keynes, investments are primarily linked to the animal spirits of
entrepreneurs.
The investment function is given by the int. rate, the change in output and Tobin’s q:
I = I(r − , ΔY +, q + )
Chapter 9
These are the money aggregates taken into account:
- M = currency in circulation + bank deposits
- M0 = currency in circulation + bank reserves
- M1 = currency in circulation + sight deposits + accounts at banks
- M2 = M1 + time (or savings) deposits at banks with unrestricted access
- M3 = M2 + large, fixed-term deposit accounts at non-bank institutions
Sight deposits accounts are accounts that can be converted into cash; cheques or bank
transfers are made against them; receive barely any interest.
Central banks
- Are public or quasi-public
- Are made to control money and credit conditions
- Create currency
- Create bank reserves (funds held by commercial banks in the central one)
- The sum of currency and bank reserves is the monetary base (MO)
Commercial banks
- Are financial intermediaries
- Are the custodians of the payments system
- Maturity transformation is the practice of taking in short-term liabilities and using
them to acquire long term assets.
- Bank runs or failures are overwhelming surges or withdrawals
A bailout means that depositors, creditors, and owners are shielded from losses that they
would incur, had the bank gone out of business.
The money multiplier process is the following: any time new money is injected in the
economy the result is an increase in money stock which is a multiple of that initial increase.
The reserve ratio is the proportion of deposits set aside in the form of bank reserves.
To put up collateral means to pledge someone’s own assets that would be forfeited should
the person fail to repay the debt.
Banks have the tendency to lend as much as possible, so reserves regulations come in. For
example: reserves > rr x deposits
deposits < 1/rr reserves
The money / interbank / open market is a network of banks that facilitates buying
(borrowing) or selling (lending) reserves. The rate used is the interbank interest rate
Chapter 10
Central banks set the monetary policy: they control interest rates, exchange rates, or
financial conditions in general.
Central banks can set any interest they want, provided it stands ready to provide or withdraw
liquidity in any amount needed to meet the derived demand corresponding to the rate. To
enforce the rate, central banks provide their interbank markets with whatever volume of
reserves demanded. They carry out open market operations: they purchase and sell
assets using reserves, their own liabilities.
Non-performing loans are those loans that may not be repaid in the future.
Monetary policy should first and foremost be dedicated to achieving price stability.
Moreover, central banks have to be concerned with the level of economic activity. For
instance, the objectives of monetary policy are: low and stable inflation, GDP growth, and
high employment.
Central banks use available instruments to affect variables, identifying and focusing on
intermediate targets. These are the following:
- Money growth targeting. If the money multiplier is stable, a choice of monetary
base implies a choice of the money supply. Money growth targeting implies
forecasting GDP growth (g) and allowing money to grow at a rate ( μ ) that delivers
low inflation.
π = μ − g
- (Expected) inflation targeting. It is the use of monetary instruments - usually the
interbank interest rate - to bring the realized inflation rate as close as possible to the
target. If forecasted inflation is too high, the central bank raises the interest rate.
- Exchange rate targeting. Central banks sometimes have to fix a country’s nominal
exchange rate. In order to do so, they have to give up the option of setting interest
rates. Countries have to give up the control of inflation to a foreign country because
of political issues.
The Tailor rule states that the central bank raises the interbank market interest rate (i) when
π > π , and when y > y. The target inflation rate is meant to capture the central bank’s
price stability objective. The potential output is a trend level that corresponds to the level of
GDP observed if the economy is operating at a sustainable level and unemployment is at an
equilibrium level. The neutral or natural interest rate i s the rate that central banks would
want to set if inflation and output were at their desired levels. Also see output gap, zero
lower bound.
Chapter 11
Business cycles can be explained by disturbances that originate in goods and financial
markets. We use the Keynesian assumption that prices are constant.
Y = C + I + G + (X - Z)
This definition of GDP can be seen as a market equilibrium condition. Y is the aggregate
supply of goods and services by domestic producers. The other side of the equation is the
aggregate demand for goods produced domestically. While demand responds to
exogenous forces, supply only responds to demand.
Determinants of demand (functions)
● Consumption function
● Investment function
● Net imports, as a component of absorption (A) - the total domestic spending.
● Import function
● Export function
● Net export function
There is then the desired demand function:
The goods market also has an equilibrium:
- GDP returns to equilibrium level as firms adjust the production level to meet the
market’s demand.
- Any disequilibrium in the market for goods is relatively short-lived.. Firms use
inventories and unfilled orders as buffers.
Equilibrium always responds to demand, sometimes by a larger amount. This can be seen
in the mechanism of the Keynesian demand multiplier. An increase in ΔG gives rise to an
increase Δ Y, which is a multiple of the former.
