1. Nominal and real interest rates, and how to use the formula linking the nominal and real
interest rates on a loan with the inflation rate.
a. Nominal interest rate (i) the interest rate you actually see on the loan, bond,
b. Real interest rate (r ) = nominal interest rate – inflation. So if the nominal interest rate is 7%, and inflation is 5%, then the real interest rate is 2%. The real interest rate is money the lender actually receives as income (AKA not nullified by
c. r = i – inflation
2. Who gains and who loses from an unexpected increase or decrease in inflation and why. a. Who wins from an unexpected increase in inflation: the borrower.
i. If you’re borrowing at a fixed rate, say 5%, and the inflation is higher than expected, (say 10%), then the money you use to pay off the loan is less
valuable than the money you were leant, even when accounting for interest b. Who loses from an unexpected increase in inflation: the lender
i. If I lend you $100 at 5% interest rate expecting inflation to be 5% and it ends up being 10%, all of a sudden I’m not getting the value of my money back. I get back $105, but the market equivalent of my $100 loan is now
c. An unexpected decrease in inflation benefits lenders and hurts borrowers 3. How nominal interest rates reflect expected inflation.
a. Nominal interest rates are equal to expected inflation rates. Any inaccuracy in the predicted inflation rate is revealed in the difference between inflation and nominal We also discuss several other topics like What is geology?
interest rate, ie real interest rate
4. Shoeleather costs, menu costs and unitofaccount costs of inflation. a. Shoe leather costs: increased costs of transactions by inflation
i. People spend time running back and forth to the bank to convert their money into something valuable (wearing down shoe leather) and their time and labor is wasted where it could be spent elsewhere
We also discuss several other topics like Does it matter that this happened in Detroit?
b. Menu costs real cost of changing a listed price
i. Manual labor required to keep changing price of eggs to $2 to $3 to $4 and so on
c. Unit of account costs arise from the way inflation makes money a less reliable unit of measurement
i. People use resources less efficiency because the value of those resources is unpredictable
5. Why debtcreation is necessary for aggregate expenditure to exceed GDP. a. Aggregate expenditure is total spending on domestic products, GDP is equal to
total income in an economy. The only way that spending on domestic spending
could exceed income is if a country borrowed (ie created debt)
6. The argument that saving causes investment and the policy implications of this argument. a. S+NCI = I+(GT).
i. NCI= Net Capital Inflow =IMX
ii. I= Investment
iii. G=Govt spending, T= Tx Tr
iv. So basically money we save+ money being saved in the country by foreigners= Investment by firms + (Money the govt spends money we
b. Argument is that left hand side constrains right hand side. The more we save, the
more money there is in the bank systems to lend out for investment
c. Policy implications:
i. ) boosting private sector saving allows more investment to take place
ii. 2) govt budget deficit should be cut because it “crowds out” investment (I) by sucking up finance that could otherwise be used for investment If you want to learn more check out What are the main macroeconomics variables?
1. Ie when govt borrows from bank less for firms to borrow
7. The Keynesian argument that investment causes saving.
a. S+NCI = I+(GT).
b. Right hand side constrains left
i. As investment increases, income increases (more jobs, higher wages) and
then people have more disposable income to save
ii. Counterargument to above position:Why would firms take out money for investment without proper incentive (if people are saving instead of
spending, there’s no reason to invest)
8. The rule of 70 and how to apply it.
a. Rule of 70: Number of years for variable to double= 70/ annual growth rate of variable
i. So if the annual growth rate of real GDP is 2%, it will take 35 years to double
9. The aggregate production function and the concept of diminishing returns to physical
a. APF shows the relationship between the physical capital per worker employed in the economy (independent variable) and real GDP per worker, or worker
productivity (dependent variable), “ceteris paribus”
b. There are diminishing returns because as you invest in capital it has a reduced impact on GDP overall (with all else equal.) At some point, if you only have 5 If you want to learn more check out Why is Langston Hughes famous?
farmers, 100 tractors is just as good as 5]
10. How to use the aggregate production function to analyze a change in the capital/labor ratio, a change in technology, or a change in the skills of the workforce.
a. One example of an aggregate production function: GDP per worker= T * (Physical capital per worker).4 * (Human capital per worker).6
i. (Where T=Technology)
ii. Notice the powers of physical capital and human capital are inverses (.4+.6 =1)
b. Capital/ labor ratio when this ratio goes up real GDP per worker will also go up (but with diminishing returns
c. A technological advancement, or an improvement in human knowledge/ skills will also improve GDP per capita
11. The link between the balance of international trade and capital flows. a. If we have a trade deficit there is a positive NCI (Net capital inflow), if we have a
trade surplus a negative NCI
i. In other words, when we have a trade deficit, IMX>0, there is a capital inflow because countries have extra $ left over from the US buying from
them, that they can then in turn invest in our economy
ii. When there’s a trade surplus (IMX)<0, that’s a net capital outflow, because we have more money going abroad to purchase assets, including
b. A country that spends more on imports than it does on exports must borrow the difference from another country, which is why net capital inflow= imports– Don't forget about the age old question of What is Encoding?
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12. Net capital inflow.
a. total inflow of funds into a country minus the total outflow of funds out of a
c. In the US NCI has been positive recently, (that is more money has been coming into our economy to be invested by foreigners than has been flowing out to be invested in foreign countries)
i. Any difference between our countries total savings and the money we spend (AE) can be made up by foreign money coming in (ie positive NCI
is often associated with foreign lending)
13. Private sector saving, public sector saving and national saving.
a. National Saving (SNational) is Private sector saving + public sector saving b. Private sector saving= money that comes into households in the form of income,
that isn’t spent on Consumption Spending or given the govt via taxes
c. Public Sector saving = Tx GTr
14. The identity, S+NCI = I+(GT), the two ways of interpreting it in terms of causality, and
the policy implications of each of these interpretations.
a. See number 6 and 7. Either the left side restricts the right, or the right side restricts the left (Keynesian.) Keynesian view says that if firms increase spending (I), overall income in the economy will rise, people will have more money to spend (and save.) The spending will encourage further increase in I, while
increase in saving increases S overall, and therefore money in the bank that firms
have to borrow from, to Invest even more!
b. The opposite idea is that if we as consumers save more, there will be more in the bank for firms to borrow to spend on Investment. But without a net increase in income, if we are saving more it means that we are spending less, giving firms no
incentive to produce more, and therefore no incentive to invest more.
15. The identity, I = Snational+NCI, and the two ways of interpreting it in terms of causality. a. Investment equals national savings plus net capital inflow
i. 2 Interpretations: 1) Right side constrains left side. Domestic saving (Snational) plus foreign saving (NCI) determines I
ii. 2) Keynesian interpretation : left hand side determines right hand side (rise in AE, etc) Notice that the increase in Y causes Tx to rise and Tr to fall (as unemployment benefits fall) so T grows and growth in Yd raises S
1. Investment boosts industry, which boosts income and disposable
income, and it’s this disposable income that changes the right hand
side. With more disposable income, people save more. Also, with a
higher national income, there are fewer transfer payments to poor
(Tr) and more money paid in Taxes (Tx)
2. Argument against this interpretation: If the economy is already
operating at full employment, you can’t get the economy to grow.
Greer argues that we have never seen full employment, so this
argument is irrelevant
16. The concept of future value and how to use the formula for future value.
a. Basic concept of future value: a sum of money inhand today will have a greater future value because the money can be used to purchase an interest bearing financial asset, which will allow the sum to grow
b. Future value (FV) of a present value in hand (PV) is determined by: i. FV=PV(1+i)n
ii. i=nominal interest rate on the financial asset
iii. n= number of years in the future that the future sum will be obtained iv. e.g. FV of $100 that grows at 4% one year from now = $100 (1.04)1= $104
1. After 2 years, $100(1.04)2= $108.16, etc
17. The concept of present value and how to use the formula for present value. a. PV=FV/ (1+i)n
i. Note: Present value is often referred to as “present discounted value” because future cash stream are being discounted by the relevant interest rate
ii. The farther out in the future we are looking the more heavily the future value is being discounted, i.e. larger npower in the denominator
18. Net present value and how to use it to determine whether an investment project is profitable.
a. Net present value (NPV) of the project is the sum of the cash flows of an investment project, with cash outflows recorded negatively and cash inflows recorded positively, and each cash flow discounted to its present value
b. Accounts for monetary investments (negative) and gains (positive) over several years, discounted using PV=FV/ (1+i)n
c. If NPV is positive, the project is worth it and will be profitable
19. Why the quantity of loanable funds demanded is negatively related to interest rates.
Demand for loanable funds decreases as interest rate goes up ( the slope of the demand curve is negative) because as the interest rate increases, it makes more and more sense just to stick your money in the bank and let it grow, rather than putting it towards an investment project. So you won’t be borrowing money for investing if the interest rate is high. In other words, you won’t be demanding loanable funds.
20. The noninterest rate influences on the demand for loanable funds and what happens to the demand for loanable funds when one of these influences changes.
a. Changes in perceived business opportunities (positive correlation)
b. Changes in govt borrowing – ie as govt borrows more (increasing a budget deficit) it demands more loanable funds, shifts curve to the right (positive correlation)
21. Why the quantity of loanable funds supplied is positively related to interest rates.
a. When interest rates rise, people are rewarded for putting their money in the bank. Increase in individual’s savings contributes is the same as an increase in the
loanable funds supply, which is simply money in the bank system
22. The noninterest rate influences on the supply of loanable funds and what happens to the supply of loanable funds when one of these influences changes.
a. 1. Changes in private savings behavior (anything encouraging people to be looser/tighter with their money)
b. 2. Changes in net capital inflows change as foreigners perception of that country/ the stability of its economy changes
23. How the supply of and demand for loanable funds determines the market equilibrium
a. The interest rate where the supply curve for lenders supplying loanable funds and investors demanding loanable funds intersect gives us r*, the equilibrium interest rate. Just like an equilibrium supply, any shift to the left or right would lead to a
surplus or shortage of loanable funds
24. Analyze the effects of a change in supply of or change in demand for loanable funds on
interest rates and the dollar volume of loan transactions.
a. If demand for loanable funds goes up, interest rates will go down. If supply goes
up, interest rates will go up for r*
b. If demand or supply goes up, there will be a higher volume of loan transactions 25. The investment demand function.
a. Investment demand refers to the demand by businesses for physical capital goods and services used to maintain or expand its operations.
26. What a financial asset is and the four types of financial assets.
a. paper claim that entitles the buyer to future income from the seller
i. Loans given, stocks, bonds, and bank deposits
27. The three tasks of a financial system and how the system accomplishes each of these
a. Reduction of transaction costs, risk management, provision of liquidity 28. The concept of liquidity.
a. asset is liquid if it can be quickly converted into cash with relatively little loss of
29. What a financial intermediary is and the four types of financial intermediaries.
30. an institution that transforms the funds it gathers from many individuals into financial assets
a. Mutual funds, pensions funds, life insurance companies, and banks
31. Crowding out of investment
a. occurs when a govt budget deficit drives up the interest rate and leads to reduced investment spending
BOOK NOTES 9 and 10
Real GDP per capita best measure of the advancement of a country/ the quality of life of its citizens Rule of 70:
o Number of years for variable to double= 70/ annual growth rate of variable
o So if the annual growth rate of real GDP is 2%, it will take 35 years to double
Labor productivity – output per worker
o Sustained economic growth occurs only when the amount of output produced by the average worker (labor productivity) is increasing steadily
o Real GDP usually grows because of population growth, but real GDP per capita grows as labor productivity does
Labor productivity grows because of improvements in sources of economic growth : o Physical capital humanmade resources like machines and buildings
o Human capital improvement in labor created by the education and knowledge embodied in the workforce
o Technological progress advance in the technical means of producing goods and services,
Aggregate production functionhypothetical function that shows how productivity (real GDP per worker) depends on quantities of physical and human capital per worker, and state of technology
o One example of an aggregate production function: GDP per worker= T * (Physical capital per worker).4 * (Human capital per worker).6
o A.P.F.s demonstrate diminishing returns to physical capital when, holding the other 2 factors fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity
The more money you poor into inputs (a nicer building, more machines,) the less marginal return you get from each one
i.e. if I buy a tractor I will be much more productive, if I buy a tractor that’s twice as expensive, my productivity will not improve the same amount (less change)
important to remember this only applies when human capital and technology are fixed
Growth Accounting estimates the contribution of each major factor in the aggregate production function to economic growth
Total factor productivity the amount of output that can be achieved with a given amount of factor inputs o Usually an increase in this is crucial to country’s economic growth
Reasons for differences in growth rates between countries:
o Higher rates of investment spending
o Rate of increasing education level of citizens
o Research and development (R&D) spending to create and implement new technologies Rate new technologies are actually applied to production affects growth rate too How govt affects sources of economic growth (human, physical, technology):
o Govt policies
1. Govt subsidies to infrastructure ( roads, power lines, ports, info networks, etc. Underpinnings for economic activity.)
∙ Foundation for economic activity
2. Govt subsidies to education
3. Govt subsidies to Research and development
4. Maintaining a wellfunctioning financial system
∙ Amount of savings people have, ability of economy to move savings to
∙ Wellregulated and wellfunctioning financial system will be trusted and people will put their money into it
o Protection of property rights
Prop rights right of owners of valuable items to dispose of those items as they choose
∙ Intellectual prop rights right of an innovator to accrue rewards of their
Protected property rights increases motivation to innovate
o Political stability and good governance good laws and people that can reliably enforce them, and reliable govt institutions
Need to know money, life, and property are safe for healthy economy
Convergence hypothesis international differences in real GDP per capita tend to narrow over time (because countries that start with lower GDP per capita have higher growth rates)
Sustainable longrun economic growth: longrun growth that can continue in the face of the limited supply of natural resources and the impact of growth on the environment
o Some experts question whether this is possible b/c of limited supply of nonrenewable resources
o Economists are optimistic because scarce resources become expensive, incentivizing people to use them less and find better alternatives
Sustainable long run growth leads to issues with climate change and pollution. It’s possible to combat this, but (most economists agree) only through govt intervention of some sort
o The long view ( consequences are way down the road) and the sharing of consequences with other countries makes it hard to impose effective regulations
Savings and investment spending identity savings and investment spending are always equal for the economy as a whole
This idea is supported if we look at the GDP calculation, GDP= C+I+G+XIM
o If this were a closed economy, ie no imports or exports, GDP = C+I+G
Meaning that GDP (total income) would equal total spending. This makes sense, since we know every dollar spent is a dollar of income for someone else
Income can be spent on consumption ( C), Govt purchases of goods and services (G) (through taxes), or saved (S)
∙ So GDP must also = C+G+S
∙ GDP = total income = consumption spending + savings
We also know from before GDP= C+G+I
So I= S, Savings= investment
Budget surplus the difference between tax revenue and govt spending when tax revenue exceeds govt spending
Budget deficit difference between tax revenue and govt spending when govt spending exceeds tax revenue Budget balance the difference between tax revenue and govt spending
o Applies to both above cases
o Defined as: SNational= TGTR
T= tax revenues
G= govt spending on goods and services
National savings –sum of private savings and the budget balance, the total amount of savings generated within the economy
o SNational= Sgovernment +Sprivate
o In a closed economy, Snational= Investment, or National Savings= Investment
Net Capital Inflow total inflow of funds into a country minus the total outflow of funds out of a country
o In the US NCI has been positive recently, (that is more money has been coming into our economy to be invested by foreigners than has been flowing out to be invested in foreign countries)
o A dollar from national savings and a dollar from capital inflow are not the same. Both are borrowed from a saver, and paid back with interest. But the interest can either be paid back to a domestic saver ( national savings) or a foreign one (capital inflow)
o NCI= IM X
A country that spends more on imports than it does on exports must borrow the difference from another country, which is why net capital inflow= imports–exports
So remember, even when foreign nations/ businesses are investing in our country, what this really means is that we are borrowing money from them. When we have a positive net capital inflow, it means we are borrowing more than we are lending/ investing in foreign economies
o I= SNational + (IMX) = SNational +NCI
In an open economy: Investment spending = national savings + net capital inflow When NCI is positive, some investment spending is funded by the savings of foreigners
when it is negative, some portion of national savings is funding investment in other countries
Loanable funds market hypothetical market that illustrates the market outcome of the demand for funds generated by borrowers and the supply of funds provided by lenders
o How borrowers and lenders are brought together
o The “price” determined in the loanable funds mkt is the interest rate, r
“r” is a nominal interest rate, meaning it is unadjusted for inflation
Present value present value of X is the amount of money needed today in order to receive X at a future date given the interest rate
o Present value is always less than X, because the interest rate will grow it
SO. Demand for loanable funds decreases as interest rate goes up ( the slope of the demand curve is negative) because as the interest rate increases, it makes more and more sense just to stick your money in the bank and let it grow, rather than putting it towards an investment project. So you won’t be borrowing money for investing if the interest rate is high. In other words, you won’t be demanding loanable funds.
Supply curve for loanable funds is positive
o As interest rates rise, supply will also increase, because supply for loanable funds comes from individuals saving. More people are sticking money in the bank if interest rates are high, so more money is available to borrow
Equilibrium interest rate interest rate at which Q of loanable funds supplied equals Q of loanable funds demanded (r*)
Factors causing shifts of Demand curve for loanable funds:
o 1. Changes in perceived business opportunities (positive correlation)
o 2. Changes in govt borrowing – ie as govt borrows more (increasing a budget deficit) it demands more loanable funds, shifts curve to the right
o Increase in demand for loanable funds raises equilibrium interest rate (r*)
Causes of shifts in the supply of loanable funds curve:
o 1. Changes in private savings behavior (anything encouraging people to be looser/tighter with their money)
o 2. Changes in net capital inflows change as foreigners perception of that country/ the stability of its economy changes
The biggest factor that affects/ changes the interest rate (r*) is expected changes of future inflation
o If you expect inflation to go up sharply, you will want the interest rate to be high when you lend money
Fisher effect says an increase in expected future inflation drives up the nominal interest rate, leaving the expected real interest rate unchanged
o Because both borrowers and lenders are basing decisions off expected inflation, the supply and demand for loanable funds may shift to change nominal interest rate, but the real interest rate will remain the same (people will value that interest rate the same as they did before, once inflation is accounted for.)
Wealth value of household’s accumulated savings
Financial Asset paper claim that entitles the buyer to future income from the seller o Loans given, stocks, bonds, and bank deposits
Physical asset –tangible object that can be used to generate future income
Liability is a requirement to pay income in the future
o Ie if you take out a loan for a new car, that money is a liability to you and a financial asset to the bank
Three important problems facing borrowers and lenders:
o 1. Transaction Costs the expenses of negotiating and executing a deal
Using banks as an intermediary allows us to borrow $100,000 from one place rather than a $1000 from 100 places. One borrower, one lender
o 2. Financial risk uncertainty about future outcomes that involve financial losses or gains
People are usually more sensitive to losing X amount of money than gaining it, making them riskadverse
Diversification helps solve this problem selling shares of your company so that many people will share the loss and gain of a given risk
∙ Diversification investing in several different things so that the possible losses
are independent events
o 3. Issue of liquidity
Liquid asset is liquid if it can be quickly converted into cash with relatively little loss of value
Illiquid cannot be converted with minimal loss
Stocks, bonds, and banks are big responses to this concern of illiquidity among saver
Types of Financial Assets:
Loan lending agreement between an individual lender and an individual borrower o Good aspect: tailored to the need of the borrower
o Bad aspect: high transaction costs, investigation credit, negotiating terms, etc
Bonds IOU issued by the borrower to the lender the seller of the bond promises to pay back the principal plus a fixed interest rate to the owner of the bond
o People can easily get information about the bond issuer (credit history, etc) included for free o A bond is a liability for the seller, and a financial asset for the owner
o Default occurs when a borrower fails to make payments as specified by the loan or bond contractor
Once a bond’s risk of default has been rated, it can be sold on the bond market as a standard product
o A bond is like a prenegotiated loan, with parameters already in place. Usually an issuer makes a lot of bonds available and can sell them to numerous buyers
Loanbacked securities assets created by pooling individual loans and selling shares in that pool (a process called securitization)
o Mortgagebacked securities best known example, thousands of mortgages are pooled and shares are sold to investors (think the Big Short)
o Can be done with student loans, auto loans, all types
o Investors like them because they have more diversification and liquidity than a single loan, but it’s harder to tell what’s in them and if they are reliable
Stocks share in the ownership of a company
o Financial asset for the owner of the stock, liability for the company’s point of view
o Companies accept this liability to manage risk if things go south
Financial intermediaries an institution that transforms the funds it gathers from many individuals into financial assets
o Mutual funds, pensions funds, life insurance companies, and banks
o ¾ of financial assets Americans own are held through these intermediaries
Mutual fund financial intermediary that creates a stock portfolio and then resells shares of this portfolio to individual investors
o A share of a stock portfolio ie you can have the benefit of a diversified group of stocks, without having to spend the time selecting the stocks yourself, or pay the cost of buying all the individual stocks (ie I may want to have Microsoft, Google, and Disney stock, but maybe I can’t afford to buy all three. Instead I buy a mutual fund from Bob. Bob buys Microsoft, Google, and Disney stock, creates a stock portfolio, and my mutual fund is simply a share (say 10%) of his portolio.)
o Often mutual funds do the research for you too, and invest in reliable companies
Pension funds type of mutual fund that holds assets in order to provide retirement income to its members o Nonprofits do the investing for you
Life insurance companies sells policies that guarantee a payment to a policyholder’s beneficiaries when the policyholder dies
Bank a financial intermediary that provides liquid assets in the form of bank deposits to lenders and uses those funds to finance the illiquid investment spending needs of borrowers
Bank deposit a claim on a bank that obliges the bank to give the depositor his or her cash when demanded o Essentially makes you a lender to the bank
The value of a good or service comes from its consumption, but the value of a financial asset comes from its ability to generate higher future consumption of goods or services (money!)
o Does this by: provide regular income to their owners in the form of interest payments or dividends o Selling the financial asset (like a stock) later for a higher value than you purchased it
o So financial value today is valuable because of what an investor thinks they could get from it in the future – this is what drives demand in the financial market
This applies to other assets too, including physical ones people expect to get money from its resale or for it to make them money
Efficient markets hypothesis asset prices embody all publicly available information
o Any difference between market price and the value suggested by careful analysis is an opportunity for profits. Because people are always looking for this profit, the market price will adjust to the true worth of a stock and it will never be over or under priced
o Some disagree with this hypothesis, and think you can make money buying and selling when things are over and underpriced
Random walk movement over time of an unpredictable variable
o Movements of stock values are based on new info, new info is new and therefore unpredictable, almost all stock value changes are random walks
In this chapter, we are assuming:
1. Producers are wlling to supply additional output at a fixed price, so that changes in aggregate spending contribute to changes in aggregate output
2. We take interest rates as given
3. There is no govt spending and no taxes
4. Export and imports are zero
Marginal propensity to consume (MPC) the increase in household savings when disposable income rises by $1
o MPC= change in consumer spending / change in disposable income
Remember disposable income is income + govt transfers (Tr) – taxes (Tx)
o MPC is a number b/w 1 and 0, b/c people ususally spend some but not all of an additional dollar Marginal propensity to save (MPS) the increase in household savings when income rises by $1 o So MPS+MPC always =1