Principles of Macroeconomics
Principles of Macroeconomics Econ 102
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This 8 page Class Notes was uploaded by April Jerde on Thursday September 17, 2015. The Class Notes belongs to Econ 102 at University of Wisconsin - Madison taught by Elizabeth Kelly in Summer 2015. Since its upload, it has received 7 views. For similar materials see Principles-Macroeconomics in Economcs at University of Wisconsin - Madison.
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ECON 102 FALL 2004 REVIEW SHEET FOR MATERIAL AETER MIDTERM 2 This is not meant to be a complete list but is instead a guideline of many of the topics covered in the last pa1t of the course Professor Kelly reserves the right to ask questions about material that is not listed here or that is found in your text but was not covered in the lectures Please review your notes carefully work the practice questions and take care of yourself physically and mentally in preparation for the exam If you need additional questions remember to check the website for help wwwsscwisceduNekellyecon102 In addition remember that the Final Exam is comprehensive and includes Q the topics covered during the semester Therefore you should make sure you know the material in the review sheets 1 amp 2 SHORT R UN KEYNESIAN MODEL Equilibrium GDP in the Short Run Keynesian model the level of output at which output and aggregate expenditure are equal Graphically the equilibrium GDP is the point at which the aggregate expenditure line crosses the 450 line Indeed at this point we have YAE Adjustments toward the equilibrium If the aggregate expenditure is less than GDP then inventories are going to increase and firms will slow their production in the future Output will then decline If the aggregate expenditure is greater than GDP then inventories are going to decrease and firms are going to increase their production in the future Output will then rise Remark Unplanned change in inventories Output 7 Aggregate Expenditure Expenditure multiplier any change in a autonomous consumption spending b investment spending c government purchases d net exports will shift the aggregate expenditure line upward or downward depending on the direction of the change in the variable This will change the equilibrium GDP The change in the equilibrium GDP is equal to the initial change in any of the variables in the list above multiplied by the expenditure multiplier Expenditure Multiplier 1 MPC Tax multiplier any change in the tax level will cause a change in the equilibrium GDP equal to the initial change in the tax level multiplied by the tax multiplier Tax multiplier 1 MPC THE BANKING SYSTEMAND THE MONEY SUPPLY Terms Balance sheet A financial statement showing assets liabilities and net worth at a point in time Banking panic A situation in which depositors attempt to withdraw funds from many banks simultaneously Bond An IOU issued by a corporation or government agency when it borrows funds Cash in the hands of the public Currency and coins held outside of banks Demand deposit multiplier The number by which a change in reserves is multiplied to determine the resulting change in demand deposits Under the assumption of no monetary drains and zero excess reserves it must be that DD reservesRRR The money multiplier is equal to JRRR Discount rate The interest rate the Fed charges on loans to banks Excess demand for bonds The amount of bonds demanded exceeds the amount supplied at a particular interest rate Excess reserves Reserves in excess of required reserves Excess supply of money The amount of money supplied exceeds the amount demanded at a particular interest rate Federal funds rate The interest rate charged for loans of reserves among banks Loan An IOU issued by a household or noncorporate business when it borrows funds Money demand curve A curve indicating how much money will be willingly held at each interest rate M1 A standard measure of the money supply including cash in the hands of the public checking account deposits and travelers checks M2 Ml plus savings account balances noninstitutional money market mutual fund balances and small time deposits Open market operations Purchases or sales of bonds by the Federal Reserve System Required reserve ratio RRR The minimum fraction of checking account balances that banks must hold as reserves Required reserves The minimum amount of reserves a bank must hold depending on the amount of its deposit liabilities Run on the bank An attempt by many of a bank39s depositors to withdraw their funds How the Fed changes the money supply 1 open market operations 2 changing required reserved ratio 3 changing the discount rate The mechanism through which open market operations affect the money supply a purchase a sale of bonds increases the amount of cash in the hand of public Under the assumption of no monetary drains this cash is deposited in a bank The bank loans out the resulting excess reserves The amount of the corresponding loan is deposited in another bank This process continues infinitely leading to a change in the demand deposits a part of money supply equal to change in DDamount of OM ORRR What determines the money demand 1 the price level shifts the money demand curve a higher price level requires more money for purchases 2 the real income shifts the money demand curve a higher real income leads to more purchases and thus requires more money 3 the interest rate a movement along the money demand curve a lower interest rate decreases the opportunity cost of holding money and thus increases the quantity of money demanded The supply of money is determined by the Fed A mechanism that leads to the equilibrium in the money market is the following Let the interest rate be higher than the equilibrium rate That will cause the excess supply of money and therefore an excess demand for bonds In turn the price of bonds will go up driving down the real ie realized interest rate on bonds The Fed can affect the interest rate through changing the money supply A decrease in the interest rates increases three types of spending in the economy spending on 1 plant and equipment 2 new housing and 3 consumer durables AGGREGATE DEMAND AND AGGREGATE SUPPLY Aggregate demand AD curve A curve indicating equilibrium GDP at each price level Aggregate supply AS curve A curve indicating the price level consistent with firms39 unit costs and markups for any level of output over the short run Long run aggregate supply curve A vertical line indicating all possible output and pricelevel combinations at which the economy could end up in the long run Movement along AD curve an increase in prices shifts the money demand rightwards increasing the interest rate As a result the autonomous consumption and private investment spending decreases and the equilibrium output drops Demand shock Any event that causes the AD curve to shift Factors causing AD curve to shift not induced by a change in price level changes in government purchases changes in taxes changes in autonomous consumption spending changes in autonomous investment spending changes in net exports changes in money supply changes in propensity to consume 99 9 An example of a shift of AD curve an autonomous increase in investment spending 7 causes aggregate expenditure to shift upwards for all price levels This leads to higher equilibrium outputs for all price levels and correspondingly shifts the AD curve to the right Movement along AS curve an increase in output raises the prices of inputs and also raises the input requirements per unit of output This increases costs per unit and drives the total price level up Factors causing AS curve to shift not induced by a change in the output changes in world prices of oil and other major imputs changes in weather technological change adjustments in the longrun bERNt POLICIES Monetary policy changes in the money supply An increase in the money supply leads to a lower interest rate This causes an increase in spending the autonomous consumption and planned investment go up Thus the aggregate expenditure increases and the shortrun equilibrium output goes up Fiscal policy changes in government expenditure or taxation An increase in government purchases increases the shortrun output through an expenditure multiplier process This creates an increase in money demand higher real income causing interest rates to increase and spending to fall As a result the output falls a bit somewhat offsetting the initial increase Crowding out When effects in the money market are included in the shortrun model an increase in government purchases raises the interest rate and crowds out some private investment spending It may also crowd out consumption spending However complete crowding out does not occur in the short run model ECON 102 SPRING 2004 REVIEW SHEET FOR MIDTERM 2 This is not meant to be a complete list but is instead a guideline of many of the topics covered for this midterm Professor Kelly reserves the right to ask questions about material that is not listed here or that is found in your text but was not covered in the large lecture Please review your notes carefully work the practice questions and take care of yourself physically and mentally in preparation for the exam If you need additional questions remember to check the website for help wwwsscwisceduNekellyecon102 THE CLASSICAL MODEL Assumptions markets clear by price adjustment there is a market for labor loanable funds and each good and service all capital labor and land are being used Labor Market Full Employment is achieved by the economy on its own there is no need for government intervention In particular the real wage will adjust instantaneously such that the quantity of labor demanded is equal to the quantity of labor supplied There is no cyclical unemployment in this model Remark In the labor market households supply labor while businesses demand labor The quantity of labor households supply increases as the real hourly wage increases the quantity of labor businesses demand decreases as the real hourly wage increases At any quantity of labor the supply of labor curve shows the opportunity cost of the last worker hired while the demand for labor curve shows the benefit for businesses from the last worker hired if this concept is not clear to you draw the picture depicting the labor market and consider a fixed quantity of labor What is the real wage at which individuals are willing to work What is the wage that businesses are willing to pay to hire new workers What does this imply Aggregate Production Function It shows the total output an economy can produce with different quantities of labor holding constant land capital and technology The principle of the diminishing returns to labor tells us that as the number of workers employed increases output will initially increase at an increasing rate and then eventually increase at a decreasing rate we can see this from the shape of the aggregate production function As the employment of labor increases the amount of capital available per laborer decreases leading to lower productivity for subsequently hired workers Therefore as the number of workers increases the output produced increases but by smaller amounts Say s law Total spending Total value of production or supply will create its own demand Remember in a model in which households consume save and pay taxes and government and business have a role in spending Say s law does not generally hold it does only if Leakages income earned but not spent Injections spending from sources other then Households Leakages Savings Taxes Imports S T M Injections Investments Government spending Exports I G Exports This condition in the Classical model is guaranteed by the equilibrium in the loanable funds market Loanable funds market In general the Supply of loanable funds Savings S The supply of loanable fund increases as the real interest rate increases Demand for loanable funds Govemment s demand for loanable funds Businesses demand of loanable funds Govemment s demand forf loanable funds Budget Deficit GT This demand is not affected by the real interest rate Businesses demand for loanable funds Investments I It decreases as the real interest rate increases Remark make sure you know how to deal with a Budget Surplus instead of a Budget Deficit In this case the Government does not demand funds it supplies them Quantity Theory of Money Supply of Money controlled by the Government or Central bank M S M Demand for Money demand for transactions MD kPY where Y Real GDP and hence PY is the nominal GDP k percentage of income that people desire to hold as money In equilibrium money supply money demand or MS MD Remember in the Classical model a change in the supply of money does not a ect the real GDP it affect the price level and the Nominal GDP PY Demand Management Policies Fiscal Policy a change in G or 7 designed to change total spending and then total output in the economy In the Classical model these policies have a crowding out effect AG AC Al the increase in G completely crowds out private sector spending consumption investment The total spending is therefore unchanged Moneta Policy a change in the supply of money to achieve macroeconomic goals In the Classical model any change inM will be re ected in a change in the price level P Policies that enhance growth 1 Policies that promote an increase in the Supply of Labor this will increase the equilibrium quantity of labor and consequently real GDP The equilibrium real wage will decrease To check this draw the picture of the labor market and the aggregate production function and consider the effects of a shift in the supply of labor 2 Policies that promote an increase in the Demand of Labor the equilibrium quantity of labor will increase and consequently real GDP The equilibrium wage in this case will increase Again you should be able to check that these statements are true 3 Policies that promote an increase in the Capital Stock the production function shifts up at any quantity of labor real GDP increases The capital stock increases if investment is greater than capital depreciation In order to increase investment the government needs to pursue policies that will increase the demand or the supply of Loanable funds 4 Policies that shrink the budget de cit these will lower the real interest rate and encourage private investment 5 Policies that promote the growth of human capital the growth of human capital will shift the aggregate production function up I I 6 Policies that support 39 change the effects are the same as in 5 Contractions and Expansions A country faces a contraction recession when actual output is lower than the Full Employment or potential level of output unemployment rate is relatively high A country faces an expansion boom when actual output is higher than the potential or full employment level of output unemployment rate is relatively low The Classical model is inadequate to explain these uctuations that affect the economy in the Short Run SHORT R UN KEYNESIAN MODEL The basic features of the model are in this model income in uences spending and spending in uences income the model focuses on spending the model focuses on the short run Total Spending is the sum of a Consumption spending household spending on the consumption of goods and services In the Keynesian model consumption spending has a positive linear relationship to disposable income Disposable income YD Y T Consumption C a bY T where a autonomous consumption income the part of consumption spending that is independent of income 7 MPC Marginal Propensity to Consume AY T the amount by which consumption spending rises when disposable income rises by one dollar 0quot Investment spending plant and equipment purchases by rms new home construction and planned inventory adjustment In the Keynesian model developed thus far investment spending is treated as a constant autonomously determined value Government purchases goods and services that government agencies buy during the year In the Keynesian model Government purchases are treated as a autonomously determined value 0 d Net Exports foreign sector contribution to total spending In the Keynesian model net exports are treated as a autonomously determined value and they are computed as Net Exports NX X 7 M Total Exports 7 Total Inputs Aggregate Expenditure AE the sum of consumption and investment spending government purchases and net exports It is the total spending of the economy as a whole AEC1PGNX 7C 11 G X7M Equilibrium GDP in the Short Run Keynesian model the level of output at which output and aggregate expenditure are equal Adjustments toward the equilibrium If the aggregate expenditure is less than GDP then inventories are going to increase and rms will slow their production in the future Output will then decline If the aggregate expenditure is greater than GDP then inventories are going to decrease and rms are going to increase their production in the future Output will then rise Remark Change in inventories Output 7 Aggregate Expenditure Graphically the equilibrium GDP is the point at which the aggregate expenditure line crosses the 450 line At this point we have YAE see Chapter 10 Figure 8 in your book p 241 Mathematically the equilibrium GDP can be obtained from the following equation a bTIP GNX 1 b you should be able to derive this equation from the equilibrium equality Y AE if you can t do it check Appendix 1 in the book Y The Short Run Keynesian model can explain uctuations in the economy Indeed the equilibrium GDP does not necessarily equal Full Employment GDP therefore equilibrium employment can be either lower or greater than full employment check Chapter 10 Figure 9 in your book p243 Expenditure multiplier any change in a autonomous consumption spending b investment spending c government purchases d net exports will shift the aggregate expenditure line upward or downward depending on the direction of the change in the variable This will change the equilibrium GDP The change in the equilibrium GDP is equal to the initial change in any of the variables in the list above multiplied by the expenditure multiplier Expenditure Multiplier 1 MPC Tax multiplier any change in the tax level will cause a change in the equilibrium GDP equal to the initial change in the tax level multiplied by the tax multiplier Tax multiplier 1 MPC