Macroeconomics summary

Resume of Gregory Mankiw Macroeconomics, 7th Edition

Macroeconomics is the study of the economy as a whole, including growth in incomes, changes in prices, and the rate of unemployment. Macroeconomists attempt both to explain economic events and to devise policies to improve economic performance.

Economists use many types of data to measure the performance of an economy. Three macroeconomic variables are especially important: real gross domestic product (GDP), the inflation rate, and the unemployment rate. Real GDP measures the total income of everyone in the economy (adjusted for the level of prices). The inflation rate measures how fast prices are rising. The unemployment rate measures the fraction of the labor force that is out of work. Macroeconomists study how these variables are determined, why they change over time, and how they interact with one another

In other words, they assume that markets are normally in equilibrium, so the price of any good or service is found where the supply and demand curves intersect. This assumption is called market clearing

Microeconomics is the study of how households and firms make decisions and how these decisionmakers interact in the marketplace. In microeconomic models, households choose their purchases to maximize their level of satisfaction, which economists call utility, and firms make production decisions to maximize their profits. Because economy-wide

The consumer price index, or CPI, measures the level of prices .

CPI turns the prices of many goods and services into a single index measuring the overall level of prices.

CPI = . In this CPI, 2009 is the base year. The index tells us how much it costs now to buy 5 apples and 2 oranges relative to how much it cost to buy the same basket of fruit in 2009. (5 × Current Price of Apples) + (2 × Current Price of Oranges) /(5 × 2009 Price of Apples) + (2 × 2009 Price of Oranges)

The consumer price index is a closely watched measure of inflation

A stock is a quantity measured at a given point in time, whereas a flow is a quantity measured per unit of time.

A person’s wealth is a stock; his income and expenditure are flows.

➤ The number of unemployed people is a stock; the number of people losing their jobs is a flow.

➤ The amount of capital in the economy is a stock; the amount of investment is a flow.

➤ The government debt is a stock; the government budget deficit is a flow.

Nominal GDP, Real GDP (constant prices set of 3 years)-> gdp deflactor = n / r

■ Consumption (C) (households)

■ Investment (I) (all)

■ Government purchases (G)

■ Net exports (NX). T

hus, letting Y stand for GDP, Y = C + I + G + NX.

Investment, as macroeconomists use the term, creates new capital.

The unemployment rate is the statistic that measures the percentage of those people wanting to work who do not have jobs. Every month, the U.S. Bureau of Labor Statistics computes the unemployment rate and many other statistics that economists and policymakers use to monitor developments in the labor market.

Part 2

Capital is the set of tools that workers use: the construction worker’s crane, the accountant’s calculator, and this author’s personal computer. Labor is the time people spend working. We use the symbol K to

The demand for the economy’s output comes from consumption, investment, and government purchases. Consumption depends on disposable income; investment depends on the real interest rate; and government purchases and taxes are the exogenous variables set by fiscal policymaker

If the interest rate is too high, then investment is too low and the demand for output falls short of the supply. If the interest rate is too low, then investment is too high and the demand exceeds the supply. At the equilibrium interest rate, the demand for goods and services equals the supply.

Inflation is simply an increase in the average level of prices, and a price is the rate at which money is exchanged for a good or a service.

When the government prints money to finance expenditure, it increases the money supply. The increase in the money supply, in turn, causes inflation. Printing money to raise revenue is like imposing an inflation tax

The answer is the holders of money. As prices rise, the real value of the money in your wallet falls. Therefore, when the government prints new money for its use, it makes the old money in the hands of the public less valuable. Inflation is like a tax on holding money

Suppose you deposit your savings in a bank account that pays 8 percent interest annually. Next year, you withdraw your savings and the accumulated interest. Are you 8 percent richer than you were when you made the deposit a year earlier? The answer depends on what “richer’’ means. Certainly, you have 8 percent more dollars than you had before. But if prices have risen, each dollar buys less, and your purchasing power has not risen by 8 percent. If the inflation rate was 5 percent over the year, then the amount of goods you can buy has increased by only 3 percent. And if the inflation rate was 10 percent, then your purchasing power has fallen by 2 percent.

The interest rate that the bank pays is called the nominal interest rate, and the increase in your purchasing power is called the real interest rate.

  1. Money is the stock of assets used for transactions. It serves as a store of value, a unit of account, and a medium of exchange. Different sorts of assets are used as money: commodity money systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole function is to serve as money. In modern economies, a central bank such as the Federal Reserve is responsible for controlling the supply of money.
  2. The quantity theory of money assumes that the velocity of money is stable and concludes that nominal GDP is proportional to the stock of money. Because the factors of production and the production function determine real GDP, the quantity theory implies that the price level is proportional to the quantity of money. Therefore, the rate of growth in the quantity of money determines the inflation rate.
  1. Seigniorage is the revenue that the government raises by printing money. It is a tax on money holding. Although seigniorage is quantitatively small in most economies, it is often a major source of government revenue in economies experiencing hyperinflation.
  1. The nominal interest rate is the sum of the real interest rate and the inflation rate. The Fisher effect says that the nominal interest rate moves one-for-one with expected inflation.
  1. The nominal interest rate is the opportunity cost of holding money. Thus, one might expect the demand for money to depend on the nominal interest rate. If it does, then the price level depends on both the current quantity of money and the quantities of money expected in the future.
  1. The costs of expected inflation include shoeleather costs, menu costs, the cost of relative price variability, tax distortions, and the inconvenience of making inflation corrections. In addition, unexpected inflation causes arbitrary redistributions of wealth between debtors and creditors. One possible benefit of inflation is that it improves the functioning of labor markets by allowing real wages to reach equilibrium levels without cuts in nominal wages.
  1. During hyperinflations, most of the costs of inflation become severe. Hyperinflations typically begin when governments finance large budget deficits by printing money. They end when fiscal reforms eliminate the need for seigniorage.
  1. According to classical economic theory, money is neutral: the money supply does not affect real variables. Therefore, classical theory allows us to study how real variables are determined without any reference to the money supply. The equilibrium in the money market then determines the price level and, as a result, all other nominal variables. This theoretical sep

rWith this convention, a rise in the exchange rate—say, from 120 to 125 yen per dollar—is called an appreciation of the dollar; a fall in the exchange rate is called a depreciation. When the domestic currency appreciates, it buys more of the foreign currency; when it depreciates, it buys less. An appreciation is sometimes called a strengthening of the currency, and a depreciation is sometimes called a weakening of the currency.

■ The real exchange rate is related to net exports. When the real exchange rate is lower, domestic goods are less expensive relative to foreign goods, and net exports are greater.

■ The trade balance (net exports) must equal the net capital outflow, which in turn equals saving minus investment. Saving is fixed by the consumption function and fiscal policy; investment is fixed by the investment function and the world interest rate.

  1. Net exports are the difference between exports and imports. They are equal to the difference between what we produce and what we demand for consumption, investment, and government purchases.
  2. The net capital outflow is the excess of domestic saving over domestic investment. The trade balance is the amount received for our net exports of goods and services. The national income accounts identity shows that the net capital outflow always equals the trade balance.
  1. The impact of any policy on the trade balance can be determined by examining its impact on saving and investment. Policies that raise saving or lower investment lead to a trade surplus, and policies that lower saving or raise investment lead to a trade deficit.
  2. The nominal exchange rate is the rate at which people trade the currency of one country for the currency of another country. The real exchange rate is the rate at which people trade the goods produced by the two countries. The real exchange rate equals the nominal exchange rate multiplied by the ratio of the price levels in the two countries.
  3. Because the real exchange rate is the price of domestic goods relative to foreign goods, an appreciation of the real exchange rate tends to reduce net exports. The equilibrium real exchange rate is the rate at which the quantity of net exports demanded equals the net capital outflow. 6.
  4. The nominal exchange rate is determined by the real exchange rate and the price levels in the two countries. Other things equal, a high rate of inflation leads to a depreciating currency

Unemployment represents wasted resources. Unemployed workers have the potential to contribute to national income but are not doing so.

  1. The natural rate of unemployment is the steady-state rate of unemployment. It depends on the rate of job separation and the rate of job finding.
  1. Because it takes time for workers to search for the job that best suits their individual skills and tastes, some frictional unemployment is inevitable. Various government policies, such as unemployment insurance, alter the amount of frictional unemployment.
  1. Structural unemployment results when the real wage remains above the level that equilibrates labor supply and labor demand. Minimum-wage legislation is one cause of wage rigidity. Unions and the threat of unionization are another. Finally, efficiency-wage theories suggest that, for various reasons, firms may find it profitable to keep wages high despite an excess supply of labor.
  1. Whether we conclude that most unemployment is short-term or long-term depends on how we look at the data. Most spells of unemployment are short. Yet most weeks of unemployment are attributable to the small number of long-term unemployed.
  1. The unemployment rates among demographic groups differ substantially. In particular, the unemployment rates for younger workers are much higher than for older workers. This results from a difference in the rate of job separation rather than from a difference in the rate of job finding.
  1. The natural rate of unemployment in the United States has exhibited longterm trends. In particular, it rose from the 1950s to the 1970s and then started drifting downward again in the 1990s and early 2000s. Various explanations of the trends have been proposed, including the changing demographic composition of the labor force, changes in the prevalence of sectoral shifts, and changes in the rate of productivity growth.
  1. Individuals who have recently entered the labor force, including both new entrants and reentrants, make up about one-third of the unemployed. Transitions into and out of the labor force make unemployment statistics more difficult to interpret.
  1. American and European labor markets exhibit some significant differences. In recent years, Europe has experienced significantly more unemployment than the United States. In addition, because of higher unemployment, shorter workweeks, more holidays, and earlier retirement, Europeans work fewer hours than Americans.

The figure shows that countries with high rates of population growth tend to have low levels of income per person. The international evidence is consistent with our model’s prediction that the rate of population growth is one determinant of a country’s standard of living. .

  1. The Solow growth model shows that in the long run, an economy’s rate of saving determines the size of its capital stock and thus its level of production. The higher the rate of saving, the higher the stock of capital and the higher the level of output.
  2. In the Solow model, an increase in the rate of saving has a level effect on income per person: it causes a period of rapid growth, but eventually that growth slows as the new steady state is reached. Thus, although a high saving rate yields a high steady-state level of output, saving by itself cannot generate persistent economic growth
  3. The level of capital that maximizes steady-state consumption is called the Golden Rule level. If an economy has more capital than in the Golden Rule steady state, then reducing saving will increase consumption at all points in time. By contrast, if the economy has less capital than in the Golden Rule steady state, then reaching the Golden Rule requires increased investment and thus lower consumption for current generations.
  1. The Solow model shows that an economy’s rate of population growth is another long-run determinant of the standard of living. According to the Solow model, the higher the rate of population growth, the lower the steady-state levels of capital per worker and output per worker. Other theories highlight other effects of population growth. Malthus suggested that population growth will strain the natural resources necessary to produce food; Kremer suggested that a large population may promote technological progress.


Long-run economic growth is the single most important determinant of the economic well-being of a nation’s citizens. Everything else that macroeconomists study—unemployment, inflation, trade deficits, and so on—pales in comparison.

Fortunately, economists know quite a lot about the forces that govern economic growth. The Solow growth model and the more recent endogenous growth models show how saving, population growth, and technological progress interact in determining the level and growth of a nation’s standard of living. These theories offer no magic recipe to ensure an economy achieves rapid growth, but they give much insight, and they provide the intellectual framework for much of the debate over public policy aimed at promoting long-run economic growth.

  1. In the steady state of the Solow growth model, the growth rate of income per person is determined solely by the exogenous rate of technological progress.
  2. Many empirical studies have examined to what extent the Solow model can help explain long-run economic growth. The model can explain much of what we see in the data, such as balanced growth and conditional convergence. Recent studies have also found that international variation in standards of living is attributable to a combination of capital accumulation and the efficiency with which capital is used.
  1. In the Solow model with population growth and technological progress, the Golden Rule (consumption-maximizing) steady state is characterized by equality between the net marginal product of capital (MPK − d ) and the steady-state growth rate of total income (n + g). In the U.S. economy, the net marginal product of capital is well in excess of the growth rate, indicating that the U.S. economy has a lower saving rate and less capital than it would have in the Golden Rule steady state.
  1. Policymakers in the United States and other countries often claim that their nations should devote a larger percentage of their output to saving and investment. Increased public saving and tax incentives for private saving are two ways to encourage capital accumulation. Policymakers can also promote economic growth by setting up the right legal and financial institutions so that resources are allocated efficiently and by ensuring proper incentives to encourage research and technological progress.
  1. In the early 1970s, the rate of growth of income per person fell substantially in most industrialized countries, including the United States. The cause of this slowdown is not well understood. In the mid-1990s, the U.S. growth rate increased, most likely because of advances in information technology.
  1. Modern theories of endogenous growth attempt to explain the rate of technological progress, which the Solow model takes as exogenous. These models try to explain the decisions that determine the creation of knowledge through research and development.

When the economy experiences a period of falling output and rising unemployment, the economy is said to be in recession.

Average workweek of production workers in manufacturing. Because businesses often adjust the work hours of existing employees before making new hires or laying off workers, average weekly hours is a leading indicator of employment changes. A longer workweek indicates that firms are asking their employees to work long hours because they are experiencing strong demand for their products; thus, it indicates that firms are likely to increase hiring and production in the future. A shorter workweek indicates weak demand, suggesting that firms are more likely to lay off workers and cut back production.

Average initial weekly claims for unemployment insurance. The number of people making new claims on the unemployment-insurance system is one of the most quickly available indicators of conditions in the labor market. This series is inverted in computing the index of leading indicators, so that an increase in the series lowers the index. An increase in the number of people making new claims for unemployment insurance indicates that firms are laying off workers and cutting back production, which will soon show up in data on employment and production.

New orders for consumer goods and materials, adjusted for inflation. This is a very direct measure of the demand that firms are experiencing. Because an increase in orders depletes a firm’s inventories, this statistic typically predicts subsequent increases in production and employment.

New orders for nondefense capital goods. This series is the counterpart to the previous one, but for investment goods rather than consumer goods.

Index of supplier deliveries. This variable, sometimes called vendor performance, is a measure of the number of companies receiving slower deliveries from suppliers. Vendor performance is a leading indicator because deliveries slow down when companies are experiencing increased demand for their products. Slower deliveries therefore indicate a future increase in economic activity

New building permits issued. Construction of new buildings is part of investment—a particularly volatile component of GDP. An increase in building permits means that planned construction is increasing, which indicates a rise in overall economic activity

Index of stock prices. The stock market reflects expectations about future economic conditions because stock market investors bid up prices when they expect companies to be profitable. An increase in stock prices indicates that investors expect the economy to grow rapidly; a decrease in stock prices indicates that investors expect an economic slowdown.

Money supply (M2), adjusted for inflation. Because the money supply is related to total spending, more money predicts increased spending, which in turn means higher production and employment.

Interest rate spread: the yield spread between 10-year Treasury notes and 3-month Treasury bills. This spread, sometimes called the slope of the yield curve, reflects the market’s expectation about future interest rates, which in turn reflect the condition of the economy. A large spread means that interest rates are expected to rise, which typically occurs when economic activity increases.

Index of consumer expectations. This is a direct measure of expectations, based on a survey conducted by the University of Michigan’s Survey Research Center. Increased optimism about future economic conditions among consumers suggests increased consumer demand for goods and services, which in turn will encourage businesses to expand production and employment to meet the demand.

Most macroeconomists believe that the key difference between the short run and the long run is the behavior of prices. In the long run, prices are flexible and can respond to changes in supply or demand. In the short run, many prices are “sticky’’ at some predetermined level. Because prices behave differently in the short run than in the long run, various economic events and policies have different effects over different time horizons

  1. Economies experience short-run fluctuations in economic activity, measured most broadly by real GDP. These fluctuations are associated with movement in many macroeconomic variables. In particular, when GDP growth declines, consumption growth falls (typically by a smaller amount), investment growth falls (typically by a larger amount), and unemployment rises. Although economists look at various leading indicators to forecast movements in the economy, these short-run fluctuations are largely unpredictable.
  1. The crucial difference between how the economy works in the long run and how it works in the short run is that prices are flexible in the long run but sticky in the short run. The model of aggregate supply and aggregate demand provides a framework to analyze economic fluctuations and see how the impact of policies and events varies over different time horizons.
  1. The aggregate demand curve slopes downward. It tells us that the lower the price level, the greater the aggregate quantity of goods and services demanded.
  1. In the long run, the aggregate supply curve is vertical because output is determined by the amounts of capital and labor and by the available technology but not by the level of prices. Therefore, shifts in aggregate demand affect the price level but not output or employment.
  1. In the short run, the aggregate supply curve is horizontal, because wages and prices are sticky at predetermined levels. Therefore, shifts in aggregate demand affect output and employment.
  1. Shocks to aggregate demand and aggregate supply cause economic fluctuations. Because the Fed can shift the aggregate demand curve, it can attempt to offset these shocks to maintain output and employment at their natural levels.
  1. The Keynesian cross is a basic model of income determination. It takes fiscal policy and planned investment as exogenous and then shows that there is one level of national income at which actual expenditure equals planned expenditure. It shows that changes in fiscal policy have a multiplied impact on income.
  1. Once we allow planned investment to depend on the interest rate, the Keynesian cross yields a relationship between the interest rate and national income. A higher interest rate lowers planned investment, and this in turn lowers national income. The downward-sloping IS curve summarizes this negative relationship between the interest rate and income.
  1. The theory of liquidity preference is a basic model of the determination of the interest rate. It takes the money supply and the price level as exogenous and assumes that the interest rate adjusts to equilibrate the supply and demand for real money balances. The theory implies that increases in the money supply lower the interest rate.
  1. Once we allow the demand for real money balances to depend on national income, the theory of liquidity preference yields a relationship between income and the interest rate. A higher level of income raises the demand for real money balances, and this in turn raises the interest rate. The upward-sloping LM curve summarizes this positive relationship between income and the interest rate.
  1. The IS–LM model combines the elements of the Keynesian cross and the elements of the theory of liquidity preference. The IS curve shows the points that satisfy equilibrium in the goods market, and the LM curve shows the points that satisfy equilibrium in the money market. The intersection of the IS and LM curves shows the interest rate and income that satisfy equilibrium in both markets for a given price level.
  1. The IS–LM model is a general theory of the aggregate demand for goods and services. The exogenous variables in the model are fiscal policy, monetary policy, and the price level. The model explains two endogenous variables: the interest rate and the level of national income .
  1. The IS curve represents the negative relationship between the interest rate and the level of income that arises from equilibrium in the market for goods and services. The LM curve represents the positive relationship between the interest rate and the level of income that arises from equilibrium in the market for real money balances. Equilibrium in the IS–LM model—the intersection of the IS and LM curves—represents simultaneous equilibrium in the market for goods and services and in the market for real money balances.
  1. The aggregate demand curve summarizes the results from the IS–LM model by showing equilibrium income at any given price level. The aggregate demand curve slopes downward because a lower price level increases real money balances, lowers the interest rate, stimulates investment spending, and thereby raises equilibrium income.
  1. Expansionary fiscal policy—an increase in government purchases or a decrease in taxes—shifts the IS curve to the right. This shift in the IS curve increases the interest rate and income. The increase in income represents a rightward shift in the aggregate demand curve. Similarly, contractionary fiscal policy shifts the IS curve to the left, lowers the interest rate and income, and shifts the aggregate demand curve to the left.
  1. Expansionary monetary policy shifts the LM curve downward. This shift in the LM curve lowers the interest rate and raises income. The increase in income represents a rightward shift of the aggregate demand curve. Similarly, contractionary monetary policy shifts the LM curve upward, raises the interest rate, lowers income, and shifts the aggregate demand curve to the left.

Fiscal Policy Suppose that the government stimulates domestic spending by increasing government purchases or by cutting taxes.

Monetary Policy Suppose now that the central bank increases the money supply. Because the price level is assumed to be fixed, the increase in the money supply means an increase in real money balances

Trade Policy Suppose that the government reduces the demand for imported goods by imposing an import quota or a tariff. What happens to aggregate income and the exchange rate? How does the economy reach its new equilibrium? Because net exports equal exports minus imports, a reduction in imports means an increase in net exports.

We now turn to the second type of exchange-rate system: fixed exchange rates. Under a fixed exchange rate, the central bank announces a value for the exchange rate and stands ready to buy and sell the domestic currency to keep the exchange rate at its announced level.

A reduction in the official value of the currency is called a devaluation, and an increase in its official value is called a revaluation

1.The Mundell–Fleming model is the IS–LM model for a small open economy. It takes the price level as given and then shows what causes fluctuations in income and the exchange rate.

  1. The Mundell–Fleming model shows that fiscal policy does not influence aggregate income under floating exchange rates. A fiscal expansion causes the currency to appreciate, reducing net exports and offsetting the usual expansionary impact on aggregate income. Fiscal policy does influence aggregate income under fixed exchange rates.
  2. The Mundell–Fleming model shows that monetary policy does not influence aggregate income under fixed exchange rates. Any attempt to expand the money supply is futile, because the money supply must adjust to ensure that the exchange rate stays at its announced level. Monetary policy does influence aggregate income under floating exchange rates.
  3. If investors are wary of holding assets in a country, the interest rate in that country may exceed the world interest rate by some risk premium. According to the Mundell–Fleming model, an increase in the risk premium causes the interest rate to rise and the currency of that country to depreciate.
  4. There are advantages to both floating and fixed exchange rates. Floating exchange rates leave monetary policymakers free to pursue objectives other than exchange-rate stability. Fixed exchange rates reduce some of the uncertainty in international business transactions. When deciding on an exchange-rate regime, policymakers are constrained by the fact that it is impossible for a nation to have free capital flows, a fixed exchange rate, and independent monetary policy.
  1. The two theories of aggregate supply—the sticky-price and imperfect-information models—attribute deviations of output and employment from their natural levels to various market imperfections. According to both theories, output rises above its natural level when the price level exceeds the expected price level, and output falls below its natural level when the price level is less than the expected price level.
  1. Economists often express aggregate supply in a relationship called the Phillips curve. The Phillips curve says that inflation depends on expected inflation, the deviation of unemployment from its natural rate, and supply shocks. According to the Phillips curve, policymakers who control aggregate demand face a short-run tradeoff between inflation and unemployment.
  1. If expected inflation depends on recently observed inflation, then inflation has inertia, which means that reducing inflation requires either a beneficial supply shock or a period of high unemployment and reduced output. If people have rational expectations, however, then a credible announcement of a change in policy might be able to influence expectations directly and, therefore, reduce inflation without causing a recession.
  1. Most economists accept the natural-rate hypothesis, according to which fluctuations in aggregate demand have only short-run effects on output and unemployment. Yet some economists have suggested ways in which recessions can leave permanent scars on the economy by raising the natural rate of unemployment

We began this chapter by discussing two models of aggregate supply, each of which focuses on a different reason why, in the short run, output rises above its natural level when the price level rises above the level that people had expected. Both models explain why the short-run aggregate supply curve is upward sloping, and both yield a short-run tradeoff between inflation and unemployment. A convenient way to express and analyze that tradeoff is with the Phillips curve equation, according to which inflation depends on expected inflation, cyclical unemployment, and supply shocks.

Keep in mind that not all economists endorse all the ideas discussed here. There is widespread disagreement, for instance, about the practical importance of rational expectations and the relevance of hysteresis. If you find it difficult to fit all the pieces together, you are not alone. The study of aggregate supply remains one of the most unsettled—and therefore one of the most exciting—research areas in macroeconomics.

  1. Classical or Keynesian? You decide whether you want a classical special case (which occurs when EP = P or when a equals zero, so output is at its natural level) or a Keynesian special case (which occurs when a equals infinity, so the price level is completely fixed).
  1. Closed or Open? You decide whether you want a closed economy (which occurs when the capital flow CF always equals zero) or an open economy (which allows CF to differ from zero).
  1. Small or Large? If you want an open economy, you decide whether you want a small one (in which CF is infinitely elastic at the world interest rate r*) or a large one (in which the domestic interest rate is not pinned down by the world rate).
  1. Floating or Fixed? If you are examining a small open economy, you decide whether the exchange rate is floating (in which case the central bank sets the money supply) or fixed (in which case the central bank allows the money supply to adjust).
  2. Fixed velocity? If you are considering a closed economy with the Keynesian assumption of fixed prices, you decide whether you want to focus on the special case in which velocity is exogenously fixed.

The dynamic AD–AS model also yields some important lessons. It shows how various macroeconomic variables—output, inflation, and real and nominal interest rates—respond to shocks and interact with one another over time. It demonstrates that, in the design of monetary policy, central banks face a tradeoff between variability in inflation and variability in output. Finally, it suggests that central banks need to respond vigorously to inflation to prevent it from getting out of control. If you ever find yourself running a central bank, these are good lessons to keep in mind.

  1. The dynamic model of aggregate demand and aggregate supply combines five economic relationships: an equation for the goods market, which relates quantity demanded to the real interest rate; the Fisher equation, which relates real and nominal interest rates; the Phillips curve equation, which determines inflation; an equation for expected inflation; and a rule for monetary policy, according to which the central bank sets the nominal interest rate as a function of inflation and output.
  1. The long-run equilibrium of the model is classical. Output and the real interest rate are at their natural levels, independent of monetary policy. The central bank’s inflation target determines inflation, expected inflation, and the nominal interest rate.
  1. The dynamic AD–AS model can be used to determine the immediate impact on the economy of any shock and can also be used to trace out the effects of the shock over time.
  1. Because the parameters of the monetary-policy rule influence the slope of the dynamic aggregate demand curve, they determine whether a supply shock has a greater effect on output or inflation. When choosing the parameters for monetary policy, a central bank faces a tradeoff between output variability and inflation variability.
  1. The dynamic AD–AS model typically assumes that the central bank responds to a 1-percentage-point increase in inflation by increasing the nominal interest rate by more than 1 percentage point, so the real interest rate rises as well. If the central bank responds less vigorously to inflation, the economy becomes unstable. A shock can send inflation spiraling out of control.
  1. Advocates of active policy view the economy as subject to frequent shocks that will lead to unnecessary fluctuations in output and employment unless monetary or fiscal policy responds. Many believe that economic policy has been successful in stabilizing the economy.
  2. Advocates of passive policy argue that because monetary and fiscal policies work with long and variable lags, attempts to stabilize the economy are likely to end up being destabilizing. In addition, they believe that our present understanding of the economy is too limited to be useful in formulating successful stabilization policy and that inept policy is a frequent source of economic fluctuations.
  3. Advocates of discretionary policy argue that discretion gives more flexibility to policymakers in responding to various unforeseen situations.
  4. Advocates of policy rules argue that the political process cannot be trusted. They believe that politicians make frequent mistakes in conducting economic policy and sometimes use economic policy for their own political ends. In addition, advocates of policy rules argue that a commitment to a fixed policy rule is necessary to solve the problem of time inconsistency.

When a government spends more than it collects in taxes, it has a budget deficit, which it finances by borrowing from the private sector. The accumulation of past borrowing is the government debt

Fiscal policy and government debt are central in the U.S. political debate. This chapter discussed some of the economic issues that lie behind the policy decisions. As we have seen, economists are not in complete agreement about the measurement or effects of government indebtedness. Nor are economists in agreement about the best budget policy. Given the profound importance of this topic, there seems little doubt that the debates will continue in the years to come.

  1. The current debt of the U.S. federal government is of moderate size compared to the debt of other countries or compared to the debt that the United States has had throughout its own history. The 1980s and early 1990s were unusual in that the ratio of debt to GDP increased during a period of peace and prosperity. From 1995 to 2001, the ratio of debt to GDP declined significantly, but after 2001 it started to rise again.
  1. Standard measures of the budget deficit are imperfect measures of fiscal policy because they do not correct for the effects of inflation, do not offset changes in government liabilities with changes in government assets, omit some liabilities altogether, and do not correct for the effects of the business cycle.
  1. According to the traditional view of government debt, a debt-financed tax cut stimulates consumer spending and lowers national saving. This increase in consumer spending leads to greater aggregate demand and higher income in the short run, but it leads to a lower capital stock and lower income in the long run.
  1. According to the Ricardian view of government debt, a debt-financed tax cut does not stimulate consumer spending because it does not raise consumers’ overall resources—it merely reschedules taxes from the present to the future. The debate between the traditional and Ricardian views of government debt is ultimately a debate over how consumers behave. Are consumers rational or shortsighted? Do they face binding borrowing constraints? Are they economically linked to future generations through altruistic bequests? Economists’ views of government debt hinge on their answers to these questions.
  1. Most economists oppose a strict rule requiring a balanced budget. A budget deficit can sometimes be justified on the basis of short-run stabilization, tax smoothing, or intergenerational redistribution of the tax burden.
  1. Government debt can potentially have other effects. Large government debt or budget deficits may encourage excessive monetary expansion and, therefore, lead to greater inflation. The possibility of running budget deficits may encourage politicians to unduly burden future generations when setting government spending and taxes. A high level of government debt may increase the risk of capital flight and diminish a nation’s influence around the world. Economists differ in which of these effects they consider most important.

Many economists believe that it would be desirable for Americans to increase the fraction of their income that they save. There are several reasons for this conclusion. From a microeconomic perspective, greater saving would mean that people would be better prepared for retirement; this goal is especially important because Social Security, the public program that provides retirement income, is projected to run into financial difficulties in the years ahead as the population ages. From a macroeconomic perspective, greater saving would increase the supply of loanable funds available to finance investment; the Solow growth model shows that increased capital accumulation leads to higher income. From an openeconomy perspective, greater saving would mean that less domestic investment would be financed by capital flows from abroad; a smaller capital inflow pushes the trade balance from deficit toward surplus.

  1. Keynes conjectured that the marginal propensity to consume is between zero and one, that the average propensity to consume falls as income rises, and that current income is the primary determinant of consumption. Studies of household data and short time-series confirmed Keynes’s conjectures. Yet studies of long time-series found no tendency for the average propensity to consume to fall as income rises over time.
  1. Recent work on consumption builds on Irving Fisher’s model of the consumer. In this model, the consumer faces an intertemporal budget constraint and chooses consumption for the present and the future to achieve the highest level of lifetime satisfaction. As long as the consumer can save and borrow, consumption depends on the consumer’s lifetime resources.
  1. Modigliani’s life-cycle hypothesis emphasizes that income varies somewhat predictably over a person’s life and that consumers use saving and borrowing to smooth their consumption over their lifetimes. According to this hypothesis, consumption depends on both income and wealth.
  1. Friedman’s permanent-income hypothesis emphasizes that individuals experience both permanent and transitory fluctuations in their income. Because consumers can save and borrow, and because they want to smooth their consumption, consumption does not respond much to transitory income. Instead, consumption depends primarily on permanent income.
  1. Hall’s random-walk hypothesis combines the permanent-income hypothesis with the assumption that consumers have rational expectations about future income. It implies that changes in consumption are unpredictable, because consumers change their consumption only when they receive news about their lifetime resources.
  1. Laibson has suggested that psychological effects are important for understanding consumer behavior. In particular, because people have a strong desire for instant gratification, they may exhibit time-inconsistent behavior and end up saving less than they would like.

While spending on consumption goods provides utility to households today, spending on investment goods is aimed at providing a higher standard of living at a later date. Investment is the component of GDP that links the present and the future.

The best stock investors, in his view, are those who are good at outguessing mass psychology

First, all types of investment spending are inversely related to the real interest rate. A higher interest rate raises the cost of capital for firms that invest in plant and equipment, raises the cost of borrowing for home-buyers, and raises the cost of holding inventories. Thus, the models of investment developed here justify the investment function we have used throughout this book.

Second, there are various causes of shifts in the investment function. An improvement in the available technology raises the marginal product of capital and raises business fixed investment. An increase in the population raises the demand for housing and raises residential investment. Most important, various economic policies, such as changes in the investment tax credit and the corporate income tax, alter the incentives to invest and thus shift the investment function.

Third, it is natural to expect investment to be volatile over the business cycle, because investment spending depends on the output of the economy as well as on the interest rate. In the neoclassical model of business fixed investment, higher employment raises the marginal product of capital and the incentive to invest. Higher output also raises firms’ profits and, thereby, relaxes the financing constraints that some firms face. In addition, higher income raises the demand for houses, in turn raising housing prices and residential investment. Higher output raises the stock of inventories firms wish to hold, stimulating inventory investment. Our models predict that an economic boom should stimulate investment and a recession should depress it. This is exactly what we observe.

  1. The marginal product of capital determines the real rental price of capital. The real interest rate, the depreciation rate, and the relative price of capital goods determine the cost of capital. According to the neoclassical model, firms invest if the rental price is greater than the cost of capital, and they disinvest if the rental price is less than the cost of capital.
  2. Various parts of the federal tax code influence the incentive to invest. The corporate income tax discourages investment, and the investment tax credit—which has now been repealed in the United States—encourages it.
  3. An alternative way of expressing the neoclassical model is to state that investment depends on Tobin’s q, the ratio of the market value of installed capital to its replacement cost. This ratio reflects the current and expected future profitability of capital. The higher is q, the greater is the market value of installed capital relative to its replacement cost and the greater is the incentive to invest.
  4. Economists debate whether fluctuations in the stock market are a rational reflection of companies’ true value or are driven by irrational waves of optimism and pessimism.
  5. In contrast to the assumption of the neoclassical model, firms cannot always raise funds to finance investment. Financing constraints make investment sensitive to firms’ current cash flow.
  6. Residential investment depends on the relative price of housing. Housing prices in turn depend on the demand for housing and the current fixed supply. An increase in housing demand, perhaps attributable to a fall in the interest rate, raises housing prices and residential investment.
  7. Firms have various motives for holding inventories of goods: smoothing production, using them as a factor of production, avoiding stock-outs, and storing work in process. How much inventories firms hold depends on the real interest rate and on credit conditions.
  1. The system of fractional-reserve banking creates money, because each dollar of reserves generates many dollars of demand deposits.
  2. The supply of money depends on the monetary base, the reserve–deposit ratio, and the currency–deposit ratio. An increase in the monetary base leads to a proportionate increase in the money supply. A decrease in the reserve–deposit ratio or in the currency–deposit ratio increases the money multiplier and thus the money supply.
  3. The Federal Reserve changes the money supply using three policy instruments. It can increase the monetary base by making an open-market purchase of bonds or by lowering the discount rate. It can reduce the reserve–deposit ratio by relaxing reserve requirements.
  4. To start a bank, the owners must contribute some of their own financial resources, which become the bank’s capital. Because banks are highly leveraged, however, a small decline in the value of their assets can potentially have a major impact on the value of bank capital. Bank regulators require that banks hold sufficient capital to ensure that depositors can be repaid.
  5. Portfolio theories of money demand stress the role of money as a store of value. They predict that the demand for money depends on the risk and return on money and alternative assets.
  6. Transactions theories of money demand, such as the Baumol–Tobin model, stress the role of money as a medium of exchange. They predict that the demand for money depends positively on expenditure and negatively on the interest rate.
  7. Financial innovation has led to the creation of assets with many of the attributes of money. These near moneys make the demand for money less stable, which complicates the conduct of monetary policy.

Lesson 1: In the long run, a country’s capacity to produce goods and services determines the standard of living of its citizens. Of all the measures of economic performance introduced in Chapter 2 and used throughout this book, the one that best measures economic well-being is GDP. Real GDP measures the economy’s total output of goods and services and, therefore, a country’s ability to satisfy the needs and desires of its citizens. Nations with higher GDP per person have more of almost everything—bigger homes, more cars, higher literacy, better health care, longer life expectancy, and more Internet connections. Perhaps the most important question in macroeconomics is what determines the level and the growth of GDP. The models in Chapters 3, 7, and 8 identify the long-run determinants of GDP. In the long run, GDP depends on the factors of production—capital and labor—and on the technology used to turn capital and labor into output. GDP grows when the factors of production increase or when the economy becomes better at turning these inputs into an output of goods and services. This lesson has an obvious but important corollary: public policy can raise GDP in the long run only by improving the productive capability of the economy. There are many ways in which policymakers can attempt to do this. Policies that raise national saving—either through higher public saving or higher private saving—eventually lead to a larger capital stock. Policies that raise the efficiency of labor—such as those that improve education or increase technological progress—lead to a more productive use of capital and labor. Policies that improve a nation’s institutions—such as crackdowns on official corruption—lead to both greater capital accumulation and a more efficient use of the economy’s resources. All these policies increase the economy’s output of goods and services and, thereby, improve the standard of living. It is less clear, however, which of these policies is the best way to raise an economy’s productive capability.

Because aggregate demand influences output in the short run, all the variables that affect aggregate demand can influence economic fluctuations. Monetary policy, fiscal policy, and shocks to the money and goods markets are often responsible for year-to-year changes in output and employment. Because changes in aggregate demand are crucial to short-run fluctuations, policymakers monitor the economy closely. Before making any change in monetary or fiscal policy, they want to know whether the economy is booming or heading into a recession.

In addition to GDP, inflation and unemployment are among the most closely watched measures of economic performance. Chapter 2 discussed how these two variables are measured, and subsequent chapters developed models to explain how they are determined. The long-run analysis of Chapter 4 stresses that growth in the money supply is the ultimate determinant of inflation. That is, in the long run, a currency loses real value over time if and only if the central bank prints more and more of it. This lesson can explain the decade-to-decade variation in the inflation rate that we have observed in the United States, as well as the far more dramatic hyperinflations that various countries have experienced from time to time. We have also seen many of the long-run effects of high money growth and high inflation. In Chapter 4 we saw that, according to the Fisher effect, high inflation raises the nominal interest rate (so that the real interest rate remains unaffected). In Chapter 5 we saw that high inflation leads to a depreciation of the currency in the market for foreign exchange. The long-run determinants of unemployment are very different. According to the classical dichotomy—the irrelevance of nominal variables in the determination of real variables—growth in the money supply does not affect unemployment in the long run. As we saw in Chapter 6, the natural rate of unemployment is determined by the rates of job separation and job finding, which in turn are determined by the process of job search and by the rigidity of the real wage. Thus, we concluded that persistent inflation and persistent unemployment are unrelated problems. To combat inflation in the long run, policymakers must reduce the growth in the money supply. To combat unemployment, they must alter the structure of labor markets. In the long run, there is no tradeoff between inflation and unemployment.

Although inflation and unemployment are not related in the long run, in the short run there is a tradeoff between these two variables, which is illustrated by the short-run Phillips curve. As we discussed in Chapter 13, policymakers can use monetary and fiscal policies to expand aggregate demand, which lowers unemployment and raises inflation. Or they can use these policies to contract aggregate demand, which raises unemployment and lowers inflation. Policymakers face a fixed tradeoff between inflation and unemployment only in the short run. Over time, the short-run Phillips curve shifts for two reasons. First, supply shocks, such as changes in the price of oil, change the short-run tradeoff; an adverse supply shock offers policymakers the difficult choice of higher inflation or higher unemployment. Second, when people change their expectations of inflation, the short-run tradeoff between inflation and unemployment changes. The adjustment of expectations ensures that the tradeoff exists only in the short run. That is, only in the short run does unemployment deviate from its natural rate, and only in the short run does monetary policy have real effects. In the long run, the classical model of Chapters 3 through 8 describes the world.

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