1

MS 201/401 - Principles of Macroeconomics

Lecture 8 Recommended books:

1 . Macroeconomics by N. G Mankiw2. Mac… ……………….by M Swann

Lecture plan concepts: calculating GDP Unemployment Inflation Interest rate Money Market Relation between money and interest rate.

2

3

Two Main Methods of Measuring GDP Presenting the expenditure approach

WhereC = consumption expenditures I = investment expendituresG = government expendituresX = exports M = imports

GDP(Y) = C + I + G + X-M

Figure 8-3 Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year)

Gross Domestic Product and Gross Domestic Income, 2009 (in billions of 2009 dollars per year)

Business Cycle Definition: alternating increases and

decreases in the level of business activity of varying amplitude and length

How do we measure “increases and decreases in business activity?” Percent change in real GDP!

Expansion ExpansionRecession

The Phases of the Business Cycle

Boom

Secular growth trend

DownturnUpturn

Trough

Peak

0 Jan.-Mar

Tota

l Out

put

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

July-Sept.

Oct.-Dec.

Jan.-Mar

Apr.-June

Long-Run Economic Growth

Secular long-run growth, or long-run growth, is the sustained upward trend in aggregate output per person over several decades.

A country can achieve a permanent increase in the standard of living of its citizens only through long-run growth. So a central concern of macroeconomics is what determines long-run growth.

Recession What is a recession?

Generally, 2 or more quarters of declining real GDP

Implication: it’s not officially a called a recession until the economy has already been declining for 6 months!

10

Unemployment

• “ the inability of labor force participants to find jobs”.•Unemployment implies that we are producing inside the PPF , rather than on it.• If the output of economy does not grows with the pace so that it could absorb the new labor force enters into the market than unemployment increases.• Depends on the phases of Business Cycles

How is Unemployment Measured?

The unemployment rate is calculated as the percentage of the labor force that is unemployed.

100forceLabor unemployedNumber =ratent Unemployme

Kinds of Unemployment 1. Seasonal Unemployment 2. Frictional Unemployment 3. Structural Unemployment 4. Cyclical Unemployment

12

Inflation Inflation is an increase in the overall level of

prices. The quantity theory of money is used to

explain the long-run determinants of the price level and the inflation rate.

Inflation is an economy-wide phenomenon that concerns the value of the economy’s medium of exchange.

When the overall price level rises, the value of money falls

13

The Quantity Theory of Money

How the price level is determined and why it might change over time is called the quantity theory of money. The quantity of money available in the

economy determines the value of money.

The primary cause of inflation is the growth in the quantity of money.

Velocity and the Quantity EquationThe velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet.

V = (P x Y)/MWhere: V = velocity

P = the price levelY = the quantity of outputM = the quantity of money

Velocity and the Quantity Equation

The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of three other variables: the price level must rise, the quantity of output must rise, or the velocity of money must fall.

Interest Rate Interest is a rental amount charged by

financial institutions for the use of money. Called also the rate of capital growth, it is

the rate of gain received from an investment.

It is expressed on an annual basis. For the lender, it consists, for convenience,

of (1) risk of loss, (2) administrative expenses, and (3) profit or pure gain.

For the borrower, it is the cost of using a capital for immediately meeting his or her needs. 17

TIME VALUE OF MONEY

The time-value of money is the relationship between interest and time. i.e.

Money has time-value because the purchasing power of money changes with time.

18

EARNING POWER OF MONEY

The earning power of money represents funds borrowed for the prospect of gain.

Often these funds will be exchanges for goods, services, or production tools, which in turn can be employed to generate and economic gain.

19

PURCHASING POWER OF MONEY

The prices of goods and services can go upward or downward, and therefore, the purchasing power of money can change with time.

Price Reductions : Caused by increases in productivity and availability of goods.

Price Increases : Caused by government policies, price support schemes, and deficit financing.

20

Demand Curve for Money If interest rates are

high, more wealth will be held in bonds

If interest rates are low, more wealth will be held as liquid money, because the opportunity cost, i.e., the income foregone, is low.

Supply Curve for MoneySupply of Money is

Unilaterally fixed by the Central Bank. For USA, it is the Federal Reserve System.

At equilibrium, money demand = money supply

Shifts in Demand for MoneyIncome effect: Increase in income

increases the amount of money individuals want to hold. Therefore, an increase in GNP/Income shifts the money demand curve to the right.

Price Level Effect: Increases in price levels reduce the real value of money. Therefore, more money is held by individuals, thus shifting the money demand curve to the right.

Changes in Equilibrium Interest Rates

Changes in Income

Money demand curve moves to the right

Money supply curve remains at previous level

Interest rate increases

Income Effect: Increase in money supply increases demand for money and thus shifts the demand curve to the right, thereby increasing interest rates.

Price-level EffectExpected Inflation Effect

These 3 effects work against the liquidity effect on the direction of interest rate movements. In reality, the final outcome depends upon which effect is stronger and which one comes into play earlier.

The supply of money curve:

O

Rat

e of

inte

rest

Quantity of money

MS

The Demand for Money The motives for holding money

transactions and precautionary motive assets or speculative motive the total demand for money

Determinants of demand for money money national income frequency with which people are paid financial innovations speculation about future return on assets rate of interest

The demand for money (liquidity preference) curve

O

Rat

e of

inte

rest

Md

Money

Monetary EquilibriumEquilibrium in the money market

equilibrium interest rate where D and S of money are equal

Equilibrium in the money market

O

Rat

e of

inte

rest

Md

Money

MS

re

Me

Monetary EquilibriumEffects of changes in money supply

on national incomeeffect on interest rates

Ms r

The demand for and supply of money

OMoney

Rat

e of

inte

rest

MS

Md

r1

Q1

OMoney

Rat

e of

inte

rest

Md

r1

Q1

r2

Q2

MS' MS

The demand for and supply of money

Monetary Equilibrium Effects of changes in money supply on national

incomeeffect on interest rates

Ms price level demand $ er r effects of changes in interest rates on

investmentr (opp cost /cost of borrowing) I

effects of changes in interest rates on the exchange rate, and imports and exportsr $d (capital outflow) er X, M

effects of changes in investment, imports and exports on national incomeI, X, M Y

Money Supply, Money Demand, and the Equilibrium Price Level

Quantity fixedby the Fed

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

Money supply

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4MoneydemandEq

uilib

rium

va

lue

of

mon

eyEquilibrium

price level

The Effects of Monetary Injection

Quantity ofMoney

Value ofMoney (1/P) Price

Level (P)

A

MS1

0

1

(Low)

(High)

(High)

(Low)

1/2

1/4

3/4

1

1.33

2

4Moneydemand

M1

MS2 1. An

increase in the money supply...

2. ..

.dec

reas

es

the

valu

e of

m

oney

...

3. …and

inc re ases th e price level

M2

B

The Short-Run Tradeoff between Inflation and Unemployment

Unemployment and Inflation The natural rate of unemployment depends

on various features of the labor market. Examples include minimum-wage laws, the

market power of unions, the role of efficiency wages, and the effectiveness of job search.

The inflation rate depends primarily on growth in the quantity of money, controlled by the central Bank.

The misery index, one measure of the “health” of the economy, adds together the inflation rate and unemployment rate.

Unemployment and Inflation Society faces a short-run tradeoff between

unemployment and inflation. If policymakers expand aggregate demand, they

can lower unemployment, but only at the cost of higher inflation.

If they contract aggregate demand, they can lower inflation, but at the cost of temporarily higher unemployment.

The Phillips Curve

The Phillips curve illustrates the short-run relationship between inflation and

unemployment.

The Phillips Curve...

Unemployment Rate

(percent)

0

Inflation Rate

(percent per

year)

4

B6

A

7

2

Phillips curve

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The Phillips curve shows the short-run combinations of unemployment and inflation that arise as shifts in the aggregate demand curve move the economy along the short-run aggregate supply curve.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The greater the aggregate demand for goods and services, the greater is the economy’s output, and the higher is the overall price level.

A higher level of output results in a lower level of unemployment.

How the Phillips Curve is Related to the Model of Aggregate Demand and Aggregate Supply...

Phillips curve

0

(b) The Phillips Curve

Inflation Rate

(percent per year)

Unemployment Rate (percent)

0

(a) The Model of AD and AS

Price Level

Low AD

High ADB

4

6

(output is

8,000)

A

7

2

(output is

7,500)

A

7,500

102

(unemployment is 7%)

B

8,000

106

(unemployment is 7%)

Short-run AS

AS2

1. An adverse shift in aggregate supply…

An Adverse Shock to Aggregate Supply...

Quantity of Output

0

Price Level

P1Aggregate demand

(a) The Model of Aggregate Demand and Aggregate Supply

Unemployment Rate0

(b) The Phillips Curve

A

Inflation Rate

Phillips curve, PC1

Aggregate supply, AS1

A

Y1

P2

3. …and raises the price level…

B

2. …lowers output…

Y2

B

4. …giving policymakers a less favorable tradeoff between unemployment and inflation.

PC2

Effectiveness of controlling interest rates inelastic demand for loans

problem of possibly high interest rates

Effectiveness of Monetary Policy

Monetary Policy The significance of monetary policy The policy setting

relationship between the government and the central bank

degree of central bank independence Medium- and long-term policy

control of banks’ liquidity ratio restricting size of PSNCR

Monetary Policy Short-term monetary control

techniques to control money supplyopen-market operationsreduced central bank lending to the banks

fundingvariable minimum reserve ratios

techniques to control interest ratesannouncing changes in interest ratesbacking up announcements

operations in the discount and repo markets credit rationing

Effectiveness of Monetary Policy

Medium and long-term control over the money supply: reducing PSNCR automatic fiscal stabilisers the desire to cut taxes difficulty in cutting government expenditure

Short-term control of the money supply use of money supply targets ways in which banks resist attempts to restrict

the growth in the money supply demand-determined money supply

O

Demand for loans

Q1Q2

Assume that the authoritieswant to reduce the

demand for money to Q2

r1

Loans

Rat

e of

inte

rest

An inelastic demand for loans

r2

O

Demand for loans

r1

Q1Q2

A large rise in therate of interest (to r2)

will be necessary

Loans

Rat

e of

inte

rest

An inelastic demand for loans

Effectiveness of controlling interest rates inelastic demand for loans

problem of possibly high interest ratesreasons for an inelastic demand for loans

unstable demand for moneyproblem of changing expectationsspeculation

possible conflict between domestic goals and exchange-rate goals

Using monetary policy use of interest rates to meet inflation target

Effectiveness of Monetary Policy