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College notes (Week 1-4) Intermediate Macroeconomics: Output & Time (ECB2VMAE)
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This document includes notes from the lectures week 1-4 of the Intermediate Macroeconomics course.
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Introduction – Chapter 1,2 & 3: Booms & Recessions (I): The Keynesiancross (Ch.2); Money, Interest Rates and the Global Economy (Ch. 3)
Chapter 1 – Macroeconomic essentials
Macroeconomics Looks at the big picture, at the way things are and how they develop after
we add everything up, in the whole economy or in large segments or sectors of the
economy.
Nominal income = P (prices) * Y (real income)
“The most important goal of macroeconomics is to develop an understanding of what makes
income differ between countries and what makes them grow or fluctuate over time.” The
focal point of macroeconomics is the level of income. Incomes are paid out to factors of
production that are employed by firms to produce goods and services. This output is then
put on the market for people to buy. There are two major things that can go wrong in this
process:
Firms may not use all available production factors to produce output, thus leaving
factors idle in the form of unemployment or slack.
People may not want to buy all that is being produced, that is demand may fall short
of output.
Aggregate output
Total production or aggregate output, the value of all goods and services produced by firms,
may be measured either by adding up all incomes, or by adding up all expenditures; As one
person’s spending is another person’s income. So all spending must add up to the same
amount to which all incomes add up.
→ Leakages and injections
Income received by households may not arrive at firms as demand for three main reasons:
1. People save
If people save part of their income, their expenditures fall short of what they have
produced and received as income.
2. Government levy taxes
The taxes that governments levy on citizens are part of income which is prevented
from turning into demand.
3. People buy foreign goods
Income earned at home which is used to buy goods produced in a foreign country.
Each of the leakages described above has a counterpart representing an injection into the
circular flow.
1. Firms invest
Firms build or buy new production facilities, new machines, distribution networks
and so on. These investments are typically financed via credit banks or credit markets
in general.
2. Government spending
Government spending on things such as public consumption, infrastructure or
transfers paid to households or firms represents an injection from the outside into
the income circle.
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, 3. Foreigners buy our goods
If residents of foreign countries decide to buy domestically produced goods.
→ If investment is understood to include inventory changes, the leakages and injections
always balance, and the formula (S – I) + (T – G) + (IM – EX) = 0 holds at all times.
S – I → domestic private net savings
T – G → public net savings (called the budget surplus)
IM – EX → net imports
Net exports are depicted by: EX – IM = NX, or as an approximation the Current
Account (CA)
MV = PY
The quantity equation (MV = PY) states that the money supply M times the velocity of
money circulation V equals nominal income PY (where P is the price level and Y denotes real
income).
The quantity equation becomes a theory of inflation, the quantity theory of money, by letting
V be constant (fixed). Then the money supply M determines nominal income PY.
The price level P remains constant only if the money supply grows at the same pace at which
real income grows. If the money supply grows faster than real income, prices begin to
increase and inflation is the result.
The national income accounts reveal who buys aggregate output and how aggregate income
is spent.
Quantity equation → MV = PY → (V, velocity, assumed fixed)
Long run: Y determined by production factors → ∆ M = ∆ P
Short run: Y determined by M → ∆ M = ∆ Y (P assumed fixed)
The government budget and balance of payments
In addition to the national income accounts, which measure the circular flows with leakages
and injections, there are two other accounts important within macroeconomics. These two
accounts simply trace the interactions between the domestic private sector and the
government sector on the one hand, and with other countries on the other hand:
a. The government budget is primarily a planning instrument. In hindsight it breaks
down government receipts and expenditures, and shows how deficits are being
financed.
Purpose → to break up the catch-all variables G and T into more detailed
subcategories, and to show how a given budget deficit is being financed.
b. The balance of payments records a country’s trade in goods, services and financial
assets with other countries.
Purpose → adds detail to the general notion of exports and imports and traces how a
given imbalance between exports and imports is being financed.
The balance of payments is subdivided into three major accounts:
1. The current account CA records the flow of goods and services across borders. It
measures the net demand for domestic currency which results from the net sales
of domestically produced goods and services to the world, plus cross-border
income flows and transfer payments.
→ approximation of CA = EX – IM
2. The capital account CP records all purchases and sales of foreign assets, that is of
such thing as bonds, stocks or securities, that do not involve the central bank. It
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, registers the net demand for the domestic currency which results from the net
sales of domestic bonds and other assets to foreigners.
→ CP = ∆ F
F = net foreign assets = domestic holdings of foreign assets – foreign holdings of
domestic assets
3. The official reserve account OR tracks the involvement of the central bank in the
foreign exchange market. It measures the net demand for domestic currency
which the purchase or sale of currency reserves held by the central bank
constitutes.
→ OR = –∆ RES
RES = central bank foreign currency reserves
Since purchases of currency must equal sales, the three accounts that make up the
balance of payments must add up to zero → CA + CP + OR = 0. This can be rewritten
as: EX – IM = ∆ F + ∆ RES.
If exports exceed imports, this means that traders exercise and excess demand for
domestic currency (which they need to buy our exports). This can be balanced either
by us accepting – i.e. buying – foreign debt titles (which raises F), or the central bank
can supply the required domestic currency, thus running up foreign currency reserves
RES.
The central bank balance sheet
Assets: Government securities (the amount of government debt held by the central bank) →
BCB; Currency reserves (the amount of foreign currencies in the central bank’s vaults) → RES
Liabilities: Currency in circulation (money) → M
So, ∆ M = ∆ BCB + ∆ RES
Summary
Macroeconomics looks at the big picture, at what things like income, spending,
unemployment or inflation look like after we add everything up.
The circular flow model shows the real and monetary flows between households and
firms. It can be enhanced to account for interactions with the government sector and
other countries. Leakages out of and injections into this circle always balance. At the
core of this ‘model’ is the identity between income and output on the one hand, and
between spending and output on the other.
Output, income and spending all measure the same thing. Depending on whether we
define a country by its geographic boundaries or by its residents, the empirical
counterpart of these concepts is gross domestic product (GDP) or gross national
income (GNI). The latter used to be called gross national product (GNP)
The central bank is the arm of the government responsible for monetary policy. If the
central bank provides the economy with more money, this raises nominal income,
which is defined as the price level times real income. Only economic analysis will
reveal under what circumstances it is more likely for the price level to rise or for real
income to rise.
The national income accounts reveal who buys aggregate output and how aggregate
income is spent.
The government budget records the interactions between the private sector and the
government sector. It also reveals how the government finances budget surpluses or
deficits.
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, The balance of payments records the interaction with the rest of the world. It also
reveals how imbalances in the trade of goods and services are being financed.
Economists work with simplified pictures of the world, which they call models.
Models are instrumental in understanding the key economic issues in today’s world.
Chapter 2 - Booms and Recessions (I): The Keynesian Cross (goods market)
The most important goal of macroeconomics is to develop an understanding of what makes
income differ between countries, and what makes them grow or fluctuate over time.
Actual income may be divided into:
a. The steady-state income results when all variables including the capital stock, have
adjusted to their desired or equilibrium levels.
b. Potential income is the income that can be produced with current labour and capital.
The capital stock may or may not have reached its equilibrium level.
c. The business cycle refers to recurring fluctuation of income relative to potential
income. A boom (or expansion) describes rising income which culminates in a peak. A
recession describes declining income which bottoms out at a through.
If we want to understand how output and income move in the short run, during booms and
recessions, the key word is demand.
The production possibilities laid out by the production function under normal use of
production factors do not strictly limit output in the short run. Firms do have a certain
flexibility to adjust the volume of goods and services produced to the demand that they
experience. → The production function shows how the use of labour and machinery
generates output.
In chapter 2, it is assumed that, at current prices, firms produce exactly the amount of
output that is demanded. The short run AS-curve (aggregate supply) is therefore assumed to
be horizontal. In the long run, however, labour and capital utilization will have to return to
normal levels and put a lid on the output that can be produced, no matter what the price
level is. This makes the long-run AS curve vertical (chapter 6).
Demand-side analysis
Long run supply line is vertical; Short run supply line is horizontal
Ignore price effect: everything that is demanded is supplied at the same price →
horizontal supply curve
To analyse the functioning of the economy we can focus on demand
Total spending (or total demand) on domestically produced goods: Total expenditure = C + I
+ G + EX – IM ( = total income)
Aggregate expenditure is the sum of all planned or voluntary spending on domestically
produced goods and services. (Planned investment = I)
Actual expenditure is the sum of all categories of demand, including unplanned investment.
(Unplanned investment = Iu)
Income = expenditure
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