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Macroeconomics Summary

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  • Macroeconomics (EBP812B05)
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  • Macroeconomics

In this document you will find a summary of the exam material for the subject Macroeconomics, given in the first year of the Bachelor's Economics and Business Economics and in the Pre-Master/Minor Finance at the FEB at the University of Groningen. The summary provides an overview of the most impor...

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  • No
  • 1 t/m 12
  • December 5, 2021
  • January 13, 2022
  • 56
  • 2021/2022
  • Summary

Subjects

  • macroeconomics
  • economics
  • pre master
  • finance
  • pre master finance
  • pre msc
  • feb
  • the goods market
  • goods market
  • market
  • goods
  • financial markets
  • financial
  • is lm model
  • tec
  • economics and business economics
  • is
  • lm

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MACROECONOMICS




Pre-Master Finance
2021-2022

,Table of Contents
Week 1) Introduction and the Goods Market ................................................................................ 2
Chapter 1) A Tour of the World .......................................................................................................... 2
Chapter 2) A Tour of the Book ............................................................................................................ 4
Chapter 3) The Goods Market ............................................................................................................ 8
Week 2) Financial Markets I and the IS-LM Model ....................................................................... 13
Chapter 4) Financial Markets I .......................................................................................................... 13
Chapter 5) Goods and Financial Markets: The IS-LM Model ............................................................ 18
Week 3) Financial Markets II ...................................................................................................... 22
Chapter 6) Financial Markets II: The Extended IS-LM Model ........................................................... 22
Week 4) Labour Market and the Philips Curve ............................................................................ 29
Chapter 7) The Labour Market.......................................................................................................... 29
Chapter 8) The Philips Curve, the Natural Rate of Unemployment, and Inflation ........................... 34
Week 5) The Philips Curve & The IS-LM-PM Model ...................................................................... 38
Chapter 9) From the Short to the Medium Run: The IS-LM-PC Model............................................. 38
Week 6) Economic Growth I ....................................................................................................... 43
Chapter 10) The Facts of Growth ...................................................................................................... 43
Chapter 11) Saving, Capital Accumulation, and Output ................................................................... 45
Week 7) Economic Growth II ...................................................................................................... 52
Chapter 12) Technological Progress and Growth ............................................................................. 52




1

,Week 1) Introduction and the Goods Market
Chapter 1) A Tour of the World
1.1. The Crisis
• From 2000 to 2007 the world economy had a sustained expansion.
• In 2007, however, signs that the expansion might be coming to an end started to appear →
housing prices, which had doubled since 2000, started declining.
• Many of the mortgages that had been sold during the previous expansion were of poor quality →
many of the borrowers had taken too large a loan and were increasingly unable to make the
monthly payments. And, with declining housing prices, the value of their mortgage often exceeded
the price of the house, giving them an incentive to default. Banks that had issued the mortgages
had often bundled and packaged them together into new securities and then sold these securities
to other banks and investors which led to such complexity that the value of the mortgages was
nearly impossible to assess.
• This complexity and opaqueness turned a housing price decline into a major financial crisis, a
development that few economists had anticipated. Stock prices collapsed. Hit by the decrease in
housing prices and the collapse in stock prices, people sharply cut their consumption. Firms
sharply cut back their investment.

1.2. The Euro Area
• In 1957, the European Union (EU) was formed, which is an economic zone where people, goods,
and services can move freely. Currently, the number of EU member countries is 27 (after Brexit).
• In 1999, the EU started the process of replacing national currencies with one common currency,
the euro. The countries that participated (currently 19) are known as the euro area or common
currency area.
• The euro area faces two main issues today: How to reduce unemployment, and whether and how
it can function efficiently as a common currency area.
• The average unemployment rate of the Euro Area reflects variances of unemployment in different
countries: Germany has a low unemployment rate, while Greece and Spain have higher ones. Italy
and France are somewhere in the middle.
o Part of the high unemployment rate today is probably still a result of the crisis and the
sudden collapse in demand. A housing boom that turned into a housing bust, plus a
sudden increase in interest rates, triggered the increase in unemployment from 2008 on.
o However, the problems of the high unemployment rate in Spain is not only due to the
crisis. Even at the peak of the boom, the unemployment rate in Spain never went below
8% (nearly three times the unemployment rate of 3% in Germany today)
o The challenge is to understand what the low-unemployment European countries are
doing right, and whether what they do right can be exported to the other European
countries.
• Advantages of having a common currency:
o No more changes in exchange rates for European firms to worry about;
o No more need to change currencies when crossing borders;
o The euro contributes to the creation of large economic power in the world.
• Substantial economic costs of the symbolism of the euro:
o A common currency means a common monetary policy → the same interest rate across
the euro countries, which is problematic when one country is booming while the other is
in recession.


2

, o A common currency also means the loss of the exchange rate as an instrument of
adjustment within the euro area.
• Example the deep recession of Greece: if they had their own currency, they could have
depreciated their currency vis-à-vis other euro members to increase the demand for their exports.
However, an euro-exit would mean giving up the other advantages of being in the euro and it
could be extremely disruptive.

1.3. The United States
• When economists look at a country, the first two questions they ask are:
o How big is the country from an economic point of view? To answer this question,
economists look at output → the level of production of the country as a whole.
o What is the standard of living in the country? To answer this question, they look at the
output per person.
• When economists want to dig deeper and look at the health of the country, they look at three
basic variables:
o Output growth – the rate of change of output
o Unemployment rate – the proportion of workers in the economy who are not employed
and are looking for a job
o Inflation rate – the rate at which the average price of goods in the economy is increasing
over time
• The mean macroeconomic problems US policymakers are facing are:
o Whether policy makers have the necessary tools to handle a recession (short run)
o How to increase productivity growth in the long run
• Using history as a guide, expansions do not go on forever, and the United States will, sooner or
later, go through another recession. It may come from several places:
o It may be triggered by a trade war, leading for example to a sharp decrease in exports.
o It may come from increased uncertainty, leading people to consume less and firms to
invest less.
o It may come from another financial crisis, despite the measures that have been taken
since 2009 to decrease risk.
o It may come from events that we simply have not thought about.
• The Fed (Federal Reserve Bank, the US central bank) will have to play a central role in a recession.
o Part of the mandate of the Fed is to fight recessions.
o The Fed has the best policy instrument to do so, namely the control of the interest rate.
▪ By decreasing the interest rate, the Federal Reserve can stimulate demand,
increase output, and decrease unemployment.
▪ By increasing the interest rate, it can slow down demand and increase
unemployment.
• The interest rate cannot be decreased further than zero, because interest rates cannot be
negative. If it were, then nobody would hold bonds; everybody would want to hold cash instead,
because cash pays a zero interest rate. This constraint is known as the zero lower bound; and this
is the bound the Fed ran into in December 2008.
• The problem the Fed now faces is that with the current low interest rates and the zero lower bond,
the measurements they can take to fight recessions are limited as decreasing the interest rate by
2% will not have much effect on demand.
• In the short run, what happens to the economy depends on movements in demand and the
decisions of the central bank.


3

,• In the longer run, however growth is determined by other factors, the main one being productivity
growth: without productivity growth, there just cannot be a sustained increase in income per
person.
o One particular reason to worry is that the slowdown in productivity growth is happening
in the context of growing inequality. When productivity growth is high, most are likely to
benefit, even if inequality increases. The poor may benefit less than the rich, but they still
see their standard of living increase.
o Since 2000, the real earnings of workers with a high school education or less have actually
decreased however. If policymakers want to invert this trend, they need to either raise
productivity growth or limit the rise of inequality, or both.

1.4. China
• There are two main reasons why China is perceived as one of the major economic powers in the
world:
o When comparing the output per person in a rich country like the United States and a
relatively poor country like China, one must be careful. The reason is that many goods are
cheaper in poor countries. The same income (expressed in dollars) buys you much more
in China than in the United States. If we want to compare standards of living, we must
correct for these differences → with PPP (purchasing power parity) measures.
o China has been growing very rapidly for more than three decades.
▪ A useful rule, called the rule of 70: the number of years it takes for a variable to
double is equal to 70 divided by the growth rate of the variable.
• It is difficult to see the effects of the crisis in the data. Growth barely decreased during 2008 and
2009, and unemployment barely increased. Chinese exports slowed during the crisis. But the
adverse effect on demand was nearly fully offset by a major increase in public investment. The
result was sustained growth of demand, and, in turn, of output.
• Output growth in China has two sources:
o High accumulation of capital → the investment rate (the ratio of investment to output) in
China is 46% (in the Euro area this rate is only 23.3%). More capital means higher
productivity and higher output.
o Rapid technological progress. One of the strategies followed by the Chinese government
has been to encourage foreign firms to relocate and produce in China. As foreign firms are
typically much more productive than Chinese firms, this has increased productivity and
output. Another aspect of the strategy has been to encourage joint ventures between
foreign and Chinese firms. By making Chinese firms work with and learn from foreign
firms, the productivity of the Chinese firms has increased dramatically.
• Most economists (and the Chinese authorities themselves) believe that lower growth is now
desirable, that the Chinese people will be better served if the investment rate decreases, allowing
more output to go to consumption. Achieving the transition from investment to consumption is
the major challenge facing the Chinese authorities today.

Chapter 2) A Tour of the Book
2.1. Aggregate Output
• It was not until the end of World War II that national income and product accounts were put
together. Measures of aggregate (total) output have been published on a regular basis in the
United States since October 1947.
• Like any accounting system, the national income accounts first define concepts and then construct
measures corresponding to these concepts.

4

,• The measure of aggregate output in the national income accounts is called the gross domestic
product (GDP). Three different but equivalent ways to think about aggregate output (GDP):
1. GDP is the Value of the Final Goods and Services Produced in the Economy during a Given
Period. (production side)
▪ An intermediate good is a good used in the production of another good.
• Some goods can be both final goods and intermediate goods, e.g.,
potatoes sold directly to consumers are final goods, while potatoes used
to produce potato chips are intermediate goods.
2. GDP is the Sum of Value Added in the Economy during a Given Period. (production side)
▪ The value added by a firm is defined as the value of its production minus the value
of the intermediate goods used in production.
▪ Some of the revenues of a firm go to pay workers – this component is called labour
income. The rest goes to the firm – that component is called capital income or
profit income.
3. GDP is the Sum of Incomes in the Economy during a Given Period. (income side)
▪ Aggregate production and aggregate income are always equal.
• Distinction between nominal GDP and real GDP:
o Nominal GDP is the sum of quantities of final goods produced times their current price.
Nominal GDP increases over time for two reasons:
▪ The production of most goods increases over time.
▪ The price of most goods also increases over time.
o If our goal is to measure production and its change over time, we need to eliminate the
effect of increasing prices on our measure of GDP. That’s why real GDP is constructed as
the sum of the quantities of final goods times constant (rather than current) prices.
▪ To construct real GDP, we need to multiply the number of products in each year
by the common price. The level of real GDP in each year would be different
(because common prices are not the same in different years); but its rate of
change from year to year would be the same.
▪ The problem when constructing real GDP in practice is that there is obviously
more than one final good. Real GDP must be defined as the weighted average of
the output of all goods. The relative prices of the goods would appear to be the
natural weights. If one good costs twice as much per unit as another, then that
good should count for twice as much as the other in the construction of real
output.
▪ The measure of real GDP in the US national income accounts uses weights that
reflect relative prices and change over time. The measure is called real GDP in
chained (year) dollars. → the year used to construct prices is called the base year.
The base year is changed from time to time. It is the year when, by construction,
real GDP is equal to nominal GDP.
• The level of real GDP is an important number that gives the economic size of a country. A country
with twice the GDP of another country is economically twice as big as the other country.
• Equally important is the level of real GDP per person, the ratio of real GDP to the population of
the country. It gives us the average standard of living of the country.
• In assessing the performance of the economy from year to year, economists focus on the rate of
growth of real GDP, often called just GDP growth. Periods of positive GDP are called expansions.
Periods of negative GDP growth are called recessions.
o GDP growth in the year t is constructed as (𝑌𝑡 − 𝑌𝑡−1 )/𝑌𝑡−1 and is expressed as a %.


5

,2.2. The Unemployment Rate
• Employment is the number of people who have a job. Unemployment is the number of people
who do not have a job but are looking for one. The labour force is the sum of employment and
unemployment: ⏟
𝐿 = 𝑁
⏟ + 𝑈
⏟
Labour force Employment Unemployment
• The unemployment rate is the ratio of the number of people who are unemployed to the number
𝑈
of people in the labour force: 𝑢 = 𝐿
• Today, most rich countries rely on large surveys of households to compute the unemployment
rate. In the United States, this survey is called the Current Population Survey (CPS).
o Survey classifies a person as employed if he or she has a job at the time of the interview;
it classifies a person as unemployed if he or she does not have a job and has been looking
for a job in the last four weeks.
o Note that those who do not have a job and are not looking for one are counted as not in
the labour force. When unemployment is high, some of the unemployed give up looking
for a job and therefore are no longer counted as unemployed. These people are known as
discouraged workers.
o A higher unemployment rate is typically associated with a lower participation rate,
defined as the ratio of the labour force to the total population of working age.
• Economists care about unemployment for two reasons.
o They care about unemployment because of its direct effect on the welfare of the
unemployed. Although unemployment benefits are more generous than they were during
the Great Depression, unemployment is still associated with financial and psychological
suffering.
o The unemployment rate provides a signal that the economy is not using some of its
resources. When unemployment is high, many workers who want to work do not find
jobs; the economy is clearly not using its human resources efficiently.

2.3. The Inflation Rate
• Inflation is a sustained rise in the general level of prices – the price level. The inflation rate is the
rate at which the price level increases. (deflation is a sustained decline in the price level).
• Macroeconomists typically look at two measures of the price level, two price indexes: the GDP
deflator and the Consumer Price Index.
o The GDP Deflator → increases in nominal GDP can come either from an increase in real
GDP or from an increase in prices. The GDP deflator in year t, 𝑃𝑡 , is defined as the ratio of
Nominal GDP𝑡 $𝑌𝑡
nominal GDP to real GDP in year t: 𝑃𝑡 = Real GDP𝑡
= 𝑌𝑡
.
▪ In the year in which real GDP is equal to nominal GDP, this definition implies that
the price level is equal to 1.
▪ The GDP deflator is called an index number, which is chosen arbitrarily and has
𝑃𝑡 −𝑃𝑡−1
no economic interpretation. Its rate of change, , has a clear economic
𝑃𝑡−1
interpretation: it gives the rate at which the general level of prices increases over
time, the rate of inflation.
▪ One advantage to defining the price level as the GDP deflator is that it implies a
simple relation between nominal GDP, real GDP, and the GDP deflator: $𝑌𝑡 = 𝑃𝑡 𝑌𝑡
▪ The GDP deflator gives the average price of output – the final goods produced in
the economy. However, consumers care about the average price of consumption
– the goods they consume. The set of goods produced in the economy is not the
same as the set of goods purchased by consumers, for two reasons:

6

, • Some of the goods in GDP are sold not to consumers but to firms, to the
government, or to foreigners.
• Some of the goods bought by consumers are not produced domestically
but are imported from abroad.
o The Consumer Price Index (CPI) is used to measure the average price of consumption, or,
equivalently, the cost of living.
▪ Is published monthly instead of quarterly like the GDP.
▪ The CPI gives the cost in dollars of a specific list of goods and services over time.
• If a higher inflation rate meant just a faster but proportional increase in all prices and wages – a
case called pure inflation – inflation would be only a minor inconvenience because relative prices
would be unaffected. However, there is no such thing as pure inflation:
o During periods of inflation, not all prices and wages rise proportionately.
o Inflation leads to other distortions. Variations in relative prices also lead to more
uncertainty, making it harder for firms to make decisions about the future such as
investment decisions. Tax interacts with inflation to create more distortions. If tax
brackets are not adjusted for inflation, for example, people move into higher and higher
tax brackets as their nominal income increases, even if their real income remains the
same.

2.4. Output, Unemployment, and the Inflation Rate: Okun’s Law and the Philips Curve
• The Okun’s law states that if output growth is high, unemployment will decrease. This plots
quarterly changes in the unemployment rate against the quarterly rate of growth of output.
o The key to decreasing unemployment is a high enough rate of growth.
o It takes an annual growth rate of about 2% to keep unemployment constant. This is for
two reasons: population (and thus the labour force) increases over time, so employment
must grow over time just to keep the unemployment rate constant; output per worker is
also increasing with time, which implies that output growth is higher than employment
growth.
• The Philips curve suggests that when unemployment becomes very low, the economy is likely to
overheat and this will lead to upward pressure on inflation. This curve plots the rate of inflation
against the unemployment rate.
o The core inflation rate is the inflation rate constructed by leaving out volatile prices, such
as food and energy.
o On average, higher unemployment is associated with lower inflation; lower
unemployment is associated with higher inflation.
o The Philips curve relation is not only not as tight as Okun’s law, but it has evolved over
time, complicating in important ways the jobs of central banks, which have to care about
both inflation and unemployment.

2.5. The Short Run, the Medium Run, and the Long Run
• In the short run (say a few years), movements in the demand for goods determines the level of
aggregate output in an economy. Changes in demand, perhaps as a result of changes in consumer
confidence or other factors can lead to a decrease in output (a recession) or an increase in output
(an expansion).
• In the medium run (say a decade), the economy tends to return to the level of output determined
by supply factors: the capital stock, the level of technology, and the size of the labour force.




7

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