Macroeconomics Study Guides

Site: Saylor Academy
Course: ECON102: Principles of Macroeconomics (2021.A.01)
Book: Macroeconomics Study Guides
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Date: Monday, April 15, 2024, 6:01 AM


Keep the following two comprehensive study guides handy throughout your macroeconomics course study. They provide brief oulines for many of the major macroeconomics topics studied in this course and can help prepare you for your final economics exams.

I. Basic Economic Concepts

Economic Goals

1. Economic growth - produce more and better goods and services
2. Full employment - suitable jobs for all citizens who are willing and able to work
3. Economic efficiency - achieve the maximum production using available resources
4. Price-level stability - avoid large fluctuations in the price level (inflation + deflation)
5. Economic freedom - businesses, workers, consumers have a high degree of freedom in economic activities
6. Equitable distribution of income - try to minimize gap between rich and poor
7. Economic security - provide for those who are not able to earn sufficient income
8. Balance of trade - try to seek a trade balance with the rest of the world

Basic Economic Problem

1. Society's material wants, that is, the material wants of its citizens and institutions, are virtually unlimited and insatiable.
2. Economic resources - the means of producing goods and services-are limited or scarce.


Types of resources

Land - all natural resources usable in the production process

Capital - all manufactured aids to production (tools, machinery, equipment, and factory, storage, transportation, and distribution facilities used in producing goods and services

Labor - physical and mental talents of individuals available and usable in producing goods and services

Entrepreneurial ability - the entrepreneur 1) takes the initiative in combining the other resources to produce a good or service. 2) makes basic business-policy decisions, 3) is an innovator, and 4) is a risk bearer.

Factors of production

Several objectives must be satisfied to reach full production:

1) Full employment - use all available resources

2) Full production - use resources efficiently (productive efficiency - production in least costly way, allocative efficiency - production of goods and services most wanted by society)

Production Possibilities Curve              

The production possibilities curve represents the combinations of maximum output that can be reached in the economy. It is a frontier because it shows the limit of output. Anything under the curve is attainable, but involves inefficient use of resources. Anything outside the curve is unattainable with current resources. Usually, the curve is some type of consumer goods versus some type of capital goods.

Each point on the curve represents a maximum output of the two goods. Different points on the curve mean different production combinations of the two goods.

The curve bows outwards because of the Law of Increasing Opportunity Cost, which states that the amount of a good which has to be sacrificed for each additional unit of another good is more than was sacrificed for the previous unit. The rationale for this law is that some economic resources are not completely adaptable to alternative uses, so the resources will yield less of one product.

Shifts in this curve can be caused by increases in resource supplies or advances in technology. Also, if an economy favors "future goods" (technology; etc.), the curve will shift faster because of more economic growth.

Determinants for Production

One must compare marginal benefits and marginal costs to determine the best or optimal output mix on the Production Possibilities Curve.

II. Basic Economic Measurements

Gross Domestic Product

Gross Domestic Product (Expenditures Approach)                        

Expenditures approach:  \mathrm{GDP}=\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}

 C = personal consumption expenditures (durable consumer goods, nondurable consumer goods, consumer expenditures for services)

I_g  = gross private domestic investment (all final purchases of capital by businesses, all construction, changes in inventories)

G = government purchases (government spending on products and resources)

X_n= net exports (exports - imports)

Some types of transactions do not involve purchasing of a final good or service, so they should not be counted in GDP. These include public transfer payments (social security, welfare, etc), private transfer payments (monetary gifts, etc), security transactions (stocks and bonds), and secondhand sales (they don't reflect current production).

Gross Domestic Product (Income Approach)

GDP - Compensation of employees + Rents + Interest + Proprietors' income + Corporate profits (Corporate income taxes + dividends + undistributed corporate profits) + indirect business taxes + depreciation (consumption of fixed capital) + net foreign factor income

GDP growth

The GDP growth rate is calculated with the formula

 \text { Growth Rate }=\dfrac{\mathrm{GDP}_{\text {new }}-\mathrm{GDP}_{\text {old }}}{\mathrm{GDP}_{\text {old }}} \cdot 1 \mathrm{OO}

If the growth rate is between 2-4%. it is considered "acceptable".

Nominal vs. Real GDP

Nominal GDP is sometimes inaccurate because if there is a lot of inflation, the actual GDP growth isn't as high as the figures seem to say. Therefore, we have a measure of GDP that is adjusted for inflation: real GDP. This is calculated by the formula

 \text { Real GDP }=\dfrac{\text { Nominal GDP }}{\text { Price index (in hundredths) }} 

Difference between approaches

The expenditures approach tells us GDP by telling us how much the final user pays for each thing, giving us the value of the final product. The income approach adds all the wage. rent, interest, and profit incomes created in producing the product. They both add up to the same amount because money spent on a product is received as income by those who helped to make it.

Multiple counting/Value added

If we were to count the prices of intermediate goods instead of final goods in the expenditures approach, since the value of final goods already includes the value of intermediate goods, it would be counting the same thing multiple times, making GDP seem higher than it really is.

To avoid multiple counting, accountants calculate only the value added by each firm in each stage of the product, instead of just how much each firm sells its product to the next firm.


GDP includes the money spent for replacing capital goods used by the year's production, so it somewhat exaggerates the value of the output available. NDP makes allowance for this money spent by subtracting depreciation (consumption of fixed capital) from GDP.

For NDP to grow year to year, the stock of capital must increase.


National Income includes all income earned by US-owned resources, whether located at home or abroad. To calculate Nl. we must subtract net foreign factor income earned in the United States (since it isn't US-owned resources) and the indirect business taxes (since government isn't an economic resource and indirect taxes aren't a payment to resources.


Personal Income includes all income received, whether earned or unearned. This is NI - social security contributions - corporate income taxes - undistributed corporate profits + transfer payments.


This is the amount of money households can spend. It is PI minus personal taxes.



This is a measure of inflation. It is calculated by the formula

 \mathrm{CPI}=\dfrac{\text { price in specific year }}{\text { price in base year/period }} \cdot 100


This is the increasing general level of prices from year to year.

The rate of inflation is calculated by the formula

 \text { Inflation Rate }=\dfrac{\mathrm{CPI}_{\text {new }}-\mathrm{CPI}_{\text {old }}}{\mathrm{CPI}_{\text {old }}} \cdot 100

If the rate of inflation is less than 3 percent (and greater than 0 percent, of course), it is considered "acceptable".

Types of Inflation

Demand-pull inflation: more spending than the economy's capacity to produce. The excess demand increases the prices of the limited real output, causing prices to rise. Cost-Push (Supply-side) inflation: Per-unit production costs (total input cost + units of output) rise, reducing the amount of companies willing to sell products at the current price level. Then, supply decreases, causing the price level to increase.

Wage-price spiral

As price level rises, labor will demand and get higher nominal wages. Businesses will agree, hoping to get back the money by increasing prices. Then, as prices increase even more, labor will find that it has a reason to demand even more wage increases, but that causes more prices increases, and so on.

Rule of 70

If we divide 70 by the annual rate of inflation, this quotient is the number of years it takes for inflation to double the price level.

Fighting inflation

We can fight inflation by trying to reduce demand or by trying to prevent a wage-price spiral from getting out of hand. We can use either fiscal or monetary policy (means of doing so is explained later). Fiscal action will result in a budget surplus.

Real vs. Nominal values

A Nominal value is an unadjusted value. A real value is a nominal value adjusted for inflation.

\text { Real Value }=\dfrac{\text { Nominal Value }}{\text { Price index (in decimal form) }}

Therefore, we can't just look at nominal values when trying to determine the status of the economy. Since lots of inflation can lead to very high nominal values, we can get a false impression that the economy is doing well when the real value is perhaps even decreasing.

Inflationary expectations

The effects of unexpected inflation are:

It hurts people with fixed nominal incomes, since the money they earn Isn't worth as much anymore. It hurts people who save in fixed-value accounts It benefits debtors (borrowers) while hurting creditors (lenders).

The effects of inflation can be lessened if people expect it (anticipated inflation), since then they can get a chance to prepare for the damages that the inflation may cause.

For example, a person who has a fixed nominal income can try to adjust it if they know that its value is going to decrease. Many unions have labor contracts with cost-of-living adjustment (COLA) clauses, in which workers' wages increase if there is inflation.



Frictional - includes workers who are searching for jobs or waiting to take jobs in the near future. This unemployment is inevitable, since many workers switch to better jobs.

Structural - changes over time in consumer demand and technology change the 'structure- of total demand for labor. Some skills will not be needed as much or become obsolete, and new skills will appear. This is a mismatch between job seekers' skills and the skills needed for the job. This is also inevitable because the demand for labor will always change over time as new technologies arise.

Cyclical - this type of unemployment is caused by recession. People who are laid off because of decreased overall spending in the economy.

Full employment

This is NOT zero unemployment, as frictional and structural unemployment are regarded as unavoidable in an economy. Therefore, full employment means no cyclical unemployment, and the full-employment rate is equal to the frictional plus structural rates. It is also called the natural rate of unemployment.


In order to decrease cyclical unemployment, we must try to increase overall spending in the economy so businesses find their inventories decreasing and so hire more people. We do this by increasing aggregate demand with fiscal or monetary policy.


Unemployment means unemployment in the labor force, not the whole population. The labor force is total population - under 16 and/or institutionalized - people not in the labor force. Then, the unemployment rate is

 \dfrac{\text { Unemployed people in the labor force }}{\text { Total number of people in the labor force }} \cdot 100

Criticism of unemployment rate

The unemployment rate has been subject to some criticism, however.

First of all, part-time workers are counted as fully employed; however, some part-time workers are people who can't get a full-time job because of recession. This tends to understate the unemployment rate.

Also, discouraged workers who are not actively searching for jobs anymore are not counted in the labor force. This understates the unemployment rate, especially in recession.


This is the amount by which actual GDP falls short of potential GDP (the GDP that can be attained at the natural rate of unemployment).

Okun's Law

For every 1 percentage point that the actual unemployment rate exceeds the natural rate, a GDP gap of about 2% occurs.

For example, if the actual rate Is 6% and the natural rate is 4%. there will be a GDP gap of 4%.

III. Economic Models


Law of Demand: inverse relationship between price and quantity demanded

Law of Supply: direct relationship between price and quantity supplied


MPS is the slope of the savings schedule. It is equal to  \dfrac{\text { change in savings }}{\text { change in income }} .

MPC is the slope of the consumption schedule. It is equal to \dfrac{\text { change in consumption}}{\text { change in income}} .

 \text{MPS + MPC = 1.}

The Multiplier Effect

A change in aggregate expenditures causes a greater increase in GDP because the same money is used many times over. The multiplier determines how much larger the increase in GDP is. The multiplier's value can be found by the formula \text
                    { Multiplier }=\dfrac{1}{\mathrm{MPS}}=\dfrac{1}{1-\mathrm{MPC}}.

This multiplier is called the simple multiplier.

IV. Economic Policies

Fiscal Policy


The government has two tools for regulating fiscal policy: a change in government spending or changes in taxes. The government can also use both if it thinks the economy needs it.

Inflationary Situation

If the inflation is demand-pull inflation, the government should use a contractionary fiscal policy. It can decrease government spending, increase taxes, or both. The government is aiming for a budget surplus, where tax revenues are larger than government spending.

Both increased taxes and decreased government spending reduces consumption spending, which causes a decrease in aggregate demand (first graph). Then, if prices are flexible downward, the decrease in aggregate demand causes the equilibrium price level to decrease, ending the inflation. If prices are not flexible downward (because of the ratchet effect), the policy will stop price level from increasing. Since inflation usually occurs in the vertical range of the aggregate supply curve, GDP shouldn't decrease by much.

 Recessionary situation

The government now needs to use an expansionary fiscal policy. The aim of the policy is to increase aggregate demand, which shifts the AD curve to the right and will cause an increase in real GDP.

The government has two tools to use: it can increase government spending or decrease taxes (or both). Increasing government spending will increase aggregate demand (since \mathrm{AD}=\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}). Decreasing taxes will increase consumption spending (it increases it by the tax increase times the MPC), which will also increase aggregate demand (graph l).

Then, since aggregate demand is increased (rightward shift of AD curve), equilibrium GDP will either increase (if the economy is in the horizontal or intermediate ranges) or stop declining (if the economy is in the vertical range).

If the economy is on the horizontal range, the full effect of the multiplier will be felt: when AD increases by an amount, GDP will increase by the multiplier times that amount.

The final equilibrium will have a higher GDP and the same or slightly increased price level since recession usually means the horizontal range of the AS curve.

Impact of policies on AD/AS equilibrium

An expansionary fiscal policy shifts (or tries to shift) the Aggregate Demand curve to the right. This will shift the equilibrium GDP up (as long as the economy isn't in the vertical range) and shift the price level up (as long as the economy isn't in the horizontal range). Usually, the government uses an expansionary fiscal policy when the economy is in the horizontal range, so the policy only shifts equilibrium GDP up.

A contractionary fiscal policy shifts the Aggregate Demand curve to the left. This will lower equilibrium price level (when it's not in horizontal range) and lower equilibrium GDP (when it's not in vertical range). However, the economy is usually in the vertical range when the government uses this policy, so the policy usually only shifts price level down.

G vs. C, I

G can be directly changed "on whim", since fiscal policy can quickly be enacted to change government spending. However, C and I are much more uncontrollable, since they both depend on confidence, which is a hard thing to change.

They both, however, increase aggregate demand, and increase GDP by the amount times the multiplier.

Issue of Debt and Deficits

Deficit spending is expansionary, and it counters recession. There's two ways of financing a deficit. The government can enter the money market and borrow, competing with private business borrowers for funds. This might cause a crowding-out effect, "taking up" some space for investment spending and consumer spending. The crowding-out effect reduces the expansionary impact of the deficit spending. The government can also make more money, making spending increase without any harm done to investment. However, making more money can have an inflationary effect too. To counter demand-pull inflation, fiscal policy has to involve making a budget surplus. However, a surplus can do one of two things: debt reduction (paying off debt, but then it might offset the anti-inflationary impact because the government is putting money back into circulation), or impounding (keeping the surplus funds, doing nothing with them; this way, the full extent of the anti-inflationary policy will be met).

Debt can actually be inflationary because if the government tries to pay it off quickly, there will be inflation because the money supply increases.

Crowding Out Effect

If the government were to finance a deficit (expansionary fiscal policy) by entering the money market and borrow money, it would make less room for investment, since as the government's share of the "pie" grows, everyone else's becomes smaller. Then, investment spending decreases, causing aggregate expenditures to not increase as much.

Balanced Budget Multiplier

Equal increases in government spending and taxation increase the equilibrium GDP.

If G and T are both increased by an amount, the equilibrium GDP will rise by the same amount, regardless of what the multiplier is.

This happens because a change in government spending has more of an impact on AE than a tax change. This is because government spending has a direct effect on AE. i.e. a $20 increase in government spending will result in a $20 increase in AE. However, since if people are taxed, their consumption only decreases by a fraction of the tax (since the tax affects both savings and consumption). For example, a $20 increase in taxes in an economy with a MPC of .75 only results in $15 added to AE.

Then, let's look at how much these values affect equilibrium GDP. Since the multiplier is 4. the $20 increase by GDP results in a $80 increase in GDP. Also, the $15 decrease by taxes results in a $60 decrease in GDP. Therefore, the net increase in GDP is 80- 60 which is $20, the same as how much G and T were changed.

Monetary Policy

Who controls?

The Board of Governors of the Federal Reserve System ("Fed") is responsible for controlling the U.S banking system (and the money supply). The Board of Governors has seven members, appointed by the President with confirmation of the Senate. It directs the activities of the 12 Federal Reserve Banks, which then control the nation's banks.

There are several entities that help the Board of Governors. The Federal Open Market Committee (FOMC) is made up of the 7 members of the BoG plus 5 of the presidents of the Federal Reserve Banks. It sets the Fed's monetary policy and directs open-market operations. There are also three Advisory Councils (made of private citizens) that meet with the BoG to give their views on banking and monetary policy.

Required reserve ratio

This is how much percent of a bank's reserves must keep on deposit with the Federal Reserve Bank or as vault cash.

Money multiplier

Since banks lend their excess reserves, a system of banks will "magnify" original excess reserves into a larger amount of new demand-deposit money, causing the money supply to grow by more than the original excess reserves.

It is equal to \dfrac{1}{\text { Required reserve ratio }}.

The maximum demand-deposit creation (money created) equals the excess reserves that can be lent out by commercial banks times the money multiplier.

For example, if someone deposited S100 into a bank, and the required reserve ratio was 0.2. then the bank's excess reserves would increase by $80. and since the money multiplier is t/O.2-5, the money supply will be increased by 80*5-400.

Tools of Monetary Policy

It has three tools:

  1. Open-market operations - these are the most important means the Fed has to control the money supply. It refers to the buying and selling of government bonds (securities) by the Federal Resene Banks. Buying bonds increases the money supply; selling them decreases it.
  2. The reserve ratio - the Fed can also increase or decrease the Reserve ratio. Increasing the Reserve ratio decreases banks' excess reserves, causing the money supply to decrease. Decreasing it increases banks' excess reserves, increasing the money supply. This is really powerful, and so it is not used very often.
  3. The discount rate - the discount rate is the rate that Federal Reserve Banks charge for loans to commercial banks. When commercial banks borrow from FRBs, their reserves increase. Therefore, if the discount rate increases, banks are less encouraged to borrow, keeping their excess reserves the same and therefore restricting the money supply. 

Open-market operations - difference between buying/selling to the public and buying/selling to banks

If the Fed buys or sells securities to the public, the money supply will increase/decrease less than if the Fed buys or sells them to banks. This is shown in the following examples:

Let's assume that the required reserve ratio is 0.2. The money multiplier is then 5.

If the Fed buys $1000 worth of securities from commercial banks, the excess reserves will increase by $1000. Then, the money supply will increase by $1000*5= $5000.

If they buy securities from the public, the public gets more money, and when they deposit it into banks (whether directly or indirectly), bank reserves increase. However, since the required reserve ratio is 0.2, the bank needs to put $200 of the money in the Federal Reserve Bank, and so excess reserves only increase by $800. Then, the money supply will increase by $800*5=$4000.

If the Fed sells $1000 worth of securities to commercial banks, then excess reserves will decrease by $1000, so the money supply will decrease by $1000*5=$5000.

If the Fed sells $1000 of securities to the public, then after the transaction is cleared, the hank will have $1000 less in securities. $200 of that money can be taken from Federal reserves, and so excess reserves only decrease by $800, causing the money supply to decrease by $800*5=$4000.

Checking account money

Most of it comes from demand deposits, which are deposits in commercial banks that are meant to be checkable.

M1, M2, M3

Ml is the narrowest definition of money supply. It includes currency (coins * paper money) and checkable deposits (demand deposits in banks or thrifts).

M2 includes Ml plus near-monies (highly liquid financial assets which do not directly function as a medium of exchange but can be readily convened into currency or checkable deposits without risk of financial loss). Near-monies are noncheckable savings accounts, money market deposit accounts, small time deposits, and money market mutual funds.

M3 is M2 plus large time deposits.

Change in composition of money

It does not necessarily impact stock of money in the economy, as it can still be considered money (because it can be redeemed for purchasing power at a later date).

Transaction demand for money

This is the amount of money people want to use as a medium of exchange; varies directly with nominal GDP. It has no relationship with the rate of interest, so its qty demanded vs. interest rate graph is a vertical line.

Asset demand for money

This is the amount of money- people want to hold as a store of value; varies inversely with rate of interest. Its qty demanded vs. interest rate graph has a negative slope.

Interest rate graph

Dm, or total demand for money, equals transaction demand plus asset demand. Sm is always vertical because quantity supplied doesn't vary with the rate of interest. When the money supply decreases (shifts to the left), the price for money (which is the same as the interest rate) rises. When the money supply increases (shifts to the right), the price for money decreases. 
 Inflationary Situation In this situation, we want a tight money policy. To do this, we can 1) sell government securities, 2) increase the reserve ratio, or 3) increase the discount rate. All three of these will decrease the supply of money. Our graphs will be as follows:

If supply of money decreases, then the rate of interest increases. Then, when the rate of interest increases, the amount of investment decreases.

Then, since investment decreases, aggregate expenditures  \left(\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}\right)
                decreases. That then shifts the GDP down by the change times the multiplier. Finally, when GDP decreases, price level will drop (since the economy most likely is in the vertical range of the aggregate supply curve) and therefore inflation will decrease.

Recessionary Situation

In this situation, we want a loose money policy. To do this, we can 1) buy government securities, 2) decrease the reserve ratio, or 3) decrease the discount rate. All three of these will increase the supply of money. Our graphs will be as follows:

If supply of money increases, then the rate of interest decreases. Then, when the rate of interest decreases, the amount of investment increases.

Then, since investment increases, aggregate expenditures  \left(\mathrm{C}+\mathrm{I}_{\mathrm{g}}+\mathrm{G}+\mathrm{X}_{\mathrm{n}}\right)
                 increases. That then shifts the GDP up by the change times the multiplier. Finally, when GDP increases, price level will stay about the same (since this economy most likely started in the horizontal range). Now since the GDP is increasing, we are out of a recession.

Net export effect

Easy money policy → decreased foreign demand for dollars → dollar depreciates → net exports increase (AD increases, strengthening the easy money policy)
Tight money policy → increased foreign demand for dollars → dollar appreciates → net exports decrease (aggregate demand decreases, strengthening the tight money


Both fiscal and monetary

Summary: recessionary

Fiscal policy: increase government spending, decrease taxes

Monetary policy: loose money policy - buy government securities, lower reserve ratio,

lower discount rate

Summary: inflationary

Fiscal policy: decrease government spending, increase taxes

Monetary policy: tight money policy - sell government securities, raise reserve ratio, raise discount rate

V. Alternative Theories/Approaches


Stagflation is increasing inflation and rising unemployment in an economy at the same time. It is usually caused by a decrease in supply (supply-shock inflation). Stagflation in the 1970s proved that the Phillips Curve didn't represent a stable inflation-unemployment relationship.

Phillips Curve

The main concept of this is a stable, inverse relationship between inflation and unemployment. The short-run Phillips curve has a negative slope; the long-run Phillips curve is vertical.

The Adaptive Expectations Theory predicts that there is a short-run tradeoff between inflation and unemployment but there is no long-run tradeoff. In the short run, the inverse relationship works, but in the long run, it seems that the graph will always shift back to a vertical line.

Supply-side economics

They believe that changes in aggregate supply are active forces in determining the levels of both inflation and unemployment. Economic disturbances can be generated on both the supply side and the demand side of the economy. They also contend that certain government policies have reduced the growth of aggregate supply over time, and if these policies were reversed, the economy could achieve low levels of unemployment without producing rapid inflation.

Supply-siders also say that the US tax-transfer system has "eroded" productivity and decreased incentives to work, invest, innovate, and assume entrepreneurial risks. If taxes were decreased, people would have more money after taxes and they would have more of an incentive to work.

Supply-siders also believe that reductions in marginal tax rates increase aggregate supply. They believe in the Laffer Curve, which says that up to a certain point in tax rate, tax revenue increases, and at that point, tax revenue is a maximum. However, when taxes go past that point, tax revenue starts to decrease again. Criticisms of the Laffer Curve include 1) evidence that tax cuts don't necessarily increase incentive to work, 2) inflation might still occur because AD might overwhelm AS, and 3) no one knows where we are on the curve.

"Old" Classical theory

They believe that the AS curve is vertical and it is the only factor in determining real output. The AD curve is still downsloping, and classical economists view it as stable when the money supply is constant. Also, domestic output doesn't change when price level decreases; it's only the AD curve moving down. They believe in Say's law, which says that supply creates its own demand.

"New" Classical theory

Their theory is that when the economy occasionally diverges from its full-employment output, internal mechanisms within the economy automatically move it back to that output. In their opinion, if a change in AD moves the equilibrium outside of AS_{LR}, there will be a change in AS that will bring it back.

Rational Expectations Theory

It states that businesses, consumers, and workers understand how government policies will affect the economy and anticipate the impacts in their own decision making. In other words, everyone knows what's going to happen and they plan for it. For example, when the government begins some expansionary polices, workers will anticipate that a result will be higher inflation which would cause a decrease in their real wages. So, the workers quickly ask for more money for their nominal wage. If things work out well, there will be no temporary increases in profit, output, or unemployment.

They also say that policies designed to push unemployment below its natural rate will quickly increase the rate of inflation, having no effect on unemployment.


Monetarists believe that the economy is stable in the long run at the natural rate of unemployment, and the observed instability of the economy is caused by inappropriate monetary policy. Keynesians, on the other hand, believe that the economy is potentially unstable and observed instabilities are caused by fluctuations in AD and AS.

They believe that changes in the money supply directly changes AD, which directly changes GDP. They do not think investment is an important issue.

Monetarists also believe that without government interference, the economy would be very stable. The government caused the economy to become what it is today: downward wage inflexibility, business cycles, etc.

Monetarist Equation of Exchange

MV  \,= \, PQ, where M is the supply of money, V is the velocity of money (the number of times per year the average dollar is spent on final goods and services), P is the price level (average price at which each unit of physical output is sold), and Q is the physical volume of goods and services produced.

The left side is the total amount spent; the right side is total amount received. Monetarists believe that V is stable, or that the factors altering velocity change gradually and predictably.



VI. International Aspects of the Economy

Comparative Advantage

When it's cheaper for one nation to produce something than another. For example, if two products on the production possibilities curve are coffee and wheat, and the United States needs to spend 2 coffees to make a wheat, while Brazil only needs to spend 1.5 coffees, Brazil has a comparative advantage over the US in wheat (because it's relatively cheaper to make) and the US has a comparative advantage over Brazil in coffee.

Terms of Trade

The price of a good or service (the amount of one good or service which must be given up to obtain one unit of another good or service).

Exchange rates

Flexible exchange-rate system: rates at which national currencies are exchanged for one another are determined by demand and supply and in which no government intervention occurs.

Fixed exchange-rate system: governments determine rates at which currencies are exchanged and make necessary adjustments in their economies to ensure that these rates continue.

Appreciation/depreciation of money

When the currency depreciates, then American goods seem cheaper to foreigners, so they will buy more, increasing exports, and making the trade balance "more favorable". Likewise, when the currency appreciates, American goods seem more expensive to foreigners, and foreign goods seem cheaper to Americans, so imports increase and the trade balance becomes "less favorable".

Fiscal/Monetary policy


Expansionary policy → higher domestic interest rate → increased foreign demand for dollars → dollar appreciates → net exports decline → balance of trade becomes less "favorable"

Contractionary policy → lower domestic interest rate → decreased foreign demand for dollars → dollar depreciates → net exports increase → balance of trade becomes more "favorable"


Easy money policy → decreased foreign demand for dollars → dollar depreciates net exports increase → balance of trade becomes more "favorable"

Tight money policy → increased foreign demand for dollars → dollar appreciates → net exports decrease → balance of trade becomes less "favorable"

Favorable/unfavorable trade balances

If exports exceed imports, you get a trade surplus which is considered a "favorable balance of trade". If imports exceed exports, you get a trade deficit which is considered an "unfavorable balance of trade".

A "favorable" balance of trade is not entirely good, however. We cannot buy as much foreign goods now (since our dollar is worth less) so foreign companies don't get as much business from us. However, when foreign prices rise, Americans turn to American companies to buy things from, helping American companies make more money.

Likewise, a "unfavorable" balance of trade isn't entirely bad either. Since our dollar has grown in value, we can buy more foreign goods, so foreign companies get more money. However, because of cheaper foreign goods, American companies won't get as much business (or they have to lower prices), so they don't get as much money.



VII. AD/AS Graph

Aggregate Demand Shifters

These cause shifts in aggregate demand:

  1. C(consumer wealth, consumer expectations, household indebtedness, taxes)
  2. I (interest rates, expected returns on investment, business taxes, technology, degree of excess capacity)
  3. G
  4. X_n (National income abroad, exchange rates)

Aggregate Supply Shifters

These cause shifts in aggregate supply:

  1. Input Prices (domestic resource availability [land, labor, capital, entrepreneurial ability], prices of imported resources, market power)
  2. Productivity
  3. Legal - institutional environment (business taxes and subsidies, government regulation)

AS Curve ranges

Horizontal range - includes only real levels of output which are substantially less than full-employment output. A change in real output in this range won't affect price level at all.

Vertical range - economy has already reached its full-capacity real output. Any increase in the price level at this range won't affect real output at all.

Intermediate range - an expansion of real output is accompanied by a rising price level. The full-employment output is found in this range.

Principles of Macroeconomics Lecture Notes

Read both sets of lecture notes. Use these notes as a review of the material covered in Unit 1 and Unit 2 in preparation for Unit 3.

"Introduction to Macro Data" covers:

  1. Gross Domestic Product (GDP)
    • What is Gross Domestic Product and how we measure it? Why is this measure important?
    • What are the definitions of the major expenditure components?
    • What are the trends in these components over time?
  2. Inflation
    • What is the difference between 'Real' and 'Nominal' variables?
    • How is inflation measured?
  3. Interest Rate
    • How is inflation measured?
    • Why do we care about Inflation?
  4. Unemployment 
    • How is Unemployment measured?
    • Why do we care about Unemployment?

"Supply Side of the Macro Economy" covers:

  1. Production Function
  2. Labor Market
    • Labor Demand
    • Labor Supply
    • Equilibrium Wages and Employment

Source: Veronica Guirrieri,
Creative Commons License This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License.

Introduction to Macro Data

Goals and Outline of Topic 1

  1. Gross Domestic Product (GDP)
    - What is Gross Domestic Product and how we measure it? Why is this measure important?
    - What are the definitions of the major expenditure components?
    - What are the trends in these components over time?

  2. Inflation
    - What is the difference between 'Real' and 'Nominal' variables?
    - How is inflation measured?

  3. Interest Rate
    - How is inflation measured?
    - Why do we care about Inflation?

  4. Unemployment
    - How is Unemployment measured?
    - Why do we care about Unemployment?


Gross Domestic Product (GDP)

    • GDP is a measure of output! 
    • Why Do We Care? 

Because output is highly correlated (at certain times) with things we care about (standard of living, wages, unemployment, inflation, budget and trade deficits, value of currency, etc…) 

    • Formal Definition: 

GDP is the Market Value of all Final Goods and Services Newly Produced on Domestic Soil During a Given Time Period (different than GNP)


Three ways of measuring GDP

    • Production Method: Measure the Value Added summed across all firms (value added = sale price less cost of raw materials)
    • Income Method: Labor Income (wages/salary) +  Capital Income (rent, interest, dividends, profits)+ Government Income (taxes)
    • Expenditure Method: Spending by consumers (C) + Spending by businesses (I) + Spending by government (G) + Net Spending by foreign sector (NX)
    • Fundamental identity of national income account:

total production = total income = total expenditure

A simple example of how GDP is measured

Orange Inc Transactions

Wagos paid to Orange Inc employees


Taxes paid to government


Revenue received from sale of oranges


• Oranges sold to public


• Oranges sold to Juice Inc


Juice Inc Transactions

Wagos paid to Juice Inc employees


Taxes paid to government


Oranges purchased from Orange Inc


Revenue received from sale of orange juice


What is the total value (in dollars) of the economic activity generated by these 2 firms?

Production Method (value added: sales – intermediate good): 35K + (40K– 25K) = 50K

Income Method (Wages + Profits + Taxes) = 15K + 10K + 15K + 3K + 5K + 2K = 50K

Expenditure approach (expenditure by final users): 10K + 40K = 50K 

"Production" Equals "Expenditure"

  • GDP (for us Y) is a measure of Market Production!
    Market value = how much you have to spend to buy
  • What is produced in the market has to show up as being purchased or held by some economic agent; 
  • Who are the economic agents we will consider on the expenditure side?
    • Consumers (refer to expenditure of consumers as "consumption")
    • Businesses (refer to expenditure of firms as "investment")
    • Governments (refer to expenditures of governments as "government spending")
    • Foreign Sector (refer to expenditures of foreign sector as "net exports")
  • For us, we will predominantly spend our time working with the Expenditure Approach:

 Y = C + I + G + NX

Back to a Simple Example

  • I produce oranges and I can potentially:

  • sell them to some domestic customer (Consumption)
  • sell them to some business (Investment)
  • keep them in my stock room as inventory (Investment)
  • sell them to the city of Boston for their shelters (Government spending)
  • sell them to some foreign customer (Net Export)

Defining the Expenditure Components

  • Consumption (C): 

  • The Sum of Durables, Non-Durables and Services Purchased Domestically by NonBusinesses and Non-Governments (ie, individual consumers).
  • Includes Haircuts (services), Refrigerators (durables), and Apples (non-durables).
  • Does Not Include Purchases of New Housing.

  • Investment (I):

  • The Sum of Durables, Non-Durables and Services Purchased Domestically by Businesses
  • Includes Business and Residential Structures, Equipment and Inventory Investment
  • Land purchases are NOT counted as part of GDP (land is not produced!!)
  • Stock purchases are NOT counted as part of GDP (stock transactions do NOT represent production – they are saving!)

There is a difference between financial and economic investment!!!!!!!

  • Government Spending (G):  Goods and Services Purchased by the domestic government. 
  • For the U.S., 2/3 of this is at the state level (police and fire protection, school teachers, snow plowing) and 1/3 is at the federal level (President, Post Office, Missiles). 
  • NOTE: Welfare and Social Security are NOT Government Spending. These are Transfer Payments. Nothing is Produced in this Case.
  • Net Exports (NX): Exports (X) - Imports (IM); 

  • Exports: The Amount of Domestically Produced Goods Sold on Foreign Soil
  • Imports: The Amount of Goods Produced on Foreign Soil Purchased Domestically. 

More on Expenditure Components

  • Only include expenditures for goods that are "produced".

  • If I give $10 to a movie theater to watch a movie, it is counted as expenditure.
  • If I give $10 to my friend for a birthday present, it is not counted as expenditure.
  • If I give $10 to the ATM machine to put in my savings account, it is not counted as expenditure.

  • The second example would be considered a "transfer" (once I give $10 to my friend, he can go to the movies if he wants to – once that $10 is spent, it will show up in GDP).

  • "Transfers" are defined as the exchange of economic resources from one economic agent to another when no goods or services are exchanged.

  • The third example is considered "saving" (I am delaying expenditure until the future). Once I spend the $10 in the future, it will show up in GDP.

Examples of Expenditure Method

  • How would these transactions be counted as part of 2008 U.S. GDP Calculation?

(Assume the production/transaction took place in 2008 if not otherwise specified)

  1. I purchase a $500 Swiss watch.
  2. I receive $200 unemployment check from the state government.
  3. The city of Chicago spends $1 million this year repairing its streets.
  4. US steel purchases a new $10 million steel rolling machine for its factory. 
  5. Ford Motor Company purchases $10 worth of steel for building fenders. 
  6. I buy a 1998 Ford Escort from a Dealer.
  7. I buy a plot of land for $100,000.
  8. I pay a local accountant $175 for her help in filling in my taxes. 
  9. A U.S. travel agent is paid $1000 for services rendered to U.S. customers while in  Tokyo for a year.

Preview: Accounting vs Economics

 Y = C + I + G + NX

  • Macroeconomics studies the determinants of Y (= aggregate supply) and C+I+G+NX (aggregate demand), and shows how, in equilibrium, prices/wages/interest rates/exchange rates have to adjust such that AS = AD.

  • Classic economics believes prices/wages move immediately to attain equilibrium.
  • Keynesian economics sticky prices/wages give rise to unemployment and an active role to monetary policy.

  • With this basic setup we can understand how changes in the determinants of aggregate demand and supply affect growth and prices in an economy.

What GDP Is Not!

  • GDP is not, or never claims to be, an absolute measure of well-being! 

  • Size effects: But even GDP per capita is not a perfect measure of welfare

  • Ideally, what we would like to measure is quality of one's life:

  • Present discounted value of utility from one's own consumption and leisure and that of one's loved ones.

More on What GDP Is Not!

  • GDP Does Not Measure:

  • Non-Market Activity (home production, leisure, black market activity)
  • Environmental Quality/Natural Resource Depletion
  • Life Expectancy and Health
  • Income Distribution
  • Crime/Safety


Defining Saving

The saving of any economic unit is its current income minus its current needs

Y_{d} = \text{Disposable Income = Y - T + Tr} (1)

T = Taxes

Tr = Transfers (ie, Welfare)

Y_{d} = C + S_{HH} (2)

S_{HH} = Personal (Household or Private) Saving Personal (Household or Private) Saving

S_{HH} = \text{Y - T + Tr – C} \ll \text{Combine (1) and (2)}\gg (3)

 \text{Personal Savings Rate} = S_{HH}/Y_{d}

For simplicity, I abstract from business saving (things like retained earnings and depreciation). For those interested, see the text.

A Look at Actual U.S. Household Saving Rates: 1970 – 2008 

Defining Saving (continued)

 S_{govt} = T - (G + Tr)            (4)

 S_{govt} = Government (Public) Saving

• Includes Federal, State and Local Saving

• What government collects (T) less what they pay out (G and Tr)

  S  = S_{HH} + S_{govt}            (5)

 S = National Savings


 S  = \text{Y - C – G} \ll \text{Combine (3) and (5)} \gg          (6)

S  = \text{I + NX}  \ll \text{Combine (6) and Y = C+I+G+NX} \gg          (7)

PART II: Inflation

Real versus Nominal variables

  • Using current market values allows summing different types of goods and services, but how to compare variables over time? 

Production today

20 computers  

20 bicycles

Production tomorrow

20 computers

20 bicycles

  • If prices of computers and bicycles double between today and tomorrow, the current market value of GDP (i.e., nominal GDP) also doubles. However, the amount of physical production remains unchanged.
  • What's wrong? Nominal GDP today is expressed in terms of dollars of today and nominal GDP tomorrow is expressed in terms of dollars of tomorrow. If there is inflation, the purchasing power of the dollar has changed over time.
  • By looking at the current market value of goods changes over time, you can't tell whether this change reflects changes in the goods produced or in their prices. That is why we need to look at the "real" GDP or at constant prices.

Prices and Inflation

  • To compare the market value of output over time, we need to know how does the purchasing power of 1$ change over time. For that we need a price index.
  • How Are Prices Measured? 
  • Price Indexes measure the cost of a fixed 'basket' of goods over time

 P(t) \approx \sum_{g} w_{g} p_{g}(t)  

(weights are usually fixed or slowly moving)

  • Inflation rate = % change in P, where P is the general price level 

\text{– Inflation = [P(t+1) - P(t)] / P(t)}

Prices and Inflation

  • GDP Deflator (one prominent price index): 

 \text{Value of Current Output at Current Prices /}

 \text{Value of Current Output at Base Year Prices}

  • Another prominent price index is the CPI (consumer price index) – measures price changes of consumer goods. BLS surveys over 80,000 goods per month in different locations around the country.
  • I will often use the CPI as our measure of a price index in this class.

Using Prices to distinguish between Nominal and Real Variables

  • Nominal GDP is output valued at Current Prices
  • Comparing Nominal GDPs over time can become problematic

  • Confuses changes in Output (production) with changes in prices

  • Real GDP is output valued at some Constant Level of Prices (prices in a base year).

\text{Real GDP(t) = Nominal GDP(t) / Price Index (t)}

  • Growth in Real GDP:

 \text{% Δ in Real GDP = [Real GDP (t+1) - Real GDP (t)] / Real GDP (t)}

or (approximately)

\text{% Δ in Real GDP = % Δ in Nominal GDP - % Δ in P}


Example of Price Index Calculations

Veronica's Basket of Goods (goods I produce in my world)































Y(2000) = 80.00 (10 + 45 + 25)

Y(2008) = 160.00 (40 + 80 + 40)

Nominal GDP went up by 100%!

Compute GDP Deflator for Veronica's World (with 2000 as Base Year)































Current Output at Current Prices: 160.00

Current Output at Base Year Prices: 100.00 (1*20 + 3*20 +0.50*40)

GDP Deflator for 2000 = 1.00 (Price Index in the Base Year ALWAYS = 1)

GDP Deflator for 2008 = 1.60 

Inflation Rate Between 2000 and 2008 = 60%

What is real GDP growth between 2000 and 2008 in Veronica's World?    40% (approx).

What is real GDP growth between 2000 and 2008 in Veronica's World?    25% (actual)

Notes on Price Indexes

  • Need to Pick a Basket of Goods (cannot measure all prices)
  • 'Ideal/Representative' Basket of Goods Change Over Time

  • Invention (Computers, Cell Phones, VCRs, DVDs).
  • Quality Improvements (Anti-Lock Brakes)

  • Criticisms of Price Indices:

  • Part of the Change in Prices Represents a Change in Quality - Actually, not measuring the same goods in your basket over time. 
  • Technology advances drive down the price of 'same' goods over time
  • Substitution of goods in reaction to prices changes
  • Arbitrary choice of the goods (Housing included in US CPI not in EU CPI)
  • How do we account for "sales"?

  • Boskin Report Concludes that CPI Overstates Inflation by 1.1% per year (quality adjustment/substitution bias)
  • Overstating Inflation means understated Real GDP increases - makes it appear that the U.S. Economy has Grown Slower Over Time. (Same for Stock Market, Housing Prices, Wages - any Nominal Measure)
  • Measures to Get Around Problems with CPI - Chain Weighting 

  • Read Box 2.2 in the Text to get a sense of chain weighting

Focus on Real Variables

  • Which is better: Real or Nominal?

  • In this class, we will focus on the 'Real'! We are trying to measure changes in production, expenditures, income, standard of livings, etc. We will separately focus on the changes in prices. 
  • From now on, both in the analytical portions and the data portions of the course, we will assume everything is real unless otherwise told.

  • ie, \text{Y = Real GDP, C = Real Consumption, G = Real Government Purchases, etc...}

PART III: Interest Rate

Interest Rates

i_{0,1} = the nominal interest rate between periods 0 and 1

(the nominal return on the asset)

\pi^{e}_{0,1} = the expected inflation rate between periods 0 and 1

r^{e}_{0,1} = the expected real interest rate between periods 0 and 1


r^e _{0,1} = i_{0,1} - \pi^e _{0,1} (or \: i_{0,1} = \pi^e _{0,1} + r^e _{0,1)}

r^a _{0,1} = i_{0,1} - \pi^a _{0,1} (or \: i_{0,1} = \pi^a _{0,1} + r^a _{0,1)}

where r^{a} and \pi^{a} are the actual real interest rate and inflation

Interest Rate Notes

  • The Formula given is approximate. The approximation is less accurate the higher the levels of inflation and nominal interest rates. The exact formula is  r^{e} = (1 + i) / (1 + \pi ^e) - 1
  • Central Banks are very interested in r since it may affect the savings decisions of households and definitely affects the investment decisions of firms. The press talks about Central Banks setting i, but the Central Banks are really trying to set r.
  • 3 easy ways of measuring expected inflation:

  • Recent actual inflation.
  • Survey of forecasters.
  • Interest rate spread on nominal vs. inflation-indexed securities (WSJ) 

Why We Care About Inflation?

  • Note: We will have a whole lecture on this later in the course
  • Inflation is Unpredictable
  • Indexing Costs (even if you know the inflation rate - you have to deal with it).
  • Menu Costs (have to go and re-price everything)
  • Shoe-Leather Costs (you want to hold less cash - have to go to the bank more often).
  • Caveat: There may be some benefits to small inflation rates - more on this later.
  • An Example of how inflation can affect real returns.
  • Suppose we agree that a real rate of 0.05 over the next year is fair.
    • borrowing rate, salary growth rate, etc.
  • Suppose we also agree that expected inflation over the next year is 0.07.
  • We should then set the nominal return equal to 0.12 ( i = r^{e} + \pi^{e} ) 

Summary: i = 0.12

                        r^{e}= 0.05

                        \pi{e} = 0.07

  • Suppose that actual inflation is 0.10  (\pi^{a} > \pi^{e} ) 

In this case, r^{a} = 0.02 (r^{a} = i - \pi^{a})

Borrowers/Firms are better off

Lenders/Workers worse off

  • Suppose that actual inflation is 0.03  (\pi^{a} < \pi{e} )

In this case,  r^{a} = 0.09 \: ( r^{a} = i - \pi^{a} )

Borrowers/Firms are worse off

Lenders/Workers better off

It has been shown that higher inflation rates are correlated with more variability. 

People/Firms Don't Like the Uncertainty

PART IV: Unemployment

Measuring Unemployment

  • Standardized Unemployment Rate:

Labor Force = #Employed + #Unemployed but Looking Unemployment Rate = # Unemployed but Looking/Labor Force

This is the definition used in most countries, including the U.S.

Types of Unemployment 

  • Frictional Unemployment: Result of Matching Behavior between Firms and Workers.
  • Structural Unemployment: Result of Mismatch of Skills and Employer Needs  + Industry/Product structural change

  • Cyclical Unemployment: Result of Output being below full-employment
  • Is Zero Unemployment a Reasonable Policy Goal?

– No! Frictional and Structural Unemployment may be desirable (unavoidable).


Why We Care About Unemployment

  • Depreciation of Human Capital
  • Productive Extranalities 
  • Social Extranalities
  • Individual Self Worth

PART V: Preview of the model

The Mechanics of The Course (1)


The Demand Side

  • The aggregate demand (AD) curve represents the expenditure (demand) side of the economy. 
  • Aggregate demand curve will relate price changes with changes in 'real' expenditures.
  • Demand side of the economy will be the expenditure side of the economy!

 \text{Y = C + I + G + NX } (what we learned above)

  • We will prove later in the course that the AD curve slopes down (take my word for it now). As prices increase, aggregate demand in the economy will fall. 


The AD Curve: Graphical Representation

Let Y = Real GDP

Let P = the aggregate price level (measured by some price index)


The AD curve does not need to slope down linearly - it could have some curvature. We draw it linearly for simplicity.

The AD curve only shifts when C, I, G, or NX changes.

The Mechanics of The Course (2) 

The Supply Side

  • The aggregate supply (AS) curve represents the production (supply) side of the economy. The supply side of the economy is determined by firm production.
  • Aggregate supply curve relates price changes with changes in production.
  • The focus of next week's lecture will be on the aggregate production function for the economy. 

Y = f(inputs in the economy; land, labor, machines, oil, etc)

  • We will prove later in the course that the short run AS curve slopes upward (take my word again!). As prices increase, aggregate production in the economy will rise. 

The AS Curve: Graphical Representations 

Let Y = Real GDP

Let P = the aggregate price level (measured by some price index)


The short run AS curve is not linearly sloped. We usually draw it linearly for simplicity. In the real world, the SRAS curve is flatter at lower levels of GDP.

The AS curve only shifts when the price of factors of production change (things like oil prices, wages, and such) or the means of production change (technology) – wait for next week!

LONG RUN: Potential Output (Y*)

  • Potential Output (Y*) is going to be the level of output in the economy where the economy is in long run equilibrium. In other words, if no shocks hit the economy, the economy will stay at Y* (or it will gravitate towards Y*).

(ok, that definition is kind of technical, what does Y* really mean?)

  • Think of it this way, Y* is the level of economic activity that the economy was designed to sustain:

  • People are working the 'right' amount given labor market conditions (not working too much, not working too little),
  • Machines are working the right amount given profit maximizing conditions (not working too much, not working too little)

  • We will formalize this (and all concepts) as the course progresses.

Macroeconomic Equilibriums

  • Short run equilibrium: AD = AS
  • Long run equilibrium: AD = AS = Y* (economy at its potential level)

  • Formal definition of "recession": Y < Y*.
  • Formal definition of "expansion": Y > Y*

  • Note: Y* is not static – it evolves over time (as does AD and AS).

We are going to eventually model a "three equation dynamic system".

Short run equilibrium: AD equals short run AS (SRAS)

What does that mean? What is produced is equal to what is purchased (total expenditures).

Long run equilibrium: AD equals short run AS at the potential level of output 

      (Long run AS curve - Y* = LRAS)

What does that mean? What is produced is equal to what is purchased and what is produced is equal to the sustainable level of production. 

How are these equilibriums ensured? prices in the economy adjust (price level, interest rates, wages).

Business Cycles vs. Economic Growth

  • Business cycle analysis focuses on high frequency movements of Y

  • Why do we have recessions? Why do we have periods of economic expansions? 
  • High frequency macroeconomic analysis focus on quarters, years, maybe a decade

  • Economic growth analysis focuses on the evolution of Y* over time.

  • Typically focus is on low frequency macroeconomic analysis (decades, centuries)


Demand Shocks

The relationship between inflation and output when aggregate demand shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) 

If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y'). Prices will fall (from P to P').

If the economy receives a negative aggregate demand shock short run equilibrium If the economy receives a negative aggregate demand shock, short run equilibrium will move from point (a) to point (b). Output will fall (from Y* to Y’). Prices will fall (from P to P’).

Demand shocks cause prices and output to move in the same direction. (You should be able to illustrate a positive demand shock)

Supply Shocks

The relationship between inflation and output when aggregate supply shifts: Suppose we are in long run equilibrium at point (a) (AD = SRAS = LRAS) 

If the economy receives a negative short run aggregate supply shock, short run equilibrium will move from point (a) to point (c). Output will fall (from Y* to Y''). Prices will rise (from P to P'').

Supply shocks cause prices and output to move in opposite directions. (You should be able to illustrate a positive supply shock)

Reinterpreting the Business Cycle Data 1970-2001

1970 recession:

Inflation increasing at start of recession! 
High Increasing Inflation (supply shock: rising oil prices)

1981 recession:

Dramatic decrease in inflation at start of recession
No inflation (demand shock: Fed induced recession)

1990 recession:

Little increase in inflation/but low level of inflation (demand shock: fall in consumer confidence/oil price increase)

Rapid growth in mid 1990s:

No inflation (supply shock: IT revolution)

2001 recession:

No inflation (demand shock: over confidence by firms: inventory adjustment)

Current recession:

Inflation first up and then down (supply shock: oil price increase + demand sock: credit crunch + confidence loss)


The Supply Side of the Economy

Goals of Topic 2

Introduce the Supply Side of the Macro Economy:

  1. Production Function
  2. Labor Market:

  • Labor Demand
  • Labor Supply
  • Equilibrium Wages and Employment

Source: Veronica Guirrieri,
Creative Commons License This work is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike 3.0 License.

Production Function

The Production Function

  • GDP (Y) is produced with capital (K) and labor (N):

 \text{Y = A F(K,N)}

where A is Total Factor Productivity (TFP) 

= an index of efficiency in the use of inputs (technology)

  • Sometimes, I will modify the production function as follows:

\text{Y = A F(K,N, other inputs)}

where other inputs include energy/oil!

  • Realistic Example is a Cobb Douglas function for F(.):

 Y =A \, K^{a}N^{1-a}

with 0< α < 1


  • Y is GDP (it is measured in dollars). As noted above, we want to measure Y in "real" terms.<<you should know what this means from lecture 2>>.
  • For our Cobb Douglas production function, N is measured in number of workers and K in dollars:

– K often is measured as the replacement cost of capital

– N often is measured in number of workers

  • N can also be measured using
    total hours worked = number of workers × hours per worker
  • Wage differentials can help to measure "effective labor supply", taking into account "skill" differentials.

N.B.: sometimes we will use N to denote total population (e.g. income per capitaY/N)

Graphical Representation 1

  • Hold A and N constant (at levels A* and N*)
  • Graph Y as a function of K


1. As K increases Y increases (the curve is upward-sloping)

2. As K increases the marginal increase in production decreases (the curve becomes flatter as K increases)

Graphical Representation 2

  • Hold A and K constant (at levels A* and K*)
  • Graph Y as a function of N


1. As N increases Y increases (the curve is upward-sloping)

2. As N increases the marginal increase in production decreases (the curve becomes flatter as N increases)

Aggregate Production Function: Fact 1

1. Constant Returns to Scale

FACT 1: If you double the inputs, you double the output!

\text{2Y = AF(2K,2N)}


2Y = A (2K)^{α} \, (2N)^{1- α}= 2A \, K^{a}N^{1- α}

CRUCIAL: \text{α + (1- α) = 1}!

Aggregate Production Function: Fact 2

2. Diminishing Returns to N and K

Define \text{MPN = Marginal Product of Labor = dY/dN}

Define \text{MPK = Marginal Product of Capital = dY/dK}

FACT 2: MPN decreases with N and MPK decreases with K


      • \text{MPN = (1- α) A (K/N)}^{a}

Fixing A and K, MPN falls when N increases

      • \text{MPK = α A (N/K)}^{1-a}

Fixing A and N, MPK falls when K increases

Aggregate Production Function: Fact 3

3. Complementarities between A, K and N

FACT 3: The higher the level of capital (or technology), the higher the marginal product of labor (and symmetrically for capital!)


      • \text{MPN = (1- α) A (K/N)}^{a}

Increasing A or K, increases MPN

      • \text{MPK = α A (N/K)}^{1-a}

Increasing A or N, increases MPK

Aggregate Production Function: Fact 4

4. Elasticities and Income Shares

      • Elasticity is the percentage increase in Y (dependent variable) resulting from a 

1% increase in X (independent variable), everything else constant

\eta_{\mathrm{N}}=\% \text { change in } \mathrm{Y} / \% \text { change in } \mathrm{N}=(\mathrm{d} \mathrm{Y} / \mathrm{Y}) /(\mathrm{d} \mathrm{N} / \mathrm{N})=\mathrm{MPN} /(\mathrm{Y} / \mathrm{N})

FACT 4: Labor Elasticity ~.7

Capital Elasticity ~.3


      • \eta_{N}=(1-\alpha) \text { and } \eta_{K}=\alpha

That's why we pick  \text{α =.3} !!

      • Share of labor income out of total GDP is about 70%
        Share of capital income out of total GDP is about 30%

Two Notions of Productivity

  • \text{Labor Productivity = Y/N = A (K/N)}^{3}

Driven by A and K/N

  • \text{Total Factor Productivity (TFP) = Y/F(K,N) = A} 

Basically TFP is a 'catch-all' for anything that effects output other than K and N. 

  • Workweek of labor and capital 
  • Quality of labor and capital
  • Regulation
  • Infrastructure
  • Specialization
  • R&D, Innovation
  • Strategy (Entrepreneurial methods/new management techniques)

  • Some of the above tend to make TFP procyclical (capital utilization) 

(Definition of Procyclical: Variable increases when Y is high, decreases when Y is low)

Simple examples (in words)

  1. Technology: "It costs FedEx $2.40 to track a package for a customer who calls by phone, but only $0.04 for one who visits its website", says Rob Carter, the firm's technology boss.
  2. Technology: "Airline kiosks reduce costs of boarding to less than a third". 
  3. Management: Southwest’s oil hedging. Estimated oil price paid by SW: $31. United: $56. 
  4. Infrastructure: Imagine what it takes to buy intermediate inputs from a different region with roads like in Nigeria.

Measure of Labor productivity

Productivity Levels

United States = 100

Country GDP per capita
Labour productivity

Per person employed
Per hour worked
1995 2003 1995 2003 1995 2003
United States
100 100 100 100 100 100
Euro area
72 70 84 77 95 89
70 81 73  97 90
France 75 74 83 88 108 107
Italy 75 70
93 80 104 88
Spain 57 62 78 73 83 75
Netherlands 78 78 80 73 107
Belgium 78 76 98 92 111 106
Austria 84 79 81 74
98 87
Greece 47
52 64 70 61 64
Portugal 47 49 47 49
47 51
Finland 69 72 81 76 87 80
Ireland 64 87 86
92 86 99
81 74 82 69 71 69
United Kingdom
72 77 76 79 81 83
Canada 80 87 89 86 92 86
Sweden 77 75
70 71 80 86
Denmark 81 80 76 75 92 89
 Norway 86 96 84 92 110 123
 Iceland 81  76  83 74  84  73

The Labor Market

Part I: Labor Demand

  • In a competitive market, a firm can sell as much Y as it wants at the going
  • price p, and can hire as much N as it wants at the going wage w.
  • Facing w and p, a profit maximizing firm hires N to the point where
    \text{MPN = w/p} (the benefit from an additional worker, in terms of additional output, must equal the cost of hiring him). <<This is straight from micro>>

Why? MPN is decreasing in N, hence:

  • If MPN> w/p then the firm can increase profits by increasing N.
  • If MPN< w/p then the firm can increase profits by decreasing N.

  • With Cobb-Douglas: \text{MPN =.7 Y/N =.7 A (K/N).3}
  • If firms maximize profits: \text{w/p =.7 Y/N =.7 A (K/N).3}

The Labor Demand Curve

Notes on the Labor Demand Curve

  • For the moment keep A and K constant.
  • N_{d} slopes downward: N_{d} =\text{ MPN =.7 A * (K/N)}^{3}
  • N_{d}shifts up with A and K (complementarity)
  • Caveat: Who says that there is a demand for more Y?
    • Need to look at the demand side of economy (next lectures).

Part II: Labor Supply

  • Labor Supply Ns Results from Individual Optimization Decisions
  • Households compare benefits of working (additional lifetime resources) with cost of working (forgone leisure + effort)
  • How much labor an household will choose to supply as the real wage (before taxes) wp varies?
  • 2 effects:
    1. Substitution effect: higher real wage means higher reward to working, hence you want to work more!
    2. Income effect: higher real wage means you are richer, hence you need to work less to consume the same goods!

Refresh your memory from Micro!

  • Think of an agent who gets utility from consuming apples and bananas
  • From the utility maximization problem you get

\text{MU(apples)/ MU(bananas) = P(apples)/P(bananas)}

  • If P(apples) increases:
    1. Substitution effect: you want to increase MU(apples)/ MU(bananas). By the law of diminishing marginal utility you need to consume less apples and more bananas! You subsitute away from apples towards bananas
    2. Income effect: you spend more for the apples that you buy, so you are poorer. You will consume less apples AND bananas!

From Micro to Macro

  • The two goods that the household can consume are now consumption (C) and leisure (L)
  • The household can spend 1 unit of time either working (N) or having fun (L), that is \text{N + L = 1}
  • The budget constraint is \text{WN = PC (and P(C)=P} for simplicity) with \text{N=1-L}. Then we can write a static version of the maximization problem as:

\text{Max U(C,L)}

 \text{s.t. W = PC + WL}

  • The price of leisure is the foregone wages, that is P(L) = W. Then

\text{MU(L)/ MU(C) = W/ P}

  • If W/P increases:
    1. Substitution effect: you want to increase \text{MU(L)/ MU(C)}. By the law of diminishing marginal utility you need to subsitute away from leisure towards consumption goods. Then you need to work more!
    2. Income effect: you have higher wages, so you are richer. You will consume more C and L. To consume more L, you need to work less!

Back to the Labor Supply

  • In reality the household problem is not static. Define \text{PVLR = present value of life time resources}, that determines the household income. life time resources, that determines the household income.
  • For simplicity to graph the Labor Supply we separate income and substitution effects by separating PVLR from the current real wage w/p effects by separating PVLR from the current real wage w/p.
  • PVLR represents the income effect and w/p the substitution effect.
  • SHORTCUT: if w/p increases permanently PVLR increases as well, BUT if w/p increases temporarily only, then PVLR increases just a tiny bit so that we assume that PVLR does not change!

The Labor Supply Curve

  • Factors Affecting Labor Supply
  • The Real Wage (w/p)
  • The Household's Present Value of Lifetime Resources (PVLR)
  • The Marginal Tax Rate on Labor Income(tn)
  • The Marginal Tax Rate on Consumption (tc)
  • Value of Leisure (reservation wage) - non-'work' status (VL)
  • The Working Age Population (pop)
  • Labor Supply (Ns) shows the relationship between real wages and hours worked holding everything else constant (included (PVLR)!)

The Labor Supply Curve: Substitution Effect

The Labor Supply Curve: Income effect

\text{PVLR → PVLR'(< PVLR) = income effect}!

What affects the Labor Supply?

  • The Real Wage - HOLDING PVLR fixed: A higher w/p encourages individuals to substitute away from leisure toward work (leisure becomes more expensive). This is a substitution effect.  <<This is why the labor supply curve slopes upwards>>
  • Estimating this substitution effect is difficult since PVLR is not easily held constant. Estimates range from 0 - 2 (For a 1% increase in after-tax w/p holding PVLR fixed, labor supply either increases between 0% and 2%). Very Wide Range – little consensus.
  • \text{PVLR = initial wealth + present discounted value of earnings}
  • A higher PVLR induces individuals to work less (lower Ns ) for a given after-tax wage, allowing them to enjoy more leisure (If leisure is preferred to work – as I get richer, I can afford to work less). <<This is represented by a shift of the supply curve >>
  • PVLR is net of taxes and non-work governmental transfers and inclusive of all other transfers.
  • Marginal tax rate on labor income- Should have same substitution effect as the before tax real wage. Studies of the 1986 U.S. Tax Reform found that only high-earning married women worked more in response to lower marginal income tax rates. income tax rates.
    • Marginal tax rate on consumption - see above
    • Value of Leisure - If leisure/no-work becomes more/less attractive, households will work less/more (think about welfare programs, child care,…)
  • Working Age Population: Usually defined as 16-64 (includes changes in Labor Force Participation Rates)

Recap on Labor Supply

  • Substitution Effect:

– For a given PVLR, a higher after tax wage increases NS.

          • This is why Labor Supply Curve Slopes Upward
  • Income Effect

– For a given after-tax wage, higher PVLR decreases (Ns).

  • Evidence:

– Weak Consensus is that, with equal (%) increase in PVLR and after-tax wage, (Ns)falls (income effect dominates)

Part III: Labor Market Equilibrium

Temporary Increase in A

Permanent Increase in A

N* < N" → Here income effect is dominated!

Can Technological Progress destroy jobs?


A N w/p are trending up over time A, N, w/p are trending up over time.

N/pop is trending down (except in U.S. since 1980).

Higher A countries have higher w/p and lower N/pop.


Adjusting for pop, higher A goes with lower N.

Higher A reduces Nd and destroys jobs? - NO! Labor Demand Increases.

Higher A increases PVLR and reduces Ns.It is Labor Supply that falls


What happened to US Wage inequality?


Differential shift of A on different skill markets

Permanent Increase in pop

Population and Jobs

Temporary vs Permanent Increase in Taxes (tc or tn)

Temporary Increase in Taxes (tc or tn)

After tax wage SHIFTS the supply curve!!


Permanent Increase in Taxes (tc or tn)

Income effect can dominate or not! Try the other case


Labor Market Equilibrium (Long Run)

  • We define Long Run Equilibrium in macroeconomics as occurring when the labor market clears.
  • By definition, long run macro equilibrium exists when \text{N = N*}.
  • At N*, labor demand = labor supply. So, by definition, all workers who want a job (the suppliers) are able to find a firm looking for a worker (the demanders).
    Long run equilibrium is characterized by zero cyclical unemployment!
  • It is an equilibrium such that there is no incentive for real wages to change at N*
    Real wages have 2 components: nominal wages (w) and the price level (p).
  • Define Y* as the long run equilibrium level of output (output when labor market is in equilibrium):
    \text{Y* = A K.3(N*).7}

Long Run Aggregate Supply

  • Suppose prices (p) increase. What happens in the labor market?
      • In terms of equilibrium, nothing happens!
      • Increasing prices have no effect on labor demand (A and K do not change).
      • Increasing prices have no effect on labor supply (taxes, population, etc. do not change).
      • You may ask "Doesn't PVLR change when prices increase???" No!
        • As long as nominal wages adjust, real wages will be unchanged when p increases.
        • The % change in prices will be matched exactly by the % change in nominal wages – real wages will not change (so PVLR will not change).
        • No effect on labor supply.
      • Key: Because real wages will not change, changes in prices will have NO effect on the labor market (.e., it will have no effect on N).*
  • Conclusion: Changing prices will have NO effect on Y* (since N* is constant).

Long Run Aggregate Supply curve

  • If labor market clears, changes in prices will lead to equal changes in nominal wages.
    As a result, there will be no change in N* and hence no change in Y*.
  • Leads to a vertical LRAS curve. Prices do not affect production in the long run!

What shifts Y*? (the LRAS)

  • Anything that affects the labor market will affect Y*!
  • If N* increases, Y* will shift to the right.
  • If N* decreases, Y* will shift to the left.
  • Summary: Y* will shift right if:
  • A increases
  • K increases
  • population increases
  • labor income taxes fall (and income effect is small relative to substitution effect)
  • labor income taxes rise (and income effect is large relative to substitution effect)

Take out

  • In the long run – when labor markets clear.
    – Supply side of economy (labor market, K, A, other inputs like oil) determines output.
    – Demand side of economy (C+I+G+NX) will determine prices.
  • In the short run – when labor markets do not clear:
    – Demand and Supply jointly determine prices and output.
    – Three outstanding issues (we will get to them soon):
        • What determines demand?
        • When is the labor market NOT in equilibrium?
        • What does the supply curve look like when labor market doesn't clear?

Preview: Disequilibrium in Labor Markets

  • When do we get cyclical unemployment in our models? So far NO unemployment! We need some frictions  in the labor market to get cyclical unemployment.
  • Cyclical unemployment occurs when labor demand is smaller than labor supply at current wages (one story: nominal wages do not adjust to clear the labor market).
  • Cyclical unemployment occurs only in disequilibrium!


Trends in Actual (Standardized) Unemployment Rates














































































Why is Unemployment So High In Europe?

  1. High labor income tax rates (tn)
  2. Firing restrictions
  3. Centralized wage setting
  4. High minimum wages
  5. Powerful unions and insiders
  6. Generous unemployment benefits