Chapter 10

Aggregate Supply and Aggregate Demand

Quantity Supplied and Supply
The quantity of real GDP supplied is the total quantity of goods and services, valued in constant base
year (2005) dollars, that firms plan to produce during a given period. Aggregate supply is the
relationship between the quantity of real GDP supplied and the price level. We distinguish two time
frames associated with different states of the labor market:

Long-run aggregate supply

Short-run aggregate supply

Long-Run Aggregate Supply

Long-run aggregate supply is the relationship between the quantity of real GDP supplied and the
price level when real GDP equals potential GDP. At full employment, the quantity of real GDP
supplied is potential GDP, which depend on the full-employment quantity of labor. Potential GDP is
independent of the price level when the money wage rate changes in step with the price level to
maintain full employment. So the long-run aggregate supply curve (LAS) is vertical at potential GDP.
The long-rum aggregate supply curve is vertical because potential GDP is independent of the price
level. The reason for this independence is that a movement along the LAS curve is accompanied by a
change in two sets of prices; the price of goods and services- price level and the prices of the factors
of production, the money wage rate. Because the price level and money wage rate change by the
same percentage, the real wage rate remains unchanged at its full-employment equilibrium level.
Short-Run Aggregate Supply
Short-run aggregate supply is the relationship between the quantity of real GDP supplied and the
price level when the money wage rate, the prices of other resources, and potential GDP remain
constant. A rise in the price level with no change in the money wage rate and other factor prices
increases the quantity of real GDP supplied. The short-run aggregate supply curve (SAS) is upward
sloping.
Changes in Aggregate Supply
Aggregate supply changes if an influence on production plans other than the price level changes.
These influences include
Changes in Potential GDP
When potential GDP increases, both the LAS and SAS curves shift rightward. The two supply curves
shifts by the same amount only if the full-employment price level remains constant.
Potential GDP changes for three reasons:
An increase in the full-employment quantity of labor: Potential GDP increase
because labor force increases. But (with constant capital and technology) potential
GDP increase only if the full-employment quantity of labor increases.
An increase in the quantity of capital (physical or human) : for the economy, the
larger the quantity of capital (human capital), the more productive is the labor force
and the greater is its potential GDP.

 An advance in technology: Technological change enables firms to produce more

from any given amount of factors of production, so increase potential GDP.
The quantity of real GDP demanded, Y, is the total amount of final goods and services produced in
the United States that people, businesses, governments, and foreigners plan to buy. This quantity is
the sum of consumption expenditures, C, investment, I, government expenditure, G, and net
exports, X M.
That is,

Y = C + I + G + X M.

Buying plans depend on many factors and some of the main ones are
The price level
Expectations
Fiscal policy and monetary policy
The world economy
The Aggregate Demand Curve
Aggregate demand is the relationship between the quantity of real GDP demanded and the price
level. The aggregate demand curve (AD) plots the quantity of real GDP demanded against the price
level.
Wealth Effect
A rise in the price level, other things remaining the same, decreases the quantity of real wealth
(money, bonds, stocks, etc. that people own in terms of the goods and services that money, bonds,
and stocks will buy). To restore their real wealth, people increase saving and decrease spending.
(decrease consumption) The quantity of real GDP demanded decreases. Similarly, a fall in the price
level, other things remaining the same, increases the quantity of real wealth, which increases the
quantity of real GDP demanded (increase consumption)
Substitution Effects
Intertemporal substitution effect: A rise in the price level, other things remaining the same,
decreases the real value of money and raises the interest rate. When the interest rate rises, people
borrow and spend less, so the quantity of real GDP demanded decreases. This substitution effect
involves changing the timing of purchases of capital and consumer durable goods is call
Intertemporal substitution effect a substitution across time. Saving increase to increase future
consumption. Similarly, a fall in the price level increases the real value of money and lowers the
interest rate. When the interest rate falls, people borrow and spend more, so the quantity of real
GDP demanded increases.
International substitution effect: A rise in the price level, other things remaining the same, increases
the price of domestic goods relative to foreign goods. So imports increase and exports decrease,
which decreases the quantity of real GDP demanded. Similarly, a fall in the price level, other things
remaining the same, increases the quantity of real GDP demanded.
Changes in Aggregate Demand
A change in any influence on buying plans other than the price level changes aggregate demand.
The main influences on aggregate demand are

Expectations
Expectations about future income, future inflation, and future profits change aggregate demand.
Increases in expected future income increase peoples consumption today and increases aggregate
demand. A rise in the expected inflation rate makes buying goods cheaper today and increases
aggregate demand. An increase in expected future profits boosts firms investment, which increases
aggregate demand.
Fiscal Policy and Monetary Policy
Fiscal policy is the governments attempt to influence the economy by setting and changing taxes,
making transfer payments, and purchasing goods and services. A tax cut or an increase in transfer
payments increases households disposable incomeaggregate income minus taxes plus transfer
payments. An increase in disposable income increases consumption expenditure and increases
aggregate demand. Because government expenditure on goods and services is one component of
aggregate demand, an increase in government expenditure increases aggregate demand. The Feds
attempt to influence the economy by changing the interest rate and adjusting the quantity of money
is called monetary policy. An increase in the quantity of money increases buying power and
increases aggregate demand. A cut in interest rates increases expenditure and increases aggregate
demand.
The World Economy
The world economy influences aggregate demand in two ways:
A fall in the foreign exchange rate lowers the price of domestic goods and services relative to foreign
goods and services, which increases exports, decreases imports, and increases aggregate demand.
An increase in foreign income increases the demand for U.S. exports and increases aggregate
demand.
Decreases if

Expected future income, inflation, or profit decreases.

Fiscal policy decreases government expenditure, increase taxes, or decrease transfer

payments

Monetary policy decrease the quantity of money and increase interest rate

The exchange rate increases or foreign income decreases.

Increases if

Expected future income, inflation, or profit increases.

Fiscal policy increases government expenditure, decrease taxes, or increase transfer

payments

Monetary policy increase the quantity of money and decrease interest rate

The exchange rate decreases or foreign income increases.

Short-Run Macroeconomic Equilibrium

Short-run macroeconomic equilibrium occurs when the quantity of real GDP demanded equals the
quantity of real GDP supplied at the point of intersection of the AD curve and the SAS curve.

Long-Run Macroeconomic Equilibrium

Long-run macroeconomic equilibrium occurs when real GDP equals potential GDPwhen the
economy is on its LAS curve. Long-run equilibrium occurs at the intersection of the AD and LAS
curves.
The Business Cycle in the AS-AD Model
The business cycle occurs because aggregate demand and the short-run aggregate supply fluctuate,
but the money wage does not change rapidly enough to keep real GDP at potential GDP. An above
full-employment equilibrium is an equilibrium in which real GDP exceeds potential GDP. A fullemployment equilibrium is an equilibrium in which real GDP equals potential GDP. A below fullemployment equilibrium is an equilibrium in which potential GDP exceeds real GDP.
Fluctuations in Aggregate Demand
One reason real GDP fluctuates around potential GDP is that aggregate demand fluctuates.
Figure 10.10 shows the effects of an increase in aggregate demand. Suppose world economy expand
An increase in aggregate demand shifts the AD curve rightward. Firms increase production and the
price level rises in the short run.

At the short-run equilibrium, there is an inflationary gap. The money wage rate begins to rise and
the SAS curve starts to shift leftward. The price level continues to rise and real GDP continues to
decrease until it equals potential GDP.

Fluctuations in Aggregate Supply

Fluctuations in short-run aggregate supply can bring fluctuations in real GDP around potential GDP.
Figure 10.11 shows the effects of a rise in the price of oil. With higher energy and transportation
costs, firm decreases production. Aggregate supply decreases The SAS curve shifts leftward. Real
GDP decreases and the price level rises. The economy experiences stagflation. (real GDP
decreaseeconomy recession Price level increase.economy inflation)

Macroeconomists can be divided into three broad schools of thought:

The Classical View
A classical macroeconomist believes that the economy is self-regulating and always at full
employment. The term classical derives from the name of the founding school of economics that
includes Adam Smith, David Ricardo, and John Stuart Mill. A new classical view is that business cycle
fluctuations are the efficient responses of a well-functioning market economy that is bombarded by
shocks that arise from the uneven pace of technological change.
The Keynesian View
A Keynesian macroeconomist believes that left alone, the economy would rarely operate at full
employment and that to achieve and maintain full employment, active help from fiscal policy and
monetary policy is required. The term Keynesian derives from the name of one of the twentieth
centurys most famous economists, John Maynard Keynes. A new Keynesian view holds that not
only is the money wage rate sticky but also are the prices of goods.
The Monetarist View
A monetarist is a macroeconomist who believes that the economy is self-regulating and that it will
normally operate at full employment, provided that monetary policy is not erratic and that the pace
of money growth is kept steady. The term monetarist was coined by an outstanding twentiethcentury economist, Karl Brunner, to describe his own views and those of Milton Friedman.

Reference: Michael Parkin. Macroeconomics. (Eleventh Edition).

Chapter 11
Expenditure Multipliers
Expenditure Plans
The components of aggregate expenditure sum to real GDP. That is, Y = C + I + G + X M.
Two of the components of aggregate expenditure, consumption expenditure and imports, are
influenced by real GDP. So there is a two-way link between aggregate expenditure and real GDP.
Two-Way Link Between Aggregate Expenditure and Real GDP Other things remaining the same,
An increase in real GDP increases aggregate expenditure.
An increase in aggregate expenditure increases real GDP.
Consumption and Saving Plans
Consumption expenditure is influenced by many factors (Disposable income, real interest rate,
wealth and expected future income) but the most direct one is disposable income. Disposable
income (aggregate income minus taxes plus transfer payment) is aggregate income or real GDP, Y,
minus net taxes, T. Call disposable income YD. The equation for disposable income is YD = Y T
Disposable income, YD, is either spent on consumption goods and services, C, or saved, S. That is,
YD = C + S. The relationship between consumption expenditure and disposable income, other things
remaining the same, is the consumption function. The relationship between saving and disposable
income, other things remaining the same, is the saving function.
Figure 11.1 illustrates the consumption function and the saving function. When consumption
expenditure exceeds disposable income, saving is negative (dissaving). When consumption
expenditure is less than disposable income, there is saving.

Marginal Propensities to Consume and Save

The marginal propensity to consume (MPC) is the fraction of a change in disposable income spent
on consumption. It is calculated as the change in consumption expenditure, C, divided by the
change in disposable income, YD, that brought it about. That is, MPC = C YD
Figure 11.2(a) shows that the MPC is the slope of the consumption function. When disposable
income increases by $2 trillion, consumption expenditure increases by $1.5 trillion. The MPC is
0.75 (1.5/2).

The marginal propensity to save (MPS) is the fraction of a change in disposable income that is saved.
It is calculated as the change in saving, S, divided by the change in disposable income, YD, that
brought it about. That is,
MPS = S YD.
Figure 11.2(b) shows that the MPS is the slope of the saving function. When disposable income
increases by $2 trillion, saving increases by $0.5 trillion. The MPS is 0.25 (0.5/2).

The MPC plus the MPS equals 1. To see why, note that, C + S =YD. Divide this equation by YD to
obtain, C/YD + S/YD = YD/YD or MPC + MPS = 1.
Consumption as a Function of Real GDP
Consumption expenditure changes when disposable income changes and disposable income changes
when real GDP changes Disposable income changes when either real GDP changes or net taxes
change. If tax rates dont change, real GDP is the only influence on disposable income, so
consumption expenditure is a function of real GDP. We use this relationship to determine real GDP
when the price level is fixed.
Import Function
In the short run, U.S. imports are influenced primarily by U.S. real GDP. The marginal propensity to
import is the fraction of an increase in real GDP spent on imports. If an increase in real GDP of $1
trillion increases imports by $0.25 trillion, the marginal propensity to import is 0.25 (0.25/1).
Marginal propensity to import = import real GDP When the price level is fixed, aggregate
demand is determined by aggregate expenditure plans. Aggregate planned expenditure is planned
consumption expenditure plus planned investment plus planned government expenditure plus
planned exports minus planned imports. Planned consumption expenditure and planned imports
are influenced by real GDP. When real GDP increases, planned consumption expenditure and
planned imports increase. Planned investment plus planned government expenditure plus planned
exports are not influenced by real GDP.
Aggregate Planned Expenditure
The relationship between aggregate planned expenditure and real GDP can be described by an
aggregate expenditure schedule, which lists the level of aggregate expenditure planned at each

level of real GDP. The relationship can also be described by an aggregate expenditure curve, which
is a graph of the aggregate expenditure schedule.
Figure 11.3 shows how the aggregate expenditure curve (AE) is built from its components.

Consumption expenditure minus imports, which varies with real GDP, is induced expenditure. The
sum of investment, government expenditure, and exports, which does not vary with GDP, is
autonomous expenditure. (Consumption expenditure and imports can have an autonomous
component.)
Actual Expenditure, Planned Expenditure, and Real GDP
Actual aggregate expenditure is always equal to real GDP. Aggregate planned expenditure may differ
from actual aggregate expenditure because firms can have unplanned changes in inventories.
Equilibrium Expenditure is the level of aggregate expenditure that occurs when aggregate planned
expenditure equals real GDP.
Figure 11.4 illustrates equilibrium expenditure. Equilibrium occurs at the point at which the AE curve
crosses the 45 line in part (a). Equilibrium occurs when there are no unplanned changes in business
inventories in part (b).

Convergence to Equilibrium
From Below Equilibrium If aggregate planned expenditure exceeds real GDP, there is an unplanned
decrease in inventories. To restore inventories, firms hire workers and increase production. Real
GDP increases.

From Above Equilibrium If real GDP exceeds aggregate planned expenditure, there is an
unplanned increase in inventories. To reduce inventories, firms fire workers and decrease
production. Real GDP decreases.

When autonomous expenditure changes, so does equilibrium expenditure and real GDP. But the
change in equilibrium expenditure is larger than the change in autonomous expenditure. The
multiplier is the amount by which a change in autonomous expenditure is magnified or multiplied to
determine the change in equilibrium expenditure and real GDP.
The Basic Idea of the Multiplier
An increase in investment (or any other component of autonomous expenditure) increases
aggregate expenditure and real GDP. The increase in real GDP leads to an increase in induced
expenditure. The increase in induced expenditure leads to a further increase in aggregate
expenditure and real GDP. So real GDP increases by more than the initial increase in autonomous
expenditure.
Figure 11.5 illustrates the multiplier. An increase in autonomous expenditure brings an unplanned
decrease in inventories. So firms increase production and real GDP increases to a new equilibrium.

Why Is the Multiplier Greater than 1? It is because an increase in autonomous expenditure induces
further increases in aggregate expenditure. The multiplier is the amount by which a change in
autonomous expenditure is multiplied to determine the change in equilibrium expenditure that it
generates.
The Size of the Multiplier is the change in equilibrium expenditure divided by the change in
autonomous expenditure.

The Multiplier and the Slope of the AE Curve

The slope of the AE curve determines the magnitude of the multiplier: Multiplier = 1 (1 Slope of
AE curve) If the change in real GDP is DY, the change in autonomous expenditure is DA, and the
change in induced expenditure is DN, then Multiplier = DY DA To see why the multiplier = 1 (1
Slope of AE curve), begin with the fact that: DY = DN + DA. But Slope of AE curve = DN DY so,
DN = (Slope of AE curve x DY). Now replace DN in the first equation DY = (Slope of AE curve x DY) +
DA. DY = (Slope of AE curve x DY) + DA Re-arrange as (1 - Slope of AE curve) x DY = DA and DY = DA
(1 - Slope of AE curve) Multiplier = DY DA So Multiplier = 1 (1 - Slope of AE curve) With the
numbers in Figure 11.5, the slope of the AE curve is 0.75, so the multiplier is DY DA = 1 (1 - 0.75)
= 1 (0.25) = 4. When there are no income taxes and no imports, the slope of the AE curve equals
the marginal propensity to consume, so the multiplier is Multiplier = 1 (1 - MPC). But 1 MPC =
MPS, so the multiplier is also Multiplier = 1 MPS. Because the marginal propensity to save (MPS) is
a fraction- a number between 0 and 1- the multiplier is greater than 1.
Imports and Income Taxes
Both imports and income taxes make the AE curve less steep and reduce the size of the multiplier.
Figure 11.6 shows how. In part (a) with no taxes or imports, the slope of the AE curve is 0.75 and the
multiplier is 4.

The Multiplier Process

Figure 11.7 illustrates the multiplier process. The MPC determines the magnitude of the amount of
induced expenditure at each round as aggregate expenditure moves toward equilibrium
expenditure.

Y = I + bI + b2I + b3I + b4I + b5I + . (where b = slope of AE curve). Multiply by b to obtain bY

= bI + b2I + b3I + b4I + b5I + . bn approaches zero as n becomes large so b(n + 1) also approaches
zero. Subtract the second equation from the first to obtain Y bY = I, or (1 b) Y = I, so that
Y = I (1 b).

Business Cycle Turning Points

Turning points in the business cyclepeaks and troughsoccur when autonomous expenditure
changes. An increase in autonomous expenditure brings an unplanned decrease in inventories,
which triggers an expansion. A decrease in autonomous expenditure brings an unplanned increase in
inventories, which triggers a recession.
Adjusting Quantities and Prices
Real firms dont hold their prices constant for long. When firms have an unplanned change in
inventories, they change production and prices. And the price level changes when firms change
prices. The AS-AD model explains the simultaneous determination of real GDP and the price level.
The two models are related.
Aggregate Expenditure and Aggregate Demand
The aggregate expenditure curve is the relationship between aggregate planned expenditure and
real GDP, with all other influences on aggregate planned expenditure remaining the same. The
aggregate demand curve is the relationship between the quantity of real GDP demanded and the
price level, with all other influences on aggregate demand remaining the same.
Deriving the Aggregate Demand Curve
When the price level changes, aggregate planned expenditure changes and the quantity of real GDP
demanded changes. There are two main reasons: A wealth effect and substitution effects change
aggregate planned expenditure and change the quantity of real GDP demanded.
Wealth Effect
Other things remaining the same, the higher the price level, the smaller is the purchasing power of
wealth. The higher the price level, other things remaining the same, the lower is aggregate planned
expenditure.
Substitution Effects
For a given expected future price level, a rise in the price level today makes current goods and
services more expensive relative to future goods and services and results in a delay in purchases an
intertemporal substitution. When the price level rises, the aggregate expenditure curve shifts
downward. A fall in price level has the opposite effect. When the price level falls, the aggregate
expenditure curve shifts upward.

Reference: Michael Parkin. Macroeconomics. (Eleventh Edition).

Chapter 12
Inflation, Jobs, and Business Cycle
In the long run, inflation occurs if the quantity of money grows faster than potential GDP. In the
short run, many factors can start an inflation, and real GDP and the price level interact. To study
these interactions, we distinguish between two sources of inflation:
- Demand-Pull Inflation An inflation that starts because aggregate demand increases is called
demand-pull inflation. Demand-pull inflation can begin with any factor that increases aggregate
demand. Examples are a cut in the interest rate, an increase in the quantity of money, an increase in
government expenditure, a tax cut, an increase in exports, or an increase in investment stimulated
by an increase in expected future profits.
Initial Effect of an Increase in Aggregate Demand Figure 12.1(a) illustrates the start of a demandpull inflation. Starting from full employment, an increase in aggregate demand (Fed cut interest rate)
shifts the AD curve rightward. With no change in potential GDP and no change in wage rateaggregate supply curve remain at LAS and SAS0

Money Wage Rate Response Real GDP cannot remain above potential GDP. There is a shortage of
labor. The money wage rate rises and the SAS curve shifts leftward. The price level rises and real
GDP decreases back to potential GDP.

A Demand-Pull Inflation Process Figure 12.2 illustrates a demand-pull inflation spiral. One-time rise
in the price level is not an inflationfor inflation, the aggregate demand must persistently increase.
Aggregate demand keeps increasing and the process just described repeats indefinitely.

- Cost-Push Inflation An inflation that starts with an increase in costs is called cost-push inflation.
There are two main sources of increased costs:
1. An increase in the money wage rate
2. An increase in the money price of raw materials, such as oil
Initial Effect of a Decrease in Aggregate Supply Figure 12.3(a) illustrates the start of cost-push
inflation. A rise in the price of oil decreases short-run aggregate supply and shifts the SAS curve
leftward. Real GDP decreases and the price level rises.

Aggregate Demand Response The initial increase in costs creates a one-time rise in the price level,
not inflation. Something more must happen to enable a one-time supply shock, which causes a one
time rise in the price level, to be converted to ongoing inflation. To create inflation, aggregate
demand must increase. That is, the Fed must increase the quantity of money persistently.
A Cost-Push Inflation Process If the oil producers raise the price of oil to try to keep its relative price
higher, ... and the Fed responds by increasing the quantity of money, ... a process of cost-push
inflation continues.

Expected Inflation Figure 12.5 illustrates an expected inflation. Aggregate demand increases, but the
increase is expected, so its effect on the price level is expected.

So If inflation is expected because people expected inflation, the money wage rate increased and
the price level increasedBut the expectation was correct. Aggregate demand was expected to
increase.. and it did increase. It s the actual and expected in aggregate demand that caused the
inflation.
Forecasting Inflation To expect inflation, people must forecast it. The best forecast available is one
that is based on all the relevant information and is called a rational expectation. A rational
expectation is not necessarily correct, but it is the best available.

Inflation and the Business Cycle When the inflation forecast is correct, the economy operates at full
employment. If aggregate demand grows faster than expected, real GDP moves above potential
GDP, the inflation rate exceeds its expected rate, and the economy behaves like it does in a demandpull inflation. (Real GDP decrease and price level increase) If aggregate demand grows more slowly
than expected, real GDP falls below potential GDP, the inflation rate slows, and the economy
behaves like it does in a cost-push inflation. (Both Real GDP and price level increase) A Phillips curve
is a curve that shows the relationship between the inflation rate and the unemployment rate There
are two time frames for Phillips curves:
The Short-Run Phillips Curve shows the tradeoff between the inflation rate and unemployment
rate, holding constant
1. The expected inflation rate
2. The natural unemployment rate
Figure 12.6 illustrates a short-run Phillips curve (SRPC)a downward-sloping curve. It passes
through the natural unemployment rate and the expected inflation rate.

With a given expected inflation rate and natural unemployment rate: If the inflation rate rises above
the expected inflation rate, the unemployment rate decreases. If the inflation rate falls below the
expected inflation rate, the unemployment rate increases.

The Long-Run Phillips Curve shows the relationship between inflation and unemployment when the
actual inflation rate equals the expected inflation rate.
Figure 12.7 illustrates the long-run Phillips curve (LRPC), which is vertical at the natural
unemployment rate. Along LRPC, a change in the inflation rate is expected, so the unemployment
rate remains at the natural unemployment rate.

The SRPC intersects the LRPC at the expected inflation rate10 percent a year in the figure. If
expected inflation falls from 10 percent to 6 percent a year, ... (a change in the expected inflation
rate shifts the short run Phillips curve but it does not shift the long run Phillips curve) the short-run
Phillips curve shifts downward by an amount equal to the fall in the expected inflation rate.

Business cycles are easy to describe but hard to explain. Two approaches to understanding business
cycles are:
Mainstream Business Cycle Theory Because potential GDP grows at a steady pace while aggregate
demand grows at a fluctuating rate (because the money wage rate is sticky), real GDP fluctuates
around potential GDP. If aggregate demand grows faster than potential GDP, real GDP move above
potential GDP and an inflationary gap emerges. And if aggregate demand grows slower than
potential GDP, real GDP move below potential GDP and a recessionary gap emerges Expansion
Initially, potential GDP is $10 trillion and the economy is at full employment at point A. Potential
GDP increases to $13 trillion and the LAS curve shifts rightward.

Real business cycle theory regards random fluctuations in productivity as the main source of
economic fluctuations. These productivity fluctuations are assumed to result mainly from
fluctuations in the pace of technological change. But other sources might be international
disturbances, climate fluctuations, or natural disasters. Well explore RBC theory by looking first at
its impulse and then at the mechanism that converts that impulse into a cycle in real GDP.
The RBC Impulse The impulse is the productivity growth rate that results from technological change.
Most of the time, technological change is steady and productivity grows at a moderate pace. But
sometimes productivity growth speeds up, and occasionally it decreaseslabor becomes less
productive, on average. A period of rapid productivity growth brings an expansion, and a decrease
in productivity triggers a recession. The figure on the next slide shows the RBC impulse.

The RBC Mechanism Two effects follow from a change in productivity that gets an expansion or a
contraction going:
1. Investment demand changes.
2. The demand for labor changes.
Figure 12.10(a) shows the effects of a decrease in productivity on investment demand. A decrease in
productivity decreases investment demand, which decreases the demand for loanable funds. The
real interest rate falls and the quantity of loanable funds decreases.

The Key Decision: When to Work? To decide when to work, people compare the return from
working in the current period with the expected return from working in a later period. The when-towork decision depends on the real interest rate. The lower the real interest rate, the smaller is the
supply of labor today. Many economists believe that this intertemporal substitution effect is small,
but RBC theorists believe that it is large and the key feature of the RBC mechanism.
Criticisms and Defence of RBC Theory
The three main criticisms of RBC theory are that
1. The money wage rate is sticky, and to assume otherwise is at odds with a clear fact.
2. Intertemporal substitution is too weak a force to account for large fluctuations in labor supply and
employment with small real wage rate changes.
3. Productivity shocks are as likely to be caused by changes in aggregate demand as by technological
change.
Defenders of RBC theory claim that
1. RBC theory explains the macroeconomic facts about business cycles and is consistent with the
facts about economic growth. RBC theory is a single theory that explains both growth and cycles.
2. RBC theory is consistent with a wide range of microeconomic evidence about labor supply
decisions, labor demand and investment demand decisions, and information on the distribution of
income between labor and capital.

Reference: Michael Parkin. Macroeconomics. (Eleventh Edition).

Chapter 13
Fiscal Policy
The Federal Budget
The federal budget is the annual statement of the federal governments outlays and tax revenues.
The federal budget has two purposes:
1. To finance the activities of the federal government
2. To achieve macroeconomic objectives
Fiscal policy is the use of the federal budget to achieve macroeconomic objectives, such as full
employment, sustained economic growth, and price level stability.
The Institutions and Laws
The President and Congress make fiscal policy. Figure 13.1 shows the timeline for the 2013 budget.

Employment Act of 1946

Fiscal policy operates within the framework of the Employment Act of 1946 in which Congress
declared that it is the continuing policy and responsibility of the Federal Government to use all
practicable means to coordinate and utilize all its plans, functions and resources to promote
maximum employment, production and purchasing power.
The Council of Economic Advisers
It monitors the economy and keeps the President and the public well informed about the current
state of the economy and the best available forecasts of where it is heading. This economic
intelligence activity is one source of data that informs the budget-making process.
Highlights of the 2013 Budget
The projected fiscal 2013 Federal Budget has receipts of $3,136 billion, outlays of $4,133 billion, and
a projected deficit of $997 billion. Receipts come from personal income taxes, Social Security taxes,
corporate income taxes, and indirect taxes. Personal income taxes are the largest revenue source.
Outlays are transfer payments, expenditure on goods and services, and debt interest. Transfer
payments are the largest item of outlays.

Surplus or Deficit
The federal governments budget balance equals receipts
minus outlays. If receipts exceed outlays, the government has
a budget surplus .If outlays exceed receipts, the government
has a budget deficit. If receipts equal outlays, the government
has a balanced budget. The projected budget deficit in fiscal
2013 is $997 billion.
The Budget in Historical Perspective
Figure 13.2 shows the governments receipts, outlays, and
budget balance as a percentage of GDP. The budget deficit peaked at almost 12 percent of GDP in
2010. The previous peak was 6 percent in 1983. The deficit declined through 1989 but climbed again
during the 19901991 recession and then began to shrink. In 1998, a surplus emerged, but by 2002,
the budget was again in deficit. The deficit after 2008 reached a new all-time high because outlays
increased.
Budget Balance and Debt
Government debt is the total amount that the government
has borrowed. It is the sum of past deficits minus past
surpluses.
Figure 13.4 shows the federal governments gross debt and
net debt.

State and Local Budgets

The total government sector includes state and local governments as well as the federal
government. In 2013, when federal government outlays were about $4,133 billion, state and local
outlays were a further $2,000 billion. Most of state expenditures were on public schools, colleges,
and universities ($550 billion); local police and fire services; and roads.
Supply-Side Effects of Fiscal Policy
Fiscal policy has important effects on employment, potential GDP, and aggregate supply called
supply-side effects. An income tax changes full employment
and potential GDP.
Full Employment and Potential GDP
Figure 13.5 illustrates full employment and potential GDP.
Equilibrium employment is full employment and the real GDP
produced by the full-employment quantity of labor is potential
GDP.
The Effects of the Income Tax
Figure 13.5(a) illustrates the effects of an income tax in the
labor market.

The supply of labor decreases because the tax decreases the

after-tax wage rate. The before-tax real wage rate rises but the
after-tax real wage rate falls. The quantity of labor employed
decreases. The gap created between the before-tax and after-tax
wage rates is called the tax wedge. When the quantity of labor
employed decreases potential GDP decreases. The supply-side
effect of a rise in the income tax decreases potential GDP and
decreases aggregate supply.
Taxes on Expenditure and the Tax Wedge
Taxes on consumption expenditure add to the tax wedge. The reason is that a tax on consumption
raises the prices paid for consumption goods and services and is equivalent to a cut in the real wage
rate. If the income tax rate is 25 percent and the tax rate on consumption expenditure is 10 percent,
a dollar earned buys only 65 cents worth of goods and services. The tax wedge is 35 percent.
Taxes and the Incentive to Save and Invest
A tax on capital income lowers the quantity of saving and investment and slows the growth rate of
real GDP. The interest rate that influences saving and investment is the real after-tax interest rate.
The real after-tax interest rate subtracts the income tax paid on interest income from the real
interest. Taxes depend on the nominal interest rate. So the true tax on interest income depends on
the inflation rate.
Figure 13.6 illustrates the effects of a tax on capital income. A tax
decreases the supply of loanable funds. Investment and saving
decrease. A tax wedge is driven between the real interest rate and
the real after-tax interest rate.

Tax Revenues and the Laffer Curve The relationship between the
tax rate and the amount of tax revenue collected is called the
Laffer curve.

At the tax rate T*,

tax revenue is maximized. For a tax rate below T*, a rise in the tax rate
increases tax revenue. For a tax rate above T*, a rise in the tax rate
decreases tax revenue.

Generational Effects of Fiscal Policy

Generational accounting is an accounting system that measures the lifetime tax burden and benefits
of each generation.
Generational Accounting and Present Value Taxes are paid by people with jobs. Social security
benefits are paid to people after they retire. So to compare the value of an amount of money at one
date (working years) with that at a later date (retirement years), we use the concept of present
value.

A present value is an amount of money that, if invested today, will grow to equal a given future
amount when the interest that it earns is taken into account.
The Social Security Time Bomb
Using generational accounting and present values, economists have found that the federal
government is facing a Social Security time bomb! In 2008, the first of the baby boomers started
collecting Social Security pensions and in 2011, they became eligible for Medicare benefits. By 2030,
all the baby boomers will have reached retirement age and the population supported by Social
Security will have doubled. Under the existing Social Security laws, the federal government has an
obligation to pay pensions and Medicare benefits on an already declared scale. To assess the full
extent of the governments obligations, economists use the concept of fiscal imbalance.
Fiscal imbalance is the present value of the governments commitments to pay benefits minus the
present value of its tax revenues. Gokhale and Smetters estimated that the fiscal imbalance was $79
trillion in 20105.8 times the value of total
production in 2010 ($13.6 trillion).
Generational Imbalance
Generational imbalance is the division of the fiscal
imbalance between the current and future
generations, assuming that the current generation will
enjoy the existing levels of taxes and benefits. The bars
show the scale of the fiscal imbalance.
International Debt
How much investment have we paid for by borrowing from the rest of the world? And how much
U.S. government debt is held abroad? In June 2012, the United States had a net debt to the rest of
the world of $7.4 trillion. Of that debt, $4.8 trillion was U.S. government debt. U.S. corporations
used $6.5 trillion of foreign funds. Foreigners hold 40 percent of U.S. government debt.
Fiscal Stimulus is the use of fiscal policy to increase production and employment. Fiscal stimulus can
be either

Automatic

Discretionary

Automatic fiscal policy is a fiscal policy action triggered by the state of the economy with no
government action.
Discretionary fiscal policy is a policy action that is initiated by an act of Congress.
Automatic Fiscal Policy and Cyclical and Structural Budget Balances Two items in the government
budget change automatically in response to the state of the economy.

Tax revenues

Needs-tested spending

Automatic Changes in Tax Revenues Congress sets the tax rates that people must pay. The tax
dollars people pay depend on tax rates and incomes. But incomes vary with real GDP, so tax
revenues depend on real GDP. When real GDP increases in an expansion, tax revenues increase.
When real GDP decreases in a recession, tax revenues decrease.

Needs-Tested Spending
The government creates programs that pay benefits to qualified people and businesses. These
transfer payments depend on the economic state of the economy. When the economy is in an
expansion, unemployment falls, so needs-tested spending decreases. When the economy is in a
recession, unemployment rises, so needs-tested spending increases.
Automatic Stimulus
In a recession, receipts decrease and outlays increase. So the budget provides an automatic stimulus
that helps shrink the recessionary gap. In a boom, receipts increase and outlays decrease. So the
budget provides automatic restraint that helps shrink the inflationary gap.
Cyclical and Structural Balances
The structural surplus or deficit is the budget balance that would occur if the economy were at full
employment and real GDP were equal to potential GDP. The cyclical surplus or deficit is the actual
surplus or deficit minus the structural surplus or deficit. That is, a cyclical surplus or deficit is the
surplus or deficit that occurs purely because real GDP does not
equal potential GDP.
Figure 13.9 illustrates a cyclical deficit and a cyclical surplus. In part
(a), potential GDP is $14 trillion. If real GDP is $13 trillion, the
budget is in deficit and it is a cyclical deficit. If real GDP is $15
trillion, the budget is in surplus and it is a cyclical surplus.

In part (b), if real GDP and potential GDP are $13 trillion, the budget
is a deficit and the deficit is a structural deficit. If real GDP and
potential GDP are $14 trillion, the budget is balanced. If real GDP
and potential GDP are $15 trillion, the budget is a surplus and the
surplus is a structural surplus.

U.S. Structural Budget Balance in 2012

Figure 13.10 shows the actual budget deficit. In 2012, the budget
deficit was $1.1 trillion. With a recessionary gap of $0.85 trillion,
how much of the deficit was a cyclical deficit? How much was
structural?

The figure shows the structural deficit, calculated by the CBO. The
gap between the structural deficit and the actual deficit is the
cyclical deficit. The cyclical deficit in 2012 was $0.4 trillion. Most of
the 2012 budget deficit was a structural deficit.
Discretionary Fiscal Stimulus
Most discretionary fiscal stimulus focuses on its effects on
aggregate demand.

Fiscal Stimulus and Aggregate Demand

Changes in government expenditure and taxes change aggregate demand and have multiplier
effects. Two main fiscal multipliers are Government expenditure multiplier and Tax multiplier
The government expenditure multiplier is the quantity effect of a change in government
expenditure on real GDP. Because government expenditure is a component of aggregate
expenditure, an increase in government expenditure increases real GDP. When real GDP increases,
incomes rise and consumption expenditure increases. Aggregate demand increases. If this were the
only consequence of the increase in government expenditure, the multiplier would be >1. But an
increase in government expenditure increases government borrowing and raises the real interest
rate. With the higher cost of borrowing, investment decreases,which partly offsets the increase in
government expenditure. If this were the only consequence of the increase in government
expenditure, the multiplier would be < 1. Which effect is stronger? The consensus is that the
crowding-out effect dominates and the multiplier is <1. The tax multiplier is the quantity effect of a
change in taxes on aggregate demand. The demand-side effects of a tax cut are likely to be smaller
than an equivalent increase in government expenditure.
Graphical Illustration of Fiscal Stimulus
Figure 13.11 shows how fiscal policy is supposed to
work to close a recessionary gap. An increase in
government expenditure or a tax cut increases
aggregate expenditure. The multiplier process
increases aggregate demand.
Fiscal Stimulus and Aggregate Supply
Taxes drive a wedge between the cost of labor and the take-home pay and between the cost of
borrowing and the return on lending. Taxes decrease employment, saving, and investment and
decrease real GDP and its growth rate. A tax cut decreases these negative effects and increases real
GDP and its growth rate. The supply-side effects of a tax cut probably dominate the demand-side
effects and make the multiplier larger than the government expenditure multiplier.
Magnitude of Stimulus
Economists have diverging views about the size of the fiscal multipliers because there is insufficient
empirical evidence on which to pin their size with accuracy. This fact makes it impossible for
Congress to determine the amount of stimulus needed to close a given output gap. Also, the actual
output gap is not known and can only be estimated with error. So discretionary fiscal policy is risky.
Time Lags
The use of discretionary fiscal policy is also seriously hampered by three time lags:

Recognition lagthe time it takes to figure out that fiscal policy action is needed.

Law-making lagthe time it takes Congress to pass the laws needed to change
taxes or spending.

Impact lagthe time it takes from passing a tax or spending change to its effect on
real GDP being felt.

Reference: Michael Parkin. Macroeconomics. (Eleventh Edition).

Chapter 14
MONETARY POLICY
Monetary Policy Objectives and Framework
Monetary policy objectives stem from the mandate of the Board of Governors of the Federal
Reserve System as set out in the Federal Reserve Act of 1913 and its amendments. The law states:
The Fed and the FOMC shall maintain long-term growth of the monetary and credit aggregates
commensurate with the economys long-run potential to increase production. So, as to promote
effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
Goals and Means The Feds monetary policy objective has two distinct parts:
1. A statement of the goals or ultimate objectives
2. A prescription of the means by which the Fed should pursue its goals
Goals of Monetary Policy The goals are maximum employment, stable prices, and moderate longterm interest rates. In the long run, these goals are in harmony and reinforce each other, but in the
short run, they might be in conflict. The key goal is price stability. Price stability is the source of
maximum employment and moderate long-term interest rates.
Means of Achieving the Goals By keeping the growth rate of the quantity of money in line with the
growth rate of potential GDP, the Fed is expected to be able to maintain full employment and keep
the price level stable.
Operational Stables Prices Goal The Fed also pays close attention to the CPI excluding fuel and
foodthe core CPI. The rate of increase in the core CPI is the core inflation rate. The Fed believes
that the core inflation rate provides a better measure of the underlying inflation trend and a better
prediction of future CPI inflation.
Figure 14.1 shows the core inflation rate and the CPI inflation
rate.The CPI inflation rate is volatile and the core inflation
rate is a better indicator of price stability.Except from 2004 to
2008, the core inflation rate was within the Feds comfort
zone.
Operational Maximum Employment Goal Stable prices is
the primary goal but the Fed pays attention to the business cycle. To gauge the overall state of the
economy, the Fed uses the output gapthe percentage deviation of real GDP from potential GDP. A
positive output gap indicates an increase in inflation. A negative output gap indicates unemployment
above the natural rate. The Fed tries to minimize the output gap.
Responsibility for Monetary Policy The Feds FOMC makes monetary policy decisions. The Congress
plays no role in making monetary policy decisions. The Fed makes two reports a year and the
Chairman testifies before Congress (February and June). The formal role of the President is limited to
appointing the members and Chairman of the Board of Governors.

The Conduct of Monetary Policy is a variable that the Fed can directly control or closely target. The
Fed has two possible instruments:
1. Monetary base
2. Federal funds ratethe interest rate at which banks borrow monetary base overnight from
other banks.
The Feds choice of policy instrument (which is the same choice as that made by most other major
central banks) is the federal funds rate. The Fed sets a target for the federal funds rate and then
takes actions to keep it close to its target.
Figure 14.2 shows the federal funds rate. When the Fed
wants to avoid recession, it lowers the Federal funds rate.
When the Fed wants to check rising inflation, it raises the
Federal funds rate.

Figure 14.3 illustrates the market for reserves. The x-axis

measures the quantity of reserves held. The y-axis
measures the federal funds rate. The banks demand
curve for reserves is RD.

The demand for reserves slopes downward because the federal funds rate is the opportunity cost of
holding reserves and the higher the federal funds rate, the fewer are the reserves demanded.

The red line shows the Feds target for the federal funds rate. The Fed uses open market operations
to make the quantity of reserves supplied equal to the quantity demanded at the target rate. The
supply curve of reserves is RS. Equilibrium in the market for reserves determines the actual federal
funds rate. By using open market operations, the Fed adjusts the supply of reserves to keep the
federal funds rate on target.
The Feds Decision-Making Strategy The Feds decision begins with an intensive assessment of the
current state of the economy. Then the Fed forecasts three variables
Inflation Rate If it is above the comfort zone or expected to move above it, the Fed considers raising
the federal funds rate target. If it is below the comfort zone or expected to move below it, the Fed
considers lowering the federal funds rate target.

Unemployment Rate If the unemployment rate is below the natural unemployment rate, a labor
shortage might put pressure on wage rates to rise, which might feed into inflation. The Fed might
consider raising the federal funds rate. If the unemployment rate is above the natural
unemployment rate, a lower inflation rate is expected.
Output Gap If the output gap is positive, an inflationary gap, the inflation rate will most likely
accelerate. The Fed might consider raising the federal funds rate. If the output gap is negative, a
recessionary gap, inflation might ease. The Fed might consider lowering the federal funds rate.
Monetary Policy Transmission, Quick Overview When the Fed lowers the federal funds rate:
1. Other short-term interest rates and the exchange rate fall.
2. The quantity of money and the supply of loanable funds increase.
3. The long-term real interest rate falls.
4. Consumption expenditure, investment, and net exports increase.
5. Aggregate demand increases.
6. Real GDP growth and the inflation rate increase.
Interest Rate Changes Figure 14.5 shows the fluctuations in three interest rates:

The short-term bill rate

The long-term bond rate

The federal funds rate

Exchange Rate Fluctuations The exchange rate responds to changes in the interest rate in the
United States relative to the interest rates in other countriesthe U.S. interest rate differential. But
other factors are also at work, which make the exchange rate hard to predict.
Money and Bank Loans When the Fed lowers the federal funds rate, the quantity of money and the
quantity of bank loans increase. Consumption and investment plans change.
Long-Term Real Interest Rate Equilibrium in the market for loanable funds determines the long-term
real interest rate, which equals the nominal interest rate minus the expected inflation rate. The longterm real interest rate influences expenditure plans.
Expenditure Plans The ripple effects that follow a change in the federal funds rate change three
components of aggregate expenditure: Consumption expenditure, Investment, Net exports
A change in the federal funds rate changes aggregate expenditure plans, which in turn change
aggregate demand, real GDP, and the price level. So the Fed influences the inflation rate and the
output gap.
The Fed Fights Recession If inflation is low and the
output gap is negative, the FOMC lowers the
federal funds rate target. An increase in the
monetary base increases the supply of money. The
short-term interest rate falls.

The increase in the supply of money increases the supply of loanable funds. The real interest rate
falls

The fall in the real interest rate increases aggregate planned expenditure. Real GDP increases to
potential GDP.

The Fed Fights Inflation If inflation is too high and the output gap is positive, the FOMC raises the
federal funds rate target. A decrease in the monetary base decreases the supply of money. The
short-term interest rate rises.

The decrease in the supply of money decreases the supply of loanable funds. The real interest rate
rises.

Loose Links and Long and Variable Lags

Long-term interest rates that influence spending
plans are linked loosely to the federal funds rate. The
response of the real long-term interest rate to a
change in the nominal rate depends on how inflation
expectations change. The response of expenditure

plans to changes in the real interest rate depends on many factors that make the response hard to
predict. The monetary policy transmission process is long and drawn out and doesnt always respond
in the same way.
The Key Elements of the Crisis The three main events that put banks under stress were:
1. Widespread fall in asset prices
2. A significant currency drain
3. A run on the bank
Extraordinary Monetary Stimulus
The Policy Actions Policy actions dribbled out for more than a year.
1. Massive open market operations were used to increase bank reserves.
2. Deposit insurance was expanded.
3. The Fed bought troubled assets from banks
Policy Strategies and Clarity Two other approaches to monetary policy that other countries have
used are
Inflation Rate Targeting is a monetary policy strategy in which the central bank makes a public
commitment
1. To achieve an explicit inflation target
2. To explain how its policy actions will achieve that target
Taylor Rule is a formula for setting the interest rate. By using a rule to set the interest rate,
monetary policy contributes towards lessening uncertainty. With less uncertainty, financial markets,
labor markets, and goods markets work better as traders are more willing to make long-term
commitments.

Reference: Michael Parkin. Macroeconomics. (Eleventh Edition).