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These could be induced either by higher

government spending or lower taxes
!Either choice leads to a reduction in national saving
1. GDP = C + I + G + NX GDP = domestic spending/absorption +NX 6. !The
Budget Deficits
saving curve and
shifts up andInterest
to the left Rates
- Value of final goods and services produced in a country – Production w/in a country. Budget in
-!Increase surplus: Sgovt =rates
real interest T – (G + TR + INT) = govt revenues-govt outlays
- Total value added in production; total expend on goods/svcs; total income generated - –TR – transfer
Lower pmts
equilibrium (pension,
level of private welfare,
investmentunemployment benefits)
- C = spending by domestic households | I = Gross private invest. (new physical capital) INTcrowding
-!The – net interest pmts (service of natl debt - int on govt loans to students, farmers)
out effect
- G = Govt purchases of new goods or services→does not include govt transfers - –Budget deficit:
Government (G + TR
borrowing + INT)
reduces funds– T. Amt to
available govt needs to borrow to cover expenditures
(pensions, welfare, unemployment benefits) - Primary deficit:sector
finance private deficit excluding INT. If no primary deficit, a govt doesn’t need to
- NX = Exports – Imports of goods and services (trade surplus) borrow to cover expenses, so can default (not pay INT) and run country on its own.
- Count for unsold finished goods by including increase in inventories in investment 6.1. Market for Goods & Services Desired National Saving = Desired Investment
- GNP: Production by residents home or abroad. GNP = GDP + NFP (net factor pmts) - Closed economy (NX=0) and Y is fixed at LT level (determined by agg supply alone)
- NFP = income paid to domestic factors of production by the rest of the world – income - Y = Cd + Id + G | Sd = Y – Cd – G = Id | G, Sgovt, so S
paid to foreign factors of production by the domestic economy OR income receive from - T, The Effects of a Larger
Sgovt, but Cd, SdBudget Deficit
pvt, overall natl savings Sd b/c inc in Sgovt exceeds fall in Sdpvt
US owned foreign assets – income from domestic assets held by foreigners. - Larger Budget Deficit: induced by higher G (govt spending) or lower T
- Investment includes spending to maintain/replace existing goods (consumption of fixed
capital or depreciation exp). Included in gross product, excluded in net product (better). - In long run, real rates are determined
by S and I, not monetary policy
- National Income – income generated by production of goods and svcs
- Private Income = GDP + NFP + NUT (net unilateral foreign transfers or gifts) + TR
(transfers from govt) + INT (interest on govt debt) – T (taxes to govt)
- Government Income = T – TR – INT
- National Income U.S. + NUT → bestWealth
= GNPHousehold economic indicator
- National Saving: S = GNP + NUT – C – G (natl income less public/private consump)
- 2006 and 2009
Spvt = (GNP + NUT +TR + INT – T) – C | S = Spvt + Sgovt = GNP +NUT– C – G
- Sgovt = (T – TR – INT) – G → govt budget surplus (most gvts have a deficit)
- GDPI = Fixed Investment + Δ Business Inventory 7. International Trade and Finance
- CA = NX + NFP - CA = NX + NFP + NUT | The balance on all int’l flows of goods and services
2. Market Prices Prices measure value/society’s preferences - For most countries, NUT + NFP ≈ 0, so CA and NX are 15 pretty close
- KFA – capital and financial account measures net exports of assets to foreign countries
- Prices measure value / society’s preferences – only when mkts are competitive
and the net flow of unilaterial transfers of assets into our country (usually very small)
- Nominal values – reflect current market prices (doesn’t reflect changes in P over time!)
- All international transactions involve a swap of goods and/or assets so CA + KFA = 0
- Price index to measure inflation. Inflation = ΔPt/Pt-1
- A CA deficit equals the net sale of domestic assets to foreigners KFA = -CA
- CPI – average of prices paid by consumers. Overstates inflation
- Countries with really large trade deficits have big, + KFA (financial account surplus)
- PCE – average of prices of consumer goods (incl purch for consumers by firms and govt)
- China has big trade surplus, so KFA deficit → buying a lot of foreign assets
- Use Purchasing Power Parity to estimate long-run exchange rates for int’l comparisons
- KFA surplus means country selling more assets to foreigners than purchasing from
them → this is a reduction in national wealth. But, CA (trade) deficit means increased
3. Core Macro Model
demand for dometic securities → high stock prices, keeps domestic interest rates low.
- Production = Spending | Aggregate Supply = Aggregate Demand - Large trade deficit countries, must be able to maintain confidence of foreign investors.
- Cobb-Douglas: Y = A K0.35 N0.65 (A-productivitiy, K physical capital, N labor)
Large trade deficits a problem when deficits are mainly used to fund C (not I)
- Long run GDP can only be determined by our ability to produce, not spend. In the ST,
there is elasticity in supply and GDP is also determined by aggregate demand.
- ST growth can be encouraged by stimulating spending/demand.
8. Sources of Trade Deficits
- Financial mkts match saving of households with funding needs of firms and govts. - Goods market equilibrium. Sd = Id + CA = Id – KFA| CAhome + CAfor = 0
- Asset prices are determined to match aggregate S and I - National saving = domestic investment, I, + net investment in foreign countries, -KFA
- Monetary policy: how central bank affects aggregate spending and ST growth (regulate - Trade deficits arise naturally when national saving is too low to finance domestic
supply of money or target interest rates or exchange rates). investment (so require foreign funding so +KFA)
Borrowing Constraints - KeySaving, Investment and a Trade Deficit
difference for an open economy →Int’l trade allows Sd and Id to be different.
4. Household Consumption and Saving - If Sd > Id, CA > 0 | If Sd < Id, CA < 0.
High budget deficit: high Expectation of growth or
- Households prefer to have fairly smooth consumption over lifetime. Consumers happiest spending and/ or low taxes increase in productivity
with Manyconsumption
households= future
face borrowing
consumption.constraints (US) Emerging economies!
Low Saving and the Current Account
- Real after-tax
– E.g.,interest
those rate
withr =poor/no
(1-tax ratecredit
on interest)
historyx nominal int rate - inflation rate
and little S2
- PV of consumption expenditures = PV of consumption resources S1
current income
– In this case they: New Deficit

• Can not
- Slope of budget lineborrow
= -(1+r) | Optimal
enough consump/saving
to fund when tangent to budget line
desired consumption Initial Deficit

- Optimal desired consumption

• Are probably Optimal
using all their current desired saving

- Small open economies, real interest rate is fixed and determined in world markets. Large
– They face the additional constraint open economies are large enough to affect world interest rate.
- Borrowing constraints: c £ y(1- t)+ a can’t consume more than current resources - Budget deficits lower S, CA. For small openTheeconomies,
“Twin Deficits” in can
the U.S.lead to larger inflow of
foreign investment
Saving, Investmentand
andno effectSurplus
a Trade on real interest rates. For large open economies, smaller
- Determinants
– Theseof consumers
Private Saving:are very sensitive to current
- Income effect:  y(1-t) =  lifetime inflow of foreign funds but domestic and world interest rates rise.
income and wealth resources, shifts budget constraint out. - Twin deficit: CA deficit and the govt budget deficit
current and future c, savings, MPC<1
- expected future y or a, c and cf, but 9. Money & Inflation
savings bc current c  but not current y.
- M1 liquid assets (currency, checking acct, demand deposits); M2 also includes savings
- r increases slope of budget line. Income deposits, money-markets→assets that can be monetized in a short amt of time.
effect makes savers wealthier and
- Money demand Md = P x L | P=avg price of a transaction | L=#of transactions
borrowers/consumers less wealthy, so c. 21

Substitution effect decreases c and 10 - Md as Y, b/c there is more trade in high income countries | VM1 > VM2
encourages savings - Money velocity, V = PY/M = nominal GDP/nominal money supply - measures fin effic
- Opportunity cost of holding money vs income bearing vehicles is nominal rate, i=r+ Πe
5. Business Investment I = Fixed Investment + ΔInventories 15-25% of GDP - M = Md /P = L(Y,i) | P = M/L | inflation rate = growth rate in P. Comes from Msupply
- Fixed Investment = ΔK + d.K = Kt+1 – Kt + dKt | d=depr rate | Includes residential b/c Md doesn’t change much. Money growing faster than volume of transactions.
(new homes) and non residential (busi structures/plants, equip, software) - π good for borrowers (lowers real val of nom debt), bad 19 for creditors. Mkts less eff
- Fluctuations in I are often the main source of ST cycles & recessions 10. Money & Financial Markets M + NM = Md + NMd
- Marginal Productivity of Capital: MPK = Δy/Δk | Always positive, but diminishing - Money Supply fixed at M; Nonmonetary assets fixed at NM (pay nominal rate i)
- User cost of capital (uc) = (r+d)Pk/(1-t) |set MPK=uc to find desired capital stock k* - Y, transactions, L shift out, i. Want to transact more, but not enough M. i bc
- Cost of funding ρ = (1-t)r + rp | ρ = AT risk free interest rate + risk premium. convinces us to hold less cash. i is opportunity cost of holding money.
- ρ = uc and  in desired stock of capital - Increase in Money Supply M/P = Real Money Supply. L = Money Demand
- Real rate = nominal rate – expected inflation : r = i – πe - Central bank issues money to buy ST
- Temporary changes do not affect LT k*, but can change the timing of investment bonds→creates excess M→i needs to fall to allow
- Desired Investment - Expected MPK curve shifts out, k  investors to absorb extra liquidity
- Banks target a value for ST int rates – usually int
* term
rate for overnight bank lending (Fed Funds rate).
spread = LT - CBs now trying to manipulate LT rates to show
int rate – ST commitment to keeping ST rates low (loss
int rate otherwise)
- Yield curve (bond yields and maturity): Steep-expect rates  in future. Inverted-expect
rates  in future (recession indicator).- * LT rates avg of ST prevailing rates. 3 yr rate = (1/3)
(prevailing rate now, 1 yr from now, 3 yrs from now)
11. The Labor Market: N = E x h (employment x hours) 16. Macroeconomics in an Open Economy
- N Demand: MPN = W/P = w  real wage paid. MPN(marginal productivity) as N - Value of our currency  when nominal exchange
- Total factor productivity A, production function, ND right (willing to pay N more rate, enom,  (appreciation/revaluation)
The Effect
- N Supply: afterTofreal
marginal val of C (low for rich), and marginal val of leisure - enom: How much foreign currency you can obtain w/
- Wealth, NSleft (wealthy willing to work less) | working population, NSright one unit of domestic currency
- Y = Cd + Id + G + NX | Sd = Id + CA
- Difference in Open Economy: Shocks to CA will shift
 oil prices, A
IS curve. CA acts like an Id
-  CA: 1) Macro condition of trading partners. D for our goods rise with for income Yfor.
- Y = AK0.3N0.7
2) Our int’l competitiveness. Our real exchange rate/effective terms of trade, e.
- W & E deter by: Labor productivity
- High e makes foreign goods cheap relative to domestic,  our demand for them.
(drives ND), labor-leisure choice, and
- Recession: consum/busi confidence or fiscal policy tighten, shift IS down, new SR equi
w lower output & employment, and lower real inters rates. Now invest is unattractive for
- foreigners. Investors sell domestic assets and buy relatively more attractive foreign assets.
12. Labor Frictions & Unemployment u = unemployment rate Our currency supply  so value  (exchange rate depreciation).
- Unemployment – a person who is looking for work but can’t find a job - BUT: depreciating currency boosts competitiveness and NX, shifting IS curve back up.
- Population: employed + unemployed + not in labor force - Flexible e mitigates severity of recession.
13Effect of an Increase in Government Spending
- u = Unemployed/Labor Force | = natural rate of u, when labor mkt in equilibrium 17. Fixed Exchange Rates Effects on Currency Markets
- labor force participation=labor force/adult pop | employment ratio = employ/adult pop - Can have disequilibrium in private trade and!financial flows. interest rates makes domestic
Output and Employment Fall in domestic
- = full employment: # workers willing to work at mkt wage = # avail jobs at that wage A Drop in Domestic Spending
- Overvalued Currency: Supply of currency > Demand
AF(K,N)  European Unemploy assets lessofattractive
currency. Demand for foreign
Y1 E * High u benefits reduces goods/assets > demand for our goods → volume – Thisof imports
reduces + private
the demand financial
for our currency outflows
incentive to work (NS left). > value of exports + private financial inflows. – And leads to a loss in central bank reserves
As does high income taxes.
o CB has to buy its own currency to satisfy!the surplus
It forces of private sellers→there
a contraction in the money supply isn’t
Excess unemployment
* High SS, pension, health enough private demand for the currency to–meet private
LM curve shiftssupply.
up CB buys domestic
E contributions by emplyers currency and sells foreign assets (foreign reserves).
F → even
– Output falls affects CB’s B/S and  BASE

inc cost of hiring (ND left). - Undervalued Currency: Too much demand ! for
point goods/assets. Excess demand
As does high labor mkt
N regulation for currency. CB  holdings of foreign assets –and Recessions are magnified
domestic Msupply →in inflationary
fixed exchange rates
• E.g., Great Depression and the end of the Gold Standard
N1 N
Summary - In monetary policy, CB can control either M or enom (great if trying to fight inflation)
13. General Macroeconomic Equilibrium Key Factors That Shift the IS Curve
- Why fixed currency? → Reduces uncertainty and helps int’l trade. Can raise credibility of
13.1. Goods Market Equilibrium – IS Curve Increase in Shifts the IS
govt trying to control inflation, boosts competitiveness..
- Slopes down: r = 15-Y/500. As r, CdId, so Y. G Right Higher desired spending
- Dangers of fixed currency? → Amplifies economic cycles.
- Y = Cd + Id + G | Sd = Y – Cd – G = Id T Left Lower desired spending
- Reduced demand for our Currency (ie from drop in domestic spending, which drops int
Amplification of Business Cycles
- Shocks that raise desired aggregate spending will shift Household Wealth Right Higher desired spending
rates and makesDemand
Reduced domestic assets
for our less attractive
IS curve  and right. Consumer Confidence
Higher desired spending
- Forces contraction of money supply, LM shifts up, output falls even further.
Business Expectations
Right Higher desired spending
Money Market Equilibrium
European Labor Market – LM Curve (MPKf)
Key Factors That Shift the LM Curve enom Initial Reserve Loss
- Msupply = Mdemand | M/P = L(Y, r+ πe) Increase in Shifts the LM Explanation

- Slopes up: r = 1/500[Y-2000]. As Y, volume for M Right Higher real money supply
transactions, so Md , but if M doesn’t change then r P Left Lower real money supply
IS curve
New Reserve Loss
- Shocks that Msupply shift LM curve and right. enom F

- Shocks that  Mdemand shift LM curve and left. p Right eLower real money demand

13.3. Labor Market Equilibrium – FE Curve

Currency Traded
- Msupply = Mdemand | M/P = L(Y, r+ πe) | Labor27 mkt adjusts very slowly.
- Eventually CB will run out of reserves and can’t purchase domestic currency.
- Shocks that full employment will shift FE line to right b/c potential output rises.
o Ex. productivityA, labor force, incentives to work 18. Brief History of Economic Cycles
- Shocks that  Mdemand shift LM curve and left. - Recession – decline in output, income, employment, and trade lasting at least 6 mo.
Typically 2 consecutive qtrs of negative GDP growth. 31
14. Understanding Business Cycles - Stagflation – recession with a reduction in potential GDP. Main case of recession is A.
Labor Market: The FE Line
Shifts FE line left. (ex. Oil shocks in 70s). Also drop in consu/busi confidence, IS left.
- LT equilibrium = intersection of IS, LM, FE | ST equil = intersection of just IS, LM Long run adj requires  prices.
- Above FE: shortage workers, wages, prices, economy An overheated (inflation pressure)
Increase in Government Spending
- Workers/firms negotiate wages as a function of expected future P: W = W(Pe)
- Below FE: excess workers, wages, prices, economy weak (pressure to cut costs/w) - Current prices are markup over costs, so affected by expected P: P = markup* W(Pe)
- Converging to Long Run equilibrium: LM curve

→shifts LM right if P expectations fall

o Above FE: prices, Real money supply - Monetary contraction →ultimate goal is to lower P. Decrease in nominal money stock M
P rises
(M/P), LM curves shift left (up) to restore G increases
LM left.
labor mkt equil
- Aggregate GDP and consumption fall very little during actual recessions.
▪ Ex. Budget deficit , G(spending). In IS curve

LT, same Y&employ, higher r, lower C&I. 19. Determinants of Long Run Growth – Solow Growth Model
o Below FE: prices, Real money supply - Household Consumption C – save a constant fraction (s) of income every year
(M/P), LM curves shift right (down) - If I>dxK the stock of K will begin to ; if I<dxK the less stock of K will begin to 
- Shock: Money supply , encourages I & C, Y. LM shifts  and right. Then, output is - G & NX=0, so Y = C + I | S = Y – C = I | In equilibrium: S = sY = sAF(K,N) = I
above FE, so prices will rise until the real stock of money (M/P) returns to initial value. - LR Eq: GDP constant, K reaches constant K*. I = dK (I just to replace K that is depr),
In LT, same output, employments, and real int rate sAF(K,N) = dK.
- Money neutrality – monetary expansion has no effect on LT employ, Y, or real in rate. - If start w/ K<K*, I&S exceeds the amt needed to replace depr K, so K begins to rise
Nominal wages & prices are higher by same proportion asEffects
the increase in the Msupply
of Macroeconomic Shocks - If start w/ K>K*, I&S is too low to replace depr K, so K falls
- In long run, only productivity changes output! And output = FE level. Convergence to the Long Run
- Convergence to the LR. If I>dK, the economy will grow.
- If both Msupply & prices rise by same proportion, there !Increased
is no change in real
budget money supply.
deficit Steady-State Investment
dK * Effect of higher savings or higher
Think of a Δ in M or P relative to the expected growth –ofAdjustment
money and to the long run
inflation. Saving productivity
• Output is above full employment sAF(K1,N) sAF(K,N)

• Prices rise
15. Monetary Policy & Institutions • LM curve shifts to the left dK1

- Total notes central bank has printed: BASE = Currency– +Bank

New long-run equilibrium
• Same output and employment
money * cu=CU/DEP – determined by public pref for cash over deposits
• Higher interest rates - K1 K* K

- * res=RES/DEP – determ• Lower
by banks’ lending decision
consumption and investment - Higher s means we can fund higher stock of K in LR and have higher level of LR ouput
- M is a multiple of base→bank lending & private dep expand total Msupply beyond o BUT: 1) tradeoff btwn present/future C (the cost of higher S in SR is lower C). 2) s is
monetary base, so may change w/o CB intervention. Money multiplierwhen cu or res capped at 100%.
- M (nom Msupply) = Currency + Bank Deposits | M = Money Multiplier x BASE - Key factor in econ growth is sustained productivity improvement, A → no upper bound!
The Bathtub Model
- real Msupply = (nom Msupply)/P = L = real Mdemand o A affected by: tech & innovation, quality of human capital, business practices, energy
- Open-mkt bond purchase by Fed: it pays for the bonds 8/7/14&
with newly created CU or DEP, costs,26and cost of doing business & levels of corruption
increasing Msupply. Bond prices , interest rates . - S = I, so sY = (n+d)K; n-pop growth, Y-production func, d-depr rate, s-savings rate
- How can Fed interest rates: interest rate Fed pays on reserves which will res-dep - Population growth: GDP, but GDP/capita (decreasing marg productivity of labor)
ratio,  money The multiplier
Taylorand Rulemoney supply, upward pressure on int rates
- W/ govt: private and national S = s(1-t)Y → LR public saving=0/govt budget deficit =0
- Basel III: int’l agreement to prevent banks from becoming grossly under-capitalized. - In equil: (n+d)K = s.(1-t)Y = s.(1-t).A.F(K,N) → higher t work like lower s or lower A,
!A waybanks to hold
to conduct more equity
predictable when
but activist holding riskier assets in their portfolios.
policy lead to lower standards of living in LR.
- Taylor Rule: rT = 0.02 + 0.5y + 0.5(p – 0.02), π: inflation over last 4 qt, y: %dev Y is from FE Y. - LR capital to output ratio: s(1-t)/(n+d) | steady-state I/GDP: s(1-t)
• p is the inflation rate over the last 4 quarters; and - t= A,  LR capital &GDP | n,  LR GDP, but GDP/capita
CB should
• y israise real in rates
the percentage if output
deviation of output is full- FE Y or π rises above 2% annual target.
employment output
– The central bank should raise real interest rates if
• Output is above full-employment output; or