Macroeconomics 1.

Measuring a Nation’s Income

Definition
● study of economy-wide phenomena
○ inflation, unemployment, economic growth
● main variables
○ GDP, exchange rate, balance of payment, economic growth, interest rate,
(un-)employment
● every transaction has a buyer and a seller → total expenditure = total income in an economy

Gross Domestic Product (GDP)

● measures the total income of everyone in the economy
● measures the total expenditure on the economy’s output of goods and services
● can be measured by expenditure, production, income
○ market value of all final goods and services produced within a country in a given period
of time

Components of GDP (Y):

● Consumption C, Investment I, Government Purchases G, Net Exports NX (Exports - Imports)

→ Y = C + I +G +NX

Usefulness of GDP:
● Firms can predict sales and plan investment
● Government can predict revenues in the future
● Individuals can plan to invest in the stock market and understand business cycle

Circular Flow Model:

Macroeconomics 1. Measuring a Nation’s Income

Nominal versus Real GDP

Nominal GDP Real GDP

● uses current prices ● uses constant prices

● choose one year as base
year
● not affected by price changes
𝑟𝐺𝐷𝑃 × 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 𝑛𝐺𝐷𝑃
● Nominal GDP= 100
● Real GDP= 𝐷𝑒𝑓𝑙𝑎𝑡𝑜𝑟 × 100

GDP Deflator

𝑛𝐺𝐷𝑃
● 𝑟𝐺𝐷𝑃
× 100
● measures current level of prices relative to the level of prices in the base year

GDP & Quality of life

→ GDP high → better healthcare + educational system

- Rich countries: higher GDP per person

● Better life expectancy, literacy, internet usage
- Poor countries: lower GDP per person
● Worse life expectancy, literacy, internet usage, high infant mortality, child malnutrition, fewer
households with electricity
Macroeconomics 2. Measuring the Cost of Living

Definition: Inflation
● price increase
○ inflation rate: percentage change of a price index over time (compared to previous
period)

Consumer Price Index (CPI):

● measures the cost of living of a typical consumer
● measures the average change in prices over time in a fixed market basket of goods and
services (monthly)
● increase of CPI: consumers have to spend more income to maintain a constant living
standard

Calculating CPI
1. Fix the basket: Decision of goods and services
a. most important goods & services to typical consumers
b. assign different weights
2. Find the prices of each good in each year
3. Computation of basket cost in each year
4. Choose base year and compute CPI in each year
𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑜𝑓 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠 𝑖𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑦𝑒𝑎𝑟
a. CPI = 𝑝𝑟𝑖𝑐𝑒 𝑜𝑓 𝑏𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟
× 100

𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 2 − 𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 1

b. Inflation rate in year 2 = 𝐶𝑃𝐼 𝑖𝑛 𝑦𝑒𝑎𝑟 1
× 100

Core CPI
● measures overall cost of consumer goods & services excluding food and energy which are
volatile in prices (substantial short-run volatility)
● shows ongoing inflation trends better
Macroeconomics 2. Measuring the Cost of Living

Problems of CPI:
CPI can’t measure changes in the cost of living and the price level correctly

3 measurement problems:
● Substitution bias
○ tendency to purchase inexpensive alternatives instead of expensive items when
prices change
● Introduction of new goods
○ consumers can maintain a constant living standard using less income thanks to more
variety of goods to choose
● Unmeasured quality change
○ loss of quality while stable price = loss in value (of money)
○ increase in quality while stable price = increase in value

GDP deflator versus CPI

GDP Deflator CPI

● deals with all goods & services ● only deals with consumption goods
produced domestically ● fixed components for a certain period
● components change every year ● includes price changes

Nominal and Real Interest Rates

● nominal: interest rate as usually reported ( e.g. bank) → no correction for the
effects of inflation
● real: interest rate corrected for the effects of inflation

→ Real interest rate = Nominal interest rate - Expected inflation rate

Macroeconomics 3. Production and Growth

Principles
→ Standard of living in a country depends on its ability to produce goods & services in the long run
→ Changes of production capacity in a country determines whether its standard of living improves or
deteriorates

Productivity
= the quantity of goods & services produced from each unit of labor input
● Input factors
○ Physical capital per worker: equipment
○ Human capital per worker: knowledge & skills through education, training & experience
○ Natural resources per worker: land, forest, river, oil
○ Technological Knowledge: understanding of the best ways to produce goods & services

Economic Growth & Public Policy

→ What can government policy do to raise productivity and living standards?

● Encourage saving & investment

● Diminishing Returns & Catch-up Effect
○ Countries that start off poor tend to grow quicker than countries that start off rich
○ higher saving leads to higher growth
○ the more capital an economy has, the less additional output the economy gets from an
extra unit of capital
● Investment from Abroad
○ Foreign direct investment (FDI)
○ Foreign portfolio investment → purchasing stocks
○ increase the economy's stock of capital
○ higher productivity & wages
● Education & Training
○ Big wage gap between educated and uneducated workers
● Health & Nutrition
○ Healthier workers are more productive
● Property Rights
○ ability to exercise authority over the resources they own
● Political Stability
● Free Trade
○ deepens specialization and competition
● Research & Development
○ Knowledge is a public good
○ Technological advances contribute to improved standard of living
Macroeconomics 3. Production and Growth

● Externality
○ = an uncompensated impact of one person´s action on the well-being of a bystander
○ negative externalities: lower standard of living (e.g. pollution, noise)
○ positive externalities: raise standard of living (bee raising, education)
● Population Growth
○ lowers productivity due to stretching natural resources
○ enhances rate of technological progress due to more scientists and engineers
Macroeconomics 4. Saving, Investment and the Financial System

Financial System
● Group of financial institutions in the economy that help to match one person’s saving with
another person’s investment

● Financial institutions consist of financial markets and intermediaries

● Financial markets markets are institutions through which savers can directly provide funds to
borrowers e.g bond/stock market
● Financial intermediaries are institutions through which savers can indirectly provide funds to
borrowers e.g banks, mutual funds

The Bond Market

→ Bond is a certificate for debt financing and represents loans made to the issuer
● Identifies the time at which the loan will be repaid (date of maturity)
● Identifies rate of interest that will be paid periodically
● Buyer of a bond gives money in exchange for promise of interest and eventual repayment of the
amount borrowed = Principle
● Kinds: government bond, corporate bond, bank debenture

Bond Characteristics
● term, profitability= length of time until the bond matures; long term bond riskier than short term
bonds → higher interests
● credit risk = probability that borrower will fail to pay some of the interest or principal → different
interest rates
● stability = claim for interest payment regardless of financial situation of borrower

Types of Bonds
● Interest Rate Bonds → pay interest periodically
● Zero Interest Rate Bonds → don’t pay interest and issued at a deep discount

Stock Market
Stock = claim to partial ownership in a firm
● Dividend Right: claim to the profit a firm makes
● Voting Right: power to elect the board of directors
● Higher risk and higher profit than bonds
● Equity financing → raising capital through the sale of stocks
Macroeconomics 4. Saving, Investment and the Financial System

Banks
● Intermediaries (Vermittler) to take in deposits from savers and to make loans to borrowers
● Pay interest to a depositor in return and charge interest to borrowers

Mutual Funds
= an institution that sells shares to the public and uses the proceeds (Erlös) to buy a portfolio of stocks
and bonds
+ diversification of risks of small, individual investors
Macroeconomics 5. The Basic Tools of Finance

Finance
= the field that studies how people make decisions regarding the allocation of resources over time and
the handling of risk

Present Value: Measuring the Time Value of Money

Present Value (PV):
● Amount of money today that would be needed , using prevailing interest rates, to produce a
given future amount of money

Formula:

𝑋
PV = 𝑁
(1+𝑟)
r = interest rate X = amount to be received in N years (future value)

→ 100€ in a bank account today, how much will it be worth in N years?

→ 100€ investing at an interest rate of 5% for 10 years:
10
(1, 05) × 100€ = 163€

● Firms need to calculate PV to compare profits of projects that occur at a different time
● e.g. Project 1: profit of 1.5 million € in 5 years
● Project 2: profit of 2 million € in 10 years
● Project 1 PV = 1.175million €
● Project 2 PV = 1.228 million €

Rule of 70
→ The Rule of 70 is a calculation that determines how many years it takes for an investment to double in
value based on a constant rate of return
→ Divide 70 by the annual rate of growth or yield

Examples of the Rule of 70

● At a 3% growth rate, a portfolio will double in 23.33 years because 70/3=23.33
● At an 8% growth rate, a portfolio will double in 8.75 years because 70/8=8.75
● At a 12% growth rate, a portfolio will double in 5.8 years because 70/12=5.8

Future Value and Compounding:

● Future Value: amount of money in the future that an amount of money today will yield, given
prevailing interest rates
Macroeconomics 5. The Basic Tools of Finance

● Compounding: the accumulation of a sum of money in e.g a bank account, where the interest
earned remains in the account to earn additional interest in the future

Managing Risk
● Potential Risk needs to be taken into account while decision making through:

Risk Aversion
● behavior that dislikes uncertainty e.g. the game toss a coin (Münze werfen mit Geldeinsatz)
● insurance premium is higher than expected return

Macroeconomics 5. The Basic Tools of Finance

How to reduce risk

Markets for Insurance
● Insurance contract: Person facing a risk pays fee to company
● Possibility of not needing the insurance but you have ease at mind

Problems:
● adverse selection: high risk persons applying
● moral hazard: adventurous behavior of insured people
● can’t distinguish between high & low risk people; can’t monitor behavior of all customers

Diversification
= reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks
● Firm specific risk: affects only a single company
○ Eliminating all risks is possible by diversification
● Market risk: affects all companies in the stock market
○ Eliminating risk by diversification is impossible (e.g.finance crisis 2008)

Risk-return tradeoff
● theory of investing
● increased investment = increased risk
Macroeconomics 6. Unemployment

Types of Unemployment

● Cyclical Unemployment:
Cyclical unemployment is a type of unemployment which is related to the cyclical trends in the
industry or the business cycle. If an economy is doing good, cyclical unemployment will be at its
lowest, and will be the highest if the economy growth starts to falter.

● Frictional unemployment:
Frictional unemployment occurs with voluntary employment transitions within an economy. As
workers choose to move from one job to another and new workers enter the workforce for the
first time, a temporary period of unemployment is created.
● Example : unemployment that students experience until they are employed after graduation

● Seasonal unemployment:
Seasonal unemployment describes a situation where workers are unemployed at certain
times of the year when demand has decreased.

● Structural unemployment:
Structural unemployment occurs when changes in the economy or technological advancements
create a mismatch between the skills workers possess and the skills employers require. As a
result, even when jobs are available, individuals might be unable to secure employment due to
the gap between their qualifications and the job market demands.

Natural Rate of Unemployment

→ Normal rate of unemployment around which the unemployment rate fluctuates
Determinants:

Classification of Adult Population according to ILO

1. Employed: employee, self-employer, unpaid family worker, temporarily absent person (Elternzeit,
Mutterschutz..)
2. Unemployed: Those who have willingness and ability to work, but are not employed
3. Not in the labor force: Not employe and not unemployed: full-time students, retirees
Macroeconomics 6. Unemployment

Definition of Unemployment Rate

● Labor force : Number of employed + Number of unemployed over age 15
● Unemployment rate : U = (B/(A + B)) x 100

U : Unemployment rate
A : Number of employed
B : Number of unemployed
A+B : Labor force
● Labor force participation rate = ((A+B) /Adult Population) x 100
● Employment rate = (A/Adult Population) x 100

Are Unemployment Statistics correct?

→ It is difficult to distinguish the unemployed from people not in the labor force
● The unemployed who apply for unemployment benefits need to express the willingness to work,
though in fact they will leave the labor force soon.
● Black work

Why does Unemployment occur?

● If wages were flexible enough to balance the quantity of labor supplied and the quantity of labor
demanded, then no unemployment would occur
● very little wage flexibility or too high wages (set by state)
● too high unemployment benefits
● very high search costs for employees and employers
● insufficient education
Macroeconomics 6. Unemployment

Job Search

→ Process by which workers find appropriate jobs given their tastes and skills
● Workers differ in their tastes and skills
● Jobs differ in their attributes
● Information on job candidates and job vacancies is disseminated slowly

Minimum Wage

● Can cause unemployment

● Forces the wage to remain above the equilibrium level

Minimum Wage and Unemployment

→ If the minimum wage is set above the equilibrium level, it causes unemployment due to the resulting
surplus of labor supply
→ Minimum wage is beneficial to the employed who are covered by the system, while it is harmful to the
unemployed who are willing to work under the minimum wage level
Macroeconomics 6. Unemployment

Unions and Collective Bargaining

Unions:
● Worker association
● Bargain with employers over wages, benefits and working conditions
→ Unions set the wages higher than those of the market equilibrium level using the right for collective
bargaining and the right to strike
→ As a type of supply cartel, unions cause wage differences between union members and non-union
members. Union workers earn 10 - 20% more than similar workers who do not belong to unions.

● Better off: employed workers (insiders)

● Worse off: unemployed workers (outsiders)
● (insider-outsider issue)
Critics:
● Type of a cartel
● Allocation of labor
○ high union wages reduce unemployment in unionized firms below the efficient level →
causing unemployment
○ some workers benefit at the expense of other workers
Macroeconomics 5. Unemployment

Advocates:
● Necessary cue to the market power of the firms that hire workers
● In the absence of a union, firms pay lower wages and offer worse working conditions
● Unions help firms respond efficiently to workers’ concerns and keep a happy and productive
workforce

Theory of Efficiency Wages and Unemployment

→ Some firms voluntarily pay above-equilibrium wages (efficiency wages) to increase worker productivity
● Worker health
● Better paid workers
○ Eat a more nutritious food and are healthier and more productive
● Worker turnover
● Firms can reduce turnover among its workers
● Worker quality
○ Firm pays a high wage
○ Attracts a better pool of workers
○ Increases the quality of its workforce
Macroeconomics 6. Unemployment

● Worker effort
○ High wages make workers more eager to keep their jobs
→ Efficiency wages cause unemployment as well. But they are different from minimum wage and unions
because firms pay more wages voluntarily.

Effects of Efficiency Wages

● Worker health : productivity increase due to better nutrition (especially in the developing
countries)
● Decrease of worker turnover
● Hiring the better qualified workforce
● Increase of work incentive (e.g. : Henry Ford)

Facts about unemployment

● The lower the qualification is, the higher is the risk of unemployment
● The longer one has been out of the labor market, the less likely one is to find a job.
● The older you are, the less likely you are to find work if you become unemployed.
Macroeconomics 7. The Monetary System

Meaning of Money

Money = Set of assets in an economy that people regularly use to buy goods and services
Liquidity = Ease with wich an asset can be converted into the economy’s medium of exchange (money)

→ If there was no money, people would exchange goods or services

Functions of Money

1. Medium of exchange:
- money makes trade easier
2. Unit of account
- scale people use to post prices and record debts
3. store of value
- Item that people can use to transfer purchasing power from the present to the future

Kinds of Money

Commodity Money:
- Money that takes the form of a commodity (=Ware) with intrinsic value e.g. gold or cigarettes
- intrinsic value = item would have value even if it wasn’t used as money

Gold standard:
- Gold as money or
- paper money that is convertible into gold on demand

Fiat money:
= money without intrinsic value

Measure of Money Stock

Money stock = Quantity of money circulating in the economy

Currency = Paper bills and coins in the hands of public
Demand deposits = balances in bank accounts
Macroeconomics 7. The Monetary System

European Central Bank

Top priority of objectives:
- Ensuring price stability, i.e. keeping inflation at 2% using monetary policy
- In addition, supporting general economic policy of the EU such as full employment and
economic growth

→ The ECB’s most important decision for price stability normally relates to the key interest rates
- Any change it makes to interest rates affects the interest rates commercial banks charge their
customers for borrowing money
- In other words, its decision influences consumer spending and business investment as a whole.

Executive Board in ECB

- consists of President, Vice-President and 4 other members
- all members are determined by the European Council

Responsibilities:
- prepare Governing Council meetings
- manage day-to-day business of ECB
- implement monetary policy for the euro area

Governing Council in ECB

- main decision-making body of ECB
- 6 members of the Executive Board plus governors of national central banks in EU countries
Macroeconomics 7. The Monetary System

Federal Reserve System in the USA

- oversees the banking system
- regulates the quantity of money in the economy

Banks and Money Supply

Reserves: Deposits that banks have received but haven’t loaned out
Fractional-reserve banking: the bank holds only a fraction of deposits as reserves
Reserve ratio: Central banks can change the reserve ratio to influence money supply
Reserve Requirement: Minimum amount of reserves that banks must hold
Macroeconomics 8. Money Growth and Inflation

Inflation
= increase in the overall level of prices
- lowers value of money → determined by supply and demand
- concerns the value of economy’s medium of exchange

Deflation
= decrease in the overall level of prices

Hyperinflation
- extraordinary high rate of inflation
- inflation that exceeds 50% per month

Classical Theory of Inflation

→ explains the long-run determinants of the price level

Money demand reflects how much wealth people want to hold in liquid form; depends on credit cards
and availability of ATM machines and the interest rate and average level of prices

Money supply determined by the central bank and the banking system; to increase supply of money, the
central bank buys government bonds

→ Money supply and money demand are brought into equilibrium by the overall level of prices

Effects of a Monetary Injection

Economy is in equilibrium in the beginning

- if central bank doubles supply of money by printing bills and dropping them on the market or by
purchasing bonds
- supply curve shifts right
- in new equilibrium value of money decreases and price level increases

Nominal Variables and Real Variables

Nominal variables are variables measured in monetary units (Dollar prices, nominal wage, nominal GDP…

Real variables are variables measured in physical units (quantity of production, relative price, real wage…
→ no currency unit in relative price
→ real wage is an exchange rate of one unit of labor with goods and services
Macroeconomics 8. Money Growth and Inflation

→ real interest rate is an exchange rate of goods and services produced today with those that will be
produced in the future

𝑓𝑢𝑡𝑢𝑟𝑒 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠 − 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑔𝑜𝑜𝑑𝑠 𝑎𝑛𝑑 𝑠𝑒𝑟𝑣𝑖𝑐𝑒𝑠

Classical Dichotomy
- theoretical separation of nominal and real variables
→ theory that different factors influence real and nominal variables
→ change of money supply influences only nominal variables

Monetary neutrality
= an increase in the rate of money growth rates the rate of inflation but doesn't affect any real variable;
correct in long run, not realistic in short run

Quantity Equation

→ M x V = P x Y M= quantity of money V= velocity of money

P= price level Y= real GDP
→ V = (PxY)/M

1. Velocity of money is relatively stable over time

2. If M expands, proportionate changes in nominal value of output (P × Y)
3. Y is primarily determined by factor supplies and available production technology
- Money does not affect output Y (monetary neutrality)
4. Change in money supply induces proportional changes of P
5. When the central bank increases money supply rapidly
- High rate of inflation

Inflation Tax
= revenue the government raises by printing money
→ like a tax on everyone who holds money
Macroeconomics 8. Money Growth and Inflation

Costs of Inflation:
1.Shoeleather costs
- Resources wasted when inflation encourages people to reduce their money holdings
2. Menu costs
- Costs of changing prices
- Inflation increases menu costs that firms must bear
3. Misallocation of resources
- In market economies, relative prices allocate scarce resources
- In inflation, it is difficult for producers to know whether price increase of their products results
from increase of relative prices or from the overall increase of prices.
- It hinders the signal function of price from working, which limits the efficient allocation of
resources and
increase of the productivity.
- Markets are less able to allocate resources to their best use
Macroeconomics 9: Open-Economy Macroeconomics; Basic Concepts

Basic Concepts

Closed Economy
- Economy, that does not interact with other economies in the world (e.g. North Korea)

Open Economy
- Economy that interacts freely with other economies around the world (e.g. Germany)
- buys and sells goods and services in world markets
- buys and sells capital assets such as stocks and bonds in world financial markets

Flow of Goods

Exports: Goods and services that are produced domestically and sold abroad
Imports: Goods and services that are produced abroad and sold domestically
Net exports: The value of a nation’s exports minus the value of its imports

Trade surplus: Germany, China

- exports > imports
- country sells more goods and services abroad than it buys from other countries
Trade deficit: USA
- imports > exports
- country sells fewer goods and services abroad than it buys from other countries
Balance trade: export = import

Factors influencing exports, imports and net exports

- Tastes of consumers for domestic and foreign goods
- Prices of goods at home and abroad
- Exchange rates at which people can use domestic currency to buy foreign currencies
- Incomes of consumers at home and abroad
- Cost of transporting goods from one country to another
- Government policies toward international trade (e.g. free trade policy)

International Debtors and Creditors

→ if a country exports more than it imports (e.g. Germany), it provides goods to the foreign country by
credit → Germany’s net claims on foreign countries increase: creditor

→ if a country imports more than it exports (e.g. USA), the foreign country provides with goods on credit
→ the net liabilities of the USA to foreign countries increase: debtor
Macroeconomics 9: Open-Economy Macroeconomics; Basic Concepts

Net capital outflow: net foreign investment

Net capital outflow:

- Purchase of foreign assets by domestic residents
- Minuse the purchase of domestic assets by foreigners (FDI, FPI)
→ Purchasing American stocks by Germans leads to increasing net capital outflow of Germany.
→ Purchasing German stocks by foreign investors leads to decreasing net capital outflow of Germany.

Variables that influence net capital outflow

- real interest rates paid on foreign assets
- real interest rates paid on domestic assets
- perceived economic and political risks of holding foreign assets
- Government policies that affect foreign ownership of domestic assets

Net exports and net capital outflow

Net exports (NX) → imbalance between a country’s exports and imports

Net capital outflow (NCO) → imbalance between the amount of foreign assets bought by domestic
(inländisch) residents and the amount of domestic assets bought by foreigners

→ NX = NCO, because every transaction affecting net export always infleunces net capital
outflow by the same amount
Macroeconomics 9: Open-Economy Macroeconomics; Basic Concepts

Relationship among saving, investment, net export and net capital outflow

Net export is a component of GDP: Y = C + I + G + NX

Saving is the rest of GDP which remains after using for consumption and government expenditure:
(S=Y-C-G)
Y - C -G = I + NX
S = I + NX = I + NCO

→ International trade is influenced by international prices: Nominal and real exchange rate

Nominal exchange rate

= the rate at which a person can trade the currency of one country for the currency of another
e.g. European terms: currency unit of a country paying for a dollar
- 1$ = 0.93€ → 1$ costs 0.93 Euro
- increase of nominal exchange rate (depreciation:weaken), means decrease in the value of a
currency as measured by the amount of foreign currency it can buy
- decrease of nominal exchange rate (appreciation: strengthen), means increase in the value of a
currency as measured by the amount of foreign currency it can buy
→ nominal exchange rate doesn’t take into account the price levels of two countries

Real exchange rate

= the rate at which a person can trade goods and services of one country
- relative price of goods and services between two countries (no currency unit)
- exchange rate corrected by taking into account price levels of two countries to overcome the
limit of nominal exchange rate

Real exchange rate and net export

(𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 * 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒)
real exchange rate = 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒
= (e x p*) /P e = nominal exch. rate
p* = foreign price index ($)
P = domestic price index (€)

real exchange rate goes up, if nominal exchange rate increases, foreign price index increases or
domestic price index falls.
Then export increases and import decreases due to the fall of relative price of domestic products
compared to foreign products
Macroeconomics 9: Open-Economy Macroeconomics; Basic Concepts

Example:
Assumption:
- nominal exchange rate (€/$): 0.93
- one product such as a bottle of beer: 0.465€ in Germany, 1$ in the US
(0.93 * 1$)
→ real exchange rate = 0.465€
=2

→ German beer costs half of American beer

→ If (€/$)↑, price of American beer↑ or price of German beer↓, then real exchange rate↑

Purchasing power parity

= Theory of exchange rates which states that nominal exchange rate is determined by price levels of two
countries
- Nominal exchange rate between the currencies of two countries must reflect the price levels in
those countries
- When the central bank increases the money supply and causes the price level to rise, it also
causes that country’s currency to depreciate relative to other currencies

Why do exchange rates fluctuate over time?

- PPP theory states that one unit of any currency can buy the same amount of goods in any
country → a unit of currency should have the same purchasing power in every country
- Basic logic behind the PPP theory is the Law of one price, this states that a good should cost
the same everywhere in the world; if prices change, then the nominal exch. rate must also adjust
in order to reestablish PPP

Limitations of PPP
→ Conditions for a perfect market doesn’t hold in reality
- many goods are not easily traded
- tradable goods are not always perfect substitutes
- trade barriers among countries
calculating nominal exch. rate according to PPP:
1/P = e/p* → e = p*/p p= price index in the US (measured in dollar)
p*= price index in Germany (measured in Euro); e=nominal exchange rate (€/$ base)
Macroeconomics 10: Aggregate Demand and Aggregate Supply

Economic Fluctuations
- are irregular and unpredictable → economic boom and recession are repeated but no pattern in
their amplitude and durations
- most macroeconomic quantities fluctuate together → income, expenditure, investment and
employment move in the same direction
- Investment spending varies greatly
- output falls; unemployment rises
- negative relationship between real GDP and unemployment rate

Recession:
= Period of declining real incomes and rising unemployment
Depression:
= severe recession

Assumptions of Classical Economics

Classical dichotomy:
- separation of variables into real and nominal
Monetary neutrality:
- changes in the money supply affect nominal variables but don’t affect real variables

→ classical theory better as changes in money supply affect prices and other nominal variables but don’t
affect real GDP, unemployment…

Short-run Economic Fluctuations

- assumption of monetary neutrality no longer appropriate
- in reality price and income don’t respond immediately to changes in the money supply and it
takes time to respond
- real + nominal variables highly intertwined
- important variables: real GDP + CPI/GDP deflator

AD-AS Model
- aggregate demand (AD) and aggregate supply (AS)
- used to explain short-run fluctuations in economic activity
Aggregate demand curve
- shows the quantity of goods and services that households, firms, the government, and
customers abroad want to buy at each price level
- slopes downwards
Aggregate supply curve
- shows the quantity of goods and services that firms choose to produce and sell at each price
level
- slopes upwards
Macroeconomics 10: Aggregate Demand and Aggregate Supply

Aggregate Demand Curve

- Y = C+I+G+NX
- 3 effects explain why AD curve slopes downwards
- wealth effect (C)
- Interest-rate effect (I)
- Exchange-rate effect (NX)
- assumption: government spending (G) is fixed by policy

Wealth effect
→ price level and consumption ( C )
Decrease in price level:
- increase in the real value of money
- consumers are wealthier and increase spending
- increase in quantity demanded of goods and services
- price level↓ → real value of financial and physical asset↑ → C↑

Interest-rate effect
→ price level and investment (I)
Decrease in price level:
- decrease in interest rate
- increase of spending on investment goods
- price level↓ → money demand for → C↑ -> transaction motive↓
- S↑, demand for bonds and bond price↑ → interest rate↓ → I↑ and durable consumption↑
- inverse relationship between bond price and interest rate

Exchange-rate effect
→ price level and net exports (NX)
Decrease in price level:
- decrease in interest rate
- increase in real exchange rate
- increase of net exports
1. price level↓ → interest rate↓ → capital outflow↑ → nominal exchange rate↑ → real exchange rate↑ →
Export↑, Import↓
2. price level↓ → real exchange rate↑ → Export↑, Import↓
(𝑛𝑜𝑚𝑖𝑛𝑎𝑙 𝑒𝑥𝑐ℎ𝑎𝑛𝑔𝑒 𝑟𝑎𝑡𝑒 * 𝑓𝑜𝑟𝑒𝑖𝑔𝑛 𝑝𝑟𝑖𝑐𝑒)
- Real exchange rate = 𝑑𝑜𝑚𝑒𝑠𝑡𝑖𝑐 𝑝𝑟𝑖𝑐𝑒

→a fall in price level increases quantity of goods and services demanded because:
- consumers are wealthier: stimulates demand for consumption goods
- interest rates fall: stimulates demand for investment goods
- exchange rate (currency) depreciates: stimulates demand for net exports
Macroeconomics 10: Aggregate Demand and Aggregate Supply

The AD curve might shift due to:

- changes in consumption, investment, government purchases or net exports

→Why does the Aggregate-Demand curve slopes downwards?

1. The Wealth Effect: A lower price level increases real wealth, which stimulates spending on
consumption
2. The Interest-Rate Effect: A lower price level reduces the interest rate, which stimulates
spending on investment
3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate,
which stimulates spending on net exports

Why might the Aggregate-Demand curve shift?

1. Shifts Arising from Changes in Consumption: An event that causes consumers to spend more at
a given price level (a tax cut, a stock market boom) shifts the aggregate-demand curve to the
right. An event that causes consumers to spend less at a given price level (a tax hike, a stock
market decline) shifts the aggregate-demand curve to the left
2. Shifts Arising from Changes in Investment: An event that causes firms to invest more at a given
price level (optimism about the future, a fall in interest rates due to an increase in the money
supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest
less at a given price level (pessimism about the future, a rise in interest rates due to a decrease
in the money supply) shifts the aggregate-demand curve to the left
3. Shifts Arising from Changes in Government Purchases: An increase in government purchases of
goods and services (greater spending on defense or highway construction) shifts the
aggregate-demand curve to the right. A decrease in government purchases on goods and
services (a cutback in defense or highway spending) shifts the aggregate demand curve to the
left
4. Shifts Arising from Changes in Net Exports: An event that raises spending on net exports at a
given price level (a boom overseas, speculation that causes an exchange rate depreciation)
shifts the aggregate-demand curve to the right. An event that reduces spending on net exports
at a given price level (a recession overseas, speculation that causes an exchange-rate
appreciation) shifts the aggregate-demand curve to the left
Macroeconomics 10: Aggregate Demand and Aggregate Supply

Aggregate supply curve

→ long-run aggregate supply curve (LRAS) is vertical because price level doesn’t affect the long-run
determinants of GDP such as
- supplies of labor, capital, natural resources, and available technology
short run:
- aggregate supply curve is sloping upwards

→ The LRAS curve might shift due to changes in labor, capital, natural resources, technological
knowledge, and natural level of output as a result of improved job matching program and decrease of
unemployment benefit

Long-run growth and inflation

Short-run aggregate supply curve

→ slopes upwards in the short run:
- price level affects economy’s output
- increase in overall level of prices in economy
- tends to raise quantity of goods and services supplied
- decrease in level of prices
- tends to reduce quantity of goods and services supplied
Macroeconomics 10: Aggregate Demand and Aggregate Supply

Why does the AS curve slope upward in the short-run?

Sticky-wage theory (most plausible):
- Nominal wages are slow to adjust to changing economic conditions due to
- Long-term contracts for workers and firms
- Slowly changing social norms
- Nominal wages are based on expected prices
- Don’t respond immediately when actual price level is different from what was expected
→ price level↑ → real wage(W/P)↓ → employment↑ → production↑

Sticky-price theory:
- Prices of some goods and services
- Slow to adjust to changing economic conditions
- Firms with low prices expand sales and productions
→ price level↑ → immediate price increase (no effect)
or no price increase → demand↑ → production↑ (effect)

Misperceptions theory:
- Changes in the overall price level
- Can temporarily mislead suppliers about changes in individual markets
- Can lead to misperceptions as changes in relative prices
- Suppliers respond to changes in level of prices
- Change quantity supplied of goods and services
→ price level↑ → misperception as an increase of relative prices → production↑

Implications of the Theories

→ According to all three theories, when the actual price level differs from the expected price level, output
diverges in the short-run from its natural level
→ Quantity of output = Natural level of output+a (P-Pe)
→ Where a: number that determines how much output responds to unexpected changes in the
price level
P: actual price level
Pe: expected price level
→ But over time, due to people's reasonable expectations, expected price level converges to actual price
level, and as a result, a long-run aggregate supply curve is vertical
Macroeconomics 10: Aggregate Demand and Aggregate Supply

Forces that the short-run AS curve might shift:

- Changes in labor (increase of minimum wage, reduction of working time), capital, natural
resources, technological knowledge, the expected price level

→ In case of decrease in the expected price level, aggregate supply curve shifts right
Macroeconomics 10: Aggregate Demand and Aggregate Supply

Economic Fluctuation due to a shift of AD curve

→ AD curve shifts → output changes in the short run
→ shift of AD curve affects price level but output remains constant in the long run → Classical dichotomy
→ Government policy affecting the aggregate demand such as increase of government expenditure and
increase of money supply can reduce economic fluctuations → shifting from AD2 to AD1

Shift in aggregate supply

→ Firms → increase in production costs as a result of e.g. oil price increase → AD curve shifts left →
short-run: stagflation → output falls and price level rises
→ We cannot achieve both price stability and output growth by managing aggregate demand
Macroeconomics 11: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Effects of Monetary and Fiscal Policy on Aggregate Demand

- expenditure of households and firms determine overall demand of goods & services
- Change of these expenditures shift AD curve —> fluctuations of production and employment in
the short run
- Monetary and fiscal policy are used to stimulate the economy and to stabilize imbalances
caused by the AD shift

Theory of Liquidity Preference

= Keynes Theory —> suitable for explaining the factors that determine an economy‘s short-run interest
rate
- Interest rate is determined by money demand and money supply
- Interest rate adjusts —> creates balance
= theory of money demand because money is the economy‘s medium of exchange
- Money demand for transaction motive increases if price level increases
- Interest rate increases due to decrease of saving as money demand for transaction
motive increases
- Decrease of aggregate demand (consumption and investment) as interest rate
increases
—> Draw of a downward sloping AD curve because AD decreases if price level increases

Demand for Money

—> Theory of Liquidity Preference —> interest rate is most important factor that affects money demand
- Money is a medium of exchange and an asset without any profit
- Interest rates rise —> Opportunity costs increase —> reduces money demand
—> inverse relationship between money demand and interest rate

Supply of Money
- Money supply controlled by a central bank
- Quantity of money supplied is fixed by central bank and doesn‘t change due to interest rate
- Central bank alters the money supply using mainly
- Open market operations: purchase and sale of government bonds
- Reserve requirements: changing the quantity of reserves in the banking system
—> supply of money is vertical —> bc fixed by central bank
Macroeconomics 11: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Changes in the Money Supply: Monetary Policy

Changes in monetary policy aimed at expanding aggregate demand
—> Increasing the money supply
—> Lowering the interest rate
Changes in monetary policy aimed at contracting aggregate demand
—> Decreasing the money supply
—> Raising the interest rate
Central banks can influence aggregate demand by changing money supply. (eg.: Abenomics, Quantitative
Easing)
—> Increase of money supply causes interest rates to fall in the given money demand curve
—> Fall of interest rate shifts AD curve to the right because demand for goods and service rises at a
given price level
Macroeconomics 11: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Fiscal Policy and Aggregate Demand

- Instruments of fiscal policy are changes in government spending and tax
- tax cut influences economic growth in the long run by affecting saving and investment
- changes in government spending influences aggregate demand in the short run

Changes in Government Purchases

—> Changes in money supply and tax affect decision making of households and firms indirectly.
—> Changes in government purchases of goods and services affect AD curve directly.

Government policymakers:
- Set the level of government spending and taxation

Changes of government purchases have two effects:

- multiplier effect
- crowding-out effect

The multiplier effect

= additional shifts in aggregate demand
- results when fiscal policy increases income and subsequently increases consumer spending

Spending multiplier
= 1 / (1-MPC)
 - Marginal propensity to consume (MPC) = fraction of extra income that sonstigeres spend
Size of the spending multiplier
- Depends on the MPC
- The larger MPC is, the larger the multiplier
- If MPC=3/4, spending multiplier = 1/(1-3/4)= 4
- If MPC=9/10, spending multiplier = 1/(1-9/10)= 10

Macroeconomics 11: The Influence of Monetary and Fiscal Policy on Aggregate Demand

Crowing-out effect
Results when fiscal policy raises the interest rate and therefore reduces investment spending
—> increase in income
—> money demand and interest rate increases
—> AD curve shifts left

Changes in Taxes
A decrease in personal income taxes
- Households income increases
- Multiplier effect: AD increases
- Crowding-out effect: AD decreases

Using Stabilization Policy

Keynes: for active stabilization policy:
- Key role of AD in explaining short-run economic fluctuations
- The government should actively stimulate AD
- When AD appeared insufficient to maintain production at its full-employment
level
- Keynes and his followers argue that AD fluctuations in the short run result largely from irrational
waves of pessimism and optimism of people
- Forecasting of people on economy has the characteristic of self-fulfilling prophesy
- Therefore, government should conduct discretionary stabilization policy using
government spending and tax instrument
Monetarist: against active stabilization policy:
- Government
- Should avoid active use of monetary and fiscal policy to try to stabilize the economy
because they affect the economy with a time lag
- Policy instruments:
- Should be set to achieve long-run goals
- They argue that the economy should be left alone to deal with short-run fluctuations so that the
problems can be solved by self-healing ability of the economy
Macroeconomics 11: The Influence of Monetary and Fiscal Policy on Aggregate Demand

- Especially, fiscal policy can expand the fluctuations due to the big time lag from planning to
implementation
- Fine tuning of the fluctuations might be impossible

Automatic Stabilizers (Built-in Stabilizers)

Automatic stabilizers
- Changes in fiscal policy
- That stimulate AD (or break AD)
- When the economy goes into a recession (an excessive boom)
- Without policymakers having to take any deliberate action
Examples:
- The progressive income tax system
- Benefits of social security: increase of public assistance in a recession, while decrease of it in a
boom
- Unemployment insurance:
- boom: accumulation of fund and decrease of benefits
- recession: decrease of fund and increase of benefits
(in reality?)