Principles of Macroeconomics

Principles of Macroeconomics-MSc in Banking & Finance 1

Academic Program: MSc in Banking and Finance Semester: Spring 2012/13 Instructor: Dr. Nikolaos I. Papanikolaou Office: Luxembourg School of Finance, KB2-E02-21 Phone: (00352) 466644 6938 Email: nikolaos.papanikolaou@uni.lu Home Page: http://npapanikolaou.wordpress.com Office hours: Thursday 10:00-12:00 or by appointment Course web site: https://moodle.fdef.uni.lu/fdef/login/index.php (use your enrollment key to access the course content)

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The Classical view vs. the Keynesian view Gross Domestic Product & Economic activity Business cycles Economic activity and Business cycles Consumer Price Index & Inflation rate GDP Deflator vs. CPI Unemployment The Circular Flow of Income The National Income Identity Exercises

Lecture notes – Set 2

Principles of Macroeconomics - MSc in Banking & Finance

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The Classical approach

It relies upon the ‘invisible hand hypothesis’ of Adam Smith: if

there are free markets, the laws of demand and supply will drive

the overall economy to an equilibrium (market-clearing process).

It assumes that prices and wages are flexible (and not sticky).

If there is a shortage (surplus) of labour, wages will rise (fall),

which implies that the level of employment is determined by

prices and wages.

Government should have only a limited role in the economy.

Classical view vs. Keynesian view

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The Keynesian approach

The Great Depression: Classical theory failed because high unemployment was persistent.

Keynesian approach: Persistent unemployment occurs because wages and prices adjust slowly, so markets remain out of equilibrium for long periods.

The level of employment is determined by the level of aggregate demand for goods and services.

Government should intervene to restore full employment through the increase in spending.

Classical view vs. Keynesian view

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Gross Domestic Product (GDP) is the main measure of economic activity and an indicator of well-being. It is calculated as the market value of all final goods and services produced within a nation during a specific time period, usually one calendar year.

For those goods that are not traded in the market place, we use an estimation of their value, which is called imputed value.

Nominal GDP is measured at current market prices, whereas Real GDP is measured at constant prices taking some specific calendar year as the basis year. This conversion from nominal to real units allows us to eliminate the problems created by having a measuring stick that essentially changes length over time, as the price level changes.

The ratio of Nominal GDP to Real GDP produces the so-called GDP Deflator, which accounts for price changes over time.

GDP & Economic activity

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The term business cycles refers to the fluctuations of the overall activity and performance in an economy. Expansions vs. contractions: An expansion refers to the improvement of economic performance and an increase in economic activity; the converse holds true in a contraction (or recession). The economy is expanded when moving from a trough to a peak; it is contracted between a peak and trough. Rule of thumb: two consecutive quarters of negative economic growth rate define a recession. An economic variable X can be either procyclical or countercyclical to GDP. When X increases (decreases) in economic expansions and decreases (increases) in recessions (i.e., it is positively linked to GDP), then it is called procyclical (countercyclical).

Business cycles

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Economic activity and business cycles

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The Consumer Price Index (CPI) is a composite indicator that relies on the weighted prices of a number of goods and services consumed by a typical (representative) household. CPI is the weighted price of this ‘basket’ of goods and services relative to the price of the same basket in some base year (or month).

𝜋𝑡+1 =(𝑃𝑡+1 − 𝑃𝑡)

𝑃𝑡

where:𝜋𝑡+1 = inflation rate 𝑃𝑡 can be either measured by CPI or by GDP deflator An increase (decrease) in 𝜋𝑡+1 implies an increase (decrease) in the average level of prices. The so-called ‘core inflation’ excludes energy and food prices as they tend to be very volatile.

CPI & Inflation rate

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GDP deflator measures the prices of all goods produced, whereas CPI measures prices of only the goods and services bought by the representative household.

GDP deflator includes only those goods and services produced domestically. Imported goods are not a part of GDP and therefore do not show up in the GDP deflator.

CPI assigns fixed weights to the prices of different goods, whereas the GDP deflator assigns changing weights.

GDP deflator vs. CPI

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The labour force (L) is the sum of the employed (E) and unemployed (U) individuals: L = E + U, where U consists of all individuals that do not have a job and have actively sought for one during the past four weeks.

The unemployment rate (u) is defined as the percentage of the labour force that is unemployed: u = U/L

The employment-population ratio is the percentage of the adult population (N) who are in the labour force (L):

Employment-population ratio = L/N

Unemployment

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Households Firms

Income

Labour

Goods

Expenditure

GDP can be viewed as: the total income of everyone in the economy

the total expenditure on the economy’s output of goods and services

The Circular Flow of Income

For the entire economy it must hold that: Total income = Total expenditure

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The National Income Identity

Y = C + G + I + (X-M) Y = Total Income (Total Expenditure , or Total Production)

C = Total Consumption spending on durables and non-durable

goods and services

G = Total Government Expenditure (consumption & investment)

I = Total Private Investment (residential & non-residential)

augmented by the change in inventories

X-M = Exports of domestic goods and services – Imports of foreign

goods and services (Net Exports)

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The National Income Identity

GDP = C + G + I + (X-M)

GNP = GDP + Receipts from the rest of the world + Payments to the rest of the world

NNP = GNP – Depreciation

National Income (NI) = NNP + Subsidies – Taxes

Personal Income (PI)= NI +Other personal income –Other personal expense

Disposable PI = PI – Personal taxes

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a) Calculate nominal GDP for all three years. b) Calculate real GDP for all three years using 2005 as the basis year. c) Why does real GDP not increase between 2006 and 2007 but nominal GDP does? d) Calculate the GDP deflator for 2006.

Exercise 1 Consider the following economy that produces only soda and pizza:

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Exercise 2 Answer the following questions using the information provided in the Table below:

a) Calculate the private consumption.

b) What is the value of gross domestic investment?

c) What is the value of net exports?

d) Calculate the value of government spending.

e) Calculate the gross domestic product.

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Exercise 3 Consider an economy that is described by the following relationships:

C = cY , with c = 0.75

G = 250

NX = 250

I = 𝐼–̅ br , with 𝐼 ̅ = 500 and b = 5,000

a) Assume that the autonomous investment decreases from 500 units to

300 units. What will be the effect on output, ceteris paribus?

b) At the same time with what is happening in (a), the interest rate

decreases from 0.06 to 0.05; calculate the resulting change in Y.

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Exercise 4 Consider an economy that is described by the following relationships:

C = c(Y - T) , with c = 0.75

G = 250

NX = 250

I = 𝐼–̅ br , with 𝐼 ̅ = 500 and b = 5,000

Assume that the government increase expenditure by 500 units. This increase is

financed 50% by taxes (T) and the rest by bond issuance. The increased demand

in the bonds market drives up interest rate from 0.05 to 0.06.

a) What is the effect of the aforementioned changes on the equilibrium income?

b) Would it have been better to finance the expenditure entirely by taxes?

Principles of Macroeconomics - MSc in Banking & Finance