ECN 515 Notes on Macroeconomics

The University of North Carolina at Pembroke
ECN 515--Managerial Economics
Notes on Macroeconomics
last updated December 7, 2001

Key Topics

Aggregate Demand/Aggregate Supply
    Things that shift AD and AS
    The AS curve in the long run
    Double-deficit equation
Money
    Banks and money
    Determinants of the money multiplier
    Money and aggregate demand
The Labor Market:
   Wages
   Unemployment

Why Does Macroeconomics Matter?
Management can't do anything about, can they?

To anticipate effects on the firm
     interest rates
     customers' incomes
     prices
     wage rates
To recognize proper macro policy

Macroeconomic Variables: Measures of Total Output

Gross Domestic Product:

measured and reported quarterly
Value (at then-current prices) of all final goods and services produced within the boundaries of a country during a given period of time (usually a year)
Final goods and services: goods sold to the ultimate user--households, businesses, government, or foreigners. Goods left in inventory at the end of the year are considered final goods, so net increases inventories are added to a year's GDP.

Gross National Product:

same as GDP except that all production by people who are normally residents of the U.S. counts toward the U.S. GNP, regardless of where that production takes place. When an American performes a service in Mexico, the value of that service adds to the U.S. GNP but it adds to the Mexican GDP.
better measure of the U.S. standard of living than is GDP.

Disposable Personal Income:

measued montly
All income of American households (including welfare payments and profits) minus taxes

Industrial Production Index:

measured monthly
reported as a percentage of the level in a base year. By construction, the value of the index in the base year must be 100.
excludes services, such as retailing, banking, medicine. Also excludes agriculture.

Adjustments:
Real GDP--inflation adjusted. Real values should reflect what the value would have been had prices remained constant since the base year.
GDP per capita

Macroeconomic Variables: Measures of the Price Level

GDP Deflator
     quarterly
     all final goods in the economy
Consumer Price Index (CPI)
     monthly
     typical prices for urban consumers
Producer Price Index (PPI)
     monthly
     prices of producers' output

Macroeconomic Variables: Measures of Unemployment

Household survey:
     number employed = E
        must be 16 or older, not institutionalized
     number unemployed = U
        must be 16 or older, actively looking for work, not institutionalized (prison, long-term hospital)
     number not in the labor force
        anyone 15 or younger (regardless of whether the person is working),
        people who have not actively looked for work,
        institutionalized people
     unemployment rate = U÷LF
    Example: if E = 4,000 and U = 1,000 and there are 3,000 not in the labor force (8,000 people contacted in all), the labor force would be 4,000+1,000 = 5,000, and the unemployment rate would be 1,000/5,000 = 20%.

Establishment survey:
employment, layoffs
States' ESC survey:
new unemployment claims

Macroeconomic Variables: Measures of Interest Rates

Federal funds rate
     overnight loans between banks
     indirectly controlled by the Fed
Discount rate
     short-term loans from Fed to banks
Prime rate
     loans from banks to best corporations
Interest rates on bonds
Stock market returns

The Aggregate Demand/ Aggregate Supply Model

AD and AS are similar to the demand and supply for a specific commodity, such as cotton.
When AD > AS, P rises. When AD < AS, the price level falls
Actual income, Y, is the smaller of AD and AS. When AS > AD, businesses will not hire workers to produce goods they cannot sell. So Y will equal AD. When AD > AS, businesses will only produce what they want to produce. So Y will equal AS.

Aggregate Demand
The value of all final goods and services that consumers, businesses and governments want to buy from U.S. businesses.
AD = C + I + G + (EX – IM)
C = Consumption, depends on
     disposable income (Yd)    mpc = dC/dYd. Lower taxes shifts the AD rightward
     consumer confidence; greater confidence encourages consumption and shifts AD rightward
I = Investment in capital goods, depends on
     interest rates (r), higher r decreases I and shifts the AD curve leftward.
     expected future profit
G = government spending; an increase in government spending shifts the AD curve rightward
EX = exports, depends on
    foreign prices; when foreign prices rise, U.S. exports increase and AD shifts rightward
    foreign incomes; when foreign incomes increase, U.S. exports increase and AD shifts rightward
    the exchange rate; when the dollar appreciates (gains in value), U.S. exports fall and AD shifts leftward.
IM = imports; depends on
    foreign prices; when foreign prices rise, U.S. imports fall and AD shifts rightward
    U.S. incomes; when U.S. incomes rise, U.S. imports rise and AD shifts leftward

Aggregate Supply

The value of all final goods and services that U.S. businesses are willing to offer at the given price.

AS increases as P increases
AS decreases as wage rates (W) increase. (the AS curve shifts leftward)
When prices of inputs to the American economy as a whole rise (as when OPEC raised oil prices), the AS curve shifts leftward. This tends to raise prices and reduce production.

Aggregate Supply--Short-run

As P rises, U.S. firms will want to supply more output.

AS will shift left when
    Wages fall
    the costs of imported raw materials fall
    the capital stock K rises (investment, I, increases the stock of capital. I = DK)
    competitiveness increases: Monopolies tend to raise prices and reduce output. The trend of mergers and greater monopoly power will shift the aggregate supply curve to the left.

Aggregate Supply--Long-run

real output will be fixed at the natural rate of output--the "full-employment" level
The price level may rise or fall, but in the long run, the level of real output will return to the natural rate of output. For example, in the short run, an increase in AD will raise P and raise Y, moving upward along a short-run AS curve. But in the long run, the increased production will necessitate increased labor, pushing wages upward. As wage rates rise, the short-run AS curve will shift leftward and upward. This shift will continue until equilibrium is re-established in the labor market. Ultimately, wage rates will rise in proportion to the price level and the levels of employment and real output will be at their natural levels.

AD/AS Equilibrium

When AD > AS, P rises until AD = AS = Y.
When AD < AS, P falls until AD = AS = Y.
Sources of income:
Y = AD = C + I + G + (EX – IM)
Uses of income:
Y = C + S + T
S = Saving
T = Taxes
C + I + G + (EX – IM) = C + S + T
(EX – IM) = (S – I) + (T – G)

Double-Deficit Equation

(EX – IM) = (S – I) + (T – G)
trade surplus = net private saving
+ government budget surplus
A country with a budget deficit will have a trade deficit, unless its citizens save more than its businesses invest.
Tariffs will not reduce a trade deficit (unless they indirectly increase S or reduce I--not a strong effect)

Money

Anything that is readily and generally accepted as final payment for goods and services

Two components of money:
Cash in the hands of the non-bank public,
Checkable deposits ("demand deposits")
Not credit cards (not final payment)

Money Demand

Money demand refers to the amount of money that the public wants to hold at a given level of wealth.
The public can hold several assets: money, gold, bonds, stocks, real estate, cars, . . .
Money pays no interest, but it does have provide convenience.

MD = a•P•Y^b•e^-cr, where a, b, c > 0 are constants
This says that MD will be proportional to the price level, P.
MD will increase as Y (real output or real income) increases.
MD will decrease as the interest rate, r, increases. As the interest rates on bonds rise, people will want to hold less of their wealth in the form of money and more of their wealth in the form of bonds. This is why the MD curve has its negative slope.

Money Supply

The Federal Reserve limits the number of demand deposits banks can create by imposing required reserves in proportion to deposits.
RR = rr•DD
Total Reserves = vault cash + bank's deposits at the Federal Reserve Bank.
Banks also want to hold some excess reserves. Assume: ER = er•DD
Public wants to hold some cash
Assume: C = cr•DD
cr = the currency ratio = Cash/Demand Deposits
rr = the required-reserve ratio = RR/DD it is 3% for some banks, 10% for others.
er = the excess-reserve ratio = ER/DD
TR = RR + ER or ER = TR - RR

Money Multiplier

The Federal Reserve has no direct control over C or DD, but it can control the monetary base.
The Federal Reserve creates MB whenever it buys an asset. Most often, the Fed creates MB by buying U.S. Treasury bonds from third-party bond dealers in the open market. (The Federal Open Market Committee oversees this procedure. It is called the "policy making" committee of the Fed in the newspapers.)
MB = C + TR = C_public + C_vault + Dep_FRB
Dep FRB = banks' deposits at their Federal Reserve Bank
MS = MB•(1 + cr)/(rr + er +cr)

Example: If MB = $200 billion, and
cr = 0.14
rr = 0.03
er = 0.02, then
MS = 200(1.14/0.19) = 1,200 billion
the money multiplier = m = 6 = 1200/200
m tells how much the money supply will rise for each dollar of new monetary base.

Money Supply

Money Market

When there is an excess of MS over MD, the interest rate will fall to attain equilibrium.
If the banks have more money to lend than people want to borrow, the banks will lower interest rates to make borrowing more attractive.
When there is a shortage of money (MD > MS), interest rates will rise.

When the Federal Reserve System increases the money supply, interest rates will fall.

Effect of Higher Income

Higher income shifts the Money demand curve to the right.
Higher prices also shift the MD curve to the right.
Higher interest rates move us to a higher point on the same MD curve. No shift of MD