DOTE final

Measuring a Nation’s Income

Economy’s Income & Expenditure

⚫ An economy’s total income equals its total expenditure

⚫ Every dollar spent by a buyer becomes a dollar of income of a buyer

GDP

⚫ Definition of GDP: market value of all final goods and services newly produced
within a country in a given period of time
◼ All items produced in the economy (market, exclude illegal, homemaking)
◼ Produced but not sold yet, count as this year’s GDP, next year will be
deducted to prevent double counting
◼ Used goods sold does not count

⚫ Y = C + I + G + NX
◼ Y = GDP
◼ C = consumption - spending by households
◼ I = investment - spending on equipment, structures, inventories
◼ G = government purchases - government consumption, X subsidy
◼ NX = net exports - Exports – Imports

⚫ Distinction between real GDP (constant prices) and nominal GDP (current prices)
◼ Depending on the quantity, not the price
◼ Nominal GDP increases faster than the real GDP

⚫ GDP deflator: nominal GDP/real GDP × 100

⚫ Inflation rate: (deflator in year 2– deflator in year 1)/deflator in year 1 ×
100%
⚫ Limitation of GDP as a measure of economic well-being
◼ Distribution of income, leisure, environment, crime rate, divorce rate, drug
addiction not included in GDP
Measuring the Cost of Living

⚫ CPI:
◼ An average of the prices of the goods and services purchased by typical
households.
◼ Cost of basket in current yr/Cost of basket in base yr × 100

⚫ Inflation rate: (CPI in year 2 – CPI in year 1)/CPI in year 1 × 100%

⚫ CPI is overestimated when

◼ Substitution bias: price of one good increases, consumers buy less
◼ Increase in quality bias: consumers enjoy better life
◼ New product bias: price of a new product declines when they enter market
◼ Outlet bias: offer lower prices

⚫ Dollar figures from different times

◼ Amount in today's dollars =
Amount in year T dollars × (Price level today/ Price level in year T)

⚫ Nominal interest rate (without a correction of inflation)

⚫ Real interest rate (Nominal interest rate – Inflation rate)
Production and Growth

⚫ Economic Growth Facts

◼ Real GDP per person as a measurement of living standard
◼ Huge differences in real GDP per person and its growth rate globally

⚫ Rule of 70
◼ For example, if an economy grows at 1% per year, it will take 70 / 1 =
70 years for the size of that economy to double

⚫ Productivity = Y/L (Output / Input [Labour × Time])

◼ Quantity of goods and services produced from each unit of labor input
⚫ Determinants of Productivity
◼ Physical capital - Stock of equipment and structures
◼ Human capital - Knowledge and skills
◆ More physical and human capital input, additional return is smaller
◼ Natural resources - Provided by nature
◆ It does not limit the growth, when you can look for alternatives
◼ Technological knowledge
◆ best ways to produce goods and services
⚫ Policies that influence productivity growth
◼ Saving and investment
◆ diminishing return (Benefit from an extra unit of an input declines) and
catch-up effect (Countries start off poor tend to grow more rapidly than
those start off rich)
◼ Investment from abroad
◆ Another way for a country to invest in new capital
◆ E.g. World Bank (Funds from world’s advanced countries - Encourages
flow of capital to poor countries)
◼ Education (But has opportunity cost)
◼ Human capital (Healthier workers - more productive)
◼ Free trade
◆ inward-oriented policies (avoid interaction, tariffs and quota to protect
industrial growth) vs. outward-oriented policies (Integrate into the
world economy)
◆ Coastal areas receive more trade
⚫ Research and Development
◼ Primary reason why living standards have improved over time
◼ patent 申請專利
⚫ Population Growth
◼ good for labour-intensive industry and better chance of getting new tech
◼ stretch the resources and dilute the physical capital (lower K/L)
Saving, Investment, and the Financial System

⚫ Financial institutions
◼ Financial markets
◆ IOU 借據- need to write down maturity date / interest / principal
◆ Bond market - Debt finance
(longer term, higher interest // corporate has higher interest than gov't)
◆ Stock market - Equity finance
◼ Financial intermediaries
◆ Banks (deposits // loans)
◆ Mutual funds - Institution that sells shares to the public
Has professional skill and reduce risk, it allows diversify

⚫ Private saving = Y(income) – T(taxes minus transfer payments) – C

⚫ Public saving = T(tax revenue) – G(government spending)
⚫ National saving = private saving + public saving = Y – C – G

⚫ Closed economy case: NX = 0

⚫ Y=C+I+G
⚫ So, I = Y – C – G = S, S = I, Saving = Investment in a closed economy
⚫
⚫ Budget surplus: T – G > 0, Budget deficit: T – G < 0

⚫ The Market for Loanable Funds

◼ single financial market and one interest rate to saver and borrower
◼ Supply and demand of loanable funds, as interest rate rises
◆ Quantity demanded declines
◆ Quantity supplied increases
⚫ Gov’t policy
◼ Shelter some saving from taxation (Private Saving increase)
◼ Investment tax credit (I increase, Demand increase)
◼ Budget deficit (Crowding out, Demand increase)
◼ Budget surplus (Public Saving increase)
The Monetary System

⚫ The Meaning of Money

◼ use to buy goods and services from other people (Every transaction would
require a double coincidence of wants)
⚫ The Functions of Money
◼ Medium of exchange
◼ Unit of account (Yardstick to post prices and record debts)
◼ Store of value
⚫ It has Liquidity
◼ Easily converted to economic medium of exchange
⚫ The Type of Money
◼ Commodity money (商品貨幣)
◼ Fiat money (法定貨幣, no intrinsic value)
⚫ Money Supply
◼ M1 = currency + traveler’s checks + demand deposits (check account
deposits) + some other liquid deposits (savings deposits)
◼ M2 = M1 + small denomination time deposits + money market mutual fund
shares + a few minor categories

⚫ Federal Reserve (Fed) = The central bank of the U.S.

◼ Regulate banks & ensure the health of the banking system
◆ Monitors each bank’s financial condition
◆ Facilitates bank transactions - clearing checks
◆ Acts as bank’s bank - lender of last resort
◼ The Fed can change the money supply by
◆ Open-market operation
⚫ (Purchase[=increase] / sale[=decrease] U.S. government bonds)
◆ Changing the money multiplier (Paying interest on reserves)
◼ But… The Fed cannot control
◆ amount of money that households choose to hold
◆ amount that bankers choose to lend

⚫ Money multiplier = 1/Reserve ratio

◼ E.g. Increase in reserves = $20000, Reserve ratio = 20%
Maximum increase in money supply = 20000 * (1/20%)
⚫ Leverage ratio = Ratio of assets to bank capital - Liabilities are fixed
◼ E.g. Leverage ratio = 20% -> every $20 assets, $1 from bank’s owners
⚫ There is capital requirement for bank
Money Growth and Inflation

⚫ Inflation = Increase in the overall level of prices

◼ 1/Price level = value of $1, measured in goods
⚫ Hyperinflation = Inflation > 50% per month

⚫ MS (Fed precisely controls MS,

fixed amount)
⚫ MD (how much wealth people
want to hold in liquid form)
⚫ ↑ supply of money
↑ demand of goods and services
↑ price of goods and services
↑ price level → ↑ quantity of money demanded

⚫ Velocity of money (V, Rate of money changes hands)

⚫ V = (P × Y) / M M×V=P×Y
P = price level, Y = real GDP, P × Y = Nominal GDP, M = quantity of money
◼ V Relatively stable over time
◼ Percentage change in M = Percentage change in P × Y
◼ But… M change does not affect Y

⚫ The Fisher Effect (Nominal interest rate = Real interest rate + Inflation rate)
◼ Higher inflation rate → Higher nominal interest rate

⚫ The Costs of Inflation

◼ Shoe leather Costs 皮鞋成本
◆ Resources wasted when inflation encourages people to reduce their
money holdings 為了減少持有現金額外花費時間和精力
◼ Menu Costs 菜單成本
◼ Distortions in Relative Prices 相對價格扭曲
◆ misallocation of resources because prices don’t all adjust, so markets
less able to allocate resources to their best use 價格調整速度不一
致，資源錯配
◼ Tax Distortions
◆ Taxes not adjusted for inflation. People may pay more taxes even when
their real incomes don’t increase
◼ Confusion and Inconvenience - changes the yardstick
◼ Arbitrary Redistributions of Wealth – e.g. hurts savers and benefits debtors
ADAS

⚫ Fluctuations are irregular and unpredictable

⚫ Most macroeconomic quantities fluctuate together
⚫ Output falls, unemployment rises

⚫ AD = C + I + G + NX
⚫ SRAS = total production of goods/services firms are willing to supply
⚫ LRAS = Vertical at Natural rate of output
◼ ↑: More resources (labor, capital) or better productivity or new tech

⚫ In long run: both AD and LRAS curve shift

◼ Continuing growth in output
◼ Continuing inflation
⚫ Everything that shifts LRAS shifts SRAS, too

⚫ Expected price level increases, SRAS curve shifts left

Monetary and Fiscal Policy on Aggregate Demand

⚫ The Theory of Liquidity Preference

◼ Interest rate adjusts to bring money supply and money demand into balance
◼ Higher r → Opportunity cost of holding cash rises → People prefer bonds
over money
◼ Lower r → Bonds are less attractive → Demand for money rises

⚫ Monetary Policy: The Fed increases the

money supply
◼ Money-supply curve shifts right
◼ AD shifts right
⚫ Above is Expansionary policy
⚫ The Zero Lower Bound occurs when
interest rates have already fallen to
around zero, expansionary = ineffective
⚫ Reverse case is Contractionary policy

⚫ Fiscal policy (setting of government spending and taxation)

⚫ Expansionary fiscal policy (an increase in G and/or decrease in T)
◼ shifts AD right
⚫ Contractionary fiscal policy (a decrease in G and/or increase in T)
◼ shifts AD left
⚫ Multiplier effect (multiple shifts in AD)
⚫ Marginal propensity to consume, MPC = △C/△Y
◼ △Y = △G(1/1-MPC)
⚫ Crowding-out effect (AD - decreases, since Interest rate - increases)
⚫ People against due to Monetary/Fiscal policy affects economy with a long lag
Open-Economy

⚫ Net capital outflow (NCO)

◼ Purchase of foreign assets by domestic residents (capital outflow) minus
the purchase of domestic assets by foreigners (capital inflow)

⚫ E.g. Real interest rates paid on foreign assets increase

→ NCO increase

⚫ NX = NCO
⚫ Open economy case: Y = C + I + G + NX
→ S = I + NX
→ S = I + NCO
(Saving = Domestic investment + Net capital outflow)

⚫ Real exchange rate =

Nominal exchange rate × Domestic price
Foreign price

⚫ Depreciation (fall) in the domestic real exchange rate

→ Higher net export
⚫ Appreciation (rise) in the domestic real exchange rate
→ Lower net export

⚫ Purchasing-Power Parity
◼ exchange rates between two currencies should adjust over time to
equalize the purchasing power of each currency
◼ same purchasing power
◼ Nominal exchange rate must reflect the price levels
◼ Limitations: Real exchange rates fluctuate over time