Notes from Mankiw's Macroeconomics 5th edition (2001)

Some parts of this document were taken directly from the book. All rights
reserved.

# DEFINITIONS
-------------

* GDP = PIB = C + I + G + NX
where C = consumption
I = investment
G = gov expenditures
NX = net exports

real GDP = GDP at constant prices

GNP = GDP + factor payments from abroad - factor payments to abroad :: total
income earned by residents of a nation
GNI = GNP :: GNI calculates the GNP by summing income, not output value
GDP deflator = nominal GDP / real GDP :: an indicator of what's happening to the
level of prices
NNP = GNP - depreciation

Notes:
- There is 'investment' only when new goods are added to the economy, like when
building a house from scratch.
- Used goods are not counted toward the GDP: they are not an addition to the
economy.
- When inventories get bigger even if the goods are not sold, it is still
counted toward the GDP.
- For intermediary goods, we only count the added value at each step, or
equivalently, the value of the final good.
- Some goods which aren't traded need to be imputed a value, such as the rent
homeowners would pay themselves.

* CPI
CPI is an indicator of the level of prices, using the change in price of a basket
of goods.
Different from the GDP deflator for 3 reasons:
- the GDP deflator reflects the level of all prices, not just those bought by
consumers
- the GDP deflator includes only domestic goods, the change in price of imports
is not reflected
- the CPI is calculated with a fixed set of goods, substitution from one product
to another or new products are
not accounted for

* Unemployment rate = # of unemployed / labor force * 100

where labor force is all the workers and those looking for a job or on a
temporary layoff. Discouraged workers
are not counted, neither are retirees and full-time students.
Okun's law :: the unemployment is negatively related to the GDP growth
Percentage Change in Real GDP = 3% - 2*Change in the Unemployment Rate

# GENERAL EQUILIBRIUM MODEL

---------------------------
This is clasical/neoclassical theory, aka the general equilibrium model
The production depends on the quantity of the factors of production and on
productivity (the ability to go from
input to output).

MV = PT or MV = PY
where M = money
V = velocity
P = typical price
T = # of transactions
(PT) = the amount of money that changes hands

Y = C + I + G

Assumptions:
- money is neutral, does not affect real variables
- velocity of money is constant
- long run :: prices are flexible
- capital, labor and thus ouput, is fixed
- the competitive firm is a price taker, it takes the price of inputs, outputs,
and wages as given. It will then
choose the quantity of each to maximize profits
- savings = Y - C - G = I
- the role of money is ignored
- no trade with other countries
- full employment
- capital stock and labor force are fixed
- ignored the role of short-tun sticky prices

Consequences:
- to maximize profits, the competitive firm must hire until the marginal product
of labor equals the real wage
(the wage in terms of the firm's output)
- the competitive firm does the same for capital :: rent or buy more until the
marginal product of capital equals
the real rental price (the price in terms of the firm's output)
- if we assume constant returns to scale, then economic profit for the
competitive firm is nil
- each factor of production is paid its marginal productivity :: this is how
output is distributed in this model
- at the equilibrium interest rate, the demand for goods and services equals the
supply
- at the equilibrium interest rate, households’ desire to save balances firms’
desire to invest, and the
quantity of loanable funds supplied equals the quantity demanded
- when gov purchases increase with no tax bump, the purchases are financed with
bonds and it crowds out
investment. Consumption is increased because disposable income is larger
- a tax cut has the same effects as an increase in gov purchases
- investment can be stoked by new technology or milder tax laws
- investment depends negatively on the real interest rate
- the money supply determines the nominal value of output
- the central bank has complete control over inflation (quantity of money
theory)

# IN THE OPEN ECONOMY

---------------------

Y = C + I + G + NX
 where NX = net exports

National income accounts :: S - I = NX :: net capital outflow (net foreign

investment) = trade balance

real exchange rate = nominal exchange rate * ratio of price levels

Assumptions:
- the economy is small and does not affect the world interest rate

Consequences:
- if the world interest rate is higher than what would prevail in the closed
economy, the economy experiences
a trade surplus
- if the world interest rate is lower than what would prevail in the closed
economy, the economy experiences a trade
deficit
- starting from balanced trade, a change in fiscal policy that reduces national
saving leads to a trade deficit
- an increase in the world interest rate due to a fiscal expansion abroad leads
to a trade surplus
- The real exchange rate is related to net exports. When the real exchange rate
is lower, domestic goods are
less expensive relative to foreign goods, and net exports are greater
- The trade balance (net exports) must equal the net capital outflow, which in
turn equals saving minus
investment. Saving is fixed by the consump tion function and fiscal policy;
investment is fixed by the
investment function and the world interest rate
- at the equilibrium real exchange rate, the supply of dollars available from
the net capital outflow balances
the demand for dollars by foreigners buying our net exports
- when savings drop from an increase in G or a tax cut, or when investment is
stoked by a tax credit, NX falls too
- a protectionist trade policy raises the real exchange rate. Despite the shift
in the net-exports schedule,
the equilibrium level of net exports is unchanged. This lowers the amount of
trade.

Notes:
- (quote) Yet trade deficits are not always a reflection of economic malady.When
poor rural economies develop
into modern industrial economies, they sometimes finance their high levels of
investment with foreign
borrowing. In these cases, trade deficits are a sign of economic development.
For example, South Korea ran
large trade deficits throughout the 1970s, and it became one of the success
stories of economic growth.The
lesson is that one cannot judge economic performance from the trade balance
alone. Instead, one must look at
the underlying causes of the international flows

# UNEMPLOYMENT
--------------

Summary:
- The natural rate of unemployment is the steady-state rate of unemployment. It
depends on the rate of job
separation and the rate of job finding
- Because it takes time for workers to search for the job that best suits their
individual skills and tastes,
some frictional unemployment is inevitable.Various government policies, such
as unemployment insurance, alter
the amount of frictional unemployment
- Structural unemployment results when the real wage remains above the level
that equilibrates labor supply and
labor demand. Minimum-wage legislation is one cause of wage rigidity. Unions
and the threat of unionization are
another. Finally, efficiency-wage theories suggest that, for various reasons,
firms may find it profitable to
keep wages high despite an excess supply of labor
- Whether we conclude that most unemployment is short term or long term depends
on how we look at the data. Most
spells of unemployment are short. Yet most weeks of unemployment are
attributable to the small number of
long-term unemployed
- The unemployment rates among demographic groups differ substantially. In
particular, the unemployment rates
for younger workers are much higher than for older workers.This results from a
difference in the rate of job
separation rather than from a difference in the rate of job finding
- The natural rate of unemployment in the United States has exhibited longterm
trends. In particular, it rose
from the 1950s to the 1970s and then started drifting downward again in the
1990s.Various explanations have
been proposed, including the changing demographic composition of the labor
force, changes in the prevalence of
sectoral shifts, and changes in the rate of productivity growth
- Individuals who have recently entered the labor force, including both new
entrants and reentrants, make up
about one-third of the unemployed.Transitions into and out of the labor force
make unemployment statistics more
difficult to interpret

# INFLATION
-----------

The costs of expected inflation include shoeleather costs, menu costs, the cost of
relative price variability,
tax distortions, and the inconvenience of making inflation corrections. In
addition, unexpected inflation causes
arbitrary redistributions of wealth between debtors and creditors. One possible
benefit of inflation is that
it improves the functioning of labor markets by allowing real wages to reach
equilibrium levels without cuts in
nominal wages.

# EXOGENOUS GROWTH MODEL

------------------------

Instead of focusing on a snapshot of the economy, we study the long run and
introduce dynamic variables.
y = f(k)
i = sy

delta k = sf(k) - d*k

where delta k = change in capital stock
d = depreciation rate

c = f(k) − d*k
where c = steady-state consumption at the golden rule level

* Golden rule
The golden rule level is the level at which consumption per worker is maximized.
At that level, more capital
will bring more depreciation and less consumption. Whereas less capital would
not provide as much output and
consumption. MPK = d

* Population growth
At this point, there is nothing to explain sustained growth. We need to add
population growth and technological
progress.
delta k = i - (d + n)*k = sf(k) - (d + n)*k
where n = population growth

The golden rule level is now MPK = d + n

* Technological progress
We include technological progress:
F = (K,L*E)
where E = efficiency of labor

We no longer use variables 'per worker' but rather variables 'per effective
worker'.
delta k = i - (d + n + g)*k = sf(k) - (d + n + g)*k

MPK = d + n + g
where g = labor-augmenting technological progress

With technological progress, total ouput grows at rate n + g.

* Endogenous growth theories

Endogenous growth theories try to explain technological progress and to not
assume diminishing returns to capital or
constant returns to scale

Assumptions:
- there is a steady state toward which an economy will go
- production function has constant returns to scale
- at the steady-state, the investment equals d * k

Consequences:
- saving rate is a key determinant of the steady-state capital stock
- steady-state capital stock. If the saving rate is high, the economy will have
a large capital stock and a
high level of output. If the saving rate is low, the economy will have a small
capital stock and a low level
of output
 - a persistent budget deficit will lowe the saving rate and lead to lower
capital stock
- at the golden rule level, the marginal productivity of capital equals the
depreciation rate
- when the economy begins above the Golden Rule, reaching the Golden Rule
produces higher consumption at all
points in time.When the economy begins below the Golden Rule, reaching the
Golden Rule requires initially reducing
consumption to increase consumption in the future
- whether or not a policymaker would try to reach the golden rule level depends
on the weight he puts on current
generations v. future ones
- when accounting for population growth, a part of the break-even investment
replaces the depreciated capital
(d*k), and the other part ensures that capital per worker is constant (n*k)
- with a population growth of n, total ouput must also grow by n if the economy
is in the steady-state. This does not
explain increasing standards of living, but it explains sustained growing
output in part
- although a high saving rate yields a high steady-state level of output, saving
by itself cannot generate
persistent economic growth
- the Solow model shows that an economy’s rate of population growth is another
long-run determinant of the
standard of living. The higher the rate of population growth, the lower the
level of output per worker
- only technological progress can explain increasing living standards
- in the steady state of the Solow growth model, the growth rate of income per
person is determined solely by
the exogenous rate of technological progress

# AGGREGATE SUPPLY AND AGGREGATE DEMAND

---------------------------------------

Notes:
- In the short run, prices are fixed
- Real money balances = M/P
- The aggregate demand curve is drawn for a fixed money supply: if the Fed
decreases the money supply, the curve will
shift inward
- The long run aggregate supply curve does not depend on price level. It is thus
vertical when x is income and
y is price level
- The short run aggregate supply curve is horizontal because prices are sticky
- Over long periods of time, prices are flexible, the aggregate supply curve is
vertical, and changes in aggregate
demand affect the price level but not output. Over short periods of time,
prices are sticky, the aggregate supply
curve is flat, and changes in aggregate demand do affect the economy’s output
of goods and services
- Supply shock = price shock

# IS-LM MODEL
-------------

A model to view how income changes in the short run where prices are fixed or a
model to view what makes the AD curve
shift.
IS = investment and savings
LM = liquidity and money
The interest rate is what influences investment and money and is thus the link
between the two axes.

E = C(Y − T) + I + G
where E = planned expenditure
C = propensity to consume
T = taxes
I and G are exogenous

Y = E

* Keynesian cross
- The Keynesian cross superposes planned expenditure and actual expenditure
- the economy is in equilibrium when Y = E: actual expenditure = planned
expenditure
- delta Y / delta G is the gov purchases multiplier :: it is larger than one
because when gov purchases, it
raises income literally, but also raises consumption for the citizens, which
raises income again, and so on
- delta Y / delta G = 1/(1 - MPC) :: found using algebra and geometric series
- When gov cuts taxes, delta Y / delta T is the tax multiplier
- delta Y / delta T = -MPC/(1 - MPC) :: found using algebra and geometric series

* IS curve
Y = C(Y - T) + I(r) + G
- The IS curve slopes downward :: an increase in the interest rate decreases
investment and planned expenditure,
and so incomes
- In summary, the IS curve shows the combinations of the interest rate and the
level of in- come that are consistent
with equilibrium in the market for goods and services.The IS curve is drawn
for a given fiscal policy. Changes
in fiscal policy that raise the demand for goods and services shift the IS
curve to the right. Changes in fiscal
policy that reduce the demand for goods and services shift the IS curve to the
left

* Theory of liquidity preference

- real money balances = M/P :: both variables are exogenous
- according to the theory of liquidity preference, the supply and demand for
real money balances determine what
interest rate prevails in the economy
- the curve is downward sloping with the interest rate against the real money
balances

* LM curve
M/P = L(r, Y ) :: supply of real money balances
- plots the interest rate against the level of income :: the more one earns, the
more they need real money balances
- in summary, the LM curve shows the combinations of the interest rate and the
level of income that are consistent
with equilibrium in the market for real money balances.The LM curve is drawn
for a given supply of real money
balances. Decreases in the supply of real money balances shift the LM curve
upward. Increases in the supply of
real money balances shift the LM curve downward.

* AD curve
- we can summarize these results as follows: A change in income in the IS–LM
model resulting from a change in
the price level represents a movement along the aggregate demand curve. A
change in income in the IS–LM model
for a fixed price level represents a shift in the aggregate demand curve
- expansionary fiscal policy (an increase in government purchases or a decrease
in taxes) shifts the IS
curve to the right.This shift in the IS curve increases the interest rate and
income. The increase in income
represents a rightward shift in the aggregate demand curve. Similarly,
contractionary fiscal policy shifts the
IS curve to the left, lowers the interest rate and income, and shifts the
aggregate demand curve to the left
- expansionary monetary policy shifts the LM curve downward. This shift in the
LM curve lowers the interest rate
and raises income.The increase in income represents a rightward shift of the
aggregate demand curve. Similarly,
contractionary monetary policy shifts the LM curve upward, raises the interest
rate, lowers income, and shifts
the aggregate demand curve to the left

* Pigou effect
As prices fall and real money balances increase, households should feel wealthier
and spend more, thus
increasing the economy's ouput

* Third equation
Keynesianism and classical theory can both use the IS-LM model but each one has a
different third equation
classical theory :: Y is fixed
keynes :: P is fixed

# MUNDELL-FLEMING
-----------------

IS* :: Y = C(Y - T) + I(r*) + G + NX(e)

LM* :: M/P = L(r*,Y)

Those curves are plotted for the exchange rate against income.

Assumption:
- we fix the interest rate to the world's interest rate
- small open economy with perfect capital mobility
- the interest rate is floating

Consequences:
- the interest rate is determined by the world's interest rate
- the LM* curve is vertical
- fiscal policy in an open economy is offset by the trade balance :: if gov
spends more money, it will not raise
income. There will be a shortage of loanable funds and the exchange rate will
appreciate since the interest rate
is fixed. Because of that, the net exports are going to fall
 - in a closed economy an increase in the money supply increases spending because
it lowers the interest rate
and stimulates investment. In a small open economy, as soon as an increase in
the money supply puts downward
pressure on the domestic interest rate, capital flows out of the economy as
investors seek a higher return
elsewhere. This capital outflow prevents the domestic interest rate from
falling. In addition, because the
capital outflow increases the supply of the domestic currency in the market for
foreign-currency exchange,
the exchange rate depreciates. The fall in the exchange stimulates net
exports. Hence, in a small open economy,
monetary policy influences income by altering the exchange rate rather than
the interest rate
- the trade policy cannot affect income, just the exchange rate

* With a fixed exchange rate

- a fiscal expansion raises income :: gov spending raises income, but the
exchange rate is fixed, so arbitrageurs sell
foreign currency to the central bank, effectively provoking an increase in the
money supply and shifting the LM*
curve outward, raising income at the equilibrium
- monetary policy has no effect because the exchange rate and the interest rate
is fixed, arbitrageurs will keep the
balance
- the fixed exchange rate can be changed thought :: that's another form of
monetary policy
- devaluation will increase net exports and income
- revaluation will diminish net exports and income
- trade policy can increase net exports and income :: an import quota will shift
the net exports schedule to the right
and thus IS* curve to the right, which will attract money from arbitrageurs
and shift the LM* curve to the
right. Income has increased under the new equilibrium

* With a risk premium

IS* :: Y = C(Y - T) + I(r* + 0) + G + NX(e)
LM* :: M/P = L(r* + 0,Y)

- When the risk premium increases, the domestic interest rate increases. This
shifts the IS* curve to the left as it
reduces investment, and shifts the LM* curve to the right, as the demand for
money supply decreases. Income thus
rises and the currency depreciates. This sounds good but it isn't:
1) the central bank might want to avoid depreciation and would decrease
money supply
2) depreciation increases the price of imported goods, causing increase in
price level
3) in times of doubt, citizens will increase their demand for money balances
All those consequences will shift the LM* curve inward

* Fixed and floating x-rates

There are advantages to both floating and fixed exchange rates. Floating exchange
rates leave monetary policymakers
free to pursue objectives other than exchange-rate stability. Fixed exchange rates
reduce some of the uncertainty
in international business transactions.
# AGGREGATE SUPPLY
------------------
Y = natY + a(P - Pe)
where a > 0
natY = natural rate of output
P = price level
Pe = expected price level

If the price level is higher than the expected price level, output exceeds its
natural rate. If the price level
is lower than the expected price level, output falls short of its natural rate

* Sticky-wage model
The assumption is that wages are sticky in the short run.

Consequences:
- when price level rises, the real wage is lower and labor cheaper
- lower wages induces firms to hire more
- additional labor produces more output
- Thus price level and output are positively related

* Imperfect-information model
It is hard to know for sure whether the price level is local or global, and even
if we know the nominal price, it is
hard to know the relative price to others goods.
Rationally, but maybe mistakenly, when the price of a firm's product increases,
the firm will try to produce more.

* Sticky-price model
Prices are sometimes sticky for the same reasons they were in the Mundell-Fleming
model.

When firms expect a high price level, they expect high costs. Those firms that fix
prices in advance set their
prices high. These high prices cause the other firms to set high prices also.
Hence, a high expected price level
Pe leads to a high actual price level P.

When output is high, the demand for goods is high.Those firms with flexible prices
set their prices high, which
leads to a high price level.The effect of output on the price level depends on the
proportion of firms with
flexible prices.

* Phillips curve
Inflation depends on:
- expected inflation
- deviation of unemployment from the natural rate
- supply shocks

Inflation is negatively related to unemployment in the short run

PI = PIe - b(u - ue) + v
where PI = inflation
PIe = expected inflation :: inflation inertia if replaced by last year's
inflation
u = unemployment
v = supply shock
 b = relationship coefficient between inflation and unemployment

* The sacrifice ratio

The percentage of a year’s real GDP that must be forgone to reduce inflation by 1
percentage point

* Natural-rate hypothesis
Fluctuations in aggregate demand affect output and employment only in the short
run. In the long run, the economy
returns to the levels of output, employment, and unemployment described by the
classical model.

Some have challenged this :: hysteresis is the term used to describe the effects
of aggregate demand on the long run

A recession can have permanent effects if it changes the people who become
unemployed. For instance, workers
might lose valuable job skills when unemployed, lowering their ability to find a
job even after the recession ends.

# POLICY DEBATES
----------------
* Lucas critique
The traditional policy evaluation that relies on econometrics measures does not
factor in the expectations of people.

* Time inconsistency
An institution sometimes has an incentive to renege a previous commitment.
Citizens know that and it makes the policy by
rule harder.

# MISC
------
There are two expectational variables in the comprehensive model :: expected
inflation and expected price level

Y = output
K = capital
L = labor time
MPL = marginal productivity of labor
MPK = marginal productivity of capital
G = government purchases
T = tax revenue

lowercase letters usually stand for 'per worker'