Updated Macro Notes Feb 2019

Macroeconomics Lecture Notes
CHAPTER ONE:
INTRODUCTION
1.1. What Macroeconomics is about?
Why have some countries experienced rapid growth in incomes over the past century while
others stay mired in poverty? Why do some countries have high rates of inflation while others
maintain stable prices? Why do all countries experience recessions and depressions—recurrent
periods of falling incomes and rising unemployment—and how can government policy reduce
the frequency and severity of these episodes? Macroeconomics, the study of the economy as a
whole, attempts to answer these and many related questions.
The issues that macroeconomics addresses include the following:
 What determines a nation’s long-run economic growth?

 What causes a nation’s economic activity to fluctuate?
 What causes unemployment?
 What causes prices to rise?
 How does being part of a global economic system affect nations’ economies?
 Can government policies be used to improve a nation’s economic performance?
Macroeconomics seeks to offer answers to such questions, which are of great practical
importance and are constantly debated by politicians, the press, and the public.
1.2. Basic Concepts and Methods of Macroeconomic Analysis
Measuring the Value of Economic Activity: Gross Domestic Product
The single most important measure of overall economic performance is Gross Domestic Product
(GDP). The GDP is an attempt to summarize all economic activity over a period of time in terms
of a single number; it is a measure of the economy’s total output and of total income. In other
words GDP is the value of all final goods and services produced in the economy in a given time
period (not that GDP is a flow not a stock).
i) Real GDP versus Nominal GDP
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Valuing goods at their market price allows us to add different goods into a composite measure,
but also means we might be misled into thinking we are producing more if prices are rising.
Thus, it is important to correct for changes in prices. To do this, economists value goods at the
prices at which they sold at in some given year. For example, in Ethiopia, we mostly measure
GDP at 1980/81 prices. This is known as real GDP. GDP measured at current prices is known
as nominal GDP.
ii) The GDP Deflator
The GDP deflator is the ratio of nominal to real GDP:
The GDP deflator is a measure of the general price level.
iii) GDP and GNP
There is a distinction between GDP and gross national product (GNP). GNP is the value of final
goods and services produced by domestically owned factors of production within a given period.
The difference between GDP and GNP corresponds to the net income earned by foreigners.
When
GDP exceeds GNP residents of a given country are earning less abroad than foreigners are
earning in that country. In Ethiopia, GDP has exceeded GNP since 1981, but the gap is well
below 1% (0.75% to be exact) during 1981 – 1998.
In simple words, GDP is territorial while GNP is national.
iv)Gross and Net Domestic Product
Capital wears out, or depreciates while it is being used to produce output. Net domestic product
(NDP) is equal to GDP minus the capital consumption allowance, a measure of depreciation
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The Business Cycle and the Output Gap
Inflation, growth, and unemployment are related through the business cycle. The business cycle
is the more or less regular pattern of expansion (recovery) and contraction (recession) in
economic activity around the path of trend growth. At a cyclical peak, economic activity
is high relative to trend; and at a cyclical trough, the low point in economic activity is reached.
Inflation, growth, and unemployment all have clear cyclical patterns.
•Business cycles are a type of fluctuation found in the aggregate economic activity of
nations
•Contraction or recession: the period of time during which aggregate economic activity is
falling
•Depression: a very severe recession
•Trough (T): the low point of the contraction
•Expansion or a boom: period of time during which aggregate economic activity grows
•The peak (P): the high point of the expansion
•The entire sequence of decline followed by recovery, measured from peak to peak or
trough to trough, is a business cycle.
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The trend path of GDP is the path GDP would take if factors of production were fully employed.
Over time, real GDP changes for the two reasons. First, more resources become available which
allows the economy to produce more goods and services, resulting in a rising trend level of
output. Second, factors are not fully employed all the time. Thus, output can be increased by
increasing capacity utilization.
Output is not always at its trend level, that is, the level corresponding to full employment of the
factors of production. Rather output fluctuates around the trend level. During expansion (or
recovery) the employment of factors of production increased, and that is a source of
increased production. Conversely, during a recession unemployment increases and less
output is produced than can in fact be produced with the existing resources and technology.
Deviations of output from trend are referred to as the output gap.
The output gap measures the gap between actual output and the output the economy could
produce at full employment given the existing resources. Full employment output is also called
potential output.
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When looking at the business cycle fluctuation, one question that naturally arises is
whether expansions give way inevitably to old age, or whether they are instead brought to an end
by policy mistakes. Often a long expansion reduces unemployment too much, causes
inflationary pressures, and therefore triggers policies to fight inflation- and such policies
usually create recessions.
Okun’s Law
A relationship between real growth and changes in the unemployment rate is known as Okun‟s
law, named after its discoverer, Arthur Okun. Okun’s law says that the unemployment rate
declines when growth is above the trend rate.
where is change in unemployment, x the magnitude in which unemployment declines due
to a percentage point growth, actual growth rate of output, and is trend output growth rate.
The figure below shows the Okun‟s law relationship between unemployment and growth in
output.
Inflation –Unemployment Dynamics
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The Phillips curve describes the empirical relationship between inflation and
unemployment: the higher the rate of unemployment, the lower the rate of inflation. The
curve suggests that less unemployment can always be attained by incurring more
inflation and that the inflation rate can always be reduced by incurring the costs of more
unemployment. In other words the curve suggests there is a trade-off between inflation and
unemployment.
1.3. The State of Macroeconomics: Evolution and Recent Developments

Classical (1776 – 1870):-
In this period the distinction between micro and macro was not clear.
The ruling principle was the invisible hand coined by Adam Smith.
Neo classical (1870 – 1936):-

Basically the neoclassical school is not different from the classical school.
The main distinction is the tool of analysis, such as the marginal analysis.
Keynesian (1936 – 1970s):-
• The main thesis of the Keynesian stream is that the economy is subjected to failure
• Therefore it may not achieve full employment level.
• Thus, government intervention is inevitable.
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• For Keynes to do about recessions, the first and most obvious thing to do is to make it
possible for people to satisfy their demand for more cash without cutting their
spending, preventing the downward spiral of shrinking spending and shrinking income.
• The way to do this is simple to print more money, and somehow get it into circulation.
• So the usual and basic Keynesian answer to recessions is a monetary expansion.
• But Keynes worried that even this might sometimes not be enough, particularly if a
recession had been allowed to get out of hand and become a true depression.
• Once the economy is deeply depressed, monetary policy has become ineffective ,has
come to be known as a “liquidity trap”.
• When monetary expansion is ineffective, fiscal expansion must take its place.
1970s – Present:-no dominant school of thought of macroeconomics.
 There have been two main intellectual traditions in macroeconomics.
 One school of thought believes that government intervention can significantly improve
the operation of the economy.
 The debate on these questions involved Keynesians on one side, and monetarists on the
other (1960s).
 In the 1970s, the debate on much the same issues brought to the fore a new group-
the new classical macroeconomists, who by and large replaced the monetarists in
keeping up the argument against using active government policies to try to improve
economic performance.
 On the other side are the new Keynesians; they may not share many of the detailed
belief of Keynesians three or four decades ago, except the belief that government policy
can help the economy perform better.
 Monetarism (Milton Friedman)
 Monetarism, as advocates of free market, started challenging Keynes’s theory in the
1970s.
 According to the Monetarists, the Keynesians’ active policy is not only unnecessary but
actually harmful
 They worsen the very economic instability that it is supposed to correct, and should
be replaced by simple, mechanical monetary rules.
 This is the doctrine that came to be known as “monetarism”.
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 A straightforward rule- “Keep the money supply steady”- is good enough, so that there is
no need for a “discretionary” policy of the form, “Pump money in when your economic
advisers think a recession is imminent.”
 The New Classical School:
 The new classical macroeconomics remained influential in the 1980s.
 It shares many policy views with Friedman.
 It sees the world as one in which individuals act rationally in their self-interest in markets
that adjust rapidly to changing conditions.
 The government, it is claimed, is likely only to make things worse by intervening.
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CHAPTER TWO:
NATIONAL INCOME ACCOUNTING
2.1. The Concepts of GDP and GNP
When judging whether the economy is doing well or poorly, it is natural to look at the total
income that everyone in the economy is earning. That is the task of gross domestic product
(GDP).GDP measures two things at once: the total income of everyone in the economy and
the total expenditure on the economy’s output of goods and services.
For an economy as a whole, income must equal expenditure since every transaction has two
parties: a buyer and a seller (Look at Figure 2.1 below).
Figure 2.1: The Circular-Flow Diagram
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What is GDP?
GDP is the market value of all final goods and services which is currently
(newly)produced in a given time period by labour and property located within the
country.
Many subtle issues arise when computing an economy’s GDP.
Let’s therefore consider each phrase in this definition with some care.
“GDP is the market value . . .” GDP adds together many different kinds of products into a
single measure of the value of economic activity using market prices.
“Of all . . .” GDP tries to be comprehensive. It includes all items produced in the economy
and sold legally in markets.
“Final . . .” GDP includes only the value of final goods since the value of intermediate
goods is already included in the prices of the final goods.
“Goods and services . . .” GDP includes both tangible goods (food, clothing, cars) and
intangible services (haircuts, housecleaning, doctor visits).
“Newly produced . . .” GDP includes goods and services currently produced. E.g. When
one person sells a used car to another person, the value of the used car is not included in
GDP.
“within a country…” Items are included in a nation’s GDP if they are produced
domestically, regardless of the nationality of the producer.
What is gross national product (GNP)?
Gross national product (GNP) is the total income earned by a nation’s permanent
residents (called nationals). It differs from GDP by including income that our citizens earn
abroad and excluding income that foreigners earn here.
GNP =GDP+ Factor Payments from Abroad - Factor Payments to Abroad.
But how we measure GDP/GNP?
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2.2. Approaches of Measuring National Income (GDP/GNP)
There are 3 approaches: Expenditure approach, Output approach and Income approach
The Expenditure Approach to Measuring GDP
The Components of GDP
GDP includes all of these various forms of spending on domestically produced goods and
services. GDP (which we denote as Y) is divided into four components: consumption (C),
investment (I), government purchases (G), and net exports (NX):
Y=C+I+G+NX. (This equation is an identity-equation)
Consumption: spending by households on goods and services, with the exception of

purchases of new housing.
Investment: spending on capital equipment, inventories, and structures, including

household purchases of new housing. Investment is also divided into three subcategories:
business fixed investment, residential fixed investment, and inventory investment.
Government purchases: spending on goods and services by local, state, and federal
governments (e.g. military equipment, infrastructure, and the services that government
workers provide.)
Net exports: spending on domestically produced goods by foreigners (exports) minus

spending on foreign goods by domestic residents (imports).
The Product Approach to Measuring GDP
The product approach measures economic activity by adding the market values of goods and
services produced, excluding intermediate goods and services. Intermediate goods and
services are those used up in the production of other goods and services in the same period
that they themselves were produced. This approach makes use of the value-added concept.
The value added of any producer is the value of its output minus the value of the inputs
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it purchases from other producers. The product approach computes economic activity by
summing the value added by all producers.
The Income Approach to Measuring GDP
The income approach measures economic activity by adding all income received by
producers of output. Hence, measuring GDP using income approach includes:
compensation to employees (C): wage and salaries, social security, pension,

health and welfare funds)
Rent (payments to households that supply property resource) (R)
Interest (payments by private firms to household, which supply capital) (I)
Profit (proprietors income and corporate profit) (π)
Deprecation (D)
Indirect business tax (IBT)
Therefore, GDP using income approach is given as follows:
GDP = C+R+ π +D+IBT+I
Points to be noted while measuring GDP
Rules for Computing GDP
1. Avoid double counting: all currently produced good service must be counted only
once. To do this, take only the final goods and services or sum the value added at
each stage of production.
2. Not to include Non-productive Transaction: households and other entities receive
money without contributing in the production process. E.g. Transfer payment
(public):-pension, social security payments, and welfare payments to the poor or
unemployed
3. Imputations: some goods and services are not sold in the marketplace and
therefore do not have market prices. If GDP is to include the value of these goods
and services, we must use an estimate of their value. Such an estimate is called an
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imputed value. Imputations are especially important for determining the value of
housing & valuing government services. No imputation is made for the value of
goods and services sold in the underground economy. The underground economy is
the part of the economy that people hide from the government either because
they wish to evade taxation or because the activity is illegal.
Concluding Remark:
 total production (GDP) = total income = total expenditure
2.3. Other Social Accounts (NNP, NDP, NI, PI and DI)

Net national product (NNP): is the total income of a nation’s residents (GNP) minus losses
from depreciation.
National Income (NI) = NNP-Indirect Business Taxes
Personal Income (PI) =NI-social security contribution-corporate profit -net interest-
transfer payment+ dividend+ personal interest income
Personal disposable Income (PDI) is the difference between personal income and personal
income taxes.
It is a type of income which households divide it as saving and consumption.
Personal disposable Income (PDI) = Personal income (PI) – Personal income taxes (PIT)
Limitations of the GDP
Now that we have seen in some detail what the GDP is, let’s examine what it is
not. In particular:
1. Gross domestic product is not a measure of the nation’s economic well-being.
2. Only Market Activity Is Included in GDP
3. International GDP comparisons are vastly misleading when the two countries
differ greatly in the fraction of economic activity that each conducts in organized
markets
4. GDP Places No Value on Leisure
5. “Bads” as Well as “Goods” Get Counted in GDP
6. Ecological Costs Are Not Netted Out of the GDP
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Inflation and Price Indexes

To measure price level countries mostly use consumer price index (CPI). The CPI is the
price of this basket of goods and services relative to the price of the same basket in some
base year.
The base year is a reference year and it is usually a normal year when there is neither natural
nor man made catastrophe (disaster).
 inflation rate: the percentage change in the price index from the preceding period
The CPI Vs. the GDP Deflator

 The GDP deflator and the CPI give somewhat different information about what’s
happening to the overall level of prices in the economy. There are three key
differences between the two measures.
1. GDP deflator measures the prices of all goods and services produced, whereas
the CPI measures the prices of only the goods and services bought by
consumers.
2. The GDP deflator includes only those goods produced domestically.
3. The CPI assigns fixed weights to the prices of different goods, whereas the GDP
deflator assigns changing weights.
Unemployment and Inflation
 Unemployment is one of the most visible indicators of economic activity.
 Unemployment (or joblessness) occurs when people are without work and actively
seeking work
 In any population survey, every adult is placed into one of three categories:
 employed,
 unemployed, or
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 not in the labor force.

 The extent of unemployment is commonly expressed as the unemployment rate
 The unemployment rate is calculated as the percentage of the labor force that is
unemployed.
 Labor Force
 The labor force is the total number of workers, including both the employed
and the unemployed. (15-65 aged people)
 Labour force=unemployed + employed
Categories of Unemployment
• Frictional unemployment: represents those individuals that have left one job but are
certain to begin their new job within a relatively short period of time.
• Causes:
• lack of adjustment between demand for and supply of labour
• lack of necessary skills for doing particular job
• Immobility of labour,
• breakdown of machinery,
• shortage of raw materials
Seasonal unemployment: certain jobs are of seasonal type
• The workers get employment during certain part of the year according to seasonal
requirement.
• For example, agricultural landless workers get work during harvest and sowing
seasons only.
Cyclical (Keynesian) unemployment: occurs when individual suffer job losses due to
change in the economic (business) cycle.
Structural unemployment: exists when broad structural changes are taking place in an
economy such that certain job categories or skills are eliminated from labor markets.
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Chapter Three:
Aggregate Demand and Supply Analysis
3.1. Introduction: Income- Expenditure Approach
A) Simple Economy Model

 Assume an economy in which there is no government and foreign trade. In such a case
national income accounts divide total expenditure into two: Consumption (C) and
investment spending (I).Accordingly, we can write the identity of output produced and
output sold:
Y=C+I ……………………………………………………………………………… (1)
 Since there is no government and external sector in our economy (by assumption), the
private sector receives the whole of the disposable income (Y). The income will be partly
spent on consumption and partly will be saved. Thus we can write:
Y=C+S……………………………………………………………………………… (2)
 Next, identity (1) and (2) can be combined to give us
C+I=Y=C+S ……………………………………………………………………… (3)
 The left-hand side of identity (3) shows the components of demand, and the right-hand
sides show the allocation of income. Identity (3) can be reformulated to let us look at the
relationship between saving and investment.
Subtracting consumption from each part of identity (3), we have
I = Y - C = S …………………………………………………………………… (4)
• Identity (4) shows that in this simple economy investment is identically equals savings.
B) An Economy with Government and Foreign Trade

We denote the government purchases of all goods and services by (G) and its tax receipt by
(TA). The government also makes transfer to the private sector (TR). The foreign sector is
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composed of imports (M) and exports (X). Net exports (exports minus imports) are denoted
by NX.
Y = C+I+G+NX ……………………………………………………………………… (5)
Now we have to recognize that part of income is spent on taxes and that the private sector
receives net transfers (TR) in addition to national income. Disposable income (YD) is thus equal
to income plus transfers less taxes:
YD =Y+TR-TA ………………………………………………………………………….… (6)
Disposable income, in turn, is allocated to consumption and saving:
YD =C+S …………………………………….……………….…………………………….. (7)
Combining (6) and (7), we have:
C+S =YD =Y+TR-TA ……………………………………………………………………. (8)

Or
C =YD-S =Y+TR-TA-S …………………………………………………………………… (8a)
Identity (8a) states that consumption is disposable income less saving or, alternatively,
that consumption is equal to income plus transfers less taxes and saving.
Substituting the right hand side of (8a) into (5) and rearranging, we get
S-I = (G+TR-TA) + NX …………………………………………………………………… (9)
The first term on the right-hand side (G+TR-TA) is the government budget deficit- i.e. the excess
of government spending over its receipts. The second term on the right-hand side is the
excess of exports over imports, or net exports.
Thus, identity (9) states that the excess of saving over investment (S – I) of the private
sector is equal to the government budget deficit plus the trade surplus
The identity suggests that there are important relations among the excess of private saving
over investment (S –I), the government budget (G+TR-TA), and the external sector.
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For instance, if, for the private sector, saving is equal to investment, then the government’s
budget deficit (surplus) is reflected in an equal external deficit (surplus).In the 1980s there was
much discussion of the twin deficit- the budget deficit and the trade deficit. Identity (9) is
helpful is seeing that budget deficit must have a counterpart: if the government spends more
than it receives in revenue, then it has to borrow, either at home (private saving exceeds
investment) or abroad (imports exceeded exports). The identity makes it clear that budget deficits
need not be matched one-for-one by negative net exports. Thus, there is no inevitable one-to-one
link between the two deficits
3.2. Aggregate Demand Analysis
3.2.1. The Goods Market and the IS Curve
A) The Keynesian Cross

To derive the Keynesian cross, we begin by looking at the determinants of planned expenditure
or planned aggregate demand. Planned expenditure (or planned aggregate demand) is the amount
of households, firms, and the government plan to spend on goods and services. The difference
between actual and planned expenditure is unplanned inventory investment. When firms sell
less of their product than planned, their stock of inventories automatically rises.
Conversely, when firms sell more than planned, their stock of inventories falls. Because
these unplanned changes in inventory are counted as spending by firms, actual expenditure can
be either above or below planned expenditure.
Assuming that the economy is closed, so that net exports are zero, we write planned
aggregate demand (or planned expenditure) AD as the sum of consumption (C), planned
investment (I), and government purchases G:
AD = C+I+G ………………………………………………………………………….....… (10)
Consumption (C) in [10] is a function of disposable income (Y-T) i.e.
C=C (Y-T) ………………………………………………....……………………………… (11)
Disposable income is total income Y minus taxes T. Assume that planned investment is fixed i.e.
I =I
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And that the levels of government purchases and taxes are also fixed i.e. G=G , T =T
Combining these equations, we obtain
AD=C ( Y −T ) + I +G ……........................................................................................ (12)
Equation [12] states that planned aggregate demand (planned expenditure) is a function of income Y,
the exogenous level of planned investment I, and the exogenous fiscal policy variables G and T.
The figure above graphs planned expenditure as a function of the level of income since the other
variables are fixed. The line slopes upward because higher income leads to higher consumption
and thus higher planned expenditure. The slope of this line is the marginal propensity to
consume, the MPC: it shows how much planned expenditure increases when income rises by one
unit.
The Economy in Equilibrium
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The economy is in equilibrium when actual aggregate demand equals planned aggregate
demand. Total output of the economy Y equals not only total income but also actual aggregate
demand. We can write the equilibrium condition as
Actual aggregate demand = Planned aggregate demand i.e. Y= AD
In the above figure, the 45°line serves as a reference line that translates any horizontal distance
into an equal vertical distance. Thus, anywhere on the 45°line, the level of aggregate demand is
equal to the level of output. For instance, at point A, both output and aggregate demand are
equal. The equilibrium output would be achieved through inventory adjustment. Unplanned
changes in inventories induce firms to change production levels, which in turn changes
income and expenditure.
For example, suppose GDP is at a level greater than equilibrium level, such as level Y1 in figure
above, because of the miscalculation of firms about the aggregate demand. In this case, planned
aggregate demand AD1 is less than production (Y1). Firms are selling less than they produce.
Firms add the unsold goods to their stock of inventories. This unplanned rise in inventories
induces firms to lay off workers and reduce production, which reduce GDP. This process of
unintended inventory accumulation and falling income continues until income falls to the
equilibrium level. At the equilibrium, income equals planned aggregate demand
Similarly, suppose GDP is at a level lower than the equilibrium level, such as the level Y2. In
this case, planned aggregate demand is AD2, which is more than output Y2. Because planned
aggregate demand exceeds production, firms are selling more than they are producing. As firms
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see their stock of inventories fall, they hire more workers and increase production. This process
continues until income equals planned aggregate demand.
In summary, the Keynesian cross shows how income Y is determined for given levels of planned
investment (I) and fiscal policy G and T. We can use this model to show how income changes
when one of these exogenous variables changes
B. Fiscal Policy and the Multiplier: Government Purchases
Since government purchases are one component of expenditure, high government purchases
imply, for any given level of income, higher planned aggregate demand. If government
purchases rise by ΔG, then the planned aggregate demand schedule shifts upward by ΔG,
as shown in the figure below.
The graph shows that an increase in government purchases leads to an even greater
increase in income. That is, ΔY > ΔG.
The ratio ΔY/ΔG is called the government purchase multiplier; and it tells how much income
rises in response to a one-unit increase in government purchases. An implication of the
Keynesian cross is that the government purchases multiplier is larger than one.Why does fiscal
policy have a multiplied effect on income? The reason is that, according to the consumption
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function, higher income causes higher consumption. Because an increase in government

purchases raises income, it also raises consumption, which further raises income and so on.
Therefore, in this model, an increase in government purchases causes a greater increase

in income
The process of the multiplier begins when expenditure rises by ΔG, which implies that income
rises by ΔG as well. This increase in income in turn raises consumption by MPC*ΔG, where
MPC is the marginal propensity to consume. This increase in consumption raises aggregate
demand and income once again. This second increase in income of MPC *ΔG again raises
consumption by MPC* (MPC *ΔG), which again raises aggregate demand and income, and so
on. We can thus write this process compactly as
Y  G  MPC * G  MPC 2 * G  MPC 3 * G  ....

 (1  MPC  MPC 2  MPC 3 ....) G
The government purchase multiplies is
Y
 1  MPC  MPC 2  MPC 3 ...
G
This expression for the multiplier is an example of an infinite geometric series. A result from
algebra allows us to write the multiplies as:
Y 1

G 1  MPC
Fiscal Policy Multiplier: Taxes
A decrease in taxes of ΔT immediately raises disposable income Y-T by ΔT and,

therefore, consumption by MPC * ΔT. For any level of income Y, aggregate demand is now
higher. As shown in the figure below, the aggregate demand schedule shifts upward by
MPC*ΔT. The equilibrium of the economy moves from point A to point B.
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As in government purchases has a multiplied effect on income; taxes do also have multiplier
impact.
The tax multiplier is

ΔY −1
=
ΔT 1−MPC
The multiplier implies that taxes and income are inversely related and a unit change in taxes
increase income by more than proportionately
The Interest rate, Investment and the IS Curve
The Keynesian cross is useful because it shows what determines the economy’s income
for any given level of planned investment. Yet it makes the unrealistic assumption that the level
of planned investment is fixed.
However, planned investment depends negatively on the interest rate. The transition from the
Keynesian cross model to the IS curve is achieved by noting that if the real interest rate changes,
this changes planned investment. The Keynesian cross analysis tells us that change in planned
investment change GDP.
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Thus, for example, if interest rates increase, planned investment falls, and so does output. Thus
higher levels of the interest rate are associated with lower level of output. To add the
relationship between the interest rate and investment, we write the level of planned
investment as
I = I(r)
Thus, we can write equation [10] as
Y = C (Y-T) +I(r) +G
Because investment is inversely related to the interest rate, an increase in the interest rate
from r1 to r2reduces the quantity of investment from I(r 1) to I(r2). The reduction in planned
investment, in turn, shifts the expenditure function downward as shown in the upper panel of the
figure above.
The shift in the expenditure function leads to a lower level of income. Hence, an increase in the
interest rate lowers income. The IS curve summarizes the relationship between the interest
rate and the level of income that results from the investment function and the Keynesian
cross. The higher the interest rate, the lower the level of planned investment, and thus the lower
level of income. For this reason the IS curve slopes downward
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How Fiscal Policy Shifts the IS Curve
In summary, the IS curve shows the combinations of the interest rate and the level of income 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
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3.2.2. The Money Market and the LM Curve
The LM curve plots the relationship between the interest rate and the level of income that arises
in the market for money balances. To understand this relationship, we begin by looking at a
theory of the interest rate, called the theory of liquidity preference.
The Theory of Liquidity Preference
We begin with the supply of real money balances. If M stands for the supply of money and P
stands for the price level, then M/P is the supply of real money balances
The theory of liquidity preference assumes there is a fixed supply of real balance. That is,
(M/ P) s  M / P
The money supply M is an exogenous policy variable chosen by the central bank. The price level
P is also an exogenous variable in this model. (We take the price level as given because the
IS-LM model considers the short run when the price level is fixed). These assumptions
imply that the supply of real balances is fixed and, in particular, does not depend on the interest
rate as shown in the figure below.
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People hold money because it is a “liquid” asset- that is, because it is easily used to make
transactions.
The theory of liquidity preference postulates that the quantity of real money balances demanded
depends on the interest rate.
The interest rate is the opportunity cost of holding money. When the interest rate rises, people
want to hold less of their wealth in the form of money. We write the demand for real money
balances as
(M/ P)d  L(r)
Where the function L ( ) denotes the demand for the liquid asset- money.
This equation states that the quantity of real balances demanded is a function of the
interest rate. This inverse relationship between money demand and interest rate can be
shown as a downward sloping demand curve. If the interest rate is above the equilibrium level,
the quantity of real money balances supplied exceeds the quantity demanded. Individuals holding
the excess supply of money try to convert some of their non-interest-bearing money into interest-
bearing bank deposits or bonds.
Income, Money Demand, and the LM Curve
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So far we have assumed that only the interest rate influences the quantity of real balances
demanded. More realistically, the level of income Y also affects money demand. When
income is high, expenditure is high, so people engage in more transactions that require
the use of money. Thus, greater income implies greater money demand. We now write the
money demand function as:
(M/ P)d  L(r, Y)
The quantity of real money balances demanded is negatively related to the interest rate and
positively related to income. Using the theory of liquidity preference, we can see what happens
to the interest rate when the level of income changes. For example, consider what happens when
income increases from Y1 to Y2
.How Monetary Policy Shifts the LM Curve
The LM curve is drawn for a given supply of real money balances. If real balances change, the
LM curve will shift. 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
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Conclusion: The Short-Run Equilibrium
We now have all the components of the IS-LM model. The two equations of this model are
Y= C (Y-T) + I(r) +G IS
M/P = L(r, Y) LM
The model takes fiscal policy, G and T, monetary policy M, and the price level P as exogenous.
Given these exogenous variables, the IS curve provides the combinations of r and Y that satisfy
the equation representing the goods market, and the LM curve provides the combinations of r
and Y that satisfy the equation representing the money market. These two curves are shown
together in the following figure
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What we have done so far is summarized as follows:
3.2. Aggregate Supply
By itself, the aggregate demand curve does not tell us the price level or the amount of output that
will prevail in the economy; it merely gives a relationship between these two variables. To
accompany the aggregate demand curve, we need another relationship between P and Y that
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crosses the aggregate demand curve—an aggregate supply curve. The aggregate demand and
aggregate supply curves together pin down the economy’s price level and quantity of output.
Aggregate supply (AS) is the relationship between the quantity of goods and services supplied
and the price level. Because the firms that supply goods and services have flexible prices in the
long run but sticky prices in the short run, the aggregate supply relationship depends on the time
horizon. We need to discuss two different aggregate supply curves: the long-run aggregate
supply curve LRAS and the short-run aggregate supply curve SRAS
3.2.1. The Long Run: The Vertical Aggregate Supply Curve (Classical Approach)
Because the classical model describes how the economy behaves in the long run we derive the
long-run aggregate supply curve from the classical model. The classical’s assumed that the
amount of output produced depends on the fixed amount of capital and labor and on the available
technology. To show this, we write
According to the classical model, output does not depend on the price level. To show that output
is fixed at this level, regardless of the price level, we draw a vertical aggregate supply curve, as
in the following figure. In the long run, the intersection of the aggregate demand curve with this
vertical aggregate supply curve determines the price level.
If the aggregate supply curve is vertical, then changes in aggregate demand affect prices but not
output.
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The vertical aggregate supply curve satisfies the classical dichotomy, because it implies that the
level of output is independent of the money supply. This long-run level of output is called the
full-employment, or natural level of output. It is the level of output at which the economy’s
resources are fully employed or, more realistically, at which unemployment is at its natural rate.
3.2.2. The Short Run: The Horizontal Aggregate Supply Curve
The classical model and the vertical aggregate supply curve apply only in thelong run. In the
short run, some prices are sticky and, therefore, do not adjust tochanges in demand. Because of
this price stickiness, the short-run aggregate supply curve is not vertical.
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Suppose that all firms have issued price catalogs and that it is too costly for them to issue new
ones. Thus, all prices are stuck at predetermined levels. At these prices, firms are willing to sell
as much as their customers are willing to buy, and they hire just enough labour to produce the
amount demanded.
The short-run equilibrium of the economy is the intersection of the aggregate demand curve and
this horizontal short-run aggregate supply curve. In this case, changes in aggregate demand do
affect the level of output.
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CHAPTER FOUR:
THEORIES OF CONSUMPTION
4.1. Introduction
The consumption decision is crucial for long-run analysis because of its role in economic
growth. The consumption decision is crucial for short-run analysis because of its role in
determining aggregate demand. Consumption is two-thirds of GDP, so fluctuations in
consumption are a key element of booms and recessions. The IS–LM model of Chapter 3 shows
that changes in consumers’ spending plans can be a source of shocks to the economy and that the
marginal propensity to consume is a determinant of the fiscal-policy multipliers.
In previous chapters we explained consumption with a function that relates consumption to

disposable income: C=C (Y−T). This approximation allowed us to develop simple models for
long-run and short-run analysis, but it is too simple to provide a complete explanation of
consumer behavior. In this chapter we examine the consumption function in greater detail and
develop a more thorough explanation of what determines aggregate consumption.
Since macroeconomics began as a field of study, many economists have written about the theory
of consumer behavior and suggested alternative ways of interpreting the data on consumption
and income.
4.2. The Keynesian Consumption Function: The Absolute Income Hypothesis (AIH)
Keynes made the consumption function central to his theory of economic fluctuations, and it has
played a key role in macroeconomic analysis ever since. Let’s consider what Keynes thought
about the consumption function.
Keynes’s Conjectures
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Instead of relying on statistical analysis, Keynes made conjectures about the consumption
function based on introspection and casual observation.
1. First and most important, Keynes conjectured that the marginal propensity to consume—
the amount consumed out of an additional dollar of income—is between zero and one. He
wrote that the “fundamental psychological law, upon which we are entitled to depend
with great confidence, . . . is that men are disposed, as a rule and on the average, to
increase their consumption as their income increases, but not by as much as the increase
in their income.’’ That is, when a person earns an extra dollar, he typically spends some
of it and saves some of it.
2. Second, Keynes posited that the ratio of consumption to income, called the average
propensity to consume, falls as income rises. He believed that saving was a luxury, so he
expected the rich to save a higher proportion of their income than the poor. Although not
essential for Keynes’s own analysis, the postulate that the average propensity to consume
falls as income rises became a central part of early Keynesian economics.
3. Third, Keynes thought that income is the primary determinant of consumption and that
the interest rate does not have an important role. This conjecture stood in stark contrast
to the beliefs of the classical economists who preceded him.
On the basis of these three conjectures, the Keynesian consumption function is often written as
Where C is consumption, Y is disposable income, is a constant, and c is the marginal

propensity to consume. This consumption function, shown in Figure 4.1, is graphed as a straight
line. Determines the intercept on the vertical axis, and c determines the slope.
Notice that this consumption function exhibits the three properties that Keynes posited. It
satisfies Keynes’s first property because the marginal propensity to consume c is between zero
and one, so that higher income leads to higher consumption and also to higher saving. This
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consumption function satisfies Keynes’s second property because the average propensity to
consume APC is
As Y rises, falls, and so the average propensity to consume C/Y falls, and finally, this
consumption function satisfies Keynes’s third property because the interest rate is not included in
this equation as a determinant of consumption.
4.2. Modigliani’s Life Cycle Hypothesis Model

This model was developed by Franco Modigliani and his collaborators Albert Ando and Richard
Brumberg to study the consumption function. One of their goals was to solve the consumption
puzzle—that is, to explain the apparently conflicting pieces of evidence that came to light when
Keynes’s consumption function was confronted with the data.
Basic Idea: The LCH of consumer behavior emphasizes that income varies somewhat
systematically over a person’s life and that consumer’s use saving and borrowing to smooth
their consumption over their lifetimes. According to this hypothesis, consumption depends on
both income and wealth.
The Hypothesis
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One important reason that income varies over a person’s life is retirement. Most people plan to
stop working at about age 65, and they expect their incomes to fall when they retire. Yet they do
not want a large drop in their standard of living, as measured by their consumption. To maintain
their level of consumption after retirement, people must save during their working years.
Consider a consumer who expects to live another T years, has wealth of W, and expects to earn
income Y until she retires R years from now. What level of consumption will the consumer
choose if she wishes to maintain a smooth level of consumption over her life?
The consumer’s lifetime resources are composed of initial wealth W and lifetime earnings of
R×Y.(For simplicity, we are assuming an interest rate of zero; if the interest rate were greater
than zero, we would need to take account of interest earned on savings as well.) The consumer
can divide up her lifetime resources among her T remaining years of life. We assume that she
wishes to achieve the smoothest possible path of consumption over her life time. Therefore, she
divides this total of W+RY equally among the T years and each year consumes
If every individual in the economy plans consumption like this, then the aggregate consumption
function is much the same as the individual one. In particular, aggregate consumption depends
on both wealth and income. That is, the economy’s consumption function is
,
where the parameter is the marginal propensity to consume out of wealth, and the parameter
is the marginal propensity to consume out of income.
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4.3. Friedman’s Permanent Income Hypothesis (PIH)
Friedman’s permanent-income hypothesis emphasizes that individuals experience both

permanent and transitory fluctuations in their income. Because consumers can save and borrow,
and because they want to smooth their consumption, consumption does not respond much to
transitory income. Instead, consumption depends primarily on permanent income.
The Hypothesis
Friedman suggested that we view current income Y as the sum of two components, permanent
income YP and transitory income YT. That is,
Permanent income is the part of income that people expect to persist into the future. Transitory
income is the part of income that people do not expect to persist. Put differently, permanent
income is average income, and transitory income is the random deviation from that average.
Friedman reasoned that consumption should depend primarily on permanent income, because
consumers use saving and borrowing to smooth consumption in response to transitory changes in
income.
Friedman concluded that we should view the consumption function as approximately
, where is a constant that measures the fraction of permanent income consumed. The
permanent-income hypothesis, as expressed by this equation, states that consumption is
proportional to permanent income.
4.4. The Relative Income Hypothesis
Relative income hypothesis states that the satisfaction (or utility) that an individual derives from
a given consumption level depends on its relative magnitude in the society (e.g., relative to the
average consumption) rather than its absolute level. It is based on a postulate that has long been
acknowledged by psychologists and sociologists, namely that individuals care about status. In
economics, relative income hypothesis is attributed to James Duesenberry, who investigated the
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implications of this idea for consumption behaviour in his 1949 book titled “Income, Saving and
the Theory of Consumer Behaviour”.
Duesenberry claimed that an individual’s utility index depended on the ratio of his or her
consumption to a weighted average of the consumption of the others. From this he drew two
conclusions: (1) aggregate saving rate is independent of aggregate income, which is consistent
with the time series evidence; and (2) the propensity to save of an individual is an increasing
function of his or her percentile position in the income distribution, which is consistent with the
cross-sectional evidence.
The relative income theory argues that the level of consumption spending is determined by the
household’s level of current income relative to the highest level of income previously earned.
Symbolically,
Where:
C = current level of consumption expenditures
Y = current level of income
Yn = the highest level of income previously earned
a and b = represent constants that relate income to consumption.
The above equation shows that when families get a temporary and short run increase in current
income above its peak level of income, it increases its consumption expenditures by an amount,
which is less proportional to the increase in current income. Consequently when current income
rises relative to peak income, the APC declines and the increase in total consumption
expenditures is not proportional to the increase in total income. In addition, when the current and
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peak income of a household increases by the same percentage amount, it increases the
consumption expenditures by an amount which is proportional to the increase in current
income. Then, the APC remains constant and the increase in total consumption expenditure is
proportional to the increase in total income. According to the RIT, changes in current
consumption are not proportional to the changes in current income only when current income
increases relative to previous peak income.
According to the relative income hypothesis, each family, in deciding on the fraction of its
income to be spent, is uninfluenced by the fact that it is no better off in relative terms. Being no
better off in this sense, its decision is to “live” as it did previously, devoting the same fraction of
its income to consumption as before.
There is a fundamental difference between RIH and AIH. The RIH explains the short run
consumption functions due to changes in current income. But the AIH explains the long run
consumption function due to changes in factors other than income on consumption.
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CHAPTER FIVE:
THEORIES OF INVESTMENT
5.1. The Concept of Investment
What is investment?
By investment, economists mean the production of goods that will be used to produce other
goods. This definition differs from the popular usage, wherein decisions to purchase stocks (e.g.
STOCK MARKET) or BONDS are thought of as investment.
Investment need not always take the form of a privately owned physical product. The most
common example of nonphysical investment is investment in HUMAN CAPITAL. When a student
chooses study over leisure, that student has invested in his own future just as surely as the factory
owner who has purchased machines. Investment theory just as easily applies to this decision.
Pharmaceutical products that establish heightened well-being can also be thought of as
investments that reap higher future PRODUCTIVITY. Moreover, government also invests. A bridge
or a road is just as much an investment in tomorrow’s activity as a machine is.
The general rule is that the economy’s investment does not include purchases that merely
reallocate existing assets among different individuals. Investment, as macroeconomists use the
term, creates new capital. Investment is the flow of spending that adds to the physical stock of
capital.
Let’s consider some examples. Suppose we observe these two events:
Smith buys for himself a 100-year-old Victorian house.

Jones builds for herself a brand-new contemporary house.
What is total investment here? Two houses, one house, or zero?
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A macroeconomist seeing these two transactions counts only the Jones house as investment.
Smith’s transaction has not created new housing for the economy; it has merely reallocated
existing housing. Smith’s purchase is investment for Smith, but it is disinvestment for the person
selling the house. By contrast, Jones has added new housing to the economy; her new house is
counted as investment.
Similarly, consider these two events:
Gates buys $5 million in IBM stock from Buffett on the New York Stock Exchange.
General Motors sells $10 million in stock to the public and uses the proceeds to build a
new car factory.
Here, investment is $10 million. In the first transaction, Gates is investing in IBM stock, and
Buffett is disinvesting; there is no investment for the economy. By contrast, General Motors is
using some of the economy’s output of goods and services to add to its stock of capital; hence,
its new factory is counted as investment.
There are three types of investment spending. Business fixed investment includes the equipment
and structures that businesses buy to use in production. Residential investment includes the new
housing that people buy to live in and that landlords buy to rent out. Inventory investment
includes those goods that businesses put aside in storage, including materials and supplies, work
in process, and finished goods.
5.2. Business Fixed Investment
The largest piece of investment spending (about ¾ of total) is business fixed investment.
 Business: these investment goods are bought by firms for use in future production.
 Fixed: This spending is for capital that will stay put for a while (as opposed for inventory
investment)
Business fixed investment includes everything from fax machines to factories, computers to
company cars. The standard model of business fixed investment is called the neoclassical model
of investment. It examines the benefits and costs of owning capital goods. Here are three
variables that shift investment: the marginal product of capital, the interest rate and tax rules.
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The Rental Price of Capital
Let’s first consider the typical production firm. A firm decides how much capital to rent by
comparing the cost and benefit of each unit of capital. The firm rents capital at a rental rate R and
sells its output at a price P; the real cost of a unit of capital to the production firm is R/P.The real
benefit of a unit of capital is the marginal product of capital MP K—the extra output produced
with one more unit of capital. The marginal product of capital declines as the amount of capital
rises: the more capital the firm has, the less an additional unit of capital will add to its output. To
maximize profit, the firm rents capital until the marginal product of capital falls to equal the real
rental price.
Figure 5.1.Shows the equilibrium in the rental market for capital. For the reasons just discussed,
the marginal product of capital determines the demand curve. The demand curve slopes
downward because the marginal product of capital is low when the level of capital is high. At
any point in time, the amount of capital in the economy is fixed, so the supply curve is vertical.
The real rental price of capital adjusts to equilibrate supply and demand.
To see what variables influence the equilibrium rental price, let’s consider a particular
production function. Consider the Cobb–Douglas production function which is given by
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, where Y is output, K is capital, L is labor, A is a parameter measuring the level of
technology, and is a parameter between zero and one that measures capital’s share of output.
The marginal product of capital for the Cobb–Douglas production function is
Because the real rental price R/P equals the marginal product of capital in equilibrium, we can
write
This expression identifies the variables that determine the real rental price. It shows the
following:
 The lower the stock of capital, the higher the real rental price of capital.
 The greater the amount of labor employed, the higher the real rental price of capital.
 The better the technology, the higher the real rental price of capital.
Events that reduce the capital stock (an earthquake), or raise employment (an expansion in
aggregate demand), or improve the technology (a scientific discovery) raise the equilibrium real
rental price of capital.
The Cost of Capital
Next consider the rental firms. These firms like car-rental companies, merely buy capital goods
and rent them out. Because our goal is to explain the investments made by the rental firms, we
begin by considering the benefit and cost of owning capital.
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The benefit of owning capital is the revenue earned by renting it to the production firms. The
rental firm receives the real rental price of capital R/P for each unit of capital it owns and rents
out.
The cost of owning capital is more complex. For each period of time that it rents out a unit of
capital, the rental firm bears three costs:
1. When a rental firm borrows to buy a unit of capital, it must pay interest on the loan. If
is the purchase price of a unit of capital and is the nominal interest rate, then is the
interest cost. Notice that this interest cost would be the same even if the rental firm did
not have to borrow: if the rental firm buys a unit of capital using cash on hand, it loses
out on the interest it could have earned by depositing this cash in the bank. In either case,
the interest cost equals .

2. While the rental firm is renting out the capital, the price of capital can change. If the price
of capital falls, the firm loses, because the firm’s asset has fallen in value. If the price of
capital rises, the firm gains, because the firm’s asset has risen in value. The cost of this
loss or gain is .
3. While the capital is rented out, it suffers wear and tear, called depreciation. If is the rate
of depreciation—the fraction of capital’s value lost per period because of wear and tear—
then the dollar cost of depreciation is .
The total cost of renting out a unit of capital for one period is therefore
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The cost of capital depends on the price of capital, the interest rate, the rate at which capital
prices are changing, and the depreciation rate.
To make the expression for the cost of capital simpler and easier to interpret, we assume that the
price of capital goods rises with the prices of other goods. In this case, equals the
overall rate of inflation . Because equals the real interest rate r, we can write the cost of
capital as
This equation states that the cost of capital depends on the price of capital, the real interest rate,
and the depreciation rate.
Finally, we want to express the cost of capital relative to other goods in the economy. The real
cost of capital—the cost of buying and renting out a unit of capital measured in units of the
economy’s output—is
The Determinants of Investment
Now consider a rental firm’s decision about whether to increase or decrease its capital stock. For
each unit of capital, the firm earns real revenue R/P and bears the real cost . The
real profit per unit of capital is
Because the real rental price in equilibrium equals the marginal product of capital, we can write
the profit rate as
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The rental firm makes a profit if the marginal product of capital is greater than the cost of capital.
It incurs a loss if the marginal product is less than the cost of capital.
We can now see the economic incentives that lie behind the rental firm’s investment decision.
The firm’s decision regarding its capital stock—that is, whether to add to it or to let it depreciate
—depends on whether owning and renting out capital is profitable. The change in the capital
stock, called net investment, depends on the difference between the marginal product of capital
and the cost of capital. If the marginal product of capital exceeds the cost of capital, firms find it
profitable to add to their capital stock. If the marginal product of capital falls short of the cost of
capital, they let their capital stock shrink.
We can also now see that the separation of economic activity between production and rental
firms, although useful for clarifying our thinking, is not necessary for our conclusion regarding
how firms choose how much to invest. For a firm that both uses and owns capital, the benefit of
an extra unit of capital is the marginal product of capital, and the cost is the cost of capital. Like
a firm that owns and rents out capital, this firm adds to its capital stock if the marginal product
exceeds the cost of capital. Thus, we can write
Where is the function showing how much net investment responds to the incentive to invest.
We can now derive the investment function. Total spending on business fixed investment is the
sum of net investment and the replacement of depreciated capital. The investment function is
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Business fixed investment depends on the marginal product of capital, the cost of capital, and the
amount of depreciation.
This model shows why investment depends on the interest rate. A decrease in the real interest
rate lowers the cost of capital. It therefore raises the amount of profit from owning capital and
increases the incentive to accumulate more capital. Similarly, an increase in the real interest rate
raises the cost of capital and leads firms to reduce their investment. For this reason, the
investment schedule relating investment to the interest rate slopes downward.
5.3. Tobin’s-q Model
Many economists see a link between fluctuations in investment and fluctuations in the stock
market. The term stock refers to shares in the ownership of corporations, and the stock market is
the market in which these shares are traded. Stock prices tend to be high when firms have many
opportunities for profitable investment, because these profit opportunities mean higher future
income for the shareholders. Thus, stock prices reflect the incentives to invest.
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The Nobel Prize–winning economist James Tobin proposed that firms base their investment
decisions on the following ratio, which is now called Tobin’s q:
The numerator of Tobin’s q is the value of the economy’s capital as determined by the stock
market. The denominator is the price of that capital if it were purchased today.
Tobin reasoned that net investment should depend on whether q is greater or less than 1. If q is
greater than 1, then the stock market values installed capital at more than its replacement cost. In
this case, managers can raise the market value of their firms’ stock by buying more capital.
Conversely, if q is less than 1, the stock market values capital at less than its replacement cost. In
this case, managers will not replace capital as it wears out.
At first the q theory of investment may appear very different from the neoclassical model
developed previously, but the two theories are closely related. To see the relationship, note that
Tobin’s q depends on current and future expected profits from installed capital. If the marginal
product of capital exceeds the cost of capital, then firms are earning profits on their installed
capital. These profits make the firms more desirable to own, which raises the market value of
these firms’ stock, implying a high value of q. Similarly, if the marginal product of capital falls
short of the cost of capital, then firms are incurring losses on their installed capital, implying a
low market value and a low value of q.
The advantage of Tobin’s q as a measure of the incentive to invest is that it reflects the expected
future profitability of capital as well as the current profitability. This expected fall in the
corporate tax means greater profits for the owners of capital. These higher expected profits raise
the value of stock today, raise Tobin’s q, and therefore encourage investment today. Thus,
Tobin’s q theory of investment emphasizes that investment decisions depend not only on current
economic policies but also on policies expected to prevail in the future.
5.4. Residential Fixed Investment
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Residential fixed investment is spending on the construction of new houses and apartment
buildings. Houses and apartment buildings are treated as capital goods because they provide a
service (shelter) over a long period of time.
The Stock Equilibrium and the Flow Supply
There are two parts to the model. First, the market for the existing stock of houses determines the
equilibrium housing price. Second, the housing price determines the flow of residential
investment.
Panel (a) of the following figure shows how the relative price of housing is determined by
the supply and demand for the existing stock of houses. At any point in time, the supply of
houses is fixed. We represent this stock with a vertical supply curve. The demand curve for
houses slopes downward, because high prices cause people to live in smaller houses, to share
residences, or sometimes even to become homeless. The price of housing adjusts to equilibrate
supply and demand.
Panel (b) shows how the relative price of housing determines the supply of new houses.
Construction firms buy materials and hire labor to build houses and then sell the houses at the
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market price. Their costs depend on the overall price level P(which reflects the cost of wood,
bricks, plaster, etc.), and their revenue depends on the price of houses PH. The higher the relative
price of housing, the greater the incentive to build houses and the more houses are built. The
flow of new houses—residential investment—therefore depends on the equilibrium price set in
the market for existing houses.
This model of residential investment is similar to the q theory of business fixed investment.
According to the q theory, business fixed investment depends on the market price of installed
capital relative to its replacement cost; this relative price, in turn, depends on the expected profits
from owning installed capital. According to this model of the housing market, residential
investment depends on the relative price of housing. The relative price of housing, in turn,
depends on the demand for housing, which depends on the imputed rent that individuals expect
to receive from their housing. Hence, the relative price of housing plays much the same role for
residential investment as Tobin’s q does for business fixed investment.
5.5. Inventory Investment
An increase in firms’ inventory holdings is called inventory investment. Increases in inventories

are included in investment spending, regardless of why inventories rose. Inventory investment
equals the increase in firms’ inventories of unsold goods, unfinished goods, or raw materials. In
particular, if a firm produces goods that it can't sell, the resulting rise in inventories counts
as investment by the firm.
Like other components of investment, inventory investment depends on the real interest rate.
When a firm holds a good in inventory and sells it tomorrow rather than selling it today, it gives
up the interest it could have earned between today and tomorrow. Thus, the real interest rate
measures the opportunity cost of holding inventories.
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When the real interest rate rises, holding inventories becomes more costly, so rational firms try
to reduce their stock. Therefore, an increase in the real interest rate depresses inventory
investment. Inventory investment also depends on credit conditions. Because many firms rely on
bank loans to finance their purchases of inventories, they cut back when these loans are hard to
come by.
5.6. Keynesian Explanation
The Keynesian Theory lays emphasis upon interest rate importance in investment decisions.
Other factor considered is the expected profitability on a project. Change in interest rates affects
the planned investments done. A fall in interest rates would bounce the profits from a planned
investment and the rise in interest rates would make the profits fall. An inverse relationship
exists between the Investment and the Rate of Interest. Look at the following figure.
5.7. Accelerator (Inventory) Model
A different approach to investment relative to the profit-maximizing model is that of the

accelerator model. This model begins with the notion that a certain amount of capital is
necessary to support a given level of economic activity. The accelerator model is the theory that
investment is determined from a set of propositions:
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 Investment is determined from the difference between the desired level of capital and the
capital that survives from the past.
 The capital that survives from the past is a constant proportion of past capital.
 The desired level of capital is proportional to the expected level of output.
 The level of capital, actual or expected, is proportional to the level of output, actual or
expected.
 If the economy is operating at full utilization of capital then investment is proportion to
the expected change in output for the period ahead.
 The expected change in output in the future will be the same as the latest known change
in output.
Let Yt be the level of output, Gross Domestic Product (GDP), in time period t. Let K t be the
capital stock available in period t and It the level of investment in period t. Let be the
expected level of output in period (t+s), s time period ahead of time period t and likewise for .
The above propositions can be represented as:
 It = −βKt
 =α
 Kt+1 = αYt+1
 −Yt = Yt-1−Yt-2
When β, the survival rate for capital, is equal to 1.0 then
 It = Kt+1E−Kt = α[Yt+1E−Yt] = α[Yt-1−Yt-2]
Thus propositions reduce to the equation:
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 It = α [Yt-1 - Yt-2], where α is called the accelerator coefficient.
The above Equation reveals that as a result of increase in income in any year t from a previous
year t-1, increase in investment will be α times more than the increase in income. Hence it is α
i.e. capital output ratio which represents the magnitude of the accelerator. If the capital output
ratio is equal to 3, then as a result of a certain increase in income, investment will increase three
times more i.e. accelerator here will be equal to 3.
Note: - The acceleration principle describes the effect quite opposite to that of multiplier.
Chapter Six
6. Monetary and Fiscal Policy
6.1. Introduction
Today we all have come to understand that one of the federal government’s most important roles
is regulating and ensuring the stability of the economy.
The government has two major ways of doing this. The government can enact fiscal policy
changes or they can enact monetary policy changes.
Fiscal Policy - Refers the power of the federal government to tax and spend in order to achieve
its goals for the economy.
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Monetary Policy - Programs that try to increase or decrease the nations level of business by
regulating the supply of money and credit.
What both of these policy options have as a goal is increasing and decreasing the level of
business activity. It is most always preferable to have a productive growing economy but an
economy can also be too productive. In that case the government may enact policies to slow
down the economy
The Purposes of macroeconomic policies are:
• Maintain long-term growth
• Stabilise the economy
– Moderating the business cycle
• Maintain employment levels where possible
• Control inflation
6.2. Fiscal Policy
Fiscal policy refers to the government’s choices regarding the overall level of government
purchases or taxes.
• Fiscal policy influences saving, investment, and growth in the long run.
• In the short run, fiscal policy primarily affects the aggregate demand
The Federal government’s control of the economy is both direct and indirect.
– Its expenditures have a direct effect on aggregate demand.
– Taxes and tax policy have an indirect effect on consumer spending
6.3. Fiscal Policy Instruments

a) Taxes
Fiscal Policies include raising or lowering of taxes. If we raise taxes we are taking money out of
circulation. When one considers the impact of taxes one must look at the sector of society being
impacted by the tax hike. Does it impact on the middle class, working class or upper class? There
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are differing philosophies on who should shoulder the tax burden. Some feel it should be the
wealthy while other look to the middle class. The reality is that the middle class pay the largest
amount of taxes overall. Raising taxes to the middle class will limit consumer spending so if you
are going to do that you had better have a good reason. Clearly raising taxes will slow down
spending, economic growth as well as inflation.
The question then comes to tax cuts. You must again ask the same questions. Who do you want
to cut taxes too? Who do you want to encourage to spend? Again, recent economic history
proves that cutting taxes to the middle class is the only effective way to encourage growth and
spending.
b) Spending Programs
Spending programs pump money into an economy and increase spending and growth. They also
have the potential impact of increasing inflation as more money circulates in the economy.
Again, when determining what spending programs to initiate depends on where you want the
impact to be. If you build highways you will create jobs for the working class, same with
housing projects, etc. These types of jobs employ many workers. If you build B2 bombers,
however, fewer workers are employed at a much higher cost. Who gets the money here? The
large corporation that builds it does, that's who. So you see how you spend the money means as
much as how much money you spend.
Spending cuts have the same impact. If you cut homeless shelter there are people out on the
streets. From an economic impact perspective that may not seem like much but now you have a
human interest issue. If you close military bases you may well shut down the town that thrives
off of the existence of the base. Some bases employ up to an over 20,000 townspeople with no
other viable means of support. You have to consider the impact and the location of the base.
When the federal government cut funding for the F-14 Tomcat Fighter built by Grumman on
Long Island it had a terrible impact on the Long Island economy as those highly technical
workers sought to find jobs. Since Long Island is a wealthy suburb of New York City, however,
those workers were more likely to find work then if the factory had been located in a more rural
area.
6.4. Fiscal Policy and IS-LM curve
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Changes in government Spending
The intersection of the IS curve and the LM curve determines the level of national income.
National income fluctuates when one of these curves shifts, changing the short-run
equilibrium of the economy
Consider an increase in government purchases of ΔG. The government-purchases multiplier in

the Keynesian cross tells us that this change in fiscal policy raises the level of income at any
given interest rate by G/(1 − MPC). Therefore, IS curve shifts to the right. The equilibrium of
the economy moves from point A to point B. The increase in government purchases raises both
income and the interest rate
Changes in Taxes
In the IS–LM model, changes in taxes affect the economy much the same as changes in
government purchases do, except that taxes affect expenditure through consumption. Consider,
for instance, a decrease in taxes of T. The tax cut encourages consumers to spend more and,
therefore, increases planned expenditure. The tax multiplier in the Keynesian cross tells us that
this change in policy raises the level of income at any given interest rate by T * MPC/(1-MPC).
Therefore, as Figure 11-2 illustrates, the IS curve shifts to the right by this amount. The
equilibrium of the economy moves from point A to point B. The tax cut raises both income and
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the interest rate. Once again, because the higher interest rate depresses investment, the increase
in income is smaller in the IS–LM model than it is in the Keynesian cross.
6.5. Monetary Policy

Monetary policy attempts to influence the level of economic activity (the amount of buying and
selling in the economy) through changes to the amount of money in circulation and the price of
money – short-term interest rates. Interest rates is the key area of Monetary Policy
The ‘official rate’ is the rate at which the national bank of a country will lend to the financial
system and influences the structure of all other interest rates
Basis of Monetary Policy is that there is a long run relationship between the amount of money
and inflation
• Demand for Money – the amount people wish to hold as cash as opposed to other assets
• The Supply of Money – the amount of money in circulation in the economy
The basic monetary policy tools are:
 Reserve Requirements
 Discount Rate
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 Open Market Operations

 Printing Money
Each policy has one basic goal, impact the money supply. All of these policy actions work using
the laws of supply and demand. The more money in circulation, the more spending there is and
the higher inflation is. The less money there is in circulation, the less spending there is, inflation
decreases. Those policies that restrict the money supply are known as "tight" and those that put
more money into circulation are known as "loose." Let’s examine each of the policy actions and
their possible results.
a) Change in Reserve Requirements

The Federal Reserve System has the power to set an amount, or percentage, of deposits that its
member banks must keep in reserve at the Fed. If the fed raises its reserve requirements then
banks have less money on hand and thus have less to lend. This lowers the amount of money in
circulation and could have the impact of slowing the economy and inflation. Conversely if the
fed lowers the reserve requirement, banks have more money on hand, more to lend and more
money goes into circulation, thus increasing spending and possibly inflation.
b) Changing the Discount Rate

One of the most important and publicly watched Fed actions, the discount rate is interest rate that
the Fed charges banks on money the banks borrow from the Fed. Member banks borrow money
from the Fed to pay out loans and other investments but they must pay a fee, the discount rate.
The reason this can be done is because the Fed acts as the central bank and makes loans to other
depository institutions. These institutions may borrow money from the Fed because they either
have an unexpected drop in their member bank reserves or because they are faced with seasonal
demands for loans. The discount window is a teller's window at the Fed that depository
institutions use to borrow member bank reserves. For a bank to obtain a loan, it must agree on
the terms of the loan in advance. Next, the depository institution delivers collateral to the
window. Then, the loan is granted and appears as an increase in the institution's member account.
If the Fed lowers the discount rate, banks are charged less for the money they borrow and thus
more people borrow. This increases the amount of money in circulation, speeds up the economy
and increases inflation. Conversely, if the Fed raises the discount rate this lowers the amount of
59 | P a g e
money in circulation because fewer loans are expended as the Prime goes up. This slows the
economy and lowers inflation.
c) Open Market Operations

Open Market Operations are the Fed's power to buy and sell government securities like T-Bills.
The Fed uses Open Market Operations more than any other tool to regulate the economy. Most
people do not pay attention to this less public action but it is very effective.
If the Fed buys back bonds it is putting money into circulation because the money is going from
the government to the people. So if the government buys bonds it increases inflation. Selling
bonds restricts the money supply. If we do this we can lower inflation rates.
d) Printing of Money
It is the simplest and clearest of all the Fed's operations. The government does not, as a matter of
sound economic policy, print money or destroy money in order to effect changes in the economy.
The power, however to do so, does exist. If the government prints money it increases the amount
in circulation and if it destroys money it restricts the amount in circulation. This has a
corresponding effect on inflation. To illustrate the possible negative effects of just printing more
money to counter deflation consider the case of the Weimar Republic in Germany during the
Depression. To counter deflation and pay off reparations debts owed to France, Germany began
to overprint money. This action caused hyperinflation. Germans saw the value of the Mark
plummet as prices skyrocketed. Shoppers literally carried money in wheelbarrows. It was
worthless.
6.6. Monetary Policies and IS-LM Curve

We now examine the effects of monetary policy. Recall that a change in the money supply alters
the interest rate that equilibrates the money market for any given level of income and, thus, shifts
the LM curve. The IS–LM model shows how a shift in the LM curve affects income and the
interest rate.
Consider an increase in the money supply. An increase in M leads to an increase in real money
balances M/P, because the price level P is fixed in the short run. The theory of liquidity
preference shows that for any given level of income, an increase in real money balances leads to
a lower interest rate. Therefore, the LM curve shifts downward, as in Figure 11-3. The
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equilibrium moves from point A to point B. The increase in the money supply lowers the interest
rate and raises the level of income.
When the Federal Reserve increases the supply of money, people have more money than they
want to hold at the prevailing interest rate. As a result, they start depositing this extra money in
banks or using it to buy bonds. The interest rate r then falls until people are willing to hold all the
extra money that the Fed has created; this brings the money market to a new equilibrium. The
lower interest rate, in turn, has ramifications for the goods market. A lower interest rate
stimulates planned investment, which increases planned expenditure, production, and income Y.
Thus, the IS–LM model shows that monetary policy influences income by changing the interest
rate.
The IS–LM model shows an important part of that mechanism: an increase in the money supply
lowers the interest rate, which stimulates investment and thereby expands the demand for goods
and services.
6.7. The Interaction Between Monetary and Fiscal Policy
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A change in one policy, therefore, may influence the other, and this interdependence may alter
the impact of a policy change.
• Suppose that the fiscal authorities increase taxes
• What effect should this policy have on the economy?
According to the IS–LM model, the answer depends on how the Fed responds to the tax increase.
Three possible outcomes In panel (a), the Fed holds the money supply constant. The tax increase
shifts the IS curve to the left. Income falls (because higher taxes reduce consumer spending), and
the interest rate falls (because lower income reduces the demand for money). The fall in income
indicates that the tax hike causes a recession
In panel (b), the Fed wants to hold the interest rate constant. In this case, when the tax increase
shifts the IS curve to the left, the Fed must decrease the money supply to keep the interest rate at
its original level. This fall in the money supply shifts the LM curve upward. The interest rate
does not fall, but income falls by a larger amount than if the Fed had held the money supply
constant. Whereas in panel (a) the lower interest rate stimulated investment and partially offset
the contractionary effect of the tax hike, in panel (b) the Fed deepens the recession by keeping
the interest rate high
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In panel (c), the Fed wants to prevent the tax increase from lowering income. It must, therefore,
raise the money supply and shift the LM curve downward enough to offset the shift in the IS
curve. In this case, the tax increase does not cause a recession, but it does cause a large fall in the
interest rate. Although the level of income is not changed, the combination of a tax increase and
a monetary expansion does change the allocation of the economy’s resources higher taxes
depress consumption, while the lower interest rate stimulates investment. Income is not affected
because these two effects exactly balance
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Macroeconomics Lecture Notes

1.1. What Macroeconomics is about?

The issues that macroeconomics addresses include the following:

 What determines a nation’s long-run economic growth?

1.2. Basic Concepts and Methods of Macroeconomic Analysis

Measuring the Value of Economic Activity: Gross Domestic Product

i) Real GDP versus Nominal GDP

ii) The GDP Deflator

The GDP deflator is the ratio of nominal to real GDP:

The GDP deflator is a measure of the general price level.

iii) GDP and GNP

In simple words, GDP is territorial while GNP is national.

iv)Gross and Net Domestic Product

The Business Cycle and the Output Gap

•Depression: a very severe recession

•Trough (T): the low point of the contraction

•The peak (P): the high point of the expansion

where is change in unemployment, x the magnitude in which unemployment declines due

Inflation –Unemployment Dynamics

1.3. The State of Macroeconomics: Evolution and Recent Developments

Neo classical (1870 – 1936):-

Figure 2.1: The Circular-Flow Diagram

Many subtle issues arise when computing an economy’s GDP.

What is gross national product (GNP)?

GNP =GDP+ Factor Payments from Abroad - Factor Payments to Abroad.

But how we measure GDP/GNP?

2.2. Approaches of Measuring National Income (GDP/GNP)

The Expenditure Approach to Measuring GDP

The Components of GDP

Y=C+I+G+NX. (This equation is an identity-equation)

Consumption: spending by households on goods and services, with the exception of

Investment: spending on capital equipment, inventories, and structures, including

Net exports: spending on domestically produced goods by foreigners (exports) minus

The Product Approach to Measuring GDP

The Income Approach to Measuring GDP

compensation to employees (C): wage and salaries, social security, pension,

Therefore, GDP using income approach is given as follows:

GDP = C+R+ π +D+IBT+I

Points to be noted while measuring GDP

Rules for Computing GDP

 total production (GDP) = total income = total expenditure

2.3. Other Social Accounts (NNP, NDP, NI, PI and DI)

Limitations of the GDP

Inflation and Price Indexes

The CPI Vs. the GDP Deflator

 not in the labor force.

A) Simple Economy Model

Y=C+I ……………………………………………………………………………… (1)

 Next, identity (1) and (2) can be combined to give us

C+I=Y=C+S ……………………………………………………………………… (3)

Subtracting consumption from each part of identity (3), we have

B) An Economy with Government and Foreign Trade

Y = C+I+G+NX ……………………………………………………………………… (5)

YD =Y+TR-TA ………………………………………………………………………….… (6)

Disposable income, in turn, is allocated to consumption and saving:

YD =C+S …………………………………….……………….…………………………….. (7)

Combining (6) and (7), we have:

C+S =YD =Y+TR-TA ……………………………………………………………………. (8)