2. Circular Flow Model

3. Gross Domestic Product
Valuation of economy
Value of production, not simply production
Final Goods
Second hand goods not included
Transfers not included

4. GDP GDP = AD (Aggregate Demand) GDP = C + I + G + (X-M)
C = Personal Consumption
I = Capital Investments
G = Government Expenditures
No transfer payments
X-M = Net Exports = eXports - iMports

5. GDP vs GNP Gross Domestic Product Gross National Product
What is produced within a country’s borders, regardless of who produces it.
Mercedes built in America count towards American GDP
Fords built in Germany count towards German GDP
Gross National Product
What is produced by the citizens of a country, regardless of where they produce it.
Mercedes built in America count towards German GNP
Fords built in Germany count towards American GNP

6. Real vs Nominal GDP Nominal Real GDPReal = (GDPNom)(Price Index)
Value of current production in current prices
Real
Value of current production in base year prices
GDPReal = (GDPNom)(Price Index)
%∆GDPReal = %∆GDPNom - %Δ Index

7. CPI Consumer Price Index
Measure inflation
Base year
Market Basket
What is the difference between the CPI and the GDP deflator?
Both are price indices but they have different market baskets. The CPI includes consumer goods whereas the GDP deflator contains all items that are produced domestically.

8. Causes of Inflation 2 types Demand-pull inflation Cost-push
Aggregate demand > productive capacity
Causes include increases in money supply or credit.
Cost-push
Prices increased by producers to cover higher costs of production.
Supply shocks such as changes in oil prices, crop failures & natural disasters.

9. 5 Major Effects of Inflation
Decreased purchasing power
Decreased value of real wages
Increased interest rates
Decreased savings & investing
Increased production costs

10. Unemployment
Unemployed – must be looking for work to be part of labor force.
Unemployment rate is % of labor force that is unemployed.
Types of unemployment include:
Frictional
Seasonal
Structural
Cyclical
Full employment is economy at full steam. Since there is always frictional & structural unemployment, the Natural unemployment rate is the unemployment rate for full employment.

11. Consumption Function Consumption Function C = a + b (DI)
a = autonomous spending
spending when income = 0
B = consumption rate
Consumption DI CF
Savings
Dissavings
Disposable Income

12. Marginal Propensity to Consume & Save
MPC = ΔC/ΔDI
MPS = ΔS/ΔDI
MPC + MPS = 1
C=Consumption, S=Savings, DI=Disposable Income
MPC= Consumption rate in
consumption function

13. Multiplier Multiplier Examples
= 1 / MPS
= 1 / (1-MPC)
Examples
MPC = .9, Multiplier = 1/.1 = 10
MPC = .8, Multipler = 1/.2 = 5
MPC = .5, Multiplier = 1/.5 = 2
NB Taxes have a smaller multiplier than direct government spending

14. AD – AS Model Long-run Aggregate Supply (LRAS) Price Level LRAS SRAS
Short-run Aggregate
Supply (SRAS) P
Aggregate Demand (AD)
= C+I+G+(X-M) AD
GDPR YO

15. AD – AS Model - Inflation
Price
Level
GDP beyond L-R
Equilibrium at Y1 & P
LRAS
SRAS
Inflationary Gap
Higher rates drive
down interest sensitive
expenditures (AD ) P P2
AD Shift causes Y to go
 to L-R YO, & P  AD
AD2
Economy producing
Beyond L-R capacity
GDPR YO Y1

16. AD – AS Model - Inflation
GDP below L-R
Equilibrium at P & Y1
Price
Level
SRAS
LRAS
SRAS2
Recessionary Gap
Lack of demand drives
down nominal wages
( SRAS  ) P P2
SRAS2 shift results
in P  & Y  AD
Economy producing
under L-R capacity
GDPR Y1 YO

17. Shifts in AD Changes in expectations Changes in wealth
Expectations  – AD 
Changes in wealth
Wealth  , - AD 
Amount of physical capital
Existing Capital  – AD 
Fiscal policy
Government spending  – AD 
Monetary policy
Money supply  – AD  17

18. Shifts in SRAS Commodity prices Nominal wages Productivity
Example is oil
Prices  - AS 
Nominal wages
Wages  - AS 
Productivity
Productivity  - AS  18

19. AD AS Model Shifts of AD Demand shock Negative Positive
Ag. Pr.
Level
SRAS
Shifts of AD
Demand shock
Negative
“Great Depression”
ADN, EN, PN, YN
Positive
WWII
ADP, EP, PP, YP EP PP PE
ESR
ADP PN EN AD
ADN
Real GDP YN YE YP 19

20. AD AS Model Positive Demand Shock
SRAS2
Ag. Pr.
Level
SRAS
Positive Demand Shock
AD shifts to AD2
E1 up to E2
P1 up to P2
YP up to Y2
Inflationary Gap
Inflation causes L-R increase in wages
SRAS shifts to SRAS2
E2 shifts to E3
P2 up again to P3
Y2 down to YP
LRAS E3 P3 P2 E2 P1 E1
AD2 AD YP Y2
Real GDP 20

21. AD AS Model Shifts of SRAS Supply shock Negative Positive Oil Crisis
SRASN
Ag. Pr.
Level
SRAS
Shifts of SRAS
Supply shock
Negative
Oil Crisis
SRASN, EN, PN, YN
Positive
Internet
SRASP, EP, PP, YP
SRASP PN EN PE
ESR PP EP AD
Real GDP YN YE YP 21

22. Continuum – Government Policies
Restrictive
Low Growth
Low Inflation
Expansionary
High Growth
High Inflation

23. Fiscal Policy Expansionary Restrictive Restrictive Expansionary
Stimulates economy
Decrease taxes and/or increase spending
Increases disposable incomes/demand
Inflationary & leads to debt
Restrictive
Reduces Disposable income/demand.
Lack of cash reduces investments.
Reduction in government spending/programs
Restrictive
Expansionary

24. Monetary Policy Easy Money Tight Money Increases growth (good)
Increases inflation (bad)
Tight Money
Decreases growth (bad)
Decreases inflation (good)
Tight Money
Easy Money 24

25. How the Fed Can Change MS
Fed Tools
Open Market Operations
Fed Funds Rate & Discount Rate
Reserve Requirements for Banks
Moral suasion 25

26. Expansionary Policy Money Supply up GDPR up Price Level up
Invest-ments up
Interest
Rates
down
GDPN up
AD up
Inflation up
Exports up
Unemploy-ment down
Exchange rates down
Imports down

27. Phillips Curve Inflation S-R trade-off between
Inflation & unemployment
LRPC
Trade-off does not
Occur in the L-R
Shifts in SRPC the result
of Δ expected inflation %2
SRPC2 %
SRPC
Unemployment
NRU/
NAIRU

28. Money Supply Interest i = nominal Rate, i interest rates MS
Δ in MS controlled
by the Fed Reserve i
M * V = P * Q
MS*Velocity or multiplier
= Price Level * Output MD
GDPR M

29. Money Supply & Interest Rates
Increased MS leads to r 
Interest
rate
Money supply
Lower r leads to C
& I  meaning AD 
MS2
AD shifts right,
leading to Price
Level  & GDPR 
Price Level
SRAS P2 P1 r1
AD2 r2
MD1
AD1 Y1 Y2
Mde1
Mde2
Quantity
of money
GDPR 29

30. Loanable Funds r = real interest rates Interest Rate, r SM
NB - With interest rates
i includes inflation
while r is for real r DM
GDPR YO

31. Terms Crowding out Rational Expectations Theory Automatic Stabilizers
Government competes with or eliminates private enterprise.
Providing a service otherwise supplied by a company
Competing in the marketplace for loans to finance debt.
Rational Expectations Theory
Businesses & consumers react to expected changes in monetary & fiscal policy, thereby negating their impact.
Automatic Stabilizers
adjust automatically, without government deliberation, to offset economic conditions

32. Crowding Out Effect – Change in Demand
government debt
creates additional
demand for funds.
Interest Rate, r S1 r2 r1
Rightward shift of
demand curve results
in r  & Q . D2 D1
Quantity of
Loanable Funds Q1 Q2

33. Crowding Out Effect – Change in Supply
Interest Rate, r
∆ in Supply:
Government is
Most credit worthy
Borrower, so Fed
Debt removes supply S1 r2 r1
Leftward shift of
Supply curves results
In r  & Q  D1
Quantity of
Loanable Funds Q2 Q1

34. Automatic Stabilizers
Deficit – Economy in recession, causes
taxes to drop below govt. expenditures $
Taxes
Surplus – Economy booms,
causes taxes to increase
above govt spending
Govt
Automatic adjustments to economic conditions by increasing deficit during recessions & increasing surplus in boom periods (income taxes)
GDPR

35. Macroeconomic Theories
Classical
Changes in MS only affect nominal rates, not real
Automatic stabilizers will correct market fluctuations
No government action
Keynesian
Fiscal policy as a tool to correct cyclical fluctuations
Govt spending up to offset recessions
Monetarists
Govt often wrong or late, only make matters worse
MS to grow at rate of GDP growth (no fiscal remedies)

36. Foreign Trade Balance of Payments Exchange Rate Changes
Revisit Comparative & Absolute advantages from Micro PP
Balance of Payments
Current Account – Transactions w/o liabilities
Capital Account – Transactions w/ liabilities
Exchange Rate Changes
Consumer tastes
Relative incomes
Relative inflation
Speculation
Money supply/ relative interest rates

37. Exchange Rates Demand for $ increases as other currencies trade for $
€/$
$/€ S
Demand Curve shifts to D2
causing $  & Q  S2
Looking at exchange rate from
other side – euros/dollar
High demand for $ means
people want to trade euros in
& this leads to excess supply $2 € $ €2 D2
Supply curve shifts to S2,
causing €  & Q  D Q Qe Q2

38. International Trade & Taxes
Example: US Oil Market
Equilibrium at $100 & 10M
Barrels.
Dollars/
Euro
SDom
Effects of tariff include
P $10, Q  1M barrels,
& Imports  2M barrels
$100
World price is $80. Effect on
US market is Demand at $80
Is 12M while Supply is 8M.
Difference of 4M is imports.
$90
Imports
$80 D
Protective tariff of
$10/Barrel added Q 8 9 10 11 12
Deadweight Loss (DWL)

39. Graph Relationships Money Market Investment Demand i I I M IMS MS i i i i MD I M M I I M I I I
Contraction of MS leads to higher i, which reduces I, causing GDP to fall Y Y
Graph reversed so
GDP is falling
GDPR

40. Graph Review – MS  Fed increases MS i  r leads to  I MS leads to
Money Supply
Investment Demand
Loanable Funds
I/R
I/R MS MS
Fed increases
MS i  S
r leads
to  I S
MS leads to
shift right in S in
loanable funds
r  & q  i r r r r i MD
I/D D Q Q I I Q M M q q
P/L = X  & M 
Supply of $ 
ER  & q 
 I =  AD
 AD =  P & Y
AD =
Inflation  &
Unemployment 
Phillips Curve
Exchange Rates
A/B
ADAS Model
P/L
LRPC
Inflation S AS S P ER P ER % AD
SRPC % D AD
Real GDP
U/R
NRU q q Q Y Y
Unemployment