Most of the content and all images used are from the book “Principles of Economics” by Gregory Mankiw.
In contrast to microeconomics, macroeconomics studies economy-wide phenomena such as inflation, unemployment, and economic growth. It attempts to explain how economic changes affect households, firms, and markets simultaneously.
How do we measure the performance of an economy? Two measures that come to mind are per capita income and life expectancy.
The main actors in any economy are consumers, workers, and employers. Each person is a consumer and furthermore, they may be a worker or an employer.
In addition to the 7 principles we studied at the beginning of microeconomics, there are 3 that are relevant to macroeconomics.
A country’s standard of living depends on its ability to produce goods and services.
Productivity is the amount of goods and services produced from each hour of a worker’s time.
Prices rise when the government prints too much money.
Inflation is an increase in the overall level of prices in the economy. In the long run, the growth in quantity of money causes inflation. The value of the money falls.
Society faces a short-run trade-off between inflation and unemployment.
This is shown in the Phillips curve (which we shall not study).
Macroeconomics is the analysis of the backdrop of economic conditions against which firms/consumers make decisions.
The measures we use are per capita income and life expectancy. It is seen that both of them vary very widely across countries. We also sometimes use the total market value of a nation’s production - its Gross Domestic Product (GDP).
What makes countries that contribute more to the global economy different?
Here, we mention some major events since the start of the millennium:
What is the difference between Ghana, India, and South Korea? The difference between the first two is due to the physical and human capital, whereas that between the latter two is attributed to knowledge.
Macroeconomic events arise from the interaction of many people trying to maximize their own welfare - firms, consumers, the government, forex dealers, FII, MNCs, RBI, etc.
More often though, to measure the performance of an economy, we use the Gross Domestic Product (GDP). It measures two things – the total income of everyone in the country and the total expenditure on the economy’s output of goods and services. This is because both of these quantities are equal – an economy’s income is the same as its expenditure. This is made clear by the circular flow diagram we studied earlier.
GDP is the market value of all final goods and services produced within a country in a given period of time.
Intermediate goods are goods used up entirely in the production of final goods.
Value added is the dollar value of an industry’s sales minus the value of the intermediate goods used in production.
The difference between the GDP calculated using the income and expenditure methods is called statistical discrepancy (it arises due to imperfect data sources).
There are several transactions that have nothing to do with final goods. As a result, we exclude things like stocks/bonds (securities), social security, unemployment compensation (government transfer payments), individual gifts, corporate gifts (private transfer payments) etc. We also exclude the transfer of second-hand goods (we have already made the purchase and it has been included in the value), household production, and legal/illegal underground transactions.
That is, we only want to count the sales of final goods that occur through the market.
Therefore, we measure the GDP as the sum of the
Gross private domestic investment consists of
The GDP can be looked at as either the total expenditure on domestically produced final goods/services or the total income earned by domestically located factors of production.
We can calculate the GDP in three different ways: output (the sum of value added in each sector), income, and expenditure.
The expenditure components of GDP are consumption, investment, government spending, and net exports.
An important identity is:
\[\text{Y} = \text{C} + \text{I} + \text{G} + \text{NX},\]where \(\text{Y}\) is the value of total output (GDP). The expression on the right is the total expenditure.
A stock is a quantity measured at a point of time. For example, a person’s wealth and the government’s debt are stocks.
A flow is a quantity measured per unit time. For example, a person’s annual savings and GDP are flow measures.
Price is the common unit using which we can measure other expenditures.
GDP is essentially an aggregate of price\(\times\)quantity.
The nominal GDP is the result when we use the price and quantity belonging to the same year.
The real GDP is the result when we fix a certain base year and use the price of that base year (we use the quantity of the year we are calculating the GDP of).
Since real GDP is not affected by changes in prices, it reflects the economy’s production of goods and services.
GDP can also be seen as the net value added across firms – we do not count the final goods because that would be double counting. This is the calculating of GDP using the output method that we mentioned earlier.
Some more rules for computing GDP are:
Now, the calculation of real GDP fixes a certain base year. This is not good because prices may change drastically over periods of time and it is misleading to use the values from 10-15 years ago. Therefore, we shift the base year prices once in a while (every 5-10 years).
We tend to overestimate the rate of inflation and underestimate the rate of real economic growth when we consider the fact that earlier, people did not have modern conveniences.
As a result, to compensate for the shift in base year prices, we chain weight to average the prices.
The GDP deflator or implicit price deflator is the ratio of the nominal GDP to the real GDP. It gives a measure of the price of output relative to its price in the base year. It reflects the level of prices in the economy (and not quantities).
Observe that the GDP deflator is equal to \(1\) in the base year.
Inflation is used to describe a situation where the economy’s price level is increasing. The inflation rate is the percentage change from one period to the next. It can be calculated as the percentage change of the GDP deflator.
We must take inflation into account when calculating the GDP. Further, it becomes difficult to compare different countries since the degree of inflation is different in different countries.
Some problems in comparing GDPs are:
The (real and nominal) per capita GDPs are of interest and per capita growth should be looked at as well.
To resolve the problems in comparing GDP, we look at purchasing power parity. How much does a particular product cost in dollars in different countries? For example, a Starbucks grande latte costs $9.83 in Oslo but $2.80 in New Delhi.
We want a dollar to have the same purchasing power in any country.
The GDP is the output produced within some geographic location. The GNI/GNP (Gross National Income/Product) is the output produced by the citizens of a geographic region. This value must be remitted back to the country. It is the total income earned by permanent residents of the country (nationals).
\[\text{GNP} = \text{GDP} + \text{Factor payments from abroad} - \text{Factor payments to abroad}\]The Net Domestic Product (NDP) is equal to \(\text{GDP}-\text{Depreciation}\) and the Net National Product (NNP) is equal to \(\text{GNP}-\text{Depreciation}\).
Depreciation is called “consumption of fixed capital”. It is the cost of producing the output of the economy.
In calculating India’s GDP, there are three categories:
Inflation measures the general increase in level of prices. How do we measure cost of living/inflation?
We usually use the Wholesale Price Index (WPI) or Consumer Price Index (CPI) to measure the level of prices or inflation. It consolidates the prices of several goods and services into a single index that measures the overall level of prices. To do this reliably, some options are:
On top of this, we assign a weight to each sector, taking into account its share in the market.
The CPI can be calculated as:
The inflation rate can be measured as the percentage change of CPI or WPI.
The WPI is used to provide estimates of inflation at the wholesale transaction level for the economy as a whole. This allows the government to check for inflation, in essential commodities in particular. It is used as a deflator for many sectors of the economy, including estimating GDP. It is also used for indexation in business contracts. Global investors track the WPI as a key macro indicator for their investment decisions.
We assign less weight to food items that are more volatile over time. As a result, core manufactured products have high weightage. According to purists, core inflation using only manufactured products carries significance as a more accurate predictor in the long term. This weeds out transitory components such as food and energy. An alternate methods is the trimmed-mean method, which strips the most volatile items off the index each month.
In any index,
In the field, price supervisors check the veracity of prices quoted by the price collectors by making spot visits. We further scrutinize in case
Producer Price Index (PPI) measures the price of a typical basket of goods bought by firms, not consumers.
The HSBC Purchasing Manager Index (PMI) measures the factory production based on the monthly responses of purchasing executives in around 500 manufacturing companies. A value over 50 means expansion and a value under 50 means contraction.
Now, should we use the WPI or the GDP deflator?
The GDP deflator measures the prices of all goods produced, whereas the WPI measures only the prices of goods/services bought by consumers. In particular, an increase in the price of goods bought by firms/government shows up in the former but not the latter. Also, imported goods are not part of the GDP and do not show up in the GDP deflator. Lastly, the WPI assigns fixed weights to the prices of different goods whereas the GDP deflator assigns changing weights (a fixed basket of goods v. a changing basket of goods).
We use two indices in general, the Laspeyres index (which works with a fixed basket of goods) and the Paasche index (which works with a changing basket of goods).
The Laspeyres price index is equal to
and the Paasche price index is equal to
\[P = \frac{\sum p_t q_t}{\sum p_0 q_t} \times 100,\]where \(P\) is the price index, \(p_t\) is the current price, \(q_t\) is the quantity used in the current period, \(p_0\) is the price of the base period, and \(q_0\) is the quantity used in the base period.
Laspeyres requires quantity data from only the base period, which allows a more meaningful comparison because changes in the index can be attributed to changes in price, but may overweight goods whose prices increase and does not reflect changes in buying patterns over time.
Paasche reflects current buying habits because it uses current quantities, but it requires quantity data from the current year, which may be difficult to obtain. It is difficult to attribute changes in the index to price changes alone and tends to overweight goods whose prices have declined. The prices need to be recomputed each year.
Fischer’s ideal index is equal to the geometric mean of these two indices.
When the prices of different goods are changing differently, the Laspeyres index tends to overstate the increase in cost of living. This is because it does not take into account that consumers can replace more expensive items with less expensive items.
Conversely, the Paasche index tends to understate the increase in cost of living. While it takes the substitution effect into account, but does not take into account the decrease in the consumers’ welfare resulting from this substitution (because we take a fixed basket of goods). This issue is known as substitution bias.
As new goods are introduced, consumers have more choice so the dollar is worth more.
Some quality change may be unmeasured. If the quality of a good deteriorates while its price remains the same, the value of a dollar is dropping.
Therefore, it is difficult to compare WPI (Laspeyres) and the GDP deflator (Paasche), since they are both bad in their own ways. They follow similar trends.
We can compare today’s prices with that of a different year’s as
\[\text{Amount in today's dollars} = \text{Amount in other year's dollars} \times \frac{\text{Price level today}}{\text{Price level in other year}}.\]When we perform the above correction, we are said to index the amount for inflation. Approximately, when we put our money in a bank, the real interest rate is equal to the nominal interest rate minus the inflation rate.
Unemployment rate is the statistic that measures the percentage of people who want to work but do not have jobs, reflecting the performance of the economy.
Labor force is the sum of the employed and unemployed, and the unemployment rate is the percentage of the labor force that is unemployed. The labor force participation rate is the percentage of the adult population that is in the labor force.
The average rate of unemployment around which the economy fluctuates is called the natural rate of unemployment. It is the rate of unemployment towards which the economy gravitates. It should be noted that natural does not mean desirable.
We have \(L = E + U\), where \(L\) is the labor force, \(E\) is the number of employed workers, and \(U\) is the number of unemployed workers.
The unemployment rate is \(U/L\). The rate of job separation (severance rate) is denoted \(s\) and the rate of job finding as \(f\).
Then, the number of people finding jobs is \(fU\) and the number of people losing jobs is \(sE\). In steady state, \(fU = sE\). Equivalently,
Any policy aimed at lowering the natural rate of unemployment should either reduce the rate of job separation \(s\) or increase the rate of job finding \(f\).
The two main reasons for unemployment are job search and wage rigidity.
Job search is the process of matching workers with appropriate jobs.
Efficiency-wage theories propose another cause of wage rigidity. They claim that high wages make workers more productive. There are four theories related to this:
When MNCs pay more wage than the equilibrium rate, the market is not cleared. Since the supply of labour is fixed, a higher supply means lower demand. This results in unemployment.
It was observed that most spells of unemployment are short, but most unemployment observed at any given time is long-term.
The unemployment caused by the time it takes workers to search for a job is called frictional unemployment. Economists call a change in the composition of demand among industries or regions a sectoral shift.
Since sectoral shifts are always occurring, there is always frictional unemployment. In an attempt to reduce frictional unemployment, some policies inadvertently increase it instead. An example of this is unemployment insurance. In this, workers collect a fraction of their wages for a certain period after losing their jobs. This decreases the incentive to find a new job. While economists agree that eliminating this will reduce the amount of unemployment, they disagree on whether it will enhance economic well-being.
Wage rigidity is the failure of wages to adjust until labour supply equals the labour demand. The unemployment resulting from wage rigidity and job rationing is called structural unemployment. Workers are unemployed not because they cannot find a job that complements their skills, but because the labor supply is greater than the labor demand. This is the case because the real wage is stuck above the equilibrium level. This is the result of a minimum wage law above the equilibrium wage. It should be noted that efficiency-wage theories claim that even in the presence of a minimum wage or a surplus of workers, firms should set their wage far above the equilibrium wage.
In job search, people are searching for jobs that suit their skills to open up, whereas in the above example, people are waiting for jobs to open up.
Globalization is a major cause for increased competition around the world. Developing countries provide cheap labour so many companies relocate their manufacturing plants to these nations. So, workers who were previously involved in manufacturing may become unemployed.
In 1914, Ford started paying $5 per day to workers (against the prevailing $2 or $3 wage). According to Ford, this is in fact “the finest cost cutting move” he has ever made. The increase in wage increases the firm’s productivity. Absenteeism fell by 75% and shop floor costs fell as well.
Some workers, known as discouraged workers claim to be unemployed but are not really trying to find a job.
A union is a worker association that bargains with workers over wages, benefits, and working conditions. The process by which unions and firms agree on the terms of employment is referred to as collective bargaining. If an agreement is not reached, a union can withdraw labour, resulting in a strike. Union workers usually earn about 10 to 20 percent more than similar workers who are not in unions. Unions just serve as an antidote against any market power that the firms that hire workers may possess.
When the wage increases due to union activity, there is a decrease in demand for labour. This causes a conflict between “insiders”, who are the union workers that gain from the increased wages, and the “outsiders”, who do not get the union jobs. Workers not in unions bear some of the cost as well. Even if the unions have this adverse effect of pushing wages above the equilibrium level and causing unemployment, the advantage is that firms have a happy and productive workforce.
The negative relationship between unemployment and GDP is called Okun’s law. It is defined as
\[\text{\% change in real GDP} = \text{Relation between real GDP and unemployment} - 2\times\text{change in unemployment rate}.\]Okun obtained the above by running a linear regression on the data.
Some problems in GDP measurement are:
The financial system is the group of institutions that helps match the savings of one person with the investments of another.
Financial markets are institutions through which savers can directly provide funds to borrowers. For example,
Financial intermediaries are institutions through which savers can indirectly provide funds to borrowers. The two main ones are
Private savings refers to the portion of a household’s income that is not used for consumption or paying taxes.
Public savings refer to the tax revenues minus the government spendings.
National savings is the sum of the private savings and public savings. This is equal to
where \(\text{Y}\) is the yearly income, \(\text{T}\) is the taxes paid minus the amount it pays back in transfer payments, \(\text{C}\) is the consumption, and \(\text{G}\) is the government purchases. This is the portion of the national income that is used for neither consumption nor government purchases.
Consider a closed economy with \(\text{NX} = 0\). Then the GDP is equal to \(\text{C} + \text{I} + \text{G}\), so the investment is equal to the national savings.
The budget surplus is the excess of tax revenue over government purchases (this is equal to the public savings). The budget deficit is the opposite (the negative of the public savings).
Investment is the purchase of new capital – it is not just the purchase of stocks and bonds! It is anything that will give future returns.
The supply of loanable funds comes from savings and the demand for loanable funds comes from investment. Households with extra income can loan it out to earn interest. Public savings, if positive, add to national savings and the supply of loanable funds.
An increase in interest rate makes saving more attractive, which increases the quantity of loanable funds supplied. This reduces the demand for loanable funds, however. As in microeconomics, the interest rate adjusts to equate supply and demand.
Incentives to encourage savings (a policy to shield some savings from taxation for example) increase the supply of loanable funds, which reduces the equilibrium interest rate and increases the equilibrium quantity of loanable funds. A government budget deficit would do the opposite.
Investment incentives (an investment tax credit for example) raise the equilibrium interest rate and reduce the equilibrium quantity of loanable funds.
A budget deficit causes a fall in the supply of loanable funds, which raises the equilibrium interest rate. The government borrows to finance its deficit, leaving less funds available for investment. This is known as crowding out, and reduces the economy’s growth rate and future standards of living.
A budget surplus would do the opposite.
It should be noted that the interest rate we are talking about above is the real rate, which is the nominal interest rate corrected for inflation.
Money is the stock of assets that can be readily used to make actions. The stock of money is made of the rupees in the hands of the public. The three main uses of money are to serve as a
In a system without money, we can either be completely self-sufficient, or use a barter economy. The latter requires a “double coincidence of wants” - each person has something that the other wants. Nowadays, this is highly unlikely with the huge variety in goods.
Money allows for more indirect transactions. Liquidity refers to the ease with which an asset can be converted to the economy’s medium of exchange. For example, money is the most liquid asset, stocks and bonds are still relatively liquid (but less so than money), and an antique painting is less liquid.
Fiat money is money by declaration. It has no intrinsic value. For example, rupee or dollar.
Commodity money on the other hand does have intrinsic value and can be used for some purpose. For example, gold or tobacco. When we use gold as money, the economy is said to be on a gold standard.
There is a general shift from commodity money to Fiat money, primarily because the latter is much more standardized.
The money supply or money stock refers to the amount of money available in the economy. It includes both currency (the paper bills and coins in the hands of the public) and demand deposits (balances in savings accounts that depositors can access on demand).
If most sellers accept cheques, assets in savings accounts are as convenient as currency.
In a fractional reserve banking system, banks keep a fraction of deposits as reserves and the rest to make loans. The RBI sets reserve requirements, which are regulations on the minimum amount of reserves that banks must hold against deposits. Banks may hold more than this minimum amount. The reserve ratio \(R\) is the fraction of deposits that banks hold as reserves, which is the total reserves as a percentage of total deposits.
A T-account is a simplified accounting statement that shows a bank’s assets and liabilities (reserves and loans are assets, whereas deposits are liabilities). It is also sometimes called a balance account.
There are three cases we shall analyze:
The money multiplier is the amount of money the banking system generates with each dollar of reserves. It is equal to \(1/R\). If the money a borrower takes is deposited back in another bank, and so on, the total amount of money that arises from one unit is \(1/R\) units.
The control over the money supply is called the monetary policy. In India, it is conducted by a partially independent institution called the Reserve Bank of India (RBI).
The monetary policy is a traditionally bi-annual policy statement through which the RBI targets a key set of indicators to ensure price stability.
At times of recession, the policy involves the adoption of tools to increase the money supply and lower interest rate, thus stimulating the aggregate demand in the economy.
At times of inflation, it seeks to contract aggregate spending by tightening the money supply or raising the rate of return
The three tools it uses to do so are:
To increase the money supply, the RBI reduces reserve requirements. Banks make more loans from each rupee of reserves, which increases the money multiplier and so money supply.
To reduce the money supply, the CRR is raised and the process works in reverse.
The RBI rarely uses this because frequent changes would disrupt the banking system.
The reverse repo rate is what the banks get when they deposit their excess funds in the RBI for short periods. Basis points are often mentioned in monetary policy reviews. 1% is equivalent to 100 basis points. For example, if the reverse repo rate is 7.75% and the RBI increases it by 25 basis points, the new rate is 8%. It is currently 3.35%.
The discount rate or bank rate is the rate of interest which a central bank charges on its loans and advances to commercial banks (loans). It is currently 4.25%.
Repo rate is the rate at which commercial banks borrow money (short-term funds) from the RBI by selling their securities. It is currently 4%.
The reverse repo rate is the rate of interest offered by the RBI when banks deposit their surplus funds with it for short periods. When banks have surplus funds but no lending/investment options, they must deposit these funds with the RBI, which they earn interest on. Discount lending is used to provide extra liquidity when financial institutions are in trouble.
Banks are mandated to invest a quarter of their deposit/borrowings inflows into government securities. Only the excess over this mandated investment can be used to borrow funds from repo window. The banks’ core borrowing usually comes from deposits, so RBI is a “lender of last resort”.
The RBI raises the repo rate to increase the overall cost of funds in the banking system. Higher costs keeps the check on demand for funds. As demand slows, so does the demand pull inflation. In a tight liquidity scenario, the repo rate acts as the base rate at which banks can borrow funds.
If funds are not very available and banks are unable to borrow at the repo rate, they may have to increase deposit rates to attract depositors.
There is a trade-off between inflation and growth.
To raise the bank rate, the RBI sells government bonds.
If households hold more money as currency (so banks have fewer reserves) or banks hold more as reserves, money supply falls. The RBI can compensate for this.
When people suspect that their banks are in trouble, a run on banks occurs where people go to withdraw their funds, holding more currency and less deposits. Under fractional-reserve banking, they do not have enough reserves to pay off all the depositors, so banks may have to close. Therefore, banks may make fewer loans and hold more reserves to satisfy depositors. These increase \(R\), reverse the process of money creation, and cause the money supply to fall.
Money demand refers to how much wealth people want to hold in liquid form. It depends on \(P\), the price level (CPI or GDP deflator). An increase in \(P\) reduces the value of money, so more money is required to buy goods and services. The quantity of money demanded is negatively related to the value of money and positively related to \(P\), other things equal.
Nominal variables are measured in monetary units, whereas real variables are measured in physical units (for example, nominal GDP and real GDP). A relative price is the price of one good with respect to the other (it is a real variable).
The real wage is equal to the ratio of the nominal wage to the price level.
Classical dichotomy is the theoretical separation between nominal and real variables. Hume and classical economists claim that monetary developments affect nominal variables and not real variables. This is referred to as monetary neutrality. It is widely believed that these do hold in the long run.
A quantity equation attempts to link the money supplied to the number of transactions made. The quantity theory of money gives the quantity equation
\[MV = PT,\]where \(M\) is the quantity of money supplied, \(V\) is the transaction velocity of money, which is the number of times a rupee exchanges hands, \(P\) is the price of a typical transaction (the number of rupees exchanged), and \(T\) is the number of transactions made in a year. The right side of the equation looks from the perspective of transactions, whereas the left looks from the perspective of money used to make transactions.
However, it is very difficult to measure \(T\), so we replace the number of transactions \(T\) with the total output of the economy \(Y\) (real GDP). The more the economy produces, the more goods are bought and sold. They are technically not the same, for example because second-hand goods should be counted in \(T\) but are not in \(Y\).
\(V\) in this new equation \(MV = PY\) is called the income velocity of money. When using the quantity equation, we usually assume that \(V\) is constant.
Observe that since \(Y\) is the amount of output and \(P\) is the price of one unit of output, \(PY\) is just the nominal GDP.
\(M/P\) is referred to as the real money balance, which measures the purchasing power of a stock of money.
If the real GDP is constant, the inflation rate is equal to the money growth rate and if it is growing, the inflation rate is less than the money growth rate.
The building blocks that determine the level of prices are:
The price level \(P\) is then the ratio of \(PY\) to \(Y\).
If both \(V\) and \(Y\) are fixed, then the percentage change in \(M\) is equal to the percentage change in \(P\).
Thus, quantity theory yields that the central bank, which controls money supply, ultimately controls the inflation rate as well. If the money supply is kept stable, the price level is stable.
The money demand function is similar to the demand function for a good. Since the demand for money balance should be equal to the supply, we get \(M/P = kY\), so the income velocity is \(1/k\). This shows the link between demand and velocity.
If we hold a lot of money for each rupee of income (\(k\) is large), \(V\) is small and money changes hands frequently. Similarly, if \(k\) is small, then \(V\) is large.
The factors of production and production function determine the level of output \(Y\). The money supply determines the nominal value of output \(PY\). The price level \(P\) is thus the ratio of the nominal value of output \(PY\) to the real value of output \(Y\).
The revenue raised by printing of money is called seigniorage. A government can finance its spending in three ways - raising revenue through taxes, borrowing from public by selling bonds, and printing money.
The government itself does not print money, it asks the RBI to print it instead.
Seigniorage causes an increase in money supply, which causes inflation. The printing of money to increase revenue is like imposing an inflation tax which is levied on the holders of money (old money becomes less valuable).
Some results of inflation are:
Hyperinflation is said to occur when the inflation rate exceeds 50% per month. When it occurs, bartering or commodity money becomes prevalent.
Why do banks print money in countries facing hyperinflation? This is due to fiscal policy, when the government has inadequate tax revenue to pay for its spending. To cover this deficit, it prints money. Due to delayed tax collection, real tax revenue drops as inflation rises, and fiscal problems worsen. The reliance on seigniorage worsens the situation.
It can be fixed by reducing government spending and increasing taxes.
The interest rate paid by the banks is called the nominal interest rate \(i\) and the increase in purchasing power the real interest rate \(r\). If \(\pi\) is the rate of inflation, we have \(i = r + \pi\). This is known as the Fisher effect.
Quantity theory together with the Fisher equation tell us how money growth influences nominal interest rate.
Suppose a borrower and lender agree on some nominal interest rate (they do not know the inflation rate over the period of the loan). The ex ante real interest rate is that expected by the borrower and lender when a loan is made, and the ex post real interest rate is that which is actually realized.
Let \(\pi\) denote the actual future inflation and \(\pi^e\) the expectation of future inflation. Then the ex ante real interest rate is \(i - \pi^e\) and the ex post rate is \(i - \pi\). Since the nominal interest rate cannot adjust to the actual inflation (because it is not know when the nominal interest rate is set), the modified Fisher effect says \(i = r + \pi^e\). The ex ante rate \(r\) is determined by the equilibirium in the market as described by the GE model.
The nominal interest rate is essentially the opportunity cost of holding money - it is what is given up by holding money instead of bonds.
The Fisher effect just says that an increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate (wealth) is unchanged.
In the long run, real GDP grows around 5% per year on average. In the short run however, it fluctuates around this trend. A recession is a period of falling real incomes and rising unemployment. A depression is a severe recession.
Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. We usually use the model of aggregate demand and aggregate supply. This differs from classical long-run theories.
In the short run, changes in nominal variables (like \(\text{P}\)) can affect real variables (like \(\text{Y}\)).
The aggregate demand curve shows the quantity of all goods and services demanded in the economy (by households, firms, the government, and customers abroad) at a given price level (\(P\) on the vertical axis and \(Y\) on the horizontal).
The aggregate demand curve slopes downward. Why is this?
If \(P\) rises,
The aggregate demand curve can shift due to
If any of the above decrease, the curve shifts to the left (the quantity of goods/services demanded at a certain price level drops).
The aggregate supply curve shows the quantity of the total quantity of goods and services firms produce and sell at any given price level. It is upward sloping in the short run and vertical in the long run.
First, let us look at the long run.
In the long run, the real GDP depends on the supplies of labour, capital, natural resources, and available technology. Since these do not significantly change in the long run, the aggregate supply is constant and the curve is vertical. What could cause a shift of the long-run aggregate supply curve?
The natural rate of output (\(Y_N\)) is the amount of output the economy produces when unemployment is at its natural rate. It is determined by the economy’s stocks of labour, capital, natural resources, and level of technology, which remain somewhat constant in the long run (an increase in \(P\) does not affect any of these) – this is a consequence of classical dichotomy.
Some factors that shift the long-run aggregate supply curve are
In the long run, the aggregate supply curve gradually shifts to the right (due to technological progress) and so does the aggregate demand (due to an increase in money supply). The short-term occurrences should be viewed as deviations from this general trend of output growing and presence of inflation.
The short-run aggregate supply curve is upward sloping. An increase in the price level raises the amount of goods and services supplied. Three theories that attempt to explain this are:
In all three theories, \(Y\) deviates from \(Y_N\) when \(P\) deviates from \(P_E\).
\[Y = Y_N + a(P-P_E),\]where \(a > 0\) measures how much \(Y\) responds to changes in \(P\). The imperfections in these theories are only short-run, and the stickiness disappears in the long run.
If the expected price level \(P_E\) changes, the short-run aggregate supply curve shifts. If it rises, workers and firms set higher wages, so at a fixed \(P\), production is less profitable, \(Y\) falls, and the curve shifts to the left.
In the long-run, \(P_E = P\), \(Y = Y_N\), and the unemployment is at its natural rate.
Stagflation is a period of falling output and rising prices.
The theory of liquidity preference is a theory about the interest rate, denoted \(r\). It adjusts to balance supply and demand for money.
Money demand reflects how much wealth people want to hold in liquid form. Suppose there are only two types of assets - money (which is liquid but pays no interest), and bonds (which pay interest but are not as liquid). Then, money demand reflects the preference for liquidity, which is influenced by \(Y\), \(r\), and \(P\).
The money supply curve is vertical (it is fixed by the RBI). To change both the interest rate and shift the aggregate demand curve, the RBI conducts OMOs to change the money supply. Reducing the money supply increases \(r\), which in turn reduces the quantity of goods and services demanded.
Fiscal policies are undertaken by the government, and monetary policies by the central bank.
There are two effects that fiscal policy has:
The multiplier effect - additional shifts in aggregate demand that result when fiscal policy increases income and thus increases consumer spending.
Marginal propensity to consume is the fraction of extra income that households consume rather than save. Using this, we can quantify the multiplier effect.
We have
\(I\) and \(NX\) do not change. This multiplicative factor is the multiplier.
The crowding out effect - if a fiscal policy raises \(r\), then investment drops, and the net increase in aggregate demand drops. So, the actual aggregate demand shift may be less than the initial fiscal expansion.
People who believe that fiscal policy affects aggregate supply significantly are called supply-siders. These effects are usually more relevant in the long run.
It is desirable to have a relatively stable economy.