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Semester 2: Principles of Macro Economics
Introduction: Major macroeconomic schools - Classical, Keynesian, Monetarists, Supply side, Rational Expectations
Introduction to Major Macroeconomic Schools
Classical Economics
Classical economics is based on the idea that free markets can regulate themselves. Key figures include Adam Smith and David Ricardo. Classical economists focus on the long-term growth of an economy, emphasizing supply-side factors like labor, capital, and technology. They believe that markets are generally efficient and that government intervention is minimal.
Keynesian Economics
Developed by John Maynard Keynes during the Great Depression, Keynesian economics argues that aggregate demand is the primary driver of economic growth and employment. Keynesians advocate for active government intervention to manage economic cycles and stimulate demand through fiscal policy, especially during recessions.
Monetarism
Monetarism, attributed to Milton Friedman, emphasizes the role of government in controlling the amount of money in circulation. Monetarists argue that inflation is always a monetary phenomenon and advocate for a steady, predictable increase in the money supply rather than discretionary fiscal policies.
Supply-Side Economics
Supply-side economics focuses on boosting economic growth by increasing supply. Proponents argue that lower taxes and reduced regulation stimulate production, investment, and job creation. This theory gained prominence during the Reagan administration in the 1980s.
Rational Expectations
Rational expectations theory suggests that individuals make decisions based on their expectations of the future, which are generally accurate. This school posits that people will adjust their behavior based on available information, making it difficult for government policies to have predictable effects. This theory challenges Keynesian views on fiscal policy.
National Income Accounting: concepts of GDP, national income, measurement, nominal vs real income, limitations of GDP
National Income Accounting
Concepts of GDP
GDP stands for Gross Domestic Product. It is the total monetary value of all final goods and services produced within a country in a specific period. GDP is used to gauge the health of a country's economy and to make international comparisons.
National Income
National Income refers to the total income earned by the residents of a country in a given period. It includes wages, profits, rents, and taxes minus subsidies. National Income is an important measure for assessing the economic performance of a nation.
Measurement of National Income
National Income can be measured through three approaches: the production approach, which sums the total outputs of various sectors; the income approach, which adds up all incomes earned; and the expenditure approach, which totals consumption, investment, government spending, and net exports.
Nominal vs Real Income
Nominal income is measured in current prices and does not account for inflation. Real income, on the other hand, adjusts for inflation and reflects the purchasing power of income. Understanding the difference is crucial for economic analysis.
Limitations of GDP
While GDP is a widely used indicator of economic performance, it has limitations. It does not account for the distribution of income among residents of a country, does not measure the informal economy or non-market transactions, and ignores environmental factors and well-being of residents.
Determination of GDP: actual and potential GDP, aggregate expenditure, consumption function, investment function, equilibrium GDP, multiplier concept
Determination of GDP
Actual and Potential GDP
Actual GDP refers to the total economic output produced in a country during a specific time period. It reflects the real output utilizing current resource availability. In contrast, Potential GDP represents the maximum economic output achievable when all resources are fully employed efficiently. The gap between actual and potential GDP indicates economic performance and can imply whether an economy is in recession or inflation.
Aggregate Expenditure
Aggregate expenditure is the total spending in an economy, including consumption, investment, government spending, and net exports. It is a critical factor in determining GDP, as it represents the demand side of the economy. The aggregate expenditure model helps in understanding the level of economic activity and its fluctuations.
Consumption Function
The consumption function illustrates the relationship between income levels and consumer spending. Typically, it states that as income increases, consumption also increases, although not at a constant rate. The function helps to analyze consumer behavior and its impact on overall economic activity.
Investment Function
The investment function signifies the relationship between the level of investment and the interest rate. It suggests that lower interest rates generally stimulate higher levels of investment, contributing positively to GDP growth. Investment is a crucial component of aggregate expenditure and directly influences the economy's productive capacity.
Equilibrium GDP
Equilibrium GDP occurs when aggregate expenditure equals GDP, meaning total output equals total spending. At this point, the economy is in balance, and there are no unintended changes in inventory levels. Understanding equilibrium GDP is vital for policymakers aiming to achieve stable economic conditions.
Multiplier Concept
The multiplier concept explains how an initial change in spending leads to a more significant overall impact on national income. It operates on the principle that an increase in one component of expenditure will lead to a chain reaction of increased consumption and investment, amplifying the initial effect on GDP.
National Income Determination in an Open Economy with Government: fiscal policy impacts, net exports function
National Income Determination in an Open Economy with Government
Concept of National Income
National income refers to the total value of all goods and services produced in a country during a specific period, usually measured annually. It is a key indicator of economic health and is used to assess the performance of a country's economy.
Open Economy vs Closed Economy
An open economy interacts with other economies around the world through trade. It allows the exchange of goods, services, and capital. In contrast, a closed economy does not engage in international trade.
Role of Government in Income Determination
Government plays a crucial role in national income determination through fiscal policy, which includes government spending and taxation. By adjusting these elements, the government can influence overall economic activity.
Fiscal Policy and National Income
Fiscal policy involves using government expenditure and revenue collection to influence the economy. Expansionary fiscal policy can stimulate national income through increased government spending while contractionary fiscal policy can slow down an overheating economy.
Net Exports and Income Determination
Net exports, which are the difference between exports and imports, directly affect national income in an open economy. Positive net exports contribute to national income growth, while negative net exports can detract from it.
Multiplier Effect in Open Economy
The multiplier effect in an open economy shows how initial changes in spending can lead to larger changes in overall income. Increased government spending, for example, can lead to higher income, which increases consumption and further raises income.
Impact of Trade Policies on National Income
Trade policies, such as tariffs and quotas, can impact national income by affecting exports and imports. Protectionist measures can help local industries but might lead to retaliation and reduced overall income in the long run.
Summary of Key Relationships
In an open economy, national income determination is influenced by government fiscal policies, net exports, and the competitiveness of domestic industries. The interplay between these factors shapes the overall economic landscape.
Money in a Modern Economy: concept, monetary aggregates, demand for money, quantity theory of money, liquidity preference, money supply and credit creation, monetary policy
Money in a Modern Economy
Concept of Money
Money serves as a medium of exchange, a unit of account, and a store of value. It facilitates transactions, measures economic value, and preserves purchasing power over time.
Monetary Aggregates
Monetary aggregates classify the total amount of money supply in an economy. M0 represents physical cash, M1 includes M0 plus demand deposits, and M2 encompasses M1 plus savings accounts and other near-money assets.
Demand for Money
The demand for money is the desire to hold cash for transactions, precautionary motives, and speculative purposes. It is influenced by interest rates, income levels, and overall economic activity.
Quantity Theory of Money
This theory posits that the money supply directly affects price levels and, consequently, inflation. The equation MV = PQ illustrates that the money supply (M) multiplied by velocity (V) equals price level (P) times quantity of goods (Q) produced.
Liquidity Preference
Liquidity preference reflects the desire to hold cash or easily accessible assets rather than invest in illiquid assets. It is determined by factors such as interest rates, risk, and economic conditions.
Money Supply and Credit Creation
The money supply encompasses all money available in an economy, including bank deposits. Banks create credit through lending, which increases the overall money supply, influenced by reserve ratios.
Monetary Policy
Monetary policy involves the regulation of money supply and interest rates by central banks to achieve macroeconomic goals, such as controlling inflation, fostering employment, and stabilizing currency.
IS-LM Analysis: derivation and shifts in aggregate demand
IS-LM Analysis: Derivation and Shifts in Aggregate Demand
Introduction to IS-LM Framework
The IS-LM model represents the interaction between the goods market and the money market. The IS curve shows combinations of interest rates and output where the goods market is in equilibrium. The LM curve represents combinations where the money market is in equilibrium.
Derivation of the IS Curve
The IS curve is derived from the equilibrium condition in the goods market, where total spending (consumption, investment, government spending, and net exports) equals total output. A decrease in interest rates typically leads to higher investment and thus shifts the curve to the right.
Derivation of the LM Curve
The LM curve is derived from the money market equilibrium, where demand for money equals supply. It depends on the level of output and the interest rate. A higher level of income increases the demand for money, causing the LM curve to shift.
Shifts in the IS Curve
The IS curve can shift due to changes in fiscal policy, such as government spending and taxation. An increase in government spending shifts the IS curve to the right, indicating higher output at every interest rate.
Shifts in the LM Curve
The LM curve can shift due to changes in monetary policy, such as changes in the money supply. An increase in the money supply shifts the LM curve to the right, resulting in lower interest rates and higher output.
Aggregate Demand and IS-LM
In the context of aggregate demand, shifts in the IS or LM curves lead to changes in overall economic activity. The intersection of the IS and LM curves determines the equilibrium level of output and interest rates.
Policy Implications of IS-LM Analysis
IS-LM analysis helps in understanding the effects of fiscal and monetary policy on the economy. Policymakers use this model to evaluate the potential impacts of policy changes on aggregate demand, output, and interest rates.
GDP and Price Level in Short Run and Long Run: aggregate demand and supply, multiplier analysis, price level changes
GDP and Price Level in Short Run and Long Run
Aggregate Demand
Aggregate demand represents the total demand for goods and services within an economy at a given overall price level and in a given time period. It is composed of consumption, investment, government spending, and net exports. In the short run, aggregate demand can fluctuate due to changes in consumer confidence, interest rates, and fiscal policies.
Aggregate Supply
Aggregate supply is the total supply of goods and services that firms in an economy plan to sell during a specific time period. In the short run, aggregate supply is influenced by various factors such as production costs, supply chain dynamics, and temporary shocks. In the long run, aggregate supply is determined by productivity and resource availability.
Short Run vs. Long Run
In the short run, the economy can experience fluctuations in real GDP and price levels due to demand shocks and other transient factors. The long run, however, is characterized by the economy's ability to reach full employment, where output is determined by available resources and technology, leading to a stable price level.
Multiplier Analysis
Multiplier analysis examines the effect of initial changes in spending on the overall economic output. A change in autonomous spending (like government expenditure) leads to a more significant overall impact on GDP. The multiplier is calculated as 1/(1-MPC), where MPC is the marginal propensity to consume.
Price Level Changes
Price level changes can occur due to shifts in aggregate demand or aggregate supply. In the short run, an increase in aggregate demand can result in higher price levels, while the long-run aggregate supply curve is vertical, indicating that price levels do not affect output in the long term. Over time, however, inflation expectations can affect wages and prices, leading to real adjustments in the economy.
Inflation and Unemployment: determinants, Phillips Curve short and long run
Inflation and Unemployment: determinants, Phillips Curve short and long run
Definition and Measurement of Inflation
Inflation is the rate at which the general level of prices for goods and services is rising, thereby eroding purchasing power. It is typically measured using price indices like the Consumer Price Index (CPI) and the Producer Price Index (PPI).
Causes of Inflation
Inflation can be caused by various factors, including demand-pull inflation, where demand exceeds supply; cost-push inflation, arising from increased production costs; and built-in inflation, which is influenced by adaptive expectations of future inflation.
Definition and Measurement of Unemployment
Unemployment refers to the situation when individuals who are capable of working are unable to find a job. It is measured using the unemployment rate, which is defined as the number of unemployed individuals divided by the labor force.
Causes of Unemployment
Unemployment can result from several factors, including cyclical unemployment due to economic recessions, structural unemployment caused by shifts in the economy, and frictional unemployment which occurs during job transitions.
The Phillips Curve: Overview
The Phillips Curve depicts the inverse relationship between inflation and unemployment. Initially observed in the short run, it suggests that lower unemployment rates correlate with higher inflation rates, creating a trade-off.
Short-Run Phillips Curve
In the short run, the Phillips Curve indicates that expansionary monetary or fiscal policies can reduce unemployment at the cost of increased inflation. This dynamic is often exploited by policymakers.
Long-Run Phillips Curve
In the long run, the relationship described by the Phillips Curve may break down. Economists argue that the long-run Phillips Curve is vertical, implying no trade-off between inflation and unemployment at the natural rate of unemployment.
Determinants of the Phillips Curve
Factors like inflation expectations, supply shocks, and policy effectiveness influence the position and slopes of the Phillips Curve. Shifts in the curve can occur due to changes in these determinants.
Trade-off Implications for Economic Policy
The understanding of the Phillips Curve has significant implications for monetary and fiscal policy decisions. Policymakers use the curve to navigate the balance between controlling inflation and lowering unemployment.
Balance of Payments and Exchange Rate: current and capital account, measures to correct deficits, foreign exchange market and exchange rate determination
Balance of Payments and Exchange Rate
Balance of Payments Overview
The balance of payments is a comprehensive record of a country's economic transactions with the rest of the world over a specific period. It consists of two main accounts: the current account and the capital account.
Current Account
The current account includes all transactions that affect a country's income, such as imports and exports of goods and services, income from abroad, and current transfers. A surplus in the current account indicates that a country is earning more from its exports than it is spending on imports.
Capital Account
The capital account records all transactions related to the purchase and sale of assets, both financial and physical. This includes investments made by residents in foreign assets and foreign investments in domestic assets.
Deficits in Balance of Payments
A deficit occurs when a country spends more on foreign transactions than it earns. This can lead to a depletion of foreign exchange reserves and can impact the country's currency value.
Measures to Correct Deficits
Countries can implement various measures to correct balance of payments deficits, including adjusting exchange rates, implementing tariffs, encouraging exports, and restricting imports.
Foreign Exchange Market
The foreign exchange market is where currencies are traded. It plays a crucial role in determining exchange rates and ensuring that foreign currencies can be exchanged for domestic currency at a specified rate.
Exchange Rate Determination
Exchange rates are determined by supply and demand in the foreign exchange market. Factors influencing exchange rates include interest rates, inflation, and political stability.
