MIDTERM REVIEW

Econ212 - Fall 2018/2019

Macroeconomic Concerns

■ The three major concerns of macroeconomics are

■ Output Growth
■ Unemployment
■ Inflation / Deflation
Macroeconomic Concerns and the Business
Cycle
The Three Market Arenas
■ Macroeconomic theory models the economy as a pattern of
interactions between households, firms , and the government in three
market arenas:
1. The Goods Market
2. The Labor Market
3. The Money / Financial Market
A Brief History of Macroeconomics
■ Classical economics
à stresses on non-intervention, is based on market-clearing models and
was developed in the nineteenth century.
à main assumption: Prices are Flexible (always adjust rapidly to
maintain equality between quantity supplied and quantity demanded)

■ Modern Macroeconomics has its roots in the work of John Maynard

Keynes, which is based on his study of the Great Depression
à Main assumption : Prices are sticky (do not always adjust rapidly to
maintain equality between quantity supplied and quantity demanded)
In the Financial Market
■ Treasury bonds, notes, or bills Promissory notes issued by the
federal government when it borrows money.
■ Corporate bonds Promissory notes issued by corporations when
they borrow money.
■ Stocks Financial instruments that give to the holder a share in
the firm’s ownership and therefore the right to share in the firm’s
profits.
■ Dividends The portion of a firm’s profits that the firm pays out
each period to its shareholders.
GDP: Definition

■ GDP is the total value of all final market goods and services
produced in a country in a given period of time.
■ In 2017
US GDP : 19.39 trillion U.S. dollars
Lebanese GDP : 51.84 billion US dollars
■ Final goods and services are included only. GDP is thus also total value
added.
■ Used goods and paper transactions are excluded.
■ Only new products are counted or new services done for old products.
■ GDP doesn’t include output produced abroad by domestically owned
factors of production
■ Include all goods produced in this year even if not sold.

■ Note: We don’t include intermediate goods to avoid double counting

GDP = Expenditure = Income
■ We can calculate GDP either by adding total expenditure in the
economy, or by summing income received by all factors of production.
■ The Expenditure Approach
There are four categories of expenditure:
1 Personal Consumption Expenditures C
2 Gross Private Domestic Investment I
3 Government Purchases and Investment G
4 Net Exports : NX = Exports - Imports

Note: Gross Investment – Depreciation = Net Investment

The Expenditure Approach: Investment

■ Investment is spending by firms on new capital equipment

and structures, and changes in firms inventories.

■ Residential investment is the only component of investment

purchases done by households.
The Income Approach
■ Components of National Income:
Compensation of employees
Proprietors; Income
Rental income
Corporate profits
Net interest
Indirect taxes minus subsidies
Net business transfer payments
Surplus of government enterprise
National income
+ Statistical discrepancy
= Net national product (NNP)
+ Depreciation
= GNP
+ Payments of factor income to the rest of the world (Income
foreigners earn here)
- Receipts of factor income from the rest of the world (Income
earned by citizens abroad)
= GDP
Nominal vs. Real GDP
■ Changes in (nominal) GDP confound growth in output with
increases in prices.
Real GDP is the value of production at fixed base-year prices.

Keep in mind that we care about fluctuations in Output once

calculating GDP and therefore in real GDP we fix the prices of the
base year so that any change in value will be because of change in
output and not prices.

■ One measure of inflation is the GDP Deflator.

GDP Deflator
■ One measure of inflation is the GDP Deflator .
1. GDP Deflator (t) = [Nominal GDP(t) / Real GDP(t) ] x 100
GDP Deflator (t-1) = [Nominal GDP(t-1) / Real GDP (t-1) ] x 100
!"# "%&'()*+ ,%(+ ) -!"# "%&'()*+( ,%(+ )-/)
2. Inflation rate = x 100
!"# "%&'()*+ ( ,%(+ )-/)

■ Example: Year (t)= 2010 ; Year (t-1) = 2009

Limitations of GDP

■ GDP doesn’t include home production or the underground

(illegal) economy.

■ GDP doesn’t directly measure social welfare:

■ "It doesn’t allow for the health of our children, the joy of their
play, the beauty of our poetry..."
Unemployment

■ Labor force = employed + unemployed

■ Population = labor force + not in the labor force

■ unemployment rate = (unemployed) / (employed +unemployed)

■ labor force participation rate = labor force / population

Types of Unemployment

■ There are ONLY three types of unemployment:

■ 1 Frictional Unemployment
■ 2 Structural Unemployment
■ 3 Cyclical Unemployment
Measuring Inflation

■ Inflation is measured by tracking the change in a price index. The

most important price indexes are:

1 The GDP Deflator

2 The Consumer Price Index (CPI)
3 Producer Price Indexes
CPI Example - Consumer Price Index

1*2) *& 3(24%) 56 ,%(+())

1. CPI (Year t) = x100
1*2) *& 3(24%) 56 3(2% ,%(+
1*2) *& 3(24%) 56 ,%(+ ()-/)
CPI (Year t-1 ) = x 100
1*2) *& 3(24%) 56 3(2% ,%(+

■ Note: The Basket’s quantities are the quantities of the base year.
Remember we are measuring inflation, so we care about fluctuations
in prices for the same basket of goods over time.
1#7 ,%(+ ) -1#7 ( ,%(+ )-/)
2. Inflation rate = x100
1#7 ( ,%(+ )-/)
Costs of Inflation

■ Inflation does not necessarily reduce people’s living

standards. The costs of inflation depend on whether it is
expected or unexpected.
■ Unexpected inflation is more harmful because it
redistributes resources.
■ The costs of expected inflation are more subtle:
administrative costs (menu costs) and inefficiencies.
Keynesian Consumption – Chapter 23

■ The Keynesian consumption function:

■ C=a+bY

■ b is the marginal propensity to consume (MPC). 0 < b < 1.

■ 1 - b is the marginal propensity to save (MPS).
■ mps + mpc = 1
■ a is autonomous consumption. Its determinants include interest rates,
taxes, and consumer confidence.
The Keynesian Cross : AE = Y
At Equilibrium

■ AE = Y è Y = C + I

■ I (actual) = I (planned) ; ie. I (unplanned)= 0

■ I=S
The Multiplier
■ What is the change in income for an increase in I of the amount ∆I?

■ We know that in equilibrium, S = I, so ∆S = ∆I

■ Since S = MPS x Y à ∆S = MPS x ∆Y à ∆Y = ∆S / MPS

■ Thus, ∆Y = ∆I x (1/MPS )

■ So the Multiplier of Investment= 1/ MPS = 1 / (1-mpc)

Example

■ If MPC = 0.5 , and investment is increased by 100, how much does

equilibrium output change?
1. Multiplier = 1 /(1-0.5) = 1/0.5 = 2
2. ∆Y = ∆I x multiplier = 100 x 2 = 200

à Output will increase by 200.

Chapter 24 – Including Government
■ disposable income = total income - net taxes

■ Yd=Y -T

■ budget deficit = G - T

■ Savings: S = Y - T - C

■ C = a + b (Y-T)
At Equilibrium
1. Y = AE ;
AE =C + I + G and C = a + b (Y - T )

è Y = AE = a + b (Y - T ) + I + G

2. Rewrite the equilibrium condition to get the savings-investment approach:

AE = C + I + G and Y = C + S + T

AE = Y è C + I + G = C + S + T
 Summary of Multipliers
1. When Taxes are Lump-Sum (ie. Constant taxes)
Policy Stimulus Multiplier ∆Y
Government Increase or decrease in the
and Investment level of government 1 ∆Y= ∆G ×
/
=#>
spending purchases: ∆G or ∆I 𝑀𝑃𝑆
multiplier
/
∆Y= ∆I ×
=#>

Tax multiplier Increase or decrease in the −𝑴𝑷𝑪 ∆Y = ∆T ×

-𝑴𝑷𝑪
𝑴𝑷𝑺
level of net taxes: ∆T 𝑴𝑷𝑺

Balanced- Simultaneous balanced-budget

budget increase or decrease in the 1 ∆Y= ∆G
multiplier level of government purchases
and
net taxes:
∆T = ∆G
2. When Taxes are as a function of Income, ie. T = constant + (t)(Y) ; t being
the tax rate

Policy Stimulus Multiplier ∆Y

/
Government Increase or decrease in the ∆Y= ∆G ×
1 =#>I JKL (M)
and Investment level of government
spending purchases: ∆G 𝑀𝑃𝑆 + mpc (t) /
multiplier ∆Y= ∆I ×
=#>I JKL (M)

Tax multiplier Increase or decrease in the −𝑴𝑷𝑪 ∆Y = ∆T ×

-𝑴𝑷𝑪
𝑴𝑷𝐒I 𝐦𝐩𝐜 (𝐭)
level of net taxes: ∆T 𝑴𝑷𝐒 + 𝐦𝐩𝐜 (𝐭)

Balanced- Simultaneous balanced-budget

budget increase or decrease in the 1 ∆Y= ∆G
multiplier level of government purchases
and
net taxes:
∆T = ∆G
Full Employment Budget

■ The full employment budget is what the government budget

would be under full employment.

■ The structural deficit is G - T in the full employment budget.

■ The cyclical deficit is the portion of the deficit due to a recession.

Automatic stabilizers and Automatic
destabilizers
Automatic stabilizers are automatic changes that reduce
government revenues and increase government spending in
recessions, and do the opposite in expansions.
■ Example: Income taxes and unemployment benefits

Automatic destabilizers increase taxation and reduce spending in

recessions, and do the opposite in expansions.
Example: Government transfer payments linked to inflation.