Lecture Notes on Macroeconomic Concepts and Models

Measuring Aggregate Output (GDP)

• Understanding Output Measurement at Aggregate Level
  • Challenging compared to factory-level measurement.
  • Example: Simple economy with a steel company and a car company:
    • Steel company sells to car company, not final consumers.
    • Incorrect GDP calculation by summing outputs ($300) corrected using three methods.

Methods to Measure GDP

1. Final Goods Method
   • GDP = Value of final goods only (Cars: $200).
2. Value Added Method
   • Value added = Revenue from sales - Cost of intermediate inputs.
   • Steel company: $100 value added; Car company: $200 - $100 = $100 value added.
   • Total value added = $200.
3. Income Method
   • Sum of incomes: Wages ($80 + $70 = $150) + Profits ($20 + $30 = $50).
   • Total income = $200.

Organizational Structure Independence

• The three methods are immune to changes in organizational structure (e.g., company mergers).
• Example: Merged companies still result in same GDP ($200).

Nominal vs Real Output

• Nominal Output: Quantity of final goods measured at current prices.
• Real Output: Quantity of final goods measured at base year prices.
• Example: GDP calculation using cars at constant prices (2012).
  • Highlights difference in growth rates of nominal vs real GDP.

Other Definitions

• Unemployment Rate: Number of unemployed over the labor force (not population).
• Inflation Rate: Rate of change of prices, measured using the deflator, CPI, etc.

Goods Market and Aggregate Demand

• Components of Aggregate Demand
  • Closed economy (no exports/imports).
  • Exogenous government expenditure and taxes.
  • Consumption is a function of disposable income (linear assumption).
  • Aggregate demand determined output assumption (prices fixed).

Equilibrium Output

• Equilibrium Condition: Aggregate demand = Aggregate supply.
• Solving for equilibrium output using equilibrium condition.
• Importance of the multiplier (
  • Higher marginal propensity to consume (C1) results in a higher multiplier.

Shifts in Aggregate Demand

• Factors shifting Aggregate Demand: Investment, government expenditure, taxes, autonomous consumption (C0).
• Example: Increase in autonomous consumption (C0), leads to greater change in equilibrium output due to multiplier effect.

Alternative Equilibrium Representation

• Saving Equals Investment
  • Derived expression shows equilibrium through savings and investment equality.
  • Paradox of Savings: Increased savings without increased income can lead to reduced output and recession.

Financial Markets and Money

• Simplified Financial Market Model: Comprising money and bonds.
• Money Demand
  • Increasing with nominal GDP.
  • Decreasing with interest rate (opportunity cost of holding cash).
• Central Bank Control
  • Controls money supply to achieve target interest rate.
  • Open market operations to influence interest rate (buying bonds increases money supply, lowers interest rates).

Bond Prices and Interest Rates

• Inverse Relationship
  • Example: Price of bond increases with demand, interest rate decreases.

ISLM Model

• Introducing ISLM Model: Foundation for understanding monetary and fiscal policy impact on aggregate demand and output.
• Components
  • Investment function dependent on output and interest rate.
  • IS Curve: Equilibrium in Goods Market (output = aggregate demand).
  • LM Curve: Equilibrium in Financial Market (money demand = money supply).
  • Equilibrium: Intersection of IS and LM curves.

Fiscal Policy Impact

• Examples: Change in government expenditure or taxes shifts IS curve.
  • Contractionary fiscal policy (reduce G or increase T) shifts IS left.
  • Balanced budget scenario's impact on IS.

Monetary Policy Impact

• Examples: Open market operations lowering interest rate shift LM curve.
  • Expansionary monetary policy increases equilibrium output.

Extended ISLM Model

• Incorporating Inflation and Credit Spreads
  • Real interest rate: Inclusive of expected inflation.
  • Credit spread: Interest rate premium due to risk.
  • New Parameters: x (credit spread), π (expected inflation).
  • Central Bank responses to changes in expected inflation and credit spread.

Labor Market and Natural Rate of Unemployment

• Wage Setting and Price Setting
  • Wage setting: Wages depend on expected prices, unemployment, and bargaining power.
  • Price setting: Firms set prices based on production costs (wages) and markup.
  • Natural Rate of Unemployment: Unemployment where actual prices equal expected prices.
  • Influence of parameters like markup and bargaining power on natural rate.

Impacts of Changes in Parameters

• Example: Increase in bargaining power (Z) or markup (M) increases the natural rate of unemployment.

Summary and Questions

• Recall and understand key concepts and their interrelations.
• Be prepared to apply models and analyze scenarios given in quizzes.

Q&A Session

• Discussion on finer points and implications of credit spread and actual defaults.