Macroeconomics Essentials

Cheatsheet Content

### Balance of Payments (BOP) - **Definition:** A record of all economic transactions between residents of a country and the rest of the world over a period. - **Components:** - #### Current Account (CA) - **Goods & Services:** Exports (+) and Imports (-) - **Primary Income:** Income earned from abroad (e.g., wages, profits, interest) (+) and paid abroad (-) - **Secondary Income:** Transfers (e.g., foreign aid, remittances) received (+) and paid (-) - #### Capital Account (KA) - Minor component, includes transfers of ownership of fixed assets. - #### Financial Account (FA) - **Direct Investment:** Purchase/sale of controlling interest in a foreign business. - **Portfolio Investment:** Purchase/sale of bonds and stocks (less than controlling interest). - **Other Investment:** Loans, deposits, trade credits. - **Reserve Assets:** Changes in foreign currency holdings by the central bank. - **Identity:** CA + KA + FA + Net Errors & Omissions = 0 - **Surplus:** Country earns more foreign currency than it spends. - **Deficit:** Country spends more foreign currency than it earns. ### Exchange Rates - **Definition:** The price of one currency in terms of another. - **Types:** - **Nominal Exchange Rate (E):** The rate at which one currency can be exchanged for another. - **Direct Quote:** Price of foreign currency in domestic currency (e.g., $1.20/€). - **Indirect Quote:** Price of domestic currency in foreign currency (e.g., €0.83/$). - **Real Exchange Rate (RER):** The rate at which the goods and services of one country can be exchanged for the goods and services of another country. - $$RER = E \times \frac{P_{domestic}}{P_{foreign}}$$ - Where $P_{domestic}$ and $P_{foreign}$ are price levels in domestic and foreign countries. - **Regimes:** - **Flexible (Floating) Exchange Rate:** Determined by market forces (supply and demand). - **Fixed Exchange Rate:** Government/central bank intervenes to maintain a specific rate. - **Managed Float:** Hybrid system where rates are generally flexible but subject to intervention. - **Appreciation:** Increase in the value of a currency. - **Depreciation:** Decrease in the value of a currency. - **Factors Affecting Exchange Rates:** - **Interest Rate Differentials:** Higher rates attract foreign capital (appreciation). - **Inflation Rate Differentials:** Higher inflation leads to depreciation (PPP theory). - **Current Account Balance:** Surpluses can lead to appreciation. - **Economic Growth/Outlook:** Strong growth attracts investment (appreciation). - **Government Policy/Intervention:** Central banks can buy/sell currency. ### AD-AS Model - **Definition:** A macroeconomic model that explains price level and output determination. - #### Aggregate Demand (AD) - **Definition:** Total demand for goods and services in an economy at a given price level. - **Components:** $AD = C + I + G + (X - M)$ - C: Consumption - I: Investment - G: Government Spending - X: Exports - M: Imports - **Downward Slope:** - **Wealth Effect:** Lower prices increase real wealth, boosting consumption. - **Interest Rate Effect:** Lower prices reduce demand for money, lowering interest rates, boosting investment. - **Exchange Rate Effect:** Lower prices make exports cheaper and imports more expensive, boosting net exports. - **Shifters:** Changes in C, I, G, (X-M) not due to price level changes (e.g., fiscal/monetary policy, consumer confidence, technology). - #### Aggregate Supply (AS) - **Short-Run Aggregate Supply (SRAS)** - **Upward Slope:** As price level rises, firms' profits increase (assuming sticky wages/input costs), leading to more output. - **Shifters:** Changes in input prices (wages, oil), technology, expectations, government policies (taxes, subsidies). - **Long-Run Aggregate Supply (LRAS)** - **Vertical Line:** Represents the economy's potential output (full employment output) and is independent of the price level. - **Shifters:** Changes in capital stock, labor force, natural resources, technology. - #### Equilibrium - Intersection of AD and AS determines equilibrium price level and real GDP. - #### Macroeconomic Issues - **Inflationary Gap:** $AD > AS_{LR}$ (output above potential) - **Recessionary Gap:** $AD ### Expenditure Model (Keynesian Cross) - **Definition:** A model that determines equilibrium output in the short run, assuming fixed prices. - **Key Concepts:** - **Planned Aggregate Expenditure (PAE):** Total planned spending in the economy. - $PAE = C + I_p + G + NX$ - $I_p$: Planned Investment (not actual investment, which includes unplanned inventory changes) - $NX$: Net Exports - **Consumption Function:** $C = \bar{C} + b(Y - T)$ - $\bar{C}$: Autonomous Consumption (independent of income) - $b$: Marginal Propensity to Consume (MPC) ($0 ### Multipliers - **Definition:** The ratio of the change in equilibrium output to the initial change in autonomous spending. - **Simple Expenditure Multiplier (No Taxes, Imports):** - $$Multiplier = \frac{1}{1 - MPC}$$ - **Government Spending Multiplier:** - $$\Delta Y = \frac{1}{1 - MPC} \times \Delta G$$ - **Tax Multiplier:** - $$\Delta Y = \frac{-MPC}{1 - MPC} \times \Delta T$$ - Note: Tax multiplier is smaller than government spending multiplier and negative. - **Balanced-Budget Multiplier:** When government spending and taxes change by the same amount, the multiplier is 1. - $$\Delta Y = 1 \times (\Delta G = \Delta T)$$ - **Multiplier with Taxes and Imports (More Realistic):** - $$Multiplier = \frac{1}{1 - [MPC(1-t) - MPI]}$$ - $t$: marginal tax rate - $MPI$: marginal propensity to import - **Significance:** Small changes in autonomous spending can lead to large changes in equilibrium output.