Macroeconomics

Cheatsheet Content

### Intro to Macroeconomics - **Definition:** Study of economy-wide phenomena, including inflation, unemployment, and economic growth. - **Key Goals:** - **Economic Growth:** Increase in real GDP over time. - **Low Unemployment:** High utilization of labor resources. - **Price Stability:** Low and stable inflation. - **Gross Domestic Product (GDP):** - **Definition:** Market value of all final goods and services produced within a country in a given period. - **Components (Expenditure Approach):** $$GDP = C + I + G + NX$$ - $C$: Consumption (household spending) - $I$: Investment (business spending on capital, inventories, new housing) - $G$: Government Purchases (spending by local, state, and federal governments) - $NX$: Net Exports (exports - imports) - **Real vs. Nominal GDP:** - **Nominal GDP:** Values output at current prices. - **Real GDP:** Values output at constant base-year prices (adjusted for inflation). - **GDP Deflator:** Measure of price level calculated as $(\text{Nominal GDP} / \text{Real GDP}) \times 100$. ### Unemployment - **Labor Force:** Sum of employed and unemployed individuals. - **Unemployment Rate:** $$\text{Unemployment Rate} = (\text{Number Unemployed} / \text{Labor Force}) \times 100$$ - **Labor Force Participation Rate:** $$\text{LFPR} = (\text{Labor Force} / \text{Adult Population}) \times 100$$ - **Types of Unemployment:** - **Frictional Unemployment:** Short-term unemployment due to job search (e.g., recent graduates, people changing jobs). Always present. - **Structural Unemployment:** Long-term unemployment due to a mismatch between worker skills and available jobs, or geographic location (e.g., automation, industry decline). - **Cyclical Unemployment:** Unemployment due to business cycle fluctuations (recessions). This is the type policymakers aim to eliminate. - **Natural Rate of Unemployment (NRU):** - The normal rate of unemployment around which the actual unemployment rate fluctuates. - NRU = Frictional Unemployment + Structural Unemployment. - When unemployment is at its natural rate, cyclical unemployment is zero. - **Full Employment:** When the economy is operating at the natural rate of unemployment. ### Inflation - **Definition:** A general increase in the overall price level in an economy. - **Deflation:** A general decrease in the overall price level. - **Disinflation:** A decrease in the rate of inflation. - **Measures of Price Level:** - **Consumer Price Index (CPI):** Measures the overall cost of goods and services bought by a typical consumer. $$\text{CPI} = (\text{Cost of basket in current year} / \text{Cost of basket in base year}) \times 100$$ - **Inflation Rate (using CPI):** $$\text{Inflation Rate} = ((\text{CPI}_2 - \text{CPI}_1) / \text{CPI}_1) \times 100$$ - **GDP Deflator:** Broader measure, includes all goods and services produced domestically. - **Causes of Inflation:** - **Demand-Pull Inflation:** Too much money chasing too few goods (e.g., strong aggregate demand). - **Cost-Push Inflation:** Increase in production costs (e.g., oil price shocks, wage increases). - **Quantity Theory of Money:** - $MV = PY$ - $M$: Money supply - $V$: Velocity of money (how often money changes hands) - $P$: Price level - $Y$: Real GDP (output) - Suggests that if $V$ and $Y$ are relatively stable, changes in $M$ lead to proportional changes in $P$. - **Costs of Inflation:** - **Shoe-leather costs:** Resources wasted when inflation encourages people to reduce their money holdings. - **Menu costs:** Costs of changing prices. - **Relative-price variability:** Distorts resource allocation. - **Tax distortions:** Inflation interacts with the tax system (e.g., capital gains tax). - **Arbitrary redistribution of wealth:** Unexpected inflation benefits debtors and harms creditors. ### Aggregate Demand (AD) - **Definition:** Total quantity of goods and services demanded in the economy at different price levels. - **Downward Slope Reasons:** - **Wealth Effect:** Lower price level increases real value of money holdings, making consumers feel wealthier and spend more. - **Interest-Rate Effect:** Lower price level reduces money demand, lowering interest rates, which stimulates investment spending. - **Exchange-Rate Effect:** Lower price level lowers interest rates, depreciating the currency, making exports cheaper and imports more expensive, thus increasing net exports. - **Shifts in AD:** - **Consumption (C):** Changes in consumer wealth, expectations, taxes. - **Investment (I):** Changes in business confidence, interest rates (not from price level), technology, taxes. - **Government Purchases (G):** Changes in government spending. - **Net Exports (NX):** Changes in foreign income, exchange rates. ### Aggregate Supply (AS) - **Definition:** Total quantity of goods and services firms produce and sell at different price levels. #### Short-Run Aggregate Supply (SRAS) - **Upward Slope Reasons:** - **Sticky-Wage Theory:** Nominal wages are slow to adjust. Unexpected lower price level makes real wages higher, increasing labor costs and reducing employment/output. - **Sticky-Price Theory:** Prices of some goods/services are slow to adjust. Unexpected lower price level leaves some firms with "too high" prices, reducing sales and production. - **Misperceptions Theory:** Firms may confuse changes in the overall price level with changes in their relative prices, leading to production adjustments. - **Shifts in SRAS:** - **Changes in Labor:** Immigration, demographics. - **Changes in Capital:** Investment in physical or human capital. - **Changes in Natural Resources:** Discovery of new resources, weather. - **Changes in Technology:** Productivity improvements. - **Changes in Expected Price Level:** If firms expect higher prices, they demand higher wages/costs, shifting SRAS left. - **Supply Shocks:** Unexpected events (e.g., oil price changes). #### Long-Run Aggregate Supply (LRAS) - **Vertical Line:** At the natural rate of output (potential output). - **Determined by:** Economy's resources (labor, capital, natural resources) and technology. - **Not affected by Price Level:** In the long run, prices and wages are flexible, and the economy's output capacity is independent of the price level. - **Shifts in LRAS:** Same factors as SRAS (labor, capital, natural resources, technology) that affect the economy's productive capacity. ### Macroeconomic Equilibrium - **Short-Run Equilibrium:** Intersection of AD and SRAS. - **Long-Run Equilibrium:** Intersection of AD, SRAS, and LRAS. Occurs when SRAS and LRAS intersect at the same point on the AD curve. - **Recessionary Gap:** Output below potential output (LRAS). Caused by insufficient AD. - **Inflationary Gap:** Output above potential output (LRAS). Caused by excessive AD. - **Self-Correction:** In the long run, sticky wages and prices adjust to return the economy to potential output. (e.g., in a recession, wages fall, SRAS shifts right). ### Money and Money Market - **Functions of Money:** - **Medium of Exchange:** Used to buy goods and services. - **Unit of Account:** Common measure for valuing goods and services. - **Store of Value:** Can be held and exchanged for goods/services later. - **Types of Money:** - **Commodity Money:** Has intrinsic value (e.g., gold, silver). - **Fiat Money:** No intrinsic value; declared legal tender by government (e.g., USD). - **Measures of Money Supply:** - **M1:** Currency, demand deposits, traveler's checks, other checkable deposits. (Most liquid) - **M2:** M1 + savings deposits, small time deposits, money market mutual funds. (Less liquid than M1) - **Fractional-Reserve Banking:** Banks hold only a fraction of deposits as reserves and lend out the rest. - **Reserve Requirement:** Minimum fraction of deposits banks must hold. - **Money Multiplier:** $1 / \text{Reserve Ratio}$. Maximum amount of money the banking system generates with each dollar of reserves. - **Federal Reserve (The Fed):** Central bank of the U.S. - **Structure:** Board of Governors, 12 regional Federal Reserve Banks, Federal Open Market Committee (FOMC). - **Dual Mandate:** Maximize employment, maintain stable prices. #### Money Market - **Demand for Money:** - **Transactions Demand:** For everyday purchases. - **Asset Demand:** To hold money as a store of value (inverse relationship with interest rate). - **Inverse relationship between interest rate and quantity of money demanded.** - **Supply of Money:** - Determined by the Fed (vertical line, independent of interest rate). - **Equilibrium Interest Rate:** Where money demand equals money supply. ### Fiscal Policy - **Definition:** Government decisions regarding government spending ($G$) and taxation ($T$). - **Tools:** - **Government Spending ($G$):** Direct impact on AD. - **Taxes ($T$):** Indirect impact on AD by affecting consumption ($C$) and investment ($I$). - **Types of Fiscal Policy:** - **Expansionary Fiscal Policy:** Increase $G$, decrease $T$. Aims to increase AD and output (used during recessions). - **Contractionary Fiscal Policy:** Decrease $G$, increase $T$. Aims to decrease AD and curb inflation (used during inflationary booms). - **Multipliers:** - **Spending Multiplier:** $1 / (1 - MPC)$ where MPC is Marginal Propensity to Consume. - **Tax Multiplier:** $-MPC / (1 - MPC)$. - The spending multiplier is generally larger than the tax multiplier. - **Crowding Out Effect:** Expansionary fiscal policy (increased G or decreased T) can raise interest rates, which reduces private investment, partially offsetting the increase in AD. - **Automatic Stabilizers:** Changes in $G$ or $T$ that occur automatically with the business cycle without explicit government action (e.g., unemployment benefits, progressive income tax). - **Lags:** Fiscal policy can be subject to significant implementation lags. ### Monetary Policy - **Definition:** Central bank actions to influence the money supply and credit conditions. - **Tools of the Fed:** - **Open Market Operations (OMOs):** - **Buying government bonds:** Increases money supply, lowers federal funds rate. - **Selling government bonds:** Decreases money supply, raises federal funds rate. - *Most frequently used tool.* - **Reserve Requirement (RR):** - **Decrease RR:** Increases money multiplier, increases money supply. - **Increase RR:** Decreases money multiplier, decreases money supply. - *Rarely changed.* - **Discount Rate:** Interest rate at which banks can borrow from the Fed. - **Decrease Discount Rate:** Encourages banks to borrow more, increases reserves, increases money supply. - **Increase Discount Rate:** Discourages borrowing, decreases reserves, decreases money supply. - **Interest on Reserve Balances (IORB):** Interest paid by the Fed on reserves held by banks. - **Increase IORB:** Encourages banks to hold more reserves, decreases money supply. - **Decrease IORB:** Encourages banks to lend more, increases money supply. - **Target:** Federal Funds Rate (the interest rate banks charge each other for overnight loans). - **Types of Monetary Policy:** - **Expansionary (Loose) Monetary Policy:** Increase money supply, decrease interest rates, increase AD (used during recessions). - **Contractionary (Tight) Monetary Policy:** Decrease money supply, increase interest rates, decrease AD (used during inflationary booms). - **Quantity Theory of Money (revisited):** In the long run, changes in the money supply primarily affect the price level, not real output. - **Short-Run Effects:** Monetary policy can influence interest rates and AD in the short run.