Principles of Macroeconomics

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Principles of Macroeconomics
Principles of Macroeconomics-MSc in Banking & Finance
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Academic Program: MSc in Banking and Finance
Semester: Fall 2012/13

Instructor: Dr. Nikolaos I. Papanikolaou
Office: Luxembourg School of Finance, KB2-E02-21
Phone: (00352) 466644 6938
Email: nikolaos.papanikolaou@uni.lu

Home Page: http://npapanikolaou.wordpress.com

Office hours: Monday 11:00-12:00 or by appointment
Course web site: https://moodle.fdef.uni.lu/fdef/login/index.php

(use your enrollment key to access the course content)

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The Classical view vs. the Keynesian view

Gross Domestic Product & Economic activity

Business cycles

Economic activity and Business cycles

Consumer Price Index & Inflation rate

GDP Deflator vs. CPI

Unemployment

The Circular Flow of Income

The National Income Identity

Exercises


Lecture notes – Set 2
Principles of Macroeconomics - MSc in Banking & Finance
Principles of Macroeconomics - MSc in Banking & Finance
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The Classical approach

It relies upon the ‘invisible hand hypothesis’ of Adam Smith: if
there are free markets, the laws of demand and supply will drive
the overall economy to an equilibrium (market-clearing process).

It assumes that prices and wages are flexible (and not sticky).

If there is a shortage (surplus) of labour, wages will rise (fall),
which implies that the level of employment is determined by
prices and wages.

Government should have only a limited role in the economy.
Classical view vs. Keynesian view
Principles of Macroeconomics - MSc in Banking & Finance
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The Keynesian approach

The Great Depression: Classical theory failed because high
unemployment was persistent.

Keynesian approach: Persistent unemployment occurs because
wages and prices adjust slowly, so markets remain out of
equilibrium for long periods.

The level of employment is determined by the level of aggregate
demand for goods and services.

Government should intervene to restore full employment through
the increase in spending.
Classical view vs. Keynesian view
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Gross Domestic Product (GDP) is the main measure of economic
activity and an indicator of well-being. It is calculated as the market
value of all final goods and services produced within a nation during
a specific time period, usually one calendar year.

For those goods that are not traded in the market place, we use an
estimation of their value, which is called imputed value.

Nominal GDP is measured at current market prices, whereas Real
GDP is measured at constant prices taking some specific calendar
year as the basis year. This conversion from nominal to real units
allows us to eliminate the problems created by having a measuring
stick that essentially changes length over time, as the price level
changes.

The ratio of Nominal GDP to Real GDP produces the so-called GDP
Deflator, which accounts for price changes over time.
GDP & Economic activity
Principles of Macroeconomics - MSc in Banking & Finance
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The term business cycles refers to the fluctuations of the overall activity and
performance in an economy.

Expansions vs. contractions: An expansion refers to the improvement of
economic performance and an increase in economic activity; the converse
holds true in a contraction (or recession). The economy is expanded when
moving from a trough to a peak; it is contracted between a peak and
trough.
Rule of thumb: two consecutive quarters of negative economic growth
rate define a recession.

An economic variable X can be either procyclical or countercyclical to
GDP. When X increases (decreases) in economic expansions and decreases
(increases) in recessions (i.e., it is positively linked to GDP), then it is
called procyclical (countercyclical).

Business cycles
Principles of Macroeconomics - MSc in Banking & Finance
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Economic activity and business cycles
Principles of Macroeconomics - MSc in Banking & Finance
Principles of Macroeconomics - MSc in Banking & Finance
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The Consumer Price Index (CPI) is a composite indicator that relies
on the weighted prices of a number of goods and services consumed
by a typical (representative) household. CPI is the weighted price of
this ‘basket’ of goods and services relative to the price of the same
basket in some base year (or month).

𝜋
𝑡+1
=
(𝑃
𝑡+1
−𝑃
𝑡
)
𝑃
𝑡

where:𝜋
𝑡+1
= inflation rate
𝑃
𝑡
can be either measured by CPI or by GDP deflator

An increase (decrease) in 𝜋
𝑡+1
implies an increase (decrease) in the
average level of prices. The so-called ‘core inflation’ excludes energy
and food prices as they tend to be very volatile.

CPI & Inflation rate
Principles of Macroeconomics - MSc in Banking & Finance
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GDP deflator measures the prices of all goods produced, whereas
CPI measures prices of only the goods and services bought by the
representative household.

GDP deflator includes only those goods and services produced
domestically. Imported goods are not a part of GDP and therefore
do not show up in the GDP deflator.

CPI assigns fixed weights to the prices of different goods, whereas
the GDP deflator assigns changing weights.
GDP deflator vs. CPI
Principles of Macroeconomics - MSc in Banking & Finance
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The labour force (L) is the sum of the employed (E) and
unemployed (U) individuals: L = E + U, where U consists of all
individuals that do not have a job and have actively sought for one
during the past four weeks.

The unemployment rate (u) is defined as the percentage of the
labour force that is unemployed: u = U/L

The employment-population ratio is the percentage of the adult
population (N) who are in the labour force (L):

Employment-population ratio = L/N

Unemployment
Principles of Macroeconomics - MSc in Banking & Finance
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Households
Firms
Income
Labour
Goods
Expenditure
GDP can be viewed as:
the total income of everyone in the economy
the total expenditure on the economy’s
output of goods and services
The Circular Flow of Income
For the entire economy it must hold that:
Total income = Total expenditure
Principles of Macroeconomics - MSc in Banking & Finance
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The National Income Identity
Y = C + G + I + (X-M)
Y = Total Income (Total Expenditure , or Total Production)
C = Total Consumption spending on durables and non-durable
goods and services
G = Total Government Expenditure (consumption & investment)
I = Total Private Investment (residential & non-residential)
augmented by the change in inventories
X-M = Exports of domestic goods and services – Imports of foreign
goods and services (Net Exports)
Principles of Macroeconomics - MSc in Banking & Finance
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The National Income Identity
GDP = C + G + I + (X-M)
GNP = GDP + Receipts from the rest of the world + Payments to
the rest of the world
NNP = GNP – Depreciation
National Income (NI) = NNP + Subsidies – Taxes
Personal Income (PI)= NI +Other personal income –Other
personal expense
Disposable PI = PI – Personal taxes

Principles of Macroeconomics - MSc in Banking & Finance
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a) Calculate nominal GDP for all three years.
b) Calculate real GDP for all three years using 2005 as the
basis year.
c) Why does real GDP not increase between 2006 and 2007
but nominal GDP does?
d) Calculate the GDP deflator for 2006.
Exercise 1
Consider the following economy that produces only soda and pizza:
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Exercise 2
Answer the following questions using the information provided in the Table below:
a) Calculate the private consumption.
b) What is the value of gross domestic investment?
c) What is the value of net exports?
d) Calculate the value of government spending.
e) Calculate the gross domestic product.

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Exercise 3
Consider an economy that is described by the following relationships:

C = cY , with c = 0.75
G = 250
NX = 250
I = 𝐼
̅
– br , with 𝐼
̅
= 500 and b = 5,000

a) Assume that the autonomous investment decreases from 500 units to
300 units. What will be the effect on output, ceteris paribus?
b) At the same time with what is happening in (a), the interest rate
decreases from 0.06 to 0.05; calculate the resulting change in Y.

Principles of Macroeconomics - MSc in Banking & Finance
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Exercise 4
Consider an economy that is described by the following relationships:

C =
c
(Y - T) , with
c
= 0.75
G = 250
NX = 250
I = 𝐼
̅

br
, with 𝐼
̅
= 500 and
b
= 5,000

Assume that the government increase expenditure by 500 units. This increase is
financed 50% by taxes (T) and the rest by bond issuance. The increased demand
in the bonds market drives up interest rate from 0.05 to 0.06.
a) What is the effect of the aforementioned changes on the equilibrium income?
b) Would it have been better to finance the expenditure entirely by taxes?

Principles of Macroeconomics - MSc in Banking & Finance