Study sheet: Macroeconomics Topics Part One

📋 Course Outline

1. GDP Measurement and Components
2. Real GDP and Its Limits
3. Consumer Price Index and Inflation
4. Income Inequality Measures
5. Productivity and Economic Growth
6. Saving and Financial Markets
7. Unemployment and Wage Setting
8. Unions and Efficiency Wages
9. Money Functions and Types
10. Central Banks and Money Creation
11. Classical Theory of Inflation
12. Inflation Costs and Purchasing Power
13. International Flows and Exchange Rates
14. Open Economy Equilibrium
15. Open-Economy Policy Effects
16. Short-Run Economic Fluctuations
17. Aggregate Demand and Supply
18. Monetary Policy and Demand

📖 1. GDP Measurement and Components

🔑 Key Concepts & Definitions

• Gross Domestic Product : the market value of all final goods and services produced within a country in a given period of time
• Consumption : household spending on goods and services except purchases of new housing, including durable and nondurable goods, physical goods, and intangibles
• Investment : spending on capital equipment, inventories, and structures, including household purchases of new housing
• Net Exports : spending on domestically produced goods by foreigners minus spending on foreign goods by domestic residents, so $NX = X - M$

📝 Essential Points

📌 GDP counts final goods and services while counting intermediary goods only once, and domestic production may be carried out by nationals or foreigners in firms owned by nationals or foreigners.

📐 Formula — Total production equals total spending and total income, and GDP is decomposed as $Y = C + I + G + NX$.

💡 Memory Hook

Y = C + I + G + NX

📖 2. Real GDP and Its Limits

🔑 Key Concepts & Definitions

• Limits of GDP : not a perfect proxy for economic well-being because market value may not reflect intrinsic value, house production and leisure are excluded, environmental harm is not incorporated, and inequality is ignored

★ Must-know

• Real GDP is computed using actual quantities valued at the prices of a reference year.

• The GDP deflator equals nominal GDP divided by real GDP.

Further detail

• In the example, nominal GDP is 2.4 in 2015, 3.7 in 2016, and 4.8 in 2017, while real GDP at 2015 prices is 2.4, 3.2, and 3.2 respectively.

💡 Memory Hook

Nominal GDP uses current prices, whereas real GDP uses reference-year prices.

📖 3. Consumer Price Index and Inflation

🔑 Key Concepts & Definitions

• Consumer Price Index : a measure of the overall cost of the goods and services bought by a typical consumer
• Inflation Rate : the percentage change in the price of the consumption basket from the preceding period and therefore the percentage change in the CPI index
• Indexation : the automatic correction of a money amount for the effects of inflation by law or contract

★ Must-know

• The CPI is calculated by valuing the same reference basket with prices from different dates while keeping the basket quantities fixed.

• For a given inflation measure and economic value, the real value equals the nominal value divided by inflation.

Further detail

📌 CPI measurement can be biased by substitution, newly introduced goods, and unobserved quality changes or technical progress.

💡 Memory Hook

CPI follows consumer prices and composition, whereas the GDP deflator follows domestic production.

📖 4. Income Inequality Measures

🔑 Key Concepts & Definitions

• Gini Index : a measure of inequality as the area between the equality line and the Lorenz curve divided by the total area under the equality line, written as $Gini = A/(A+B)$
• Percentiles : groups of equal size formed by sorting people according to their income levels

★ Must-know

• In France in 2011, the average after-tax monthly available income per adult was 522 dollars for the bottom decile and 4226 dollars for the top decile, giving a top-to-bottom ratio of 8.

Further detail

📌 Consumption inequality is much lower than income inequality because consumption is shared within households or families and smoothed over time through borrowing, transitory shocks, and life-cycle smoothing.

• The European Union gender pay gap is 15% on average and 10% for the same work.

💡 Memory Hook

The Lorenz curve bends away from the equality diagonal as inequality increases.

📖 5. Productivity and Economic Growth

🔑 Key Concepts & Definitions

• Productivity : the quantity of goods and services produced from each hour of a worker’s time
• Production Function : a relation representing output as $Y = F(L,K,H,N)$ by combining labour, physical capital, human capital, and natural resources
• Technological Knowledge : society’s understanding of the best ways to produce goods and services and affects the production function
• Diminishing Returns : the property whereby the benefit from an extra unit of an input declines as the quantity of that input increases
• Catch-Up Effect : the tendency for countries that start poor to grow more rapidly than countries that start rich

📝 Essential Points

📐 Formula — The growth rate is expressed as $g_t = \log\left(\frac{y_t}{y_{t-1}}\right)$ or as the slope $\Delta\log(y)/\Delta t$ in a semi-log graph.

💡 Memory Hook

Investment in capital, education, institutions, and technology → higher productivity and growth.

📖 6. Saving and Financial Markets

🔑 Key Concepts & Definitions

• Financial Markets : institutions through which savers directly provide funds to borrowers
• Financial Intermediaries : institutions through which savers indirectly provide funds to borrowers, with the intermediary acting as both a borrower and a lender

★ Must-know

📌 A bond is a certificate of indebtedness with unconditional repayment and a guaranteed interest rate, whereas a stock represents partial ownership whose return depends on output through dividends.

📐 Formula — In a closed economy, aggregate saving is $S = Y - C - G$ and equals investment, so $S = I$.

• In the loanable-funds market, saving supplies funds and borrowing demands funds, with the interest rate serving as the price of funds.

Further detail

📌 Private saving is household saving, while public saving is government saving; public saving is positive with a budget surplus and negative with a budget deficit.

📌 A saving incentive shifts the supply of loanable funds rightward, reducing the equilibrium interest rate and increasing loans.

💡 Memory Hook

Savers supply funds → borrowers invest → production generates revenue → borrowers repay.

📖 7. Unemployment and Wage Setting

🔑 Key Concepts & Definitions

• Unemployment : a person without a job who is available for work at current wage rates, is of working age, is not studying or sick, and is ready to work at going market prices
• Labour Force Survey : Labour Force Surveys define an unemployed person as someone without a job willing to start within the next two weeks who has looked for work in the past four weeks or is waiting for a job to start, and define an employed person as someone who worked more than one hour in the previous week.
• Efficiency Wages : above-equilibrium wages paid by firms to increase worker productivity and that can also result in unemployment

★ Must-know

📌 Frictional unemployment results from the time needed to find a new job, whereas structural unemployment occurs when no job exists in the same labour market.

Further detail

📌 Unemployment insurance can protect workers transitioning between jobs, but poorly designed benefits can create adverse incentives, so governments can also improve matching through vacancy information and training schemes.

• The main theories of efficiency wages are:
  • worker health
  • worker turnover
  • worker effort
  • worker quality through adverse selection

💡 Memory Hook

Frictional unemployment reflects job-search time, whereas structural unemployment reflects the absence of a suitable job.

📖 8. Unions and Efficiency Wages

🔑 Key Concepts & Definitions

• Union : a worker association that bargains collectively with employers over wages and working conditions
• Efficiency wages : above-equilibrium wages paid voluntarily by firms to increase worker productivity, although they can create unemployment

📝 Essential Points

📌 Union wage increases can create labor-market segmentation between insiders represented by unions with good working conditions and outsiders who are not represented.

📌 Unions can worsen efficiency through excessive bargaining power, but they can also correct inefficiency when employers have excessive bargaining power, such as under a regional monopoly.

• The four main efficiency-wage mechanisms are:
  • better worker health
  • lower worker turnover because hiring and training are costly
  • greater worker effort when shirking is difficult to detect
  • improved worker quality because low wages discourage high-skill applicants

💡 Memory Hook

Unions bargain collectively, whereas efficiency wages are chosen by firms to raise productivity.

📖 9. Money Functions and Types

🔑 Key Concepts & Definitions

• Money : Money performs three functions: medium of exchange, store of value, and accounting measure through public prices.
• Liquidity : the ease with which a store of value can be converted into a medium of exchange
• Wealth : Wealth is all the stores of value that a person owns, such as jewellery, Treasury bills, and a house.

📝 Essential Points

📌 Commodity money has intrinsic value, fiat money has no intrinsic value but is declared legal tender, and peer-to-peer money includes bitcoin.

💡 Memory Hook

MSA: medium of exchange, store of value, accounting measure.

📖 10. Central Banks and Money Creation

🔑 Key Concepts & Definitions

• Central bank : a financial institution that controls the amount of money in the economy through monetary policy, usually with a price-stability mandate and ideally independence from government

★ Must-know

• Central banks inject money through helicopter drops and open-market operations in which they buy less-liquid assets, typically government bonds, in exchange for fresh money.

• Fractional-reserve banking allows banks to lend so that reserves are less than deposits, while bank runs, prudence, and minimum reserve requirements limit money creation.

Further detail

• In the Eurozone, M1 was 9,705 billion euros, consisting of 1,305 billion euros in currency and 8,400 billion euros in overnight deposits.

💡 Memory Hook

Inject money, regulate reserves, influence interbank liquidity.

📖 11. Classical Theory of Inflation

🔑 Key Concepts & Definitions

• Classical dichotomy : the theoretical separation of nominal variables measured in monetary units from real variables measured in physical units

📝 Essential Points

📌 Monetary neutrality is the proposition that changes in the money supply do not affect real variables.

📐 Formula — The quantity equation is $MV = PY$, where M is money supply, V is velocity of money, P is the price level, and Y is total real production.

📐 Formula — To maintain price stability, money growth should equal production growth, expressed as $(M(1+g))V = P(Y(1+g))$.

📐 Formula — The Fisher relationship is $1+r = \frac{1+i}{1+\pi}$, or approximately $r=i-\pi$, where r is the real interest rate, i the nominal interest rate, and π inflation.

💡 Memory Hook

More money with unchanged output → lower money value → higher prices.

📖 12. Inflation Costs and Purchasing Power

★ Must-know

• Hyperinflation is inflation exceeding 50% per month.

• An inflation tax occurs when a government prints money to finance spending or forces the central bank to buy government debt, thereby raising prices and financing government spending through inflation.

📌 The inflation fallacy is the belief that overall purchasing power is decreasing, even though purchasing power equals production by definition, while some categories can still lose purchasing power when profits rise faster than salaries.

Further detail

• Shoeleather costs are the time and effort spent moving wealth into and out of savings accounts to avoid holding cash during inflation.

• Menu costs are the costs firms incur when they must adjust prices frequently, such as restaurants reprinting menus.

💡 Memory Hook

Overall purchasing power equals production, whereas some groups can lose purchasing power.

📖 13. International Flows and Exchange Rates

🔑 Key Concepts & Definitions

• Net capital outflow : foreign assets bought by residents minus domestic assets bought by foreigners
• Nominal exchange rate : the rate at which a person can trade one country's currency for another country's currency
• Purchasing power parity : the theory that one unit of a currency should buy the same quantity of goods in every country

★ Must-know

📐 Formula — Net exports equal exports minus imports: $NX=X-M$; positive NX indicates a trade surplus and negative NX indicates a trade deficit.

📐 Formula — The fundamental international identity is $NCO=NX$, because exported goods are paid for with foreign currency, foreign assets, or domestic currency acquired through asset sales.

📐 Formula — National saving satisfies $S=Y-C-G$ and, using $Y=C+I+G+NX$, implies $S=I+NX=I+NCO$.

Further detail

• On August 1st, one euro equaled 1.18 dollars, so the dollar-per-euro exchange rate was $E_{\$/EUR}=1.18$ and one dollar equaled 0.8475 euros.

💡 Memory Hook

Nominal exchange rates trade currencies, whereas real exchange rates trade goods.

📖 14. Open Economy Equilibrium

★ Must-know

📐 Formula — In the open economy, loanable-funds equilibrium is $S=I+NCO$, with saving increasing in the real interest rate and domestic investment plus net capital outflow decreasing in it.

📌 In the foreign-currency market, net capital outflow supplies domestic currency and is independent of the exchange rate, while net exports demand domestic currency and decrease when the currency appreciates.

📌 Financial arbitrage causes capital inflows when the domestic real interest rate exceeds the world rate and capital outflows when it falls below the world rate.

• 🔄 A government deficit produces this sequence:
  1. reduces national saving
  2. shifts the loanable-funds supply curve left
  3. raises the interest rate
  4. triggers capital inflows
  5. appreciates the currency
  6. produces a trade deficit

Further detail

📌 An import quota decreases imports and increases demand for the domestic currency, shifting the foreign-currency demand curve to the right.

💡 Memory Hook

Higher interest rates → capital inflows → currency appreciation.

📖 15. Open-Economy Policy Effects

📝 Essential Points

📌 A government deficit is negative saving, so it shifts the supply curve in the loanable-funds market to the left, raises the interest rate, attracts capital inflows, and appreciates the currency.

📐 Formula — In the open-economy model, saving minus investment equals net capital outflows, which equal net exports: $S-I=NCO=NX=X-\frac{M}{E}$.

📌 An import quota decreases imports, increases demand for the local currency, shifts the currency-demand curve to the right, and appreciates the equilibrium exchange rate without changing anything else in the model.

📌 Under the assumption that saving and investment are exogenous, an import tax or quota does not reduce the trade deficit because the exchange-rate appreciation offsets the initial fall in imports.

• Capital flight caused by investor fears of instability increases net capital outflows, reduces net foreign investment, shifts the relevant curves to the right, raises the interest rate, and depreciates the exchange rate.

💡 Memory Hook

Deficit → trade policy → capital flight

📖 16. Short-Run Economic Fluctuations

🔑 Key Concepts & Definitions

• Aggregate demand : the quantity of goods and services that households, firms, and the government want to buy at each price level
• Aggregate supply : the quantity of goods and services that firms choose to produce and sell at each price level

📝 Essential Points

• Economic fluctuations, also called business cycles, are irregular and unpredictable in length.

• Most macroeconomic quantities fluctuate together, with many series being positively or negatively correlated, sometimes with different magnitudes or lags.

• As output falls, unemployment rises, a robust relationship also called Okun’s law.

📌 In the long run, prices and wages have time to adjust, so the classical dichotomy and monetary neutrality hold well; in the short run, rigidities prevent this separation and real and nominal shocks can affect activity.

💡 Memory Hook

Long run: prices adjust; short run: rigidities matter

📖 17. Aggregate Demand and Supply

★ Must-know

📐 Formula — The expenditure identity for aggregate demand is $Y=C+I+G+NX$.

• An increase in the price level reduces consumption through the wealth effect, reduces investment through higher interest rates, and reduces net exports because domestic goods become less competitive.

📌 The aggregate demand curve shifts right when consumption, investment, net-export demand, or government purchases increases, and it shifts left when these sources of demand decrease.

📐 Formula — Short-run aggregate supply is represented by $Y^S=Y^N+a(P-P^E)$, where natural output is $Y^N$, the price level is $P$, expected prices are $P^E$, and $a$ is positive.

📌 A negative demand shock shifts aggregate demand left, lowering output and prices, whereas a negative supply shock shifts aggregate supply left, raising prices and reducing production.

Further detail

• Long-run aggregate supply shifts with changes in:
  • The labour force
  • Capital
  • Natural resources
  • Technology

📌 An increase in expected prices shifts short-run aggregate supply to the left because current prices do not adjust immediately and firms initially sell goods too cheaply.

💡 Memory Hook

Shock → curve shift → changes in output and prices

📖 18. Monetary Policy and Demand

🔑 Key Concepts & Definitions

• Liquidity preference theory : the theory that the interest rate is the main factor determining money demand because it is the opportunity cost of holding money
• Fiscal multiplier : the increase in demand divided by the size of the government stimulus
• Marginal propensity to consume : the increase in consumption following a marginal increase in income

★ Must-know

• An increase in the price level raises money demand, shifts the money-demand curve right, raises the interest rate, reduces consumption and investment, and lowers aggregate demand.

📌 An expansionary central-bank intervention increases the money supply, lowers the equilibrium interest rate, raises demand at each price level, and increases equilibrium production and prices.

• When the zero lower bound constrains interest-rate policy, central banks can use quantitative easing and forward guidance instead of reducing the target rate further.

📐 Formula — The marginal propensity to consume satisfies $MPC=\frac{\Delta C}{\Delta Y}$, while the marginal propensity to save satisfies $MPS=1-MPC$.

📐 Formula — With a constant marginal propensity to consume $c$, the fiscal multiplier is $M=\frac{1}{1-c}$; when $c=0.8$, the multiplier equals $5$.

📌 Crowding out is the reduction in investment spending caused by higher interest rates resulting from increased government spending.

📌 Active stabilization can help end a recession, but policymakers may misidentify demand and supply shocks or face implementation lags; automatic stabilizers such as counter-cyclical taxes and unemployment benefits operate without these discretionary delays.

Further detail

📌 The multiplier can be lower in an open economy because higher demand increases imports instead of entirely increasing domestic consumption, and it can be higher during a recession; empirical estimates range from 0.5 to 3.6.

💡 Memory Hook

Money supply → interest rate → consumption and investment → output

📊 Synthesis Tables

GDP Deflator Versus CPI

Measure	Price coverage	Composition
CPI	Consumer prices, potentially including imports	Constant consumption composition
GDP deflator	Prices of domestic production	Implicitly allows composition changes

Types of Exchange Rate

Notion	What is traded	Main implication
Nominal exchange rate	Currencies	An appreciation buys more foreign currency
Real exchange rate	Goods and services	Compares purchasing power across countries
Purchasing power parity	Equal quantities of goods	Predicts a real exchange rate of 1