Study sheet: Money, Demand, Supply and Interest

📋 Course Outline

1. Macroeconomic Aggregates and Measurement
2. Macroeconomic Equilibrium
3. Schools of Macroeconomic Thought
4. Macroeconomic Schools of Thought
5. Aggregate Demand and Supply Model
6. Circular Flow and Two-Sector Economy
7. Circular Flow Models
8. National Income Accounting
9. Real and Nominal GNP
10. National Income Accounting Review
11. Consumption and Saving Functions
12. Income Equilibrium and Investment
13. National Saving and Investment Balances
14. Keynesian Cross and Thrift
15. Fiscal Policy and Multipliers
16. Proportional Taxes and Trade Multipliers
17. Government Budget and Fiscal Policy
18. Money and Its Evolution

📖 1. Macroeconomic Aggregates and Measurement

★ Must-know

📌 Microeconomics studies individuals or relatively small sectors under the ceteris paribus assumption, whereas macroeconomics studies the economy as a whole and the combined effects of individual choices.

• The main macroeconomic aggregates are:
  • total output
  • total demand
  • employment and unemployment
  • the general price level
  • the balance of payments
  • the rate of economic growth

📐 Formula — Aggregate demand is represented by $AD = C + I + G + X - M$, where C is consumption, I is investment, G is government demand, X is foreign demand for exports, and M is demand for imports.

📌 Aggregation is difficult because different goods and services have different physical units, so money is used as a common measure but must be separated into nominal and real values.

📌 National product is the value of all final goods and services produced during the year, national expenditure is spending on final goods and services produced during the year, and national income is the sum of factor incomes excluding transfer payments.

Further detail

• Real output is estimated by deflating the value of total output with an appropriate price index, converting current-price output into constant-price output.

• Consumption is household expenditure, investment is firms’ expenditure on real capital goods, and saving is disposable income not spent in the current period.

💡 Memory Hook

Output → expenditure → income

📖 2. Macroeconomic Equilibrium

🔑 Key Concepts & Definitions

• Aggregate supply : the total value of all final goods and services that firms wish to supply over a given period
• Macroeconomic equilibrium : occurs when aggregate demand equals aggregate supply, so there are no economic forces operating to change national income

★ Must-know

📌 Aggregate demand is planned expenditure by households, firms, government, and foreigners, whereas national expenditure is the actual amount spent over a given period.

📐 Formula — Under macroeconomic equilibrium, injections equal withdrawals: $I + G + X = S + T + M$.

📌 The AD–AS model represents aggregate demand as downward sloping and aggregate supply as upward sloping against the price level, with their intersection determining equilibrium real national income and the equilibrium price level.

Further detail

📐 Formula — The income identity is $Y = C + S + T$, where income is allocated to consumption, saving, and taxes.

💡 Memory Hook

AD = AS → equilibrium income and price level

📖 3. Schools of Macroeconomic Thought

★ Must-know

• In 1936, John Maynard Keynes published The General Theory of Employment, Interest and Money, arguing that investment, government spending, taxation, and exports were key variables in the business cycle, especially during depressions.

📌 Classical macroeconomics emphasizes markets that work best when left alone, whereas Keynesian macroeconomics argues that government intervention can improve economic performance.

• The new classical school rests on three assumptions:
  • economic agents maximize
  • expectations are rational
  • markets clear

📌 Under rational expectations, people use available information to form statistically best predictions and eventually understand government policies, making it impossible to fool most people most of the time.

Further detail

• Monetarism, associated especially with Milton Friedman during the 1960s and 1970s, treats money as a critical determinant of economic outcomes.

• New classical macroeconomics developed in the 1970s and is associated with Robert Lucas, Thomas Sargent, Robert Barro, Edward Prescott, and Neil Wallace.

💡 Memory Hook

Markets self-adjust versus government intervention

📖 4. Macroeconomic Schools of Thought

★ Must-know

• Classical economists assume that flexible wages and prices continuously clear markets, whereas New Keynesians argue that information problems and adjustment costs can create price rigidities and unemployment.

• Rational expectations mean that people use all available information to form statistically best predictions of the future, so predictable government policy cannot systematically fool most people.

• Monetarists oppose discretionary stop-go demand management because repeated expansions and contractions can increase inflation and unemployment, and they favor a fixed annual money-supply growth rule such as 3 percent.

• New Classical economists reject adaptive expectations and argue that rational producers anticipate the effects of announced policy, so demand management may have no temporary effect on real output.

Further detail

• New Keynesians argue that information problems and the costs of changing wages and prices can cause macroeconomic fluctuations in output and employment.

💡 Memory Hook

Classical markets clear, whereas New Keynesian markets may remain rigid.

📖 5. Aggregate Demand and Supply Model

🔑 Key Concepts & Definitions

• Long-run aggregate supply : the level of output associated with the natural level of output, denoted Qn, when the economy is in long-run equilibrium

📝 Essential Points

• 🔄 A negative aggregate-demand shock produces this sequence:
  1. Aggregate demand falls from AD2 to AD1
  2. The price level and real GNP fall
  3. Unemployment rises above its natural rate
  4. Prices and input costs gradually decline
  5. Long-run equilibrium is restored

📌 A deflationary gap occurs when real output is below the natural level and unemployment exceeds its natural rate, whereas an inflationary gap occurs when real output exceeds the natural level and unemployment falls below its natural rate.

📌 Classical economists argue that a change in aggregate demand changes the general price level but not full-employment output, so government demand management is ineffective for output and employment.

• Expansionary policies include:
  • lower taxes
  • higher transfer payments
  • higher government purchases
  • an increased money supply

💡 Memory Hook

Demand shock → output and prices change → the economy returns toward natural output.

📖 6. Circular Flow and Two-Sector Economy

🔑 Key Concepts & Definitions

• Circular flow : the continual movement of money, goods, and services between households and business firms through production, consumption, and capital formation

📝 Essential Points

📐 Formula — In a two-sector economy, total income equals consumption plus investment: $Y = C + I$.

📌 Real flows consist of factors moving from households to firms and goods and services moving from firms to households, whereas money flows move in the opposite directions.

• In the two-sector model, households supply factors of production and consume final output, while business firms employ factors, produce output, and sell goods and services.

📌 Injections increase the spending flow, whereas leakages reduce the spending flow in the circular economy.

💡 Memory Hook

Factors → income → spending → production → factor payments.

📖 7. Circular Flow Models

📝 Essential Points

📌 Injections are spending items that increase the circular flow, whereas leakages are factors that reduce spending.

• In the two-sector model, households sell factor services to businesses and purchase final output from businesses, while businesses pay factor incomes and sell goods and services to households.

• The two-sector model assumes: a closed economy, production only in the business sector, complete sale of production, complete household spending on consumption, no government or other external transactions

📌 The three-sector model adds government expenditure and taxation, while the four-sector model further adds foreign trade through exports and imports.

📌 In the four-sector open economy, equilibrium requires total leakages from savings, taxes, and imports to equal total injections from investment, government expenditure, and exports.

💡 Memory Hook

Injections increase spending, whereas leakages reduce it.

📖 8. National Income Accounting

🔑 Key Concepts & Definitions

• National income accounting : the systematic measurement of aggregate economic activity, particularly national income and its components, over a given period
• Gross national product : the total market value of all final goods and services produced in a given period by resources owned and supplied by a country's citizens, regardless of where production occurs

★ Must-know

📐 Formula — Gross national product equals gross domestic product plus net factor income: $GNP = GDP + NFI$, where net factor income equals factor income received from abroad minus factor income paid abroad.

📌 GDP measures the market value of final goods and services produced within a country's borders, whether by citizens or foreigners, whereas GNP measures production generated by resources owned by the country's citizens.

• GNP can be measured through:
  • the product or value-added approach
  • the expenditure approach
  • the income approach

📐 Formula — The expenditure approach expresses GNP as $GNP = C + I + G + (X-M)$, where consumption, investment, government expenditure, and net exports are included.

Further detail

📌 Intermediate goods must be excluded from national output calculations because counting them alongside final goods would double-count the same production.

📐 Formula — Net national product equals GNP minus depreciation, and national income equals NNP minus indirect business taxes: $NNP = GNP - D$ and $NI = NNP - IBT$.

💡 Memory Hook

GDP is produced within borders; GNP follows national-owned resources.

📖 9. Real and Nominal GNP

🔑 Key Concepts & Definitions

• Consumer price index : an index used to estimate the percentage change in the prices of a particular basket of consumption goods
• Per-capita income : calculated by dividing GNP by the size of the population and used to compare economic growth across countries

★ Must-know

📌 Nominal GNP values final output at the prices of the current period, whereas real GNP values final output at constant prices from a base period.

📐 Formula — Real GNP is calculated by multiplying nominal GNP by 100 and dividing by the price index: $Real\ GNP = \frac{Nominal\ GNP \times 100}{Price\ index}$.

📐 Formula — The annual inflation rate equals the change in the consumer price index divided by the previous year's consumer price index and multiplied by 100: $Inflation\ rate = \frac{CPI_t-CPI_{t-1}}{CPI_{t-1}} \times 100$.

Further detail

• When nominal GNP is 66 billion dollars and the price index is 110, real GNP is 60 billion dollars.

💡 Memory Hook

Nominal GNP uses current prices; real GNP uses base-year prices.

📖 10. National Income Accounting Review

🔑 Key Concepts & Definitions

• Gross National Product : The total market value of all final goods and services produced in a given time period by factors of production owned by residents of the country.
• GDP Deflator : The ratio of nominal GDP to real GDP and measures the rise in prices from the base period used for real GDP.

★ Must-know

📌 Real GDP measures output at the prices of a base year, whereas nominal GDP measures output at current prices and therefore also reflects inflation.

📐 Formula — The expenditure approach measures national output as $Y=C+I+G+NX$, where consumption, investment, government purchases, and net exports are added together.

Further detail

📐 Formula — The inflation rate is calculated as $RI=\frac{CPI_{1993}-CPI_{1992}}{CPI_{1992}}\times100=2.6\%$ when the CPI rises from 144.5 to 148.2.

💡 Memory Hook

C-I-G-NX: consumption, investment, government spending, and net exports

📖 11. Consumption and Saving Functions

🔑 Key Concepts & Definitions

• Disposable Income : The amount of income consumers can choose to spend or save in a given period.
• Consumption Function : The consumption function expresses the relationship between disposable income and consumer spending as $C=a+bY_d$, where $a$ is autonomous consumption and $b$ is the marginal propensity to consume.

★ Must-know

📐 Formula — Disposable income equals consumption plus saving: $Y_d=C+S$, so saving equals disposable income minus consumption: $S=Y_d-C$.

📐 Formula — The average propensity to consume is $APC=\frac{C}{Y_d}$, while the marginal propensity to consume is $MPC=\frac{\Delta C}{\Delta Y_d}$.

📐 Formula — The marginal propensity to save is $MPS=\frac{\Delta S}{\Delta Y_d}$ and satisfies $MPC+MPS=1$.

Further detail

📐 Formula — If the consumption function is $C=a+bY_d$, the saving function is $S=-a+(1-b)Y_d$, where $1-b$ is the marginal propensity to save.

💡 Memory Hook

Consumption spends disposable income, whereas saving is the unconsumed remainder

📖 12. Income Equilibrium and Investment

🔑 Key Concepts & Definitions

• Investment Demand : The desired change in the nation's capital stock, including newly produced structures and equipment, new residential construction, and changes in business inventories.

★ Must-know

📌 In a two-sector economy, equilibrium occurs when aggregate demand equals aggregate supply, so $C+I=C+S$ and therefore planned investment equals saving: $I=S$.

📐 Formula — In a closed economy with government and a constant tax rate, equilibrium income is $Y=\frac{1}{1-b(1-t)}(a+I+G)$.

📐 Formula — In an open economy, the net export function is $X=g-mY$, where $m$ is the marginal propensity to import, and the open-economy multiplier is $\frac{1}{1-b(1-t)+m}$.

📌 Investment demand has an inverse relationship with the interest rate: a lower interest rate encourages investment, whereas a higher interest rate discourages it.

Further detail

• With $C=500+0.6Y_d$, investment of 300, government spending of 500, and a tax rate of 0.2, equilibrium income is approximately 2,500.

💡 Memory Hook

Higher interest rates → lower investment demand → lower aggregate spending

📖 13. National Saving and Investment Balances

★ Must-know

📐 Formula — In a closed economy, saving equals investment: $S=I$, with private and government saving combined as total saving.

📐 Formula — Private saving equals disposable income minus consumption: $S_p=(Y+F+N-T)-C$, where transfers and interest income are included and taxes are subtracted.

📐 Formula — Government saving equals taxes minus transfers, interest payments, and government purchases: $S_g=T-F-N-G$.

Further detail

📐 Formula — In an open economy, rest-of-world saving equals the negative of net exports: $S_r=-X$, so a net-export deficit creates positive rest-of-world saving.

• For an open economy with consumption of $1200 billion, investment of $400 billion, government purchases of $300 billion, and net exports of -$100 billion, GNP is $1800 billion and total saving is $400 billion, equal to investment.

💡 Memory Hook

Closed economy: saving equals investment; open economy adds rest-of-world saving.

📖 14. Keynesian Cross and Thrift

🔑 Key Concepts & Definitions

• Keynesian cross : Keynes — a diagram showing that equilibrium nominal GNP occurs where aggregate nominal demand equals aggregate nominal supply
• Paradox of thrift : the possibility that attempts by households to save more reduce consumption and aggregate demand, lower national income, and ultimately reduce actual saving and investment

📝 Essential Points

📌 An expansionary gap exists when aggregate nominal demand exceeds aggregate nominal supply, causing unplanned inventory declines and rising production; a contractionary gap exists when aggregate nominal demand is below aggregate nominal supply, causing inventory accumulation and falling production.

📐 Formula — With consumption function $C=C_0+MPC\cdot Y$ and autonomous investment $I^*$, equilibrium output is $Y=\frac{1}{1-MPC}(C_0+I^*)$.

📐 Formula — The expenditure multiplier is $K=\frac{1}{1-MPC}$, so a multiplier greater than one makes the change in equilibrium output larger than the initial change in aggregate demand.

💡 Memory Hook

Demand above supply → inventories fall → production rises; demand below supply → inventories build → production falls.

📖 15. Fiscal Policy and Multipliers

🔑 Key Concepts & Definitions

• Fiscal policy : the use of government taxation and spending to alter macroeconomic outcomes such as aggregate demand, income, employment, and prices

★ Must-know

📐 Formula — In the three-sector model, aggregate demand is $AD=C+I+G$ and aggregate supply is represented by $AS=C+S+T$; equilibrium requires $C+S+T=C+I+G$.

📐 Formula — With consumption $C=a+b(Y-T)$, lump-sum taxes T, investment I, and government purchases G, equilibrium income is $Y=\frac{1}{1-b}(a-bT+I+G)$.

📐 Formula — The government expenditure multiplier is $G_m=\frac{\Delta Y}{\Delta G}=\frac{1}{1-b}$, while the lump-sum tax multiplier is $T_m=\frac{\Delta Y}{\Delta T}=-\frac{b}{1-b}$.

📐 Formula — When government spending and lump-sum taxes increase by the same amount, the balanced-budget multiplier equals one: $B_m=\frac{\Delta Y}{\Delta G}=1$.

Further detail

📐 Formula — With a proportional income tax rate t, equilibrium income is $Y=\frac{1}{1-b+bt}(a-bT+I+G)$ and the government expenditure multiplier is $\frac{1}{1-b+bt}$.

💡 Memory Hook

G-T-B: government spending multiplier, tax multiplier, balanced-budget multiplier.

📖 16. Proportional Taxes and Trade Multipliers

🔑 Key Concepts & Definitions

• Visible Export : a good produced in the home country, physically transported to and sold in an overseas market, generating foreign exchange
• Invisible Export : a service produced for foreigners either in the home country or overseas that generates foreign exchange for the home country

📝 Essential Points

📐 Formula — With a proportional income tax rate t, equilibrium national income is $Y = \frac{1}{1-b+bt}(a-bT+I+G)$.

📐 Formula — The balanced-budget multiplier with a proportional income tax is $\frac{\Delta Y}{\Delta G} = \frac{1}{1-b+bt}$ when government expenditure and taxes change together.

📐 Formula — With linear consumption and imports, the foreign trade multiplier is $\frac{\Delta Y}{\Delta X}=\frac{1}{1-b+g}$, where b is the marginal propensity to consume and g is the marginal propensity to import.

📐 Formula — With proportional taxes, the four-sector foreign trade multiplier is $\frac{\Delta Y}{\Delta X}=\frac{1}{1-b(1-t)+g}$.

💡 Memory Hook

Lump-sum taxes shift autonomous demand, whereas proportional taxes also reduce the multiplier.

📖 17. Government Budget and Fiscal Policy

🔑 Key Concepts & Definitions

• Government Budget : a financial statement of the government’s planned revenues and expenditures for a fiscal year, usually one year
• Automatic Stabilizers : built-in features that automatically promote a budget deficit during a recession and a budget surplus during an inflationary boom without new legislation
• Discretionary Fiscal Policy : a deliberate change in laws or appropriation levels that alters government revenues or expenditures to achieve macroeconomic goals
• Contractionary Fiscal Policy : a consciously designed decrease in government demand or increase in tax collections intended to move nominal GNP to a lower target level

★ Must-know

📌 A budget surplus occurs when taxes and other revenues exceed government expenditures, whereas a budget deficit occurs when expenditures exceed tax collections.

Further detail

• During a recession, automatic stabilizers reduce tax revenue and increase government expenditure, while during a boom they increase tax revenue and reduce government spending.

💡 Memory Hook

Recession → lower tax revenue and higher spending → deficit; boom → higher revenue and lower spending → surplus.

📖 18. Money and Its Evolution

🔑 Key Concepts & Definitions

• Money : any generally accepted commodity chosen by common consent to serve as a medium of exchange for goods and services and as a means of settling debts
• Barter Economy : a system in which one good is exchanged directly for another without using money
• Commodity Money : money that has value as a commodity apart from its value as money, such as gold, silver, or tobacco used in exchange
• Fiat Money : little value as a commodity but is accepted as a medium of exchange because law or tradition gives it that status
• Speculative motive : Keynes — The speculative motive is the desire to earn profit by anticipating what the future will bring, so people hold assets expected to rise in price and avoid securities expected to fall in price.
• Interest rate : The price paid for using money, usually expressed as a percentage of the principal for a specified period.

📝 Essential Points

• The main disadvantages of barter are: lack of double coincidence of needs, absence of a common unit for expressing prices, difficulty of credit sales and purchases, difficulty of storing wealth or generalized purchasing power

• Money functions as:

  • a medium of exchange
  • a unit of account
  • a standard of deferred payments
  • a store of value or liquid wealth

📌 Money is demanded for transactions that facilitate exchanges and as an asset that stores wealth and can be converted into other forms of wealth.

• Keynes identifies three motives for holding money:

  • the transactions motive
  • the precautionary motive
  • the speculative motive

• The transactions motive is the demand for money needed for normal day-to-day transactions, and its volume depends on national income and employment and the general price level.

📐 Formula — Speculative demand for money is a negative function of the interest rate: $L_s=L(r)$.

📌 An increase in the required reserve ratio reduces the money supply, whereas a decrease in the ratio increases the money supply.

• When the central bank buys securities, bank reserves and the money supply increase; when it sells securities, bank reserves and the money supply decrease.

📌 Quantity theory states that, other things being equal, doubling the quantity of money doubles the price level, whereas income theory emphasizes income, consumption, saving and expenditure as determinants of the price level.

• The equilibrium interest rate is determined by the intersection of the demand for money and the supply of money; in the cited model it is 7% at a money quantity of 3 billion Birr.

💡 Memory Hook

Barter → primitive money → commodity money → fiat money

📊 Synthesis Tables

Measures of Total Output

Measure	What it records	Exclusions or components
National product	Final goods and services produced	Excludes intermediate goods
National expenditure	Spending on final domestically produced goods and services	Includes consumption, investment, government expenditure, and exports
National income	Factor incomes generated by production	Excludes transfer payments

Macroeconomic Schools

School	Market view	Policy implication
Classical	Markets clear through flexible prices	Laissez-faire
Keynesian	Price adjustment can be slow	Manage aggregate demand
Monetarist	Discretionary policy destabilizes the economy	Fixed money-growth rule
New Classical	Rational expectations limit policy effects	Demand management is frustrated
New Keynesian	Rigidities can prevent market clearing	Explain and address market failures