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FOREIGN TRADE UNIVERSITY
Department of Macroeconomics
Hoang Xuan Binh (Assoc., Prof.,PhD)
MACROECONOMICS

CHAPTER I
INTRODUCTION LECTURE PROGRAMME

Introduction
Module title: Macroeconomics
Level: Undergraduate
Module Convenor: Hoang Xuan Binh
Office hours: 8.00 -12.00 on Monday
Room: B208, Faculty of International Economics
Foreign Trade University (Hanoi Campus)
Tel: 84- 02432595161(ext 2588)
Cellphone: 0912782608
Email:binhhx@ftu.edu.vn

INTRODUCTION
Module Context:
The module is designed especially for
students taking Macroeconomics at FTU. It
is intended to provide students with an
understanding of important macroeconomic
factors and variables. The course analyses
how macroeconomic variables operate;and it
develops an understandings of the
international money and financial market, in
or outflows of capital. The course also draws
on the debates in real economy and tries to
use both old and new theories to understand
them.

Introduction
Learning outcomes
By the end of this module it is expected that students:
1.will have an understanding of how important
macroeconomic variables are interacting in the
economy.
2.will be able to interpret such variables and events as
GDP,GNP,CPI or inflation,unemployment… and relate
them to changes of other variables and events in the
economy.
3.will be ready to explain significant events in real
economy by using economic theories.
4.will be familiar with current debates on open-
economy and able to make a critical assessment of the
various arguments which are put forward.

Teaching and learning methods:
In class contact hours there will be lectures,
discussions and assistance with students’assignment
work,reading and using books. During the seminars the
students will be expected to discuss the provided topics
on the problems of real economy.
Assessment methods:
There is a written assignment and final examination.
It is worthy 30% and 60% respectively. Class
participation is 10% .
Suggested Supplementary Reading
Mankiw, Principles of Economics 7th ed.
Mankiw, Macroeconomics 8th ed. ,
Sloman J., (2003), Economics, 5th ed.

Lecture programme
Chapter 1: Introduction lecture programme
Chapter 2:The Data of Macroeconomics
Chapter4: Money and Monetary policy
Chapter6: Inflation and Unemployment
Chapter7: Economic Growth
Chapter 8: The Open economy
Chapter3: Aggregate Demand and Fiscal policy
Mid term presentation assignment
Revision
Chapter5: AD- AS Model

Everyone is concerned about macroeconomics
lately. We wonder why some countries are growing faster
than others and why inflation fluctuates. Why?
Because the state of the macroeconomy affects
everyone in many ways. It plays a significant
role in the political sphere while also affecting
public policy and social well-being.
I.Introduction
There is much discussion of recessions-- periods in which
real GDP falls mildly-- and depressions, concerns with
issues such as inflation, unemployment, monetary and
fiscal policies.

Economists use models to understand what goes on in the economy.
Here are two important points about models: endogenous variables
and exogenous variables. Endogenous variables are those which the
model tries to explain. Exogenous variables are those variables that
a
model takes as given. In short, endogenous are variables within a
model, and exogenous are the variables outside the model.
Price
Demand
Q*
P
Supply
Quantity
*
This is the most famous
economic model. It describes
the ubiquitous relationship
between buyers and sellers in
the market. The point of
intersection is called an
equilibrium.

Economists typically assume that the market will go into
an equilibrium of supply and demand, which is called
the market clearing process. This assumption is central
to the Pho example on the previous slide. But, assuming
that markets clear continuously is not realistic. For
markets to clear continuously, prices would have to
adjust instantly to changes in supply and demand. But,
evidence suggests that prices and wages often adjust
slowly.
So, remember that although market clearing models
assume that wages and prices are flexible, in actuality,
some wages and prices are sticky.

Microeconomics is the study of how households and firms
make decisions and how these decision makers interact in the
marketplace. In microeconomics, a person chooses to
maximize his or her utility subject to his or her budget constraint.
Macroeconomic events arise from the interaction of many
people trying to maximize their own welfare. Therefore, when
we study macroeconomics, we must consider its
microeconomic foundations.

II. Research aims and research methods:
1. Aims and objectives of
macroeconomics
Yield, Economic growth,
unemployment, inflation, budget,
Balance of Payments,
2. Research method
- Mathematics, general equilibrium,
Walras methods (equilibrium in all
market…

III. Macroeconomics system
1. Inputs
+ Exogenous variables: weather,
politics, population, technology and
patents or know-how
+Endogenous variables: direct
impacts-fiscal policy,monetary
policy, external economic policy
2. Black box: AS+AD
2.1. Aggregate Demand

2.2.Aggregate Supply
*Related factors: Price, Income,
Expectation…
* Related factors: Price,production cost,
potential output (Y*)
Y*: maximization of output which
economy can produce, with full-
employment and no inflation.
Full-employment=population–outof
working age - invalids -(pupils +
students) – servant-unwilling to work

Yield, employment,
Average price,
Inflation,interest,budget,
Trade balance and balance of
International payment,
Economic Growth
3. Outputs

Macroeconomics
Recession
Depression
Models
Macroeconomic system
Inputs
Outputs
Endogenous variables
Exogenous variables
Market clearing
Flexible and sticky prices
Microeconomics

CHAPTER II
DATA OF MACROECONOMICS

I. Gross domestic products-GDP
Gross Domestic Product (GDP) is the
market value of all final goods and
services produced within an economy in a
given period of time.

There are 2 ways
of viewing GDP
Total income of everyone in the economy
Total expenditure on the economy’s
output of goods and services
Households Firms
Income $
Labor
Goods
Expenditure $
For the economy as a whole, income must equal expenditure.
GDP measures the flow of dollars in this economy.
Income, Expenditure
And the Circular Flow

1) To compute the total value of different goods and services,
the national income accounts use market prices.
Thus, if
$0.50 $1.00
GDP = (Price of apples  Quantity of apples)
+ (Price of oranges  Quantity of oranges)
= ($0.50  4) + ($1.00  3)
GDP = $5.00
2) Used goods are not included in the calculation of GDP.
II.Computing GDP
1.Rules for computing
GDP

3) The treatment of inventories
depends on if the goods are stored or
if they spoil. If the goods are stored,
their value is included in GDP.
If they spoil, GDP remains unchanged.
When the goods are finally sold out of
inventory, they are considered used
goods (and are not counted).

4) Intermediate goods are not counted
in GDP– only the value of final goods.
Reason: the value of intermediate
goods is already included in the market
price.
Value added of a firm equals the value
of the firm’s output less the value of the
intermediate goods the firm purchases.
5) Some goods are not sold in the marketplace
and therefore don’t have market prices. We must
use their imputed value as an estimate of their
value. For example, home ownership and
government services.

The value of final goods and services measured at
current prices is called nominal GDP. It can change
over time either because there is a change in the amount
(real value) of goods and services or a change in the
prices of those goods and services.
Hence, nominal GDP Y = P  y, where P is the price
level and y is real output– and remember we use output
and GDP interchangeably.
Real GDP or, y = YP is the value of goods and services
measured using a constant set of prices.

Let’s see how real GDP is computed in our apple and
orange economy.
For example, if we wanted to compare output in 2002 and
output in 2003, we would obtain base-year prices, such as 2002
prices.
Real GDP in 2002 would be:
(2002 Price of Apples  2002 Quantity of Apples) +
(2002 Price of Oranges  2002 Quantity of Oranges).

Nominal GDP measures the current dollar value of the output
of the economy.
Real GDP measures output valued at constant prices.
The GDP deflator, also called the implicit price deflator for
GDP, measures the price of output relative to its price in the
base year. It reflects what’s happening to the overall level of
prices in the economy.
GDP Deflator = Nominal GDP
Real GDP

In some cases, it is misleading to use base year prices that
prevailed 10 or 20 years ago (i.e. computers and
college). In 1995, the Bureau of Economic Analysis
decided to use chain-weighted measures of
real GDP. The base year changes continuously
over time. This new chain-weighted
measure is better than the more
traditional measure because it
ensures that prices will not be
too out of date.
Average prices in 2001
and 2002 are used to measure
real growth from 2001 to 2002.
Average prices in 2002 and 2003
are used to measure real growth from
2002 to 2003 and so on. These growth
rates are united to form a chain that is
used to compare output between any two
dates.

3. Methods of computing GDP
*Expenditure approach
GDP = C + I + G + (X-M)

Government
purchases of goods
and services
Y = C + I + G + NX
Total demand
for domestic
output (GDP)
is composed
of
Consumption
spending by
households
Investment
spending by
businesses and
households Net exports
or net foreign
demand
This is the called the national income accounts identity.

*The Factor Incomes Approach: it
measures GDP by adding together all the
incomes paid by firms to households for
the services of the factors of production
they hire. According to this approach, GDP
is the sum of incomes in the economy
during a given period
GDP = w + r + i +  + D +Te
W: wage, r :rent fixed capital, i: interest, 
profit, D: Depreciation, Te: indirect tax

3. The output approach
Total Value added = Total Revenues
– Total Cost
GDP =  Value added in all
industries
=> GDP = VAT. 1/Value added
tax
Example:
One firm gains value added is 80, 1000 firms is
80,000. 80 = total revenues – total cost
(production cost)

II.Gross national products)-GNP
1. Definition:
GNP is the market value of all final goods
and services produced by domestic residents
in a given period of time.
2. Computing methods:
GNP = GDP + NFA
NFA: Net Income from Abroad

*3 cases :
+ GNP > GDP (Tn>0): domestic economy
has impacts in other economies.
+ GNP < GDP (Tn<0): foreign economies
have impacts in domestic economy.
+ GNP = GDP (Tn=0): no conclusion

4. Net Economic Welfare -NEW
GDP, GNP doesn’t compute some
goods and services which aren’t sold,
or illegal transactions or activities of
black market, negative externality…

V1 + Value of Rest
+ Value of goods and services which arent
sold
+ Revenues from transactions in black
market
V2-negative externality for natural
resources,environment, such as noise traffic jam
…
NEW reflects welfare better than GNPm but
it is very difficult to have enough data to
compute NEW,therefore, economists still
use GDP and GNP.

Tn
C
I
G
NX
GNP
D
NNP
Te
NI
(Y)
Td-TR
Yd
NNP= GNP-D ; Y=NI=NNP-Te=GNP-D-
Te
Yd = NI - (Td-TR) = (C+S)
D-Depreciation
NNP-Net National
Product
NI-National Income
Yd-Disposal Income
TR (transfer)-
Td: Direct tax

National income accounts
Consumption
Investment
Government Purchases
Net Exports
Labor force
Gross domestic product (GDP)
Consumer Price Index (CPI)
Unemployment Rate
Stocks and flows
Value added
Nominal versus real GDP
GDP deflator
GNP
NEW

CHAPTER III
AGGREGATE DEMAND
& FISCAL POLICY

Today’s lecture is the first in a series of four
lectures aimed at analysing different (separate)
markets in the economy. This will then enable
us to bring the various markets together and
to analyse the behaviour of the whole
economy (this is also referred to as general
equilibrium analysis). Today we will introduce
an analysis of the economy as originally
described by the economist John Maynard
Keynes. His theory of how the macroeconomy
works will help us explain how the economy’s
income (GDP) is determined. Today we analyse
the model in its simplest form and we will
assume that the economy does not have a
government and that it does not trade with the
rest of the world. We will relax these
assumptions.

The Keynesian Theory of Income Determination: the
theory that will be presented hereafter was developed by
the Cambridge economist John Maynard Keynes in the
wake of the 1920s Great Depression. He argued that the
cause of a low level of income (GDP) in the economy was
given by the lack of AD.
John Maynard Keynes (right) and Harry Dexter White at the Bretton

Personal and marital life
Born at 6 Harvey Road, Cambridge, John Maynard
Keynes was the son of John Neville Keynes, an
economics lecturer at Cambridge University, and
Florence Ada Brown, a successful author and a social
reformist. His younger brother Geoffrey Keynes (1887–
1982) was a surgeon and bibliophile and his younger
sister Margaret (1890–1974) married the Nobel-prize-
winning physiologist Archibald Hill.
Keynes was very tall at 1.98 m (6 ft 6 in).
In 1918, Keynes met Lydia Lopokova, a well-known
Russian ballerina, and they married in 1925. By most
accounts, the marriage was a happy one. Before
meeting Lopokova, Keynes's love interests had been
men, including a relationship with the artist Duncan
Grant and with the writer Lytton Strachey. For medical
reasons, Keynes and Lopokova were unable to have

I. Aggregate Planned Expenditure and
Aggregate Demand
1.Assumptions: a model nearly
always starts with the word ‘assume’
or ‘suppose’. This is an indication that
reality is about to be simplified in
order to focus on the issue at hand
*Prices, Wages and Interest Rate are
Constant

*The Economy Operates at less than
full Employment: this implies that
firms are willing to supply any
amount of the good at a given price
P. In other words, assume that the
supply of goods is completely
elastic at price P. This assumption is
generally valid only in the short run

*Closed Economy and No Government:
we assume that the economy does not
trade with the rest of the world so that
both exports and imports are equal to
zero (X=M=0). We also assume that there
is no government in the economy so that
government expenditures and taxes are
equal to zero (G=T=0). This implies that
aggregate demand is therefore reduced
to the following expression:
AD  C + I

APE reflects the total planned
expenditure at each income, with
assumption of given price.
1. Aggregate Planned Expenditure
*Households: Consumption  C =
f(Yd): the main determinant of
consumption is surely income, or more
precisely
C = f1(Y)

-Firms: to create the demand through
their investment
I = f2(Y)
APE = C + I = f1(Y) + f2(Y)
1.1. Consumption
function
*The relationship between consumption
expenditures and disposable income, other
things remaining the same, is called
consumption function. The consumption
function that we will use in our model and that
shows the positive link between consumption
and disposable income is the following (figure
1): Yd
MPC
C
Y
f
C .
)
(
1 



*Determinants of Consumption:
+Autonomous Consumption (C): this is
the amount of consumption expenditure
that would take place even if people had
no current disposable income
+Induced Consumption: this is
consumption expenditure that is in
excess of autonomous consumption
and that is induced by an increase in
disposable income

Y
C
MPC



+Marginal Propensity to Consume
(MPC): it is the fraction of a change in
disposable income that is consumed.
It is calculated as the change in
consumption expenditures (DC)
divided by the change in disposable
income (DYd) that brought it about. It
gives the effect of an additional
pound of disposable income on
consumption. The MPC determines
the slope of the consumption
function

0 < MPC< 1 :This reflects the fact that
people are likely to consume only part
of any increase in income and to save
the rest
*Example. The following is an
example of a consumption function:
C = 20 + 0.7xYd
Autonomous Consumption: 20
MPC = 0.7

+NetPrivateSavings-S: savings by
consumers is equal to their disposable
income minus their consumption
=> S = Yd - C
and, by using the definition of
disposable income this identity can be
rewritten as:
S = Y – T – C (but T = 0, no government)
However, given that there is no
government in our simple economy,
T=0 and savings are equal to: S = Y - C
1.2.The Saving Function: the economy’s
savings function can be derived by using the
private savings expression and the
consumption function:

Y
MPS
C
S
Y
MPC
C
Y
MPC
C
Y
S
C
Y
S
.
).
1
(
.












+The Marginal Propensity to Save
(MPS): the propensity to save tells us
how much people save out of an
additional unit of income. The
assumption we made earlier that MPC
is between zero and one implies that
the propensity to save is given by
(1-MPC) and that it is also between 0
and 1.
The Saving Curve: it traces the
relationship between the level of net
saving and income

1.3.Investment function (I): the second
expenditure in APE that we will analyse
today is investment
*Determinants of Investment: we can
distinguish four major determinants of
investment
+Increased Consumer Demand:
investment is to provide extra capacity.
This will only be necessary, therefore, if
consumer demand increases

+Expectations: since investment is made
in order to produce output for the future,
investment must depend on firms’
expectations about future market
conditions
+Cost and Efficiency of Capital
Equipment: if the cost of capital
equipment goes down or machines
become more efficient, the return on
investment will increase and firms will
invest more

+Interest rate: the higher the rate of
interest, the more expensive it will be
for firms to borrow the money to
finance their investment expenditures
and the less profitable will the
investment be

+Level of Investment in the Economy:
in this model we will take investment
as given or, in other words, we will
regard it as an exogenous variable.
The main reason for taking investment
as given is to keep our model simple.
Thus we will assume that investment is
given by a fixed/constant amount (a
bar over a variables indicates that the
variable is regarded as an exogenous
variable) that does not change with the
level of income in the economy:
I
I 

.
APE C I C I MPC Y
    
*The Determination of Equilibrium
Output: When P, w is constant,the
equilibrium in the goods market
requires that the supply of goods
(GDP=Y) equals the demand for
goods (APE):
Y = APE =AD

)
(
1
1
I
C
MPC
Ye 


This equation is called the equilibrium
condition. By replacing the above
expression for aggregate planned
expenditure in the equilibrium
condition we get:
As you can see the above expression is
an equation in one endogenous variable:
Y. Thus we can solve this equation for Y
and this will give us the equilibrium level
of output (Ye)produced in the economy
.
Y APE
Y C I MPC Y

  

*Example 1. Assume that in the
economy the level of autonomous
consumption c0=100, the marginal
propensity to consume is MPC=0.5 and
the investment spending is I=200 .
Determine the equilibrium level of
output produced in the economy.
200

I 200

I 200

I

-Firms invest in economy
-Government sector expenditure: G
I
I 
+G will increase APE and will shift the
APE curve upwards.
+Taxation reduces the level of
disposable income available for
consumption and will tend to reduce
APE. Such a reduction in APE is
reflected by a downward rotation of the
APE curve. Why?
2. APE & Ye in closed economy with a
Government Sector

T
T 
.( )
APE C I G C I G MPC Y T
       
0
.( )
1
( )
1 1
Y APE
Y C I G MPC Y T
MPC
Y C I G T
MPC MPC

    
   
 
This is due to the fact that taxation
reduces the overall MPC by the
household so that for each extra pound
of income the household will now
consume less since some of the extra
income must be paid in taxes
2.1.Fixed taxation

MPC
MPC
mt



1
Multiplier Effect of taxation
T
m
G
I
C
m
Y t



 )
(
0
2.2. Taxation depends on income: T = t.Y
(t:tax rate)
Y
t
MPC
C
T
Y
MPC
C
C )
1
(
)
( 





I
I  G
G 

(1 )
APE C I G C I G MPC t Y
        
0
(1 )
1
( )
1 (1 )
Y APE
Y C I G MPC t Y
Y C I G
MPC t

     
  
 
=>Equilibrium point of economy:

)
1
(
1
1
t
MPC
m



 Multiplier of consumption
in the closed economy
with Government sector
MPC
m
t
MPC
m







1
1
)
1
(
1
1
This reflects that the income based tax
is less efficient than fixed tax.

3. 2. APE & Ye in open-economy with a
Government Sector and foreign trade
*Assuption: T = t.Y (t- taxrate)
Economy has 4 sector
X doesn’t depend on domestic
income,therefore
X X

*C = C + MPC.(Y-T) = C + MPC.(1-t).Y
*I = I
*G = G
*NX=X-M: netexport

M derives from production inputs, or
consumptions of households=>M
increases when I or Ye rises.
Ta cã: M = MPM.Y
*MPM (Marginal Propensity to Import): it
is the fraction of an increase in GDP that
is spent on imports. It is calculated as
the change in imports (M) divided by
the change in GDP ( Y) that brought it
about, other things remaining the same.
The MPM is a positive number smaller
than one
MPM = M/  Y and 0<MPM <1

 
(1 )
APE C I G X M
APE C I G X MPC t MPM Y
    
       
 
0
(1 )
1
( )
1 (1 )
Y APE
Y C I G X MPC t MPM Y
Y C I G X
MPC t MPM

       
   
  
*Equilibrium point of economy:
MPM
t
MPC
m






)
1
(
1
1
open-economy
multiplier
m” < m’ < m. open-economy multiplier is less
efficient than closed economy multiplier.

The Multiplier Spending Chain
I = £1 million - Marginal Propensity to Consume: mpc = 0.8
Round N.
Spending in This Round Cumulative Total I
1 £1,000,000 (G £1,000,000 (G1)
2 £ 800,000(C2=0.8*G) £ 1,800,000
3 £ 640,000(C3=0.8*C2) £ 2,440,000
4 £ 512,000(C4=0.8*C3) £ 2,952,000
5 £ 409,600(C5=0.8*C4) £ 3,361,600
6 £ 327,680(C6=0.8*C5) £ 3,689,280
7 £ 262,144(C7=0.8*C6) £ 3,951,424
8 £ 209,715(C8=0.8*C7) £ 4,161,139
9 £ 167,772(C9=0.8*C8) £ 4,328,911
10 £ 134218(C10=0.8*C9) £ 4,463,129
................... ............................................... .....................................
50 £ 18(C50=0.8*C49) £ 4,999,929
................ ........................................ ..................................
“Infinity” 0 £ 5,000,000

II.Fiscal policy:
1. Fiscal policy: Government use
taxation and consumption to regulate
aggregate demand.
2. Classification of fiscal policy
2.1. Expansionary fiscal policy
2.2. Contractionary fiscal policy

*State Budget: total sum of revenues
and consumption of Government in
given time (one year)
B = T - G
+ B = 0: Budget balance
+ B > 0: Budget surplus
+ B < 0: Budget deficit
3. Fiscal policy and Budget decifit

-Real budget deficit: When consumption >
revenues
*Classification:
-Cyclic budget deficit: when economy
faces recession due to cyclic business.
-Structural budget deficit: is calculated in
term of assumptions with potential
output.
where Br= Bc + Bs =>Bc = Br - Bs

*Note: fiscal policy can reach
following objectives:
+Budget balance=>Y can fluctuate.. .
+Y*=> Budget deficit can happen.
When there is recession in economy, G
increase or T decrease or both to keep
high consumption => Y rises to Y* but
Budget deficit happens.

4. How to reduce budget deficit
-Inreasing revenues and decreasing
consumption
-Public debt: Government bond
-Borrowings from foreign countries
or international orgnizations
-Printing money or using reserve
from foreign currency

CHAPTER IV
MONEY AND MONETARY POLICY

I. Money
1. The Meaning and functions of Money
a.Definition of Money: money is any
commodity or token that is generally
acceptable as the means of payment. A
means of payment is a method of settling
a debt. In general terms money can be
defined as the stock of assets that can be
readily used to make transactions.
Roughly speaking, the coins and
banknotes in the hands of the public
make up the nation’s stock of money

Money
Stock of assets
Used for transactions
A type of wealth
Without Money
Self-sufficiency
Barter economy

b. Development of money
Cattle, iron, gold,silver,diamond ….and
banknote today
Batter => commodity money=> cash,
cheque, credit card…
2. The Functions of Money: money has
three main purposes. It is a medium of
exchange, a unit of account and a store
of value

2.1. Medium of Exchange: it is an object
that is generally accepted in exchange for
goods and services. Money acts as such a
medium
2.2. Unit of Account (A Means of
Evaluation): a unit of account is an
agreed measure for stating the prices of
goods and services. It allows the value of
one good to be compared with another
2.3. Store of Value: any commodity or
token that can be held and exchanged later
for goods and services is called a store of
value. Money acts as a store of value.

Functions of Money
• Store of value
• Unit of account
• Medium of exchange
• International Money
The ease with which money is converted into other things--
goods and services-- is sometimes called money’s liquidity.

3.Types of Money
*Depend on the Liquidity:
M 0= Cash; (Wide Monetary Base) =
Cash in circulation with the public and
held by banks and building societies
+Banks’ balances with the Central
Bank
M1 = Cash + Deposit (D: Deposit is
unlimited time deposit). Liquidity of M1 is
smaller than M0 but it is still good to
measure the cash in circulation in economy.
M2= M1 + limited time deposit: Liquidity of
M2 is very low,therefore,there are some
developed economies such as US and UK
where use to measure the cash in
circulation.

Fiat Money: money takes different
forms.
Money that has no intrinsic value is
called fiat money because it is
established as money by government
decree, or fiat
In the UK economy we make
transactions with an items whose sole
function is to act as money: pound
coins and banknotes. These pieces of
paper with the portrait of the queen
would have little value if they were not
widely accepted as money.
*Money can be divided into:

Commodity Money: although fiat
money is the norm in most economies
today, historically most societies have
used for money a commodity with
some intrinsic value.
Money of this sort is called commodity
money and the most widespread
example of commodity money is gold

II. Central Bank and creation money of
commercial bank
1.Banks are the Financial Intermediaries.
They are private firms licensed by the
Central Bank under the Banking Act to
take deposits and make loans and
operate in the economy.
Retail Banks: they specialise in
providing branch banking facilities to
member of the general public but they
do also lend to businesses albeit often
on a short-term basis. They are the most
important banks in the UK for the
functioning of the economy and for the
implementation of monetary policy

2. The creation of Money by commercial
banks
The Creation of Money: banks create
money. However this does not mean that
they have smoke-filled back rooms in
which counterfeiters are busily working.
Notice that most money is deposits, not
currency. What banks create is deposits
and they do so by making loans. But the
amount of deposits they can create is
limited by their reserves

Desired Reserver rate
Required Reserve Rate
Excessive Reserve Rate

The Deposit Multiplier: this is the
amount by which an increase in bank
reserves is multiplied to calculate the
increase in bank deposits. It is given
by the following formula:
Reserves
in
Change
Deposit
in
Change
Multiplier
Deposit 
Alternatively, it can also be defined
as:
Ratio
Reserve
Desired
1
Multiplier
Deposit 
if banks want to keep 10% of their deposits as
reserves, so that the desired reserve ratio is
0,10 (ra), the deposit multiplier is given by the
following expression:1/ra =10. See example

Banking
system
Deposits
Desired
reserve(ra)
Lending
NH1 1 1.ra (1-ra)
NH2 (1-ra) (1-ra).ra (1-ra)2
NH3 (1-ra)2
(1-ra)2
.ra (1-ra)3
... ... ... ...
NH(n+1) (1-ra)n
(1-ra)n
.ra (1-ra)n+1
a
n
a
a
n
a
n
a
a
a
r
r
r
r
r
r
r
D
1
1
2 )
1
(
1
1
)
1
(
1
)
1
(
1
1
)
1
(
...
)
1
(
)
1
(
1




















10
1
,
0
1
1
1
0
1
1 






a
a r
r
D
0 < ra < 1 =>

Firstbank
Balance Sheet
Secondbank
Balance Sheet
Thirdbank
Balance Sheet
Assets Liabilities Assets Liabilities Assets Liabilities
Reserves $200 Deposits $1,000
Loans $800
Reserves $128 Deposits $640
Loans $512
Reserves $160 Deposits $800
Loans $640
Assume each bank maintains a reserve-deposit ratio (rr) of 20% and that the initial deposit is $1000.
Mathematically, the amount of money the original $1000 deposit creates is:
Original Deposit =$1000
Firstbank Lending = (1-rr)  $1000
Secondbank Lending = (1-rr)2  $1000
Thirdbank Lending = (1-rr)3  $1000
Fourthbank Lending = (1-rr)4  $1000
Total Money Supply = [1 + (1-rr) + (1-rr)2 + (1-rr)3 + …]  $1000
= (1/rr)  $1000
= (1/.2)  $1000
= $5000 Money and Liquidity Creation
.
.
.
The process of transferring funds
from savers to borrowers is called
financial intermediation.

III. Central Bank and money supply
1. Roles of Central Bank
*Government’s Bank: the central bank is
the acts as the government’s agent both
as its banker and in carrying out
monetary policy
*Supervision of Monetary System: the
central bank oversees the whole
monetary system and ensures that
banks and financial institutions operate
as stably and as efficiently as possible

2. Functions of Central Bank
*To Issue Notes: the Central Bank is
the sole issuer of banknotes. The
amount of banknotes issued by Central
Bank depends largely on the demand
for notes from the general public
For example, BOE issues banknotes in
England and Wales (in Scotland and
Northern Ireland retail banks issue
banknotes).

*It Acts as a Bank
+To the Government: the government deposits
its revenues from taxation in the central bank
and uses CB in order to borrow money from
the market
+To other Recognised Banks: all banks
licensed by CB hold operational balances in
the CB. These are used for clearing purposes
between the banks and to provide them with a
source of liquidity
+To Overseas Central Banks: these are
deposits in sterling held by overseas
authorities as part of their official reserves
and/or purposes of intervening in the foreign
exchange market in order to influence the
exchange rate of their currency.

*It Manages the Government’s Borrowing
Programme: whenever the government
runs a budget deficit (it spends more than
what it receives in taxes) it will have to
finance that deficit by borrowing. It can
borrow by using bonds (gilts), National
Savings certificates or Treasury bills. The
CB organises this borrowing
*It Supervises the Financial System: it
advises banks on good banking practice.
It discusses government policy with them
and reports back to the government. It
requires banks to maintain adequate
liquidity: this is called prudential control.

*It Provides Liquidity to Banks – Lender
of Last Resort: it ensures that there is
always an adequate supply of liquidity
to meet the legitimate demands of
depositors in recognised banks
*It Operates the Government’s
Monetary and Exchange Rate Policy
+Monetary Policy: the CB manipulates
the interest rate in the economy and
influence the size of the money supply
+Exchange Rate Policy: the CB
manages the country’s gold and
foreign currency reserves

3. The Supply of Money
*Definition of Money Supply: the quantity
of money available is called the money
supply. In an economy that uses fiat
money, such as most economies today,
the government controls the supply of
money: legal restrictions give the
government a monopoly on the printing
of money
*Monetary Policy: the control over the
money supply is called monetary policy

4. Implement of money supply
a.Measures of Money Supply:
Recall that we can denote money supply
as the sum of currency and deposits
s
D
C
M
Deposit
Dem
and
Currency
Money


Central Bank issues H0, (Basic Money,
High Powered Money), H0 < M0. Ho is
divided into
U and R

+ Sectors keep a part of Ho, denote as U.
U can’t create other means of payment
and it can be decrease due to
damages..in the circulation. Assuption, U
is constant.
+ The rest of Ho denote as R (Ho = U +R).
The banking system will use R to create
money as followings:

R
r
D
a


1
Basic Money (H0)
U R
U D
Money supply : MS
Where: H0 = U + R and MS = U + D
MS >Ho due to the creation of money from
commercial banks.

b.The Central Bank's Policy Tools: there
are three main tools that the Central Bank
can use to control money supply and
implement monetary policy
*Reserve Requirements: these are
regulations by the central bank that
impose on banks a minimum reserve-
deposit ratio. An increase in reserve
requirements raises the reserve-deposit
ratio and thus lowers the money multiplier
and the money supply

*Discount Rate: it is the interest rate that
the central bank charges when it makes
loans to banks. Banks borrow from the
central bank when they find themselves
with too few reserves to meet reserve
requirements. The lower the discount
rate, the cheaper are borrowed reserves
and the more banks borrow at the
central bank’s discount window.
=> discount rate decreases =>the
monetary base and the money supply go
up.

*Open-Market Operations: they are the
purchases and sales of government
bonds by the central bank.
When the central bank buys (sells) bonds
from (to) the public, the pounds it pays
(receives) for the bonds increase
(decrease) the monetary base and
thereby increase (decrease) the money
supply.
The term 'Open Market' refers to
commercial banks and the general CB
conducts an open market operation, it
does a transaction with a bank or some
other business but it does not transact
with the government

Example of US economy?
In the United States, monetary policy is
conducted in a partially independent institution
called the Federal Reserve, or the Fed.

• To expand the Money Supply:
The Federal Reserve buys U.S. Treasury Bonds
and pays for them with new money.
• To reduce the Money Supply:
The Federal Reserve sells U.S. Treasury Bonds
and receives the existing dollars and then
destroys them.

The Federal Reserve controls the
money supply in three ways.
1) Open Market Operations (buying and
selling U.S. Treasury bonds).
2)  Reserve requirements (never really
used).
3)  Discount rate which member banks
(not meeting the reserve requirements)
pay to borrow from the Fed.

IV. Money market
1. Money Demand: the demand for money
refers to the desire to hold money: to
keep your wealth in the form of money,
rather than spending it on goods and
services or using it to purchase financial
assets such as bond or shares
2.Reasons for Holding Money
The Transactions Motive: since money is
a medium of exchange it is required for
conducting transactions.

The Precautionary Motive: unforeseen
circumstances can arise, such as a car
breakdown. Thus individuals often
hold some additional money as a
precaution
The Speculative Motive: certain firms
and individuals who wish to purchase
financial assets such as bonds or
shares may prefer to wait if they feel
that their price is likely to fall. In the
meantime they will hold idle money
balances instead

3.The Demand for Money Function: the
relationship between the demand for
money and the interest rate is described
by the demand for money function
This expression simply states that the
demand for money is a function (f) of
income Y and the interest rate I
= denotes the nominal money
demand
Y = denotes nominal income (GDP) and it
captures the overall level of transactions
in the economy.
)
,
(


 i
Y
f
M d
d
M

In fact, it is reasonable to assume that
the overall level of transactions is
roughly proportional to nominal income.
The positive sign above Y denotes that
there is a positive relationship between
income and demand for money: the
higher the level of income (transactions)
the higher the demand for money
i = is the interest rate and the negative
sign above it denotes the negative
relationship between the interest rate and
the demand for money. The higher the
interest rate, the smaller the demand for
money since individuals prefer to hold
their wealth in bonds

d. Determinant of money demand
*Level of price:
n
r
n
r
MD
P
MD MD const
MD
P
MD MD const
 

 
 


 

 
 


MDn (nominal Money Demand computing
based on researched price (usually
higher than based price)
MDr (real Money Demand, computing
depend on based price (constant price).

*Interest rate (i)
*Income (Y)
Y increases (decreases) => MD increases
(decreases)
i increases (decreases) => MD decreases
(increases)
MD = k.Y–h.i
Money demand function can be
written:
k-income-elasticity of MD
h-interest rate –elasticity of MD.

Note:
+ i change=>quantity demanded move
along MD, otherthings being equal.
+ Y change=>MD shift rightwards or
leftwards. Depends on income-elastricity
of money demand (k).
+ Slope of MD depends on the interest
rate –elastricity of money demand (h).
1
kY
i MD
h h
 

2. Money supply
* The Determinants of Money supply
-The level of price: nominal MS doesn’t
depend on P but real MS does because:
0
H
m
MSn 

P
MS
MS n
r 
-Central Bank: i can change but MS
maybe constant If CentralBank doesn’t
want to change MS.

3. Equilibrium in the Money Market:
the equilibrium in the money market
requires that money supply be equal
to money demand, that Ms=Md
This equilibrium condition tells us
that the interest rate must be such
that people are willing to hold and
amount of money equal to the existing
supply. This equilibrium relation is
also called LM and will be discussed
in more detail in the next lecture
)
,
( i
Y
f
M
M d
s



*Note:
+ If I # i0 =>imbalance between supply
and demand which puts pressure to
push I up or down to equilibrium point
i0. When MS, MD changes =>quilibrium
point (E) changes which leads to
changes of i0.

V. Monetary policy
1. Expansionary monetary policy
2.Contractionary monetary policy

I. Aggregate Demand
1.Classical theory
P, w flexible
At Full employment (potential output).

2. Keynesian view
Short term
P and w fixed
Positive unemployment rate
Horizontal Aggregate Supply curve at P0

3. Real Aggregate supply
*Short-run: P,w, costs change slowly due to
short term labour force contract, ….=> TC
change stable => P increases => TR
increases =>Firms increase output =>AS
increases from the left to the right.
*Long-run: P,w, costs change =>TC
increases=> no engine to increases output,
Y at potential out. AS tends to be vertical at
Y*.

SAS
LAS
P
Y* Y
0
II. AD-AS MODEL
AD

CHAPTER VI
INFLATION AND UNEMPLOYMENT

Unemployment is the number of
people of working age who are
without work, but who are available
for work at current wage rates. If the
figure is to be expressed as a
percentage, then it is a percentage of
the total labour force.
I.Unemployment

-The labour force is defined as: those in
employment (including the self-
employed, those in the armed forces
and those on government training
schemes) plus those unemployed.
-The labour force doesn’t include
people who are out of working age,
students, pupils, invalids. People who
are at working age but unwilling to
work doen’t belong to labour force

employment
unemployme
nt
Labour
force
Out of
labour
force
Out
In
Working
age
Popula
tion
Labour force

2. Computing unemployment rate
u - Unemployment Rate): to be
expressed by fraction of unemployment
with the total labour force. It can be
expressed by percentage as the formula
below:
U (Unemployed): L (Labour Force):
%
100


L
U
u

Unemployment is a problem for the
economy because:
Output and incomes are lost.
Human capital depreciates.
Crime may increase.
Human dignity suffers.

3. Types and causes of unemployment
Frictional unemployment occurs when
people leave their jobs, either
voluntarily or because they are
sacked or made redundant, and are
then unemployed for a period of time
while they are looking for a new job.
They may not get the first job they
apply for, despite a vacancy existing.
The employer may continue
searching, hoping to find a better-
qualified person.

Likewise, unemployed people may
choose not to take the first job they are
offered. Instead, they may continue
searching, hoping that a better job will
turn up. The problem is that
information is imperfect. Employers are
not fully informed about what labour is
available; workers are not fully
informed about what jobs are available
and what they entail. Both employers
and workers, therefore, have to search:
employers searching for the right
labour and workers searching for the
right jobs.

Structural Unemployment refers to
unemployment arising because there is
a mismatch of skills and job
opportunities when the pattern of
demand and production changes.
Examples in the UK include
unemployment resulting from a decline
in the production of textiles,
shipbuilding, cars, coal and steel. Those
workers who become structurally
unemployed are available for work but
they have either the wrong skills for the
jobs available or they are in the wrong
location.

Demand-deficient Unemployment is also
referred to Keynesian unemployment.
Demand-deficient unemployment occurs
when aggregate demand falls and
wages and prices have not yet adjusted
to restore full employment. Aggregate
demand is deficient because it is lower
than full-employment aggregate demand
which implies that output is less than
full employment output.

Classical Unemployment describes
the unemployment created when the
wage is deliberately maintained above
the level at which the labour market
clears. It can be caused either by the
exercise of trade union power or by
minimum wage legislation which
enforces a wage in excess of the
equilibrium wage rate.

II.Inflation
1. Definition
Inflation is a rise in the average price of
goods over time.
The term deflation is used to describe a
fall in the average price of goods over
time.
Deflation is very rare, but when it occurs it
can cause serious problems in the
economy. The inflation rate is the
percentage change in the price level. The
formula for the annual inflation rate is:

2. Computing inflation
Gp: price growth rate
1
1
100%
t t
p
t
P P
g
P



 
t-time
Pt-1: at previous time
Pt: : at current time (research time)
n
n
n
Q
Q
Q
Q
P
Q
P
Q
P
P







...
...
2
1
2
2
1
1
P is to be expressed as follows:

Actually, P is difficult to compute, we can
compute inflation as below:
Where CPI is the consumer price index and
t is time. The consumer price index
measures how much more a basket of
goods that represents goods purchased by
the average householder costs today
compared with some previous time period.
0
1
0 0
1
k
t
i i
i
k
i i
i
P Q
CPI
P Q






Name CPI (I2005/2004) %
A 1,2 30%
B 1,4 25%
C 0,9 15%
E 1,5 30%
CPI2005=1,2x30%+1,4x25%+0,9x15%+1,5x30%=1,29
5
1
1
100%
t t
p
t
CPI CPI
g
CPI



  CPIt-1:
CPIt:
Note: CPI doesnt reflect changes in quality
of goods and services or of new goods and
services.

+ GDP (D: Deflator)
1
0
1
100% 100%
n
t t
i i
n i
n
t
r
i i
i
P Q
GDP
D
GDP
P Q


   


D-GDP reflects changes in prices of total
fianl goods and services compare with
based price,therefore, this describes
inflation rate.
1
1
100%
t t
p
t
D D
g
D



 

Why is inflation a problem?: When
inflation is present in the economy,
money is losing its value. The higher
the inflation rate, the higher is the rate
at which money is losing value and
this fact is the source of the inflation
problem. Inflation is said to be good
for borrowers and bad for lenders, and
so inflation can cause inequalities in
the economy. People on fixed incomes
(e.g. pensioners and students) tend to
suffer most from inflation.

2. Types of inflation
*Moderate Inflation: inflation rate < 10%/n¨m,
prices increases slowly..
Moderate inflation can spur production
because price increases leading to
highet profit for enterprises,therefore,
firms will increases quantity.
*Galloping Inflation: inflation rate is from
10% to 99% per year. This type will
destroy economy and curb engines of
economy.

*Hyper Inflation: is defined as inflation
that exceeds 100% percent per year.
Costs such as shoe-leather and menu
costs are much worse with
hyperinflation– and tax systems are
grossly distorted. Eventually, when
costs become too great with
hyperinflation, the money loses its role
as store of value, unit of account and
medium of exchange. Bartering or
using commodity money becomes
prevalent.
In 1920s (1922-12/1923) Weimar
Germany, CPI increased from 1 to 10
millions

*Expected inflation:
depends on expectation of individuals
about gp in the future. Its impacts is small
but help to adjust production cost.
+Unexpected inflation: derives from
exogenous shocks and unexpected
factors inside economy.

The inconvenience of reducing money
holding is metaphorically called the
shoe-leather cost of inflation, because
walking to the bank more often induces
one’s shoes to wear out more quickly.
When changes in inflation require printing
and distributing new pricing information,
then, these costs are called menu costs.
Another cost is related to tax laws. Often
tax laws do not take into consideration
inflationary effects on income.

Unanticipated inflation is unfavorable because it arbitrarily
redistributes wealth among individuals.
For example, it hurts individuals on fixed pensions. Often these
contracts were not created in real terms by being indexed to a
particular measure of the price level.
There is a benefit of inflation– many economists say that some
inflation may make labor markets work better. They say it
“greases the wheels” of labor markets.

3. Causes of inflation
Demand-pull inflation is
caused by continuing rises
in AD in the economy. The
increase in AD may be
caused by either increases
in the money supply or
increases in G-expenditure
when the economy is close
to full employment. In
general, demand-pull
inflation is typically
associated with a booming
economy.
AD1
AD0
P1
P0
0 Y
Y*
P
AS

* Cost-push inflation is associated with
continuing rises in costs. Rises in costs
may originate from a number of different
sources such as wage increases and other
higher costs of production (e.g. raw
materials).
AS1
P
0
Y* Y
Y0
AS0
AD
P0
P1
Y1

*Structural (demand-shift) inflation
arises when the pattern of demand (or
supply) changes in the economy which
results I n some industries experiencing
increased demand whilst others
experience decreased demand. If prices
and wage rates are inflexible
downwards in the contracting
industries, and prices and wage rates
rise in the expanding industries, the
overall price and wage level will rise.
The problem will be made worse, the
less elastic is supply to these shifts.

*Expectations are crucial determinants
of inflation. Workers and firms take
account of the expected rate of inflation
when making decisions. Generally, the
higher the expected rate of inflation, the
higher will be the level of pay
settlements and price rises, and hence
the higher will be the resulting actual
rate of inflation.
*Inflation and Money: equilibrium point of
money market
hi
kY
MD
MS
P
MS
r
r
n





In other words, if Y is fixed (from Chapter 3) because it depends
on the growth in the factors of production and on technological
progress, and we just made the assumption that velocity is constant,
or in percentage change form:
MV = PY
% Change in M + % Change in V = % Change in P + % Change in Y
if V is fixed and Y is fixed, then it reveals that % Change in M is what
induces % Changes in P.
The quantity theory of money states that the central bank, which
controls the money supply, has the ultimate control over the inflation
rate. If the central bank keeps the money supply stable,the price level
will be stable. If the central bank increases the money supply rapidly,
the price level will rise rapidly.

The revenue raised through the printing of money is called
seigniorage. When the government prints money to finance
expenditure, it increases the money supply. The increase in
the money supply, in turn, causes inflation. Printing money to
raise revenue is like imposing an inflation tax.

* Inflation and interest rate
Economists call the interest rate that the
bank pays the nominal interest rate and
the increase in your purchasing power
the real interest rate.
This shows the relationship between the
nominal interest rate and the rate of
inflation, where r is real interest rate, i is
the nominal interest rate and p is the rate
of inflation, and remember that p is
simply the percentage change of the price
level P.
r = i – p

The Fisher Equation illuminates the distinction between
the real and nominal rate of interest.
Fisher Equation: i = r + p
Actual (Market)
Nominal rate of
interest
Real rate
of interest
Inflation
The one-to-one relationship
between the inflation rate and
the nominal interest rate is
the Fisher Effect.
It shows that the nominal interest can change for two reasons: because
the real interest rate changes or because the inflation rate changes.

+gp is high=>i is up to keep equality of r
.
+Economy has high i lead to high gp or i
can explains gp of economy.
+If real gp > expected gp => borrowers
get advantages
+If real gp < expected gp => lenders get
advantages

4.Policies to deal with inflation
4.1.Fiscal policy comprises changes in
government expenditure and/or
taxation. The aim is to affect the level of
AD through a policy known as demand
management. In the case of controlling
inflation, this involves reducing
government expenditure and/or
increasing taxation in what is called a
deflationary fiscal policy. Such policies
are likely to be effective if inflation has
been diagnosed as demand-pull since a
reduction in government expenditure or
an increase in income tax will reduce
aggregate demand in the economy.

4.2.Monetary policy is concerned with
influencing the money supply and the
interest rate. In terms of controlling
inflation, the government can aim to
reduce the money supply thus reducing
spending and, therefore, the aggregate
demand, or it can increase the interest
rate so as to increase the cost of
borrowing. Both policies can be seen as
deflationary monetary policy. Since
monetarists view the growth of the money
supply as being the main cause of
inflation, any control of inflation from a
monetarist viewpoint must involve
control of the money supply.

4.3.Prices and incomes policy aim to limit
and, in certain cases, freeze wage and
price increases. In the past they have
either been statutory or voluntary.
Statutory prices and incomes policies
have to be enforced by government
legislation, such as the EU minimum
wage legislation. With a voluntary prices
and incomes policy the government aims
to control prices and incomes through
voluntary restraint, possibly by obtaining
the support of the unions and employers.

4.4. Supply-side policy is concerned with
instituting measures aimed at shifting the
aggregate supply curve to the right.
Supply-side economics is the use of
microeconomic incentives to alter the
level of full employment and the level of
potential output in the economy. If
inflation is caused by cost-push
pressures, supply-side policy can help to
reduce these cost pressures in two ways:

(1) by reducing the power of trade unions
and/or firms (e.g. by anti-monopoly
legislation) and thereby encouraging
more competition in the supply of
labour and/or goods,
(2) by encouraging increases in
productivity through the retraining of
labour, or by investment grants to
firms, or by tax incentives, etc.

4.5.Learning to live with inflation involves
accepting the fact that inflation is here to stay
when standard anti –inflationary policy measures
appear ineffective. In such a situation we just
have to learn to live with inflation. Learning to
live with inflation involves the government,
employers and workers taking inflation into
account in their everyday transactions.
For example, the government/employers may use
indexation in wage/pensions contracts.
Indexation is when wages or pensions are
increased in line with the current rate of
inflation. Indexation is aimed at nullifying the
effects of inflation.

I. Definition
An increase on potential output
Economic growth or developments?

II.Computing of economic growth
*Computed by % changes in real GDP
%
100
1
1





t
t
t
t
Y
Y
Y
g
+gt: according to real GDP
%
100
1
1





t
t
t
pct
y
y
y
g
*gpct : by GDP per capita

II. Sources of economic growth
1.Human capital
2. Capital accumulation
3. Natural resource
4.Technological knowledge

III.Theories of economic growth
1. Classical theory of Adam Smith & Malthus
Land plays an important role for economic growth.
+Adam Smith: gold age
+Malthus: dull age

2. Economic growth theory of Keynes
I increases => outputs and income
increase=> capital .acc is up=> G
should invest to push AD, lead to
ecnomic growth.
Y
K
ICOR


 Y
I
ICOR


ICOR
s
Y
Y


ICOR (Incremental Capital-Output Ratio )
where S=I

Harrod- Domar model: explains the role of
capital accumulation for economic
growth.
ICOR
s
g 
)
(
Y
S
s 
*If ICOR is constant, g increases at the
rate of savings rate.
*Debates: +ICOR is not constant
+Model ignores technology and
human resources

3. Neo-classical economic growth
theory
Solow model or Solow-Swan Model
3.1. Introduction:
Paper of economic growth were issued in
2/1956 and 11-1956 of two economists are
Solow and Swan
*Why it is neo-classical theory: use the
role of market and government

The Solow Growth Model is designed to show how
growth in the capital stock, growth in the labor force,
and advances in technology interact in an economy, and
how they affect a nation’s total output of
goods and services.
Let’s now examine how the
model treats the accumulation
of capital.

The production function represents the
transformation of inputs (labor (L), capital (K),
production technology) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
Y = F ( K , L )
The Production Function
Income is some function of our given inputs
Let’s analyze the supply and demand for goods, and
see how much output is produced at any given time
and how this output is allocated among alternative uses.
Key Assumption: The Production Function has constant returns to scale.
z z
z

This assumption lets us analyze all quantities relative to the size of
the labor force. Set z = 1/L.
Y/ L = F ( K / L , 1 )
Output
Per worker
is some function of the amount of
capital per worker
Constant returns to scale imply that the size of the economy as
measured by the number of workers does not affect the relationship
between output per worker and capital per worker. So, from now on,
let’s denote all quantities in per worker terms in lower case letters.
Here is our production function: , where f(k)=F(k,1).
y = f ( k )

MPK = f (k + 1) – f (k)
y
k
f(k)
The production function shows
how the amount of capital per
worker k determines the amount
of output per worker y=f(k).
The slope of the production function
is the marginal product of capital:
if k increases by 1 unit, y increases
by MPK units.
1
MPK

consumption
per worker
depends
on savings
rate
(between 0 and 1)
Output
per worker
consumption
per worker investment
per worker
y = c + i
1)
c = (1-s)y
2)
y = (1-s)y + i
3)
4) i = sy Investment = savings. The rate of saving s
is the fraction of output devoted to investment.

Here are two forces that influence the capital stock:
• Investment: expenditure on plant and equipment.
• Depreciation: wearing out of old capital; causes capital stock to fall.
Recall investment per worker i = s y.
Let’s substitute the production function for y, we can express investment
per worker as a function of the capital stock per worker:
i = s f(k)
This equation relates the existing stock of capital k to the accumulation
of new capital i.

Investment, s f(k)
Output, f (k)
c (per worker)
i (per worker)
y (per worker)
The saving rate s determines the allocation of output between
consumption and investment. For any level of k, output is f(k),
investment is s f(k), and consumption is f(k) – sf(k).
y
k

Impact of investment and depreciation on the capital stock: k = i –dk
Change in
Capital Stock
Investment Depreciation
Remember investment equals
savings so, it can be written:
k = s f(k)– dk
dk
k
dk
Depreciation is therefore proportional
to the capital stock.

Investment
and Depreciation
Capital
per worker, k
i* = dk*
k*
k1 k2
At k*, investment equals depreciation and
capital will not change over time. Below k*,
investment
exceeds
depreciation,
so the capital
stock grows.
Investment, s f(k)
Depreciation, d k
Above k*, depreciation
exceeds investment, so the
capital stock shrinks.

Investment
and
Depreciation
Capital
per worker, k
i* = dk*
k1* k2*
Depreciation, d k
Investment, s1f(k)
Investment, s2f(k)
The Solow Model shows that if the saving rate is high, the economy
will have a large capital stock and high level of output. If the saving
rate is low, the economy will have a small capital stock and a
low level of output.
An increase in
the saving rate
causes the capital
stock to grow to
a new steady state.

c*= f (k*) - d k*.
According to this equation, steady-state consumption is what’s left
of steady-state output after paying for steady-state depreciation. It
further shows that an increase in steady-state capital has two opposing
effects on steady-state consumption. On the one hand, more capital means
more output. On the other hand, more capital also means that more output
must be used to replace capital that is wearing out.
The economy’s output is used for
consumption or investment. In the steady
state, investment equals depreciation.
Therefore, steady-state consumption is the
difference between output f (k*) and
depreciation d k*. Steady-state consumption
is maximized at the Golden Rule steady
state. The Golden Rule capital stock is
denoted k*gold, and the Golden Rule
consumption is c*gold.
dk
k
dk
Output, f(k)
c *gold
k*gold

3.2. Conclusions of Solow model
+The role of savings for economics
growth
+Capital accumulation is good for
short-run economic growth
+Techonology is the determinant of
long-run economic growth

4. Policies for economic growth
4.1. Increasing domestic savings and
investment
4.2. Attracting FDI
4.3. Improving human resources
4.4. R&D of new techonology

4.6. The open-door policy
4.7. Curbing growth of population
4.5. Stability of politics and economy

Government
purchases of goods
and services
Y = C + I + G + NX
Total demand
for domestic
output
Consumption
spending by
households
Investment
spending by
businesses and
households
Net exports
or net foreign
demand
Notice we’ve added net exports, NX, defined as EX-IM. Also, note that
domestic spending on all goods and services is the sum of domestic
spending on domestics goods and services and on foreign goods and
services.
is composed
of

Y = C + I + G + NX
After some manipulation, the national income accounts identity can be
re-written as:
NX = Y - (C + I + G)
Net Exports
Output
This equation shows that in an open economy, domestic spending need
not equal the output of goods and services. If output exceeds domestic
spending, we export the difference: net exports are positive. If output
falls short of domestic spending, we import the difference: net exports
are negative.
Domestic
Spending

Start with the national income accounts identity. Y=C+I+G+NX.
Subtract C and G from both sides and obtain Y-C-G = I+NX.
Let’s call this S, national saving.
So, now we have S=I+NX. Subtract I from both sides to obtain the new
equation, S-I=NX.
This form of the national income accounts identity shows that an
economy’s net exports must always equal the difference between its
saving and its investment.
S-I=NX
Trade Balance
Net Foreign Investment

S-I=NX
If S-I and NX are positive, we have a trade surplus. We would be net
lenders in world financial markets, and we are exporting more
goods than we are importing.
If S-I and NX are negative, we have a trade deficit. We would be net
borrowers in world financial markets, and we are importing more
goods than we are exporting.
If S-I and NX are exactly zero, we have balanced trade since the value
of imports equals the value of exports.
Net Capital Outflow = Trade Balance

We are now going to develop a model of the international
flows of capital and goods. Then, we’ll address issues
such as how the trade balance responds to changes in
policy.

Recall that the trade balance equals the net capital outflow, which
in turn equals saving minus investment, our model focuses on saving
and investment. We’ll borrow a part of the model from Chapter 3, but
won’t assume that the real interest rate equilibrates saving and
investment. Instead, we’ll allow the economy to run a trade deficit
and borrow from other countries, or to run a trade surplus and lend
to other countries.
Consider a small open economy with perfect capital mobility in
which it takes the world interest rate r* as given, denoted r = r*.
Remember in a closed economy, what determines the interest rate is the
equilibrium of domestic saving and investment--and in a way, the world
is like a closed economy-- therefore the equilibrium of world saving and
world investment determines the world interest rate.

C = C (Y-T)
I = I (r)
Y = Y = F(K,L)
NX = (Y-C-G) - I
or NX = S - I
The economy’s output Y is fixed by the
factors of production and the production
function.
Consumption is positively related to
disposable income (Y-T).
Investment is negatively related to the
real interest rate.
The national income accounts identity,
expressed in terms of saving and investment.
Now substitute our three assumptions from Chapter 3 and the condition
that the interest rate equals the world interest rate, r*.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)
This equation suggests that the trade balance is determined by the
difference between saving and investment at the world interest rate.

S
I(r)
Investment, Saving, I, S
Real
interest
rate, r*
rclosed
r*
NX
In a closed economy, r adjusts to
equilibrate saving and investment.
In a small open economy, the
interest rate is set by world
financial markets. The difference
between saving and investment
determines the trade balance.
In this case, since r* is above rclosed and saving exceeds investment,
there is a trade surplus.
r*'
NX
If the world interest rate decreased to r* ', I would exceed S and
there would be a trade deficit.

S
I(r)
Real
interest
rate, r*
r*
S'
An increase in government purchases or a cut in taxes decreases
national saving and thus shifts the national saving schedule to the left.
NX
The result is a reduction in national
saving which leads to a trade deficit,
where I > S.
NX = (Y-C(Y-T) - G) - I (r*)
NX = S - I (r*)

S
I(r)
Real
interest
rate, r*
r1*
A fiscal expansion in a foreign economy large enough to influence
world saving and investment raises the world interest rate
from r1* to r2*.
NX
The higher world interest rate reduces
investment in this small open
economy, causing a trade surplus
where S > I.
r2*

An outward shift in the investment schedule from I(r)1 to I(r)2 increases
the amount of investment at the world interest rate r*.
NX
As a result, investment now
exceeds saving I > S, which
means the economy is
borrowing from abroad and
running a trade deficit.
S
I(r)1
Real
interest
rate, r*
r1*
I(r)2

In the next few slides, we’ll learn about the foreign
exchange market, exchange rates and much more!

Let’s think about when the US and Japan engage in trade. Each country
has different cultures, languages, and currencies, all of which could
hinder trade. But, because of the foreign exchange market, trade
transactions become more efficient. The foreign exchange market is a
global market in which banks are connected through high-tech
telecommunications systems in order to purchase currencies for their
customers.
The next slide is a graphical representation of the flow of the trade
between the U.S. and Japan, and how the mix of traded things might be
different, but is always balanced. Also, notice how the foreign exchange
market will play the middle-man in these transactions. For instance, the
foreign exchange market converts the supply of dollars from the U.S.
into the demand for yen, and conversely, the supply of yen into the
demand for dollars.

it must supply yen which are then converted
into dollars by the foreign exchange market.
Foreign
Exchange
Market
Supply$
DemandYEN
Demand$
SupplyYEN
In order for Japan to pay for its imports of
goods and services and securities from the
U.S.,
In order for the U.S to pay for its imports of
goods and services and securities from Japan,
it must supply dollars which are then converted
into yen by the
foreign
exchange
market.

The exchange rate between two countries is the price at which
residents of those countries trade with each other.

-relative price of the currency of two countries
-denoted as e
-relative price of the goods of two countries
-sometimes called the terms of trade
-denoted as e

The nominal exchange rate is the relative price of the currency of
two countries. For example, if the exchange rate between the U.S.
dollar and the Japanese yen is 120 yen per dollar, then you can
exchange 1 dollar for 120 yen in world markets for foreign currency.
A Japanese who wants to obtain dollars would pay 120 yen for each
dollar he bought. An American who wants to obtain yen would get
120 yen for each dollar he paid. When people refer to “the exchange
rate” between two countries, they usually mean the nominal exchange
rate.

D$ shifts rightward and increases
the nominal exchange rate, e.
This is known as appreciation
of the dollar.
B
e1
e
Dollar Value of Transactions
D$
A
e0
S$
$
Suppose that there is an increase in the demand for U.S. goods and
services. How will this affect the nominal exchange rate?
Events which decrease the
demand for the dollar, and thus
decrease e would be a
depreciation of the dollar.
D$ 

The real exchange rate is the relative price of the goods of two
countries. That is, the real exchange rate tells us the rate at which we
can trade the goods of one country for the goods of another.
To see the difference between the real and nominal exchange rates,
consider a single good produced in many countries: cars. Suppose an
American car costs $10,000 and a similar Japanese car costs 2,400,000
yen. To compare the prices of the two cars, we must convert them into
a common currency. If a dollar is worth 120 yen, then the American
car costs 1,200,000 yen. Comparing the price of the American car
(1,200,000 yen) and the price of the Japanese car (2,400,000 yen), we
conclude that the American car costs one-half of what the Japanese
car costs. In other words, at current prices, we can exchange 2
American cars for 1 Japanese car.
e

We can summarize our calculation as follows:
Real Exchange Rate = (120 yen/dollar)  (10,000 dollars/American car)
(2,400,000 yen/Japanese Car)
= 0.5 Japanese Car
American Car
At these prices, and this exchange rate, we obtain one-half of a Japanese
car per American car. More generally, we can write this calculation as
Real Exchange Rate =
Nominal Exchange Rate  Price of Domestic Good
Price of Foreign Good
The rate at which we exchange foreign and domestic goods depends on
the prices of the goods in the local currencies and on the rate at which
the currencies are exchanged.
e

e = e × (P/P*)
Real Exchange
Rate
Nominal
Exchange
Rate
Ratio of Price
Levels
Note: P is the price level of the domestic country (measured
in the domestic currency) and P* is the price level of the
foreign country (measured in the foreign currency).

e = e × (P/P*)
The real exchange rate between two countries is computed from the
nominal exchange rate and the price levels in the two countries. If the
real exchange rate is high, foreign goods are relatively cheap, and
domestic goods are relatively expensive. If the real exchange rate is
low, foreign goods are relatively expensive, and domestic goods
are relatively cheap.
Real Exchange
Rate
Nominal Exchange
Rate
Ratio of Price
Levels

How does the level of prices effect exchange rates? It doesn’t. All
changes in a nation’s price level will be fully incorporated into the
nominal exchange rate. It is the law of one price applied to the
international marketplace.
Purchasing Power Parity suggests that nominal exchange rate
movements primarily reflect differences in price levels of nations. It
states that if international arbitrage is possible, then a dollar must
have the same purchasing power in every country. Purchasing
Power Parity does not always hold because some goods are not
easily traded, and sometimes traded goods are not always perfect
substitutes– but it does give us reason to expect that fluctuations in
the real exchange rate will be small and short-lived.

NX(e)
Net Exports, NX
Real
exchange
rate, e
The law of one price applied to the
international marketplace suggests that
net exports are highly sensitive to small
movements in the real exchange rate.
This high sensitivity is reflected here
with a very flat net-exports schedule.
S-I

NX(e)
Net Exports, NX
Real
exchange
rate, e
0
The real exchange rate is determined by the
intersection of the vertical line representing
saving minus investment and downward-sloping
net exports schedule.
S-I
The relationship between the real exchange rate
and net exports is negative: the lower the real
exchange rate, the less expensive are domestic
goods relative to foreign goods, and thus the
greater are our net exports.
Here the quantity of dollars
supplied for net foreign
investment equals the
quantity of dollars demanded
for the net exports of goods
and services.

NX(e)
Net Exports, NX
Real
exchange
rate, e
NX1
The fall in saving reduces the supply of dollars
to be exchanged into foreign currency, from
S1-I to S2-I. This shift raises the equilibrium real
exchange rate from e1 to e2.
S1-I Expansionary fiscal policy at home, such as an
increase in government purchases G or a cut in
taxes, reduces national saving.
A reduction in saving reduces
the supply of dollars which
causes the real exchange rate
to rise and causes net exports
to fall.
S2-I
NX2
e2
e1

NX(e)
Net Exports, NX
Real
exchange
rate, e
NX2
The increase in the world interest rate reduces
investment at home, which in turn raises the
supply of dollars to be exchanged into foreign
currencies.
S-I (r2*)Expansionary fiscal policy abroad reduces
world saving and raises the world interest
rate from r1* to r2*.
As a result, the equilibrium
real exchange rate falls from
e1 to e2.
NX1
e1
e2
S-I(r1*)

NX(e)
Net Exports, NX
Real
exchange
rate, e
NX1
As a result, the supply of dollars to be
exchanged into foreign currencies falls
from S-I1 to S-I2.
S-I1
An increase in investment demand raises
the quantity of domestic investment from I1
to I2.
This fall in supply raises the
equilibrium real exchange
rate from e1 to e2.
NX2
e1
e2
S-I2

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