III. Macroeconomic Analysis
III. Macroeconomic Analysis

Measuring Economic Performance

Gross Domestic Product (GDP): The primary measure of an economy’s performance, GDP is the total value of all final goods and services produced on a nation’s soil in a year. Intermediate goods are excluded to avoid double-counting.
GDP Exclusions: GDP does not count non-production transactions like purely financial transactions (stocks), public/private transfer payments (Social Security, gifts), and secondhand sales.
Approaches to GDP:
Expenditures Approach: GDP = C + I + G + Xn (Consumption + Gross Investment + Government Spending + Net Exports).
Income Approach: Sums wages, rents, interest, and profits.
Nominal vs. Real GDP: Nominal GDP is measured in current prices and is unadjusted for inflation. Real GDP is adjusted for inflation, providing a more accurate measure of output changes over time.
The Business Cycle: The natural fluctuation of GDP, consisting of four phases: peak, contraction (recession is two consecutive quarters of declining GDP), trough, and expansion.
Unemployment:
Frictional: Workers temporarily between jobs or searching for new ones.
Structural: Mismatch between workers’ skills and the skills demanded by employers, often due to technological change.
Cyclical: Caused by the contraction phase of the business cycle.
Inflation: A general rise in the price level over a sustained period.
Demand-Pull Inflation: Caused by an increase in aggregate demand that outpaces the economy’s productive capacity.
Cost-Push Inflation: Caused by an increase in the costs of production (e.g., input prices), which shifts the aggregate supply curve left.
Effects of Inflation: Unanticipated inflation hurts fixed-income recipients, savers, and creditors. It benefits debtors and those with flexible incomes tied to a Cost-of-Living Adjustment (COLA).
National Income and Price Determination

Aggregate Demand (AD): The total amount of real output that buyers (households, firms, government, foreigners) collectively desire to purchase at each price level. The AD curve is downward sloping due to:
Real-Balance Effect: A higher price level reduces the purchasing power of money, decreasing consumption.
Interest-Rate Effect: A higher price level increases demand for money, raising interest rates and reducing investment and consumption.
Foreign-Purchases Effect: A higher domestic price level makes domestic goods more expensive for foreigners and foreign goods cheaper for domestic consumers, reducing net exports.
Aggregate Supply (AS): The total amount of real output that producers will collectively produce at each price level. The AS curve has three ranges:
Horizontal/Keynesian Range: High unemployment and idle resources; output can increase without raising the price level.
Intermediate Range: As the economy nears full employment, output increases are accompanied by a rising price level.
Vertical/Classical Range: The economy is at full capacity; further increases in demand only raise the price level (inflation) with no change in output.
Equilibrium: The intersection of the AD and AS curves determines the economy’s equilibrium price level and real GDP.
Fiscal Policy: Government’s Role in Stabilization

Classical vs. Keynesian Economics:
Classical: Believes the economy is self-correcting and will naturally return to full employment. Advocates for a hands-off approach.
Keynesian: Argues that the economy can be in equilibrium below full employment and that government intervention is necessary to correct recessions and inflation.
Fiscal Policy Tools:
Expansionary Fiscal Policy: Used to combat a recession. Involves increasing government spending and/or decreasing taxes to shift AD to the right.
Contractionary Fiscal Policy: Used to combat inflation. Involves decreasing government spending and/or increasing taxes to shift AD to the left.
Built-in Stabilizers: Automatic changes in tax revenue and government spending that occur with fluctuations in GDP, which help to moderate the business cycle (e.g., progressive income taxes, unemployment benefits).
Problems with Fiscal Policy: Implementation can be slow due to administrative and operational lags, and it can be influenced by political pressures.
Monetary Policy: The Federal Reserve and the Money Supply

Functions of Money: Money serves as a medium of exchange, a unit of account, and a store of value.
The Money Supply:
M1: Most liquid form; includes currency, checkable deposits, and traveler’s checks.
M2: Includes M1 plus savings deposits, small-time deposits (CDs < $100k), and money market mutual funds.
M3: Includes M2 plus large-time deposits (> $100k).
The Federal Reserve (The Fed): The central bank of the United States. It is run by a Board of Governors and includes 12 district banks. The Federal Open Market Committee (FOMC) sets monetary policy.
Tools of Monetary Policy:
Tool	Expansionary Action (to fight recession)	Contractionary Action (to fight inflation)
Open Market Operations	The Fed buys government bonds, increasing bank reserves and the money supply.	The Fed sells government bonds, decreasing bank reserves and the money supply.
The Discount Rate	The Fed lowers the rate it charges banks, encouraging borrowing and increasing the money supply.	The Fed raises the rate, discouraging borrowing and decreasing the money supply.
The Reserve Requirement	The Fed lowers the percentage of deposits banks must hold, allowing them to lend more.	The Fed raises the requirement, forcing banks to hold more and lend less.
The Phillips Curve: Illustrates the short-run trade-off between inflation and unemployment. The long-run Phillips curve is vertical at the natural rate of unemployment, suggesting no long-run trade-off.