(1) The document provides an overview of macroeconomics concepts including macroeconomic models, GDP, inflation, money, and the open economy. (2) Key concepts discussed include using economic models as analytical tools to understand complex economic systems, the components and measurement of GDP, the GDP deflator as a price index, and the relationship between money, interest rates, and inflation. (3) The document also examines national income accounting including the aggregate production function, factors that determine economic growth, and the relationship between savings, investment, and the trade balance in a closed versus open economy.

1. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 1: The Science of Macroeconomics

2. Macroeconomics
• The study of an economy as a whole.
• Focussing on aggregates or averages like:
– total output of goods and services (GDP),
– the rate of unemployment,
– the price level and the rate of inflation,
– the (average) interest rate,
– the trade balance (exports - imports)
2

3. Why use economic models as analytical tools?
• Economic systems are complex, like living
organisms, and cannot be fully understood.
• Sometimes models work, sometimes not
• Correlation is not causation.
– Simultaneous interrelationships among many variables,
not simple causal links.
• Cannot do controlled experiments.
• Therefore: theoretical models are essential as maps
in trying to understand what is going on.
3

4. Macroeconomic models as tools to
understand the economy
• Simplifying reality, permitting us to think about
things that have not been observed.
• Impossible to analyze reality directly without
theory and models. Those who try use in fact
poor theories without knowing it.
• Taxonomy important for perceptions
• Which model is the best one, i.e. the most
relevant one, for the situation at hand?
4

5. An economic model - Basic structure
Exogenous variables (given)
⇓
The Model (theory or story)
⇓
Endogenous variables (to be explained)

6. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 2: The Data of Macroeconomics

7. Gross domestic product (GDP)
measures economic activity
• GDP is the market value of all final goods and
services produced in an economy during a period
of time (year, quarter)
• The value of what is produced (GDP)
GDP = total income (wages + profits).
7

8. The composition of GDP
• C = consumption, final expenditure in GDP
• Gross investment (I), also final expenditure.
Investments contain expenditures on new machines, plants,
buildings, ships, etc., and also increases in inventories.
Two more final components of GDP; government
consumption (G) and net exports (NX).
• NX = exports of goods and services – imports
• Hence, GDP = C + G + I + NX (Very important)
8

9. Value added: The contribution
to GDP of a firm
Total sales
+ increased inventories
= value of production
- intermediate goods bought from others
= value added
Value added is usually much smaller than total sales,
but much larger than profits: value added includes
wages to employees.
9

10. The GDP deflator (P):
A price index of GDP
• P is defined as nominal GDP divided by real GDP.
• This means that: P*(Real GDP) = Nominal GDP.
• The GDP-deflator measures the price level of the
final goods that GDP consists of.
• NB! This is not the same as the consumer price
index (CPI) which only represents private
consumption of goods and services.
10

11. Consumer price index (CPI)
• Monthly data, based on surveys
• Calculated as a weighted average using value
shares in a base year
• Published as the annual rate of growth (last 12
months)
• Important for monetary policy (inflation
targeting)
• Also important for wage formation
11

12. The government sector
• National economy: Private sector and government sector
• Government income = taxes + net capital income
• Government spending = transfers to the private sector +
government spending on goods and services (both
consumption and investment goods)
Simplification: T = net taxes (taxes - transfers),
G = government spending
• Government budget surplus = net capital income + (T – G)
Government surplus huge right now in Norway. Why?
12

13. GDP and welfare
• More GDP could mean less leisure (trade-off)
• Pollution and exhaustible natural resources hard to
account for
• Household production, like child care, not included
• Concern for income distribution
– China and USA have huge challenges here. How come?
• The shadow economy: faster growth than GDP?
• Conclusion: GDP is an imperfect welfare indicator.
13

14. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 3: National Income:
Where It Comes From and Where It Goes

15. Aggregate production function Y = F(K, L)
• Basic idea: Growth of labor (L) and capital (K) explains
growth of aggregate output (real GDP). May also include land
as a third factor of production, cf. immigration to the US in the
19th century, and into the 20th.
• The law of diminishing returns:
– If L increases (K constant), then MPL (marginal product of
labor) decreases
– If K increases (L constant), then MPK (marginal product of
capital) decreases
15

16. Total factor productivity (TFP)
• If total production increases more rapidly than the weighted
increase in capital and labor, total factor productivity is
improving.
Y = AKαL1- α , A is called total factor productivity:
A = Y/KαL1-
• TFP-growth is also called intensive growth, i.e. the resources
are employed more efficiently. Which means that one can
have economic growth even without an increase in the capital
stock or in the work force.
16

17. Growth accounting
• During a 10 year period, the average GDP growth rate per
year was 4.5 %, the average capital stock growth rate was
4.5 %, and the average labor input growth rate was 1.5 %.
• The labor income share of GDP is 2/3 = 1 - α.
Calculation of average TFP growth per year:
GDP growth: 4.5 %
- growth contribution of K (1/3×4.5) -1.5 %
- growth contribution of L (2/3 ×1.5) -1.0 %
= TFP growth 2.0 %.
17

18. Applying growth accounting
• For a specific time period, collect data for the average growth
rates of Y, K and L.
• Compute the average share of labor in GDP:
1- α = wL/Y
• Use the data to calculate the average rate of growth in
gA = gY - α gK - (1 - α)gL (the annual rate of growth of TFP)
• In most OECD countries, the rate of growth of TFP (gA) has
been substantial during the post WWII period.
In Norway: about half the growth rate of Y.
18

19. (1)
Final Demand
(2) What is produced
At the equilibrium interest rate, the demand for
goods and services equals the supply.
19

20. Savings = Income that is not consumed
Y – T – C = Private savings
T – G = Public savings
 Y – C – G = National savings = S
(3) Y – C – G = I
 In the closed economy, savings = real investment
20

21. r
S(r)
I(r)
I and S
P&A, no 5, p76
21

22. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 4: Money and Inflation

23. Some observations
Some months in 1923 the monthly rate of inflation exceeded five
hundred percent in Germany. What were the consequences?
In macroeconomics we consider money as a STOCK, rendering liquidity
services, as money is the accepted means of payments.
Money can also be used as a store of value
Money is a measuring rod, ie. prices are quoted in monetary terms
Monetary policy is the central bank’s control over the supply of money.
Much is happening here these days. QE3 by the Fed, what is that?
23

24. The Demand for Money
The demand for money is derived from the demand for the
SERVICES rendered by the STOCK of money.
Portfolio theory to decide on the stock of money you like to have.
Depends upon what ALTERNATIVE assets are available.
Money facilitates the exchange of goods and services (as well as of
assets). An increase in GDP, and the demand for money, ceteris
paribus, also increases.

25. Money is non-interest bearing financial assets (or low interest
rates), i.e. liquid bank deposits mostly.
OPPORTUNITY COST of money is the rate of interest foregone.
An increase in the rate of interest, and the demand
for money declines.
Money is demanded in terms of its PURCHASING POWER,
i.e. (M/P) is what is demanded

26. The stock of money in Norway
The broad monetary aggregate M2 amounted to NOK 1 697
billion at end-September 2011, of which the major part, 91.3 per
cent, consisted of bank deposits. Notes and coins only accounted
for 2.6 per cent. The rest of the broad monetary aggregate mainly
consisted of shares in money market funds and certificates of
deposits, which accounted for 5.7 and 0.4 per cent respectively.
26

27. Putting it together
i = Nominal rate of interest
Fisher effect (p. 97)
Nominal rate of interest Question 10 page 114
= real rate + expected rate of inflation P&A no 9 p115
27

28. 28

29. 29

30. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 5: The Open Economy

31. (1) Y = C + I + G + IM
(2) Y = C + I + G + NX
(3) NX = X – IM NX is Net exports
(4) NX = Y – (C + I + G)
NX = Output – Domestic spending
From (2)
(5) Y – C – G = I + NX
S – I = NX (7)
(6) Y – C – G = S
• Surplus (deficit) on the trade balance
= Net capital outflow (inflow)
• International capital markets, and need not have real
investments = domestic savings
31

32. Ex.
• Norway 1980’s: NX < 0  Borrowed in ROW
• Norway since early 1990’s: NX > 0
 accumulated claims on ROW
Expansionary fiscal policy that reduces savings in a country,
may lead to trade deficit, i.e. borrowing abroad.
32

33. e : Nominal exchange rate
ε: Real exchange rate
Define:
P*: Price level abroad
P : Price level at home
33

34. Assume P* increases from 100 to 102
P increases from 100 to 106
, and calculate
The real exchange rate stays put at 8, if the nominal rate
goes from 8 to 8.31, as the price level increases by 6% in
Norway and by 2% in Euroland.
 4% depreciation to stay competitive. What implications
for Greece in particular and EMU in general? 34

35. 35

36. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 7: Economic Growth 1

37. 37

38. Arne Jon Isachsen
Department of Economics
December 2012
Chapter 8: Economic Growth 2

39. (1)
(2)
Growth Contribution Contribution Growth in
in output of capital of labor TFP
39

40. Arne Jon Isachsen
Department of Economics
December 2011
Chapter 10: Aggregate Demand

41. Long-run analysis and prices do change to clear markets.
Economic growth is a supply side phenomenon. Growth in
production factors (capital stock and labor force) and improved
efficiency (TFP-growth) account for economic growth.
Short-run analysis and prices are sticky. Need to apply
stabilization policy (fiscal policy and monetary policy) to smooth
economic fluctuations.
41

42. • Goods market, to develop IS-curve.
• Money market, i.e. demand and supply of the STOCK of
money, to develop LM-curve.
• Equilibrium where the two intersect.
The rate of interest is the crucial variable, connecting the
monetary part of the economy (LM-curve) with the real part
(IS-curve).
42

43. Multipliers
(1)Y = C(Y-T) + I + G
Disposable income
Let
(2) C = a + b(Y-T) Where b is the
 Y = a + b(Y-T) + I + G marginal propensity to
consume
Y – bY = a – bT + I + G
(3)
Let b = 0,6   G has a multiplier of 2.5
Multiplier for T:
43

44. IS-curve
(1) Y = C(Y-T) + G + I I = I(r)
(4) I = I(r)

Supply of Demand for
loanable funds loanable funds
r
The rate of interest
does the job of
equilibrating
IS-curve
supply and demand
for goods and
services Y
44

45. LM-curve
• When r increases, the opportunity cost of holding money
increases, and the demand for money declines.
• When GDP increases, more money is demanded to facilitate
the exchange of goods and services in the market
r
Given stock of money, every LM-curve
piont of the LM-curve is an
equilibrium point.
The given stock of money
is EXACTLY demanded.
Y
45

46. IS-curve:
LM-curve:
Two equations that determine two variables, Y and r.
r LM
IS
Y
Question 4 page 309
P&A no 1 page 309
46

47. FINANCIAL CRISIS
47

48. 48

49. Even while income inequality increased, consumption
inequality has not increased commensurately…

50. What caused the financial crisis?
• Macro conditions: Global imbalances, falling long and short
real interest rates, Great Moderation, underestimation of
risk, credit expansion (Bean 2010 JEEA)
• Distorted incentives: Extreme leverage levels and risk-taking,
lack of due diligence, low lending standards, securitization of
mortgages, fraud
• Regulatory and supervisory failures: Underestimation or
disregard of the fragility of the financial sector
• Information problems: Complex asset-backed securities,
huge hidden balance-sheet liabilities
• Specific circumstances: US housing policy, subprime lending
• These causes have little or nothing to do with monetary policy
50

51. Unemployment, selected countries
Percent of the labour force, seasonally-adjusted data
12 12
10 10
8 8
6 6
4 4
2 Austria Netherlands 2
Norway United Kingdom
USA Germany
Sweden
0 0
90 95 00 05 10
Sources: Bureau of Labor Statistics and Eurostat

52. GDP Sweden, Norway, US, and other countries
Sources: Bureau of Economic Analysis, Eurostat, Federal Statistics Office Germany, OECD, SCB, Statistics 52
Finland, Statistics Netherlands, Statistics Norway, and the Riksbank

53. More on the Euro Area
• Milder reforms prior to Euro accession
• Southern Europe: Insider vs Outsider economies
– High unemployment before Euro accession
• After Euro accession – booms
– Housing (Spain)
– Local government spending (Spain)
– Federal government spending (Greece)
– Cyclically adjusted government spending rises.
• Unit labor costs rise => competitiveness falls

54. Unemployment in Periphery

55. Post Crash Policies
• Resolution means altering property rights.
• Bank bailouts – could have imposed more costs on
shareholders and bondholders
– Dividend restrictions
– Capital raising rather than asset shrinkage
– Moratorium on bonuses
• Increasing pressure to renegotiate other promises –
pensions, social security, healthcare.
• Will property rights be differentially enforced? How
will the public see this?

56. In sum, have the capitalists
subverted democracy?
• Democracy created pressure to
keep growth going.
• Populist policies produced fast-
working but unsustainable
solution
– Easy credit
– Government spending
• Private financiers were neither
blameless nor unwilling tools.
– Convergence between business
and politics
• But to argue that policy was
solely elitist in origin and intent
is a misreading of what
happened.

57. Democracy and Capitalism
• There is a growing tension between democracy and free
enterprise post-crisis.
– When the masses do not see opportunity, they have little
incentive to support property and free enterprise.
– When they see selective enforcement of property rights,
property becomes less sacrosanct
• As capitalists get delegitimized, an important constraint on
arbitrary government also is weakened.
– Russia under Putin
• Democracy suffers.

58. Restoring opportunity
• Restore opportunity and hope to the middle class.
• Policies - pay clear dividends only in the long run.
– Education and skills
– Innovation
• Need to address distress in short run
– How to get the unemployed, especially the young, into
the labor force?
– How to retrain those in sunset industries?
– How to engage the unemployable?
• How to persuade the working rich to go along?

59. Restoring faith in property
• What promises will governments keep?
– What will be defaulted on?
– What will be inflated away?
– What will be bailed out?
– Who will pay?
• How will decisions be made?
• How legitimate will it appear?