Macroeconomics: GDP, Inflation, Money, and Trade

Posted on Mar 24, 2025 in Economy

Calculating GDP

Expenditure Approach: Consumers + Investment + Government Spending + Net Exports (Exports – Imports)

Income Approach: Rent + Wages + Interest + Profits

Nominal vs. Real GDP

  • Nominal GDP: (Price per year * Quantity per year)
  • Real GDP: (Price base year (given) * Quantity per year)

GDP Deflator: (Nominal GDP / Real GDP) * 100

% Rate of Change: ((Final – Initial) / Initial) * 100

GDP per Capita: GDP / Country Population

Inflation Rate: ((GDP Deflator Final – GDP Deflator Initial) / GDP Deflator Initial)*100

Labor Force

Labor Force: Number of Employed People + Number of Unemployed People

Unemployment Rate: (Number of Unemployed / Labor Force) * 100

Labor Force Participation Rate: (Labor Force / Adult Population) * 100

Consumer Price Index (CPI)

CPI: (Market Basket in the Year You Are Looking For / Market Basket in the Base Year) * 100

GDP Growth Rate (Long Time Period)

GDPt=50 = GDPt=0(1+g)50 (Small differences in growth have large effects over time.)

The Rule of 70: 70 / % Growth

Production Function

Y = F(K, L, H, M, A)

  • K = Capital
  • L = Labor
  • H = Human Capital
  • M = Natural Resources
  • A = Technology

The Financial System

Formed by:

  • Financial Markets (Bond Market and Stock Market)
  • Financial Intermediaries (Banks and Investment Funds)

Savings: Disposable Income – Total Consumption

Saving Rate: Savings / Disposable Income

Wealth: Stock of Assets – Liabilities

Types of Savings

  • Private: Y – T – C
  • Public: T – G
  • National: (Private + Public) or (Y – C – G)

Budget Surpluses and Deficits

  • T > G: Budget Surplus (T – G) – Positive Public Saving
  • T < G: Budget Deficit (G – T) – Negative Public Saving

Market for Loanable Funds

A hypothetical market where people put their savings as a supply, and investors demand this money to invest. (Real Interest Rate = i – π)

Money and Monetary Policy

Three Functions of Money

  1. Medium of Exchange
  2. Unit of Account
  3. Store of Value

Two Kinds of Money

  • Commodity Money: (Gold, Silver, Tobacco)
  • Fiat Money: (US Dollar, Euro)

Money Multiplier: (Money Supply / Monetary Base) = M / H

Monetary Base (H): Circulating Cash (C) + Bank Reserves (R)

Money Supply (M): Circulating Cash (C) + Deposits (D)

Money Supply = Money Multiplier * Monetary Base

Classical Dichotomy

The theoretical separation of nominal and real variables. Hume and classical economists suggested that monetary developments affect nominal variables but not real variables.

If the central bank doubles the money supply:

  • All nominal variables, including prices, will double.
  • All real variables, including relative prices, will remain unchanged.

Monetary Neutrality: The proposition that changes in the money supply do not affect real variables.

Velocity of Money

The rate at which money changes hands to purchase GDP.

  • P x Y = Nominal GDP = (Price Level) x (Real GDP)
  • M = Money Supply
  • V = Velocity

Velocity Formula: V = (P * Y) / M

Quantity Equation: M x V = P x Y

Costs of Inflation

  • Shoe-leather Costs: Resources wasted when inflation encourages people to reduce their money holdings.
  • Menu Costs: The costs of changing prices.
  • Misallocation of Resources from Relative-Price Variability: Firms don’t all raise prices at the same time, so relative prices can vary, which distorts the allocation of resources.
  • Confusion & Inconvenience: Inflation changes the yardstick we use to measure transactions.

Nominal Interest Rate: Real Interest Rate + Inflation Rate

Real Interest Rate: Nominal Interest Rate – Inflation Rate

International Trade and Finance

Net Exports (Trade Balance): Exports – Imports

  • Trade Surplus: Exports > Imports (Net Exports and NPO > 0; Saving > Investment)
  • Trade Deficit: Exports < Imports (Net Exports and NPO < 0; Saving < Investment)
  • Balanced Trade: Exports = Imports (Net Exports = NPO = 0; Saving = Investment)

NPO (Net Capital Outflow): The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners (always equal to net exports).

Exchange Rates

Nominal Exchange Rate: The rate at which a person can trade the currency of one country for the currency of another (Local Currency / Foreign Currency).

Real Exchange Rate: The rate at which a person can trade the goods and services of one country for the goods and services of another. (Nominal Exchange Rate * Domestic Price) / Foreign Price

Trade Policy: A government policy that directly influences the quantity of goods and services that a country imports and exports.

Capital Flight: A large and sudden reduction in the demand for assets located in a country.

Aggregate Demand and Aggregate Supply

Model of Aggregate Demand and Aggregate Supply: The model that most economists use to explain short-run fluctuations in economic activity around its long-run trend.

Why Does the Aggregate Demand Curve Slope Downward?

  1. The Wealth Effect: A lower price level increases real wealth, which encourages spending on consumption.
  2. The Interest Rate Effect: A lower price level reduces the interest rate, which encourages spending on investment.
  3. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, which encourages spending on net exports.

Shifts Arise From: Consumption, Investment, Government Purchases, and Net Exports.

Why Does the Short-Run Aggregate Supply Curve Slope Upward?

  1. The Sticky Wage Theory: An unexpectedly low price level raises the real wage, which causes firms to hire fewer workers and produce a smaller quantity of goods and services.
  2. The Sticky Price Theory: An unexpectedly low price level leaves some firms with higher-than-desired prices, which depresses their sales and leads them to cut back production.
  3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, which induces a fall in production.

Shifts Arise From: Labor, Capital, Natural Resources, Technology, and the Expected Price Level.

Multiplier Effect

The additional shifts in aggregate demand that result when expansionary fiscal policy increases income and thereby increases consumer spending.

Theory of Liquidity Preference

Keynes’s theory that the interest rate adjusts to bring money supply and money demand into balance.

Crowding-Out Effect

The offset in aggregate demand that results when expansionary fiscal policy raises the interest rate and thereby reduces investment spending.