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1
Chapter 20
Introduction to macroeconomics
and national income accounting
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
20.1
Macroeconomics is
 the study of the economy as a whole
 it deals with broad aggregates
 but uses the same style of thinking
about economic issues as in
microeconomics.
20.2
Some key issues in macroeconomics
 Inflation
– the rate of change of the general price level
 Unemployment
– a measure of the number of people looking for
work, but who are without jobs
 Output
– real gross national product (GNP) measures
total income of an economy
 it is closely related to the economy's total output
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20.3

More key issues in macroeconomics
 Economic growth
– increases in real GNP, an indication of
the expansion of the economy’s total
output
 Macroeconomic policy
– a variety of policy measures used by
the government to affect the overall
performance of the economy
20.4
Inflation in the UK, 1950-99
0
5
10
15
20
25
30
195
0
19
70
19
90
% p.a.
Source: Economic Trends Annual Supplement, Labour Market Trends
20.5
Inflation in selected European countries
0 1 2 3 4 5
% change 1998 compared with 1997

Greece
Portugal
Italy
Spain
UK
Finland
EU
Belgium
France
Germany
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20.6
Inflation in UK, USA and Germany
0
2
4
6
8
10
12
14
16
% p.a.
1960-73 1973-81 1981-90 1990-98
UK USA Germany
20.7
Unemployment in the UK, 1950-99

0
2
4
6
8
10
12
14
195
0
19
70
19
90
% p.a.
Source: Economic Trends Annual Supplement, Labour Market Trends
20.8
Unemployment
in selected European countries
0 5 10 15 20
% unemployment (ILO measure) 1998
Greece
Portugal
Italy
Spain
UK
Finland
EU
Belgium
France

Germany
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20.9
Unemployment
in UK, USA and Germany
0
2
4
6
8
10
% p.a.
1960-73 1973-81 1981-90 1990-98
UK USA Germany
20.10
Economic growth
in UK, USA and Germany
0
1
2
3
4
5
% p.a.
1960-73 1973-81 1981-90 1990-98
UK USA Germany
20.11

The circular flow of income,
expenditure and output
Y
Households Firms
C + I
I
C
S
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20.12
Government in the circular flow
Y
C + I + G
I
C
S
Households FirmsGovernment
C + I + G - T
e
T
e
G
B - T
d
Y + B - T
d
20.13

Adding the foreign sector
 To incorporate the foreign sector into
the circular flow
 we must recognize that residents of a
country will buy imports from abroad
 and that domestic firms will sell
(export) goods and services abroad.
20.14
GDP and GNP
 Gross domestic product (GDP)
– measures the output produced by
factors of production located in the
domestic economy
 Gross national product (GNP)
– measures the total income earned by
domestic citizens
 GNP = GDP + net income from abroad
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20.15
Three measures of national output
 Expenditure
– the sum of expenditures in the economy
– Y = C + I + G + X - Z
 Income
– the sum of incomes paid for factor
services
– wages, profits, etc.

 Output
– the sum of output (value added)
produced in the economy
20.16
National income accounting: a summary
GNP
(and
GNI)
at
market
prices
GDP
at
market
prices
NYA
C
X - Z
I
NYA
G
NNP
at basic
prices
Deprec'n
National
income
Indirect
taxes
Wages

and
salaries
Self-
employment
Profits,
rents
20.17
What GNP does and does not measure
 Some care is needed:
– to distinguish between real and nominal
measurements
– to take account of population changes
– to remember that GNP is not a
comprehensive measure of everything
that contributes to economic welfare
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Chapter 21
The determination of national income
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
21.1
Aggregate output in the short run
 Potential output
– the output the economy would produce
if all factors of production were fully
employed

 Actual output
– what is actually produced in a period
– which may diverge from the potential
level
21.2
Some simplifying assumptions
 Prices and wages are fixed
 The actual quantity of total output is
demand-determined
– this will be a “Keynesian” model
 For now, also assume:
– no government
– no foreign trade
 Later chapters relax these assumptions
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21.3
Aggregate demand
 Given no government and no
international trade, aggregate
demand has two components:
– Investment
 firms’ desired or planned additions to
physical capital & inventories
 for now, assume this is autonomous
– Consumption
 households’ demand for goods and services
 so, AD = C + I

21.4
Consumption demand
 Households allocate their income
between CONSUMPTION and
SAVING
 Personal Disposable Income
– income that households have for
spending or saving
– income from their supply of factor
services (plus transfers less taxes)
21.5
Consumption and income in the UK
at constant 1995 prices, 1989-1998
350
375
400
425
450
475
500
400 425 450 475 500 525 550
Real disposable income (£bn.)
Household consumtpion
expenditure (£bn.)
Income is a strong influence on consumptionIncome is a strong influence on consumption
expenditure expenditure –– but not the only one.but not the only one.
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21.6
The consumption function
IncomeIncome
C = 8 + 0.7 YC = 8 + 0.7 Y
The consumption function shows desired aggregateThe consumption function shows desired aggregate
consumption at each level of aggregate incomeconsumption at each level of aggregate income
00
With zero income,With zero income,
desired consumptiondesired consumption
is 8 (“autonomousis 8 (“autonomous
consumption”).consumption”).
{{
88
The The marginal propensitymarginal propensity
to consumeto consume (the slope of(the slope of
the function) is 0.7 the function) is 0.7 –– i.e.i.e.
for each additional £1 of for each additional £1 of
income, 70p is consumed.income, 70p is consumed.
21.7
The saving function
S = S = 8 + 0.3 Y8 + 0.3 Y
IncomeIncome
00
The saving function showsThe saving function shows
desired saving at eachdesired saving at each
income level.income level.
Since all income is either Since all income is either
saved or spent on saved or spent on
consumption, the savingconsumption, the saving
function can be derivedfunction can be derived

from the consumption from the consumption
function or function or vice versa.vice versa.
21.8
The aggregate demand schedule
IncomeIncome
CC
Aggregate demand isAggregate demand is
what households planwhat households plan
to spend on consumptionto spend on consumption
and what firms plan toand what firms plan to
spend on investment.spend on investment.
AD = C + IAD = C + I
II
The AD function is The AD function is
the vertical additionthe vertical addition
of C and I.of C and I.
(For now I is assumed (For now I is assumed
autonomous.)autonomous.)
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21.9
Equilibrium output
Output, IncomeOutput, Income
4545
oo
lineline
The 45The 45
o o

line shows the line shows the
points at which desiredpoints at which desired
spending equals output spending equals output
or income.or income.
ADAD
Given the Given the ADAD schedule,schedule,
This the point at whichThis the point at which
planned spending equalsplanned spending equals
actual output and income.actual output and income.
equilibrium is thus at E.equilibrium is thus at E.
EE
21.10
An alternative approach
Output, IncomeOutput, Income
An equivalent view ofAn equivalent view of
equilibrium is seen byequilibrium is seen by
equatingequating
II
planned investment (planned investment (II))
SS
to planned saving (to planned saving (SS))
The two approaches are equivalent.The two approaches are equivalent.
again giving usagain giving us
equilibrium at Eequilibrium at E
EE
21.11
Effects of a fall in aggregate demand
Output, IncomeOutput, Income
4545
oo

lineline
ADAD
00
YY
00
Suppose the economySuppose the economy
starts in equilibrium starts in equilibrium
at Yat Y
0.0.
a fall in aggregate a fall in aggregate
demand to ADdemand to AD
11
ADAD
11
Leads the economyLeads the economy
to a new equilibrium to a new equilibrium
at Yat Y
11

YY
11
Notice that the change in equilibrium output isNotice that the change in equilibrium output is
larger than the original change in AD.larger than the original change in AD.
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21.12
The multiplier
 The multiplier is the ratio of the

change in equilibrium output to the
change in autonomous spending that
causes the change in output.
 The larger the marginal propensity to
consume, the larger is the multiplier.
– The higher is the marginal propensity to
save, the more of each extra unit of
income “leaks” out of the circular flow.
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Chapter 22
Aggregate demand, fiscal policy,
and foreign trade
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
22.1
Some key terms
 Fiscal policy
– the government’s decisions about spending
and taxes
 Stabilization policy
– government actions to try to keep output close
to its potential level
 Budget deficit
– the excess of government outlays over
government receipts
 National debt

– the stock of outstanding government debt
22.2
Government
in the income-expenditure model
 Direct taxes
– affect the slope of the consumption
function
– and hence the slope of the AD
schedule.
 Government expenditure affects the
position of the AD schedule
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22.3
Fiscal policy?
Income,
output
45
o
line
AD
0
Y
0
But this ignores some
important issues –
prices, interest rates,
and the need to fund

the government
spending.
AD
1
This seems to suggest
that the government
could influence aggregate
output in the economy
by raising AD from AD
0
to AD
1
,
Y
1
thus raising equilibrium
output from Y
0
to Y
1
.
22.4
but in surplus at high levels
then the budget will be in
deficit at low levels of
income
The government budget
The budget deficit equals total government spending
minus total tax revenue.
If government spending is

independent of income
G
Income, output
but net taxes depend on
income,
The balanced budget multiplier states that an increase in
government spending plus an equal increase in taxes leads
to higher equilibrium output.
Balanced
budget
22.5
Deficits and the fiscal stance
 The size of the budget deficit is not a good
measure of the government’s fiscal
stance.
 The structural budget shows what the
budget would have been if output had
been at the full-employment level.
 The inflation-adjusted budget uses real
not nominal interest rates to calculate
government spending on debt interest.
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22.6
Automatic stabilizers
 mechanisms in the economy that
reduce the response of GNP to
shocks

– for example, in a recession:
– payments of unemployment benefits
rise
– and receipts from VAT and income tax
fall
22.7
Limits on active fiscal policy
 Time lags: it takes time
– to diagnose the problem
– to take action
– for the multiplier process to operate
 Uncertainty
– the size of the multiplier is not known
– aggregate demand is always changing
 Induced effects on autonomous demand
– changes in fiscal policy may induce offsetting effects in
other components of aggregate demand
Why can’t shocks to aggregate demand
immediately be offset by fiscal policy?
22.8
Limits on active fiscal policy (2)
 The budget deficit
– concern about inflation if the budget deficit
grows
 Maybe we’re at full employment!
– unemployment may be (at least partly)
voluntary
Why doesn’t the government expand fiscal
policy when unemployment is persistently high?
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22.9
Foreign trade
and income determination
 Introducing exports (X) & imports (Z)
 TRADE BALANCE
– the value of net exports (X - Z)
 TRADE DEFICIT
– when imports exceed exports
 TRADE SURPLUS
– when exports exceed imports
 Equilibrium is now where
– Y = C + I + G + X - Z
22.10
At higher income levels, there is a trade deficit.
At relatively low income,
exports exceed imports – there is a trade surplus.
Exports, imports and the trade balance
Income
but that imports increase
with income
Imports
Assume that exports
are independent of
income,
Exports
There is trade balance at income Y*, but there is no
guarantee that this corresponds to full employment.

Y*
22.11
Foreign trade and the multiplier
 The marginal propensity to import
– is the fraction of additional income that
domestic residents wish to spend on
additional imports.
 The effect of foreign trade is to
reduce the size of the multiplier
– the higher the value of the marginal
propensity to import, the lower the
value of the multiplier.
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Chapter 23
Money and modern banking
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
23.1
Some key questions
 Why does society need money?
 Why do governments wish to
influence money supply?
 How do financial markets interact
with the “real” economy?
 What is the relationship between
money and interest rates?

23.2
Money
 Any generally accepted means of
payment for delivery of goods or the
settlement of debt
 Legal money
– notes and coins
 Customary money
– IOU money based on private debt of the
individual
 e.g. bank deposit.
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23.3
Money and its functions
 Medium of exchange
– money provides a medium for the exchange of goods
and services which is more efficient than barter
 Unit of account
– a unit in which prices are quoted and accounts are kept
 Store of value
– money can be used to make purchases in the future
 Standard of deferred payment
– a unit of account over time: this enables borrowing and
lending
23.4
Modern banking
 A financial intermediary

– an institution that specializes in bringing
lenders and borrowers together
 e.g. a commercial bank, which has a government
licence to make loans and issue deposits
 including deposits against which cheques can be
written
 Clearing system
– a set of arrangements in which debts between
banks are settled
23.5
A beginner’s guide to the financial markets
 Financial asset
– a piece of paper entitling the owner to a
specified stream of interest payments over a
specified period
 Cash
– Notes and coin, paying no interest
– the most liquid of all assets.
 Bills
– financial assets with less than one year until
the known date at which they will be
repurchased by the original owner
– highly liquid
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23.6
A beginner’s guide to the financial markets
(continued)

 Bonds
– longer term financial assets – less liquid because there
is more uncertainty about the future income stream
 Perpetuities
– an extreme form of bond, never repurchased by the
original issuer, who pays interest forever
 e.g. Consols
 Gilt-edged securities
– government bonds in the UK
 Industrial shares (equities)
– entitlements to receive corporate dividends
– not very liquid
23.7
Credit creation by banks
 Commercial banks need to hold only
a proportion of assets as cash
reserves
– this enables them to create credit by
lending
 EXAMPLE:
– suppose the public needs a fixed £10m
for transactions
– and the commercial bank maintains a
10% cash reserve
23.8
Credit creation – example
Commercial bank :
Liabilities
Assets
Deposits

Cash Loans Total
Cash
ratio
%
Public
cash
holding
Money
supply
Initial position:
100 10 90 100
Central bank issues £10m extra; the public deposits it
10
10
110
110 20 90 110
1
18.2 10 120
110 11 99 1102 10 19 129
119 20 99 1193 16.8 10 129
200 20 180 200
n
10 10 210
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23.9
The monetary base and the
money multiplier

 The monetary base or stock of high-
powered money
– the quantity of notes and coin in private
circulation plus the quantity held by the
banking system
 The money multiplier
– the change in the money stock for a £1
change in the quantity of the monetary
base
23.10
The money multiplier
Suppose the banks wish to hold cash reserves R as
as fraction (c
b
) of deposits (D), and the private sector
wish to hold cash (C) as a fraction (c
p
) of bank
deposits (D).
Then R = c
b
D and C = c
p
D
Monetary base H = C + R = (c
b
+ c
p
) D
Money supply = C + D = (c

p
+ 1) D
So M =
(c
p
+ 1)
(c
p
+ c
b
)
H
Money supply = money multiplier × monetary base
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Chapter 24
Central banking and the
monetary system
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,
6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
24.1
The central bank
 acts as banker to the commercial
banks in a country
 and is responsible for setting interest
rates.
 In the UK, the Bank of England fulfils

these roles.
 Two key tasks:
– to issue coins and bank-notes
– to act as banker to the banking system
and the government.
24.2
The Bank and the money supply
 Three ways in which the central bank MAY
influence money supply:
– Reserve requirements
 central bank sets a minimum ratio of cash reserves
to deposits that commercial banks must meet
– Discount rate
 the interest rate that the central bank charges when
the commercial banks want to borrow
 setting this at a penalty rate may encourage
commercial banks to hold more excess reserves
– Open market operations
 actions to alter the monetary base by buying or
selling financial securities in the open market
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24.3
The repo market
 A gilt repo is a sale and repurchase
agreement
– e.g. a bank sells you a gilt with a simultaneous
agreement to buy it back at a specified price at

a specified future date.
– this uses the outstanding stock of long-term
assets (gilts) as backing for new short-term
loans
 Used by the Bank of England in carrying
out open market operations
24.4
Other functions of the Bank of England
 Lender of last resort
– the Bank stands ready to lend to banks and
other financial institutions when financial
panic threatens
 Banker to the government
– the Bank ensures that the government can
meet its payments when running a budget
deficit
 Setting monetary policy to control
inflation
– more of this later
24.5
The demand for money
 The opportunity cost of holding
money is the interest given up by
holding money rather than bonds.
 People will only hold money if there
is a benefit to offset that opportunity
cost.
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24.6
Motives for holding money
 Transactions
– payments and receipts are not perfectly
synchronized:
 so money is held to finance known transactions
 depends upon income and payment arrangements
 Precautionary
– because of uncertainty:
 people hold money to meet unforeseen
contingencies
 depends upon the (nominal) interest rate
24.7
Motives for holding money (2)
 Asset
– people dislike risk
– so may hold money as a low-risk component
of a mixed portfolio
 depends upon opportunity cost (the nominal interest
rate)
 Speculative
– people may hold money rather than bonds
– if bond prices are expected to fall
– i.e. the interest rate is expected to rise
 depends upon the rate of interest and on
expectations about bond prices
24.8
The demand for money: summary
 The demand for money is a demand

for real money balances
 It depends upon:
– real income
– nominal interest rate (the opportunity
cost of holding money)
– the price level (currently assumed fixed)
– expectations about future interest rates
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24.9
Money market equilibrium
Real money holdings
LL
Other things being equal,
the demand for real money
balances will be lower when
the opportunity cost (the rate
of interest) is relatively high.
The position of this
schedule depends upon
real income and the price
level.
When money supply is L
0
, money market equilibrium
occurs when the rate of interest is at r
0
.

L
0
r
0
24.10
Reaching money market equilibrium
Real money holdings
LL
L
0
r
0
If the rate of interest is
set below the market
equilibrium – say at r
1
r
1
there is excess demand for
money (the distance
AB)
A B
This implies an excess
supply of bonds
– which reduces the price
of bonds
and thus raises the rate of interest until equilibrium
is reached.
24.11
Monetary control

Real money holdings
LL
L
0
r
0
Given the money demand schedule:
The central bank can
EITHER set the interest
rate at r
0
and allow money
supply to adjust to L
0
OR set money supply at L
0
and allow the market rate
of interest adjust to r
0
BUT cannot set both
money supply and interest
rate independently.
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24.12
Monetary control – some provisos
 Monetary control cannot be precise unless
the authorities know the shape and

position of money demand
 Controlling money supply is especially
problematic
– and the Bank of England has preferred to work
via interest rates
 The situation is further complicated by the
relationship between the interest rate and
the exchange rate
24.13
Targets and instruments of
monetary policy
 Monetary instrument:
– the variable over which the central bank
exercises day to day control
– e.g. interest rate
 Intermediate target
– the key indicator used as an input to frequent
decisions about when to set interest rates
 The financial revolution has reduced the
reliability of money supply as an indicator
– and central banks increasingly use inflation
forecasts as the intermediate target
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Chapter 25
Monetary and fiscal policy in a
closed economy
David Begg, Stanley Fischer and Rudiger Dornbusch, Economics,

6th Edition, McGraw-Hill, 2000
Power Point presentation by Peter Smith
25.1
Bringing together the real and financial sectors
Having seen equilibrium in the goods
and money markets separately,
it is now time to explore the links
between them
and to look at simultaneous
equilibrium in both.
25.2
Consumption revisited
 Income is a key determinant of
consumption
 but other factors shift the consumption
function
– household wealth
– availability of credit
– cost of credit
 These create a link between the financial
and real sectors
– because interest rates can be seen to influence
consumption.
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