UNIT 1

1. The GDP.
- The total production of an economy in a given period .
- Computed using both official administrative data and statistical data.
Main aim  summarize all the data provided by showing the total production in dollars (or the
corresponding currency).

There’re two main ways of studying the GDP.

The Circular Flow Diagram shows us how can we compute in the both ways having the same result. That’s
because both are the same. In other words,
1.1. Production side  supply side.
The only elements that generate value are the capital and the labour.

- There’s an inelastic aggregate supply in the long run. Then the aggregate demand it’s not necessary in
the long run because the production is totally determined by the aggregate supply. There’s a moment
in the long that even if the prices increase, the economy as a whole decide not to produce more.
Because the marginal costs will increase so much that the firms won’t find worth to produce more. The
supply can’t change because of price change but because of other factors.

1.1.1. From micro to macro.

Marginal costs increase with output. In order to study the reaction of the firm to prices it’s essential to
study the marginal costs.
P ( j)
P

Then, we know that at the non-aggregate level, firms increase their production as prices increase. But not
in the aggregate long-run level.

This happens because each individual firm know that if the aggregate prices increase, the aggregate costs
will increase. Then it’s not worth to produce more

1.1.2. The classical dichotomy.

With flexible prices  real variables are determined on the supply side.
a) REAL VARIABLES.
- Not determined by the amount of money in circulation  changes in money doesn’t affect to
household’s and firms decisions.

b) Real wages, rental cost of capital and output  determined on the supply side.

c) Real interest rate  determined by decisions regarding investment and saving.

d) Nominal variables  determined by the amount of money. CPI and the quantity of money have a
negative relation (if one rises, the other falls).

1.1.3. The aggregate supply.

Connects the price level and the amount of goods and services willed to be produced in an economy.

a) Production function  determined by the amount of goods and services available.

b) Technological progress  depends on the amount of knowledge accumulated in the society.
c) Factors markets  amount of inputs used as the firm’s decisions regarding them.

1.1.4. Production function

It represents the relation between the outputs and the quantity of inputs used.
Y =F ( A , K , L)
- K and L represent the amount and capital used. Intermediate inputs aren’t included in the
production function.
- A  represents the “state of the art of technological knowledge.
Theoretically the technology is constant but it’s important to know that the technology is always
changing. The changes in A are the ones that determine most of the changes in the production.

Here we can see that there’re diminishing returns to scale of the labour. That’s, three’s a moment that if
we increase the quantity of labour, the production rise in a lower quantity than labour.
Firms hire workers till the next unit of labour will be profitless.
Competitive firm’s demand for labour is determined by:
P·MPL=W
W
MPL=
P
According to this we assume that the marginal product labour is equal to the real wage (ratio that
measures the relation between the labour and output price.
Basic assumptions regarding the production funciton.
a) Constant returns to scale in many production funcions.
b) Marginal returns to scale of the labour market.
- If one factor increases the production will increase but it will increase in a lower level as the second
derivative is negative.
c) Capital and labour are cooperative factors  both rise at the same time.
d) Resources are supposed to be fully used

It’s important to know that technology is not bad for labour, but it’s good. However, it’s true that there’s
technology such as robots that can substitute labour, nevertheless we’ll only consider the labour-friendly
technology.

1.1.5. The labour market and the capital market .

The essential elements here are the output price according to the wage that workers have been hired and
the rental cost capital.

Firms decide the quantity of each factor of production taking into account the profits they might get with
them. Represented on the following equation.
Profit=PF ( K , L )=WL−RK
a) Labour market.
How do firms decide how much labour they need? Both firms and workers consider the real wages. Then
if there’s a change in prices but the nominal wage adjusts to it, there won’t be any changes on the quantity
of labour.

We have to consider that the downward sloping of the curve if because of the marginal productivity of
labour.

Regariding the demand of labour, it’s important to know that the higher the prices are the less quantity of
demand will be. On the other hand, regarding the supply of labour, the higher the prices are the higher the
supply will be.

It’s important to consider the marginal product of labour (extra unit of output by getting an extra unit of
labour). Most of them diminishing marginal returns
b) The Capital market.
We have the same case as in the labour market. Changes in overall prices doesn’t affect to the quantity of
capital then to the real rental cost if the nominal rental cost adjust to the price level.

The labour and capital market tend to be in an equilibrium price as all markets do. In the long-run
economies tend to move to that equilibrium in order to reach the condition of the full-employment.

MARGINAL PRODUCT OF CAPITAL

The best way to decide how much capital to rent.
Shows how an extra cost in capital increases revenues.
It’s subject to diminishing marginal returns.
In order to reduce at maximum that diminishing return, we’ll have to consider the real rental price of
capital.
R
MPK =
P

1.1.6. The aggregate supply.

Inelastic supply in the long run

- It doesn’t worth the increase of the production.
- As production rises there’s a point in which
Marginal revenue increase = marginal cost increase
It doesn’t worth to produce more quantities even if there’s an increase in the price
Shift changes
Change in productivity or labour/capital supply  sifts to the right.
1.2. GDP income.
The value of all goods and services produced in an economy must be equal to the total income
PY =WL+ RK +economic profits
The income is distributed among the marginal contribution of capital and labour and the aggregate profits.
Then, if there’s any change in the production, that change will be also reflected on the income.
.

Profits
Y =MPl∗L+ MPk∗K +
P
The capital income is the competitive return of the capital owners.
Y =C + S+T
With constant returns to scale, the payment of the factors of production exhausts total output.
F ( K , L )=( MPL·L ) +(MPK·K )

1.2.1. The three uses of income.

It comes from 3 resources.
Y =C + S+T
Then we know that households obtain a compensation for offering their labour and firms get the profits
after selling their products/services.

1- To pay taxes  disposable income = Y-T

2- Purchase goods and services  consumption
3- Accumulate for the future  savings.

1.3. Spending.
1.3.1. Income and spending.
Aggregate output=aggregate income earned

Thus  household’s income = consumption. But that’s not the reality.

- Households allocate part of their money on savings and taxes.

Total spending=Y =C+ I +G

a) Consumption  what households spend their money on.
- The most important variable here is the disposable income (Y-T) = income after taxes.

- We analyse it by using the MPC (marginal propensity to consume). It shows how my consumption
increases as I earn 1 euro more
It’s the slope of the Consumption Function.
dC
MPC=
dY

b) Investment.
Carried out by both households and firms.
1- Firms  using the non-distributed profits to increase or replace the existing capital.
2- Households  acquiring houses (the rest is just consumption).

Interest rate  establishes the quantity of investment in the funds market.

- Real interest rate: nominal interest rate corrected for the effects of the inflation (key variable in this
case).
- Prospects of future profits: it’s also an important variable. Generates shifts of the investment function
curve

If there’re any financial crises most of time is not a lack of saving but lack of investment which generate an
increase of the interest rate.

The interest rate has also an impact on consumption and savings.

c) Public spending.
Two types of government spending.
- Government purchases  the acquisition of different goods and services in order to offer them to the
citizens.
- Government transfers  even if they are an expenditure, they aren’t considered as that because these
payments aren’t. done in exchange for some economy outputs.
However, there’s an effect on the demand of goods and services as they generate a leftwards shift of
the goods and services demand (negative taxes). Then, they may generate.

Assume G as an exogenous variable  given variable whose changes don’t depend on the market
functioning but on the government policies.
The budget equilibrium (G=T).
- Budget deficit: G>T
- Budget surplus: G<T.

1.3.2. Aggregate demand.

Y D=C (Y −T )+ I ( r ) +G
Keep in mind that this shall be equal to the aggregate supply.

1.4. Aggregate supply and demand.

Interest rate  determines the equilibrium both in the economy’s output market and in the loanable
funds market.

a) The supply and demand for the Economy’s output.

- Y =C + I + G
- C=C ( Y −T )
- I =I ( r )
- G∧T →exogenous variables
The interest rate has a key role. If r increases  investment decreases  demand for output falls
At the equilibrium interest rate, the demand for goods and services equals the supply
b) The Supply and Demand for Loanable Funds.
This market represents how the interest rate adjustment ensures the goods market equilibrium
R is the variable that determines that savings and investment are the same.
- Better to define the interest rate not as the price of money but as the price of time or the price of
loans.

THE SUM OF TOTAL SAVING MUST BE EQUAL TO TOTAL INVESTMENT

We can see here that the financial market provides equilibrium to the goods and services market.
- Affect part of the income to households they withdraw it form spending (S+I) and its transferred to
other agents with no income that spend it too (G+I).
- Demand and Supply equilibrium is equal to the saving investment equilibrium. The supply doesn’t
have such a high dependence but the demand does

The real interest rate can also affect the consumption/saving decision .
a) Reduction in public savings
Change in public deficit then government funds will change

Here we can see that if there’s a rise in the public spending and a reduction of taxes there’ll be a rise in the
interest rate generating a fall of the Investment.
It’s important to know that a rise of the deficit in the short run can be good in the way to solve some
economic problems in order to rise the aggregate demand. However, this increase of the deficit must be
compensated afterwards because deficit can be good in the short run but harmful in the long run.
2. Closed vs open economy.
Is there any change if the economy is open or closed?
- GDP: from the production side, everything is the same, because we have to take into account the goods
are produced in the country not abroad. Form the income side, it’s exactly the same. From the
aggregate demand side there’s a change that we’ll analyse later. We have to consider that the
aggregate demand is not only formed by our goods but also by foreign goods imported inwards.

Then in an open economy the aggregate demand should be written in a different way:
Y =C d + I d + G d + EX
d m
C =C−C
Id = I – I m
Gd = G – Gm
3. The open economy.
The overall amount of investment in the way we increase the amount of deficit we increase in the
international worldwide trade. When you have a trade deficit is because someone is lending more to you
then you have more funds to spend.

3.1. Main features of the open economy.

a) There’s not a dependence of the domestic economic conditions.
b) The financial market is gonna be more complex.
c) Our economy is gonna be a smaller economy. That’s we have to assume that our economy is small
enough that the financial decisions that we make don’t affect to the world interest rate.

3.2. Small open economy.

We have to assume that we trade with assets in this kind of economy. Then,

3.3. The net exports.

3.4. The fiscal policy in the open economy.

a) Domestic fiscal policy  increase in public spending or a tax cut.
- Increase in G  reduction of the savings and supply of domestic currency in the financial market.
That’s, the national currency becomes more expensive net exports fall because the real and nominal
exchange rate appreciates.
b) Foreign fiscal policy  increase of foreign public spending ( ΔG*) tax cut ( )
- Rise in G: increase in the world interest rate reducing the domestic investment, generating an
appreciation of the real exchange rate and an increase of the net exports.
It’s important to know that the net exports of the rest of world will decrease while our net exports will
increase
Moreover, there’ll be a reduce of the of the Investment (I(r*), thus, the reduction of foreign total
savings increasing the scarcity of the foreign currency, appreciating the real exchange rate.

3.5. Public and trade deficits.

The reduction of public savings doesn’t necessary imply a reduction of public investment. That’s because
the country can borrow in the international capital market.

- Do just in case the economy is prepared to. That implies an increase of trade deficit, thus it can affect
the economy in the middle run.
- Fiscal deficits generate an undermine of the countries position by reducing the investment or
worsening the competitive position of domestic firms.
3.6. Investment.

4.