NATIONAL INCOME AND PRODUCT ACCOUNTS (NIPA) Life Cycle Hypothesis: To see where economy is today

Gross Domes8c Product (GDP) Impact of r on S

Measure of total economic ac8vity in a given year (NEWLY produced G&S) 1. Subs8tu8on effect (dominates) – Opp Cost of
1. Product Value added approach: ∑Mkt. value of FINAL goods and services NEWLY consumpDon today ­. That is, I will have more
produced in the market by domesDcally located capital & labor during the Yr. purchasing power tomorrow if I save today. Hence Sav­
• GDP = ∑ Value added by all G&S 2. Income effect: Since r­, can save less today & earn
• Value Added = Final Revenue - Cost of Intermediate Goods the same amt. tom., so Sav. ¯
• Avoids double coun8ng of intermediate goods
• Intermediate G&S: Used up in the producDon of other G&S in the same period Impact of G on S
that they themselves were produced. • ­ G à ¯S & ¯C ; (C declines < G)
• Capital Goods: itself produced & is used to produce other goods; but NOT USED • Temporary Inc. change, consumpDon no change
UP in the same period as produced. Eg. Lathe Machine, Roads, airports, telecom • Permanent changes, consumpDon changes
networks, factories, IPs, goods produced out of R&D, SoUware, IT, Banking Serv.
Investments: In eqm : MPL = W/P = w; MPK = R/P =r
2. Expenditure Approach: GDP as spending by ulDmate users of the final G&S during • Firm employs capital Dll the MPK equals real rental rate (r); r = cost of capital
the year. • Desired I = (Desired K – Current K) + Deprecia8on
Y = C + I + G + NX C = ∑ ConsumpDon; I = ∑ Investment in Capital Goods
As desired K ↑ à I ↑ ; Note: K is a stock variable, I is a flow
G = ∑ Govt Spending; NX = ∑ Net Exports
3. Income Approach: Accounts for GDP by how factors of producDon (L&K)are
compensated/ addiDon of income earned by firms, labour, govt. When r is less, investment is more;
i. Na8onal Inc. = Comp. + Proprietor’s Inc. + Rental Inc. + Corp. Profits + Net Int. firms can raise more capital at
lower cost of capital
ii. Net Na8onal Product = NI + Indirect taxes (excise, GST)
iii. GNP = NNP + Dep.; Dep = value of capital goods dep in the yr GNP is measured
iv. GDP = GNP - NFP; *Sta8s8cal Difference = Exp. Approach GDP – Income
Approach GDP Cost of Capital
Data for Exp Approach/ produc>on approach is combined from various sources • No Arbitrage condn: r = MPK – d
• MPK = r + d (Determines the desired capital stock)
Gross Na8onal Product (GDP) • Due to d, we will stop invesDng < in case there was no d
Value created by factors of producDon (K & L) owned by country’s ciDzens wherever
the factors are located Capital Market Equilibrium
* DisDncDon for GDP & GNP imp. for countries with many ciDzens working abroad • r has to ¯ for household savings to ¯ in eqm
e.g. Japanese cars made in US – US GDP not GNP • r is determined in eqm by household Supply of S & Firms Demand of I
US company makes road in Saudi – US GNP not GDP • Eqm can shift, if demand/supply curve shifts:
• GDP = GNP - NFP • S shifts with G (­ G à ¯S)
NFP = Net Inc. earned from Foreign Assets (NIFA) = Inc. from abroad – Inc. sent • I shifts with tech innovation (­ MPK)
abroad = Inc. paid to domes>c factors of prod. by rest of the world – paid to • Crowding out:
foreign by domes>c economy

Real GDP vs Nominal GDP

• Real GDP values O/P @base year prices. Picks up ­in GDP coming from higher Qty
If Govt borrowing ­, Pvt Sector
of G&S, rather than higher prices.
cannot borrow because cost of
borrowing ­
• Nominal GDP values O/P @current prices
ECONOMIC GROWTH
• Price index = e.g. GDP deflator (calc Qtrly) Production Function: Y = AK0.3L0.7; Diminishing returns: K or L doubled, O/P < doubles
• Infla8on: Y-o-Y growth rate on price level Productivity Shocks: Unexpected changes in A

Growth Accounting (process of acc. for economic growth)

• ΔY/Y = ΔA/A + 0.3(ΔK/K) + 0.7(ΔL/L) => ΔA/A =ΔY/Y -0.3(ΔK/K) -0.7(ΔL/L);
• A = Total Factor Prody; includes all activities that ­productivity e.g. R&D, tech, etc.
• ΔA/A is the TFP growth rate. Captures growth in output over and beyond what can
be accounted for by measurable inputs. Backed out as a residual

Labor Productivity: Al=Y/L, and its growth is: ΔAl/Al= ΔY/Y -ΔL/L
Given Y = AK0.3L0.7. => Al=Y/L = A(K/L)0.3
Real vs Nominal Interest Rates r = i - p = R - p; r = Real, R or i = Nominal • Al can increase due to increase in TFP (Pure Tech Growth) or in capital per labor
• Real interest rate measures by how much has the purchasing power of the asset ­
SOLOW MODEL
Limita8ons of GDP: a) Some underground and informal acDvity b) DepleDon of natural
resources, environmental degradaDon c) Homemakers contribuDon d) Human capital
formaDon e) UN agempts at reforms (HDI: Human Development Index)

SAVINGS & WEALTH

Use of Pvt Sav : To

fund I or CA Def or BD
• When CA > 0, NX +
NFP >0
Money Recd > Paid
Country has extra
savings that can be Steady State (SS):
• Long run position of the economy such that Δk=0 (i.e. i= δk)
used for lending or • Investment is sufficient to cover depreciation
investments abroad. Equilibrium depends on savings rate
• If BD is high, Pvt
Savings will fund • Growth Dynamics: No matter where an economy starts, it will end up at k*. If k <
Govt’s deficit. k*, i(=sy)>d, & capital stock (and output) ­ till you approach k*.
• If k > k*, i(sy) < d, & capital is wearing out faster than it is replaced, and CS ¯ till you
approach k*. Steady state never reached in finite time but useful for long run
• Why Save? – ConsumpDon Smoothing & PrecauDonary Measures • Sustained growth requires sustained tech. progress: A­, y­, sy­, Steady State­
Consump(on Smoothing: Savings (=Inv.) are more vola>le. GDP fluctuates, C will • Convergence: Solow Model predicts convergence in per capita GDP
also change but < GDP as some needs s>ll prevail. => Sav change by larger amount • LimitaDons: Diff countries have diff steady states, Convergence holds within subsets
x MONEY, INFLATION, BANKING SYSTEM, MONEY CREATION NEUTRALITY DEBATE & MONETARY POLCY
• Money – Any asset used as Medium of Exchange, unit of account & store of value
• Measures: CU, M1(CU + demand & checking depo), M2 (M1+ saving + time depo) Keynesians (Phillips ) Classical Economists (Phelps, Lucas)
• Central Banks create money - ↑Money supply – Buy govt. bonds with new
money; ↓ supply – Sell govt. bonds for currency-open market sale Money is Non-Neutral in short run (not long-run) Money = Neutral in short run
• Change in Nominal Qty (M or i) affects a Real Qty • Change in Nominal Qty (M or i) affect Nominal
(O/P, Inv., Consumption, economic activity) Prices only
• Quantity Theory: • M ↑ à Inf↑ à P↑ à Economic growth ↑ • Instead of adaptive expectations, people have
• Assumes labour doesn’t demand ↑ wages with rational expectations => demand ↑ wages
↑M (=> W is same) with ↑M (=> W↑)
• ↑M à Disposable Inc ↑, Demand of G&S ↑, • ↑M à Disposable Inc ↑, Demand of G&S ↑,
Sales ↑, P↑, with more P Co employs more L, L Sales ↑, P↑, W ↑, L does not increase
↑, employment ↑, GDP↑ • Feel Govt. is not doing anything
• Demand Govt. interventions: exploitation of • Relation between unanticipated inflation (π- πe
inflation-unemployment tradeoff. M↑ during & cyclical unemployment (u – u)
recessions & M↓ during booms

PHILIPS CURVE
• -ve relation b/w inflation & unemployment

• Short run : Non-Neutral

• Long run : Neutral
• Neutrality of Money: Changes in M have no real effect on economy in long run • 1970s – Stagflation (Inflation inc, wages inc, no
change in u)
• Clear separation of M & real variables – O/P, Unemployment & Economic Growth CLASSICAL RESPONSE
SUMMARY
Interest And Money Demand: Md / P = L(i,Y). => Md/P = M/P = L(r + πe, Y) Clear evidence on long-run neutrality of money. All
economists agree on LR neutrality.
• Md depends on i (=Opp cost of holding 1$ cash) i ­à L↓ à Md ↓ Evidence on short-run non-neutrality is mixed.
• Y­ à L­ (more transactions require more money), • Keynesians believe in evidence, advocate
• Future M ­, πe ­, i ­, Md/P¯ but M is fixed, thus P ­ (What RBI does tomorrow exploitation of inflation-unemployment
tradeoff
affects prices today i.e. inflation) • Classical economists feel it is futile to try to
exploit non- neutrality even if it exists
Fractional Reserve Banking: Maximum Money Creation = (1 / res) x Dep
• A dollar injected becomes: 1 + (1-res) + (1-res)2 + (1-res)3+ ... = 1/res ; res = x%
Since 1/res > 1, Banking system creates money not wealth
Central Bank Commercial Banks

Assets Liabilities Assets Liabilities

Government Bonds Currency Res @ Central Bank Deposits

Res held by banks Loans

• m is a factor
of mkt forces
• Base is
controlled by
RBI

Money Supply is affected by:

• BASE: Directly controlled by the Fed. High BASE, High M
• res: Low res à high m. Fed policy & bank behaviour determine res Central Banking
• cu: Low cu à high m. Determined by household & firm behaviour Case for rules (Central bank follows a set of simple, pre-specified, & announced rules)
• Even if money non-neutral, long lags (~quarters) before policy takes effect (trickle-
Bank Failure / Run: cu ­ à res ­ (loans ¯ ) à m ¯ à M ¯ down effect); will destabilize economy (it’s hard to judge what policy actions are
• As people withdraw deposits, cu ↑, Banks hold excess reserves, res needed to hit the inflation target and hard for the public to tell if the central bank is
• As M¯, No Buyers, People are willing to sell for less, P ¯, CPI ¯ à Deflation doing the right thing, so central banks may miss their targets, losing credibility)
• Monetary Policy has a role in controlling wide-spread bank run: If Fed ­BASE, M­ • The Bank cannot be trusted to act prudently when it is under political pressure
even though m¯ • Forcing the Bank to keep its promises will increase credibility in monetary system

Hyperinflation:
More independent banks are, lower is the infla8on; India 4% ± 2%
• Very high level of inflation (>= 50% per month)
• Over reliance on printing money to cover operations Taylor rule
• Costs of high inflation: Allows the Fed to take economic conditions into account
• Huge costs involved with economizing on cash holdings
• Makes it hard for customers to shop around for best prices and distorts
efficient resource allocation (Prices change too fast)
• i = Nominal Fed funds rate,
• Redistributes wealth from creditors to debtors
• π= inflation rate over the last 4 quarters,
• y = % deviation of output from full-employment output

The Taylor rule

• The rule works by having the real Fed funds rate (i – π) respond to:
• y, the difference between output and full- employment output
• π – 0.02, the difference between inflation and its target of 2 percent
• If either y or π increase, the real Fed funds rate is increased, causing
monetary policy to tighten (and vice- versa)