2/2/26: Introduction
Overview and Goals
Macroeconomics studies the economy as a whole, focusing on aggregate outcomes rather than individual markets or agents. It is not a simple aggregation of microeconomics due to general equilibrium effects and feedback loops across markets. The goal of the course is macroeconomic literacy: the ability to interpret macroeconomic events, data, and policy discussions using structured economic reasoning.
Modeling Approach
Because the full economy is too complex to model exactly, macro relies on simplified, reduced-form models that capture essential mechanisms rather than full microfoundations. Emphasis is on intuition, trade-offs, and empirical relevance rather than heavy mathematics.
Core Macroeconomic Variables
Key variables that organize macro analysis include:
- Interest rates: intertemporal prices affecting saving, investment, asset prices, and policy transmission.
- Inflation: sustained changes in the price level, central to monetary policy and real vs. nominal distinctions.
- Output and growth: levels and growth rates of GDP, tied to productivity and aggregate demand.
- Labor markets: employment, unemployment, and wage dynamics.
- Exchange rates: relative prices across countries affecting trade and capital flows.
Policy and Global Context
Macroeconomic outcomes are shaped by:
- Monetary policy (interest rates, inflation control).
- Fiscal policy (government spending, taxation, debt).
- Global forces: trade balances, tariffs, capital flows, and cross-country growth differences.
Real-world examples (e.g. Japan, China, global inflation episodes) motivate why macro models matter.
Technology and Growth
Technological change (including AI) affects productivity and aggregate demand, but its macro impact depends on adjustment frictions, labor markets, and policy responses rather than technology alone.
2/4/26: Basic Macroeconomic Concepts
Aggregate Output and GDP
National income and product accounts were developed at end of WW2 to measure aggregate output. Main measure of aggregate output is called GDP or Gross Domestic Product.
Suppose an economy has two firms and goods:
Steel is an intermediate good, or a good used in production of another good.
Methods to calculate GDP
- GDP is the value of all final goods (and services) produced in the economy during a given period. Hence, in this example, GDP would be \boxed{\$200}. This is good as our calculation is invariant to changes like merging firms.
- GDP is the sum of value added in the economy during a given period. VA from steel: \$100; VA from Car: \$200-\$100=\$100. Sum of VA = \boxed{\$200}.
- GDP is the sum of income in the economy during a given period. Wages = \$80+\$70 = \$150; Profit = \$20+\$30 = \$50; Sum of incomes= \boxed{\$200}.
Nominal GDP vs Real GDP
Nominal GDP is the sum of quantities of final goods produced times their current price. However, production and price increases over time. So, real GDP is the sum of quantities of final goods times constant price.
- We denote nominal GDP by $\$Y_t$ and real GDP by $Y_t$.
Chained Real GDP reduces the impact of which year is chosen as base. It utilizes a chain-weighting method to update price levels annually.
Volatility
Long-run trends in nominal vs real GDP. Grey regions signal recession periods.
Employment, unemployment, labor force participation
Employment is the number of people with a job: $N$. Unemployment is the number of people who do not have a job but are looking for one: $U$. The labor force is the sum of the employed and the unemployed: $L$.
The unemployment rate is the ratio of the unemployed to the labor force, or $\frac{U}{L}$.
Current Population Survey (CPS) surveys households to compute unemployment rate.
Note:
- Those that do not have a job and are not looking for one are counted as not in the labor force.
- Discouraged workers are those who give up looking for a job and so no longer count as unemployed.
- Participation rate is the ratio of the labor force to the total population of working age
Inflation rate
Inflation is a sustained rise in the general level of prices, the price level $P_t$.
The inflation rate is the rate at which price level increases:
\[\pi_t = \frac{P_t - P_{t-1}}{P_{t-1}}\]Deflation is a sustained decline in price level: $\pi_t < 0$.
The GDP deflator is one measure of $P$:
\[P_t = \frac{\$Y_t}{Y_t}\]Another is the CPI, or Consumer Price Index, which measures cost of living.
2/9/26: The Goods Market
Motivation: Short-run equilibrium output
We will study how equilibrium output is determined across the short run, medium run, and long run. In the short run, the key mechanism is the feedback loop between aggregate demand, production, and income:
- Changes in demand $\to$ changes in production
- Changes in production $\to$ changes in income
- Changes in income $\to$ changes in demand
Short run assumption: output is demand-determined (prices sticky).
Aggregate Demand (GDP) decomposition
Aggregate demand is the total demand for goods and services:
\[ Z \equiv C + I + G + X - IM \]Closed economy simplification (for now): set $X=IM=0$, and ignore inventory investment, so
\[ Z \equiv C + I + G. \]Interpretation of components:
- Consumption $C$: goods/services purchased by consumers
- Investment $I$: nonresidential + residential investment
- Government spending $G$: government purchases of goods/services (excludes transfers)
- Exports $X$: foreign purchases of domestic goods/services
- Imports $IM$: domestic purchases of foreign goods/services
Behavioral assumptions in the goods market
We separate exogenous policy/decisions from endogenous behavior:
- Exogenous: $I = \bar I$, and fiscal policy variables $G, T$
- Endogenous: $C = C(Y_D)$
Disposable income:
\[ Y_D \equiv Y - T. \]The consumption function
Assume a linear consumption function:
\[ C = c_0 + c_1 Y_D = c_0 + c_1(Y - T). \]Definitions:
- $c_1$ = marginal propensity to consume (MPC): extra consumption from \$1 more disposable income.
- $c_0$ = autonomous consumption: captures omitted factors (e.g., wealth, sentiment).
Equilibrium condition in the goods market
Start from the definition of demand (closed economy):
\[ Z = C + I + G. \]Substitute the functional forms:
\[ Z = c_0 + c_1(Y - T) + \bar I + G. \]Goods market equilibrium: production equals demand:
\[ Y = Z. \]Important: this is an equilibrium condition (not a behavioral “function”), and in the short run output adjusts to demand.
Solving for equilibrium output and the multiplier
Solve:
\[ Y = c_0 + c_1(Y - T) + \bar I + G \] \[ Y - c_1 Y = c_0 - c_1 T + \bar I + G \] \[ Y = \frac{1}{1-c_1}\left(c_0 - c_1 T + \bar I + G\right). \]The term
\[ \frac{1}{1-c_1} \]is the multiplier. Intuition: when $c_1$ is larger, an initial increase in demand raises income more, which feeds back into more consumption, amplifying the total effect.
Multiplier as an infinite series (round-by-round amplification)
Example logic: an initial $\$1$ increase in autonomous spending raises output/income, which raises consumption by $c_1$, which raises income again, etc. This becomes:
\[ 1 + c_1 + c_1^2 + c_1^3 + \cdots = \frac{1}{1-c_1}. \]Alternative equilibrium view: Saving = Investment (IS relation)
Define private and public saving:
\[ S \equiv Y_D - C = Y - T - C, \qquad S_G \equiv T - G. \]Goods market equilibrium implies:
\[ I = S + S_G = (Y - T - C) + (T - G) = Y - C - G. \]This is the IS relation interpretation: equilibrium output is the level of $Y$ that makes investment equal total saving.
Paradox of Saving
Key short-run warning: “thrift” isn’t always expansionary in the short run. If desired private saving increases (i.e., for a given income, people consume less), then demand falls; to restore equilibrium, output $Y$ falls. So an attempt to save more can reduce income enough that actual saving may not rise as intended.
Lecture 4: The Financial Markets
Overview
Lecture 3 covered fiscal policy (e.g. a $\$$1B increase in $G$). Lecture 4 introduces monetary policy: how the central bank influences aggregate demand through financial markets. Monetary policy is the main anti-cyclical tool in the short run (fiscal policy is slower); in the medium/long run it determines the price level and inflation.
Federal Reserve (U.S. central bank)
- Board of Governors: 7 members, DC, appointed by President and confirmed by Senate.
- 12 Regional Federal Reserve Banks.
- FOMC (Federal Open Market Committee): Board plus 4 Regional Bank presidents (rotating votes)—sets the policy rate.
Demand for money (simplified portfolio)
We reduce the complexity of financial markets to two assets:
- Money: used for transactions; pays no interest (currency + checkable deposits).
- Bonds: pay interest rate $i$; cannot be used for transactions.
Trade-off: more money $\Rightarrow$ more liquidity, less interest; more bonds $\Rightarrow$ more interest, less liquidity. At the aggregate level:
\[ M^d = \$Y \cdot L(i), \qquad L'(i) < 0. \]So money demand increases with nominal income $\$Y$ and decreases with the interest rate $i$.
Equilibrium interest rate (simple case: no banks)
Central bank supplies a fixed amount of money: $M^s = \bar{M}$. In equilibrium:
\[ M^s = M^d \quad \Rightarrow \quad \bar{M} = \$Y \cdot L(i). \]- An increase in money supply $\Rightarrow$ lower $i$ (more money, lower opportunity cost of holding it).
- An increase in nominal income $\$Y$ $\Rightarrow$ higher $i$ (demand for money shifts right).
In practice, most central banks choose the interest rate and then adjust the money supply to achieve it (interest rate targeting).
Liquidity trap
Zero lower bound (ZLB): the nominal interest rate cannot go (much) below zero. When $i \approx 0$, the economy is in a liquidity trap: expansionary monetary policy becomes ineffective (increasing $M$ no longer lowers $i$).
Open market operations
Central banks change the money supply by buying or selling bonds in the bond market:
- Expansionary open market operation: central bank buys bonds $\Rightarrow$ increases $M$.
- Contractionary open market operation: central bank sells bonds $\Rightarrow$ decreases $M$.
Bond prices and the interest rate
Suppose a bond pays $\$100$ in one year and nothing before. If its price today is $P_B$, then
\[ i = \frac{\$100 - P_B}{P_B}. \]So: higher bond price $\Rightarrow$ lower $i$; higher $i$ $\Rightarrow$ lower bond price today.
Equilibrium with financial intermediaries (banks)
- Banks: financial intermediaries; liabilities = checkable deposits (money); they hold reserves (deposits at the central bank).
- Central bank money (monetary base / high-powered money) $H$: liabilities of the central bank.
If people hold no currency, money demand is demand for checkable deposits: $M^d = \$Y L(i)$. Banks' demand for reserves is a fraction of deposits:
\[ H^d = \theta M^d = \theta \cdot \$Y \cdot L(i), \]where $\theta$ is the reserve ratio. Equilibrium: $H = H^d$. The federal funds market is the market for bank reserves; the federal funds rate is the rate in that market and is the main monetary policy rate—the Fed controls it by changing $H$.