Macroeconomics

Week 2

Demand side approach

Gross Domestic Product (GDP): is the market value of all final goods and services
produced within a territory in a given period of time.

To measure the GDP it is not necessary to measure the components of the products
fabricated because they are taken into account when a company buys them to build the new
goods. Second hand goods are not taken into account to measure the GDP because they
are part of a past economy. The only thing taken into account are the services given by
people or the products that have been produced that year.

Spanish Gross National Product (GNP): market value of all final goods and services
produced by Spanish citizens, regardless of their current location.

Net Domestic Product = GDP - Depreciation

GDP = C + I + G + X – M
C Private consumption: the goods and services bought by households(non-durable, durable goods
and services).
I Investment: consists of goods bought for future use (business fixed investment, Residential
investment, Inventory investment).
Investment = Gross capital formation = Gross Fixed capital formation + Change in Inventories
G Government public expenditure: are the goods and services bought by the Government (the
military and public goods and services).
Government expenditure = Government consumption + social transfers
NX Net exports: value of goods and services sold to other countries (exports) minus the value of
goods and services that foreigners sell us (imports). NX=X-M
X Exports: produced within the territory. It has a direct effect on GDP (it makes it higher).
M Imports: not produced within the territory. Purchase of imports has no direct impact on GDP.

Supply side approach

Gross Domestic Product: is the aggregated added value of the firms in a territory during an
specific period of time

GDP = GVA (Primary Sector) + GVA(Secondary Sector) + GVAR (Tertiary Sector) + Net Taxes

Sum of Value Added of all firms = Gross Value Added (GVA) GDP = GVA + net indirect taxes
(V.A.T)
Income approach
Gross Domestic Product: total income earned thanks to the production factors in a territory
during an specific period of time
GDP = Compensation of employees (salaries + social contributions) + Operating surplus +
Net indirect taxes
● Compensation of employees: total remuneration, in cash or in kind, payable by an
employer to an employee
● Operating surplus: It is the surplus generated by operating activities after the labour
factor input has been recompensed (a proxy for post-tax profits). Not only
‘companies’, also self employed.

GDP – Compensation of employees – Net taxes = Operating surplus

Example from the presentation:

Orange Inc. Transactions in € Juice Inc. Transactions in €

Wages paid to employees 15.000 Wages paid to employees 10.000
Taxes 5.000 Taxes 2.000
Revenue from sale of oranges 35.000 Oranges purchased from Orange Inc.
Sold to public 10.000 25.000
Sold to Juice Inc. 25.000 Revenue from sale of orange juice 40.000

Demand 10k +40k -25k (sold to the other company)= 50k

Supply Supply: 35k+40k-25k= 50k

Income 15k + 10k +(35k-15k-5k)+(40k-10k-2k-25k)= 50k

Year 1 Year 2

YEAR 1 YEAR 2 %

GDP: 46000€ - 66000€ 435%

 Computers 5 10 100%

Bikes 200 250 25%

Price euros €

Computers 1200 600 -50%

Bikes 200 240 +20%

Market value €

Computers 6000 6000 -0%

Bikes 40000 60000 -50%

(6000 ÷ 46000)-1 = 34.8%

𝑦𝑒𝑎𝑟 2
𝑦𝑒𝑎𝑟 1
− 1 = 𝑝𝑒𝑟𝑐𝑒𝑛𝑡𝑎𝑔𝑒 𝑜𝑓 𝑣𝑎𝑟𝑖𝑎𝑡𝑖𝑜𝑛

𝑃*𝑄 𝑃*𝑄
𝑃
= 𝑃
=𝑄
Thus, if we divide GDP at Market Prices (P*Q) by Market Prices (P), we would obtain Q
(GDP at Constant Prices).

GDP deflator (P): represents the evolution of prices in the economy (similar to inflation).

𝐺𝐷𝑃 𝑎𝑡 𝑀𝑎𝑟𝑘𝑒𝑡 𝑝𝑟𝑖𝑐𝑒𝑠 (𝑃*𝑄)

𝐺𝐷𝑃 𝑑𝑒𝑓𝑙𝑎𝑡𝑜𝑟 (𝑃) = 𝐺𝐷𝑃 𝑎𝑡 𝐶𝑜𝑛𝑠𝑡𝑎𝑛𝑡 𝑝𝑟𝑖𝑐𝑒𝑠 (𝑄)

Quarter on Quarter growth

The QoQ growth is a useful way to analyze the latest evolution of GDP (economic
momentum). When we talk about the evolution of GDP for a given quarter, it usually means
that we are referring to the QoQ growth rate.
● QoQ only takes into account the actual quarter and the last quarter. That is why
economists also compute the annualized QoQ growth (insight: they want to know
how much a country would grow in a year if the growth was equal to the actual
quarter).
Example:
 𝐐𝐧 (𝐘𝐞𝐚𝐫𝑡)
𝐀𝐧𝐧𝐮𝐚𝐥𝐢𝐳𝐞𝐝 𝐐𝐨𝐐 % =( 𝐐𝐧−𝟏 (𝐘𝐞𝐚𝐫𝑡) ) 𝑎 𝑙𝑎 4 − 1

Year on Year growth

The YoY growth provides a less noisy picture of the evolution of GDP (that is why
economists typically talk about this kind of growth) • It compares the current quarter over the
same quarter one year ago.

Annual growth
Annual growth is the most comprehensive measure, since it takes into account the evolution
of the whole year with respect to last year

GDP is usually expressed in % terms comparing the current quarter over the same quarter
from the year ago. (%YoY = year over year).
Piled Bars (the components of GDP) represent contributions to growth, not growth
● Contribution = Share * Growth
GDP = Compensation of employees (salaries + social contributions) + Operating
surplus + Net taxes
● Two arithmetic “tricks” for working with percentage changes:
-The percentage change of a product of two variables is approximately the
sum of the percentage changes in each of the variables.
-The percentage change of a ratio is approximately the percentage change in
the numerator minus the percentage change in the denominator.

Note: ¡¡¡YoY is taking into account two quarters of different years (with a period of for
quarters between them) and annual is comparing all the quarters of two years.!!!

GDP Deflator
It is a measure of inflation in the prices of goods and services produced in the United States,
including exports. The gross domestic price deflator closely mirrors the GDP price index,
although they are calculated differently.
𝐴𝑛𝑛𝑢𝑎𝑙 𝑦𝑒𝑎𝑟 2−𝐴𝑛𝑛𝑢𝑎𝑙 𝑦𝑒𝑎𝑟 1
𝐴𝑛𝑛𝑢𝑎𝑙 𝑦𝑒𝑎𝑟 1
= 𝐺𝐷𝑃 𝐷𝐸𝐹𝐿𝐴𝑇𝑂𝑅
International measures
Economists measure GDP across countries with a base-100 index.
1. We set 2008Q2 as 100 (the spark of the global financial crisis) , and then we apply
the QoQ% variations to that index.
2. Trick: the last data of Spain is around 105. That means it’s grown 5% since 2008
(accumulated). Germany, on the contrary, has grown three times more
3. PARA CAMBIAR DE UN GDP EN BASE 100 A UNO NORMAL SE HACE UNA
REGLA DE TRES Y VICEVERSA.

Week 3

Saving and investment

Investments can only be paid with your savings, with the help of the Government or with the
help of Others.
-Let’s assume a closed economy: (NX(net exports)= 0)
GDP = C + I + G GDP – C – G = I
Total Savings = Investment
If you can’t ask ‘others’ for help, then the only way you can invest is by saving (either the
private sector or the government).
-Let’s assume an open economy: (NX(Net exports) <> 0)
GDP = C + I + G + NX GDP – C – G = Total Savings
Total Savings = Investment + NX Total Savings - Investment = NX

Trade deficit and capital inflows

When S (savings) < I
A country is using more resources than are available to it from domestic production
alone. A country can do that only by importing goods from the rest of the world.
In fact, the country must import more from the rest of the world than it exports to the
rest of the world, so that on balance it is receiving real resources from abroad.
More imports than exports
𝑇𝑜𝑡𝑎𝑙 𝑠𝑎𝑣𝑖𝑛𝑔𝑠 = 𝑁𝑋 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠 = 𝐸𝑥𝑝𝑜𝑟𝑡𝑠 − 𝑖𝑚𝑝𝑜𝑟𝑡𝑠 + 𝐼𝑛𝑣𝑒𝑠𝑡𝑚𝑒𝑛𝑡𝑠
S < I (negative) = NX (negative) = trade deficit

○ Financing needs: the country needs money from foreign countries to

purchase the rest of goods that it needs.
○ Capital inflows: the money from other countries is entering our
country, allowing us to finance the part of investment that our domestic
savings couldn’t manage.

S < I (negative = financing needs) = NX (negative = capital inflows)

Trade surplus and capital outflows
When S > I
The national output that is neither consumed nor invested is usually exported to
foreigners, in that way many countries export more than they import which means having
positive savings.
S > I (positive) = NX (positive = trade surplus)
○ Lending capacity: a country has a surplus of money that it can use to
finance other countries.
○ Capital outflows: there’s more money flowing out of our country than
coming in - because we already have too much.
S > I (positive = lending capacity) = NX (positive = capital outflows).

The intuition behind Saving and Investment

GDP = C + I + G + X – M + T – T
T: Direct taxes (which are not included in the demand side because they’re not an
expenditure. They have no counterparty)
● Disposable Income = Total Income – Taxes → GDP – T
● Private Savings = Disposable Income – Consumption → PS = (GDP – T) – C
● Government: Surplus (T-G) or Deficit (G-T)
● External sector: Capital inflows (M-X) or Capital outflows (X-M)
● Total Savings = PS + Gov. Surplus = S

As we knew, Investment can only be financed through Private Savings (PS), Public Savings
(T-G) or Capital Inflows (M - X).

Saving-Investment identity
The Saving Identity can adopt various forms, depending on the object of our analysis:
Practical example

In a country where Private Savings is greater than Investment (PS > I), and there’s trade
Deficit (M > X), then:

PS – I = (G – T) + (X – M) G-T must be positive to satisfy the equation

This means that G > T → The Government runs a budget
+ ? - deficit.

Since the private sector savings are higher than investment (PS > I), then it’s the
Government that is reducing the overall savings by running a budget deficit (it spends
more than it receives from taxes).

In a country where Private Savings is greater than Investment (PS > I), and there’s trade
Surplus (M < X), then:

PS – I = (G – T) + (X – M) The sign of G-T is undefined with the current information

+ ? -

-First of all, we know that the economy has lending capacity (X-M is positive: trade
surplus). Which means that S > I (total savings higher than investment)
-Since the private sector savings is already higher than investment (PS > I), then we don’t
actually know what’s going on with the savings of the Government.
-It could be true that there’s a government deficit (G > T), offset by the savings of the
private sector (so that total savings are actually higher than Investment).
-Or the gov. is running a budget surplus (G < T).

Saving and Investment in Spain

Prior 2008 (them happy days),
- Private savings were lower than
investment (PS < I).
- The Government runs a
balanced budget (T ~ G).
- We also had a trade deficit (X <
M). Capital from abroad flooded this
country.
- After the Global Financing Crisis
(2008) and the Debt Crisis (2012) the
situation changed:
- Private Savings is higher than
Investment (PS > I)
 - We became a net exporter country (we now have trade surplus and can finance other
countries, X > M)
- The Government kept spending more, running a budget deficit (G > T).
- Due to austerity measures, G>T has been diminishing over the years.

Saving and Investment in Germany

Since the 2000s, Germany has always had
PS-> I.
- Government balance has been
mostly in deficit until the Sovereign Debt
Crisis (2012). Ever since, Germany has been
focused on running a government surplus.
- Germany is a net exporter country
(X>M), which also means that it can finance
other countries (capital outflows > capital
inflows).

Week 4

Aggregate Supply and Aggregate Demand

What determines GDP?

● Keynes proposed that an economy’s total income (GDP) was, in the short run,
determined largely by the spending plans of households, businesses, and
government (Planned Expenditure).
● The more people want to spend, the more goods and services firms can sell.
● Keynes believed that the problem during recessions was low aggregate demand (low
planned exp.)

Actual Expenditure = GDP = C + GFKF + var.Inv + G

Planned Expenditure f(Planned Cons. Planned Invest. Planned Gov. Exp)

GDP is an accounting framework. It tells you how much output (and hence,
expenditure and income) was produced in a given period of time.
However, before that, there was a planned expenditure: society (households, firms
and the gov.) was willing to spend some specific amount. A.D. is a model (it allows
you to make forecasts).
In this lecture we’re interested in analyzing (with a model) the determinants of
planned expenditure (aggregate demand).
Actual expenditure vs. Planned expenditure
Firms’ production is based on their sales expectations. Since they are not always correct,
they can end up producing more/less goods and services than people are willing to buy
(aggregate demand).
Actual Production (GDP) = Planned Expenditure + Unplanned Expenditure (Inventories)

Imagine that an economy is willing to spend 100b€ on goods and services (Aggregate
Demand). Yet, firms ended up producing 110b€ (GDP), which is more than people wanted,
leaving them with goods unsold, and rising inventories.
GDP = Production = 110 = 100 (Aggregate Demand) + 10 (rising inventories).

This is why actual production (GDP, which takes into account inventories) can be higher,
lower or equal to Planned Expenditure, although it will always be equal to actual
expenditure.
Aggregate Demand = planned expenditure = P.C + P.I + P.G

Planned C = the amount of goods and services that

households are willing to spend.
We don’t know that amount. We only know what they
finally consumed ( C ) . Planned C Planned C depends
on many things. However, there is one variable in
particular that is a really good predictor: Income, and
more precisely, disposable income
(Y – T): income – direct taxes = YD
We refer to the total income of the economy.

Households, at the aggregate level, will be willing to consume more when their income rises.

Aggregate Demand = Planned expenditure = P.C + P.I + P.G

Planned C f(Y-T) → Planned C is a function of

disposable income → The amount of goods and
services that humans are willing to spend
depends on how much they earn.
This is because of many reasons, but above all a
positive linear relationship.
Algebraically: Planned C = intercept + slope*YD
Macroeconomics: Planned C = Autonomous
Consumption + Marginal Propensity to Consume * YD

Autonomous Consumption(c0): It reflects the amount of goods and services that HH

would be willing to spend even if they had no income (basic needs such as food or clothes).
Marginal Propensity to Consume(c’): MPC is the proportion of an increase in income that
gets spent on consumption. MPC is somewhere between 0 and 1. You can’t spend more
than your disposable income (MPC<1).
 Private Consumption = Marginal Propensity to Consume * Disposable Income + Autonomous
Consumption
𝐂 = 𝐂𝟎 + 𝒄 ′ ∗ 𝒀d
𝐏𝐥𝐚𝐧𝐧𝐞𝐝 𝐄𝐱𝐩𝐞𝐧𝐝𝐢𝐭𝐮𝐫𝐞 = 𝐀𝐃 = 𝐏. 𝐂 + 𝐏.𝐈 + 𝐏. 𝐆 = 𝐂𝟎 + 𝒄 ′ ∗ (𝐘 − 𝐓) + 𝐏.𝐈 + 𝐏. d
We have made P.Consumption endogenous to Income = P.C f(Y-T)
The same could be applied to P.I. However, as a matter of simplicity, we’re going to assume
that P.I is just Gross fixed capital formation (it does not include inventories because they are,
by definition, unplanned).
There are two reasons that justify this assumption:
1. Investment represents a small share of GDP in most advanced countries.
2. Investment decisions take more time to materialize (and thus, are less dependent on
current income)
As for P.G, this is pretty fair to assume that it does not depend on income in such a direct
way. Governments can decide to spend more or less due to a recession, but also, because
it’s election year, or because it was promised to their voters.
Thus, we assume I, G and T (direct taxes) as exogenous to income.
𝐀𝐃 = 𝐂𝟎 + 𝒄 ′ ∗ (𝐘 − 𝐓) + 𝐈 + 𝐆

The Keynesian Cross

The Keynesian cross is just the representation of how actual expenditure (GDP) and
planned expenditure (Aggregate Demand) interact.
When GDP = Aggregate Demand (Y*): we plot a 45º line to make viewing easier. We call it
Aggregate Supply.
At equilibrium (Y*), firms don’t need to deplete or
increase their inventories. Firms are producing the
just amount people are demanding.
Actual Production < Aggregate Demand
This situation is unstable: firms need to hire more
workers to increase production (because they’re
running out of inventories). Tus GDP continues to
increase until a level of optimal inventories
(equilibrium)

How to compute Y*

𝐀𝐃 = 𝐀𝐒 = 𝐘 ∗ = 𝟏 /(𝟏 − 𝒄 ′) ∗ (𝐂𝟎 − 𝐜 ′𝐓 + 𝐈 + 𝐆) In practice, we’re going to assume that

the economy is at point Y* (this is,
Autonomous Expenditure production and planned expenditure are
the same), but we're not going to stay
there forever. (nor that we want to).
AD can be moved due to:
1. Demand Shocks: imagine, for instance, the effect of ‘Coronavirus’ in the marginal
propensity to consume.
2. Policy shocks: the Government can decide to increase/decrease public expenditure
or taxes.
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 (𝟏 − 𝒄 ′) ∗ (𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G)
 Let’s suppose marginal propensity to consume (c’)
decreases because people start to watch the news and it’s
all about ‘recession is on its way.
AD’ represents the effect of this negative shock. In the
new equilibrium (Y**), GDP has decreased.
Intuition: if people start to spend less (this is, if they start
saving more) then consumption will be lower, which in turn
will affect the overall Aggregate demand, yielding a lower
GDP.
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 /(𝟏 − 𝒄 ′) ∗ (𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G)
EXAMPLE:
● C0 = 50
● c’ = 0.6
● T = 20
● I = 100
● G = 50
𝐘 ∗ = 𝟏 (𝟏 − 𝟎. 𝟔) ∗ 𝟓𝟎 − 𝟎. 𝟔 ∗ 𝟐𝟎 + 𝟏𝟎𝟎 + 𝟓𝟎 𝐘 ∗ = 𝟏𝟖𝟖 (𝟏 − 𝟎. 𝟔) = 𝟏𝟖𝟖 (𝟎. 𝟒) = 𝟒𝟕0
(1-c’) is known as the marginal propensity to save. It’s the part of Yd that you are not willing
to consume.
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏/ (𝟏 − 𝒄 ′) ∗ 𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G

● C0 = 50
● c’ = 0.6 → 0.7
● T = 20
● I = 100
● G = 50
𝐘 ∗ = 𝟏 (𝟏 − 𝟎. 𝟕) ∗ 𝟓𝟎 − 𝟎. 𝟕 ∗ 𝟐𝟎 + 𝟏𝟎𝟎 + 𝟓𝟎 𝐘 ∗ = 𝟏𝟖𝟔 (𝟏 − 𝟎. 𝟕) = 𝟏𝟖𝟔 (𝟎. 𝟑) = 𝟔𝟐0
● In this example, consumers also feel that the situation is improving and are beginning
to spend more of their disposable income. From 60% to 70%.
● Notice that the intercept has slightly changed.
● That’s why c’ is also in the right hand-side term of the equation.
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 (𝟏 − 𝒄 ′) ∗ 𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G

Keynes vs the Classics

The Classics believed unemployment existed due to an excess of Supply of Labour
When wages are W1, demand for labour (jobs available) is Q2 but supply for labour (people
seeking work) is Q1. There is an excess of supply – unemployment – of Q1-Q2.
Well, you just have to reduce wages to W* (pay workers less), until there is no excess of
supply Q* (thus, no unemployment).

Well, you just have to reduce wages to W* (pay workers less), until there is no excess of
supply Q* (thus, no unemployment).

Keynes, however, believed that the demand for labour depends on the output firms
want to produce.
If wages (part of the income of a country) fall, that means workers earn less, thus reducing
consumption. If consumption declines, AD declines, and firms will cut back production. So,
when wages fall, labour demand falls. That is, the labour demand shifts left, which means
unemployment persists (Q*-Q3).
𝐀𝐃 = 𝐂𝟎 + 𝒄 ′ ∗ ( 𝐘 − 𝐓) + 𝐈 + G

Equilibrium does not mean Full employment.

Keynes conceived a model where equilibrium could be above
or below the output obtained at full employment (Potential
GDP: Ypot).
Full employment does not mean 0% unemployment rate.
Economists believe an unemployment rate of 5% can be
compatible with full employment. Thus, equilibrium and
unemployment can coexist.
If the situation depicted in the graph persists, then there will
always be unemployment.
This is, wages will fall permanently, causing a deflationary gap
(prices will tend to go down).
The same applies if Y*> Y full employment (creating an inflationary gap).
Whether Y* is above or below Y at full employment, Keynes provided the tools to converge
to potential. In this case (Y*<Ypot), we just need to increase AD up to the point where
AD=AS=Ypot.
Government can decide to increase Public Spending 𝐓 + 𝐈 + 𝐆 (G) or to reduce taxes
(increasing Disposable Income). These policies are called expansionary fiscal policies
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 /(𝟏 − 𝒄 ′) ∗ (𝐂𝐨 − 𝐜 ′ T+ 𝐈 + G)

Goldilocks: not too hot or too cold but just right

It’s a hard task to keep the economy at potential This means that our policies to increase AD
can lead to a point where AD > Ypot.
This situation will generate an inflationary gap in the
long-run, which is just as bad as a deflationary gap. The
Government, then, will need to apply contractionary fiscal
policies: reducing Public Spending (G) and or increasing
taxes (reducing Disposable Income).
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏/ (𝟏 − 𝒄 ′) ∗ (𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G)
Great depression
Keynes's explanation helped make sense of the Great Depression of the 1930s, where
unemployment, far from being reduced, actually increased. From the classical perspective,
that situation was impossible. Yet, almost 25% of the US workforce was unemployed.
Keynes’ model (the one we’ve studied), did have the answers: the Aggregate Demand was
very low, and all the Government had to do was to stimulate it.
Keynes' vision of the Economy (the AD) worked really well from the 40s until 1972. In 1973,
the OPEC proclaimed an oil embargo, which made oil prices increase from 3$ up to 12$(
300% increase) . The Economy collapsed (GDP fell), unemployment rate increased (in
response to the loss in activity), but prices did not fall. Actually, they went up. The same
dynamics happened some years later in the second oil crisis (1979).
The AD cannot explain this inverse relationship between prices and activity.
Why? Because that type of inflation wasn’t demand driven. Input costs (oil prices) were
making prices go up. Supply-driven inflation.
Some decades later, the Global Financial Crisis hit the world. Unlike in the previous crises,
unemployment raised (due to the fall in activity) but inflation did not go up (it went down with
activity).
The AD is pulling down prices (and not costs)
In this context, Keynes’ model does have the answers to escape this situation:
● Expansionary Fiscal policies

Week 5
Fiscal policy

Y* is
Whether Y* is above or below Y at full employment, Keynes provided
the tools to converge to potential. In this case (Y*<Ypot), we just need
to increase AD up to the point where AD=AS=Ypot.
Governments can decide to increase Public Spending (G) or to
reduce taxes (increasing Disposable Income). These policies are
called expansionary fiscal policies.
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 /(𝟏 − 𝒄 ′) ∗ (𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + 𝐆)

Expansionary fiscal policy:

Governments can help AD converge to the Potential Equilibrium by increasing public

spending (G). As you can see in the graph, the increase in G (ΔG) is lower than the increase
from Y* to Ypot(ΔY). PURCHASE GOV. MULTIPLAYER
𝚫𝐘 /𝚫𝑮 = 𝟏 /(𝟏 − 𝒄 ′)
Governments can also help AD converge to the Potential Equilibrium by reducing taxes (T).
Likewise, these policies have a multiplier effect. The ratio ΔY/ΔT is called the tax multiplier.
The negative sign indicates that income moves in the opposite direction from taxes. The tax
multiplier is always 1 minus the Government purchases multiplier . TAX MULTIPLAYER
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 /(𝟏 − 𝒄 ′) ∗ 𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G
𝚫𝐘 /𝚫𝑻 = −𝒄 ′ /(𝟏 − 𝒄 ′) = 𝒄 ′ ∗ 𝚫𝐘/ 𝚫𝑮 = (𝟏 − 𝚫𝐘 /𝚫𝑮 )

Taxation
Comparing tax rates across countries is difficult since there are different taxation rates.
Implicit tax rate is obtained by dividing the amount of money collected from a certain tax by
the total value of the category that tax applies for.
● Implicit taxes are needed to compare taxation across countries.
● Total tax collection is also known as tax burden.
● Direct taxes: labour(Social contributions, IRPF in Spain) and capital (Corporate
Income, savings income).
○ Corporate income: impuesto sobre la renta.
○ Savings income:
● Indirect taxes: VAT(IVA), energy, tobacco and other consumption taxes.
In relation to our GDP, Spain collects less indirect taxes than the average of the eurozone.
𝒕𝒂𝒙 𝒐𝒏 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐𝒏/ 𝒄𝒐𝒏𝒔𝒖𝒎𝒑𝒕𝒊𝒐n = percentage of IVA
In Spain, the amount that corporations pay on taxes plus the amount that all the private
sector pays for savings has been higher than the average in Europe.

By using the implicit tax, you can get corporate taxes across countries
Implicit taxes are needed to compare taxation across countries.

In Spain, social security payments by employers are higher than the personal income tax
(IRPF)

Optimal taxation
The Laffer Curve is based on the economic idea that people will adjust their behavior in the
face of the incentives created by income tax rates.
If tax rates reached 100%, all people would choose not to work because everything they
earned would go to the government. Therefore, it must be true that somewhere along the
range there is a maximum point (t*).

In reality, Tax Revenues (T) are not exogenous to

income, as we are assuming in our AD model.
They depend on the tax rate and the total Income
(GDP).
𝐀𝐒 = 𝐀𝐃 = 𝐘 ∗ = 𝟏 (𝟏 − 𝒄 ′) ∗ 𝐂𝐨 − 𝐜 ′𝐓 + 𝐈 + G

𝑰𝒏 𝒓𝒆𝒂𝒍𝒊𝒕𝒚: 𝑻 = 𝒕 ∗ Y
At the end of the day, the Government should apply a taxation scheme that maximizes the
tax revenue without jeopardizing the economic activity.
Fiscal policies take time to implement and their impact on the economy is not instantaneous.
When Governments spend more than they earn, they run a Budget Deficit (G>T). Running a
Balanced Budget is a hard task, and also prevents the operation of automatic stabilizers.
Budget deficits, however, bring about another economic concept: debt.

Week 6
Limits to fiscal policy

Fiscal policies take time to implement and their impact on the economy is not instantaneous.
When Governments spend more than they earn, they run a Budget Deficit (G>T). Running a
Balanced Budget is a hard task, and also prevents the operation of automatic stabilizers.
Budget deficits, however, bring about another economic concept: debt, which is a stock
variable.

Government deficit
● 𝐁𝐭−𝟏 is the Government debt at the end
of year t-1
● 𝐫 is the interest rate on Government
debt at the year t-1
● 𝐆𝐭 is the Government spending during
year t
● 𝐓𝐭 is taxes minus transfers during year t

Transfers are payments made by the Gov. that include welfare, financial aid, social security,
and government making subsidies for certain businesses. They can be interpreted as
”negative taxes”.

—------->

Debt is the accumulation of deficit through time.

 Example:
Previous debt = 100 Current debt = ?
G=9 Current deficit = ?
Tax revenues = 2 Primary deficit = ?
Transfers = 1 Interest expenses = ?
Interest on debt = 2%

𝑩𝐭 = (𝟏 + 𝐫)𝐁𝐭−𝟏 + 𝐆𝐭 − 𝐓t 𝑷𝒓𝒊𝒎𝒂𝒓𝒚 𝒅𝒆𝒇𝒊𝒄𝒊𝒕 = 𝟗 − (𝟐 − 𝟏) = 𝟖

𝑩𝐭 = (𝟏 + 𝟎. 𝟎𝟐 )∗ 𝟏𝟎𝟎 + 𝟗 − (𝟐 − 1) 𝑰𝒏𝒕𝒆𝒓𝒆𝒔𝒕 𝒆𝒙𝒑𝒆𝒏𝒔𝒆𝒔 = 𝟎, 𝟎𝟐 ∗ 𝟏𝟎𝟎 = 𝟐
𝑩𝐭 = 𝟏𝟏0 𝑮𝒐𝒗𝒆𝒓𝒎𝒆𝒏𝒕 𝒅𝒆𝒇𝒊𝒄𝒊𝒕 = 𝑪𝒉𝒂𝒏𝒈𝒆 𝒊𝒏 𝒅𝒆𝒃𝒕 = 𝟖 + 𝟐 = 𝟏𝟏𝟎 − 𝟏𝟎𝟎
= 𝟏0

Debt is a stock variable and needs to be relativised on income.

Debt growth (Gov. deficit) in absolute nominal terms.
Debt growth in relative nominal terms (Y).
Analyzing the evolution of debt growth is key to understanding its sustainability. If the
snow-ball effect is expected to remain positive (r > g), then the debt is not sustainable
Snowball effect: if the interest rate on the debt is higher than the nominal GDP growth rate
then the debt is not sustainable.
- The cost of debt = interest payments on accumulated debt + interest payments on
new debt
- Interest payments on accumulated debt = Current Interest payments / Debt from the
previous period
Risk premium is the higher return you will expect to earn from a riskier asset.
Austerity measures: Government reduced public spending and increased taxes in order to
reduce the overall deficit (primary deficit + interest payments).

Week 7
Money and banking

The past agricultural and chasing economic surplus gave birth to writing, money,
bureaucracy, technology.
IOU=currency
Money should have 3 characteristics:
● Store of value: something that is expected to retain its value in a reasonably
predictable way over time.
● Unit of account: what goods and services are priced in terms of.
● Medium of exchange: something that people hold because they plan to swap it for
something else, rather than because they want the good itself.
Fiat money: money that is just a special form of IOU that everyone in the economy trusts and
is not convertible to any other asset.
Commodity money: whose value comes from the material is made off (gold, silver coins).
There are 2 types of money:
● Base money: is not in circulation, central bank deposit for example.
● Broad money: it is the money supply, it is in circulation and can be bank deposits,
currency of households…
The different types of money supply are typically classified as “Ms” and they go from more
liquid to less liquid. (M0, M1, M2. M3. MB) we do not have to know which is one.

Bank deposits are money deposits. People usually change their banknotes with credit card
money, so the amount of the bank deposits is increasing. Banks need to ensure that they
can always obtain sufficient amounts of currency to meet the expected demand from
depositors for repayment of their IOUs.

Money creation
Commercial banks create money (in the form of bank deposits) by making new loans.
- When a bank makes a loan, for example, to someone taking out a mortgage, it does
not typically do so by giving them thousands of euros worth of banknotes. Instead, it
credits their bank account with a bank deposit of the size of the mortgage. At that
moment, new ‘broad’ money is created. Bank deposits are simply a record of how
much the bank itself owes its customers.
But there are certain limits for money creation:
- Banks themselves face limits on how much they can lend. They have to regulate and
stabilize the fiscal system, the loans given may be profitable and mitigate the risk of
creating new loans(borrowers might not return the interest rates).
- Behavior of money holders (households and businesses): the economy would be
destroyed if the money is wasted in a foreign economy.
- Monetary Policy: by influencing the level of interest rates in the economy, the central
bank affects how much households and companies want to borrow.

Risks of making loans

Liquidity risk: paying short-term debt
Banks have enough assets to pay back debts but not enough money: if people start
withdrawing money massively, the bank may not have enough currency and could collapse.
In order to reduce liquidity risk, banks try to make sure that some of their deposits are fixed
for a certain period of time.
Solvency risk: paying long-term debt
The value of a bank’s assets is lower than a bank’s liabilities. When banks issue long-term
debt to nonbank financial companies, those companies pay for them with bank deposits.
That reduces the amount of deposit, or money, liabilities on the banking sector’s balance
sheet and increases their non-deposit liabilities.
Credit risk
This is the risk to the bank of lending to borrowers who turn out to be unable to repay their
loans. In part, banks guard against credit risk by having sufficient capital to absorb any
unexpected losses on their loans.

How is the value of the money maintained??

1. Government interventions: the government accepting taxes in the form of monetary
payment is securing the validity of the money.
2. Central banks control and stabilize the value of the money in terms of the number of
goods and services it can buy through inflation and deflation.
 Week 9
Monetary Policy (I)

Remembering the example of the hangover cooperative, let’s assume we’ve printed too
many coupons and now everyone has 200. This is inflation: the price of 1 hour-class note
has just increased from 1 coupon to 2 coupons. Yet, the service is the same.

The quantity theory of money

Money x Velocity = Price x Output Y denotes the amount of output (Real GDP)
MxV=PxY P is the price of output (GDP deflator)
M is quantity of money
V is the income velocity of money, it measures the number of
times a euro bill enters someone’s income in a period of time

If velocity is constant
For so, a change in the quantity of Money (M) must cause a proportionate change in nominal
GDP (P*Y).

% Change in M= %Change in P + %Change in Y

Money Supply growth GDP deflator growth Real GDP growth

The percentage change in the quantity of money M is under the control of the CENTRAL
BANK. The percentage change in the price level P is the rate of INFLATION; this is the
variable in the equation that we would like to explain. The percentage change in output Y
depends on growth in other factors *(Factors of productions, technological progress,
education level) which for our present purposes we are taking as given.

The quantity theory of money states that the central bank, which controls the money
supply, has ultimate control over the rate of inflation.
A government can finance its spending in three ways:
1. It can raise revenue through taxes, such as personal and corporate income taxes.
2. It can borrow from the public by selling government bonds (next lesson).
3. It can print money. When the government prints money to finance expenditure, it
increases the money supply. The increase in the money supply, in turn, causes
inflation. Printing money to raise revenue is like imposing an inflation tax.

What is inflation?
Inflation is a general, sustained upward movement of prices for goods and services in an
economy.
According to the quantity theory of money, if % M = % Y, inflation would be zero.
If inflation is too low, or negative, then some people may put off spending because they
expect prices to fall. Although lower prices sounds like a good thing, if everybody reduced
their spending then companies could fail and people might lose their jobs. So governments
usually maintain inflation at 2%.
The Consumer Price Index (CPI) is a measure that examines the weighted average of prices
of a basket of consumer goods and services, such as transportation, food, and medical care.
It is calculated by taking price changes for each item in the predetermined basket of goods
and averaging them.
Inflation is usually defined as the year-on year % variation of the CPI at every month.

● GDP deflator measures the prices of all goods and services produced. Imported
goods are not part of GDP and do not show in the GDP deflator
● CPI measures the prices of only the goods and services bought by consumers.
● GDP deflator has a quarterly frequency, whereas CPI is published each month.

Week 11
Monetary policy III

Central banks
Monetary policy: mechanisms through which a Central Bank carries out its mandate.
Central bank possesses the monopoly of increasing the monetary base in the state (print
money).
It acts as a lender of last resort to the banking sector during times of financial crisis.
Central banks in most developed nations are institutionally independent from political
interference.
Monetary base: Sum of bank reserves

The Central bank is committed to keep the value of money stable in terms of inflation.
Knowing that interest rates are inverse to investment, and that the less Aggregated demand
the less inflation, it is needed to decrease the investment. To deal with inflation:
1. The central Bank sells Bonds to Banks, generating a reserves-deficit.
2. More banks need to borrow reserves from other banks, increasing the price at which
this transaction takes place: the interest rate goes up.
3. Investment goes down, AD goes down. Inflationary forces abate
If the bank needs to lower the interest rates to promote investment and end with deflation
then:
1. The central Bank buys Bonds from Banks, generating a reserves-surplus.
2. Less banks need to borrow reserves from other banks, reducing the price at which
this transaction takes place: the interest rate goes down.
3. Investment goes up, AD goes up. Inflationary forces appear.
Monetary policy in the Eurozone
- Deposit rate: defines the interest banks receive – or have to pay in times of negative
interest rates – for depositing money with the ECB overnight.
- Marginal lending: the rate at which banks can borrow from the ECB overnight.
- Refinancing rate: is the interest rate banks pay when they borrow money from the
ECB for one week
The Euribor is the rate at which banks would be willing to lend each other in a period of
time. Mortgages in Spain are indexed to the Euribor, which is influenced by the interest rates
that the ECB controls (deposit rate and refinancing rate).

Hyperinflation is a term to describe rapid, excessive, and out-of-control price increases in

an economy. While inflation is a measure of the pace of rising prices for goods and services,
hyperinflation is rapidly rising inflation. The response to a depression is usually an increase
in the money supply by the central bank and if the increase in money supply is not supported
by economic growth, the result can lead to hyperinflation.
There are nominal and real interest rates:
- The real interest rate measures the true cost of borrowing and thus, determines the
quantity of investment.
- The nominal interest rate is the rate that investors (and consumers) pay to borrow
money

Real interest rate = Nominal interest rate - Inflation r = i - %p

When we say that Investment depends negatively on interest rate, we refer to the real
interest rate. Savings and the interest rate pay are not always making you richer, it depends
on inflation.

The liquidity trap

An economy is said to be in a “liquidity trap” when the ability to use conventional monetary
policy (interest rate, monetary base) to stimulate demand has vanished, because short-term
interest rates are close to zero.

Week 12
The open economy

Nominal Exchange Rate(e): Nominal = Prices = the relative price of domestic currency in
terms of foreign currency. 1 euro = 1,11 USDollar
If you exchange 100 EUR you will get 110 USD. But, will that be enough for your trip? We all
know that the cost of life in the US is different from Spain. For so it is important to take into
account real exchange rates.
Real Exchange Rate 𝝐 : Real = Quantities = the relative price of domestic goods and
services in terms of foreign goods and services.
𝝐 = 𝒆 ∗ 𝑷𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 /𝑷𝒇𝒐𝒓𝒆𝒊𝒈n
A price index compares the prices of goods in a period of time, in relation to another period
of time, usually called the base period.

Spain has depreciated by 5.17% from 2018Q3 to 2019Q3 = (1.10/1.16-1).

The effective real exchange rate

To compare different currencies we need to obtain a nominal effective exchange rate
(NEER), in order to obtain the real effective exchange rate (REER)
𝑹𝑬𝑬𝑹 = 𝑵𝑬𝑬𝑹 ∗ 𝑾𝑷𝒅𝒐𝒎𝒆𝒔𝒕𝒊𝒄 /𝑾𝑷𝒇𝒐𝒓𝒆𝒊𝒈𝒏
Example:
Let’s assume that Norway trades 90% with the Eurozone and 10% with Sweden.
1 NOK = 0.1 EUR = 1,07 SEK → the NEER of Norway is approx. 0.19
0,9*0,1+0,1*1,07=0,197= NEER

Aggregate Demand in the open Economy

Net exports (X-M) depend negatively on the real
exchange rate when 𝐍𝐗 (−𝝐 )
If a country has cheaper goods, then other countries are
going to import items from them. This country might not
import from other countries because the goods are more
expensive. This means that the net exports are going to
be positive, which means that the country has lending
capacity. CAPITAL OUTFLOWS.
At the equilibrium real exchange rate, the supply of
domestic currency available from the net capital outflow
balances the demand for domestic currency by foreigners
buying our products.

Expansionary fiscal policy at home, such as an increase in government purchases or a cut in

taxes, reduces national saving (higher consumption). For so domestic goods become more
expensive relative to foreign goods, which causes exports to fall and imports to rise.

Expansionary fiscal policy causes real exchange rate to appreciate: Domestic goods have
become more expensive than foreign goods. ↓ 𝐗 −↑ 𝑴 =↓ 𝑵X