Macroeconomics is the study of the economy as a system

REAL GROSS NATIONAL PRODUCT (GNP) measures the income of an economy,

the quantity of goods and services the economy can afford to purchase.
ECONOMIC GROWTH is a rise in real GNP.
INFLATION is the increase in the average price of goods and services.
INFLATION RATE is the percentage increase in the average price of goods and
services and is measured by the Consumer Price Index (CPI).
LABOUR FORCE is people at work or looking for work. It excludes people neither
working nor looking for work.
UNEMPLOYMENT RATE is the fraction of the labour force without a job.
The CIRCULAR FLOW shows how real resources and financial payments flow
between FIRMS and HOUSEHOLDS (inital lewel of analysis closed economy)
The EXTENDED CIRCULAR FLOW shows how real resources and financial
payments flow between FIRMS, HOUSEHODLS, GOVERNMENT and FOREIGN
SECTOR (international trade)
EXTENDED CIRCULAR FLOW includes the role of investment and savings in the
economy, the role of government spending, and finally the role of international
trade.
INVESTMENT (I) is the purchase of new capital goods by firms.
SAVING (S) is part of income NOT SPENT buying goods and services.
A LEAKAGE from the circular flow is money no longer recycled from households to
firms.
An INJECTION is money that flows to firms without being cycled through
households.
In a closed economy:
GDP = C + I
Y=C+S
GDP = Y
C+I=C+S
Follows:

I=S

GOVERNMENTS rise revenue through DIRECT TAXES - Td (income taxes, profit

taxes) and INDIRECT TAXES - Te (VAT, excises).
TAXES finance two kinds of expenditure.

GOVERNMENT SPENDING on goods and services (G) is purchases by the

government of physical goods and services.
Governments also spend money on TRANSFER PAYMENTS or BENEFITS (B).
BENEFITS include pensions, unemployment benefit and subsidies to firms.
Transfer payments are payments that do not require the provision of any goods
or services in return.
GDP in closed economy with savings and taxes: Y = C + I + G Ti = S + C +
Td B
The foreign sector plays an important role in an OPEN ECONOMY or economy that
deals with other countries.
EXPORTS (EX) are domestically produced but sold abroad (in foreign countries).
IMPORTS (IM) are produced abroad but purchased for use in the domestic
economy.
The DIFFERENCE between EXPORTS and IMPORTS is trade balance or NET
EXPORT.
LEAKAGES from the extended circular flow are:
SAVING (S)
TAXES (net of benefit subsidies) (NT)
IMPORTS (IM)
INJECTIONS to the circular flow are:
INVESTMENT (I)
GOVERNMENT SPENDING (G)
EXPORTS (EX)
In an open economy: GDP = C + I + G + (EX IM) - expenditure approach
SUM OF ALL LEAKAGES from an economy EQUALS to the SUM OF ALL INJECTIONS
to the economy this is a law in macroeconomics.
S + NT + IM = I + G + EX
If a countrys INVESTMENTS exceed its SAVINGS then the country is a net foreign
debtor that is reflected in the fact that IMPORTS are higher than EXPORTS for
the same amount.
Gross domestic product (GDP) is the total market value of all final goods and
services produced within a given period by factors of production located within a
country.

In the circular flow transactions do not take place exclusively between a single
firm and a single household.
Firms hire labor services from households but buy raw materials and machinery
from OTHER FIRMS.
To avoid double counting we use VALUE ADDED.
VALUE ADDED is the increase in the value of goods as a result of the production
process.
When calculate GDP we EXCLUDE intermediate goods to avoid double counting.
INTERMEDIATE GOODS are partly finished goods that form inputs to a subsequent
production process that then uses them up.
When we calculate GDP we ONLY SUM UP the total value of FINAL GOODS
purchased during the year and the difference between INVENTORIES at the end
of the year and at the beginning of the year.
The term final goods and services in GDP refers to goods and services produced
for final use.
Intermediate goods are goods produced by one firm for use in further processing
by another firm.
INVENTORIES or STOCKS are goods currently held by a firm for future production
or sale.
GROSS NATIONAL PRODUCT measures total income earned by domestic citizens
regardless of the country in which their factor services were supplied.
GNP equals GDP plus NET PROPERTY INCOME FROM ABROAD.
In developed countries GNP is usually greater than GDP.
In developing countries GDP is usually greater than GNP.
GROSS NATIONAL PRODUCT - Depreciation= NET NATIONAL PRODUCT - Indirect
taxes = NATIONAL INCOME (the sum of rental income, profits, income from selfemployment, and wages and salaries)
DEPRECIATION or capital consumption is the rate at which the value of the
existing capital stock declines per period as a result of usage or obsolescence.
Rates of depreciation are set up by the law or bylaws in in countries all over the
world.
Enterprises are obliged to use these rates of depreciation when calculating costs
and preparing PROFIT AND LOSS ACCOUNTS.

NOMINAL GNP measures GNP at the prices prevailing when income was earned
(at current market prices). Nominal GDP includes all the components of GDP
valued at their current prices.
REAL GNP or GNP at constant prices, adjusts for inflation by measuring GNP in
different years at the prices prevailing at some particular date known as the base
year.
The GNP deflator is the ratio of nominal GNP to real GNP expressed as an index.
PER CAPITA REAL GNP is real GNP divided by the total population. It is real GNP
per HEAD.
Microeconomics is the study of how individual households and firms make
decisions and ho they interact with one another in markets.
Macroeconomics is the study of the economy as a whole.
For an economy as a whole, income must equal expenditure
National income and product accounts are data collected and published by the
government describing the various components of national income and output in
the economy.
GDP can be computed in two other ways:
The expenditure approach: A method of computing GDP that measures the total
amount
spent on all final goods during a given period.
The income approach: A method of computing GDP that measures the income
wages, rents, interest, and profitsreceived by all factors of production in
producing final goods.
Personal income is the income received by households after paying social
insurance taxes but before paying personal income taxes.
The personal saving rate is the percentage of disposable personal income that is
saved.
Weight is the importance attached to an item within a group of items.
Base year is the year chosen for the weights in a fixed-weight procedure.
Fixed-weight procedure uses weights from a given base year.
The underground economy is the part of an economy in which transactions take
place and in which income is generated that is unreported and therefore not
counted in GDP.
Gross National Income (GNI) is a measure used to make international
comparisons of output.
Potential output is the economys output when inputs are fully employed.

The natural rate of unemployment (NRU) is the rate of unemployment that

corresponds to the economys potential output.
In macroeconomics, aggregate demand is the total demand for final goods and
services in the economy at a given time and price level
Initial model of the impact of aggregate demand on the economys output is
based on two assumptions:
All prices and wages are fixed at a given level;
At these prices and wage levels there are workers without a job who would like to
work, and firms with spare capacity they could profitably use.
In such a model output is demand-determined.
The consumption function is determined by:
Autonomous spending (A);
Marginal propensity to consume (MPC); and
Disposable income (Yd).
The consumption function: C = A + MPC x Yd
Disposable income (Yd) is the difference between national income in the
economy (Y) and net taxes (NT). Yd = Y NT
Disposable income can be allocated only to consumption and saving.
Marginal propensity to consume (MPC) is the change in consumption (C) divided
by the change in disposable income (Yd). MPC = C / Yd
The marginal propensity to save (MPS) is the change in saving ( S) divided by
the change in disposable income ( Yd) : MPS = S / Yd
MPC + MPS = 1
The saving function is determined by:
Autonomous consumption = negative saving: (- A);
Marginal propensity to save (MPS); and
Disposable income (Yd)
The saving function: S = - A + MPS x Yd
Aggregate demand (planned aggregate expenditures) in closed economy with
taxes
Households consumption of goods and services (C); and
Private investments (I);
AD = C + I
AGGREGATE DEMAND IN closed economy with taxes:
Government spending on goods and services (G)
AD = C + I + G
Aggregate demand in open economy with taxes:

Net exports
AD = C + I + G + (XM)
The autonomous spending multiplier (M) answers the question by how much will
equilibrium income be changed if autonomous spending on C, I, G or X is
changed: Y = AD x M
If income tax is zero and if the economy is a closed economy then the multiplier
is equal to the reciprocal value of the marginal propensity to save: M = 1 / (1MPC) or M = 1 / MPS
The multiplier is the ratio of the change in equlibrium income to the change in
autonomous spending that caused the change.
When taxes on income were introduced then the disposable income IS NOT equal
to the national income. Income tax is reagarded as a leakage from the circular
flow of income and production.
The size of the multiplier with taxes on income is thus determined in the following
way:
M = 1 / [1-MPC(1-t)]
where (t) denotes the net income tax (if income tax is 10% then t=0.1)
The size of the multiplier decreases with the introduction of income taxes.
In the open economy (an economy that trades its goods and services with the
rest of the world) the multiplier is determined by: M = 1 / [1- MPC(1-t) + MPM]
Increase in the marginal propensity to import decreases the size of the multiplier.
Imports are regarded as leakages thus any increase in the marginal propensity to
import increases leakages to foreign countries which decreseas the proportion of
income to be spent on domestic goods and services.
MONEY is any generally accepted means of payment for delivery of goods or
settlement of debt. It is the MEDIUM of EXCHANGE.
Functions of money:
Medium of exchange
The unit of account the unit in which prices are quoted and accounts kept.
Store of value money is a store of value because it can be used for future
purchases of goods and services.
TOKEN MONEY is a means of payment whose value or purchasing power as
money greatly exceeds its cost of production or value in uses other than as
money.
IOU money is a medium of exchange based on the debt of a private firm or
individual.
Bank reserves are the money available in the bank to meet possible withdrawals
by depositors.
The reserve ratio is the ratio of reserves to deposits.

The money supply is the value of the stock of the medium of exchange in
circulation.
Liquidity is the cheapness, speed and certainty with which asset values can be
converted back into money.
The money in sight deposits can be withdrawn on sight without prior notice.
Time deposits, paying higher interest rates, require the depositor to give notice
before withdrawing money.
Commercial banks are financial intermediaries licensed to make loans and issue
deposits, including deposits against which cheques can be written.
The interest rate spread is the excess of the loan interest rate over the deposit
interest rate.
The monetary base or stock of high-powered money is the quantity of notes and
coins in private circulation plus the quantity of reserves held by the banking
system.
The money multiplier is the ratio of the money stock to the monetary base.
MONETARY BASE (M0) the cash in circulation held by the public plus cash held
by the banks in the banks vaults plus reserves of commercial banks held in their
accounts at the Central Bank of Bosnia and Herzegovina .
MONETARY AGGREGATE M1 is the sum of all sight deposits in the domestic
currency and cash in circulation held by the public.
QUASI-MONEY (QM) is the sum of time and savings deposits in the domestic
currency, sight deposits in foreign currencies, and time and savings deposits in
foreign currencies.
MONETARY AGGREGATE M2 is the sum of M1 and QM.
Functions of a central banks:
1.Money supply (printing money or creating new deposits)
2.Regulation of credit potential of commercial banks
3.Lender of last resort function liquidity management of the economy
4.Banking supervision
5.Fiscal agent of the government
The monetary instrument is the variable over which the central bank makes dayto-day choices.
An intermediate target is a key indicator used to guide interest rate decisions.
The transmission mechanism of monetary policy is the channel through which it
affects output and employment.
Monetary policy instruments:
1. Open market operations buying and selling government bonds
2. Required reserves / obligatory reserves

3. Discount window operations

4. Repurchase agreements (Repo)
INFLATION is the growth rate of the price of aggregate output.
With and INFLATION TARGET, the central bank adjusts interest rates to try to keep
inflation close to the target inflation rate.
The central bank sets the nominal interest rate (r) not the real interest rate.
the ii schedule shows that at higher inflation rates the central bank will wish to
have higher real interest rate.
The macroeconomic demand schedule MDS shows how higher inflation induces
lower output
because a central bank raises
interest rates.
The MDS relates aggregate demand, output, and inflation.
Supply shocks may be beneficial, such as technical progress (positive supply
shock), or may be adverse such as higher real oil prices or loss of capacity after
earthquake (negative supply shock).
Monetary policy accomodates a permanent supply change by altering the real
interest rate (shift in the ii schedule) to induce a similar change in aggregate
demand.
In the classical model with a vertical AS schedule, a rise in government spending
crowds out an equal amount of private spending. Aggegate demand remains
equal to potential output.

Monetary reserves:
Foreign exchange reserves usually held in USD or EUR or in both currencies
Monetary gold
Special drawing rights (SDR)
Country reserves with the IMF
SOURCES of national income:
Exports of goods
Exports of services
Gifts from abroad to the home country
Income received from abroad
Y = C+I+G+(X-M)
NOMINAL EXCHANGE RATE is the price of foreign currency expressed in terms
national currency (it is bilateral exchange rate).
REAL EXCHANGE RATE is nominal exchange rate multiplied by a ratio of CPI in
foreign country with CPI in our country.

EFFECTIVE EXCHANGE RATE is an average of a countrys exchange rate against

all its trade partners, weighted by the relative size of trade with each country.
An EXCHANGE RATE REGIME describes how governments allow exchange rates to
be determined.
In a FIXED RATE REGIME governments maintain the convertibility of their
currency at a fixed exchange rate.
A currency is CONVERTIBLE if the central bank will buy or sell as much of the
currency as people wish to trade at the fixed exchange rate.
The system of FIXED EXCHANGE RATES referes to a system that permits only very
small deviations from officially declared currency values.
The central bank is an active participant in the exchange market and is
responsible for maintaining the central parity or fluctations within the declared
limits (+/- 1 percent) around central parity.
Under a pegged rate system governments fix the price of their currency and
stand ready to support the fixed price in the foreign exchange market.
Central banks are active participants in the foreign exchange market.
This requires that central banks that peg their currency must have a sufficient
supply of foreign exchange reserves to defend the value of their currency
In a system of FLEXIBLE EXCHANGE RATES exchange rates are completely free to
vary.
The foreign exchange market is cleared at all times by changes in the exchange
rate.
The exchange rate is determined by the supply of and the demand for a foreign
currency WITHOUT intervention of the central bank.
In a system of flexible exchange rates (system of free floating) the central bank
has no direct influence on the exchange rate.
A DEVALUATION is a rise in the nominal exchange rate governments commit
themselves to maintain.
A REVALUATION is a fall in the nominal exchange rate governments commit
themselves to maintain.
DEVALUATION supports exporters and REVALUATION makes imports cheaper.
In a FLOATING EXCHANGE RATE REGIME the exchange rate is allowed to find its
equilibrium level WITHOUT central bank intervention using the forex reserves.
A monetary policy rule specifies how the central bank adjusts interest rates in
response to changes in particular economic variables.

By setting up a monetary target the central bank adjusts interest rates to

maintain the quantity of money demanded in line with the given target for money
supply.
The IS schedule shows combinations of income and interest rates at which
aggregate demand equals actual output.
The LM schedule shows combinations of interest rates and income yielding
money market equlibrium when the central bank pursues a given target for the
nominal money supply.
The basic assumption in the money market equilibrium model is that people
(transactors) divide their wealth (W) between desired real money holdings (Ld)
and desired real bond holdings (Bd).
Hence, the total desired wealth is equal to:
W = Ld + Bd
On the other hand, real wealth is equal to the sum of real money supply (Lo) and
real supply of bonds (Bo). In the money market equilbrium the desired wealth
equals real wealth:
Lo + Bo = Ld + Bd