Macroeconomics Review

The key to understanding macroeconomics: one persons spending is another persons

income. (Technically this should be one entitys spending is anothers income, as it includes
governments and corporations. )

Individually we have many reasons to save money. We evaluate savings mechanisms by rate of
return, perceived risk, and liquidity. However, a well-run society will channel peoples savings
toward financing economic activity by others. These productive ways to save are limited to
putting money in banks, buying new (IPO) stocks and bonds, and buying new real estate, as
well investing directly in businesses. Other types of savings, such as paying down debt, putting
money under your mattress, and buying second-hand assets, are non-productive.

Banks keep a fraction of their deposits in reserve, and loan out the less. When everyone puts
their money in banks, an initial amount of savings is multiplied by the bank money multiplier =
(1 / rrr) [rrr = required reserve ratio] to determine how much activity ultimately gets financed.
For example, if the rrr = .2, then $1000 of income deposited ultimate finances 1000 * (1/.2) or
$5000 of economic activity. (Note that this means an additional $4000, as we get $5000 rather
than $1000.)

Once upon a time, banks were vulnerable to panic = people pulling their money out of banks at
the first sign of trouble, which, in a Tragedy of the Commons effect, would weaken the economy
as banks would be unable to make new loans to finance economic activity. This problem
persisted until the creation of the FDIC [Federal Deposit Insurance Corporation] in 1933, which
guaranteed that all deposits (up a a mostly-irrelevant limit) would be paid bank in full by the
Federal Government.

GDP = Gross Domestic Product = the total amount of goods and services produced in a country
in a given year.

GDP = Consumption + Investment + Government spending, + Net Exports (= Exports

Imports). For example, we we know that a countrys GDP is 500 billion, and C = 300 billion, I
= 100 billion, G = 120 billion and Ex = 40 billion, we can solve algebraically to get IM = 60
billion.

The business cycle has 3 parts: boom (=GDP high and growing), recession (=GDP shrinking)
and recovery (=GDP relatively low compared to the long-term trend, but growing.) The name
cycle is deceptive, as the duration and intensity of these vary wildly and are extremely difficult
to predict.

Inflation is the (gradual) rise in average prices of stuff which we collectively purchasegoods
and services. Typically its fairly modesta few % each yearbut it can get much larger,
particularly if the government funds itself by printing money. Thats called hyperinflation and
can be very destructive as people& businesses attempt to avoid cash and move their wealth
overseas.

To ger the percent change in your real wage, take the percent change in your wage over last year
and subtract the inflation rate. (This actually is close enough math, but it works well enough
for modest inflation rates.) By similar logic, real interest rate = interest rate inflation. Real
GDP growth = GDP growth inflation. real means youre measuring in terms of stuff, not
dollar bills.

For people in debt, inflation is a good thing. For those who have fixed income-producing assets
such as bonds and treasury bills, inflation is a bad thing.

When an asset price bubble pops, people feel poorer, and respond by reducing Consumption in
favor of savings (in the broad sensepaying down debt, buying assets, etc.). When enough
people do this, Investment also drops and jobs are lost, which causes people to feel even poorer,
etc. We can represent this by Aggregate Demand curve moving left, so that it hits the
Aggregate Supply at a lower real GDP. (Its also worth noting that if the economy is at or above
capacity (as determined by the Aggregate Supply curve), increasing Aggregate Demand mostly
just raises prices with minimal effect on real output.)

Keynesianism (named after John Maynard Keynes) dictates that Government should do the
opposite: borrow and spend (= run a deficit) during a recession, then reduce spending and pay
down debt (= run a surplus) when the economy is booming.

Debt represents the total amount owed (or, if you wish, net debt = a negative net wealth). It is
measured in dollars. A Deficit, whether by a person, corporation, or government, is measured in
dollars-per-year. For example, if you have $60,000 of debt at the end of last year and then run a
deficit of $20,000 of this year, your new debt (as of the end of this year will be $80,000.

While, all things being equal, wed rather run a surplus / generate savings, there can be good
reasons to run a deficit. Good reasons include something that costs money but will improve your
future prospects (for example, going to college), or minimizing the disruptions in your life during
a temporary shortage of income. Also retirees. Of course, there are bad reasons to run deficits as
well, such as a drug habit or in general living beyond your means..

Companies face a similar issue, looking at TR and TC. A deficit, once again is good for
positioning yourself to be more profitable later (Start-ups nearly always run a deficit), and also
minimizing the impact of a temporary downturn. Governments face the same issue, looking at
taxes and spending. Deficits are useful to position the country to be wealthier later (by building
infrastructure and/or conducting scientific research) or to smooth out a downturn.
Any deficit must be financed by borrowing (in which case it adds to the debt) or selling off
assets (which still reduces net worth). The impact of debt is determined by the debt/income ratio
or, for governments, the debt/GDP ratio. Higher debt/GDP (or debt/income) is worse, but so
long as the debt grows slower than income or GDP it is becoming less of a problem.