# Book Review on A Concise Guide to Macroeconomics

Book: “A Concise Guide to Macroeconomics: What Managers, Executives, and Students Need to Know” by David A. Moss.

Review: This is an excellent book! Can’t recommend it highly enough! This lays down clearly the basic relationships among economic variables without going into equations or formulas. It is what makes macroeconomics interesting.

Key Points:

1. Output
1. The total amount of output that a country produces constitutes its ultimate budget constraint (i.e. in the long run, it cannot use more output than it produces)
2. A country can use more output than it produces only if it borrows the difference from foreigners.
3. Three ways of calculating national output
1. Value added – Value added (i.e. output created) equals the sales price minus the cost of all nonlabor inputs used to produce it. Add up all the value added (i.e. output created) at each stage of production.
2. Expenditure – Simply take the final sales price.
3. Income – Add up all the money paid to factors of production, i.e. labor and capital (salaries, interest, dividends, rent, royalties). Total income should equal the total payment for national output.
4. National Output (GDP) = Consumption by households (C) + Investment in productive assets (I) + Government spending on goods and services (G) + Exports (EX) – Imports (IM). Investment in productive assets (I) only includes spending on output that is not expected to be used up in the short run of typically 1 year (e.g. hammer used by a carpenter), so as to avoid double counting [My note: The sales price paid by consumers would include the amortized price of any tools used during production, hence there seems to be double counting here.].
5. Current and Financial Accounts
1. Current transactions, such as exports and imports of goods and services are recorded in the current account in the Balance of Payments (BOP) statement. Financial transactions, including sales of stocks and bonds to foreigners, are recorded in the financial account (used to be called the capital account).
2. Deficits on the current account are accompanied by capital inflows (borrowing) on the financial account, whereas surpluses are accompanied by capital outflows (lending) on the financial account. The two accounts are perfect opposites with a deficit in one necessarily accompanied by a surplus of the same amount in the other.
6. How to view current account deficits
1. Current account deficits can arise when a company is borrowing from abroad for domestic investment which will increase future output. Hence current account deficits may not be bad (i.e. simply consuming beyond its means).
2. Countries with current account surpluses need to make sure they get a good return (i.e. much larger additional output in the future) on the output they are giving today.
1. For two countries and two goods, a country enjoying an absolute productivity advantage in both goods would benefit from specializing in what it was relatively best at producing and then engaging in trade for everything else.
8. Economic growth and productivity
1. Three sources of economic growth
1. Increases in labour
2. Increases in capital (i.e. plant and equipment)
3. Increases in efficiency in which these two factors are used (i.e. productivity)
2. Productivity typically refers to labour productivity (i.e. output per worker hour)
3. When wages rise faster than labour productivity, unit labour costs (i.e. cost of labour needed to produce a unit of output) are rising.
9. The depression from 1929 to 1933 was driven by expectations and psychology that became self-fulfilling. National output declined by more than 30%.
2. Money
1. Interest rates, exchange rates, and the aggregate price level, constitute ‘prices’ of money relative to time, foreign currency, and all goods and services respectively.
2. Nominal interest rate = (1 + Real interest rate) * (1 + Expected inflation)
3. Nominal and Real GDP
1. Real GDP = Nominal GDP after controlling for inflation. Real GDP increases only with changes in quantity. Nominal GDP can increase either due to changes in price or quantity. To calculate real GDP, use a constant set of prices.
2. Price deflator = Nominal GDP / Real GDP. [My note: there will be problems comparing GDP across periods due to technological changes, e.g. a more powerful computer at the same price level after accounting for inflation, is that considered an increase in output?.]
4. Money supply and its effects on other variables
1. When money supply rises, interest rates tend to fall (quantity increases so price falls), currency tends to depreciate (since quantity increases), aggregate price level rises (unless supply of goods and services has also increased). The converse holds.
2. Growth in money supply can spark inflationary expectations which will push long-term nominal interest rates upward. If inflation takes hold, short-term nominal interest rates will eventually rise as well. Short-term nominal rates will almost surely fall immediately, causing real interest rates to very likely fall.
5. Real Exchange Rates
1. Real exchange rate is the ratio of the domestic price level and the price level in another country, where the price level in another country is converted into domestic currency units via the nominal exchange rate. If the real exchange rate appreciates, the amount of output you can obtain from another country increases (for a fixed quantity of your own output).
2. Inflation increases the aggregate price level within the country, as a result making the country’s own goods and services more expensive, which will increase imports and decrease exports, just as if the currency had appreciated. Even if nominal exchange rate depreciates, inflation can cause real exchange rate (i.e. the effective exchange rate after controlling for inflation) to appreciate.
3. % change in real exchange rate ~= % change in nominal exchange rate – (Japanese inflation % – U.S. inflation %)
4. If foreign inflation is 0, real appreciation of Currency X ~= Inflation rate of Country X – Nominal depreciation of Currency X
5. In early 1990s, Mexico pegged their nominal exchange rate, but had a rapidly appreciating real exchange rate due to inflation. Hence, Mexico’s trade position deteriorated and required large inflows of foreign capital. The need to buy large amounts of foreign capital by selling large amounts of Pesos would lead to a significant depreciation of the nominal exchange rate. The Peso collapsed in late 1994.
6. Substantial money growth is likely to cause the nominal exchange rate to depreciate, hence causing the real exchange rate to depreciate. However, money growth can also spark domestic inflation, which can cause the real exchange rate to appreciate (if the inflation-rate differential exceeds the nominal rate of depreciation).
6. For an American subsidy operating in China, a real appreciation of the yuan due to to Chinese inflation, will either hurt market share if it passes the higher cost (due to inflation) to Chinese consumers, or will hurt margins. Three effects on the subsidiary are:
1. More intense price competition from foreign imports into the Chinese market.
2. More intense price competition from foreign producers within foreign markets; and
3. A more favorable effective rate of repatriation on profit margins earned within China.
7. Nominal wages tend to be sticky because that is what workers are focused on. When prices rise, workers don’t demand sufficient wage increases so their purchasing power drops. When prices fall, they oppose lower wages even though their real purchasing power has grown. This is a cause of unemployment during periods of deflation as employers cannot pay increasing real wages.
8. Central Banks
1. Money Multiplier = 1 / (proportion of leakage) = 1 / (proportion not lent out).
2. Central banks’ objectives
1. Vigorous but sustainable GDP growth
2. Low unemployment
3. Low inflation
4. Stable exchange rates
3. Phillips Curve shows an inverse relationship between inflation rate and unemployment (study based on 100 years of British data). The Phillips curve can move over time and there are short-run (“expectations-augmented” Phillips curve) and long-run Phillips curves.
4. Central banks can target a particular exchange rate by raising interest rates when their currency depreciates to encourage people to hold their currency, or lowering interest rates when their currency appreciates.
5. Appreciating the exchange rate can further weaken the domestic economy by undercutting exports.
6. It is difficult, if impossible, to achieve all objectives simultaneously, hence most central banks appear to make low inflation their dominant policy objective.
7. Three tools of monetary policy
1. Discount rate – Lending to commercial banks. Lowering the discount rate will encourage banks to borrow, hence increasing the monetary base which increases money supply. Raising the discount rate will discourage borrowing and slow the growth of the monetary base. [My note: This can effectively “reverse” money growth if the money growth is kept low compared to real output growth.]
2. Reserve requirement – Higher reserve requirement increases leakage which lowers the money multiplier which reduces the money supply. Converse is true.
3. Open market operations – Purchases injects liquidity and increases the monetary base which increases money supply. Sales withdraws liquidity and reduces the monetary base.
8. In the U.S., the discount window is almost never used. Open market operations is used to move the federal funds rate (the interest rate commercial banks charge one another for overnight lending).
9. Sentiment and psychology is important – Even if the Fed increases the money supply, if suddenly all Americans decided to hold more money and not spend (e.g. they are very worried about losing their jobs), the demand for money will rise. The demand for money reduces the supply of money to the market and can cause interest rates to rise (i.e. borrowers would need to pay higher interest costs to obtain funding). The demand for money can also cause assets (e.g. bonds) to be liquidated which would cause interest rates to rise (if bonds are sold at low prices, buyers of existing bonds will be earning a higher yield, which will cause new bond issuance to increase their yields as well).
3. Expectations
1. Inflation
1. If people expect consumer prices to rise, workers will demand higher wages to maintain real incomes, firms will try to raise prices to maintain earnings. Prices and wages will rise in reality as individuals and firms try to protect themselves against expected price increases.
2. For expectations of inflation to be low, Central banks must  be credible. The public must believe that the central bank will aggressively and effectively combat inflation (e.g. interest rate hikes) the moment the price level beings to rise too much.
3. To kill high inflation in the 1970s, Federal Reserve Chairman Paul Volcker pushed the federal funds rate to 20% at its peak, inducing the worst economic downturn since 1930s, and unemployment reached nearly 10% in 1982, with real DGP falling about 2%. [My note: One interesting thing is that even if the Fed manages to win over inflation, the higher aggregate price levels would remain. The Fed would not “cause deflation” to push down price levels back to their original levels before the high inflation period.]
4. Wage and price controls are unlikely to work because governments are unlikely to enforce and punish violators. It also creates distortions in the economy which cannot be fixed without a free market price.
5. Reducing money supply does not work well as it can cause interest rates to skyrocket due to the high money demand (during high inflation). This is especially so if the country is facing inflation of > 1000% per year.
2. Output
1. Say’s Law – Supply creates its own demand – Since production generates income equal to the full value of the product that is sold, total income should always be sufficient to buy all the output that is produced.
2. Negative expectations can cause people to hold back on expenditure, including both consumption and investment. This causes a gap between potential GDP (i.e. feasible supply) and actual GDP (effective demand).
3. This can cause a downward spiral: firms lay off workers and reduce new investment to produce less goods, rising unemployment reduces income, which further reduces demand, etc.
3. Monetary Policy
1. Central banks can lower interest rates to encourage consumption (saving money is less attractive, borrowing money is cheaper), encourage investment (cheaper to finance, higher NPV for projects). But this does not always work:
1. “Liquidity trap” – when interest rates are very low but still above zero, people might simply hold money as other assets pay too little interest. The more money the central bank creates, the more money people want to hold. With money demand rising in tandem with money supply, interest rates would stop falling even as the central bank injects ever larger amounts of money.
2. New investment might always look unattractive at any realistic interest rate when expectations of future demand are severely depressed (Keynes).
2. A bad recession can cause deflation when prices fall as a result of declining demand. Even if nominal rate of interest is 0, the real rate of interest can be positive and high if deflation is severe. Real interest rate ~= Nominal interest rate – Expected inflation. [My note: (1+0) = (1 + 0.2) * (1 – 0.16)]. For example, a borrower repaying only the principal would actually be repaying more in terms of real output. This happened in the U.S. in 1932 where deflation was about 10% and real interest rate was about 15%.
3. Monetary policy is useless against significant deflation.
4. Fiscal Policy
1. The government can get the economy moving again by spending more than it received in taxes, and run a large budget deficit (expansionary fiscal policy).
2. Why it works
1. When people and firms see the government aggressively creating new demand and buying goods and services, this can change people’s expectations. [My note: people’s expectations would change if they are confident that the government can and will sustain budget deficit spending to jump start the economy.]
2. Keynes believed a burst of deficit spending would lead both consumption and investment to rise. The GDP will increase by more than the increase in government spending because individuals and businesses will increase their levels of consumption and investment. Change in GDP = (Change in deficit spending by government) * Income multiplier where income multiplier = 1 / proportion leakage from the income-expenditure cycle.
3. How it works
1. The government should not finance the increased spending via additional taxes as that may impact consumption and investment. It should be financed by issuing bonds so that no other expenditure variables (in the GDP) would have to decline.
4. While the nominal GDP (i.e. P * Q) would increase:
1. In times of high unemployment, the increase will come mainly from increase in Q (i.e. real GDP) because businesses would first put idle resources back to work (e.g. idle factories, equipment, workers, re-hire).
2. In times of full employment, businesses will raise prices because production is maxed out, and nominal GDP increases will be due to increase in price level P. In the latter scenario, actual GDP (demand) exceeds potential GDP (supply), i.e. economy is overheating.
3. In normal times (modest unemployment), both real GDP (Q) and inflation (P) rise.
5. The central bank will have to estimate potential GDP growth (i.e. growth of potential output, what the factories etc. can potentially churn out), and compare it to actual GDP growth (demand). If actual GDP is growing at 4% but the central bank estimates potential output growth at 3%, it is likely to tighten monetary policy and raise short-term interest rates to prevent overheating.
6. Why deficit spending may not work
1. “Rational expectations” or “Ricardian equivalence” argues that if individuals are perfectly rational, they will anticipate that higher taxes will be required to pay off the debt accumulated from budget deficits, hence they will save every dollar of new income derived from deficit spending, negating any Income multiplier. [My note: this is ridiculous – people are short-sighted].
2. Deficit spending may drive up interest rates and negatively impact private investment and consumption (a.k.a. “crowding out”). The government competes with private borrowers and borrows from the market to fund the budget deficits. This pushes up interest rates.
3. The central bank may raise interest rates if they expect the budget deficit spending to be inflationary, negating the desired effect of deficit spending.
5. Interest Rates
1. If traders expect interest rates to rise, they will sell bonds and in fact cause long-term interest rates (i.e. bond yields) to rise. Hence interest rates can move depending on the bond markets’ anticipation of central bank actions.
6. Exchange Rates
1. If traders expect the Euro to appreciate, they will buy Euros, and effectively cause the Euro to appreciate.
2. If traders expect the Fed to raise interest rates, they are likely to buy dollars, effectively causing the dollar to appreciate.
4. Exchange Rates
1. Current Account Balance
1. Increased domestic demand for foreign products will bid up the price of the foreign currencies needed to buy them, causing the domestic currency to depreciate. The current account balance also deteriorates.
2. Increased foreign demand for domestic financial assets will result in increased foreign demand for domestic currency causing the domestic currency to appreciate. This can also cause the current account balance to deteriorate [my note: only if the country takes the foreign currency to import goods and services. If the country takes the foreign currency to purchase foreign financial assets, they may be no impact to the current account].
3. It is important to look at what factors are driving the current account surplus or deficit. A current account deficit by itself may not mean a currency depreciation.
4. In general, sustained current account deficits are more typically associated with long-term currency depreciation than with long-term appreciation (opposite is generally true of sustained current account surpluses).
2. Inflation
1. In general, when one country experiences a consistently higher inflation rate than another, the first country’s currency will depreciate relative to that of the other country.
2. Relative higher inflation raises domestic prices more, making imports cheaper. The greater domestic demand for the other country’s products, hence its currency, causes the domestic currency to depreciate.
3. Purchasing Power Parity (PPP) – Law of One Price – A unit of currency should have the same purchasing power in one country as in another, excluding transportation costs and taxes. When different rates of inflation undermines the parity, the exchange rate will adjust to re-establish the parity. [My note: S1/S0 = (1+IP_US)/(1+IP_F). S is expressed in USD per unit of foreign currency. This is a long-term thing, doesn’t work over short-term. There is some good info here.]
3. Interest Rates
1. Short-term driver of exchange rates.
2. A country’s currency tend to appreciate when its interest rate rises relative to that of other countries (and depreciates when its interest rate falls). Higher interest rates gives foreigners a higher return which increases demand of the domestic currency.
3. Uncovered Interest Rate Parity – If country A’s interest rate rises above country B’s (with no additional investment risk), then country A’s currency should undergo an immediate appreciation then depreciate after that.  [My note: F/S = (1+i_US)/(1+i_UK). \$1 earning U.S. interest rate should give the same if converted to another currency, invested with the other country’s interest rate, then converted back. The fact that the carry trade works is both because of the stability of exchange rates and the fact that the IRP doesn’t always work.]
4. In general, interest rates impact short-term exchange rate movements (increase -> appreciate), inflation impacts medium-term movements (relatively high inflation -> depreciation), current account imbalances impact longer-term movements (deficits -> depreciation, over extended periods of time).
5. Exchange rates are extremely difficult to predict. Warren Buffett and former Treasury secretary Robert Rubin both lost money betting that the dollar will depreciate.
6. [My note: If the domestic currency appreciates, it will lower aggregate price levels if most of the consumed goods in the country are imported. If most goods consumed are still locally produced, the currency appreciate may not have much impact to aggregate price levels. There needs to be evidence that the cheaper imports can be sustained before there will be a switch from local goods to imported goods.]
5. Balance of Payments (BOP) Statement
1. Current Account
1. Merchandise trade (i.e. goods) are tangible products. Services are intangible products.
2. Income receipts and payments include financial returns on cross-border investments (e.g. interest and dividends from foreigners / (to foreigners) on domestic holdings of foreign assets / (foreign holdings of domestic assets), remitted or reinvested earnings on foreign direct investment (FDI) abroad) and compensation (including wages and salaries) for cross-border work (e.g. compensation paid by foreigners to domestic residents for work done abroad).
3. Unilateral transfers (a.k.a “net current transfers”) are non-reciprocal transactions such as foreign aid or cross-border charitable assistance (e.g. Red Cross).
2. Capital and Financial Account
1. Capital account includes only unilateral transfers of capital such as the forgiveness of one country’s debts by the government of another country (usually negligible).
2. Financial account covers all other financial transactions such as cross-border trades of stocks and bonds.
3. Direct investment (a.k.a. foreign direct investment) involves the cross-border purchase of an equity stake in a company large enough to give the new owner managerial influence in the company (usually > 10%).
4. Portfolio investment involves cross-border purchases of stocks, bonds, and other financial instruments (not in sufficient amount to allow managerial influence). This is “hot money” that portfolio managers can quickly liquidate and exit the country.
5. Changes in official reserves, reflect increases or decreases in the government’s stockpile of gold and foreign currencies.
6. Errors and omissions is a residual category to balance the discrepancies in the accounts (i.e. make credits and debits equal).
3. Every cross-border transaction involves a credit (+) and a debit (-) in the BOP. All credits and debits sum to zero.
4. Credits
1. Credits are a source of funds (e.g. foreign exchange). Credits occur when there is:
1. Increase in a liability (i.e. an increase in a domestic obligation to foreigners)
2. Decrease in an asset (i.e. a decrease in a domestic claim on a foreign entity)
3. Source of foreign exchange (i.e. foreign currency)
2. Examples:
1. Exports [My note: asset decrease]
2. Income receipts (e.g. interest and dividends earning on foreign investments) [My note: asset decrease due to pay back of money. The “income” will result in a debit in another item.]
3. Unilateral transfers from abroad (e.g. foreign aid or charitable assistance received from foreigners) [My note: retained earnings increase]
4. Capital inflows (e.g. increase in foreign deposits in domestic banks or foreign purchases of domestic companies, stocks, or bonds). This constitutes lending from abroad. [My note: liability increase. This can be both “active” – foreigners buy stocks, or “passive” – payment of domestic currency to foreigners for goods and services. The increase in liability itself is not a capital inflow, but rather, it results in a capital inflow which will be reflected under debits. The liability refers to oweing future output.]
5. Decrease in official reserves (government stocks of gold or foreign exchange) [My note: asset decrease]
6. [My note: Source of capital can also include using existing own capital via decrease in domestic deposit in a foreign bank, or sales by locals of foreign companies, stocks, or bonds. This would be an asset decrease.]
5. Debits
1. Debits are a use of funds (e.g. foreign exchange). Debits occur when there is:
1. Decrease in a liability (i.e. a decrease in a domestic obligation to foreigners)
2. Increase in an asset (i.e. an increase in a domestic claim on a foreign entity)
3. Use of foreign exchange (i.e. foreign currency)
2. Examples:
1. Imports [My note: asset increase]
2. Income payments (e.g. interest and dividends paid to foreigners) [My note: liability decrease due to pay back of money]
3. Unilateral transfers to foreigners (e.g. foreign aid or charitable assistance given to foreigners) [My note: retained earnings decrease]
4. Capital outflows (e.g. increase in domestic deposits in foreign banks or domestic purchases of foreign companies, stocks, or bonds) This constitutes lending to foreigners. [My note: asset increase. This can be both “active” – locals buy foreign stocks, or “passive” – payment of foreign currency to locals for goods and services]
5. Increase in official reserves (government stocks of gold or foreign exchange) [My note: asset increase]
6. [My note: Use of capital can also include foreigners using up their claims on domestic output via decrease in foreign deposits in domestic banks, or sales by foreigners of domestic companies, stocks, or bonds. This will be a liability decrease.]
6. My note: A pure exchange of currencies should result in a Capital Inflow credit and a Capital Outflow debit. For example, an exchange of Chinese toys with US\$ results in a debit (-) under Import and a credit (+) under capital inflows (increase in foreign deposits in domestic banks). If the Chinese converts the US\$ to RMB with a U.S. bank, there should be a debit (-) under capital outflows (decrease in foreign deposits in domestic banks) and a credit (+) under capital inflows (decrease in domestic deposits in foreign banks) under the U.S. BOP. If the conversion of money is done through a Chinese bank, it may not show up in the BOP of either country because it can be an internal transaction recorded within the Chinese bank.
7. My note: Where the currency is held does not matter. What matters is who is holding to claim on who’s output. Hence “increase in foreign deposits in domestic banks” is the essentially the same as “increase in foreign claims on domestic output held in foreign banks”.
8. My thought: For domestic currency deposits held in the a foreign bank, is it always the case that the foreign bank will hold an account with a domestic bank for that amount? not necessarily, because the foreign bank can always hold domestic cash. For large amounts, I’m not sure whether domestic banks will be willing to transfer physical cash over, most likely it will be a bank account under the foreign bank’s name instead.
9. Errors and omission reflects the net value of all transactions that are either mis-recorded or not picked up by government officials.
10. For example, a rich person sneaking in a suitcase of foreign currency into the U.S. will show up as
1. A debit on errors and omissions in the originating country’s BOP [My note: would have been a unilateral transfer to foreigners (debit). There should be a corresponding credit in the originating country’s BOP when the foreign currency is banked into a U.S. bank, which is a capital inflow since it is an increase in foreign deposits in domestic banks of the originating country.]
2. A credit on errors and omissions in the U.S. BOP. [My note: would have been a unilateral transfer from abroad (credit). There should be a corresponding debit in the U.S. BOP when the foreign currency is banked into a U.S. bank, which is a capital outflow since it is an increase in domestic deposits in foreign banks.]
3. [My note: Notice that the single event of the person sneaking a suitcase of cash into the U.S. and depositing into a U.S. bank, should generate a set of debit and credit in both the originating country’s BOP and the U.S.’s BOP.]
11. Another example, say drugs or cigarettes are smuggled into the U.S. from Thailand. This will show up as
1. A credit on errors and omissions in Thailand’s BOP. This would have been an Export (credit), with a corresponding debit as a capital outflow (increase in domestic deposits in foreign banks – Thailand’s US\$ bank accounts at U.S. banks would have more US\$).
2. A debit on errors and omissions in U.S.’s BOP. This would have been an Import (debit), with a corresponding credit as a capital inflow (increase in foreign deposits in domestic banks – Thailand’s US\$ bank accounts at U.S. banks would have more US\$).
12. I also just read an article about how Japan wants to lend California money to build a high-speed rail. I was thinking that if Japan lends Yen to California, and wants California to pay back in Yen, how would the BOP accounts look like? When California wants to pay back in Yen, the BOP accounts may be:
1. First convert US\$ to Yen. Assuming that the U.S. Bank does not have Yen, and would be exchanging US\$ for Yen with a Japanese bank. The U.S. BOP accounts:
1. Increase in foreign deposit in domestic bank (credit)
2. Increase in domestic deposit in foreign bank (debit)
2. Next to repay the Yen.
1. Decrease in domestic deposit in a foreign bank (credit)
2. Income payment to Japan (debit)
3. Potentially it could be done in a single step if a Japanese bank can facilitate the immediate repayment
1. Increase in foreign deposit in domestic bank (credit)
2. Income payment to Japan (debit)
13. My note: How you pay for imports (debit in BOP) may affect what precisely is the corresponding credit. When paid using domestic currency, it will show up as a increase in foreign deposits in domestic banks (a capital inflow), i.e. you owe foreigners more of your output. When paid using foreign currency, it will show up as a decrease in domestic deposits in foreign banks (also a capital inflow), i.e. you have a lesser claim on the foreign country’s output (a.k.a foreigners owe you less in terms of their output).
14. When a country suffers a severe financial crisis, one sometimes see unusually large negative errors-and-omissions numbers on the country’s BOP statement in the months leading up to the crisis (i.e. some people were engaging in capital flight).
15. My question: How do two countries cancel out their debts? e.g. if the U.S. owes Rupiahs to Indonesia, and Indonesia owes US\$ to U.S., what is the fair way for both countries to cancel out their debts? If both countries want the debts to be cancelled, then it should be done at the nominal exchange rate. Though this may be complicated by issues such as maturity date of debt, terms and conditions of specific debts, etc.
6. GDP Accounting Fundamentals
1. Three approaches for measuring the value of total output
1. Value added – Sum up the “value added” at each state of production, where “value added” = sales revenue – cost of non-labor inputs (i.e. inputs purchased from other firms). Do it over all goods and services produced within the nation.
2. Expenditure – Calculate the nation’s spending on final goods and services. It is final if it does not represent an input into the current production of another good or service.
3. Income – Sum of wages, salaries, interest, dividends, rent, and royalties. Adjust by adding depreciation, indirect business taxes, etc. This is because the expenditure and value-added is ultimately allocated to factors of production (i.e. labor and capital).
2. Transactions not associated with production of new goods and services (e.g. government welfare payments, capital gains and losses, sale of used goods) are excluded.
3. GDP constituents
1. Consumption (C) = all household purchases of new goods and services for current use
2. Investment (I) = expenditures intended to increase future output of final goods and services
3. Government expenditure (G) = government spending on goods and services
4. Net exports (EX – IM)
4. Net Domestic Product (NDP) = GDP less depreciation. Depreciation (a.k.a. consumption of fixed capital) = the value of wear and tear, obsolescence, accidental damage, and aging. This depreciation takes place during the year after the output has been produced / purchased, so NDP (a.k.a. net output) measures the amount of output that can be consumed, more accurately.
5. GDP vs GNP
1. GDP measures the market value of all final goods and services produced within a country’s borders over a given year. GNP (Gross National Income = GNP – indirect business taxes) measures output produced by a country’s residents, regardless of where they produce it. Toyota’s profits on production in U.S.’ plants, is included in Japanese GNP but excluded in U.S. GNP.
2. GNP = GDP + net income payments from abroad (a.k.a. net international factor payments). [My note: Net Foreign Factor Income (NFFI) = Factor payments received from foreigners by domestic citizens MINUS factor payments made to foreign citizens for domestic production. National income = NDP + NFFI.]
3. Countries which received large foreign investments and hence pay substantial remittances abroad, will have GNP lower than GDP.
4. Countries which large amounts of labour and capital overseas, will have GDP higher than GNP.
6. Historical Comparison
1. To control for changes in the aggregate price level (inflation), the simple fixed-price approach of selecting one base year failed to account for introduction of new goods, disappearance of old goods, improvements in the quality of existing goods, changes in consumption patterns (e.g. consumers buy more of goods with falling relative prices).
2. Commerce Department in 1996 adopted a chained method where every year became a base  year for the year that was immediately adjacent to it. This accounted for changes in the mix of goods and services sold in the market. However, components of GDP after being deflated with a chained price index no longer necessarily summed exactly to real GDP. [My notes: Am surprised that it took so long to implement this obvious method. It is the year-to-year changes that matter.]
7. Cross-Country Comparison
1. Using market exchange rates to convert GDPs to a common currency unit is misleading because this should only be done for goods and services that are actually traded internationally (developing countries may have non-tradable goods being a large portion of GDP).
2. Standard solution is to create an index of purchasing power parity (PPP), essentially calculating the value of all goods and services in each country using the prices of a common country (e.g. U.S.). The Economist Intelligence Unit (EIU) and the University of Pennsylvania have produced PPP-adjusted estimates of GDP.
8. Investment
1. Gross product = C + I + G + (EX – IM) = Gross income. And Gross income + transfer payments (Tr) = C + private savings (S) + taxes (T), because all income must ultimately be used on one of the three ways. [My note: these are all in the same period, think of it as a continuous process throughout the year where income was spent or saved and in turn generated new income, etc.]
2. Re-arranging, we get I = S + (T – G – Tr) + (IM – EX). Investment is funded out of Private savings (personal savings + retained earnings of firms), Government budget surplus (Government savings), and Net imports (borrowing from abroad).
3. If (IM – EX > 0), then there is foreign borrowing and domestic expenditure exceeds domestic output (C + I + G > GDP). [My note: actually if a country can somehow sustain it (e.g. inflate away the debt, etc.), domestic expenditure is a better gauge of the wealth of the country (in terms of what the citizens enjoy) than domestic output]
4. Analysts view a current account deficit of more than 5% of GDP as a red flag. Mexico’s current account deficit jumped from 3% of GDP in 1990 to 7% in 1994. Net imports increased from 1.1 to 4.8% of GDP. There was huge capital inflows. However, total investment (as a share of GDP) was falling and consumption was rising. It suffered a currency crisis in 1994-1995 with the peso.
7. Short History of Money and U.S. Monetary Policy
1. Gold and Silver as Currency
1. Before the establishment of the Fed in 1914, the dollar coin is equal to 371.25 grains of fine silver, or 24.75 grains of fine gold.  Banks issued notes that can be redeemed for coins [My note: this effectively made gold and silver the single global currency.]
2. Theoretically, if the country experienced inflation, imports would increase and exports would fall. Gold and silver will flow out of the country. This decreases the money supply which will help to lower prices (countering inflation). If there is deflation, gold and silver will flow in, pushing up prices.
3. In practice, there was no price stability because the quantity of gold is unstable. When the quantity of gold rose very slowly compared to output, it leads to deflation (in terms of gold). When there is a dramatic increase in gold supply, there was a decade of inflation.
4. Interest rates also swung wildly in response to seasonal demands for money (e.g. increase in money demand at harvest time can cause dramatic rise in interest rates) because the money supply was inflexible.
5. Irving Fisher proposed  in 1913 that the dollar’s gold content should be dynamically adjusted so as to maintain the purchasing power of the dollar (i.e. when the gold can buy more goods, the dollar’s gold content would be proportionately reduced, and do the converse when gold “depreciates”). [My note: this proposal would effectively create a separate dollar currency tied to output, with a floating exchange rate with gold. Previously, the dollar as a currency is exactly the same as gold.]
2. Establishment of the Fed
1. The Fed was set up to create a more elastic money supply that changes depending on money demand. Money was injected or “withdrawn” through the discount window. However, the law required the Fed to keep a gold reserve equal to at least 40% of the currency it issued.
2. Theoretically, if people believed that too much currency had been issued, they would exchange their dollars for gold at the Fed. The Fed would be forced to raise its discount rate to “contract” the money supply so as not to fall below the 40% requirement.
3. Because of the peg to gold, the Fed was unable to lower its discount rate even when the U.S. fell into the Great Depression from Oct 1929 to 1933. Because of this, the U.S. outlawed and confiscated private gold. The gold standard was dropped in 1971.
3. Fiat Currency
1. To know how much money to create, a policy objective is required (e.g. low inflation? low unemployment?)
2. Money Supply * Money Velocity = Nominal GDP = Price level * Quantity of Output (i.e. real GDP). Monetarists like Milton Friedman favored growing M1 at a rate equal to the rate of expected real GDP growth so that the price level is stable (i.e. very low inflation). They assume that Velocity is stable.
3. By 1990s, the consensus is for the central bank to target a low and stable inflation rate. That is done by focusing on moving the short-term interest rate (fed funds rate) by controlling money supply.
4. How to think about the changes
1. When the dollar was pegged to gold, the price of the dollar was fixed. Supply and demand (of both gold and goods) then only moved the quantity (i.e. the amount of dollars or gold needed for each good or service).
2. When the dollar was floated, the quantity of dollars (i.e. money supply) was fixed by the central bank. Supply and demand then moved the price of the dollar (i.e. how much gold is a dollar worth).
3. Initially the goal was to make the dollar stable relative to gold. However, this caused the aggregate price level to fluctuate wildly.
4. Now the goal is to stabilize the purchasing power of the dollar relative to output (goods and services), i.e. target low inflation.
8. Key Terms
1. Monetary Base: Total liabilities of the central bank, includes all currency outstanding plus reserves of commercial banks held at the central bank.
2. Money Multiplier: Total money supply / monetary base
3. Money Supply: M1 = currency in circulation + demand deposits. M2 = M1 + time deposits (i.e. savings accounts).
4. Velocity of Money: Number of times money circulates within an economy in a period of time (e.g. 10 times a year). V = Nominal GDP / Money Supply. M*V = GDP = P*Q.
9. Data sources for future research

1. Domestic expenditure, domestic output, sources of investment: Bureau of Economic Analysis, U.S. Department of Commerce
2. U.S. Balance of Payments: Bureau of Economic Analysis, U.S. Department of Commerce
10. -END-