STUDY SESSION 5 ECONOMICS: Macroeconomic Analysis READING ASSIGNMENTS Reading 21 Reading 22 Reading 23 Reading 24 Reading 25 Reading 26 Reading 27 Reading 28 Demand and Supply in Factor Markets Monitoring Cycles, Jobs, and the Price Level Aggregate Supply and Aggregate Demand Money, Banks, and the Federal Reserve Money, Interest, Real GDP, and the Price Level Inflation Fiscal Policy Monetary Policy T his study session introduces the macroeconomic concepts that have an impact on all firms in the same environment, be it a country, a group of related countries, or a particular industry. This study session explains the business cycle and how to forecast changes in the business cycle and the impact on, among other things, price levels and profitability. Supply and demand for resources, such as labor and capital, are strongly interrelated. An increase in wages, for instance, results in increased prices for the goods and services provided, which, in turn, results in a change in purchasing power. As a result of the higher prices, inflation increases, leading to a demand for higher wages. To prevent this vicious circle from spiraling out of control, governments devise fiscal and monetary policies. These policies are typically related to measures to control inflation, such as changes in interest rates. Because interest rates are reflected in the cost of capital, changes in interest rates lead to a change in the demand for capital and, therefore, affect the investment decisions of a firm. 227 228 Study Session 5 LEARNING OUTCOMES Reading 21: Demand and Supply in Factor Markets The candidate should be able to: a. explain the difference between marginal revenue and marginal revenue product; b. discuss how the labor demand curve is derived from the marginal revenue product curve, the conditions of profit maximization, the factors determining the demand and for labor, elasticity of the demand for labor, and labor market equilibrium; c. explain the difference between physical and financial capital, and how the demand for physical and financial capital are related to each other; d. discuss how a firm compares the future marginal revenue product of capital with the current price of capital, and the relationship between the quantity of financial capital demanded and the interest rate; e. discuss the main influences on demand and supply of capital, and capital market equilibrium; f. distinguish between the supply of renewable and non-renewable natural resources, and explain how equilibrium in a natural resource market is achieved; g. explain how differences occur between large and small incomes; h. distinguish between economic rent and opportunity costs. Reading 22: Monitoring Cycles, Jobs, and the Price Level The candidate should be able to: a. discuss the phases of the business cycle, how the start and end of a recession can be identified, and interpret the main labor market indicators and the relationship of the labor market indicators with the business cycle; b. discuss the concepts of aggregate hours and real wage rates, and how they relate to GDP; c. discuss the types of unemployment, full employment, and the relationship between unemployment and real GDP; d. explain the construction of the CPI, calculate CPI, discuss the relationship between CPI and the inflation rate, and discuss the problems associated with CPI bias. Reading 23: Aggregate Supply and Aggregate Demand The candidate should be able to: a. explain the fundamentals of aggregate supply in the long run and in the short run, and discuss different reasons for changes in aggregate supply and the associated movements along the LAS and SAS curves; b. explain the effects that cause the aggregate demand curve to slope downwards, the main factors influencing aggregate demand, and how changes in these factors influence aggregate demand and the aggregate demand curve; c. discuss the difference between short-run and long-run macroeconomic equilibrium, and explain how the relationship between economic growth, inflation and changes in aggregate demand and aggregate supply influence short- and long-run macroeconomic equilibrium; d. compare and contrast the main schools of macroeconomic thought in relation to aggregate demand and aggregate supply. Study Session 5 229 Reading 24: Money, Banks, and the Federal Reserve The candidate should be able to: a. discuss the functions of money, and the problems that arise when using commodities as money; b. compare and contrast the different depository institutions, their economic function, and the impact of financial regulation, deregulation, and innovation; c. explain how banks create money, and calculate the amount of loans a bank can generate, given a certain amount of deposits; d. discuss the goals and targets of the U.S. Fed, the balance sheet, and compare and contrast the policy tools. Reading 25: Money, Interest, Real GDP, and the Price Level The candidate should be able to: a. discuss the factors determining the demand for money, define the demand for money curve, and the effects of changes in real GDP and financial innovation on the demand for money curve; b. explain how interest rates are determined, the influence on the money market equilibrium, and the interaction between interest rate changes and the money supply; c. discuss the short-run and long-run effects of money on real GDP; d. explain the quantity theory of money. Reading 26: Inflation The candidate should be able to: a. discuss the difference between inflation and price-level, and calculate the inflation rate; b. distinguish between the factors resulting in demand-pull and cost-push inflation, and the impact on price levels, and aggregate demand and supply; c. discuss the effects of unanticipated inflation on the labor market and the market for financial capital; d. distinguish between anticipated and unanticipated inflation, and discuss the adverse effects of anticipated inflation; e. discuss the impact of inflation on unemployment, define the short-run and longrun Phillips curve, and discuss changes in the natural rate of unemployment; f. explain the impact of inflation on the nominal interest rate, and discuss how this is related to the money supply discussed in the previous reading. Reading 27: Fiscal Policy The candidate should be able to: a. interpret potential GDP, and the effects of income tax and tax on expenditure on potential GDP; b. discuss the sources of investment sources, and the influence of fiscal policy on capital markets; c. define the generational effects of fiscal policy; 230 Study Session 5 d. compare and contrast how the government purchases multiplier, the tax multiplier, the balanced budget multiplier, and discretionary fiscal policy can assist in stabilizing the business cycle; e. discuss the limitations of discretionary stabilizers, and distinguish between discretionary fiscal policy and automatic stabilizers. Reading 28: Monetary Policy The candidate should be able to: a. distinguish between price level stability, and sustainable real GDP growth; b. compare and contrast the policies that can be implemented to achieve price level stability; c. discuss policy credibility in relation to aggregate demand and aggregate supply, and the Phillips curve; d. compare and contrast the new Monetarist and new Keynesian feedback rules.