14 Exam Preparation

Lecture from: 16.12.2025 | Video: Video ETHZ

Course Overview: Principles of Macroeconomics

This document synthesizes the entire course into a logical structure, showing how the individual lectures connect to build a complete model of the economy.

1. The Core Framework (Long Run vs. Short Run)

The course is divided into two distinct time horizons with different governing rules.

Horizon	Primary Constraint	Key Driver	Main Model
Long Run (Trend)	Resources (Supply Side)	Productivity ($Y/L$)	Solow Growth Model
Short Run (Cycle)	Demand (Demand Side)	Aggregate Demand ($C+I+G+NX$)	AD-AS / IS-LM

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2. The Mental Map of Macroeconomics

graph TD
    subgraph Long_Run [The Long Run: Growth & Living Standards]
        Productivity[Productivity Y/L] --> |Determines| LivingStandards[Why are we rich/poor?]
        Factors[Production Function <br> K, L, H, N, A] --> |Determines| Productivity
        Solow[Solow Model] --> |Analyses| Factors
        Saving[Saving s] --> |Accumulates| Capital[Capital K]
        Tech[Technology A] --> |Drives| LongRunGrowth[Sustained Growth]
    end

    subgraph Money_Prices [Money & Prices]
		direction TB
        MoneySupply[Money Supply M] --> |Determines| PriceLevel[Price Level P]
        QuantityTheory[Quantity Theory <br> MV = PY] --> |Valid in| Long_Run
        CB[Central Bank] --> |Controls| MoneySupply
        Inflation[Inflation] --> |Cost of| MoneyHoldings
    end

    subgraph Open_Economy [The Open Economy]
        FlowGoods[Net Exports NX] --- |=| FlowCapital[Capital Outflow NCO]
        ExRates[Real Exchange Rate] --> |Balances| FlowGoods
        Interest[Real Interest Rate] --> |Balances| FlowCapital
    end

    subgraph Short_Run [The Short Run: Business Cycles]
        Sticky[Sticky Prices/Wages] --> |Causes| Deviations[Output Gaps]
        IS_LM[IS-LM Model] --> |Derives| AD_Curve[Aggregate Demand]
        Expectations[Expectations Pe] --> |Shifts| AS_Curve[Short-Run Aggregate Supply]
        Phillips[Phillips Curve] --> |Trade-off| Infl_Unemp[Inflation vs Unemployment]
    end

    Long_Run --> |Trend Line| Short_Run
    Money_Prices --> |Nominal Anchor| Long_Run
    Open_Economy --> |External Context| Short_Run

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3. Detailed Concept Breakdown

A. Measuring the Economy (The Scorecard)

Before analyzing, we must measure.

• GDP ($Y$): Total Income = Total Expenditure. ($Y=C+I+G+NX$).
• CPI/Deflator: Measuring the price level ($P$) to separate Real vs. Nominal variables.
• Unemployment: Measuring labor utilization (Natural Rate vs. Cyclical).

B. The Long Run (The Supply Side)

Assumption: Prices are flexible. Resources are fully utilized.

1. Production: $Y=AF(K,L,H,N)$. Output depends on inputs.
2. Growth: Capital accumulation ($sY=\delta K$) leads to a steady state. Only technological progress ($g_A$) creates sustained growth (Solow).
3. Finance: Saving ($S$) equals Investment ($I$). The interest rate ($r$) balances the market for loanable funds.
4. Money: Money is neutral. Doubling $M$ doubles $P$ but leaves $Y$ unchanged (Classical Dichotomy).

C. The Open Economy extension

Assumption: We trade with the world.

1. The Identity: $NX=NCO$. Trade balance matches capital flows.
2. Exchange Rates:
   • Nominal ($e$): Currency price.
   • Real ($ϵ$): Goods price. Balances demand for Net Exports.
3. Policy: Trade restrictions affect the volume of trade, not the balance (because of exchange rate appreciation).

D. The Short Run (The Demand Side)

Assumption: Prices/Wages are sticky. Demand drives production.

1. IS-LM:
   • IS: Goods Market equilibrium (Fiscal Policy).
   • LM: Money Market equilibrium (Monetary Policy).
2. AD-AS:
   • AD: Downward sloping (Wealth, Interest-Rate, Exchange-Rate effects).
   • SRAS: Upward sloping (Sticky Wages, Sticky Prices, Misperceptions).
   • Adjustment: Over time, price expectations ($P^e$) adjust, shifting SRAS until output returns to the natural rate.
3. Phillips Curve: The menu of choices. Lower unemployment is bought with higher inflation in the short run. In the long run, the curve is vertical (natural rate).

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4. Exam Strategy Checklist

When faced with a macroeconomic shock question:

1. Time Horizon: Are we asked about the Short Run (immediate impact) or the Long Run (final equilibrium)?
2. The Shock: Does the event shift Aggregate Demand (C, I, G, NX shocks) or Aggregate Supply (costs, oil, technology)?
3. The Mechanism (Short Run):
   • Shift the curve.
   • Identify new $P$ and $Y$.
   • Identify effect on Unemployment ($u$).
4. The Adjustment (Transition):
   • Compare Actual $P$ vs. Expected $P^e$.
   • Shift SRAS to restore long-run equilibrium.
5. Policy Response (Optional):
   • Fiscal (Budget, Taxes) vs. Monetary (Interest Rates).
   • Active stabilization vs. Passive correction.

Remember the Identity

In almost every problem, start with the relevant identity.

• Growth? $Y=AF(K,L)$.
• Trade? $NX=NCO$.
• Money? $MV=PY$.
• Demand? $Y=C+I+G+NX$. Writing the equation first clarifies which variables are moving.