Download In the study of Macroeconomics we look at how the

The Circular Flow Model: is a visual diagram of the economy that shows how dollars flow
through markets among households and firms.
Basically what the Circular Flow model shows us is that
Firms produce goods and services using inputs, called the Factors of Production.
Households own the factors of production and consume all the goods and services that the
firms produce
Here we have two decision makers: Households and Firms
The interact in Two markets
The Product Market or the market for goods and services: households are the buyers and
the firms are the sellers
In the Factor Market named after the Factors of Production, households are sellers, and
the firms are buyers.
The inner loop of the circular flow model:
The households sell the use of their labor, land, and capital to the firms in the markets
for the factors of production. The firms then use these factors of production to
produce goods and services.
The factors of production flow from households to firms, and goods and services flow
from firms to households.
The outer loop of the circular flow model:
The households spend money to buy goods and services from the firms. The firms
use some of the revenue from these sales to pay for the factors of production, such
as the wages of their workers. What's left is profit of the firm owners, who themselves
are members of a household.
Spending on goods and services flows from households to firms, and income in the
form of wages, rent, and profit flows from firms to households.
Example: You take your income and buy a drink at starbucks. Your money becomes their
revenue, to which they will pay rent/wages/etc. The money then becomes someone else's
income… and the flow starts all over again.
Business Cycle: a period of macroeconomic expansion followed by a period of
contraction.
Expansion: a period of economic growth as measured by a rise in real GDP
Economic Growth: a steady, long term increase in real GDP
Peak: the height of an economic expansion, when real GDP stops rising
Contraction: a period of economic decline marked by falling real GDP
Trough: the lowest point in an economic contraction, when real GDP stops falling
Recession: a prolonged economic contraction
We are now going in to a recession… two consecutive quarters of falling real
GDP
Depression: a recession that is especially long and severe
The Great Depression: real GDP fell by 27% from 1929 to 1933 and
unemployment rose from 3% to 25%, at the same time the price level fell about 22%
over these 4 years
Stagflation: a decline in real GDP combined with a rise in the price level
1970’s: originated in the oil fields of the Middle East. Our supply of oil from the
Middle East decreased because of OPEC (the Organization of Petroleum Exporting
Countries) … aggregate supply went down because so much of our livelihood depends
on oil. Prices increased and output decreased… not a good combination.
OPEC is a cartel, which is a group of sellers that attempts to thwart competition and
reduce production in order to raise prices.
The GREAT DEPRESSION:
Before we begin our discussion over the Great Depression we need to understand the difference
between a bull and bear market.
1. Bull Market is a market where there is a steady rise in the stock market over a period of
time
2. Bear Market is a market where there is a steady drop in the stock market over a period
of time.
During the 1920’s, or the roaring 20’s, America was experiencing a long-term Bull market.
When Herbert Hoover took office the United States economy seemed to be in excellent
shape. The stock market is widely viewed as the nation’s main economic indicator, and the stock
market was soaring.
But there were signs of trouble, first,
1. A relatively small number of companies and families held much of the nation’s wealth.
2. People were buying new goods like refrigerators and radios and going in to debt doing so.
3. Industries were also producing more goods than consumers could buy. These surpluses
that firms developed caused prices of goods and services to slump.
4. People saw that the Stock market was going up; they thought that this would continue, so
they made high risk investments with borrowed money in the hopes of getting a big return.
5. To attract less-wealthy investors, stock brokers encouraged a practice called “buying on the
margin”
a. “Buying on the margin”: allowed investor to purchase a stock for only a fraction of
its price and borrow the rest from the brokerage firm.
b. Broker’s loans to these investors when from about $5 million in 1928 to $850
million in September 1929.
The Crash of 1929:
September 3rd, the Dow Jones reached a peak of 381.2, after this peak in September, stock
prices began to fall. Some brokers demanded repayment of loans. Tuesday, October 24th 1929,
investors were worried about falling stock prices and began selling, and stock prices fell further.
By Monday, October 28th, the values of shares of stock were dropping to a fraction of what people
had paid for them. Investors raced to get what was left of their money out of the stock market.
“Black Tuesday”: October 29th, 1929, a record of 16.4 million shares was sold, compared with the
average 4-8 million shares per day earlier in the year.
People lost an estimated $45 billion in wealth and the market did not reach its 1929 peak level for
another 25 years.
People’s confidence in the market was shot, and people and firms were less willing and less able to
spend money. Banks could not make loans. Fearful that banks would run out of money, people
rushed to their banks demanding their money. To pay back these deposits, banks had to recall
loans from borrowers, but they could not do so fast enough to play all the depositors demanding
their money. Many banks failed. Production stopped. Unemployment rose. Prices fell.
In 1933, FDR declared a bank “holiday”. He temporarily closed all banks to stop the banking panic.
Congress the passed the Banking Act of 1933, which created the Federal Deposit Insurance
Corporation (FDIC) to insure deposits. This meant that even in a bank failed, deposits would be
guaranteed by the federal government.
The Great Depression substantially increased the role of the Federal government in the
economy.
From 1929 to 1933 and unemployment rose from 3% to 25%,
Speaking of Unemployment,
There are 4 types of unemployment.
1. Frictional Unemployment: Unemployment that occurs when people take time to find a
job.
a. For example, people might change jobs and need time before they can find
another job. While people are looking for work between jobs they are
considered frictionally unemployed.
2. Seasonal Unemployment: unemployment that occurs as a result of harvest schedules
or vacations, or when industries slow or shut down for a season
a. Air conditioning, Christmas Trees, Firework stands
3. Structural Unemployment: Unemployment that occurs when workers’ skills do no
match the jobs that are available
a. 5 major causes of structural unemployment
i. The development of new technology
ii. The discovery of new resources
iii. Changes in consumer demand
iv. Globalization
v. Lack of education
4. Cyclical Unemployment: unemployment that rises during economic downturns and
falls when the economy improves.
a. During recessions or depressions
Full Employment: zero unemployment is not an achievable goal in a market economy. But when
the unemployment rate is around 4-6% it is considered normal.
The level of employment reached when there is no cyclical unemployment.
In the study of Macroeconomics we look at how the economy is doing as a whole. One way to
monitor an economy’s performance is looking at the “income” or Gross Domestic Product, GDP,
of a nation.
A nation’s GDP is the most closely watched economic statistic because it is thought to be
the best single measure of a society’s economic well-being.
Gross Domestic Product (GDP): is the market value of all final goods and services produced
within a country in a given period of time.
“GDP is the Market Value”: the value, or how much, every good in the market cost all
together (gross means whole or entire)
“… of all…”: this includes all items produced in the economy and sold legally in markets
(excludes the black market or the garden you have at home that only you eat from)
“…Final…”: all inputs by itself are not part of GDP. GDP includes only the value of final
goods. EX: Pizza would be included in GDP but the dough, cheese, pepperoni, and sauce
are not because by themselves they are not a pizza, they are not final goods, they are
inputs. The pizza is a final good and what is included into GDP. If these inputs were
counted as GDP then when they are made to make pizza you would be counting them
twice, or double counting, and would skew the correct GDP
“… Goods and Services…”: this includes goods like books, clothes, cars, food; and includes
services like haircuts, housecleaning, doctor visits.
“…Produced…”: this only includes goods and services currently produced. If General
Motors produces and sells a new car, the value of the car is included in GDP. But when one
person sells a used car to another person, the value of the used car is not included in GDP.
“… within a Country…”: When anybody, whether American or not, produces a good or
service in the United States the value of that good or service is included in the GDP of the
United States. But when an American produces a good or service in another country, then
it is not counted as a part of GDP
“…In a given Period of Time”: Usually the interval of time of which GDP is measured is
either a year or a quarter (3 months)
Just like if you were to judge who well a person is doing economically, you would look at their
income. Someone with a high income can more easily afford life’s necessities and luxuries. People
with a higher income enjoy a higher standard of living (better housing, health care, and more
vacations).
The same logic applies to a nation’s overall economy.
GDP is what is looked at when judging how well an economy is doing.
GDP measures two things:
1. The total income of everyone in the economy
2. The total expenditures on the economy’s output of goods and services
How does this do this? It is because they are one in the same
For an economy as a whole, income must equal expenditure (Remember the Circular Flow
Model)
We can compute GDP for this economy in one of two ways: by adding up the total
expenditure by households or by adding up the total income (wages, rent, and profit) paid
by firms.
Economists are interested in the composition of GDP. If we say GDP is the total expenditures of
the economy’s output… what really do we add up to get GDP?
GDP (or Y) = Consumption (C) + Investment (I) + Government Purchases (G) + Net Exports (X)
Consumption is consumer goods and services, which are broken down into
1. Durable: goods that last for a relatively long time
a. Cars
b. Refrigerators
2. Nondurable: goods that last a short period of time
a. Food
b. Clothing
Investment is business goods and services.
When a firm or business buys capital it is a part of Investment spending in GDP
An investment is the purchase of a good that will be used in the future to produce more
goods and services.
An investment is also an education
Government Spending includes spending on goods and services by local, state, and federal
governments.
This includes salaries of government workers and spending on public works
Net exports equal the purchase of domestically produced goods by foreigners (exports) minus the
domestic purchases of foreign goods (imports)
Exports - imports
Net actually means that imports are subtracted from exports.
So if we import 200 dollars worth of goods and export 200 dollars worth of goods… our net export
is 100 dollars. Because 300 (exports) – 200 (imports) = 100. This is a favorable balance of trade.
Since exports and imports are trade between two countries. Anytime a country exports more than
it imports it is called a favorable balance of trade because it is good for the country if you export
more than you import because you are not dependent on other countries for you wellbeing.
But we import oil. We do not export oil. We do not have a favorable balance of trade
when it comes to oil… We have a trade deficit. We import more than we export and therefore are
dependent on other countries for our wellbeing.
In the definition of Gross Domestic Product, and even in the phrase itself, we are dealing with
goods and services produced within a country. So even an immigrant from another country
working in America, producing goods and services contributes to the U.S. GDP
Besides GDP there are also other measures of economy income, and that is GNP: Gross National
Product. The GNP is the annual income earned by U.S.-owned firms and U.S. citizens.
GNP is a measure of the market value of all goods and services produced by Americans in
one year.
This does not include that immigrant working in America because he is not a U.S. citizen.
But GNP does include American ran companies overseas.
Hence, “National”… think of American.
There are several other measurements of the economy…. GDP, GNP
1. Net National Product
2. National Income
3. Personal Income
4. Disposable income
These are all measurements used to judge the wellness of an economy, but the one we’ll be
dealing with the most is GDP.
So why are there so many measurements of the economy?
The more economists know about the nation’s economic health, the better the
chance of anticipating and preventing problems
We’ve been talking a lot about GDP in the last few days. Let’s look at it more carefully… There are
actually 2 types of GDP. GDP measures the total spending on goods and services in all markets in
the economy. If total spending rises from one year to the next, one of two things must be true:
1. The economy is producing a larger output of goods and services, or
2. Goods and services are being sold at higher prices.
Economists want to separate these two effects. Economists want a measure of the total quantity
of goods and services the economy is producing that is not affected by changes in the prices of
those goods and services. We have to distinguish between REAL and NOMINAL GDP
1. Economists use a measure called Real GDP. REAL GDP answers a hypothetical question:
what would be the value of the goods and services produced this year if we valued
these goods and services at the prices that prevailed in some specific year in the past?
Real vs. Nominal GDP
2. Economists use a measure called Real GDP. REAL GDP answers a hypothetical question:
what would be the value of the goods and services produced this year if we valued
these goods and services at the prices that prevailed in some specific year in the past?
REAL GDP: the production of goods and services valued at a constant price
This accounts for inflation: which is an increase if the overall level of prices in the economy
VS. Nominal GDP: the production of goods and services valued at current price.
(If needed watch video again)
We have to adjust old prices into current dollars so we can make sense of the information.
Because of inflation, prices can be misleading at times because… it’s like comparing two fractions
with different denominators…
Because what is bigger: 357/481 or 768/842… you can’t really tell unless you get common
denominators.
The GDP deflator finds the common denominator; it is a measure of the price level calculated as
the ratio of nominal GDP to real GDP times 100… which looks like this,
(Nominal GDP/Real GDP) * 100 = GDP DEFLATOR
We have to use previous years, and not the base year, because in the base year
real=nominal GDP and therefore the GDP deflator would equal 100.
Consumer price Index (CPI) is computed each month by the Bureau of Labor Statistics (BLS). The
CPI is determined by measuring the price of a standard group of goods meant to represent the
“market basket” of typical urban consumers
FOOD AND BEVERAGES (breakfast cereal, milk, coffee, chicken, wine, full service meals,
snacks)
HOUSING (rent of primary residence, owners' equivalent rent, fuel oil, bedroom furniture)
APPAREL (men's shirts and sweaters, women's dresses, jewelry)
TRANSPORTATION (new vehicles, airline fares, gasoline, motor vehicle insurance)
MEDICAL CARE (prescription drugs and medical supplies, physicians' services, eyeglasses
and eye care, hospital services)
RECREATION (televisions, toys, pets and pet products, sports equipment, admissions);
EDUCATION AND COMMUNICATION (college tuition, postage, telephone services,
computer software and accessories);
OTHER GOODS AND SERVICES (tobacco and smoking products, haircuts and other personal
services, funeral expenses).
They look at the cost of these goods month to month to see how prices change over time and
therefore inflation and deflation
Inflation: prices rise over time
Deflation: prices lower over time
A little inflation (1-3%) is normal but when the inflation rate is over 5% then the economy can
become unstable and unpredictable. Any deflation is a bad thing.
Hyperinflation: inflation that is out of control
3 causes of inflation
1.
Quantity theory (too much money in the economy)
2.
Demand-Pull theory (more demand than supply and producers raise prices to lower the
demand)
3.
Cost-Push theory (producers raise prices in order to meet increased costs of inputs)
In Macroeconomics, we study the economy as a whole. When we are talking about the whole
economy, like Macroeconomics we talk about
Aggregate demand: This is the amount of goods and services in the economy that will be
purchased at all possible price levels.
P
AD
GDP
Just like our demand for goods and services, Aggregate demand, which is the demand for the
whole economy for goods and services, is also downward sloping on a graph where Price is on the
y-axis and Quantity is on the x-axis.
To understand the downward slope of the Aggregate demand curve we must examine how
the price level affects the quantity of goods and services demand for consumption,
investment and net exports…
We need to turn to the equation for GDP
Y=C+I+G+NX
1. Let’s first look at Price level and Consumption: The Wealth Effect
a. A decrease in the price level makes consumers “wealthier”, which in turn
encourages them to spend more. The increase in consumer spending means a
larger quantity of goods and services demanded.
i. When prices fall, the dollars that you have in your pocket are more
valuable. If something goes on sale, that same dollar can buy more of
these cheaper goods and services.
ii. This feeling of being wealthy encourages people to spend more… even
though that dollar is still just a dollar
2. Price Level and Investment: the Interest rate effect
a. Not only do you feel wealthier when prices go down… but you need less
dollars/money to buy the same amount of goods and services as before. What
happens to this extra money that people have? Households would try to
convert some of their money into interest-bearing assets (buy bonds, put it into
a savings account)
b. When this happens... it drives down interest rates
c. Lower interest rates, in turn, encourage borrowing by firms that want to invest
in new equipment and by households who want to invest in new housing.
d. A lower price level reduces the interest rate, encouraging greater spending on
investment goods, and thereby increases the quantity of goods and services
demanded.
3. The Price Level and Net Exports: The Exchange Rate Effect
a. A lower U.S. price level means that U.S. goods and services are cheaper. This
will entice foreigners to buy U.S. goods and services and fewer foreign goods
and services.
b. Thus increasing Net Exports
These are the reasons that the Aggregate Demand Curve is downward sloping.
SHIFTERS OF Aggregate Demand:
Changes in Consumption Spending, Investment Spending, Government Spending or Net
Exports
Aggregate Supply: the total amount of goods and services in the economy available at all possible
price levels.
When the price level, or the average of all prices in the economy, changes firms respond to this
change by changing the quantity of their output, production, or aggregate supply.
As price level rises, real GDP, or aggregate supply, rises
As price level falls, real GDP, or aggregate supply, falls
Shifts in the AS curve can be caused by the following factors:
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changes in size & quality of the labour force available for production
changes in size & quality of capital stock through investment
technological progress and the impact of innovation
changes in factor productivity of both labour and capital
changes in unit wage costs (wage costs per unit of output)
changes in producer taxes and subsidies
changes in inflation expectations - a rise in inflation expectations is likely to
boost wage levels and cause AS to shift inward
Before the Great Depression, people believed that free markets regulated themselves, and that
benefited all households and firms involved.
Classical economists like Adam Smith dominated economic theory and government policy.
At the height of the Great Depression, an economist named John Maynard Keynes, wrote The
General Theory of Employment, Interest and Money.
Keynes claimed that a natural recovery to the Great Depression was impossible. He argued
that the government should lower taxes and interest rates to encourage investment and
increase spending on public projects to stimulate demand for goods and create jobs.
Keynes recognized that raising spending while cutting taxes would lead to budget deficits,
but he accepted the liability if it boosted employment and lead to economic recovery.
His theories were controversial then and today. Some critics to Keynesian Economics
blame the huge federal budget deficit that the United States built up from the 1960’s to
the 1990’s.
We saw that after the Great Depression, the role of the Government in the economy increased.
One way that the government intervenes in the economy is by raising and lowering taxes and
increasing and decreasing government spending.
This is called Fiscal Policy: the use of government spending and revenue collection (taxes) to
influence the economy.
Expansionary Fiscal Policy: used to raise the level of output in the economy by increasing
aggregate demand. When the economy is in the contracting stage of the business cycle the
government uses expansionary fiscal policy to stimulate the economy. They do this by:
1. Increasing government spending
2. Cutting Taxes
Contractionary Fiscal Policy: used to decrease the level of output in the economy by decreasing
aggregate demand. When the economy is in the expanding stage of the business cycle the
government uses the contractionary fiscal policy to slow the economy. We don’t want very high
levels of inflation. The government does this by:
1. Decreasing government spending
2. Increasing taxes
Yesterday we talked about Fiscal policy and John Maynard Keynes who is the father of Keynesian
Economics.
We said that when the government intervenes in the economy by implementing fiscal
policy by raising/lowering taxes or increasing/decreasing government spending that it’ll
cause a federal budget deficit.
The costs of this debt must be measured against the benefits of government spending.
Does the end outweigh the means… do the benefits outweigh the costs?
The government can have a
1. Balanced budget: revenues are equal to spending
a. There is the same amount of money going into the US treasury as coming out
b. Taxes = government spending
2. Budget Surplus: an excess of government receipts over government spending
a. The government is making more money than it is spending.
b. Taxes > government spending
3. Budget Deficit: a shortfall of tax revenue from government spending
a. The government is spending more money than it is receiving from taxes.
b. Taxes < government spending
When the government runs a deficit, they can do one of two things
1. Create money
a. Either by printing more money
b. Or depositing money in people’s bank accounts
This can create hyperinflation: very high inflation
2. Borrow money: how do they borrow money? They sell bonds.
a. A bond is a type of loan. Consumers and businesses buy bonds from the
government (t-bills: less than a year, t-notes: 2-10 years, t-bonds: 30 years)
b. Therefore a government now has money to cover its deficit.
The problem of borrowing money by selling bonds is it creates National Debt, or public debt.
National debt is the total amount of money the federal government owes to bondholders.
Taxes:
Before we talk about Fiscal Policy that was prevalent in the times after the Great Depression we
have to talk about taxes, because they kind of go hand in hand.
What are taxes?
Taxes are required payment to local, state, and national governments. Taxation is the
primary way that the government collects money. Taxes give the government the money it
needs to operate.
These taxes become revenue, or income received by a government from taxes and nontax
sources.
There are many kinds of taxes for many different things. Economists describe a tax according to
the value of the object taxed and how the tax is structured.
A tax base is the income, property, good, or services that is subject to a tax. The tax base
Person’s earnings: individual income tax
1. The dollar value of a good or service being sold: sales tax
2. The value of property: property tax
3. Or the value of a company’s profits: corporate income tax
When the government creates a new tax they first decide what the base will be for the tax:
income, sales, property, or profits, or some other category.
1. Proportional tax: A tax for which the percentage of income paid in taxes remains the
same for all levels of income
a. Positives: Flat tax positives - easy to calculate, everyone is taxed at the same
rate and pays the same amount per dollar of income, i.e. earn 1 buck pay .20,
earn 1,000,000 pay 200,000
b. Negatives: The major negative is that no one can agree about the amount that
should be exempted.
Most people agree that some should be exempted, but no one agrees what it
should be.
2. Progressive tax: A tax for which the percentage of income paid in taxes increases as
income increases
a. Positives: It is fair that people who earn more income should pay a higher
proportion of their income in tax. The tax supports the administration of their
country which provides the sort of operating environment in which they are
able to earn their wages in the first place. Even when paying a higher marginal
rate on the top end of their earnings, they will still take home more than people
who are paid less with a tax rate anything up to 100%.
b. Negatives: It is unfair that people who earn more should pay at a progressive
rate. Even on a standard rate, they already pay more tax, because they have a
higher taxable income. Therefore progressive tax rates are a form of double
taxation, as higher earners pay tax on more income, and then at a high level.
This is further unfair to them since high earners are the least likely group to
benefit from much taxpayer-funded activity e.g. welfare.
3. Regressive tax: A smaller percentage of income is taken in taxes as income increases
a. Negatives: Poor Pay More: One consideration, from a benefit principle view, is
that the poor tend to benefit more from government operations and public
goods (public transportation, public assistance programs, etc.) and as such
should pay accordingly
b. Positives: Regressive taxes are favored by a sizable contingent of the
population, especially those with relatively more income
Whatever the tax may be, economists agree on what makes a good tax. A good tax should have 4
characteristics
1. Simplicity: tax laws should be simple and easy to understand. It should be easy to keep
and maintain tax records, prepare own tax forms and pay taxes on a predicable schedule
2. Efficiency: Government should be able to collect taxes without spending too much time or
money.
3. Certainty: It should be clear to the tax payer when taxes are due, how much is due, and
how the tax should be paid
4. Equity: the tax system should be fair, so that no one bares too much or too little of the tax
burden
a. Benefits-received principle: a person should only pay taxes based on the level of
benefits he or she expects to receive
b. Ability-to pay principle: people should pay taxes according to their ability to pay
Laffer Curve: shows that there is some percentage between 0-100% that is idea for both
government and people.