Download Principles of Economics

Principles of Macroeconomics
Fall 2011
Instructor :
Phone :
E-Mail:
Office Hours:
John Winstandley
( 651) 503-4347
[email protected]
Before Class ( 12:30- 1:00), After Class ( 4:30-5:00)
Additional Office Hours :
SA
SA
SA
SA
SA
SA
SA
Sep. 17
Oct. 1
Oct. 15
Oct. 29
Nov. 12
Nov. 19
Dec. 3
(12:15 pm – 1:15 pm)
(12:15 pm – 1:15 pm)
(12:15 pm – 1:15 pm)
(12:15 pm – 1:15 pm)
(12:15 pm – 1:15 pm)
(12:15 pm – 1:15 pm)
(12:15 pm – 1:15 pm)
Recommended Course Text: Macroeconomics: Principles and Policy ( 11th edition), by Baumol and
Blinder
Exams: There will be 2 exams. The second exam will not be cumulative. The exam schedule is as
follows:
EXAM
1
2
DATE AND TIME
% of the Final Grade
SU Oct. 16 , 3:00 pm – 4:30 pm
SU Dec. 4 , 1:00 pm – 4:30 pm
25 %
35 %
Problem Sets: There will be 2 homework assignments. These assignments will include problems based on
the models discussed in lecture/online notes. Homeworks are due at 3:30 pm on their due date. Late
homeworks will be accepted ( before 1:00 pm on December 4), but at a loss of 25 % of the points on that
problem set.
The homework due date schedule is as follows:
HW
1
2
DUE DATE
% of the Final Grade
Oct. 2
Nov. 20
15 %
25 %
Course Grading:
If necessary, I will base a curve around a target distribution on each exam. If the actual distribution is
below the target, points will be added to each student’s score. After this curve is put into place, grades are
as follows:
93 +
: A
90 – 92 : A –
87 – 89 : B +
83 – 86 : B
80 – 82 : B 73 - 79 : C +
66 – 72 : C
60 – 65 : C 55 – 59 : D +
50 – 54 : D
0 – 49 : F
Before the First Class:
directly in class):
you should have read the notes that follow ( we will NOT cover this material
Nominal vs. Real GDP
Gross Domestic Product (GDP) : the sum of the money value of all new final goods and
services produced in the domestic economy ( and sold in a market) during a specified
period of time
- the period of time is often 3 months ( a “ quarter”)
Nominal GDP : value each good produced at its current price
One use of GDP : to track the economy’s health over time
- e.g., are we producing more now than we did 10 years ago?
Nominal GDP is not well suited for this task
Problem: increases in prices will lead to an increase in Nominal GDP
- e.g., output and price for a certain car model:
Year
0
1
Q
10
8
P
$ 10,000
$ 20,000
Nominal Value ( = P x Q)
$ 100,000
$ 160,000
- in the above case, Nominal GDP increased even though output actually fell
- so, using Nominal GDP might fool us into believing that the economy is growing
( or ,above, that the production of cars is increasing)
To solve the problem……………
- Measure the value of production by the price that prevailed in some “base year”
- doing this results in the calculation of Real GDP
- e.g., if the base year = Year 0:
Year
0
1
Q
10
8
Value ( = Price
In Year 0 )
$ 10,000
$ 10,000
Real Value
$ 100,000
$ 80,000
- In that case, the decrease in production leads to a decrease in Real GDP
- i.e., Real GDP will only increase if output actually increases
Intermediate Goods
- GDP only includes sales of final goods and services : those purchased by their
ultimate users
- in contrast, an intermediate good is a good purchased for use in the production of
another product
- these are not included in GDP
- e.g., if a car company buys the engines from another company . these
purchases are not included in GDP, to avoid “ double counting”
- when the car company sells the car to a consumer, part of the price
includes the cost of the engine
- so the engine’s value is included in GDP then
- if it was counted when the car company bought it, it would be
counted twice
The Economic Costs of Unemployment
1) Unemployment implies loss of the goods and services that the workers could have
produced
- which means less output for the economy’s residents to consume
- i.e., in the present, we lose output
but, even when the workers resume working, the costs of unemployment linger…
2) Unemployment implies workers don’t gain new skills, or that the skills they had
previously will begin to deteriorate
- so, unemployment today implies that workers will be less productive in the
future
Counting the Unemployed
- monthly survey by the government
- places those questioned into 1 of 3 categories:
1) Employed – anyone currently working in the market ( including part-time)
2 ) Unemployed – anyone not working who
- expects to return to a previous job
- e.g., a factory temporarily shuts down
or
- has looked for work in the last month
3 ) Out of the Labor Force - anyone not working who is not looking for work
- such individuals don’t factor into the unemployment rate at all
UNEMPLOYMENT RATE ( UR) =
Unemployed
Employed + Unemployed
The Unemployment Rate probably understates the true size of an economy’s problem in
matching workers with jobs
e.g., if the UR = 10%, there are 10% who want to work but can’t find a job
- in that case, clearly a lack of a good “ job match”
other mismatches that won’t show up in the UR:
“ Underemployed” - those who work part-time but would like to work full-time
- they count as Employed, so the UR doesn’t detail this problem
- but, there not “matched” with the right job
“ Discouraged Workers” – those not working who have given up looking for work
- they’re not counted as Unemployed
- this lead to a quirk of the UR: the UR falls as workers give up hope of
finding a job
- this often happens during recessions ( a recent example: it happened in the
U.S. in 2009):
- the recession implies that the economy’s output is falling
- which means fewer jobs are available
- which leads to more “ discouraged workers”
- which may mean that the UR will decrease
- this could fool one into thinking the labor market is getting better, when
it’s actually a sign that it’s so bad that people are giving up the
pursuit of a new job
Types of Unemployment
- to lead to a definition of “fully employed”………
1) Frictional - “normal” labor market turnover
- e.g., temporarily between jobs
2 ) Structural - caused by changes in the economy that imply a permanent decrease
in a certain type of skill
- e.g., machines/ software replacing people
loss of jobs in industries in which demand for the product has
permanently fallen
3 ) Cyclical - unemployment due to a general, temporary downturn in the economy
( i.e., a recession )
“ Full Employment” doesn’t mean everyone is working
- it means that there is no unemployment that simply wastes resources
- Frictional Unemployment can be good in the long-run : people look for better jobs
or for jobs for which they are more qualified
- Structural Unemployment means workers move from industries in decline to
industries making products more in demand by society
- Only Cyclical Unemployment is clearly a waste
- workers are laid off in a recession; they go back to that job as the
economy improves
- So, “Full Employment” is the absence of “wasteful” unemployment
- thus, “Full Employment” is when there is no Cyclical Unemployment
- so, “Full Employment” does NOT mean that the UR = 0 %
The Natural Rate
- the “Natural Rate of Unemployment” is this “normal” rate of unemployment, when
there is no Cyclical Unemployment, and “average” levels of Frictional and
Structural
- estimates : the “Natural Rate” in the U.S. is around 5% or 6%
Suppose the Natural UR = 5.5 %
- thus, 94.5% of the labor force are employed, helping to produce output
( which we calculate as Real GDP)
- this level of output, produced when the economy is operating with no cyclical
unemployment , is also called the “Natural Rate of Output”
- Note : the “Natural Rate of Output” is equivalent to “Potential
GDP”
- this connection is important: - higher output implies less unemployment
and
- less output implies more unemployment
- we will assume this later, when we build a supply/demand
model
Suppose Real GDP is currently below the “Natural Rate of Output”
- e.g., the economy is in a recession
- then, the UR will be above its natural rate
- as an example, say the current UR = 6.5%
- this implies that the level of Cyclical Unemployment = 6.5 – 5.5 = 1.0%
Economic Policymakers will often work to eliminate Cyclical Unemployment , by
attempting to get the economy back to its Natural Rate ( or equivalently, back to Potential
GDP)
But they won’t try to drive the UR to 0%, because they believe that Frictional and
Structural Unemployment is useful in the long-run
Inflation
One of the two main macroeconomic variables
Inflation - an increase in the general level of prices
Purchasing Power - the volume of goods and services a given amount of money will
buy
Inflation implies a decrease in the purchasing power of a given level of income
- e.g., after inflation, $1 buys less than it did before
However, wages often increase as price do
- which means that , even during inflationary times, the average purchasing power of
workers may not fall
- i.e., each $1 earned is worth less, but more $ are earned
- in fact, many economists believe that higher wages CAUSE higher prices
- more discussion in future chapters, but the basic idea:
- wage increases mean the cost of production increases, so companies
pass this increase in costs on to their customers
- so, if wages increase by 5%, causing 5% inflation, then average purchasing power
didn’t change
Real Wage Rate - the wage rate adjusted for inflation
- it measures how much one can buy with one’s wages
- Formula :
The % Change in Real Wage = % Change in Nominal Wage
+
% Change in Prices ( i.e., the inflation rate)
- e.g., suppose a worker receives a 5% Nominal Wage increase during a year when
inflation = 5%
- then, the change in the real wage = 5 -5 = 0%
Economic Policymakers are concerned with fighting inflation ( as we’ll see more in
future chapters)
But why? The above implies that inflation may not affect purchasing power at all
Reasons Economic Policymakers Try to Fight Inflation:
1) Consumers believe that inflation robs them of purchasing power
- e.g., the worker above thinks that they earned a 5% real wage increase
- then, as prices increase over the year, they feel that their raise has been stolen by
inflation
- so, maybe workers/consumers/ voters demand that policymakers fight inflation
- however, if higher wages cause inflation, the only way to avoid inflation is if
nominal wages don’t increase in the first place
2) Uncertainty over future inflation hurts the economy
- to see this, we discuss
- Inflation and Borrowing/Lending
- lenders are hurt by inflation; borrowers gain from inflation
- e.g., Bob loans Ann $ 1000, to be paid back next year
- suppose Bob wants 5% interest
- so Ann agrees to pay back $ 1050 next year
- Bob really wants $ 1050 in purchasing power next year
- i.e, to be able to buy next year what he could have bought with
$ 1050 today
- but, if inflation is , say, 10%, the $1050 he receives next year is worth
less than the $ 1000 he loaned today
- Ann gains since the $1050 she pays back next year is worth less than the
$ 1000 she receives today
How could Bob solve the problem?
- he could charge Ann 15% interest : 10% to compensate for inflation ,
plus the 5% interest that he wanted
- this 5% rate would be the Real Interest Rate – the % increase in purchasing
power that the borrower pays to the lender
- in this case, 15% in the Nominal Interest Rate
Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate
As long as they agree on the expected inflation rate , then inflation has no effect
- i.e., they agree that the “price” of money should be 5%
- both think that inflation will be 10%
- so, Ann doesn’t mind paying 15%
- maybe she’s going to invest in a business whose prices will increase by
10%
The problem comes if they don’t agree on the expectation
Uncertainty over future inflation rates can prevent economic transactions from taking
place:
- e.g., suppose Ann and Bob agree that a 5% real interest rate is fair
- yet Bob believes inflation will be 11% , but Ann believes it will be 9%
- so Bob wants 5 + 11 = 16% interest, but Ann is willing to pay only 5 + 9 + 14%
- so they can’t agree on a deal
- even though they’ve really agreed on a price ; generally ,when the two sides agree
on a price , the transaction will take place, and both sides are better off
- but not in this case, which hurts the economy : maybe Ann wants to start a business,
and thus add output to the economy; but , in this case, that output is lost,
because she never receives the capital in the first place
To prevent this problem, policymakers may target 0% inflation
Although, all the policymakers really need is constant/predictable inflation
- e.g., if it’s always 10% per year, Ann and Bob will agree
Calculating the Inflation Rate
Index Numbers - numbers expressing the cost of a market basket of goods, relative to its
cost in some “base period”
Example :
- Consumer Price Index ( CPI) - measure of the average level of prices of a
“basket” of goods and services consumed by a typical urban family in a given
year
- this is the most widely quoted measure of inflation
- e.g., if the basket costs $ 4500 now, but cost $ 3000 in the base year :
CPI( now) =
Cost of Basket Now
Cost of Basket in the Base Year
= $ 4500
$ 3000
X 100
X
100
= 150
Note : CPI( base year ) = 100
So, CPI( now) – 100 = % change in prices since the base year
- e.g., in the above example, prices have increased by 150 – 100 = 50% since
the base year
Deflating - the process of finding the real value of some nominal value, by dividing by
some price index
- this allows us to track an economic value over time
e.g., suppose Cathy earns $ 10/ hour in the base year ( Year 0), but she earns $ 12 / hour
in Year 1
Suppose CPI( Year 1) = 125
Then, Cathy’s Real Wage in Year 1 =Nominal Wage in Year 1 X 100
CPI
= $12 X 100
125
= $ 9.60
- this means that, in “Year 0 dollars”, Cathy earns $ 9.60 an hour in Year 1
“ 100” is the “deflator” = value of each Year 1 dollar, in terms of the base year
CPI
- here, it equals 100/ 125 = .8
which means that each Year 1 dollar buys what $ .80 would have bought in the base year
so ,we “deflate” each Year 1 dollar by multiplying it by .8
In general,
real value = nominal value X 100/(Price Index)
The following 5 questions, based on the notes above, will be included on Homework 1 .
So you could work on these before the first day of class. However, they are NOT due on the first
day ( they will be due, with the rest of HW 1, on October 2).
1. For the following parts, state how much the given action would change GDP ( just
give a numerical answer; you don’t have to explain) :
a.) Carter uses his own seeds to grow vegetables that would be worth $ 100, although
Carter actually eats them himself.
b.) Carter pays $10 for a packet of seeds and then uses them to grow vegetables that
would be worth $ 100, although Carter actually eats them himself.
c.) Carter pays $100 for vegetables at a farmer’s market.
d.) A vegetable producer pays $ 10 for seeds to grow vegetables which are then sold
to Carter for $ 100.
e.) Maggie buys a new bike for $ 200.
f.) Maggie buys a used bike at a garage sale for $ 20.
2. The statistical office of Shelbyville surveys the employment condition of the
residents on a monthly basis. For June and July, they found the following statistics:
Number of Residents in that Category in
June
July
Worked Full-Time for Pay
14,000
13,750
Worked Part-Time for Pay
1,000
1,000
Did not work for pay, but looked for work
1,000
850
Did not work for pay and did not look for work
( because they thought jobs were not available)
500
900
Did not work for pay because they did not want to
700
700
a.) How many of Shelbyville’s residents were officially considered to be employed in
June?
b.) How many of Shelbyville’s residents were officially considered to be unemployed
in June?
c.) How many of Shelbyville’s residents could be considered to be “discouraged
workers” during June?
d.) Solve for Shelbyville’s unemployment rate in June ( round to the nearest tenth of
a percent. As an example, if your calculation = 4.35%, you’d round to 4.4%).
Show your work.
e.) Solve for Shelbyville’s unemployment rate in July ( round to the nearest tenth of a
percent). Show your work.
f.) Note that there are fewer workers in July than June; yet your answers to
d.) and e.) should imply that there is a LOWER unemployment rate in
July. Explain how this occurred ( give an intuitive answer, based on the
scenario above, rather than a strictly numerical answer).
3. Cate lends Dave $ 500, with an agreement that he will pay her $ 505 next year.
a.) What is the nominal rate of interest on this transaction?
b.) Suppose that Cate only wants a .75 % real interest rate. What is the inflation rate
that Cate expects?
c.) Suppose that the actual inflation rate = .5 %. Of the two, who gains
unexpectedly? Explain why.
4. Erin, having recently graduated from college, is looking to work for 2 years before she
enters graduate school. She has received 2 job offers with the following salary structures:
JOB A : pays $ 25,000 in 2012 and $25,350 in 2013
JOB B : pays $ 25,000 in 2012; 2013’s salary will be equal to $25,000 plus a cost of
living adjustment ( i.e., a raise equal to the inflation rate in 2013)
Suppose that Erin has no preference for either job, other than the highest salary.
Suppose that the inflation rate in 2013 turns out to be equal to 1.0 % .
a.) What is the % increase in nominal salary from 2012 to 2013 for Job A?
b.) What is the % increase in real salary from 2012 to 2013 in Job A ( with inflation
in 2013 = 1.0 %)?
c.) What is the % increase in real salary from 2012 to 2013 for Job B ( with inflation
in 2013= 1.0 %)?
d.) With inflation equal to 1.0 % for 2013, which job should Erin take?
e.) Suppose that the CPI for 2012 is 100, while the CPI for 2013 is 101. Deflate the
2013 salary for Job A to determine how much the 2013 salary is worth in terms of
2012 dollars ( you may need to round to the nearest cent).
f.) How much is the 2013 salary for Job B worth ( in 2012 dollars)?
5. Suppose the following data is true:
Year
2008
2009
Cost of the “basket” used to
Calculate the CPI
$ 10,000
$ 10,600
CPI that year
100
?
a.) Calculate the CPI in 2009.
b.) Calculate the inflation rate in 2009.
c.) Suppose Fred received a 10 % nominal wage increase in 2009. Solve for Fred’s
real wage increase ( in percentage terms) in 2009.