Download modules 31 to 35

Modules 31­35.notebook
April 25, 2016
Warm Up:
1. Suppose the FED is committed to keeping the nominal interest rate fixed. To maintain the interest rate target in the face of an expansionary fiscal policy, the FED can do which of the following?
A) Increase the prime rate B) Increase the discount rate
C) Increase the Federal Funds rate D) Engage in open­market purchases
E) Enagae in open­market sales
2) Which of the following government policies can reduce the rate of inflation in the short run?
A) Provide investment tax credits for businesses
B) Reduce income taxes
C) Sell bonds on the open market
D) Decrease Discount rate
E) Decrease the federal funds rate
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Correct 8 Multiple Choice questions
2005 AP Exam
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1) D
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2) B April 25, 2016
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3)C
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4) B
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5) D
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6) D
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7) B
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8) B
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Activity 5­5
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Warm Up:
1) The value of which of the following is counted in the U.S. GDP?
A) Clean Air
B) Child care a father provides for his child
C) A car produced in Sweden by an American Firm
D) A car produced in the U.S. and sold in Europe
E) Medical services not provided due to preventive health care
Modules 31­35.notebook
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Warm Up:
1) The value of which of the following is counted in the U.S. GDP?
A) Clean Air
B) Child care a father provides for his child
C) A car produced in Sweden by an American Firm
D) A car produced in the U.S. and sold in Europe
E) Medical services not provided due to preventive health care
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Monetary and Fiscal Policy
•
•
•
•
Expansionary Policy
recession
Increase AD
Monetary: Ms
Fiscal: G, T, G.T.
AD
Contractionary Policy
•
•
•
•
Inflation
Decrease AD
Monetary: Ms
Fiscal: G, T, G.T. AD
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Module 30
1) Debt to GDP ratio
2) Fiscal Policy and budget surplus/deficit
3) Public Debt
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Budget Balance measures fiscal policy
+ Budget Surplus
­ Budget Deficit
Savingsgovernment = Taxes ­ Govt. Spending ­ Govt. Transfers
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Equal changes in fiscal policy don't have equal effects on GDP
Which has a bigger change in GDP?
1. Decrease Taxes by $50 million
2. Increase Government Spending by $50 million
3. Increase Government Transfers by $50 million
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Changes in the budget balance can cause fluctuations in the economy
Automatic fiscal policy stabilizers will adjust the economy in the long run without changing the Budget balance significantly.
Discretionary fiscal policy, which will adjust GDP in the short run, means the government needs to raise additional funds by borrowing money. Crowding out problem.
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Problems arise when government debt increases
1) Crowding out problem
2) Puts pressure on future budgets
3) Government defaults (worse case scenario) Can't pay debts
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Public Debt = government held debt held by individuals or institutions outside of the government.
*remember, the FED holds government debt too
Public Debt­GDP ratio = Public debt/GDP Public Debt = 50
50
GDP = 300
300
x 100
=
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Implicit Liabilities are not counted towards public debt Social Security, Medicare, Medicaid
http://www.usdebtclock.org/
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Welcome Back!
Today:
Take 2000 AP Micro Free Response questions
HW: micro graph review, complete 2000 MC.
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1) Assume that the economy is in equilibrium. If aggregate demand increases, nominal interest rates and bond prices will most likely change in which of the following ways?
Nominal I rates
Bond Prices
A. Increase
Increase
B. Increase
Decrease
C. Increase
No Change
D. Decrease
Increase
E. Decrease
Decrease
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Review: a) Draw an AD/AS model in LR equilibrium
b) Draw a money market graph in equilibrium
c) Draw a loanable funds market in equilibrium
d) List the 3 fiscal policy tools and the 3 monetary policy tools.
e) Go back. What should they do to those tools if expansionary policies are put into place.
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We will see some following statements from Janet Yellen, Mr. Drumpf, and Bernie.
Are the statements examples of Monetary or fiscal policy? Expansionary or Contractionary? And what type of tool is being used? (taxes, govt. transfers, govt. spending, Discount rate, Open Market ops, or reserve ratio? Modules 31­35.notebook
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Module 31: Monetary Policy and i rate
• Review of short run effects of monetary policy and the interest rate
• FOMC meets every 6 weeks
• Sets a "target" interest rate by changing money supply
• Typically adjust money supply by buying and selling bonds
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Expansion
Contractionary
Lower I rate, increases AD
Higher I rate, decreases AD
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Short Run: Monetary Policy
Expansionary: ∆
MS
∆ i rate
∆ AD
I C
Contractionary: ∆
MS
∆ i rate
∆ AD
I C
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Expansionary Monetary Policy increases GDP, lowers unemployment.
However, in the long run, it also raises prices. Increased Inflation. In the long run, monetary policy changes the price level but does not change real aggregate output or the interest rate.
Central Banks sometimes practice Inflation Targeting rather than unemployment targeting.
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Module 32: Money, Output, and Prices in the LR
Long­Run effect of Monetary Policy
SR: money market determines i rate
LR: Loanable Funds market determines i rate
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How does a ∆ in Money Supply ∆ Price Level ????
In the long run, the changes are proportional
%∆ = %∆
PL
MS
PL
MD
MS
MD
In the long run, they all change proportionally
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Money Neutrality:
Money is neutral in the long run
In the LR, changes in the money supply have no real effect on the economy. An increase in MS creates an equal increase in Price Level.
Real Quantity of Money: Nominal Money Supply
Price Level
MS
Price Level
Real Q of Money
1000
1.0
1000/1.0 = 1000
1050
1.05
1050/1.05 = 1000
950
0.95
950/0.95 = 1000
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This does not mean that Monetary or Fiscal policies are ineffective. Short Run changes are important. Remember Keynes' quote:
"In the long run, we are all dead"
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Module 33: Types of Inflation
1) Inflation Tax
2) Cost­push, Demand­pull Inflation
3) The policiticans' delimma
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The classical model of price level:
The real quantity of money is always at its long­run equilibrium
MS
PL
*classical economists ignore E2
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Inflation Tax:
When the government prints money to cover budget deficits, it increases the money supply, which translates to an equal increase in price level (inflation). People who are holding money lose with inflation. The more money you have, the more you pay for inflation. This is called an Inflation Tax.
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How a government creates inflation: When a government is operating at a budget deficit and tries to pay off its debts by increasing the money supply.
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2 ways inflation (Price Level) increases
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Cost­Push Inflation
SRAS
1) SRAS
Cost­Push Inflation
• Caused by increased input prices
• Historically, Oil prices!
PL
SRAS
AD
Y
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Demand­pull Inflation
2) AD
Demand­pull Inflation
• "too much money chasing too few of goods"
PL
SRAS
AD
AD
Y
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Output Gap and Unemployment Rate
Actual Unemployment Rate = Cyclical + Natural Output Gap = Actual Y ­ Potential Y
Potential Y
(+) Inflationary Gap
(­) Recessionary Gap
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Warm Up
Get out your Homework: Act. 3­7 and 5­7
1) If the real interest rate is 7% and the expected rate of inflation is 2%, what is the Nominal interest rate?
2) If lenders expect the inflation rate to increase, what will they do to their nominal rate now?
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PL
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LRAS
PL
Y
LRAS
PL
Y
LRAS
Y
Actual Y = Potential Y
Actual Y < Potential Y
Actual Y > Potential Y
Actual U = Natural U
Actual U > Natural U
Actual U < Natural U
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Homework:
• Activity 5­7
• Activity 3­7
• Read module 32 and 33, answer questions
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Module 34: Inflation and the Phillips Curve
The relationship between Unemployment and Inflation
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There is a short­run tradeoff between unemployment and inflation
• Decrease unemployment, increase AD and increase inflation
• Increase unemployment, decrease AD and decrease inflation
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1958 Alban W. H. Phillips
Noticed a negative relation between inflation and unemployment
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2 ways the SRPC shifts
1) Supply Shocks
2) Expected Inflation Rate
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How does the Expected Inflation Rate shift the SRPC?
Expect 2% inflation, shift SRPC up
Expect 2% deflation (­2%), shift SRPC down
If people expect inflation in the future, the worker will want a higher wage when negotiating their contract. If the firm expects inflation in the future, then they will sell their product for more in the future, willing to pay a higher wage.
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Inflation Rate
Demand­pull inflation
B
B
A
A
SRPC
U rate
When AD shifts, we slide up and down the SRPC
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Inflation Rate
Cost­push inflation
B
B
A
A
SRPC
U rate
When SRAS shifts, we shift SRPC the opposite direction
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Getting to the Long run...
Economists believe that expected inflation changes the actual inflation rate proportionally. A 1% change in expected inflation results in a 1% change in the actual inflation.
People determine their expectations for inflation based on past experiences.
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In the long run, actual inflation accounts for expectations
If inflation is historically high, people will come to expect high inflation and the actual rate will reflect this.
Macroeconomists believe that in the long­run, there is no trade­off between unemployment and inflation.
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Inflation rate
LRAS
PL
SRAS
A
A
AD
Y
AD/AS
Unemployment rate
Phillips Curve
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to avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation
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Persistent attempts to trade off lower unemployment for higher inflation leads to accelerated inflation over time.
What you need to understand: There are limits to expansionary policies! The limit is the natural rate of unemployment.
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Natural Rate Hypothesis
The unemployment rate at which inflation does not change over time is known as the nonaccelerating inflation rate of unemployment: NAIRU
LRPC/NAIRU
Inflation Rate
SRPC
U rate
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NAIRU is another name for the natural rate of unemployment. It is the level of employment the economy "needs" in order to avoid accelerating inflation.
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LRAS
PL
LRAS
PL
A
LRAS
PL
C
B
Y
Y
Y
@ full employment
Inflation
recessionary gap
Inflationary gap
Inflation
Inflation
C
A
B
Unemployment
Unemployment
Unemployment
Shifts in AD
Inflation
C
PL
C
B
B
A
A
AD
Y
Unemployment
Shifts in SRAS
Inflation
PL
SRAS
C
B
C
A B
A
Y
Unemployment
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Costs of Disinflation
"Inflation is hard to counteract"
A persistent attempt to keep unemployment below the natural rate leads to accelerating inflation that becomes incorporated into expectations. To reduce inflationary expectations, policy makers need to run the process in reverse and change expectations by keeping the unemployment rate above the natural rate.
Reducing expectations of inflation means shifting the SRPC down.
and the AD down
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Deflation: falling aggregate price levels
Lenders win. Borrowers lose.
Less money is borrowed. Decrease in AD.
Debt Deflation
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Deflation, and the liquidity trap, the fisher effect.
Nominal interest rates cannot fall below 0%.
Cutting interest rates to fight a slump in the economy caused by deflation can only go so far. Liquidity trap is when cutting interest rates cannot occur due to nominal rates close to 0%.
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3) Which of the following is true of the long­run Phillips curve?
A) It shows there is a trade­off between unemployment and inflation.
B) It is positively sloped when the inflation rate exceeds the unemployment rate.
C) It is vertical at the natural rate of unemployment
D) It shifts to the right if aggregate demand increases.
E) It is created by an adverse supply shock.
4) According to the short­run Phillips curve, a decrease in unemployment is expected to be accompanied by:
A) higher labor­force participation
B) an increase in inflation
C) an increase in the productivity of capital
E) a decrease in real GDP
D) an increase in the budget deficit
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https://youtu.be/zatnIhwmu1c
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Warm Up
1) Draw a short run and long run phillip's curve graph. Label all axes. Label equilibrum at the natural rate of unemployment point A.
2) Label point B. If the government decreases taxes, where is point B in the Phillip's curve graph.
3) Using point A as the starting point, label point C if Oil prices increase significantly.
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LRAS
PL
C
AS2
Inflation
LRPC
AS
B
B
A
C
A
AD2
AD
Y
SRPC
Unemployment
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Module 35:
Classical vs. Keynesian Economics
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Classical
Prices are flexible
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Keynesian
LR, we are all dead
Ignore Short­Run
SR shift AD!!!
Vertical AS curve
1936 "General Theory of MS leads to PL
employment, interest, and SRAS not important
money"
LRAS!!!!!! Horizontal AS curve
Good for a recession!
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Monetarism: led by Milton Friedman
GDP will grow steadily if the money supply grows steadily. Constant rate of growth of the money supply is needed.
Monetarism created the...
Monetary Policy Rule and the Quantity Theory of Money
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Velocity of Money "how quickly a dollar bill gets distributed in society"
Nominal GDP
Money Supply
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Quantity Theory of Money:
M x V = P x Y
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M ~ Money Supply
V ~ velocity of money
P ~ Price Level
Y ~ real GDP
Monetarism believed that V was constant in the SR and slow growing in the LR. Therefore, slow growth of the money supply would result into increased nominal GDP.
The question is, did real GDP increase, or did prices increase?
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5) If the velocity of money is stable, the quantity theory of money predicts that an increase in the money supply will lead to a proportional:
A) Increase in nominal output
B) decrease in price level
C) decrease in the nominal interest rate
D) decrease in the real interest rate
E) decrease in the unemployment rate.
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6) If a worker's nominal wages increases from $10 to $12 per hour and at the same time the general price level increases by 10%, the worker's real wage has:
A) decreased by about 10%
B) decreased by about 20%
C) increased by about 10%
D) increased by about 20%
E) not changed
7) The required reserve ratio is 0.2 and the Federal Reserve sells $1 million in securities. If there are no leakages and banks do not hold excess reserves, then which of the following is the change in the money supply?
A) Increase of $1 million
B) Increase of $1.2 million
C) Increase of $5 million
D) Decrease of $1.2 million
E) Decrease of $5 million
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Next Unit:
Economic Growth....in one day.
Modules 37­40
5­10% of the AP Exam
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Measuring Economic Growth:
Real GDP
Real GDP per Capita = Population
*Rule of 70 ~ how many years it takes for a variable to double.
70
Number of years it takes to double = Annual growth rate
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Sustained growth in real GDP per capita occurs only when the amount of output produced by the average worker increases steadily.
Economic growth: Productivity!!!!!!
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good y
Production Possibility Curve (PPC)
A­ under utilized potential (attainable/unemployment)
C
B
B­ full employment
C­ not attainable at this time (new technology)
A
good x
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A linear PPC.
The opportunity cost of producing one more unit of Good B is _______ unit of Good A.
The opportunity cost of producing one more unit of good A is ______ units of Good B.
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LRAS
PL
SRAS
C
B
A­ unemployment
A
B­ full employment
Y
good y
C­ not sustainable at this time C
B
A
good x
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Economic Growth:
good y
LRAS2
LRAS
PL
C
SRAS
C
B
B
A
A
good x
Y
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Economic growth can occur when the quantity and quality of resources and technology improves.
Society becomes more productive!!! Improvements on 3 types of productive resources: Labor, Land, and Capital 1) Human Resources: more Human Capital (education)
2) Natural Resources: find more, develop more
3) Capital goods: more machines, better machines.
4) Technology: makes the above mentioned resources more productive.
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1) Which point(s) could represent a downturn in the business cycle?
2) Which point(s) represent efficient production?
3) which point(s) are attainable only after long­run economic growth?
4) Policy that results in an increase in the production of consumer goods without reducing the production of investment goods is represented by a movement from point _____ to point _____?
5) Producing at which efficient point this year would lead to the most economic growth next year?
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