Download Real GDP - West Essex High School

Ceteris Parabus.
The Nature and Method of Economics
Semester Review
Eight Economic Goals
1. Economic Growth [Increase in GDP or per capita wealth]
we want 3% annual GDP growth.
1929-Per capita=$792; 1933-Per capita=$430; 2005-per capital= $40,000
2. Full Employment – meaning about 96% employment.
In 1932, unemployment was about 25%
3. Economic Efficiency – obtaining the maximum output
from available resources or maximum benefits at minimum
Cost.
“Doing the best with what we have.”
4. Stable Price Levels – avoid sizable inflation or
deflation. Maintain about 3% annual inflation rates.
We had 13% inflation in 79.
In 1945, $1.50 bought what $1.00 did in 1860.
Today, it takes $10 to buy what $1 bought in 1945.
Eight Economic Goals
HYPERINFLATION in Brazil 1988-1994
Prices in 1994 were 4 million times higher than in 1988.
If we had Brazil’s inflation:
1. $35 Blue jeans would increase to $140 million per pair.
2. Gas would increase from $1.25 to $5 million per gallon.
3. $20 for a pizza and movie would increase to $80 million.
5. Equitable Distribution of Income. One group
shouldn’t have extreme luxury while another is in stark poverty.
The richest 1%(3 million people) have greater wealth
than the bottom 90% of the population.
Eight Economic Goals
6. Economic Freedom – businesses, workers, and consumers
have a high degree of freedom with their resources.
The market determines the use and cost of resources.
7. Economic Security – there is an economic benefits to
provide for those not able to take care of themselves
(handicapped, disabled, old age, chronically ill, orphans,
lay-offs [unemployment insurance]).
.
8. Balance of Trade – we
should sell as much with
the rest of the world as we buy from them.
Our balance of trade as been over $400 billion a
year the last few years.
Pitfalls To Sound Reasoning
1. Bias – preconceived beliefs not warranted by facts.
We tend to accept everything that reinforces our prejudices. We will
not learn economics if we reject things before we understand them.
Try to understand things first before you reject them.
2. Loaded terminology – use of emotional terms leading
to a nonobjective analysis. [corporate profits = obscene; G
regulations = socialists; low wages = exploitation]. We must have
objectivity.
3. Definitions – certain economic terms
have different meanings than normal.
A. Utility means satisfaction.
B. Investment means purchase of
machinery, tools and factories.
C. Price ceilings are below equilibrium.
D. Price floors are above equilibrium.
4. Fallacy of composition [combining parts into a
whole]- What is true for the individual/part is necessarily
true for the group/whole.
“I’ll stand up so I can
see better.”
A. The safest way for an individual
to leave a burning theater is to
run for the nearest exit.
5. Post hoc fallacy –
because event “A” precedes event “B”, “A” is
necessarily the cause of “B”. It is a fallacy that
“association or happenstance is causation.”
Ex: Last night I turned the TV on and the Astros
were winning 6-3. They ended up losing the game
to Colorado. I “jinxed” them
.
6. Correlation v. causation – because two events
occur together [correlation], they affect each other.
Ex 1: Super Bowl Indicator: if an original NFL team
[like the Cowboys] win the Super Bowl, the stock
market goes up. It has been right over 80% of the time.
Ex 2: Hemline Indicator: The higher the skirts, the higher the
market [In the roaring 20s, short Flapper dresses
were the rage. The longer styles of the 1930s heralded
a bear market. Rising stocks in the 60s coincided with the
rise of the miniskirt, only to give way in the 70s to more
conservative dress lengths and a bear market.
Economizing Problem
Dealing with “Scarcity”
But in the real world resources are not completely adaptable
to alternative uses. Thus the PPC graph has a curve that
indicates a changing trade-off between resources. Obtaining
more of one good requires giving up larger amounts of the
alternative good.
Notes...
LAW OF INCREASING
OPPORTUNITY COSTS
As the production of a
good increases, the
opportunity cost of
producing an additional
unit rises.
Robots (thousands)
The curve represents the limit of economic production (how
much our economy can produce effectively). Also called full
employment, it represents about 96% employment and 80%
production capacity.
14
13
12
11
10
9
8
7
6
5
4
3
2
1
Production
Possibilities
Frontier or Full
Employment
1
2
3
Bread
4
5
6
7
(hundred thousands)
8
Points inside the curve represents economic inefficiency
(resources are not being fully utilized).
Point movement along the curve represents your opportunity
cost (giving up A for more B).
Points far outside the curve represents economically
unattainable (the economy can’t produce there unless it grows
A
B
F Unattainable
Robots
C
*Shows opportunity cost
more than anything
E
Inefficient
D
Bread
And How Is Economic Growth Demonstrated
on a Graph? Like This
Economic Growth
[Ability to produce a larger
total output over time]
Capital Goods
C
A
b
a
0
B
D
Consumer Goods
Factors that Cause Economic Growth;
Robots (thousands)
Q 14
Notes...
13
12
11
10
9
8
7
6
5
4
3
2
1
Economic Growth
1. Increase in resources -
2. Better resource quality -
More
of
either
or
3. Technological advances both is possible
1
2
3
4
5
6
7
8
Bread (hundred thousands)
Q
Factors that Cause Economic Growth;
These factors require Notes...
an investment in
Economic Growth
capital goods (they are 1. Increase in resources developments for
future economic
2. Better resource quality utility.)
More
of
either
or
3. Technological advances both is possible
So economies that produce a majority of capital
goods (goods for the future) will experience more
economic growth than the economy that produces a
majority of consumer goods (goods for the present.)
CURRENT
CURVE
FUTURE
CURVE
CONSUMPTION
Goods for the Present
FAVORING
FUTURE GOODS
Goods for the Future
Goods for the Future
FAVORING
PRESENT GOODS
CONSUMPTION
FUTURE
CURVE
CURRENT
CURVE
Goods for the Present
&
Change in quantity demanded = a
movement from one point to another on aP1
fixed demand curve. Any change in
P2
quantity demand occurs due to a price
level change in a product.
D
QD1QD2
Change in demand = a shift of the entire demand
Curve to the right or the left. This is caused by
Non-price factors called [“TIMER”].
Taste
Income
Market size
Expectations
Related goods
QD3
QD1
QD2
Change in Income
Normal Good – goods whose demand
varies directly with income.
Inferior Good – goods whose demand
varies inversely with income.
Demand
For
Income
Spam
Demand
For
Steak
Related goods;
There are three types of goods.
1. Independent goods – price change
of one has no impact on the other
Ex: fishhooks & pantyhose
2. Substitute goods(“competing goods”)
- price change of one affects the
demand of the other directly.
Ex: 7Up & Dr. Pepper
3. Complementary goods(“go together”)
- price change of one affects the
demand for the other inversely.
Ex: cereal & milk
Price
Demand
Of
for
7UP Dr Peppe
Cereal
Milk
Elasticity in the short run
Goods have demand Elasticity if;
1. Substitutes (margarine/butter)
2. Luxury (mink coat)
3. Expensive (car)
4. Has durability (refrigerator)
Goods have demand Inelasticity if;
1. No substitutes (milk)
2. Necessity (insulin)
3. Inexpensive (pencil)
4. No durability (gasoline)
Change in supply = a shift of the entire
supply curve to the right or the left. This
is caused by non-price factors called
Resource Cost
Alternative Output
Technology
Number of Suppliers
Expectations [about future price]
Subsidies
Taxes
S3
.
S1 S2
QS3 QS1 QS2
The Market System
Economic System
– the way a society produces goods and
1. Traditional
services
2. Pure Command
3. Pure Market
4. Mixed
a. Capitalism
b. Democratic Socialism
c. Authoritarian Socialism [Communism]
1. Traditional-[where “CUSTOM RULES”]
What, how, and for whom are answered by social customs.
Problems;
A. Change is resisted, clashes with technology
B. Heredity and caste system limits the economic role of
individuals.
2. PURE COMMAND - where the “GOVERNMENT
RULES”.
The government controls all resources. What,
How, and For Whom answered by the
government.
Vs.
Adam Smith
Karl Marx
3. PURE MARKET – where “INDIVIDUALS RULE”.
Individuals and firms control all resources.
The government has no say. WHAT, HOW &
FOR WHOM are decided by individuals.
The idea of a pure market economy (capitalism) was
first advocated by Adam Smith in his book “The
Wealth of Nations”.
According to Smith the market is governed by an
“invisible hand”. When individual
consumers/producers compete to achieve their own
private self-interest then society wins.
Smith also argued that when producers, workers, and
entire economies specialize, the result is increased
output and economic growth.
According to Smith, the role of government is defined
by the term “laissez-faire”. Government is limited to
ensuring fair competition in the market.
“The Wealth of Nations” was an attack on
mercantilism; because it stated that wealth does not
come from the accumulation of gold & silver, but from
productivity. A nation is wealthier if its citizens are
more productive.
My name is
mercantilism.
No “G”
Measuring Domestic Output
Gross National Product
All goods & services produced by
citizens of a country, either home
or aboard.
[Citizenship mattered, not geography]
China
Plano, TX
Europe
Nike in
Indonesia
Gross Domestic Product
All goods & services produced
within a country’s borders,
in a given year.
[Geography matters, not citizenship]
Provo,UT
BMW in Waco
in Chicago
Honda in Ohio
5
Ig &
4
appreciation3
of capital
2
Pos. Net
Investment
Initial
Capital
Deprec- Gross
iation Investment
Initial
Capital
5
Initial
capital
less
deprec.
1
Initial
capital
less
deprec.
0
1/1/04 During 2004
12/31/04
“Music By Ben” creates music CDs. The owner has five machines used
to create CD music (his capital stock). If during the course of the year
he expands by buying a new machine, and loses no machines, then at
the end of the year his capital stock will increase by one, showing a
positive net investment.
Net investment = initial stock – depreciation + Ig
5
Ig & 4
depreciatio3
n of capital
2
Initial
Capital
Neg. Net
Investment
Depreciation
Gross
Investment
Initial
Capital
5
Initial
capital
less
deprec.
1
Initial
capital
less
deprec.
0
1/1/04 During 2004
12/31/04
However, if the owner buys a new machine but during the same year
his two oldest machines crash, then at the end of the year his capital
stock will decrease by one, showing negative net investment.
Depreciation is the 1 machine that was not replaced during the year.
Investment-increases the capital stock.
Depreciation-decreases the capital stock.
Net Investment -change in capital stock in one year.
• C + Ig + G + Xn =
• GDP – depreciation of fixed capital =
• NDP – indirect business taxes – NFFIE =
• NI – Social Security tax - Corporate income taxes Undistributed corporate profits + transfer payments =
• PI - personal income taxes + credit spending =
• DI – credit interest payments = C & S
Undistributed corporate profits = corporate profits –
corporate income taxes – distributed dividends
How to calculate NIA
Personal taxes
403
Imports
362
+Transfer payments 283
-Corporate Income Taxes 88
Indirect business taxes
231
Exports
465
C=
Ig =
G+
Xn =
Gross Domestic Product (GDP)
-Consumption of fixed capital
Net Domestic Product (NDP)
-Net For. Factor Inc. Earn. U.S.
-Indirect business taxes
National Income (NI)
-Undistributed Corporate Profits
-Corporate income taxes
-Social Security Contributions
+Transfer payments
Personal Income (PI)
-Personal Taxes
Disposable Income (DI)
$
$
$
$
-Undistributed corp. profits
46
-Social Security contrib.
169
Personal consumption
2,316
Gross private domes invest. 503
Government purchases
673
Depreciation
307
N.F.F.I.E. in the U.S.
12
2,316
______
503
______
673
______
103
______
$______
3,595
______
-307
3,288
$_______
______
-12
______
-231
3,045
$______
-46
______
______
-88
______
-169
_______
+283
3,025
$_______
________
-403
$_______
2,622
-303
NIA Practice #1
Personal taxes
382
Imports
348
+Transfer payments 330
-Corporate Income Taxes 98
Indirect business taxes
265
Exports
377
C=
Ig =
G+
Xn =
$
$
$
$
Gross Domestic Product (GDP)
-Consumption of fixed capital
Net Domestic Product (NDP)
-Net For. Factor Inc. Earn. U.S.
-Indirect business taxes
National Income (NI)
-Undistributed Corporate Profits
-Corporate income taxes
-Social Security Contributions
+Transfer payments
Personal Income (PI)
-Personal Taxes
Disposable Income (DI)
-Undistributed corp. profits
65
-Social Security contrib.
158
Personal consumption
1,820
Gross private domes invest. 447
Government purchases
587
Depreciation
317
N.F.F.I.E. in the U.S.
-10
1,820
447
587
+29
$2,883
-317
ROW
$110
$2,566
+10
-265
$2,311
-65
-98
-158
+330
$2,320
-382
$1,938
$100
NFFI = -$10
Nominal GDP (money) v.
Real GDP (buying power)
Nominal GDP is unadjusted for effect of inflation.
Real GDP (GDP deflator) is adjusted for effect of
inflation.
Real GDP = Nominal GDP/price index x 100
Real GDP measures in terms of the value of G/S
Nominal GDP measures in terms of money
Nominal GDP = units of output x price per unit.
Calculating Real GDP;
Year
1
2
3
4
5
Units of
Output
5
7
8
10
11
Price
Per unit
$10
$20
$25
$30
$28
Nominal
GDP
$ 50
$140
$200
$300
$308
Real Price
GDP Index
$50 100
$70 200
$80 250
$100 300
$110 280
Price Index = Nominal GDP/Real GDP x 100
Real GDP = nominal GDP/price index (in hundredths)
Eight Things Do Not Count In
1. Intermediate Goods – components of the final good
A. Ford buys batteries or tires for its cars.
B. KFC buys chickens to eventually sell to customers.
Hand Sales – not current production.
A. If a 1957 Chevy is bought in 2005
2. Second
Chevy
The car was counted in the GDP of 1957, so would not be
counted this year. However, the salesman’s commission
would be counted because you are buying his service.
3. Purely Financial Transactions – stocks, bonds, CDs.
There is no current production being made if 100 shares of
Dell stock is bought. Wealth is simply transferred from one
form of paper to another.
I’m going to buy 100
shares of Dell Stock.
Exchanging one financial asset for another
4. Transfer Payments – welfare, unemployment, social security.
There is no contribution to final production.
Why didn’t I pay
attention in
Economics class?
5. Unreported “Legal” business Activity Unreported “legal” business activity does not count.
This is two-thirds of the “underground economy.”
What if an eye surgeon
doesn’t report $500 of his
his $3,400 IntraLASIK bill?
What if this
waitress doesn’t
report all tips?
What if the
dentist doesn’t
report $400 for
teeth whitening?
6. Illegal business activity Illegal business activity are unreported, so they don’t
count.
This underground economy makes up 1/10 of our GDP.
“I’m getting $1,000 to kill
you, Ziggy, but at least it
will not count in GDP.”
7. Non-market Transactions Work in your own household or volunteer work
in the community does not count because there was
no payment.
So, don’t marry your maid, gardener, or
fitness instructor, or you will hurt GDP.
8. U.S. Corporations Producing Goods Overseas -
Chevy in France
Nike in Djibouti
If U.S. corporations produce goods overseas, it does not
count in the U.S. GDP, but would count in another nations
GDP.
We are measuring production inside the U.S. Our
production outside the U.S. helps other economies.
Economic Growth and Instability
Inflation
“Too much money”
Business
Cycles
Unemployment
Unemployment 1960-Present
Inflation
“Rule of 70”
(The arithmetic of economic growth)
70
_________________________
“Rule of 70” = % annual rate of increase (3%) = 23 years
70
70
70
[Investments to double]
years [GDP (standard of living) to double]]
6 years 9 = 8
10 = ______
_____
7 years 12 = _____
“Real Income” measures the amount of goods/services nominal income will buy.
[% change in real income = % change in nominal income - % change in PL]
5%
10%
5%
6
Nominal income rose by 10%, PL increased by 4% - then real income rose by ___%.
15
Nominal income rose by 20%, PL increased by 5% - then real income rose by ___%.
Four Phases of the Business Cycle
Real GDP
per year
Peak
Peak
Trough
One cycle
Time
Peak: real GDP reaches its maximum.
Contraction: real GDP declines 6 months.
Trough: real GDP reaches its minimum.
Expansion: an upturn - real GDP rises.
The formula for determining the unemployment rate is;
Unemployment rate = unemployed
labor force X 100
Full employment
does not equal 100%
employment.
Why? Because there
are different types of
Unemployment.
Wish I had not
dropped out of
Economics.
Three Types of Unemployment
Frictional – a temporary, transitional, or short-term,
type of unemployment (someone between jobs)
Examples:
1. People who get “fired” or “quits” to
look for a better job.
2. Graduates from high school or college
who are looking for a job.
3. Seasonal jobs such as agriculture,
construction, tourism, or holiday work.
Since there will always be frictional unemployment
and it does not affect economic growth, it is not
included in unemployment rates.
(Workers plan for there job lose)
Structural – a technological, or long-term type of
unemployment, caused by changes in the job market
that make certain skills obsolete.
Causes of structural unemployment;
• Automation
• Consumer taste
• Creative destruction; as jobs are created jobs are
lost. (The creation of the auto reduced the need for
carriage makers.)
Even though these jobs do not come back, structural
unemployment is not counted in unemployment rates.
Most workers will be retained (out of the labor force)
until they can find a new job. Also structural changes are
good for economic growth.
Cyclical – an economic downturn in the business cycle,
caused by decreased aggregate demand for goods and
services. These cyclical fluctuations can lead to lay-offs,
and cyclical unemployment.
Even though these jobs will come back cyclical
unemployment is real unemployment, because it
affects economic growth.
When the economy fails to create
enough jobs for all who are able and
willing to work (unemployment is on the
rise), then the economy loses it full
potential to produce goods and
services. This called the GDP gap.
GDP gap = the amount by which actual
GDP falls short of potential GDP.
Potential and Actual GDP, 1990-1998
During 1991 recession
Potential
$300 billion of production
is lostGDP less Actual GDP
7,750
Billions
of 1992
dollars
Actual
Real
GDP
7,500
7,250
Potential GDP greater than Actual GDP
7,000
6,750
Potential Real GDP
6,500
6,250
(Full-Employment GDP)
6,000
90
91
92
93
94
95
96
97
98
99
The GDP gap measures the monetary loss of cyclical unemployment
The higher the unemployment rate, the larger the GDP gap.
Okun’s Law – for every
percentage point of
unemployment above the
natural rate (4%), there will
occur a 2% lose of
economic potential. (A 2%
GDP gap will be created
for every percent above
NRU.)
Inflation:
Inflation; is a rise in the general level of
prices.
Moderate inflation (about 2%) is necessary for
economic stability. It is the byproduct of a
strong spending/full employment economy. It
also makes it easier for businesses to adjust
real wages downward if demand falls.
Figuring Inflation
Current yr index – last yr index
172-166=6
C.P.I. = Last yr index
x 100;
166
x100 = 3.6%
130.7-124.0(6.7)
116-120(-4)
333-300(33)
11%
124.0 x 100 = ____
300 x 100 = ____
-3.3%
5.4% 120 x 100 = ____
The CPI was 166.6 in 1999 and 172.2 in 2000.
Therefore, the rate of inflation for 2000 was
(2.7/3.4/4.2)% [5.6/166.6 x 100 = 3.4%]
If the CPI falls from 160 to 149 in a particular
year, the economy has experienced (inflation/deflation)
of (5/-4.9/-6.9)%. [-11/160 x 100 = -6.9%]
If CPI rises from 160.5 to 163.0 in a particular year,
the rate of inflation for that year is (1.6/2.0/4.0)%.
Types of Inflation
Demand-Pull Inflation – an increase in total
spending beyond the full employment output
rate in the economy.
“Too many dollars chasing too few goods”
The demand for goods is pulling the price
level up.
Demand-Pull Inflation
AS
AD2
AD1
PL2
E2
“Bad News”
PL1
-higher prices
E1
“Good News”
- more jobs
Q1
Q2
Cost-Push Inflation – an increase in per-unit
production cost, which cause higher price levels.
Caused by;
1. Wage-push – an increase labor wages increase
production cost.
2. Supply-side shocks – increase in the cost of
raw materials (oil prices).
Cost-push inflation
AS2
AD
PL2
This economy is
stagnating
Inflating
$2.25
AS1
PL1
As PL are
inflating.
Stagflation
Stagnating
Q2
Q1
The Aggregate
Expenditure Model
The Consumption Function,
measures
different consumption and saving levels
at different GDP (total output) levels.
APC and APS
APC - percentage of income (Y) that is
consumed.
APS – percentage of income (Y) that is
saved
APC = C/Y = $48,000/$50,000 = .96
APS = S/Y = $2,000/$50,000 = .04
1
APC = C/Y = $52,000/$50,000 = 1.04
1
APS = S/Y = -$2,000/$50,000 = -.04 APS = S/Y
Since there are only two things you can do
with income (C or S), the sum of APC &
APS equals 1.
But what if total output changes (increase)? How
do we calculate the percentage of this new income
that will be consumed and the percentage that will
be saved?
MPC, & MPS
MPC - percentage change in income consumed.
MPS - percentage change in income saved.
Let’s say income increase by $1,000, and
consumption increase by 2/3;
MPC = C/ Y = $750/$1,000 = .75
1
MPS = S/ Y = $250/$1,000 = .25
Since there are only two things you can do with the
increased income, the sum of MPC & MPS equals 1.
Consumption
So far we have been looking at how changes in DI effect
C & S, which is illustrated by moving points on a fixed
consumption curve. The more we have the more we
consume and save.
S
D
SAVING
Consumption
C2
C
A
C1
Dissaving
B
o
45
o
H
E
F
Disposable Income
But there are
certain nonincome
$530
determinants
that can increase 510
490
or decrease
470
consumption,
450
thus shifting the 430
entire curve up 410
or down.
390
370
The
determinants are
o
called WHET.
C2
C1
Consumption
of savings
45
o
370 390 410 430 450
470
490 510 530 550
Real GDP
Non-income Determinants:
•Wealth; the greater the wealth of households, the larger their
consumption. Wealth means real assets (house, cars, T.V.) and
financial assets (stocks, bonds, insurance policies).
• Household debt; increasing debt means increasing
consumption.
• Expectation; future expectations about rising prices or
income can increase consumption.
• Taxation; a tax decrease will increase both consumption and
savings.
o
Saving
Any increase in
consumption will
mean an equal
decrease in savings.
Because you can
only do one of the
two with a dollar.
Consumption
Increase in Consumption (Decrease in Saving)
C2
C1
Increases in
consumption
means…
o
45
Disposable Income
Decrease
S1
S2 in saving
o
Disposable Income
Increase in Consumption (Decrease in Saving)
Consumption
The exception is a
change in taxes. A
decrease in taxes will
increase DI, which is
subject to MPS/MPC
rules. Some of the
new income will be
consumed and some
o
saved.
Saving
I’ll buy more and
save more.
C2
C1
Increases in
consumption
means…
o
45
Disposable Income
S2
Increase
S1
in saving
o
Disposable Income
Decrease in Consumption
Consumption
C1
C2
However, an increase
in taxes, will decrease
DI, thus decreasing
consumption and
savings.
Saving
o
o
o
Decreases in
consumption
means…
45
Disposable Income
Decrease
S1 in saving
S2
Disposable Income
Investment:
• Investments = the expenditures on new capital
goods.
• An investments marginal benefits = the expected
rate of return a business expects from its investment.
• An investments marginal cost = the expected cost of
making the investment.
• An investment project will be profitable if its
expected rate or return (r) exceeds the expected cost
(interest rate).
• Businesses will invest if r >or = i.
Remember, that nominal interest rate minus anticipated
inflation rates equal real interest rates. It is the real interest
rate that determines the expected cost of an investment.
12%
Nominal
Interest
Rate
7%
Anticipated
Inflation
=
5%
Real
Interest
Rate
So firms will undertake all investments which have
an expected real interest rate less than [or equal to]
the investments expected return.
16
Lowing the real interest rate means
that investments are more profitable;
thus demand for investment funds are
greater.
interest rate (i)
14
12
10
8%
6
4%
2
0
DIg
5
10
15
20 25 30 35
QM
QM
40
There is an inverse relationship between (i) and Qm
The quantity of money demanded for
investments increases as interest rates
decrease. This is illustrated as a
movement from point to point on a
fixed investment demand curve.
16
interest rate (i)
14
12
10
8%
6
4%
2
0
DIg
5
10
15
20 25 30 35
QM
QM
40
25%
20%
15%
10%
5%
50 100 150 200 250
Qm1
Qm2
But there are non-interest rate factors that can change the
quantity demanded for investment money. Thus shifting the
entire investment demand curve to the right or left, it is called
taste.
0
Non-interest rate determinants;
• Technology; the development of new technology shifts the
investment demand curve to the right, as businesses upgrade.
• Acquisition of operation cost; when production cost fall,
expected rates of return from prospective investments rise
shifting the demand curve to the right.
• Stock of inventory; businesses with dwindling inventories
will invest in expansion, thus shifting the demand curve right.
• Taxes; lower business taxes increases the expected
profitability of investments, and shift the demand curve right.
• Expectation; optimism about future profits increase
investments and shift the demand curve right.
Consumption
When consumption is less then GDP (below equilibrium),
the result is under spending, leading to increased
inventories of goods in the economy (called a
recessionary
Projected
spending gap).
Equilibrium
AE
Spending gap
o
Actual AE
45
o
Real GDP
When consumption is greater than GDP (above equilibrium),
the result is over spending, leading to decreased inventory of
AE2
goods in the economy (called an inflationary
spending gap).
AE1
Equilibrium
Consumption
Inflationary Spending
gap
45
o
o
Real GDP
AE with Xn & G, The Multiplier
[C+Ig]
[C+Ig+G+Xn]
S
(AE3)630
(Closed Economy)
(Open Economy)
AE3 (C+Ig+G+Xn) (Complex Economy) [Open & mixed]
AE2 (C+Ig+Xn) (Open & Private) [X(40)-M(20)]
AE1(C+Ig)[Basic Economy][Private(no G)&Closed(no X or M)]
(AE2)550
(AE1)470
S
AE(C+Ig2)
AE(C+Ig1)
Consumption
C=390
+80 +80 +80
AE(C+Ig)
45°
0 390 470 550 630 Real GDP
45°
460
YR
500 Real GDP
Y*
But in the real world the AE is determined by
spending on everything (C, Ig, G, & Xn)
AE = [C + Ig + G + Xn]
Consumption (billions of dollars)
C + Ig + Xn + G
o
C + Ig + Xn
C + Ig
45
o
390
470
550
Real GDP (billions of dollars)
Complicating this more is the fact that an
change in AE will lead to a greater change in
real GDP.
Consumption (billions of dollars)
WHY?
C + Ig + Xn + G
o
C + Ig + Xn
C + Ig
$20 billion in Xn
45
o
390
470
550
Real GDP (billions of dollars)
$80 billion
THE MULTIPLIER EFFECT
A change in AE leads to a larger change in
equilibrium real GDP. “Equilibrium GDP will
increase by a “multiple of the multiplier.”
Multiplier [4]
=
Change in Y (real GDP) [80]
Initial Change in E (expenitures)[20]
Or
Change in GDP[80] = Multiplier[4] x change in expenditures [20]
Since the multiplier effect is determined by MPC
(how much of our new money we consume in the
economy), the smaller the MPS the greater the
multiplier.
Inverse relationship between MPS & Multiplier
MPS
Multiplier
MPC
.90
.80
.75
.60
.50
1/MPS
1/.10
1/.20
1/.25
1/.40
1/.50
= Me
= 10
= 5
= 4
= 2.5
= 2
Multiplier = 1/MPS
Or
Multiplier = 1/1-MPC
INTERNATIONAL TRADE:
Net exports (X – M) can be either
positive or negative
Private-Open
Positive if exports[25] > imports[20]
Negative if imports[25] > exports[20]
Like consumption and investment, exports (X) add to the
nation’s real GDP. Thus, positive net exports must be added
as a component of the AE.
AE = C + Ig + Xn
Other things equal, positive net exports shift the AE schedule
upward and increases real GDP.
AE(C+Ig+Xn)(billions of dollars)
What is the affect on GDP?
Net Exports, Xn
(billions of dollars)
MPC=.75
X = 25
M = 20
510
AE with Positive
Net Exports[$5 x 4 = $20]
C + Ig + Xn1
C + Ig
490
470
450
430
45 o
o
430
450
470
490
510
Real domestic product, GDP (billions of dollars)
+5
0
-5
430
450
470
490
510
Real GDP
Things Abroad That Can Affect Xn
1. Prosperity Abroad; the
more prosperous our trading
partners the more then can buy from
us.
2. Tariffs; restrictions on
imports stimulate a domestic
economy.
3. Exchange Rates;
depreciation of the dollar makes
U.S. goods cheaper to foreign
buyers.
Aggregate Expenditures (billions of
dollars)
If government raise taxes (T), the result will be a
decrease in GDP. But not by the same multiple as
the multiplier effect.
o
45
o
Real GDP (billions of dollars)
Aggregate Expenditures (billions of
dollars)
Taxes (T) reduce DI (consumption and savings). So
equilibrium real GDP will be reduced by MPC/MPS.
o
45
o
Real GDP (billions of dollars)
This is called the tax multiplier effect (MT)
MPC
.90
.80
.75
.60
.50
MPC/MPS
MPC/.10
MPC/.20
MPC/.25
MPC/.40
MPC/.50
= MT
= 9
= 4
= 3
= 1.5
= 1
Taxes affect AE through consumption spending and
savings; government purchases affect AE only
through consumption.
Real GDP = 550 billion
Taxes increase by $20 billion
MPC = .75
What will be the affect on GDP?
S
C + Ig + Xn + G
Aggregate Expenditures
Ca + Ig + Xn + G
o
-20 x 3 = -$60
45
o
490
550
Real GDP (billions of dollars)
Balanced Budget Multiplier [$20 billion]
Net Change in GDP =
The increase in “T” means we
will consumed $15 less and
save $5 less.
Sa= -$5
T
GDP =
-$60
$20
Ca= -$15
The increase in “G”
flows directly into
the economy.
+$20
GDP =
$80
MT = MPC/MPS=.75/.25=3
So, 3 x -$20 = -$60
MPC = .75
G
$20
ME = 1/MPS
ME = 1/.25 = 4
So, 4 x $20 =
$80
At Equilibrium, All Injections = All Leakages
Injections = Leakages
C+Ig
Ig(20)
=
S(20)
X(10)
=
M(10)
G(20)
=
T(20)
[Private-closed]
C+Ig+Xn
[open]
C+Ig+G+Xn
[open with G]
The Aggregate Demand/Aggregate
Supply Model
Price
Level
SRAS
AD
[Production cost]
PLe
Ye
Real Domestic Output
Aggregate Demand
A curve that shows the amount of goods & services
that will be demanded at various price levels by
householders, businesses, government and
foreigners. (The demand for everything by
everybody).
Aggregate Supply
A curve that shows the amount of goods and
services that businesses will produce at various
price levels. (It refers all price levels in the market)
An increase in the economy’s price
levels will cause a decrease in
aggregate quantity demanded, which
will cause GDP output to decline.
PL3
PL2
PL1
AD
O
GDP3 GDP2 GDP1
fig
GDPr
YP
It will also shift the aggregate expenditures
schedule downward resulting in reduced
real GDP output.
Consumption (billions of dollars)
AE1
o
AE2
AE3
45
o
GDP3 GDP2 GDP1
Real GDP (billions of dollars)
Change in AD
But the entire AD curve can shift to the left or right. Caused
not by a change in PL but due to non-price level determinants
called CIG-X.
AD1 AD2
AD3
CIG-X
AD Shifters
[C+Ig+G+Xn]
PL
Consumption
Gross Investment
Gov. Purchases
Net Exports
AQD3 AQD1 AQD2 RDO
A shift right of the AD curve
(from AD1-AD2) results in
increased AD, increased GDP
output but no change in price
level.
PL1
AD2
AD1
O
GDP1
GDP2
fig
RGDP
YP
Consumption (billions of dollars)
The same shift in the AD curve is translated
as a shift upward in the AE schedule (from
AE1-AE2) resulting in increased GDP
output.
AE2
o
AE1
45
o
GDP1 GDP2
Real GDP (billions of dollars)
Three Segmented AS Curve
Think of
the AS
curve as a
PPC on
its back.
Price level
1. Horizontal (Keynesian)
2. Intermediate
3. Vertical (Classical)
Horizontal
Vertical
[Classical]
Range
[Keynesian]
Range
Upsloping or
Intermediate
Range
GDPr
Q
The horizontal range (Keynesian range) shows economic
inefficiency. Movement in this range results in a change in
real output but little or no change in price levels.
Price level
AS
PL1
AD2
AD1
Horizonta
l
GDP1 GDP2
GDPr
Price level
Because the economy is in a recessionary period, any shift
right in AD means that firms are putting idle resources
back to work. Since there is no shortage of resources, PL
AS
will remain
unchanged.
PL1
AD2
AD1
Horizonta
l
GDP1 GDP2
GDPr
The intermediate range shows economic efficiency.
Movement in this range results in a change in GDP
output and a change in price level.
Price level
AS
AD4
AD3
PL4
PL3
PL1
Upsloping or
Intermediate
Range
GDP3 GDP4
GDPr
A shift to the right means that resources are
becoming scarcer, thus the PL for these resources
increases. This increases input cost and prices at
stores.
Price level
AS
AD4
AD3
PL4
PL3
PL1
Upsloping or
Intermediate
Range
GDP3 GDP4
GDPr
As the economy exceeds full employment, it enters
the vertical range. This range shows little or no
additional real output but larger changes in price
level.
AS
Price level
AD6
PL6
PL5
AD5
Vertical
[Classical]
Range
Pure
Inflation
PL4
PL3
PL1
FE
GDP5
GDPr
The economy is at 100% productivity, and can not
add any new output. Any increase in AD will cause
demand-pull inflation.
AS
Price level
AD6
PL6
PL5
AD5
Vertical
[Classical]
Range
Pure
Inflation
PL4
PL3
PL1
FE
GDP5
GDPr
Shifts in the AS Curve
AD
Price
Level
SRAS3
Shortage
(RAP)
SRAS
1
SRAS2
AQS
AS Shifters
[RAP]
Resource cost
Actions of Gov.
Productivity
GDP3 GDP GDP2
Productivity – how many outputs
(pies) can be produced from a set
amount of inputs (apples).
1
1
2
2
3
4
3
5
6
4
7
8
5
9
10
Productivity [2] = outputs[10]/inputs[5]
An increase in productivity means more real
output can be obtained from the same inputs.
Example; If output = 10 units, input = 5 units
and the price of each input resource = $2,
then our per unit production cost will = $1.
Per unit production cost($1) = Total input cost($10)[$2x5]
Units of output (10)
Suppose increased productivity doubles output to
20 units for the same input of 5 units, & price of each
Input unit is still $2. Then our per unit production
Cost will = $.50
Per unit production cost(.50) = Total input cost($10)
Units of output (20)
The Ratchet Effect:
The ratchet effect;
prices are “flexible
upward” but “inflexible
downward.”
Increases in AD ratchet
the PL upward. Once in
place, the higher PL
remains in place until
it is ratcheted up again.
AD31
AD2
SRAS
PL2
PL1
GDP2
GDPr
GDP
Reasons for the Ratchet Effect
• Wage Contracts; a large part of the labor force
works under contracts prohibiting wage cuts.
AD1
AD2 LRAS
PL2
PL1
Y3 Y1
Y2
• Morale, Effort, & Productivity; lower wages
decreases morale and effort, which lowers
productivity and increases per-unit cost.
Reasons for the Ratchet Effect
• Minimum Wage; businesses can not legally
pay below this wage floor.
• Menu Costs; changes in
prices create unwanted cost.
It may be cheaper to keep
prices stable.
AD1
AD2 LRAS
PL2
PL1
Y3 Y1
Y2
• Fear of Price Wars; price cuts may lead to
retaliation from rival businesses.
Government “Striking Out” A Recession
Fiscal Policy
To combat the ups and downs of the business cycle, the
Federal government utilizes fiscal policy.
Fiscal Policy; deliberate changes in government spending
and tax collecting to achieve full employment, control
inflation, and encourage economic growth.
• Fiscal policy (Keynesian economics) emerged
out the Great Depression of the 1930s. But it
was not until 1946 that it became a mandatory
government function.
• Employment Act of 1946; commits the Federal
government to take action through fiscal or
monetary policy in order to maintain economic
stability.
• The Humphrey-Hawkins Act (1978); requires
the Federal government to provide five-year
economic goals, with the primary goal of
maintaining 4% unemployment and 3% inflation
rates.
• Council of Economic Advisers (CEA); organized
to help the president met these primary goals.
Expansionary Fiscal Policy
SRAS
AD2
AD1
GDP
John Maynard Keynes
When recession
occurs the
government turns
to an Expansionary
Fiscal Policy to
move AD to the
right.
PL
SRAS
AD2 LRAS
AD1
PL2
PL1
E1
E2
GDP1GDP2
G
T
AD
DI
GDP/Emp/PL
C
AD
G
GDPr
LFM
GDP/Emp/PL T
LFM
I.R.
IR
Real Interest Rate, (percent)
Loanable Funds Market
S
D
Lenders
Borrowers
1
IR=8%
E1
An expansionary
fiscal policy will cause
the government to run
a budget deficit, to
pay this deficit the
government has to
borrow funds.
Q1
Quantity Loanable Funds
Real Interest Rate, (percent)
Loanable Funds Market
D
Borrowers
1
D
S
2
Lenders
IR=10%
IR=8%
E2
E1
Q1
When government
competes with private
business for loans, it
increases the demand
for funds and drives
interest rates up.
Q2
Quantity Loanable Funds
PL
Higher interest rates decrease the demand for Ig which
reduce AD (shifting it left). So there is a counter-cyclical
effect. This is called the Crowding-out effect.
AS
Expansionary Fiscal
Policy being
crowded-out
P1
AD1 AD’2 AD2
$490 $504$510
GDPr (billions)
Contractionary Fiscal Policy
AD1 SRAS
AD2
GDP
When demand-pull
Inflation occurs the
Government turns to a
Contractionary fiscal
policy to move AD left.
PL
AD2
AS
AD1
PL1
PL2
E1
E2
GDP2 GDPI
G
T
GDP/Emp./PL
AD
DI
C
AD
GDPr
G
GDP/Emp/PL
LFM
T
LFM
I.R.
IR
PL
Lower interest rates, increase the demand for Ig which
increase AD (shifting it right). So there is a
counter-cyclical effect here also.
AS
Contractionary Fiscal
Policy being
weakened
P1
P2
P2
AD2 AD’2 AD1
$510
GDPr (billions)
Timing Problems of Fiscal Policy:
1. Recognition lags – the time between the beginning of
a recession or inflationary gap and the awareness
that it is actually happening (usually 4-6 months).
2. Administrative action lags – the time it takes
Congress to debate and decide on a course of action
(usually 6-12 months).
3. Operational lags – the time it takes to plan and
implement government projects that will support the
right fiscal policy. Taxes rates can not be changed till
the next fiscal year.
Thus the economy can be 1 to 2 years down the road
before any change occurs. By that time the business
cycle could be in a different phase, requiring a different
fiscal policy.
E4
E2
*Tell them what they want to hear.
Political Business Cycle – The
economy is manipulated to get voter
support. No politician wants to
campaign as the “tax rising”, “project
killing”, “economic wimp”. So
politicians use fiscal policy during an
election year to stimulate the
economy. After the election voters
get a “Made in Washington”
recession as fiscal policy is used to
curb inflationary pressures.
BUILT-IN STABILIZER; anything that increases
government deficits during a recessionary period,
and increases the government’s budget during
inflationary periods without requiring explicit
Taxes
action by policymakers.
Surplus
G
Deficit
GDP1
Recession
GDP2
FE
GDP3
Inflation
Government Expenditures,
G, and Tax Revenues, T
The best stabilizer we have is our progressive tax
system. Tax revenues vary directly with GDP. It
allows for deficits in recessionary periods, and
budget surpluses in inflationary periods.
Taxes
Surplus
G
Deficit
GDP1
GDP2
GDP3
Government Expenditures,
G, and Tax Revenues, T
Notice that government expenditure is a horizontal line
because budgets are annually and cannot be changed.
However tax revenue is upward slopping because as GDP
(real wealth) increases government revenues (taxes)
increase.
Taxes
G
GDPr
So during inflationary periods (wealthier economy)
more taxes are collected, which helps to curb inflation.
During recessionary periods (poorer economy) less
taxes are collected, which helps stimulate AD.
Taxes
Surplus
G
Deficit
GDP1
Recession
GDP2
FE
GDP3
Inflation
Government Expenditures,
G, and Tax Revenues, T
The steeper the slope of the tax line, the more
progressive the tax system, and the greater the
built-in stabilizers.
Taxes
Surplus
Surplus
G
Fewer
Transfers
Deficit
GDP1
GDP2
GDP3
YR
Yi
Y*
Real Domestic Output, GDP
Other types of built-in
stabilizers
• Welfare/Food Stamps
• Unemployment insurance
• Social Security
All of these programs require the
government to transfer funds to the public
(transfer payments). These funds are used
to increase consumption, and stimulate AD.
As the economy enters a recessionary
period, more people qualify for these
benefits (fewer in inflationary periods).
There is $665 billion in
currency [notes & coins].
$37 million in notes is
printed each day.
Money and Banking
MONEY DEFINITION
M1 Money: is the narrowest definition
M1
of the U.S. money supply. It includes;
•Currency in the hands of the public.
• Checkable deposits.
$1,236
billion
2-3%
46%
52%
M2 Money: is called “nearmonies” because it contains very
liquid assets that do not function
directly as a medium of exchange,
but can be converted into
currency easily.
M2 M1
$1,236
billion
• Savings accounts
• Money market accounts
• Timed deposits
• Money Market Mutual Funds
$5,899
billion
(MZM) M3 Money: includes all large
($100,000 or more) time deposits M3 M2 M1
=
$1,236
billion
$5,899
billion
$8,595
billions
D = 1/PL
Value of Money
Prices
The amount a dollar will buy varies inversely with
the price level.
When the consumer price index or “cost-of-living”
index goes up, the value of the dollar goes down.
Transactions
Demand, Dt
Nominal Interest Rate
10
M1
7.5
5
2.5
0
0
Dt
50 100 150 200 250 300
Money demanded (billions)
Households and businesses must have enough money on
hand to carry out transactions of goods and services. This
demand for money is called the transactions demand for
money.
Transactions
Demand, Dt
Nominal Interest Rate
10
7.5
M1
5
2.5
0
0
Dt
50 100 150 200 250 300
Money demanded (billions)
It is the level of nominal GDP that determines the amount
of money demanded from transactions.
The larger the value of all goods and services the larger the
amount of money needed to negotiate transactions.
This demand for
transactional funds is
independent of the interest
rate.
10
Nominal Interest Rate
7.5
M1
5
2.5
0
Dt
0
50 100 150 200 250 300
Money demanded (billions)
The transactions demand for money varies directly with nominal
GDP. So there is a direct relationship between GDP and the publics
demand for dollars. If the average dollar is exchanged 4 times a year,
and nominal GDP is 1,000 billion, then the economy will demand 250
billion in currency.
Rate of interest, i (percent)
There is also an asset demand for money (M2). Money is an
asset that can be held or invested. The disadvantage
(opportunity cost) of holding money, compared to investing it,
is the interest income that is lost.
So the asset demand for money varies inversely with the rate
of interest. The lower the interest rate the more money that
will be10held as a liquid asset.
7.5
Interest Rate
5
2.5
CDs or
Oppor. Cost
Da[hold less]
0
Da
Interest Rate
0 50 100 150 200 250 300
Oppor. Cost
Amount of money
demanded (billions)
Da[hold more]
10%
Da
8%
6%
5%
4%
2%
1%
0
0 50 100 150 200
The total demand for money (money supply) is found by
adding the transactions demand to the asset demand for
money. This is how monetary authorities know how much
money needs to be supplied in order to stabilize the value
of money & and the economy.
7.5
5
2.5
0
Dt
10
7.5
10
10%
7.5
7.5%
5
2.5
0
50 100 150 200 250 300
5
5%
2.5
2.5%
Da
+
Dm
0
50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Amount of money
demanded (billions
of dollars)
Asset
Demand, Da
0
0
50 100 150 200 250 300
Amount of money
demanded (billions
of dollars)
Transactions
Demand, Dt
Rate of interest, i (percent)
Nominal Interest Rate
10
Rate of interest, i (percent)
Sm
=
Total demand
for money, Dm
THE MONEY MARKET
If the total demand
DmMS1 MS1 for money is $200
billion, but the
money supply is
decreased by $50
E billion, the result
will be an increase
in interest rates.
10
Nominal Interest Rate
By regulating
the money
supply,
monetary
authorities
can regulate
interest rates.
7.5
5
2.5
0
0
50
100
150
200
250 300
Amount of money demanded
(billions of dollars)
Money Market
If the total demand for money is $200 billion, but the
money supply is increased by $50 billion, the result will be
a decrease in interest rates. WHY?
Dm MS1 MS2
10
Nominal Interest Rate
As more
money is
available the
demand for
loans
decreases. So
banks will
lower interest
rates to
encourage
new loans.
7.5
E
5
2.5
0
0
50
100
150 200 250 300
Amount of money demanded
(billions of dollars)
Money Market
But this
change in
interest rates
will affect the
secondary
bond market.
Old Bond Prices and the Interest Rate
$1,000 x .08 = $80
$1,333 x .06 = $80
$800 x .10 = $80
Functions of the Fed
• Issuing currency; the Fed is in charge of putting money
into circulation.
• Setting reserve requirements & holding reserves; the Fed
requires banks to keep a fraction of their account balances
in reserve in their regional Federal Reserve.
• Lending money to banks; the interest charged for these
loans are called the discount rate.
• Clearing checks; the Fed collects and clears all personal
checks, by deducting the amount from the checks bank
and adding the amount to the cashiers banks.
Functions of the Fed
• Fiscal agent; the Fed collects, and stores tax revenue, as
well as pays government purchases.
• Supervising banks; the Fed makes periodic examinations
to assess a banks assets and debts.
• Controlling the money supply; the Fed’s most important
function is utilizing monetary policy to stabilize the
economy.
Monetary Policy
the “Fed”
Janet Yellen
The Monetary Multiplier:
• The monetary multiplier is similar in concept to the
spending-income multiplier (expenditure multiplier).
• The expenditure multiplier exists because the expenditures of
one person becomes the income of someone else. So the
multiplier magnifies the initial change in spending into larger
changes in GDP.
MPC 1/MPS
= M
.90 1/.10
= 10
.80 1/.20
= 5
.75 1/.25
= 4
.60 1/.40
= 2.5
.50 1/.50
= 2
• In contrasts, the monetary multiplier exists because the
reserves and deposits loaned out by one bank are received by
another bank and then loaned out again. So it magnifies loan
able funds (excess reserves) into a larger creation of
checkable-deposit money.
1/RR
1/.10
1/.20
1/.25
1/.40
1/.50
= M
= 10
= 5
= 4
= 2.5
= 2
Since the monetary multiplier is determined by
how much new deposits are loaned out, it is the
reciprocal of the required reserve ratio, the smaller
the RR the greater the monetary multiplier.
Inverse relationship between RR & Mm
RR
Multiplier
The monetary multiplier represents the
maximum amount of new checkable- deposit
(DD) money that can be created by a single
dollar of excess reserves.
Mm
=
1
RR
By multiplying the excess reserves by the monetary
multiplier we can find the maximum amount of new
checkable-deposit money (DE) that can be created by
the banking system.
Maximum
checkabledeposit
expansion
= ER x M
m
Practice;
Suppose Tom deposits $100 into his banking
account (his paycheck), also assume that the
required reserve ratio is 20%. What will be the
maximum checkable-deposit expansion (DE)?
Mm = 5 (1/.20 = 5)
ER = $80 (100 – 20 = 80)
DE = $400 (80 x 5 = 400)
The new money supply = DE + DD (So the money
supply will grow by a multiple of 5).
Easy money Policy:
When the economy faces a recession and
unemployment, the Fed will decide to
increase the money supply in order to
increase aggregate demand. To do this the
Fed will either;
• Lower the reserve ratio; changing required reserves to
excess reserves.
• Lower the discount rate; enticing borrowing to increase
excess reserves.
• Buy securities; increasing excess reserves and the
DI of the public. Fed will do this 9-10 times!
DI
MS MS2
Real Interest Rate
1
10%
10
8%
8
6%
6
Price level
0
DM
Money Market
AD
AD
1
2
P
P2
Investment
Demand
0
QID1 QID2
AS
E2
E1
1
Real GDP
Buy
Bonds
MS
YR
I.R.
Y*
QID
AD
Y/Emp/PL
Tight money Policy:
When the economy is in an inflationary spiral,
the Fed will decide to decrease the money
supply in order to decrease aggregate
demand, which will decrease demand-pull
inflation. They will do this by;
• Increasing the reserve ratio; changing excess reserves to
required reserves.
• Raise the discount rate; discouraging borrowing to increase
excess reserves.
• Sell securities; decreasing excess reserves and the
DI of the public. The Fed will do this 9-10 times.
Dm
MS2MS1
Real Interest Rate
10
10%
8
6%
Money Market
AS
0
Price level
AD1
P1
Investment
Demand
8%
6
0
Di
AD2
P2
QID2 QID1
E1
E2
Y* YI
Sell
Bonds
MS
I.R.
QID
AD
Y/Empl./PL
Strengths of Monetary Policy
1. Speed and flexibility –Compared to fiscal policy
monetary policy can be quickly altered. The
buying & selling of bonds can occur on a daily
basis.
2. Isolation from political pressures – because the
Board of Governors serve 14 year terms.
They can enact unpopular
policies which
might get a member of Congress fired, but is
best for our economy’s health.
3. Success since the 1980s – a tight money
policy helped bring inflation from 13.5% in 1980
to 3.2% in 1983. An easy money policy helped
the economy recover from the 2000 recession.
Shortcomings of Monetary Policy
Kiss my tail! I wont
drink!
Cyclical Asymmetry “You can lead a horse
To water but you can’t make him drink”
An easy money policy during depression does
not guarantee that banks will give out loans if
people don’t have jobs.
Velocity of money “number of times per
year the average dollar is spent”
During inflation, when the Fed restrains
the money supply, velocity may increase.
During a recession, when the Fed increases the money supply, the
public may hold more money due to lower interest rates & fear.
Less Control by the Fed
Banking reforms make it easier to move near-money to checking accounts
and vice versa. Also increased global banking may led to policies that are
inappropriate for domestic monetary policy.
Extending The Analysis
Of AS To The Long Run
With
Phillip
& Laffer
Alban William Housego Phillips
1914-1975
SRAS and LRAS
Short Run– a period in which
nominal wages (input cost) remain
fixed as PL (profits) increase or
decrease.
Long Run– a period in which nominal
wages are fully responsive to PL
changes.
Reasons why wages are fixed
in the SR
• Workers
may not immediately be aware that
inflation (increased PL) is eating up their real
wages (wealth) thus they may not demand
higher wages right away.
• Many
workers are hired under fixed-wage
contracts (Mrs. Boeneman) and can not
demand higher wages until their contract
expires.
GROWTH IN THE AS/AD MODEL
Economic growth is illustrated in the AS/AD model by a
vertical long-run AS line. This line is the same as the PPF
curve. A right shift in the
LRAS1 LRAS2
c
shifting the PPF to
the right.
Price Level
a
Capital Goods
LRAS line is the same as
U
b
Consumer Goods
d
Y1 Y2
Real GDP
As LRAS shifts to the right it drags the SRAS curve
with it (what we do next week “LR” is affected by
what we do today “SR”). And this increases the PL.
LRAS1
LRAS2
SRAS2
Price Level
SRAS1
PL2
PL1
AD2
AD1
o
Y1
Real GDP
Y2
When PL are anticipated, equilibrium is the same for both the
SRAS curve & the LRAS curve at potential output.
LRAS
SRAS
Price Level
AD
PL1 [3%]
0
E1
Y
Real domestic output
But when PL (inflation) is unanticipated, in the short
run, output prices (profits) increase while input
prices (cost/wages)
LRAS
AS1
remain fixed.
AD1 AD2
6%
3%
With more profits, firms attempt
to increase supply. They offer
their workers overtime, entice
Homemakers & retirees into the
labor force, and hire and train
the structurally unemployed.
E3
E2
E1
4%
3% Unemployment
In the long run, workers will discover that their real wages
have declined because of this increased PL. They will restore
their previous level of real wages by gaining nominal wage
LRASAS3 AS1
increases.
AD1 AD2
6%
3%
Since nominal wages are
one of the determinants of
AS, the SRAS curve will
shift leftward leading to a
higher PL.
E3
E2
E1
4%
3%
You’re crazy if you think
we’re going to accept 3%
wage increases while
prices are going up 6%.
This is a naturally occurring trend in the market and
is the reason why PL continually increase from year
to year.
LRAS
AD
SRAS
Price Level
Yr 3 [3%]
Yr 2 [3%]
Yr 1 [3%]
0
E1
Y
Real domestic output
In the short run, demand-pull inflation drives up the price
level and increases real output. The initial increase in AD has
LRAS
moved the economy along its
vertical AS curve.
AD2
SRAS1
Price Level
AD1
PL2[5%]
E2
E1
PL1[2%]
o
Y
1
Y2
Real domestic output
Price Level
For a while, the economy can operate beyond its FE level of
output. But the demand pull inflation will eventually cause
adjustment to nominal wages that LRAS
will return the
SRAS2
economy back
AD2
SRAS1
to its FE output.
AD1
PL2[5%]
PL1[2%]
o
E3
E2
E1
Y1 Y2
Real GDP
Cost-push inflation occurs when an increase in production
cost causes a shift in SRAS to the left. This shift in SRAS
causes an increase in the PL, and widespread layoffs in the
labor force. This economic stagnation mixed with inflation is
LRAS SRAS SRAS
called stagflation.
AD
Price Level
1
PL2(10%)
2
E2
PL1[2%]
o
1
E1
Y2 Y1
10%
Real domestic output
If government attempts to fight unemployment by
increasing AD then inflation will spiral out of control.
Price Level
AD2 LRAS SRAS2
SRAS1
AD1
E3
PL3 [12%]
PL2 [10%]
E2
PL1[2%]
o
E1
Y2 Y1
10%
Real domestic output
But if government takes a hands-off approach
and allows a recession to occur, nominal
wages will fall and AS will return to its original
LRAS
location.
AD1
SRAS2 SRAS
Price Level
1
PL2[10%]
PL1[2%]
o
E2
E1
Y2 Y1
10%
Real domestic output
Phillips Curve – there is an inverse relationship
between inflation and unemployment. As inflation
decreases, unemployment increases.
Annual rate of inflation
7
6
5
4
3
2
1
0
1
2
3
4
5
6
7
Unemployment rate (percent)
The Phillips Curve is like an inverse of the SRAS
curve.
PRICE LEVEL
Increases in AD causes . .
AS
AD3
AD2
AD1
C
B
A
REAL OUTPUT
Y/Empl.
A Phillips Curve trade-off between
. unemployment and inflation.
INFLATION RATE
PL
PC
Phillips curve
C
B
A
UNEMPLOYMENT RATE
Finally, there seems to be no LR tradeoff between inflation and
unemployment. When you consider decades and not single years, any
rate of inflation is consistent with the natural rate of unemployment
(4%).
Increasing AD beyond FE may temporarily increase GDP/Y/employ.
But when nominal wages eventually catch up profits will fall, ending the
stimulus to produce beyond FE.
LRPC
SRPC3
12%
Inflation
c3
SRPC2
8%
4%
0
b3
c2
b2
SRPC1
C1
2%
“New Phillips Curve”
Inflat.
Gap
4%
Recess.
Gap
b1
6%
8%
Unemployment
So there is no tradeoff between the rates of inflation and unemployment
in the long-run. Like the LRAS curve, the LRPC is a vertical line at the
economy’s natural rate of unemployment (4%).
A stable Phillips Curve with the dependable series of unemploymentrate-inflation-rate tradeoffs simply does not exists in the LR. Any rate of
inflation can occur with the 4% natural rate of unemployment. Thus, the
FED has chosen to fight inflation rates before they worry about
unemployment.
LRPC
SRPC3
12%
Inflation
c3
SRPC2
8%
4%
0
b3
c2
b2
SRPC1
C1
2%
Inflat.
Gap
4%
Recess.
Gap
b1
6%
8%
Unemployment
Supply-side economists argue that if tax rates were
lowered, then people would supply more labor by
working harder and longer, which will increase
aggregate supply.
Why? If people kept more of their pay check then
the opportunity cost of leisure would increase,
making work more attractive to them.
The result would be an increase in tax revenue.
“I was on the
Laffer curve.”
Reaganomics
The Laffer Curve illustrates the
relationship between tax rates and tax
revenues. As tax rates increase from
zero to a higher percentage rate, the
government will increase its tax
revenues.
Tax rate (percent)
100
l
0
Tax revenue (dollars)
Tax revenue will continue to increase up
to some maximum level. Once that
maximum level is reached, any further
increase in tax rates will actually
decrease government revenues.
Tax rate (percent)
100
m
l
0
Tax revenue (dollars)
As tax rates increase tax payers will find
ways to not pay taxes, or they will
simply work less, since the opportunity
cost of work is directly
related
to
tax
n
rates.
Tax rate (percent)
100
m
l
0
Tax revenue (dollars)
Tax rate (percent)
As you can see
if government
increases tax
rates to 100%,
people will
simply not
work. And the
government
will collect zero
in tax revenue.
100
n
m
m
Maximum
Tax
Revenue
l
0
Tax revenue (dollars)
Deficits, Surpluses and the Public Debt
Three Budget Philosophies
“Earth Orbits Sun”
“G”
Annually Balanced Budget – each time the earth
orbits the sun we should balance the budget. This would put
the government in an economic straitjacket; because it could
not fight recessions with deficit spending. This would be like
pouring water on a drowning man.
Balancing the budget during a recession by increasing taxes
would worsen the recession.
Running a surplus during boom times and giving the money
back would be inflationary.
Tax
Cuts
Inflation
“Raise taxes”
Raise
Taxes
“Balanced”
Recession “Deficit Spending”
“Tax cut”
Cyclically Balanced Budget – run deficits during
recessions & surpluses during expansions so the budget is
balanced not each year but over the course of the business
cycle. The government could conduct counter-cyclical fiscal
policy and balance its budget over a period of years. The main
problem is that fluctuations are not symmetrical enough to
ensure that the surplus will pay off the deficit.
U.S.
Economy
Functional Finance – balance the economy not the
budget.
The annual or cyclically balanced budget is of secondary
importance. The important thing is to provide for
non-inflationary, FE & ensure the economy produces its
potential GDP. If there are chronic deficits or surpluses, so be
it. Deficits are minor problems, compared to inflation or
recessions.
It is comparative advantage
that matters, not absolute
advantage.
Ricardo
The U.S. in the
Global Economy
No nation is an island; because there are several
economic flows that link the U.S. economy with
the world.
Links between the U.S. Economy & the World:
Trade flows; The U.S. exports and imports goods and
services to other nations.
• Resource
flows; U.S. firms establish production
facilities in foreign countries and foreign firms
establish production facilities in the U.S. Labor
also moves between nations.
Ford Escort
Technology flows; Foreign firms use technology
created in the U.S. and U.S. businesses
incorporate technology developed abroad.
Financial flows; Money is transferred between
the U.S. and other countries when we:
•Pay for imports
•Buy foreign assets
•Pay interest on U.S. debt
Reasons for the Growth of international
trade:
1. Transportation technology; improvements in
transportation have shrunk the globe and
fostered international trade.
2. Communication technology; computers,
internet, telephone, and fax machines directly
link traders around the world.
3. Decline in tariffs; tariff rates have been falling
since 1940 (U.S. tariffs went from 37% to 4%
today).
Specialization & Comparative Advantage
Specialization and international trade
increases the productivity of a nation’s
resources and allows for greater total output
than would otherwise be possible.
(Specialization and exchange result in
greater overall output and income.)
Avocados
Soybeans
Mexico’s Production Alternatives
A
B
C
D
E
0
20
24
40
60
15
10
9
5
0
Five tons of soybeans must be sacrificed to
produce 20 tons of avocados. Thus in
Mexico the comparative-cost ratio is 1 ton of
soybeans (S) to produce 4 tons of avocados
(A).
1S = 4A
Avocados
Soybeans
U.S.’s Production Alternatives
A
B
C
D
E
0
30
33
60
90
30
20
19
10
0
Ten tons of soybeans must be sacrificed to
produce 30 tons of avocados. Thus in the
U.S. comparative-cost ratio is 1 ton of
soybeans (S) to produce 3 tons of avocados
(A).
1S = 3A
The U.S. has a comparative advantage over
Mexico in soybeans (1 ton of soybeans cost
3 tons of avocados and not 4 as in Mexico).
Mexico has a comparative advantage in
avocados (avocados cost 1/3 ton of
soybeans in the U.S. but only ¼ ton in
Mexico).
Before After Amount After
Special. Special. Traded Trade
Mexico
U.S.
24A
9S
33A
19S
60A
0S
0A
30S
-35A
+10S
+35A
-10S
25A
10S
35A
20S
Gain
from
Trade
1A
1S
2A
1S
If both nations specialize each can achieve
a larger total output with the same total
input of resources. They will be using their
scare resources more efficiently.
Trade Allows Nations to Consume Beyond Their PPCs
While Producing On It
Avocados
PPC (Before & after trade)
CPC (after trade)
25
24
0
CPC (before specialization & trade)
9
10
Soybeans
Terms of Trade:
•Both economies must get a better price for its
product in the world market than it can get
domestically; otherwise, there is no gain from
trade and it will not occur.
•U.S. has to get more than 3 tons of avocados for
every 1 ton of soybeans.
•Mexico has to get 1 ton of soybeans for less than
4 tons of avocados.
So the terms of trade will require that for
every ton of soybeans offered, between 3 and
4 tons of avocados must be given.
Supply & Demand Analysis of
Exports & Imports:
The amount of goods (aluminum) a nation will
export or import depends on differences between
the equilibrium world price and the equilibrium
domestic price.
World price – the equilibrium between the world
supply and demand of a product.
Domestic price – the equilibrium between the
domestic supply and demand of a product.
Let’s look at the domestic aluminum market. The
intersection of Sa and Da determines the equilibrium
domestic price and quantity of aluminum in the U.S.
$1.50
Sa
$1.25
$1.00
$.75
Da
$.50
75
100
125
150
When the world and domestic prices are equal
($1 per pound of aluminum), the quantity of
exports supplied by the U.S. economy will be
zero. There will be no surplus domestic output to
$1.50 export.
Sa
$1.25
$1.00
$.75
Da
$.50
75
100
125
150
But when the world price increases to $1.25, domestic
demand will drop to 75 million lbs. and supply will
increase to 125 million lbs. U.S. firms will export 50
million lbs. of surplus aluminum.
Sa
$1.50
$1.25
Surplus
$1.00
$.75
Da
$.50
75
100
125
150
So, as world prices increase relative to
domestic prices, U.S. exports rise (a to b).
$1.50
b
$1.25
$1.00
$.75
U.S.
export
supply
a
x
U.S.
import
demand
$.50
50
100
150
200
If the world price falls to $.75 per pound, domestic
demand will increase to 125 lbs. and domestic supply
will decrease to 75 lbs. U.S. firms will import 50 million
lbs. of aluminum to avoid a shortage.
$1.50
Sa
$1.25
$1.00
Shortage
$.75
$50
Da
75
100
125
150
So, when world prices fall relative to U.S.
domestic prices, U.S. imports increase (a to x).
$1.50
b
$1.25
$1.00
$.75
U.S.
export
supply
a
x
U.S.
import
demand
$.50
50
100
150
200
However, a trading partner (Canada) may not have the
same equilibrium domestic price & quantity; they may be
more efficient at producing aluminum than the U.S.
$1.25
Sa
$1.00
$.75
$.50
Da
50
100
125
150
If the world price increases to $1.00, Canadian domestic
demand will drop to 75 million lbs. and supply will
increase to 125 million lbs. U.S. firms will export 50
million lbs. of surplus aluminum.
Sa
$1.25
$1.00
Surplus
$.75
$.50
Da
75
100
125
150
If the world price falls to $.50 per pound, Canadian
domestic demand will increase to 125 lbs. and domestic
supply will decrease to 75 lbs. U.S. firms will import 50
million lbs. of aluminum to avoid a shortage.
$1.25
Sa
$1.00
$.75
Shortage
$50
Da
75
100
125
150
So we se that when the world price is above Canada’s
domestic price, the aluminum is exported from that
country. When the world price falls below the domestic
price, Canada imports aluminum.
$1.25
b
$1.00
$.75
$.50
0
Canadian
export
supply
a
x
50
Canadian
import
demand
100
150
200
The world price for aluminum is determined by
combining the S&D curves of both economies.
$1.50
United
States
Canada
$1.25
$1.00
$.88
$.75
0
50
100
150
200
International equilibrium (world price/quantity)
occurs where one nation’s import demand curve
intersects another nation’s export supply curve.
$1.50
United
States
Canada
$1.25
$1.00
$.88
$.75
0
50
100
150
200
Foreign Exchange Market – a market in which
various national currencies are exchanged for
one another.
$1 will buy
EXCHANGE RATES:
47.68 Indian rupee
.63 British pounds
1.48 Canadian dollars
10.91 Mexican pesos
1.36 Swiss francs
.93 European euros
119 Japanese yen
1,237 South Korean won
8.54 Swedish krona
Dollar Price of Yen
The equilibrium rate is the rate at which currency
of one nation can be exchanged for the currency
of another nation.
Sy
$.01
At this
rate, $1
will buy
100
Dy
Qe (1)
Quantity of yen
What might cause this exchange rate to
change?
Suppose incomes rise in the U.S. due to an
economic boom. Consumers will be willing
and able to buy more U.S. and Japanese
goods.
U.S. Economy
AD2
AS
AD1
YR
Y*
An increase in U.S. demand for Japanese
goods will increase the demand for yen and
raise the dollar price for yen (how much each
yen cost).
S
Price of
$.05
$.01
D
y
Dy2
D
y
Quantity of
When the dollar price of yen increases, we
say that the dollar has depreciated (it takes
more dollars to buy a single yen).
Thus the international value of the dollar has
declined.
D1
D2 S
Price of
$.05
$.01
D
Quantity of
A
Since the value of the yen has increased, the price
of Japanese goods will become more expensive to
Americans.
The result will be that American consumers will buy
less Japanese goods and more American goods.
This will cause a recessionary trend in the Japanese
economy.
Japanese Economy
AD1
AS
AD2
YR
Y*
A decrease in the dollar price of yen is called
appreciation of the dollar. The international value of
the dollar has increased.
Since it takes fewer dollars to buy a yen the price of
Japanese goods become cheaper to Americans.
Sy
Price of
$.01
$.005
A
Dy2
Quantity of
Dy
Americans will buy more Japanese goods and
fewer U.S. goods, leading to an economic
boom in Japan.
Japanese Economy
AS
PL
AD1
YR
Y*
AD2
United States
Businesses
Exporters of goods
to Mexico want
dollars not Pesos
Mexican
Businesses
Exporting goods to
U.S. want Pesos not
dollars
Foreign Exchange
Market
Mexican importers supply their pesos in
exchange for dollars in the Foreign
Exchange Market. And U.S. importers
exchange their dollars for pesos.
•When a U.S. business exports goods to Mexico, the
exporter wants to be paid in dollars. But the Mexican
importer only has pesos. The importer must exchange
pesos for dollars before the U.S. export transaction can
occur.
This problem is resolved in foreign exchange markets, in
which dollars can purchase pesos, and vice versa.
Such purchases are sponsored by major banks in each country.
The
International
Market
Thus, U.S. exports create a foreign demand for dollars, and the
fulfillment of that demand increases the supply of foreign
currency held by U.S. banks and available to U.S. buyers.
The increase in supply of foreign currency decreases its value
to U.S. dollars.
S1
$1.50
S2
$1.00
.50
# of Pesos
Also, U.S. imports create a domestic demand for
foreign currency, and the fulfillment of that demand
reduces the supplies of foreign currency held by U.S.
banks and available to U.S. consumers. Thus the
increase in the value of the foreign currency to the
dollar.
S2
So in a board sense,
any nation’s exports pay
for its imports. Because
exports provide the
foreign currency needed
to pay for imports.
S1
$1.50
$1.00
.50
# of Pesos
Exchange Rates:
Two types of exchange rates;
1. Flexible (floating) exchange rate systems;
supply and demand determine the exchange
rate with not government intervention.
2. Fixed exchange rate system; government
determines the rate of exchange by making
economic adjustments.
Dollar Price of 1 pound
The demand for pounds curve is downward-sloping
because all British G/S will be cheaper to the U.S. if
pounds become less expensive to the U.S. At lower
dollar prices for , the U.S. can get more pounds, thus
more g/s.
Cheaper
S1 British g/s will
$3
increase the
quantity of
the U.S. will
demand.
$2
$1
0
D1
Qe
Quantity of pounds
Dollar Price of 1 pound
The supply of pounds curve is upward-sloping because
the British will purchase more U.S. g/s when the dollar
price of rises, thus they will supply more pounds to get
cheap U.S. goods.
S1
$3
Depreciate
ER
$2
appreciate
$1
0
So when the
dollar
depreciates
the supply
of will
increase.
D1
Qe
Quantity of pounds
Dollar Price of 1 pound
Under flexible exchange rates, a shift in the demand for pounds
from D1 to D2 would cause a U.S. balance deficit (ab). That deficit
could be correct by changing the dollar price for pounds to $3.
The short-run shortage can be covered by using official reserves.
But in the LR the imbalance will correct itself.
S1
$3
c
balance deficit
x
$2
a
b
D2
$1
0
D1
Q1
Q2
Quantity of pounds
Q3
Dollar Price of 1 pound
Since there is a shortage, the pound will appreciate to
the dollar. This change in exchange rates will make all
British goods more expensive, causing a decline in
British exports (shift from b to c).
S1
$3
c
balance deficit
x
$2
a
b
D2
$1
0
D1
Q1
Q2
Quantity of pounds
Q3
Dollar Price of 1 pound
Since U.S. goods are cheaper now, the British will
increase their import, raising the supply of pounds (from
a to c). These two adjustments will correct the balanceof-payment deficit.
S1
$3
c
balance deficit
x
$2
a
b
D2
$1
0
D1
Q1
Q2
Quantity of pounds
Q3