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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