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Examples of Microeconomic and Macroeconomic Concerns DIVISION OF PRODUCTION PRICES ECONOMICS INCOME EMPLOYMENT Microeconomics Production/output in individual industries and businesses How much steel How much office space How many cars Distribution of Price of individual income and wealth goods and services Wages in the auto Price of medical care industry Price of gasoline Minimum wage Food prices Executive salaries Apartment rents Poverty Employment by individual businesses and industries Jobs in the steel industry Number of employees in a firm Number of accountants Macroeconomics National production/output Total industrial output Gross domestic product Growth of output National income Aggregate price level Total wages and Consumer prices salaries Producer prices Total corporate Rate of inflation profits Employment and unemployment in the economy Total number of jobs Unemployment rate The Three Basic Questions Scarcity and the Production Possibilities Curve: The production possibilities curve (or frontier) illustrates the notion of scarcity: With a given amount of resources, an increase in farm goods comes at the expense of factory goods. The curve is bowed outward because resources are not perfectly adaptable to the production of the two goods. Shifting the Production Possibilities Curve: The production possibilities curve will shift outward as a result of an increase in the economy’s resources (natural resources, labor, physical capital, human capital, and entrepreneurship) or a technological innovation that increases the output from a given amount of resources. The Marginal Principle and TV Time: If the opportunity cost of TV time is $0.35 per hour and pedaling is not required for TV time, the marginal principle is satisfied at point n, and the child will watch 20 hours of TV per week. If pedaling is required and the discomfort of pedaling is $0.85 per hour, the marginal cost of TV time is $1.20 (equal to $0.35 + $0.85), and the marginal principle is satisfied at point m, with only 3 hours of TV time per week. Diminishing Returns for Pizza Number of workers 1 2 3 Total product: pizzas produced Marginal product 12 18 21 12 6 3 4 22 1 Total Product Curve and Diminishing Returns: As the number of workers increases, the number of pizzas produced per hour increases but at a decreasing rate. The second worker increases output by 6 pizzas (from 12 pizzas to 18 pizzas), but the fourth worker increases output by only 1 pizza (from 21 pizzas to 22 pizzas). Diminishing returns occur because workers share a pizza oven. Production per Hour and Opportunity Cost Bread produced per hour Shirts produced per hour Opportunity cost of one loaf of bread Opportunity cost of one shirt Brenda Sam 6 2 1/3 shirt 3 loaves of bread 1 1 1 shirt 1 loaf of bread The Individual Demand Curve: According to the law of demand, the higher the price, the smaller the quantity demanded, everything else being equal. Therefore, the demand curve is negatively sloped: When the price increases from $6 to $8, the quantity demanded decreases from 7 pizzas per month (point d) to 4 pizzas per month (point c). From Individual to Market Demand: The market demand equals the sum of the demands of all consumers. In this case there are only two consumers, so at each price, the market quantity demanded equals the quantity demanded by Al plus the quantity demanded by Bea. At a price of $8, Al’s quantity is 4 pizzas (point c) and Bea’s quantity is 2 pizzas (point g), so the market quantity demanded is 6 pizzas (point j). Each consumer obeys the law of demand, so the market demand curve is negatively sloped. The Marginal Principle and the Output Decision: The marginal benefit curve is horizontal at the market price. To satisfy the marginal principle, the firm produces the quantity at which the marginal benefit equals the marginal cost. An increase in the price shifts the marginal-benefit curve upward and increases the quantity at which the marginal benefit equals the marginal cost. Nora’s Supply Schedule for Pizza Price ($) 4 6 8 10 12 Quantity of pizzas per month 100 200 300 400 500 Individual and Market Supply Curve: (A) Supply of individual firm. Nora supplies 300 pizzas at a price of $8 (point p) but 400 pizzas at a price of $10 (point q). (B) Market supply. There are 100 identical pizzerias, so the market quantity equals 100 times the quantity supplied by Nora’s, the typical pizzeria. At a price of $8, Nora supplies 300 pizzas (point p), so the market quantity supplied is 30,000 pizzas (point u). Supply, Demand, and Market Equilibrium: At the market equilibrium (point e, with price = $8 and quantity = 30,000), the quantity supplied equals the quantity demanded. At a price lower than the equilibrium price ($6), there is excess demand (the quantity demanded exceeds the quantity supplied). At a price above the equilibrium price ($12), there is excess supply (the quantity supplied exceeds the quantity demanded). Market Effects of an Increase in Demand: An increase in demand shifts the demand curve to the right: At each price, the quantity demanded increases. At the initial price ($8), the shift of the demand curve causes excess demand, causing the price to rise. Equilibrium is restored at point n, with a higher equilibrium price ($10, up from $8) and a larger equilibrium quantity (40,000 pizzas, up from 30,000 pizzas). Changes in Demand Shift the Demand Curve An increase in demand shifts the demand curve to the A decrease in demand shifts the demand curve to the right when left when The good is normal and income increases The good is normal and income decreases The good is inferior and income decreases The good is inferior and income increases The price of a substitute good increases The price of a substitute good decreases The price of a complementary good decreases The price of a complementary good increases Population increases Population decreases Consumer tastes shift in favor of the product Consumer tastes shift away from the product Favorable advertising Unfavorable publicity Consumers expect a higher price in the future Consumers expect a lower price in the future Market Effects of a Decrease in Demand: A decrease in demand shifts the demand curve to the left: At each price, the quantity demanded decreases. At the initial price ($8), the leftward shift of the demand curve causes excess supply, causing the price to fall. Equilibrium is restored at point n, with a lower equilibrium price ($6, down from $8) and a smaller equilibrium quantity (20,000 pizzas, down from 30,000 pizzas). Decrease in income. A decrease in income means that consumers have less to spend, so they buy a smaller quantity of each normal good. Decrease in price of a substitute good. A decrease in the price of a substitute good such as tacos makes pizza more expensive relative to tacos, causing consumers to demand less pizza. Increase in price of a complementary good. An increase in the price of a complementary good such as beer increases the cost of a beer and pizza meal, decreasing the demand for pizza. Decrease in population. A decrease in the number of people means that there are fewer pizza consumers, so the market demand for pizza decreases. Shift in consumer tastes. When consumers’ preferences shift away from pizza in favor of other products, the demand for pizza decreases. Expectations of lower future prices. If consumers think next month’s pizza price will be lower than they had initially expected, they may buy a smaller quantity today, meaning the demand for pizza today will decrease. The market moves downward along the supply curve to a smaller quantity supplied. The market moves downward along the new demand curve to a larger quantity demanded. The supply curve intersects the new demand curve at point n, so the new equilibrium price is $6 (down from $8), and the new equilibrium quantity is 20,000 pizzas (down from 30,000 pizzas). Market Effects of an Increase in Supply: An increase in supply shifts the supply curve to the right: At each price, the quantity supplied increases. At the initial price ($8), the rightward shift of the supply curve causes excess supply, causing the price to drop. Equilibrium is restored at point n, with a lower equilibrium price ($6, down from $8) and a larger equilibrium quantity (36,000 pizzas, up from 30,000 pizzas). Changes in Supply Shift the Supply Curve An increase in supply shifts the supply curve to the right when The cost of an input decreases A technological advance decreases production costs The number of firms increases Producers expect a lower price in the future Subsidy A decrease in supply shifts the supply curve to the left when The cost of an input increases The number of firms decreases Producers expect a higher price in the future Tax Market Effects of a Decrease in Supply: A decrease in supply shifts the supply curve to the left: At each price, the quantity supplied decreases. At the initial price ($8), the leftward shift of the supply curve causes excess demand, causing the price to rise. Equilibrium is restored at point n, with a higher equilibrium price ($10, up from $8) and a smaller equilibrium quantity (23,000 pizzas, down from 30,000 pizzas). Increase in input costs. A increase in the cost of labor or some other input will make pizza production more costly and less profitable at a given price, so producers will supply less. A decrease in the number of producers. The market supply is the sum of the supplies of all producers, so a decrease in the number of producers decreases supply. Expectations of higher future prices. If firms think next month’s pizza price will be higher than they had initially expected, they may be willing to sell a smaller quantity today (and a larger quantity next month). That means that the supply of pizza today will decrease. Tax. If the government imposes a tax on producers (a firm pays the government some amount for each unit produced), the tax will make the product more costly and less profitable, so firms will supply less. Market Effects of Simultaneous Changes in Supply and Demand: (A) Larger increase in demand. If the increase in demand is larger than the increase in supply (if the shift of the demand curve is larger than the shift of the supply curve), both the equilibrium price and the equilibrium quantity will increase. (B) Larger increase in supply. If the increase in supply is larger than the increase in demand (if the shift of the supply curve is larger than the shift of the demand curve), the equilibrium price will decrease and the equilibrium quantity will increase. Market Effects of Changes in Demand or Supply Change in Demand or Supply Increase in demand Decrease in demand Increase in supply Decrease in supply Change in Price Change in Quantity Increase Decrease Decrease Increase Increase Decrease Increase Decrease University Enrolment and Apartment Rent: An increase in university enrolment will increase the demand for apartments in the university town, shifting the demand curve to the right. Equilibrium is restored at point n, with a higher price ($600, up from $400) and a larger quantity (4,000 apartments, up from 3,000 apartments). Market Effects of Pesticide Residue: A report of pesticide residue on apples decreases the demand for apples, shifting the demand curve to the left. Equilibrium is restored at point n, with a lower price ($0.50, down from $0.60) and a smaller quantity (20,000 pounds, down from 26,000 pounds). Technological Innovation and the Computer Market: Technological innovation decreases production costs, increasing supply and shifting the supply curve to the right. The equilibrium price decreases, and the equilibrium quantity increases. Bad Weather and the Coffee Market: Bad weather decreases the supply of coffee beans, shifting the supply curve to the left. Equilibrium is restored at point n, with a higher price ($0.72, up from $0.60) and a smaller quantity (22 million pounds, down from 30 million pounds). The Mystery of Increasing Poultry Consumption: Because the price of poultry decreased at the same time the quantity of poultry consumed increased, we know that the increase in consumption resulted from an increase in supply, not an increase in demand. Innovations in poultry processing decreased production costs, shifting the supply curve to the right. The Mystery of Lower Drug Prices: Because the quantity of cocaine consumed decreased at the same time the price of cocaine decreased, we know that the decrease in price resulted from a decrease in demand, not an increase in supply. A decrease in the demand for cocaine decreased the price and decreased the quantity consumed. The Mystery of the Tobacco Money: The tobacco settlement increases the price of cigarettes from $3.00 to $3.40, causing movement upward along the original demand curve from point i to point p, decreasing the quantity consumed from 80 million to 72 million packs. The reduction in advertising and marketing shifts the demand curve to the left, reducing the quantity demanded at the new price ($3.40) from 72 million (point p) to 50 million packs (point n). Using Data to Draw a Demand Curve The following table shows data on gasoline prices and gasoline consumption in a particular city. Is it possible to use these data to draw a demand curve? If so, draw the demand curve. If not, why not? Gasoline Price Quantity Consumed Year (per gallon) (millions of gallons) 1999 2000 2001 1.20 1.40 1.60 400 300 360 Circular flow of economic activity through a simple market economy. Note that the flow reflects the direction in which goods and services flow through input and output markets. Name circular flow diagram. Here, goods and services flow clockwise: Labor services supplied by households flow to firms, and goods and services produced by firms flow to households. Money (not pictured here) flows in the opposite (counterclockwise) direction: Payment for goods and services flows from households to firms, and payment for labor services flows from firms to households. Composition of U.S. GDP, Second Quarter 2000 (billions of dollars expressed at annual rates) Consumption Private Investment Government Net GDP Expenditures Expenditures Purchases Exports 9,945 6,706 1,852 U.S. Trade Balance as a Share of GDP, 1960–2000 1,742 –355 Trade Balance as a Percent of GDP, 2000 From GDP to National Income, Second Quarter 2000 (billions of dollars) Gross domestic product plus net income from abroad = Gross national product minus depreciation = Net national product minus indirect taxes (and other adjustments) = National income Composition of U.S. National Income, Second Quarter of 2000 (billions of dollars) National income Compensation of employees Corporate profits Rental income Proprietor’s income Net interest GDP Data for a Simple Economy Quantity Produced 9,945 9,937 8,693 7,983 7,983 5,603 964 141 709 566 Price Year Cars Computers Cars Computers 2004 2005 4 5 1 3 $10,000 12,000 $5,000 5,000 The Core of Macroeconomic Theory In this business cycle, the economy is expanding as it moves through point A from the trough to the peak. When the economy moves from a peak down to a trough, through point B, the economy is in recession. Life-Cycle Theory of Consumption: In their early working years, people consume more than they earn. This is also true in the retirement years. In between, people save (consume less than they earn) to pay off debts from borrowing and to accumulate savings for retirement. Real GDP in the United States since 1970 has risen overall, but there have been three recessionary periods: 1974 I-1975 IV, 1980 II-1983 I, and 1990 III-1991 I. The U.S. unemployment rate since 1970 shows wide variations. The three recessionary reference periods show increases in the unemployment rate. The percentage change in the GDP price index measures the overall rate of inflation. Since 1970, inflation has been high in two periods: 1973 IV-1975 IV and 1979 I-1981 IV. Inflation between 1983 and 1992 was moderate. Since 1992, it has been fairly low. Unemployment Data, 2001 Selected U.S. Unemployment Statistics, Unemployment Rates for May 2001 (in percent) Total 4.4 Males 20 years and older 3.9 Females 20 years and older 3.8 Both sexes, 16–19 years 13.6 White 3.8 African American 8.0 White, 16–19 years 11.8 African American, 16–19 years 25.1 Married men 2.6 Married women 2.9 Women maintaining families 6.2 Relationship Between Labor and Output with Fixed Capital: With capital fixed, output increases with labor input but at a decreasing rate. Increase in the Stock of Capital: When capital increases from K * to K** the production function shifts up. At any level of labor input, the level of output increases. Demand for and Supply of Labor Shifts in Demand and Supply Determining Full Employment Output: Panel B determines the equilibrium level of employment at L* and the real wage rate at W*. Full employment output in panel A is Y*. Effects of Employment Taxes Alternative Uses of GDP for 1998 (percent of total GDP) Consumptio Investment n Japan United States France Singapore Germany 61 67 55 37 58 27 20 19 33 22 Government Net Export purchases 10 14 23 10 19 2 –1 3 20 1 Effects of an Adverse Technology Shock: An adverse shock to the economy shifts the labor demand curve to the left and leads to lower wages, reduced employment, and reduced output. Components of the CPI (consumer price index) Increased Government Spending Crowds Out Consumption Increased Government Spending Also Crowds Out Investment Components of GDP, 2001: The Expenditure Approach BILLIONS OF DOLLARS Total gross domestic product Personal consumption expenditures (C) Durable goods Nondurable goods Services Gross private domestic investment (I) Nonresidential Residential Change in business inventories Government consumption and gross investment (G) Federal State and local Net exports (EX - IM) Exports (EX) Imports (IM) Note: Numbers may not add exactly because of rounding. Source: U.S. Department of Commerce, Bureau of Economic Analysis. PERCENTAGE OF GDP 10,205.6 7,063.5 858.2 2,055.0 4,150.2 1,634.0 1,246.6 446.1 -58.6 1,839.3 615.7 1,223.6 -331.2 1,049.4 1,380.7 100.0 69.2 8.4 20.1 40.7 16.0 12.2 4.4 -0.6 18.0 6.0 12.0 -3.2 10.3 13.5 Components of GDP, 2001: The Income Approach BILLIONS OF DOLLARS Gross domestic product National income Compensation of employees Proprietors' income Corporate profits Net interest Rental income Depreciation Indirect taxes minus subsidies Net factor payments to the rest of the world Other PERCENTAGE OF GDP 10,205.6 8,199.9 6,010.0 943.5 748.9 554.8 142.7 1,351.3 739.4 11.1 -96.1 GDP, GNP, NNP, National Income, Personal Income, and Disposable Personal Income, 2001 100.0 80.3 58.9 7.3 7.3 5.4 1.4 13.2 7.2 0.1 -0.9 DOLLARS (BILLIONS ) 10,205.6 +342.1 -353.2 10,194.5 -1,351.3 8,843.2 -643.3 8,199.9 -332.6 -731.2 +439.1 1,148.7 8,723.9 -1,306.2 7,417.7 GDP Plus: receipts of factor income from the rest of the world Less: payments of factor income to the rest of the world Equals: GNP Less: depreciation Equals: net national product (NNP) Less: indirect taxes minus subsidies plus other Equals: national income Less: corporate profits minus dividends Less: social insurance payments Plus: personal interest income received from the government and consumers Plus: transfer payments to persons Equals: personal income Less: personal taxes Equals: disposable personal income Disposable Personal Income and Personal Saving, 2001 DOLLARS (BILLIONS) 7,417.7 Disposable personal income Less: Personal consumption expenditures Interest paid by consumers to business Personal transfer payments to foreigners Equals: personal saving Personal saving as a percentage of disposable personal income: -7,063.5 -204.3 -31.3 118.6 1.6% A Three-Good Economy Good A Good B Good C Total PRODUCTION YEAR 1 YEAR 2 Q1 Q2 6 11 7 4 10 12 PRICE PER UNIT YEAR 1 YEAR 2 P1 P2 $ .50 $ .40 .30 1.00 .70 .90 Per Capita GNP for Selected Countries, 1998 COUNTRY U.S. DOLLARS Switzerland 40,080 Norway 34,330 Denmark 33,260 Japan 32,380 United States 29,340 Austria 26,850 Germany 25,850 Sweden 25,620 Belgium 25,380 France 24,940 Netherlands 24,760 Finland 24,110 GDP IN YEAR 1 IN YEAR 1 PRICES P 1 × Q1 $3.00 2.10 7.00 $12.10 Nominal GDP in year 1 COUNTRY Portugal Argentina South Korea Czech Republic Brazil Mexico Turkey South Africa Colombia Jordan Romania Phillipines GDP IN YEAR 2 IN YEAR 1 PRICES P 1 × Q2 $5.50 1.20 8.40 $15.10 GDP IN YEAR 1 IN YEAR 2 PRICES P 2 × Q1 $2.40 7.00 9.00 $18.40 GDP IN YEAR 2 IN YEAR 2 PRICES P 2 × Q2 $ 4.40 4.00 10.80 $19.20 Nominal GDP in year 2 U.S. DOLLARS 10,690 8,970 7,970 5,040 4,570 3,970 3,160 2,880 2,600 1,520 1,390 1,050 United Kingdom 21,400 Australia 20,300 Italy 20,250 Canada 20,020 Ireland 18,340 Israel 15,940 Spain 14,080 Greece 11,650 Countries with Lower Income in 1870 Grew Faster China Indonesia Pakistan India Rwanda Nepal Ethiopia 750 680 480 430 230 210 100 Increase in the Supply of Capital: An increase in the supply of capital will shift the production function upward and increase the demand for labor. Real wages will increase from W* to W**, and potential output will increase from Y* to Y**. Sources of Real GDP Growth, 1929–1982 (average annual percentage rates) Due to capital growth Due to labor growth + technological progress Output growth 0.56 1.34 1.02 2.92 Percentage Contributions to Real GDP Growth Long vs. short run Output per Worker Hour (Productivity), 1952-2001 The Economy in the Short Run: In the short run, the economy produces at y0, which exceeds potential output y p Adjusting to the Long Run: With output exceeding potential, the AS curve shifts upwards as depicted by the dotted lines. The economy adjusts to the long-run equilibrium at E1. The Keynesian Cross: At equilibrium output y*, total demand Ey* equals output 0y*. Equilibrium Output: Equilibrium output (y*) is determined at E, where demand intersects the 45° line. If output were higher (y1), it would exceed demand and production would fall. If output were lower (y2), it would fall short of demand and production would rise. Adjustments to Equilibrium Output C+I Production 100 100 100 80 120 100 Inventories Depletion of inventories of 20 Excess of inventories of 20 No change Direction of Output Output increases Output decreases Output stays constant Consumption Function: The consumption function relates desired consumer spending to the level of income. Determining GDP: GDP is determined where the C + I line intersects the 45° line. At that level of output, y *, desired spending equals output. Multiplier: When investment increases by +I from l 0 to l 1, equilibrium output increases by +y from y 0 to y 1. The change in output (+y) is greater than the change in investment (+l). The Multiplier in Action Round of Increase in Spending Demand 1 2 3 4 5 . . . Total $10 8 6.4 5.12 4.096 . . . 50 million Increase in GDP and Income Increase in Consumption $10 8 6.4 5.12 4.096 . . . 50 million $8 6.4 5.12 4.096 3.277 . . . 40 million Keynesian Fiscal Policy Increase In Tax Rates: An increase in tax rates decreases the slope of the C + I + G line. This lowers output and reduces the multiplier. Increase in Exports and Imports Capital per Worker, 1952-2001 Real GDP and Unemployment Rates, 1929-1933 and 1980-1982 THE EARLY PART OF THE GREAT DEPRESSION, 1929-1933 PERCENTAGE CHANGE IN UNEMPLOYME NUMBER OF UNEMPLOYED REAL GDP NT RATE (MILLIONS) 1929 3.2 1.5 1930 -8.6 8.9 4.3 1931 -6.4 16.3 8.0 1932 -13.0 24.1 12.1 1933 -1.4 25.2 12.8 Note: Percentage fall in real GDP between 1929 and 1933 was 26.6 percent. THE RECESSION OF 1980-1982 PERCENTAGE NUMBER OF CAPACITY CHANGE UNEMPLOYMENT UNEMPLOYED UTILIZATION IN REAL RATE (MILLIONS) (PERCENTAGE) GDP 1979 5.8 6.1 85.2 1980 -0.2 7.1 7.6 80.9 1981 2.5 7.6 8.3 79.9 1982 -2.0 9.7 10.7 72.1 Note: Percentage increase in real GDP between 1979 and 1982 was 0.1 percent. Sources: Historical Statistics of the United States and U.S. Department of Commerce, Bureau of Economic Analysis. Employed, Unemployed, and the Labor Force, 1953-2001 (1) (2) (3) POPULATION 16 YEARS LABOR OLD OR OVER FORCE EMPLOYED (MILLIONS) (MILLIONS) (MILLIONS) 1953 107.1 63.0 61.2 1960 117.2 69.6 65.8 1970 137.1 82.8 78.7 1980 167.7 106.9 99.3 1982 172.3 110.2 99.5 1990 189.2 125.8 118.8 2001 211.9 141.8 135.1 Note: Figures are civilian only (military excluded). Source: Economic Report of the President, 2002, Table B-35 (4) (5) UNEMPLOYED (MILLIONS) 1.8 3.9 4.1 7.6 10.7 7.0 6.7 (6) LABORFORCE PARTICIPATION RATE 58.9 59.4 60.4 63.8 64.0 66.5 66.9 UNEMPLO YMENT RATE 2.9 5.5 4.9 7.1 9.7 5.6 4.7 Unemployment Rates by Demographic Group, 1982 and 2000 YEARS Total NOV. 1982 JULY 2000 10.8 4.2 White Men 20+ 16-19 20+ 16-19 Women 9.6 9.0 22.7 8.1 19.7 African-American Men 20.2 20+ 19.3 16-19 52.4 Women 20+ 16.5 16-19 46.3 Source: U.S. Department of Labor, Bureau of Labor Statistics. Data are not seasonally adjusted. Regional Differences in Unemployment, 1975, 1982, and 1991 1975 1982 U.S. avg. 8.5 Cal. 9.9 Fla. 10.7 Ill. 7.1 Mass. 11.2 Mich. 12.5 N.J. 10.2 N.Y. 9.5 N.C. 8.6 Ohio 9.1 Tex. 5.6 Sources: Statistical Abstract of the United States, various editions. Average Duration of Unemployment, 1979-2001 WEEKS 1979 10.8 1980 11.9 1981 13.7 1982 15.6 1983 20.0 1984 18.2 1985 15.6 1986 15.0 1987 14.5 1988 13.5 1989 11.9 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 3.6 2.6 11.7 3.5 10.2 8.6 7.1 28.5 7.0 27.2 1991 9.7 9.9 8.2 11.3 7.9 15.5 9.0 8.6 9.0 12.5 6.9 WEEKS 12.0 13.7 17.7 18.0 18.8 16.6 16.7 15.8 14.5 14.4 6.7 7.5 7.3 7.1 9.0 9.2 6.6 7.2 5.8 6.4 6.6 Inflation During Three Expansions 1972 1973 1974 INFLATION RATE 3.2 6.2 11.0 1976 1977 1978 1979 1980 5.8 6.5 7.6 11.3 13.5 1984 1985 1986 1987 1988 1989 4.3 3.6 1.9 3.6 4.1 4.8 The Consumer Price Index, 1950-2001 PERCENTAGE CHANGE IN CPI 1950 1.3 1951 7.9 1952 1.9 1953 0.8 1954 0.7 1955 -0.4 1956 1.5 1957 3.3 1958 2.8 1959 0.7 CPI 24.1 26.0 26.5 26.7 26.9 26.8 27.2 28.1 28.9 29.1 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 PERCENTAGE CHANGE IN CPI 5.8 6.5 7.6 11.3 13.5 10.3 6.2 3.2 4.3 3.6 CPI 56.9 60.6 65.2 72.6 82.4 90.9 96.5 99.6 103.9 107.6 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 1970 1971 1972 1973 1974 1975 1.7 1.0 1.0 1.3 1.3 1.6 2.9 3.1 4.2 5.5 5.7 4.4 3.2 6.2 11.0 9.1 29.6 29.9 30.2 30.6 31.0 31.5 32.4 33.4 34.8 36.7 38.8 40.5 41.8 44.4 49.3 53.8 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 1.9 3.6 4.1 4.8 5.4 4.2 3.0 3.0 2.6 2.8 3.0 2.3 1.6 2.2 3.4 2.8 109.6 113.6 118.3 124.0 130.7 136.2 140.3 144.5 148.2 152.4 156.9 160.5 163.0 166.6 172.2 177.1 Saving = Aggregate Income – Consumption All income is either spent on consumption or saved in an economy in which there are no taxes. Thus, S =Y – C. AGGREGATE INCOME, Y (BILLIONS OF DOLLARS) 0 80 100 200 400 600 800 1,000 AGGREGATE CONSUMPTION, C (BILLIONS OF DOLLARS) 100 160 175 250 400 550 700 850 An Aggregate Consumption Function Derived from the Equation C = 100 + .75Y Deriving a Saving Function from a Consumption Function Y AGGREGATE INCOME (BILLIONS OF DOLLARS) 0 80 100 200 400 600 800 1,000 The Planned Investment Function –C AGGREGATE CONSUMPTION (BILLIONS OF DOLLARS) 100 160 175 250 400 550 700 850 = S AGGREGATE SAVING (Billions OF Dollars) –100 –80 –75 –50 0 50 100 150 For the time being, we will assume that planned investment is fixed. It does not change when income changes, so its graph is just a horizontal line. Deriving the Planned Aggregate Expenditure Schedule and Finding Equilibrium (All Figures in Billions of Dollars) The Figures in Column 2 Are Based on the Equation C = 100 + .75Y. (1) (2) (3) (4) (5) (6) EQUIL PLANNED UNPLANNED AGGREGATE AGGREGATE PLANNED IBRIU AGGREGATE INVENTORY OUTPUT CONSUMPTIO INVESTMEN M? EXPENDITURE (AE) CHANGE (INCOME) (Y) N (C) T (I) (Y = C+I Y – (C + I) AE?) 100 175 25 200 −100 No 200 250 25 275 −75 No 400 400 25 425 −25 No 500 475 25 500 0 Yes 600 550 25 575 +25 No 800 700 25 725 +75 No 1,000 850 25 875 +125 No Equilibrium Aggregate Output: Equilibrium occurs when planned aggregate expenditure and aggregate output are equal. Planned aggregate expenditure is the sum of consumption spending and planned investment spending. Planned Aggregate Expenditure and Aggregate Output (Income): Saving is a leakage out of the spending stream. If planned investment is exactly equal to saving, then planned aggregate expenditure is exactly equal to aggregate output, and there is equilibrium. The S = I Approach to Equilibrium: Aggregate output will be equal to planned aggregate expenditure only when saving equals planned investment (S = I). Saving and planned investment are equal at Y = 500. The Multiplier as Seen in the Planned Aggregate Expenditure Diagram: At point A, the economy is in equilibrium at Y = 500. When I increases by 25, planned aggregate expenditure is initially greater than aggregate output. As output rises in response, additional consumption is generated, pushing equilibrium output up by a multiple of the initial increase in I. The new equilibrium is found at point B, where Y = 600. Equilibrium output has increased by 100 (600 – 500), or four times the amount of the increase in planned investment. Adding Net Taxes (T) and Government Purchases (G) to the Circular Flow of Income. Finding Equilibrium for I = 100, G = 100, and T = 100 (All Figures in Billions of Dollars) (1) (2) (3) Y T 300 500 700 900 1,10 0 1,30 0 1,50 0 10 0 10 0 10 0 10 0 10 0 10 0 10 0 (4) (5) YdY - T (C = 100 + .75 Yd) (6) (7) (8) S I (Yd - C) 200 250 -50 400 400 0 600 550 50 800 700 100 1,000 850 150 1,200 1,000 200 1,400 1,150 250 Y = Output (Income) T = Net Taxes Yd - T = Disposable Income (C = 100 + .75 Yd) = Consumption Spending S (Yd - C) = Saving 10 0 10 0 10 0 10 0 10 0 10 0 10 0 G 10 0 10 0 10 0 10 0 10 0 10 0 10 0 (9) (10) ADJUSTMENT TO DISEQUILIBRIUM C + I + G Y - (C + I + G) 450 -150 Output↑ 600 -100 Output↑ 750 -50 Output↑ 900 0 Equilibrium 1,050 +50 Output↓ 1,200 +100 Output↓ 1,350 +150 Output↓ I = Planned Investment Spending G = Government Purchases C + I + G = Planned Aggregate Expenditure Y - (C + I + G) = Unplanned Inventory Change Finding Equilibrium Output/Income Graphically: Because G and I are both fixed at 100, the aggregate expenditure function is the new consumption function displaced upward by I + G = 200. Equilibrium occurs at Y = C + I + G = 900. Finding Equilibrium After a $50 Billion Government Spending Increase (All Figures in Billions of Dollars; G Has Increased from 100 in Table 9.1 to 150 Here) 1) (2) (3) (4) (5) (6) (7) (8) (9) (10) ADJUST MENT TO (C = 100 S Y - (C + I Y T YdY - T I G C+I+G DISEQUI + .75 Yd) (Yd - C) + G) LIBRIU M 300 100 200 250 −50 100 150 500 −200 Output↑ 500 100 400 400 0 100 150 650 −150 Output↑ 700 100 600 550 50 100 150 800 −100 Output↑ 900 100 800 700 100 100 150 950 −50 Output↑ Equilibriu 1,100 100 1,000 850 150 100 150 1,100 0 m 1,300 100 1,200 1,000 200 100 150 1,250 +50 Output↓ Y = Output (Income) T = Net Taxes Yd - T = Disposable Income (C = 100 + .75 Yd) = Consumption Spending S (Yd - C) = Saving I = Planned Investment Spending G = Government Purchases C + I + G = Planned Aggregate Expenditure Y - (C + I + G) = Unplanned Inventory Change The Government Spending Multiplier: Increasing government spending by 50 shifts the AE function up by 50. As Y rises in response, additional consumption is generated. Overall, the equilibrium level of Y increases by 200, from 900 to 1,100. Finding Equilibrium After a $200-Billion Balanced-Budget Increase in G and T (All Figures in Billions of Dollars; Both G and T Have Increased from 100 in Table 9.1 to 300 Here) 1) (2) (3) (4) (5) (6) (7) (8) (9) ADJUSTM Yd (C = 100 Y - (C + I + ENT TO Y T I G C+I+G Y-T + .75 Yd) G) DISEQUILIBRIUM 500 300 200 250 100 300 650 -150 Output↑ 700 300 400 400 100 300 800 -100 Output↑ 900 300 600 550 100 300 950 -50 Output↑ 1,100 300 800 700 100 300 1,100 0 Equilibrium 1,300 300 1,000 850 100 300 1,250 +50 Output↓ 1,500 300 1,200 1,000 100 300 1,400 +100 Output↓ Y = Output (Income) T = Net Taxes Yd - T = Disposable Income I = Planned Investment Spending G = Government Purchases (C = 100 + .75 Yd) = Consumption Spending Y - (C + I + G) = Unplanned Inventory Change Summary of Fiscal Policy Multipliers POLICY STIMULUS C + I + G = Planned Aggregate Expenditure MULTIP FINAL IMPACT ON LIER EQUILIBRIUM Y GovernmentIncrease or decrease in the level of government purchases: spending G multiplier 1/MPS +G*1/MPS Tax multiplier MPC/MP S +T*MPC/MPS 1 +G Increase or decrease in the level of net taxes: T BalancedSimultaneous balanced-budget increase or decrease in the budget 1evel of government purchases and net taxes: = T multiplier + is an increase Federal Government Receipts and Expenditures, 2001 (Billions of Dollars) PERCENT AGE AMOU OF TOTAL NT Receipts Personal taxes Corporate taxes Indirect business taxes Contributions for social insurance Total Current expenditures Consumption Transfer payments Grants-in-aid to state and local governments Net interest payments Net subsidies of government enterprises Total Current surplus (+) or deficit (−) (receipts − current expenditures) 1,010.1 193.2 111.0 720.6 2,034.9 49.6 9.5 5.5 35.4 100.0 514.1 831.9 274.2 236.9 52.5 1,909.6 +125.3 26.9 43.6 14.4 12.4 2.7 100.0 The Federal Government Surplus (1) or Deficit (2) as a Percentage of GDP, 1970 I-2001 IV: The deficits in the 1980s were particularly large by historical standards. The Federal Government Debt as a Percentage of GDP, 1970 I-2001 IV: The federal government debt increased dramatically in the 1980s as a result of the large deficits. The percentage began to fall in the mid-1990s. A Decrease in the Required Reserve Ratio From 20 Percent to 12.5 Percent Increases the Supply of Money (All Figures in Billions of Dollars) PANEL 1: REQUIRED RESERVE RATIO = 20% Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Government $200 $100 Reserves Reserves $100 $500 Deposits securities $100 Currency Loans $400 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: REQUIRED RESERVE RATIO = 12.5% Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Government $200 $100 Reserves Reserves $100 $800 Deposits securities (+$100) $100 Currency Loans $700 (+$300) The Effect On the Money Supply of Commercial Bank Borrowing from the Fed (All Figures in Billions of Dollars) PANEL 1: No commercial bank borrowing from the fed Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Securities $160 $80 Reserves Reserves $80 $400 Deposits $80 Currency Loans $320 Note: Money supply (M1) = Currency + Deposits = $600. PANEL 2: commercial bank borrowing $20 from the fed Federal Reserve Commercial Banks Assets Liabilities Assets Liabilities Securities $160 $100 Reserves Reserves $100 $500 Deposits (+$20) (+$20) (+$300) Loans $20 $80 Currency Loans (+$100) $420 $20 Amount owed to Fed (+$20) Open Market Operations (The Numbers in Parentheses in Panels 2 and 3 Show the Differences Between Those Panels and Panel 1. All Figures in Billions of Dollars) PANEL 1 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Assets Liabilities Assets Liabilities Securities $100 $20 Reserves Reserves $20 $100 Deposits Deposits $5 $0 Debts Currency Loans $80 $5 Net Worth Note: Money supply (M1) = Currency + Deposits = $180. PANEL 2 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Assets Liabilities Assets Liabilities Securities $95 $15 Reserves Reserves $15 $95 Deposits Deposits $0 $0 Debts (–$5) (–$5) (–$5) (–$5) (–$5) $80 Currency Loans $80 Securities $5 $5 Net Worth (+$5) Note: Money supply (M1) = Currency + Deposits = $175. PANEL 3 Federal Reserve Commercial Banks Jane Q. Public Assets Liabilities Assets Liabilities Assets Liabilities Securities $95 $15 Reserves Reserves $15 $75 Deposits Deposits $0 $0 Debts (–$5) (–$5) (–$25) (–$5) $80 Currency Loans $60 Securities $5 $5 Net Worth (–$20) (+$5) Note: Money supply (M1) = Currency + Deposits = $155. The Nonsynchronization of Income and Spending: Income arrives only once a month, but spending takes place continuously. Jim's Monthly Checking Account Balances: Strategy 1: Jim could decide to deposit his entire paycheck ($1,200) into his checking account at the start of the month and run his balance down to zero by the end of the month. In this case, his average balance would be $600. Jim's Monthly Checking Account Balances: Strategy 2: Jim could also choose to put one half of his paycheck into his checking account and buy a bond with the other half of his income. At mid-month, Jim would sell the bond and deposit the $600 into his checking account to pay the second half of the month's bills. Following this strategy, Jim's average money holdings would be $300. The Demand Curve for Money Balances: The quantity of money demanded (the amount of money households and firms wish to hold) is a function of the interest rate. Because the interest rate is the opportunity cost of holding money balances, increases in the interest rate will reduce the quantity of money that firms and households want to hold, and decreases in the interest rate will increase the quantity of money that firms and households want to hold. An Increase in Aggregate Output (Income) (Y) Will Shift the Money Demand Curve to the Right: An increase in Y means there is more economic activity. Firms are producing and selling more, and households are earning more income and buying more. There are more transactions, for which money is needed. As a result, both firms and households are likely to increase their holdings of money balances at a given interest rate. Determinants of Money Demand 1. The interest rate: r (negative effect) 2. The dollar volume of transactions (positive effect) a. Aggregate output (income): Y (positive effect) b. The price level: P (positive effect) Adjustments in the Money Market: Equilibrium exists in the money market when the supply of money is equal to the demand for money: Md = Ms. At r1, the quantity of money supplied exceeds the quantity of money demanded, and the interest rate will fall. At r2, the quantity demanded exceeds the quantity supplied, and the interest rate will rise. Only at r* is equilibrium achieved. The Effect of an Increase in the Supply of Money on the Interest Rate: An increase in the supply of money from to lowers the rate of interest from 14 percent to 7 percent. The Effect of an Increase in Income on the Interest Rate: An increase in aggregate output (income) shifts the money demand curve from to which raises the equilibrium interest rate from 7 percent to 14 percent. The Impact of an Increase in the Price Level on the Economy—Assuming No Changes in G, T, and M s The Aggregate Demand (AD) Curve: At all points along the AD curve, both the goods market and the money market are in equilibrium. The Effect of an Increase in Money Supply on the AD Curve: An increase in the money supply (M s) causes the aggregate demand curve to shift to the right, from AD0 to AD1. This shift occurs because the increase in M s lowers the interest rate, which increases planned investment (and thus planned aggregate expenditure). The final result is an increase in output at each possible price level. The Effect of an Increase in Government Purchases or a Decrease in Net Taxes on the AD Curve: An increase in government purchases (G) or a decrease in net taxes (T) causes the aggregate demand curve to shift to the right, from AD0 to AD1. The increase in G increases planned aggregate expenditure, which leads to an increase in output at each possible price level. A decrease in T causes consumption to rise. The higher consumption then increases planned aggregate expenditure, which leads to an increase in output at each possible price level. Shifts in the Aggregate Demand Curve: A Summary The Short-Run Aggregate Supply Curve: In the short run, the aggregate supply curve (the price/output response curve) has a positive slope. At low levels of aggregate output, the curve is fairly flat. As the economy approaches capacity, the curve becomes nearly vertical. At capacity, the curve is vertical. Shifts of the Aggregate Supply Curve Factors That Shift the Aggregate Supply Curve The Equilibrium Price Level: At each point along the AD curve, both the money market and the goods market are in equilibrium. Each point on the AS curve represents the price/output decisions of all the firms in the economy. P0 and Y0 correspond to equilibrium in the goods market and the money market and to a set of price/output decisions on the part of all the firms in the economy. The Long-Run Aggregate Supply Curve: When the AD curve shifts from AD0 to AD1, the equilibrium price level initially rises from P0 to P1 and output rises from Y0 to Y1. Costs respond in the longer run, shifting the AS curve from AS0 to AS1. If costs ultimately increase by the same percentage as the price level, the quantity supplied. A Shift of the Aggregate Demand Curve When the Economy Is on the Nearly Flat Part of the AS Curve: Aggregate demand can shift to the right for a number of reasons, including an increase in the money supply, a tax cut, or an increase in government spending. If the shift occurs when the economy is on the nearly flat portion of the AS curve, the result will be an increase in output with little increase in the price level. A Shift of the Aggregate Demand Curve When the Economy Is Operating at or Near Maximum Capacity: If a shift of aggregate demand occurs while the economy is operating near full capacity, the result will be an increase in the price level with little increase in output.. Cost-Push, or Supply-Side Inflation: An increase in costs shifts the AS curve to the left. By assuming the government does not react to this shift, the AD curve does not shift, the price level rises, and output falls.. Cost Shocks Are Bad News for Policy Makers: A cost shock with no change in monetary or fiscal policy would shift the aggregate supply curve from AS0 to AS1, lower output from Y0 to Y1, and raise the price level from P0 to P1. Monetary or fiscal policy could be changed enough to have the AD curve shift from AD0 to AD1. This would prevent output from falling, but it would raise the price level further, to P2. Sustained Inflation from an Initial Increase in G and Fed Accommodation: An increase in G with the money supply constant shifts the AD curve from AD0 to AD1. Although not shown in the figure, this leads to an increase in the interest rate and crowding out of planned investment. If the Fed tries to keep the interest rate unchanged by increasing the money supply, the AD curve will shift farther and farther to the right. The result is a sustained inflation, perhaps hyperinflation. Costs of Inflation Anticipated Inflation Unanticipated Inflation Institutions do not adjust Institutions adjust Distortions in the tax system, problems in financial markets Cost of changing prices, shoe-leather costs Unfair redistributions Institutional disintegration The Classical Labor Market: Classical economists believe that the labor market always clears. If the demand for labor shifts from D0 to D1, the equilibrium wage will fall from W0 to W*. Everyone who wants a job at W* will have one Sticky Wages: If wages "stick'' at W0 instead of fall to the new equilibrium wage of W* following a shift of demand from D0 to D1, the result will be unemployment equal to L0 − L1. The Aggregate Supply Curve: The AS curve shows a positive relationship between the price level (P) and aggregate output (income) (Y). The Relationship Between the Price Level and the Unemployment Rate: This curve shows a negative relationship between the price level (P) and the unemployment rate (U). As the unemployment rate declines in response to the economy's moving closer and closer to capacity output, the price level rises more and more. The Phillips Curve: The Phillips Curve shows the relationship between the inflation rate and the unemployment rate. Unemployment and Inflation, 1960–1969: During the 1960s there seemed to be an obvious trade-off between inflation and unemployment. Policy debates during the period revolved around this apparent trade-off. Unemployment and Inflation, 1970–2001: During the 1970s and 1980s, it became clear that the relationship between unemployment and inflation was anything but simple. Changes in the Price Level and Aggregate Output Depend on Both Shifts in Aggregate Demand and Shifts in Aggregate Supply The Price of Imports, 1960 I–2001 IV: The price of imports changed very little in the 1960s and early 1970s. It increased substantially in 1974 and again in 1979–1980. Since 1981, the price of imports has changed very little. The Long-Run Phillips Curve: The Natural Rate of Unemployment: If the AS curve is vertical in the long run, so is the Phillips Curve. In the long run, the Phillips Curve corresponds to the natural rate of unemployment—that is, the unemployment rate that is consistent with the notion of a fixed long-run output at potential GDP. U* is the natural rate of unemployment. The NAIRU Diagram: To the left of the NAIRU the price level is accelerating (positive changes in the inflation rate), and to the right of the NAIRU the price level is decelerating (negative changes in the inflation rate). Only when the unemployment rate is equal to the NAIRU is the price level changing at a constant rate (no change in the inflation rate). The Fed's Response to Low Output/Low Inflation: During periods of low output/low inflation, the economy is on the relatively flat portion of the AS curve. In this case, the Fed is likely to expand the money supply. This will shift the AD curve to the right, from AD0 to AD1, and lead to an increase in output with very little increase in the price level. The Fed's Response to High Output/High Inflation: During periods of high output/high inflation, the economy is on the relatively steep portion of the AS curve. In this case, the Fed is likely to contract the money supply. This will shift the AD curve to the left, from AD0 to AD1, and lead to a decrease in the price level with very little decrease in output. Data for Selected Variables for the 1989–2001 Period Real GDP AAA Federal Qua Unemploymen Inflation Three-Month Surplu Growth Rate Bond Government rter t Rate (%) Rate (%) T-Bill Rate s/GDP (%) Rate Surplus 1989 5.0 5.2 4.3 8.5 9.7 -108.8 -0.020 I II 2.2 5.2 4.0 8.4 9.5 -127.3 -0.023 III 1.9 5.3 2.9 7.9 9.0 -140.6 -0.025 IV 1.4 5.4 3.1 7.6 8.9 -143.4 -0.026 1990 5.1 5.3 4.5 7.8 9.2 -172.1 -0.030 I II 0.9 5.3 4.7 7.8 9.4 -171.2 -0.030 III -0.7 5.7 3.9 7.5 9.4 -164.6 -0.028 IV -3.2 6.1 3.5 7.0 9.3 -184.0 -0.031 1991 -2.0 6.6 4.7 6.1 8.9 -160.1 -0.027 I II 2.3 6.8 2.9 5.6 8.9 -213.4 -0.036 III 1.0 6.9 2.5 5.4 8.8 -234.7 -0.039 IV 2.2 7.1 2.3 4.6 8.4 -253.1 -0.042 1992 3.8 7.4 3.1 3.9 8.3 -288.3 -0.047 I II 3.8 7.6 2.2 3.7 8.3 -291.8 -0.046 III 3.1 7.6 1.3 3.1 8.0 -316.5 -0.050 IV 5.4 7.4 2.5 3.1 8.0 -293.5 -0.045 1993 -0.1 7.2 3.4 3.0 7.7 -300.9 -0.046 I II 2.5 7.1 2.2 3.0 7.4 -267.3 -0.041 III 1.8 6.8 1.8 3.0 6.9 -275.5 -0.041 IV 6.2 6.6 2.3 3.1 6.8 -253.0 -0.037 1994 3.4 6.6 2.0 3.3 7.2 -237.5 -0.034 I II 5.7 6.2 1.8 4.0 7.9 -190.6 -0.027 III 2.2 6.0 2.4 4.5 8.2 -211.8 -0.030 IV 5.0 5.6 1.9 5.3 8.6 -209.2 -0.029 1995 1.5 5.5 3.0 5.8 8.3 -208.2 -0.029 I II 0.8 5.7 1.7 5.6 III 3.1 5.7 1.8 5.4 IV 3.2 5.6 2.0 5.3 1996 2.9 5.6 2.5 5.0 I II 6.8 5.5 1.4 5.0 III 2.0 5.3 1.9 5.1 IV 4.6 5.3 1.6 5.0 1997 4.4 5.3 2.9 5.1 I II 5.9 5.0 1.9 5.1 III 4.2 4.8 1.2 5.1 IV 2.8 4.7 1.4 5.1 1998 6.5 4.7 1.0 5.1 I II 2.9 4.4 1.2 5.0 III 3.4 4.5 1.5 4.8 IV 5.6 4.4 1.1 4.3 1999 3.5 4.3 2.3 4.4 I II 2.5 4.3 1.4 4.5 III 5.7 4.2 0.9 4.7 IV 8.3 4.1 1.3 5.0 2000 4.8 4.1 3.3 5.5 I II 5.2 4.0 2.5 5.7 III 1.3 4.1 1.9 6.0 IV 1.9 4.0 1.7 6.0 2001 1.3 4.2 3.3 4.8 I II 0.3 4.5 2.1 3.7 III -1.3 4.8 2.2 3.2 IV 1.4 5.6 -0.3 1.9 Note: The inflation rate is the percentage change in the GDP price index 7.7 7.4 7.0 -189.0 -197.5 -173.1 -0.026 -0.027 -0.023 7.0 -176.4 -0.023 7.6 7.6 7.2 -137.0 -130.1 -103.9 -0.018 -0.017 -0.013 7.4 -86.5 -0.011 7.6 7.2 6.9 -68.2 -33.8 -25.0 -0.008 -0.004 -0.003 6.7 26.0 0.003 6.6 6.5 6.3 41.9 72.1 56.4 0.005 0.008 0.006 6.4 89.8 0.010 6.9 7.3 7.5 117.4 147.3 143.4 0.013 0.016 0.015 7.7 236.0 0.024 7.8 7.6 7.4 244.9 229.9 222.4 0.025 0.023 0.022 7.1 205.4 0.020 7.2 7.1 6.9 186.7 -13.6 105.4 0.018 -0.001 0.010 Two Time Paths for GDP: Path A is less stable—it varies more over time—than path B. Other things being equal, society prefers path B to path A. "The Fool in the Shower"—How Government Policy Can Make Matters Worse: Attempts to stabilize the economy can prove destabilizing because of time lags. An expansionary policy that should have begun to take effect at point A does not actually begin to have an impact until point D, when the economy is already on an upswing. Hence the policy pushes the economy to points F′ and G′ (instead of points F and G). Income varies more widely than it would have if no policy had been implemented. Deficit Reduction Targets under Gramm-Rudman-Hollings: The GRH legislation, passed in 1986, set out to lower the federal deficit by $36 billion per year. If the plan had worked, a zero deficit would have been achieved by 1991. Deficit Targeting as an Automatic Destabilizer: Deficit targeting changes the way the economy responds to negative demand shocks because it does not allow the deficit to increase. The result is a smaller deficit, but a larger decline in income than would have otherwise occurred. Data for Selected Variables for Six Countries, 1980–1999 GDP Growth Rate Inflation Rate United Kingdom 1980 -1.6 1981 -1.3 1982 1.5 1983 3.6 1984 2.5 1985 3.5 1986 4.4 1987 4.8 1988 5.0 1989 2.1 1990 0.6 1991 -1.5 1992 0.1 1993 2.3 1994 4.4 1995 2.8 1996 2.6 1997 3.5 1998 2.2 1999 1.7 France 1980 1.3 1981 0.6 1982 2.2 1983 0.8 1984 1.3 1985 1.8 1986 2.4 1987 2.2 1988 4.2 1989 4.1 1990 2.6 1991 1.0 1992 1.5 1993 -1.0 1994 2.0 1995 1.7 1996 1.1 1997 2.0 1998 3.3 1999 2.4 Germany 1980 1.0 1981 0.1 1982 -0.9 1983 1.8 1984 2.8 1985 2.0 Unemployment Rate Short-Term Interest Rate 18.8 11.4 7.8 5.3 4.4 5.9 3.2 5.0 6.1 7.4 7.6 6.7 4.0 2.8 1.5 2.5 3.3 2.9 3.2 1.6 NA NA 10.3 11.1 11.2 11.5 11.6 10.6 8.7 7.3 7.1 8.9 10.0 10.5 9.6 8.7 8.2 7.0 6.3 6.1 15.2 13.0 11.5 9.6 9.3 11.6 10.4 9.3 9.8 13.1 14.1 11.0 8.9 5.2 5.2 6.3 5.8 6.5 6.8 5.0 11.7 12.0 12.1 9.6 7.5 5.8 5.3 3.0 3.1 3.2 2.9 3.0 2.0 2.4 1.8 1.7 1.4 1.4 0.8 0.6 NA NA 7.7 8.1 9.7 10.1 10.2 10.4 9.8 9.3 9.0 9.5 10.4 11.7 12.3 11.7 12.4 12.3 11.8 11.3 11.9 15.3 14.9 12.5 11.7 9.9 7.7 8.0 7.5 9.1 9.9 9.5 10.4 8.8 5.7 6.4 3.7 3.2 3.4 2.7 5.0 4.2 4.4 3.2 2.1 2.1 2.6 4.0 5.7 6.9 7.1 7.2 7.9 10.4 8.3 5.6 5.9 5.0 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2.3 1.5 3.7 3.6 5.7 5.1 2.2 -1.1 1.2 2.9 0.8 1.5 2.2 1.3 GDP Growth Rate Spain 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 Italy 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 3.2 1.9 1.5 2.4 3.2 3.9 5.0 3.7 3.7 0.8 1.0 0.8 1.0 0.6 Inflation Rate 6.5 6.3 6.2 5.6 4.8 4.2 4.5 7.9 8.4 8.2 8.9 9.9 9.4 8.7 Unemployment Rate 3.9 3.3 3.6 6.3 8.1 8.3 8.3 6.2 5.1 4.4 3.4 3.3 3.4 2.9 Short-Term Interest Rate 2.2 -0.1 1.5 2.2 1.5 1.7 2 6 2 7 7 3 0.7 -1.2 3 7 3 8 0 7 13.4 12.6 13.9 11.8 11.6 7.7 11.1 5.8 5.7 7.1 7.3 7.1 6.9 4.3 4.0 4.8 3.4 2.1 2.3 2.5 NA NA 14.9 17.5 20.3 21.7 21.2 20.6 19.5 17.2 16.2 16.4 18.4 22.7 24.1 22.9 22.2 20.8 18.8 15.9 15.7 15.8 15.7 19.8 13.4 10.9 8.6 8.0 10.8 13.6 14.2 12.5 12.4 10.5 8.1 9.8 7.2 5.0 3.8 3.0 3.5 0.5 0.5 2 6 8 8 1 9 9 0 4 20.9 19.1 17.0 15.1 11.6 9.0 7.8 6.1 6.8 6.5 8.2 7.6 NA NA 6.4 7.5 8.0 8.3 9.0 9.8 9.8 9.8 9.0 8.6 15.9 19.7 19.4 17.9 15.4 13.7 11.4 10.7 11.1 12.6 12.4 12.5 1992 0.8 4.5 8.8 1993 -0.9 3.9 10.3 1994 2 3.5 11.2 1995 9 5.0 11.6 1996 0.9 5.2 11.7 1997 5 2.6 12.0 1998 3 2.8 11.9 1999 0 1.7 11.3 Japan 1980 2.8 5.4 2.0 1981 2 4.1 2.2 1982 1 1.8 2.4 1983 3 1.8 2.7 1984 9 2.6 2.7 1985 4 2.1 2.6 1986 9 1.7 2.8 1987 2 0.1 2.8 1988 2 0.7 2.5 1989 8 2.0 2.3 1990 1 2.3 2.1 1991 8 2.7 2.1 1992 0 1.7 2.2 1993 0.3 0.6 2.5 1994 0.6 0.2 2.9 1995 5 -0.6 3.1 1996 0 -1.4 3.4 1997 4 0.1 3.4 1998 -2.8 0.3 4.1 1999 4 0.0 4.7 Source: Organization for Economic Cooperation and Development (OECD) and IMF. 14.3 10.6 9.2 10.9 8.5 6.3 4.6 2.9 10.9 7.4 6.9 6.4 6.1 6.5 4.8 3.5 3.6 4.9 7.2 7.5 4.6 3.1 2.2 1.2 0.5 0.5 0.4 0.1 The Effects of Government on Household Consumption and Labor Supply INCOME TAX RATES TRANSFER PAYMENTS Increase Decrease Increase Decrease Effect on consumption Negative Positive Positive Negative Effect on labor supply Negative* Positive* Negative Positive *If the substitution effect dominates. Note: The effects are larger if they are expected to be permanent instead of temporary. Consumption Expenditures, 1970 I–2001 IV: Over time, expenditures on services and nondurable goods are "smoother" than expenditures on durable goods. Housing Investment of the Household Sector, 1970 I–2001 IV: Housing investment fell sharply during the four recessionary periods since 1970. Like expenditures for durable goods, expenditures for housing investment are postponable. Labor-Force Participation Rates for Men 25 to 54, Women 25 to 54, and All Others 16 and Over, 1970 I–2001 IV: Since 1970, the labor-force participation rate for prime-age men has been decreasing slightly. The rate for prime-age women has been increasing dramatically. The rate for all others 16 and over has been declining since 1979 and shows a tendency to fall during recessions (the discouraged-worker effect). Plant and Equipment Investment of the Firm Sector, 1970 I–2001 IV: Over all, plant and equipment investment declined in the four recessionary periods since 1970. Employment in the Firm Sector, 1970 I–2001 IV: Growth in employment was generally negative in the four recessions the U.S. economy has experienced since 1970. Inventory Investment of the Firm Sector and the Inventory/Sales Ratio, 1970 I–2001 IV: The inventory/sales ratio is the ratio of the firm sector's stock of inventories to the level of sales. Inventory investment is very volatile. Employment and Output over the Business Cycle: In general, employment does not fluctuate as much as output over the business cycle. As a result, measured productivity (the output-to-labor ratio) tends to rise during expansionary periods and decline during contractionary periods. Economic Growth Shifts Society's Production Possibility Frontier Up and to the Right: The production possibility frontier shows all the combinations of output that can be produced if all society's scarce resources are fully and efficiently employed. Economic growth expands society's production possibilities, shifting the ppf up and to the right.e. Economic Growth from an Increase in Labor—More Output but Diminishing Returns and Lower Labor Productivity QUANTITY QUANTITY TOTAL MEASURED OF LABOR OF CAPITAL OUTPUT LABOR L K Y PRODUCTIVITY PERIOD (HOURS) (UNITS) (UNITS) Y/L 1 100 100 300 3.0 2 110 100 320 2.9 3 120 100 339 2.8 4 130 100 357 2.7 Employment, Labor Force, and Population Growth, 1947–2001 CIVILIAN CIVILIAN LABOR FORCE NONINSTITUTIONAL Percentage of POPULATION OVER 16 Number (Millions) Population YEARS OLD (MILLIONS) 1947 1960 101.8 117.3 59.4 69.6 58.3 59.3 EMPLO YMENT (MILLI ONS) 57.0 65.8 1970 1980 1990 2001 Percentage change, 1947–2001 Annual rate 137.1 167.7 189.2 211.9 82.8 106.9 125.8 141.8 60.4 63.7 66.5 66.9 78.7 99.3 118.8 135.1 +108.2 +138.7 +137.0 +1.3% +1.6% +1.6% Economic Growth from an Increase in Capital—More Output, Diminishing Returns to Added Capital, Higher Measured Labor Productivity QUANTITY QUANTITY TOTAL MEASURED OF LABOR OF CAPITAL OUTPUT LABOR L K Y PRODUCTIVITY PERIOD (HOURS) (UNITS) (UNITS) Y/L 1 100 100 300 3.0 2 100 110 310 3.1 3 100 120 319 3.2 4 100 130 327 3.3 Fixed Private Nonresidential Net Capital Stock, 1960–2000 (Billions of 1996 Dollars) EQUIPMENT STRUCTURES 1960 672.7 2,015.7 1970 1,154.8 2,744.2 1980 1,989.8 3,589.1 1990 2,722.5 4,703.5 2000 4,359.6 5,541.2 Percentage change, +548.1% +174.9% 1960–2000 Annual rate +4.7% +2.5% Years of School Completed by People Over 25 Years Old, 1940–2000 PERCENTAGE WITH LESS THAN 5 YEARS OF SCHOOL 19 13.7 40 19 11.1 50 19 8.3 60 19 5.5 70 19 3.6 80 19 NA 90 20 NA 00 NA = not available. PERCENTAGE WITH 4 YEARS OF HIGH SCHOOL OR MORE PERCENTAGE WITH 4 YEARS OF COLLEGE OR MORE 24.5 4.6 34.3 6.2 41.1 7.7 52.3 10.7 66.5 16.2 77.6 21.3 84.1 25.6 Growth of Real GDP in the United States, 1871–2000 AVERAGE PERIOD GROWTH RATE PER YEAR 1871–1889 5.5 1889–1909 4.0 1909–1929 2.8 1929–1940 1.6 1940–1950 5.6 PERIOD 1950–1960 1960–1970 1970–1980 1980–1990 1990–2000 AVERAGE GROWTH RATE PER YEAR 3.5 4.2 3.2 3.2 3.2 Growth of Real GDP in the United States and Other Countries, 1981–1998 AVERAGE GROWTH COUNTRY RATE PER YEAR United States 3.1 Japan 2.8 Germany 2.1 France 2.0 Italy 1.8 United Kingdom 2.4 Canada 2.5 Africa 2.5 Asia (excluding Japan) 7.3 Sources of Growth in the United States, 1929–1982 PERCENT OF GROWTH ATTRIBUTABLE TO EACH SOURCE 1929–1982 1929–1948 1948–1973 1973–1979 Increases in inputs 53 49 45 94 Labor 20 26 14 47 Capital 14 3 16 29 Education (human capital) 19 20 15 18 Increases in productivity 47 51 55 6 Advances in knowledge 31 30 39 8 a Other factors 16 21 16 -2 Annual growth rate in 2.8 2.4 3.6 2.6 real national income a Economies of scale, weather, pollution abatement, worker safety and health, crime, labor disputes, and so forth. Output per Worker Hour (Productivity), 1952–2001 The Velocity of Money, 1960 I–2001 IV: Velocity has not been constant over the period from 1960 to 2001. There is a long-term trend—velocity has been rising. There are also fluctuations, some of them quite large. The Laffer Curve: The Laffer curve shows the amount of revenue the government collects is a function of the tax rate. It shows that when tax rates are very high, an increase in the tax rate could cause tax revenues to fall. Similarly, under the same circumstances, a cut in the tax rate could generate enough additional economic activity to cause revenues to rise. U.S. Balance of Trade (Exports Minus Imports), 1929–2001 (Billions of Dollars) EXPORTS MINUS IMPORTS 1929 + 0.4 1933 + 0.1 1945 – 0.9 1955 + 0.4 1960 + 2.4 1965 + 3.9 1970 + 1.2 1975 + 13.6 1976 – 2.3 1977 – 23.7 1978 – 26.1 1979 – 24.0 1980 – 14.9 1981 – 15.0 1982 – 20.5 1983 – 51.7 1984 – 102.0 1985 – 114.2 1986 – 131.9 1987 – 142.3 1988 – 106.3 1989 – 80.7 1990 – 71.4 1991 – 20.7 1992 – 27.9 1993 – 60.5 1994 – 87.1 1995 – 84.3 1996 – 89.0 1997 – 89.3 1998 – 151.5 1999 – 250.3 2000 – 364.0 2001 – 331.2 Source: U.S. Department of Commerce, Bureau of Economic Analysis. Yield Per Acre of Wheat and Cotton NEW ZEALAND Wheat 6 bushels Cotton 2 bales AUSTRALIA 2 bushels 6 bales Total Production of Wheat and Cotton Assuming No Trade, Mutual Absolute Advantage, and 100 Available Acres NEW ZEALAND AUSTRALIA Wheat 25 acres × 6 bushels/acre 75 acres × 2 bushels/acre 150 bushels 150 bushels Cotton 75 acres × 2 bales/acre 25 acres × 6 bales/acre 150 bales 150 bales Production Possibility Frontiers for Australia and New Zealand before Trade: Without trade, countries are constrained by their own resources and productivity. Production Possibility Frontiers for Australia and New Zealand before Trade: Without trade, countries are constrained by their own resources and productivity. Production and Consumption of Wheat and Cotton after Specialization PRODUCTION New Zealand 100 acres × 6 bushels/acre 600 bushels 0 acres Cotton 0 Wheat CONSUMPTION New Australia Zealand Australia 0 acres 0 100 acres × 6 bales/acre 600 bales Wheat Cotton 300 bushels 300 bushels 300 bales 300 bales Expanded Possibilities after Trade: Trade enables both countries to move beyond their own resource constraints—beyond their individual production possibility frontiers. Yield Per Acre of Wheat and Cotton NEW ZEALAND Wheat 6 bushels Cotton 6 bales AUSTRALIA 1 bushel 3 bales Realizing a Gain from Trade When One Country Has a Double Absolute Advantage STAGE 1 New Zealand Australia 50 acres × 6 bushels/acre 0 acres Wheat 300 bushels 0 50 acres × 6 bales/acre 100 acres × 3 bales/acre Cotton 300 bales 300 bales STAGE 2 New Zealand Australia Wheat 75 acres × 6 bushels/acre 0 acres 450 bushels 0 Cotton 100 acres × 3 bales/acre 300 bales Wheat 25 acres × 6 bales/acre 150 bales STAGE 3 New Zealand 100 bushels (trade) 100 bushels Cotton 350 bushels (after trade) 200 bales (trade) 350 bales (after trade) 100 bales Australia Comparative Advantage Means Lower Opportunity Cost: The real cost of cotton is the wheat sacrificed to obtain it. The cost of 3 bales of cotton in New Zealand is 3 bushels of wheat (a half acre of land must be transferred from wheat to cotton—refer to Table 16.5). However, the cost of 3 bales of cotton in Australia is only 1 bushel of wheat. Australia has a comparative advantage over New Zealand in cotton production, and New Zealand has a comparative advantage over Australia in wheat production. Domestic Prices of Timber (Per Foot) and Rolled Steel (Per Meter) in the United States and Brazil UNITED STATES BRAZIL Timber $1 3 Reals Rolled steel $2 4 Reals Trade Flows Determined by Exchange Rates EXCHANGE PRICE RESULT RATE OF REAL $1 = 1 R $ 1.00 Brazil imports timber and steel $1 = 2 R .50 Brazil imports timber $1 = 2.1 R .48 Brazil imports timber; United States imports steel $1 = 2.9 R .34 Brazil imports timber; United States imports steel $1 = 3 R .33 United States imports steel $1 = 4 R .25 United States imports timber and steel The Gains from Trade and Losses from the Imposition of a Tariff: A tariff of $1 increases the market price facing consumers from $2 per yard to $3 per yard. The government collects revenues equal to the gray-shaded area. The loss of efficiency has two components. First, consumers must pay a higher price for goods that could be produced at lower cost. Second, marginal producers are drawn into textiles and away from other goods, resulting in inefficient domestic production. United States Balance of Payments, 2000 All transactions that bring foreign exchange into the United States are credited (1) to the current account; all transactions that cause the United States to lose foreign exchange are debited (2) to the current account. Current Account Goods exports 772.2 Goods imports -1,224.4 (1) Net export of goods -452.2 Exports of services 293.5 Imports of services -217.0 (2) Net export of services 76.5 Income received on investments 352.9 Income payments on investments -367.7 (3) Net investment income -14.8 (4) Net transfer payments -54.1 (5) Balance on current account (1 + 2 + 3 + 4) -444.6 Capital Account (6) Change in private U.S. assets abroad (increase is -) -579.7 (7) Change in foreign private assets in the United States 986.6 (8) Change in U.S. government assets abroad (increase is -) -1.2 (9) Change in foreign government assets in the United States 37.6 (10) Balance on capital account (6 + 7 + 8 + 9) 443.3 (11) Statistical discrepancy 1.3 (12) Balance of Payments (5 + 10 + 11) 0 Determining Equilibrium Output in an Open Economy: In a, planned investment spending (I), government spending (G), and total exports (EX) are added to consumption (C) to arrive at planned aggregate expenditure. However, C + I + G + EX includes spending on imports because imports are part of planned aggregate expenditure. In b, the amount imported at every level of income is subtracted from planned aggregate expenditure. Equilibrium output occurs at Y* = 200, the point at which planned domestic aggregate expenditure crosses the 45-degree line. Some Private Buyers and Sellers in International Exchange Markets: United States and Great Britain THE DEMAND FOR POUNDS (SUPPLY OF DOLLARS) 1. Firms, households, or governments that import British goods into the United States or wish to buy British-made goods and services 2. U.S. citizens traveling in Great Britain 3. Holders of dollars who want to buy British stocks, bonds, or other financial instruments 4. U.S. companies that want to invest in Great Britain 5. Speculators who anticipate a decline in the value of the dollar relative to the pound THE SUPPLY OF POUNDS (DEMAND FOR DOLLARS) 1. Firms, households, or governments that import U.S. goods into Great Britain or wish to buy U.S.-made goods and services 2. British citizens traveling in the United States 3. Holders of pounds who want to buy stocks, bonds, or other financial instruments in the United States 4. British companies that want to invest in the United States 5. Speculators who anticipate a rise in the value of the dollar relative to the pound The Demand for Pounds in the Foreign Exchange Market: When the price of pounds falls, British-made goods and services appear less expensive to U.S. buyers. If British prices are constant, U.S. buyers will buy more British goods and services, and the quantity of pounds demanded will rise. The Equilibrium Exchange Rate: When exchange rates are allowed to float, they are determined by the forces of supply and demand. An excess demand for pounds will cause the pound to appreciate against the dollar. An excess supply of pounds will lead to a depreciating pound. Exchange Rates Respond to Changes in Relative Prices: The higher price level in the United States makes imports relatively less expensive. U.S. citizens are likely to increase their spending on imports from Britain, shifting the demand for pounds to the right, from D to D′. At the same time, the British see U.S. goods getting more expensive and reduce their demand for exports from the United States. The supply of pounds shifts to the left, from S to S′. The result is an increase in the price of pounds. The pound appreciates and the dollar is worth less. Exchange Rates Respond to Changes in Relative Interest Rates: If U.S. interest rates rise relative to British interest rates, British citizens holding pounds may be attracted into the U.S. securities market. To buy bonds in the United States, British buyers must exchange pounds for dollars. The supply of pounds shifts to the right, from S to S′. However, U.S. citizens are less likely to be interested in British securities, because interest rates are higher at home. The demand for pounds shifts to the left, from D to D′. The result is a depreciated pound and a stronger dollar. The Effect of a Depreciation on the Balance of Trade (the J Curve): Initially, a depreciation of a country's currency may worsen its balance of trade. The negative effect on the price of imports may initially dominate the positive effects of an increase in exports and a decrease in imports. Indicators of Economic Development Populatio GDP per n Capita, (Millions) 1998 Country Group 1998 (Dollars) Life Expectancy Infant Mortality, 1998 , 1998 (Deaths Before Age One (Years) per 1,000 Births) Percentage of Population in Urban Areas, 1998 Low-income (e.g., China, Ethiopia, Haiti, India) 3,536 520 63 68 30 886 1,740 68 35 58 588 4,870 71 26 77 25,480 78 6 77 Lower middleincome (e.g., Guatemala, Poland, Philippines, Thailand) Upper middleincome (e.g., Brazil, Malaysia, Mexico) Industrial market economies (e.g., Japan, 886 Germany, New Zealand, United States) Source: World Bank, World Development Indicators, 2000. Note that all numbers refer to weighted averages for each country group, where the weights equal the populations of each nation in a specific country group. Income Distribution in Some Developing Countries SRI LANKA Per Capita GDP 1995 $29,240 $810 Bottom 20% 5.2 8.0 Second 20% 10.5 11.8 Third 20% 15.6 15.8 Fourth 20% 22.4 21.5 Top 20% 46.4 42.8 Top 10% 30.5 28.0 Source: World Bank, World Development Report, 2000. UNITED STATES BRAZI L $4,630 2.5 5.5 10.0 18.3 63.8 47.6 PAKISTA N $470 9.5 12.9 16.0 20.5 41.1 27.6 INDONESI A $640 8.0 11.3 15.1 20.8 44.9 30.3 KEN YA $350 5.0 9.7 14.2 20.9 50.2 34.9 The Structure of Production in Selected Developed and Developing Economies, 1998 PERCENTAGE OF GROSS DOMESTIC PRODUCT COUNTRY PER CAPITA INCOME AGRICULTURE INDUSTRY SERVICES Tanzania $ 220 46 15 39 Bangladesh 350 22 28 50 China 750 18 49 33 Thailand 2,160 11 41 48 Colombia 2,470 13 Brazil 4,630 8 Korea (Rep.) 8,600 5 United States 29,240 2 Japan 32,350 2 Source: World Bank, World Development Report, 2000. 25 29 43 26 37 61 63 52 72 61 The Growth of World Population, Projected to 2020 a.d.: For thousands of years, population grew slowly. From 1 a.d. until the mid-1600s, population grew at about .04 percent per year. Since the Industrial Revolution, population growth has occurred at an unprecedented rate. Total (Public and Private) External Debt for Selected Countries, 1998 (Billions of Dollars) TOTAL EXTERNAL COUNTRY TOTAL DEBTAS A PERCENTAGE OF GDP DEBT Guinea-Bissau 1.0 363 Nicaragua 6.0 295 Angola 12.7 280 Sudan 16.8 172 Indonesia 150.9 169 Thailand 86.2 76 Russian Federation 183.6 62 Peru 32.4 55 Argentina 144.0 52 Turkey 102.1 49 Mexico 159.9 41 Brazil 232.0 29 India 98.2 20 China 154.6 14 Source: World Bank, World Development Indicators, 2000. Major Trading Partners of the United States, 1999. Source: Statistical Abstract of the United States 2001 (Washington, DC: U.S. Government Printing Office, 2001). Exchange Rates in July 2001 Nation Australia Brazil Britain Canada France Germany Hong Kong Ireland Israel Japan Mexico Saudi Arabia Currency Dollar Real Pound sterling Dollar Franc Mark Dollar Punt Shekel Yen Peso Rial Percentages of Government Spending on Various Programs Value in Dollars (U.S. $ equivalent) 0.51 0.41 1.41 0.66 0.1291 0.4332 0.1282 1.07 0.24 0.0079 0.1095 0.27 Units per Dollar (Currency per U.S. $) 1.96 2.41 0.71 1.51 7.74 2.3079 7.799 0.92 4.19 125.75 9.12 3.75 Percentages of Government Spending on Various Programs Percentages of Government Revenue from Different Sources Microeconomic implications Mortgage, Corporate, and Government Interest Rates Typical Investments: A typical investment, in which a cost of $100 incurred today yields a return of $104 next year. Returns on Investment Investment Cost Return A B C D E $100 $100 $100 $100 $100 $101 $103 $105 $107 $109 Interest Rates and Investment: As the real interest rate declines, investment spending in the economy increases. Savers and Investors Components of M1, January 2001 Currency held by the public Demand deposits Other checkable deposits Travelers’ checks Total of M1 Balance Sheet for a Bank $ 534 billion $ 316 billion $ 242 billion $ 8 billion $1100 billion Process of Deposit Creation: Changes in Balance Sheets Structure of the Federal Reserve Open Market Purchase: An open market purchase increases the supply of money, decreases interest rates, and increases the level of output. Possible Pitfalls in Stabilization Policy Share of Capital Gains by Income Income Class $10,000–20,000 $20,000–30,000 $30,000–40,000 $40,000–50,000 $50,000–75,000 $75,000–100,000 $100,000–200,000 $200,000 and over Share of Capital Gains 2.6% 2.9% 4.4% 3.4% 9.0% 8.5% 15.7% 56.8% Cost per Ton of Paper with Varying Amounts of Pollution Waste per Ton Average Production Cost (Gallons) per Ton 5 4 3 2 1 0 $ 60 $ 61 $ 64 $ 71 $ 86 $116 $20 $16 $12 $8 $4 $0 Tax Cost per Ton Average Total Cost per Ton with Tax $ 80 $ 77 $ 76 $ 79 $ 90 $116 Market Effects of a Pollution Tax: The pollution tax increases the cost of producing paper, shifting the market supply curve to the left. The equilibrium moves from point i to point f. The tax increases the equilibrium price from $60 to $68 per ton and decreases the equilibrium quantity from 100 to 80 tons per day. Market Effects of Command and Control: The command-and-control policy increases the cost of producing paper, shifting the market supply curve to the left. The equilibrium price increases to $74 per ton, and the equilibrium quantity decreases to 70 tons per day. Compared to the pollution-tax policy, the command-andcontrol policy leads to a higher price and a smaller quantity. Abatement Costs: Low-Cost Firm Versus High-Cost Firm Production Cost per Ton: Waste per Ton Firm with Low (Gallons) Abatement Cost 5 4 3 2 1 0 $ 60 $ 61 $ 64 $ 71 $ 86 $116 Production Cost per Ton: Firm with High Abatement Cost $ 60 $ 67 $ 82 $112 $172 $300