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Macroeconomics
Unit Overview
3.1 Measuring national income
* Circular flow of income
* Methods of measurement - income, expenditure and output
* Distinction between
o gross and net
o national and domestic
o nominal and real
o total and per capita
3.2 Introduction to development
* Definitions of economic growth and economic development
* Differences in the definitions of the two concepts
* Gross Domestic Product (GDP) vs. Gross National Product (GNP) as measures of growth
* Limitations of using GDP as a measure to compare welfare between countries
* Allowance for differences in purchasing power when comparing welfare between countries
* Alternative methods of measurement
* Problems of measuring development
3.3 Macroeconomic models
* Aggregate demand - components
* Aggregate supply
o short-run
o long-run (Keynesian vs. neo-classical approach)
o Full employment level of national income
o Equilibrium level of national income
o Inflationary gap
o Deflationary gap
o Diagram illustrating trade/business cycle
Blog posts: "Inflation"
Blog posts: "Macroeconomics"
Blog posts: "AD/AS Model"
Blog posts: "Economic growth"
Blog posts: "Unemployment"
Unit 3 Macroeconomics
Unit Overview
3.4 Demand-side and supply-side policies
* Shifts in the AD curve / demand-side policies
o fiscal policy
o interest rates as a tool of monetary policy
* Shifts in the AS curve / supply-side policies
* Strengths and weaknesses of these policies
Higher level only:
* Multiplier
o calculation of multiplier
* Accelerator
* "Crowding out"
3.5 Unemployment and inflation
Unemployment
* Full employment and underemployment
* Unemployment rate
* Costs of unemployment
* Types of unemployment
o structural
o frictional
o seasonal
o cyclical/demand-deficient
o real wage
* Measures to deal with unemployment
Inflation
* Definitions of inflation and deflation
* Costs of inflation and deflation
* Causes of inflation
o cost push
o demand pull
o excess monetary growth
Higher level only:
* Methods of measuring inflation
* Problems of the methods of measuring inflation
* Phillips curve
o short-run
o long-run
* Natural rate of unemployment (NRU)
* Non-Accelerating Inflation Rate of Unemployment
(NAIRU)
3.6 Distribution of income
* Direct taxation
* Indirect taxation
* Progressive taxation
* Proportional taxation
* Regressive taxation
* Transfer payments
Higher level only:
* Laffer curve
* Lorenz curve and Gini coefficient
Macroeconomics
Micro vs. Macro
Intro to Macroeconomics: What is Macroeconomics?
Micro concept >>>>>> Macro equivalent
Market
National Economy
Demand
Aggregate Demand
Supply
Aggregate Supply
Price
Price level
Quantity
National Output/Income (GDP)
Decrease in demand
Recession and unemployment
Increase in demand
Inflation
Decrease in supply
Supply shock, stagflation
Increaese in supply
Economic growth
Excise (indirect) tax
Income (direct) tax
Subsidy
Government spending
Macroeconomics
The circular flow of income - macro version
Revisiting the circular flow: The macro circular flow model includes household saving and
firm investment, government taxation and spending on G&S, and foreigners who buy
exports and sell imports.
Injections: Investment and purchase of exports
Expenditures / revenue
Product market
Goods/Services
Taxes
Households
Goods/services
Taxes
Government
Goods/services
Firms
Factors of productin
Resource market
Income: W I R P
Leakages: Savings and purchase of imports
Leakages: The money that leaves the circular flow because it is not being spent on domestic G&S.
Injections: Spending that enters the circular flow from external sources i.e. foreign investors and
consumers.
Macroeconomics
The Macroeconomic Objectives
In Microeconomics, the objectives are:
·firms aim to maximize profits
·consumers aim to maximize utility
·efficient resource allocation in competitive markets
·the correction of market failure through government intervention
These can be thought of the goals of microeconomics
In Macroeconomics, the objectives are:
1)
Full - employment: Does NOT mean every single person has a job. Means
2)
Stable prices: This refers not to the prices of individual products, but to the
3)
Economic growth: The most talked about macroeconomic goal, growth occurs
4)
Income distribution: A nation's income should be somewhat equally distributed
that most people who want to work are working. Some unemploymenet will
exist in a healthy economy.
price level in the economy as a whole. A rise in the overall price level is called
inflation, a fall is called deflation.
when the total amount of goods and services an economy produces increases
from year to year.
between the upper and lower "classes" in society. Some tax systems are designed to
achieve more equitable income distribution.
Macroeconomics
Measuring national income
Gross Domestic Product: GDP is the monetary measure of the total market value of
all final goods and services produced within a country in one year.
Can be thought of as:
national income or national output or national expenditures
GDP=primary output +
GDP=W+R+I+P
secondary output + tertiery output
GDP=C+I+G+(X-M)
Why is GDP important?
>> It tells us something about the relative size of different countries' economies
>> It is a monetary measure, so it tells us how much income a country earns in a year
(assuming everything that is produced is sold).
>> When we divide GDP by the populuation, we get GDP per capita, which tells us how
many goods and services the average person consumes in a country.
>> When real GDP grows more than the population, that tells us that people on
average, have more stuff than they did before.
>> If you believe that having more stuff makes people better off, then GDP per capita
tells us how well off people in society are.
IMPLICATIONS:
GDP is the most important macroeconomic measurement!
Macroeconomics
Measuring national income
What's included and not included in GDP?
GDP includes:
·GDP includes only final products and services
·GDP is the value of what has been produced within the
borders of a nation over one year, not what was actually sold.
GDP Excludes "nonproduction transactions":
·Purely financial transactions are excluded.
>>Public transfer payments, like social security or cash welfare
benefits.
>>Private transfer payments, like student allowances or alimony
payments.
>>The sale of stocks and bonds represent a transfer of existing assets
(However, the brokers’ fees are included for services rendered.)
·Secondhand sales: If I buy a used car in 2008, that sale does not
count towards 2008's GDP, because the car was not made in 2008! The
price of the car was originally included in the year's GDP when it was
produced.
Macroeconomics
Measuring national income
Gross National Product: the total income that is earned by a country's
factors of production regardless of where the assets are located.
GNP = GDP + net property income from abroad
The value of the cars made in a Honda factory in the US count towards Japan's
GNP and America's GDP. Bank of America's operations in Japan count towards
US GNP and Japan's GDP.
Nominal GDP and real GDP:
Nominal GDP measures the money value of a nation's output. To
measure the REAL value of the nation's output, the value of
money must be taken into account. Inflation erodes the value of
money and therefore the nation's output.
REAL GDP = Nominal GDP adjusted for inflation.
Macroeconomics
Measuring national income
GDP: How is it measured? Two methods are used for measuring GDP
Expenditures approach: Measures all the spending on final goods and services
that has take place during a year. This includes:
Personal Consumption (C): the purchase by households of all goods and
services
·Including non-durables: bread, milk, toothpaste, t-shirts, socks, toys, etc...
·and durables: TVs, computers, cars, refrigerators, etc...
·and services: dentist visits, haircuts, taxi rides, accountants, lawyers, etc...
Gross Private Domestic Investment- (Ig)
·All final purchases of machinery, equipment, and tools by businesses.
·All construction (including residential).
·Changes in business inventory.
>>If total output exceeds current sales, inventories build up.
>>If businesses are able to sell more than they currently produce, this
entry will be a negative number.
Macroeconomics
Measuring national income
Components of GDP, continued...
Government Purchases (of consumption goods and capital goods) - (G)
·Includes spending by all levels of government (federal, state and local).
·Includes all direct purchases of resources (labor in particular).
·This entry excludes transfer payments since these outlays do not reflect
current production.
Net Exports- (NX)
·All spending on goods produced in the U.S. must be included in GDP,
whether the purchase is made here or abroad.
·Often goods purchased and measured in the U.S. are produced elsewhere
(Imports).
·Therefore, net exports, (Xn) is the difference: (exports - imports) and can be
either a positive or negative number depending on which is the larger
amount.
Summary:
GDP = C + I + G + NX (X-M)
Macroeconomics
Evaluating GDP
Shortcomings of GDP: GDP is reasonable and useful in measuring how well or
poorly the economy is performing but it has some shortcomings:
·Certain important work is left out of accounting (homemakers, labor of carpenters who
make own homes because GDP measures only the MARKET VALUE of output. GDP
therefore is understated.
·Our accounting system does not take reflect that we work less hours than in past years
(1900 avg was 53 hours) and that we have more leisure time
·Does not reflect improved product quality
·Does not include the underground economy
·GDP does not put a market value/cost on the environment. Higher GDP may be
accompanied by negative externalities, which are NOT subtracted from GDP.
·GDP does not tell us if the best combo of G and S are produced, weighs G and S equally, a
rifle and encyclopedias are assigned equal weight.
·Nor does it measure how GDP is distributed in among the population
·GDP does not measure the total well being, happiness, a reduction of crime or better
relationships with society, with other countries, etc...
Macroeconomics
Measuring national income
How do we determine Real GDP? We will assume that we live in an economy that
produces only one thing, Pizza..
1. Find Nominal GDP for each year
2. Determine a price index for each year (using the price index formula),
3. Adjust the nominal GDP figures by dividing by the price index (in hundredths).
What is a price index?
A price index is a measure of the price of a specified collection of goods and
services called a, “market basket” in a given year as compared to the price of an
identical basket of goods and services in a reference year.
Price of a "market basket" of
goods in a specific year
Price index for a given year
Real GDP =
=
Price of same "basket" in
the base year
Nominal GDP
Price index (in hundredths)
X 100
Macroeconomics
Measuring national income
Example:
2008: 10 pizza's @ $10/pizza. Nominal GDP = $100
2009: 12 pizza's @ $12/pizza. Nominal GDP = $144
What is the REAL GDP in 2009?
P
pizza
Price index=
2009 = $12
Ppizza 2008
= $10
=1.2 x 100 = 120
Nominal GDP in 2009 = 12 x $12 = $144
Real GDP in 2009 =
$144
1.2
= $120
Conclusions: Because the price of pizza's increased by 20% (inflation rate was 20%),
the nominal GDP growth of 44% was over-stated. After adjusting for inflation, the
nations' growth rate is only 20%
Macroeconomics
Inflation
Measuring Inflation: Inflation is defined as a persistent increase in the average
price level in the economy, usually measured through the calculation of a consumer
price index (CPI)
This year’s CPI - last year’s CPI
Rate of inflation
=
Last year’s CPI
X 100
Example: Assume our economy produces only pizzas. Therefore, the "basket of goods"
our CPI will use consists of one pizza. In a real economy the basket of goods would be
made up of hundreds of consumer products from utilities to automobiles to petrol to
shoes and electronics.
2008: Ppizza = $10
2009: Ppizza = $12
12-10
X 100 =
Rate of inflation =
10
20%
Macroeconomics
Inflation
Degrees of inflation: Not all inflation is bad. Some inflation is considered an indication of a
healthily growing economy. However, high inflation is clearly undesirable as it erodes the value
of people's incomes and the nation's output.
·Single digit inflation is called moderate inflation.
·Rapid inflation of double digits is called galloping inflation
·Extremely high inflation exceeding 50% per month, is called hyperinflation.
Deflation: A persistent fall in the average level of prices in the economy. Deflation sounds like a
good thing at first because it means the real values of people's incomes are rising. However,
deflation leads to a disincentive for firms to increase production, meaning they will cut back
output, lay off workers, leading to a recession and rising unemployment.
“the Rule of 70”: 70 / inflation rate = # years for the price level to
double)
Interpretation: In a country experiencing 5% inflation, the price level will double in only 14
years. If inflation reaches 10%, prices will double in only 7 years.
Inflation and Unemployment
Costs of inflation
Inflation's effects on the economy: Inflation is one of the "evils" in macroeconomics. In
fact, price level stability is one of the three main goals of macroeconomic policy. Inflation's
effects include:
·Loss of purchasing power: As prices rise and incomes do not, people are becoming poorer
in real terms. Real income is nominal income minus inflation. An inflation rate of 10%, for
example, accompanied by no change in nominal incomes would mean the average household
was 10% poorer at the end of the year than at the beginning.
·Loss of savings: Savers are negatively effected by inflation. If you put $1000 in the bank at
5% interest today, but there is inflation of 10% in the next year, then you will have actually lost
5% of your savings. The real interest rate is the nominal interest rate minus the rate of
inflation.
·Higher interest rates for borrowers: In times of high inflation, banks will raise the interest
rates they charge borrowers. A lender charging 4% interest when there is inflation of 6% will
actually be paid back in money worth 6% less than the money originally lent. To maintain
profits, banks must charge a higher nominal interest rate than the rate of inflation, making it
more costly for firmst and households to borrow financial capital.
·Effect on international competitiveness: High inflation at home makes domestic output
less attractive to foreigners, and imports more attractive to domestic consumers. This could
move a country's trade balance towards deficit.
Inflation and Unemployment
the Phillips Curve
·In the short-run, there is an inverse
relationship between the price level and
the unemployment rate
·When AD is weak, unemployment will
increase and there is downward pressure
on prices.
·When AD is strong, unemployment falls
and there is upward pressure on prices
as the economy approached fullemployment.
·When economy is at equlibrium, UE will
be stable at the Natural Rate of
Unemployment
Inflation (ΔPL)
Graphing the inflation/unemployment relationship: the Phillips Curve
8%
P
fe
2%
PC
2%
NRU
8%
Unemployment
Macroeconomics
Inflation
Causes and theories of inflation:
·Demand-pull inflation: an excess of total spending beyond the economy’s capacity to
produce. When resources are already fully employed, firms cannot respond to increases
in demand. “Too much spending chasing too few goods.”
·Cost-push or supply-side inflation: Prices rise because of rise in per-unit production
costs (Unit cost = total input cost/units of output).
>>Wage-push can occur as result of union strength. And Supply shocks may occur with
unexpected increases in the price of raw materials.
>>Cost push; experience has shown that rising prices and unemployment can exist
together, it is called stagflation
Complexities: It is difficult to distinguish between demand-pull and cost-push
causes of inflation, although cost-push will die out in a recession if spending does
not also rise.
Macroeconomics
Inflation
The Output Effects of Inflation
·Cost-push inflation, where resource prices rise unexpectedly, could cause both output and
employment to decline. Real income falls. Real income is nominal income /price index
·Mild inflation (<3%) has uncertain effects. It may be a healthy by-product of a prosperous
economy, or it may have an undesirable impact on real income.
·Danger of creeping inflation turning into hyperinflation, which can cause speculation, reckless
spending, and more inflation
The Redistributive effects of inflation:
Who is hurt?
1. Fixed-income groups will be hurt because their real income suffers. Their nominal
income does not rise with prices.
2. Savers will be hurt by unanticipated inflation, because interest rate returns may not
cover the cost of inflation.
3. Creditors: Unanticipated inflation hurts creditors.
Who benefits?
Debtors (borrowers) Interest payments may be less than the inflation rate
Is there any “cushioning” for inflation built into the economy?
·If inflation is anticipated, the effects of inflation may be less severe,
>>since wage and pension contracts may have inflation clauses built in
>>interest rates will be high enough to cover the cost of inflation to savers
Ex; “Inflation premium” is amount that interest rate is raised to cover effects of anticipated
inflation.
>>“Real interest rate” is defined as nominal rate minus inflation premium.
Macroeconomics
Unemployment
Four broad Macroeconomic Goals:
1) Full-employment (low unemployment)
2) Price level stability (low inflation)
3) Economic growth (increase in real GDP year on year)
4) Income distribution
Measuring unemployment: The unemployment rate is the number of people who are
unemployed (actively seeking employment but unable to find work) expressed as a
percentage of the total labor force.
Labor force: "the economically active population", usually between the ages of 16-64
Part-time workers are counted as “employed.”
“Discouraged workers” who want a job, but are not actively seeking one, are not counted
as being in the labor force, so they are not part of unemployment statistic.
This means that most country's unemployment data is skewed, i.e. it may
underestimate the number of people who are truly unemployed.
Inflation and Unemployment
Unemployment
Types of unemployment: Unemployment is defined as the percentage of the labor force
out of work. The labor force is made up of 16-65 year olds who are employed or
seeking employment.
Frictional: Describes workers "in between jobs". When someone
with marketable skills moves from one job to another. Usually thee
months or less.
Seasonal: Describes workers who work at jobs that are seasonal in
nature. Examples include fruit pickers, migrant workers, resort
employees, etc...
Structural: When workers lose their jobs due to the changing
macroeconomic structure of the economy. Factory workers who lose
their jobs due to automation are structurally unemployed. Structural
unemployment is difficult to overcome for those who experience it,
but may be evidence of a healthy economy, since often those who
are structurally unemployed are less skilled.
Frictional + Seasonal +
Structural UE
= Natural Rate of
Unemployment
(NRU)
Cyclical: Workers who lose their job due to a recession caused by weak aggregate demand
are cyclically unemployed. Cyclical unemployment is a sign of a struggling economy. The
nearly 10% unemployment in the United States in 2009 is a result of recession and the
changing structure of the US economy.
Macroeconomics
the Business Cycle
the Business Cycle
Level of real output
Four phases of the business cycle are
identified over a several-year period:
1.A boom is when business activity reaches a
temporary maximum with full employment and
near-capacity output.
2.A recession is a decline in total output,
income, employment, and trade lasting six
months or more.
3.The trough is the bottom of the recession
period.
4.Recovery is when output and employment are
expanding toward full-employment level.
Boom
Boom
Boom
Trough
Trough
Time
Theories about causation:
·Major innovations may trigger new investment and/or consumption spending.
·Changes in productivity may be a related cause.
·Most agree that the level of aggregate spending is important, especially changes on capital
goods and consumer durables.
·Cyclical fluctuations: Durable goods output is more unstable than non-durables and services
because spending on latter usually can not be postponed.
Blog posts: “Business cycle”
Macroeconomics
Unemployment
Types of unemployment:
Frictional or seasonal unemployment consists of those searching for jobs or waiting to take
jobs soon; it is regarded as somewhat desirable, because it indicates that there is mobility as
people change or seek jobs.
Structural unemployment: due to changes in the structure of demand for labor; e.g., when
certain skills become obsolete or geographic distribution of jobs changes; examples, Glass
blowers were replaced by bottle-making machines., Oil-field workers were displaced when oil
demand fell in 1980s, Airline mergers displaced many airline workers in 1980s.,Foreign
competition has led to downsizing in U.S. industry and loss of jobs.
Cyclical unemployment is caused by the recession phase of the business cycle, which is
sometimes called deficient demand unemployment
Macroeconomics
Unemployment
Definition of “Full Employment”: Full employment does not mean zero unemployment. but is
equal to the total of frictional and structural unemployment
When the economy is at full-employment, the natural rate of unemployment or NRU prevails in
the economy. With some unemployment, the economy still has room to grow in the short-run, as
there are some workers available for firms to hire if they wish to expand output.
The NRU is achieved when labor markets are in balance
·At this point the economy's potential output is being achieved.
·The natural rate of unemployment is not fixed, but depends on the demographic makeup of the
labor force and the laws and customs of the nations. Historically, Western European nations have
a higher NRU than the US and East Asian economies
WHY?
·Better "social safety net" in Western Europe means that when workers are unemployed, they
receive more government support and benefits.
·The incentive is not as strong in such economies to seek employment than in countries with few
social safety nets.
·In the US, unemployment benefits expire after only 3 months of collecting them. The incentive,
therefore, is to find work as quickly as possible in the US, whereas in France unemployment
benefits can be collected for much longer.
Macroeconomics
Unemployment
Economic cost of unemployment:
·GDP gap and Okun’s Law: GDP gap is the difference between potential and
actual GDP.
>>Economist Okun quantified relationship between unemployment and GDP
as follows:
For every 1 percent of unemployment above the natural rate, a 2 percent
GDP gap occurs. This has become known as “Okun’s law.”
·Unequal burdens of unemployment exist. Examples:
>>Rates are lower for white-collar workers than blue-collar,
>>teenagers have the highest rates,
>>blacks have higher rates than whites,
>>less educated workers, on average, have higher unemployment rates than
workers with more education.
·Non-economic costs include loss of self-respect and social and political unrest.
Macroeconomics
Economic Growth
Measuring economic growth: Economic growth is achieved when there is an increase in
a nation's real income and output in a given year.
Real GDP in year 2 - Real GDP in year 1
GDP Growth rate =
X 100
Real GDP in year 1
Example:
Switzerland's real GDP in 2008: $309 billion
Switzerland's real GDP in 2007: $305 billion
Switzerland's
GDP growth rate
309b - 305b
=
.019 X 100 = 1.9%
305b
Per-capita economic growth: If population grows faster than GDP, then the
average person may be worse off even with real economic growth.
Example: If real GDP increases by 3% while population increases by 2%, then real
GDP per capita has only increased by 1%
Macroeconomics
Measuring Economic Goals
PPC analysis of Macroeconomic goals: The simple production possibilities curve can be
used to illustrate three of the economic goals
Consumer goods
Switzerland
D
B
Full-employment output: The
economy is producing just
inside its PPC, the NRU
prevailes
C
Economic growth: A point beyond the
nation's PPC represents what could be
attained through economic growth
Inflationary gap: The economy is
producing beyond full-employment
at less than NRU. Competition for
workers puts upward pressure on
prices.
A
Deflationary gap: when the economy is
producing below full-employment. Low
aggregate demand and high
unemployment puts downward pressure
on prices
Capital goods
Practice Measuring Macroeconomic Goals: NCEE activity 11
Macroeconomic Models
Aggregate Demand
Determinants of aggregate demand: CONSUMPTION is determined by the following factors
Wealth: When value of existing wealth (real assets and financial assets)
increases, households increase C and decrease S. When wealth
decreases, C decreases and S increases.
Expectations: of future prices and incomes. If households expect prices
to rise tomorrow, then today C will shift up, S down. If we expect lower
income in the future, then C will likely shift down and S shift up, as
households choose to save more for the hard times ahead.
Real Interest Rates: Lower real interest rates lead to more C, less S and vise
versa.
Household Debt: When consumers increase their debt level, they can
consume more at each level of DI. But if Debt gets too high, C will have to
shift down as households try to pay off their loans.
Taxation: Increase in taxes shifts BOTH C and S curves downwards.
Decrease in taxes shifts both C and S curves upwards. This will be covered
more when we discuss Fiscal Policy.
Changes in any of these factors increase or decrease
Consumption, shifting the Aggregate Demand curve
Macroeconomic Models
Aggregate Demand
Determinants of aggregate demand: INVESTMENT is determined by the following factors
Real interest rates and expected rate of return: there is an inverse relationship between real
interest rates and the level of investment in the economy
·Profit-maximizing firms will only invest in new capital if the expected rate of return on
an investment is greater than the real interest rate.
·If a firm expects the return on an investment to be 5% and the real interest rate is 3%,
the firm will invest. If expected returns are 5% and real interest rate is 7%, the firm will
not invest.
Investor confidence, influenced by:
·Expectations of future sales and business conditions
·Technology: increases the productivity of capital, thereby encouraging new investment
·Business taxes: higher taxes decrease the expected return on new capital, discouraging new
investment
·Inventories: the existence large inventories will discourage new investment
·Degree of excess capacity: If firms can easily increase output because they are producing below
full capacity, they will be less likely to invest in new capital
Macroeconomic Models
Aggregate Demand
Determinants of aggregate demand: EXPORTS are determined by the following factors
Incomes abroad: As incomes in nations with which a nation trades
increase, demand for the country's exports will increase, shifting
Aggregate demand out.
Exchange rates: A weakening of a country's currency relative to other
currencies will make its exports more attractive, increasing its net
exports and shifting aggregate demand out.
Tastes and preferences: If foreign tastes and preferences shift
towards a nation's products, exports will increase, shifting aggregate
demand out.
Macroeconomic Models
Aggregate Demand
Determinants of aggregate demand: GOVERNMENT SPENDING changes in the following
situations.
Fiscal policy: Changes in government spending and/or taxation aimed at
increasing or decreasing aggregate demand
Expansionary fiscal policy: A decrease in taxes and/or an increase in
government spending.
·Used in times of weak aggregate demand, high unemployment and falling output.
·Public sector spending (G) is needed to replace the fall in private sector spending (C, I, Xn)
·Expansionary effect of fiscal policy depends on the size of the spending multiplier. The
greater proportion of new income households use to consume domestic output, the greater
the expansionary effect of a tax cut or an increase in government spending
Macroeconomic Models
Aggregate Supply
Aggregate Supply: The Keynesian vs. Classical debate
Background to the Keynesian view of the AS curve: John Maynard Keynes was an English
economist who represented the British at the Versailles treaty talks at the end of WWI. Keynes
argued that the Allies should invest in the reconstruction of Germany and opposed the reparations
being forced upon Germany after the war. When the Allies insisted on forcing Germany to pay
reparations, Keynes walked out on the Versailles talks. If they had listened to Keynes, the Allies
could have potentially avoided the second World War.
Keynes believed that during a time of weak spending (AD), an economy would be unable to return
to the full-employment level of output on its own due to the downwardly inflexible nature of wages
and prices. Since workers would be unwilling to accept lower nominal wages, and because of the
role unions and the government played in protecting worker rights, the only thing firms could due
when demand was weak was decrease output and lay off workers. As a result, a fall in aggregate
demand below the full-employment level results in high unemployment and a large fall in output.
To avoid deep recession and rising unemployment after a fall in private spending (C, I, Xn), a
government must fill the "recessionary gap" by increasing government spending. The economy will
NOT "self-correct" due to "sticky wages and prices", meaning there should be an active role for
government in maintaining full-employment output.
So which theory is right, Classical or Keynesian?
Demand and Supply-Side Policies
Monetary Policy (AP only)
The US Federal Reserve System: Who's in charge of monetary policy in the US?
The Federal Reserve: America's Central Bank
·12 banks located in different regions of the country
·Coordinated by the Fed's Board of Governors
·Bankers' banks: Provide banking services to commercial banks
>>accept deposits
>>lend money (called the "discount window", only if commercial banks
can't
borrow from one another would they borrow from the Fed)
>>Issue new currency to commercial banks
·FOMC - Federal Open Market Committee: 12 individuals, including the Chairman
of the Fed (Bernanke). Purpuse is to buy and sell government securities to control
the nation's money supply and influence interest rates. Execute monetary policy.
Fed Functions and the Money Supply
·Issue currency: the Fed can inject new currency into the money supply by issuing
Federal Reserve Notes (dollars) to commercial banks to be loaned out to the public.
·Setting reserve reuirements: this is the fraction of checking account balances that
commercial banks must keep in their vaults. The larger the reserve requirement, the
less money commercial banks can loan out.
·Lending money to banks: The Fed charges commercial banks interest on loans, this
is called the "discount rate".
·Controling the money supply: this in turn enables the Fed to influence interest rates.
Demand and Supply-Side Policies
Monetary Policy (AP Only)
Three Monetary Policy tools: Relative importance
OMO - Open-market operations is the buying and selling of government bonds in the financial
market. Because it is the most flexible, bond holdings by the central bank can be adjusted daily,
and have an immediate impact on banks' reserves and the supply of money in the economy
Reserve ratio: The RR is RARELY changed. RR in the US has been .10 since 1992. Reserves held
by the Central Bank earn no interest, so if RR is raised, banks' profits suffer dramatically since
they have to deposit more of their total reserves with the Fed where they earn no interest. Banks
prefer to be able to lend out as much of their total reserves as possible
Discount rate: Until recently, the discount rate in the US was rarely adjusted on its own, and
instead hovered slightly above the federal funds rate*. In 2008, the US Fed lowered the discount
rate to very low levels as uncertainty among commercial banks brought private lending to a halt.
The "discount window" is only supposed to be used in the case of private lenders being unable
to acquire funds, hence the Fed is the lender of last resort
Discount rate called into action - March 17, 2008...
"The Federal Reserve announced a series of steps Mar. 16 to help provide relief to a
spreading credit crisis that threatens to plunge the economy into recession: The central bank
approved a cut to its lending rate to financial institutions, from 3.5% to 3.25%, and created
another lending facility for big investment banks to secure short-term loans."
*Federal Funds Rate: The interest rate that banks charge one another on overnight
loans made from temporary excess reserves.
Demand and Supply-Side Policies
Monetary Policy (AP only)
Money Creation: What does it mean to create money in a modern economy?
Fractional reserve banking - How banks create money: By accepting deposits from
households, then lending out a proportion of those deposits to borrowers, which
themselves end up being deposited and lent out again and again, BANKS CREATE NEW
MONEY through their every-day activities.
A bank begins operations by accepting deposits from savers: Bank must keep reserve
deposits in its district Federal Reserve Bank.
·Banks can keep reserves at Fed or in cash in vaults.
·Banks keep cash on hand to meet depositors’ needs.
·Required reserves are a fraction of deposits, as noted above.
Other important points:
·Excess reserves: Actual reserves minus required reserves are called excess
reserves. This is the portion of total reserves that a bank is allowed to lend out.
·Control: Required reserves do not exist to protect against “runs,” because banks
must keep their required reserves. Required reserves are to give the Federal
Reserve control over the amount of lending or deposits that banks can create. In
other words, required reserves help the Fed control credit and money creation.
·Banks
cannot loan beyond their required required reserves
·Asset and liability: Reserves are an asset to banks but a liability to the Federal
Reserve Bank system, since now they are deposit claims by banks at the Fed.