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AP/ Honors Macroeconomics Unit 4 Notes and Terms Fiscal and Monetary Policy 1. Public Good- G or S provided by the government. Examples: Education, Military, Police, Fire, Jails, S.S., Welfare, Agriculture Subsidies 2. Private Good- G or S provided by private individuals or private companies. Examples: Shirt from Old Navy, Gas from ARCO, Car from Sanderson Ford, Education from Brophy 2 Reasons for Public Goods 3. Non-exclusion rule- difficult to exclude(keep out) individuals who are unwilling to pay. Examples: Parks, Police/Military/Fire Protection, Roads, Courts, Dams/ Flood Control 4. Shared Consumption rule- everyone can share in the use of a G or S. One person using a G or S does not lessen the benefit another person gets from it. Examples: Education, Parks, Library, Street lights, system of money, weights and measure. Free Rider- someone who receives the benefits of a good or service without having to contribute to its costs. Examples: bumming a cigarette, copying homework, borrowing yard tools Dam example- 2 people (A & B) living in a flood plain, both would benefit from a dam, only A wants to pay for it, B does not. 6. Taxes- Required payments of money to governments that are used to provide public goods and services. 7. Types of taxes A. Personal Income- on earnings B. Corporate Income- on profit C. Excise- tax on specific item (tobacco, alcohol, gas, tires, marijuana D. Tariffs- on imports E. Inheritance- >$1 mil F. Property- on land G. Sales- on purchases H. Luxury- excise tax on expensive jewelry, planes, boats, cars, china, crystal I. Social Security- on wages/salaries/tips J. Licenses and Fees- Driver’s, hunting, business, toll road/bridge 8. Federal Spending 1. Defense 2. Social Security Federal Taxes/ Revenue 1. Personal Income 2. Social Security 3. Net interest 4. Social Programs 3. Borrowing 4. Corporate Income Government Purchases vs. Government Transfers Percentage of U.S. Output 35 30 27% 25 Government Transfer Payments 31% 5% 12% 22% 19% 20 15 10 Government Purchases 5 0 1960 2005 GLOBAL PERSPECTIVE Total Tax Revenue – Selected Nations Percent of Total Output-2004 10 Sweden Denmark Norway Finland France Italy United Kingdom Germany Canada Australia United States Japan South Korea 20 30 40 50 50.7 49.6 44.9 44.3 43.7 42.2 36.1 34.6 33.0 31.6 25.4 25.3 24.6 Source: Organization for Economic Cooperation and Development Federal Expenditures-2005 Four Stand-Out Areas of Spending 0 10 20 30 Pensions & Income Security 50 35% National Defense 20% 17% Health Interest on the Public Debt 40 7% Source: U. S. Office of Management and Budget Income Tax Characteristics • Progressive Tax Rates • Brackets of Income • Marginal Tax Rate • Average Tax Rate Marginal Income Tax Rates (2009) Taxable Income 10% for the first $8,350 earned, 15% between $8,250 to $33,950, 25% between $33,950 and $82,250, 28% between $82,250 to $171,550, Progressive Tax rates with brackets of income and marginal rates. 33% between $171,550 and $372,950, and 35% above $372,950. Average rates AFTER you take tax deductions and tax credits Federal Tax Revenues-2005 Basic Revenue Sources 0 10 20 Personal Income Tax 50 37% Corporate Income Taxes All Other 40 43% Payroll Taxes Excise Taxes 30 13% 3% 4% Source: U. S. Office of Management and Budget State & Local Spending State & Local Taxes 1. Education 1. Sales 2. Health/ Welfare 2. Property 3. Public Safety 3. Excise 4. Transportation 4. Federal Grants State Government Finances • Primary Revenues • • • Sales & Excise Taxes - 48% Personal Income Taxes - 34% Corporate Income Taxes & License Fees – Most of Balance • Primary Expenditures • • • • • • Education – 35% Public Welfare – 28% Health & Hospitals – 7% Highways – 7% Public Safety – 4% Other – 19% Local Government Finances • Primary Revenues • • Property Taxes – 73% Sales & Excise Taxes – 17% • Primary Expenditures • • • • • Education – 44% Welfare, Health & Hospitals – 12% Public Safety – 11% Housing, Parks, & Sewers – 8% Streets & Highways – 5% U.S. is actually a “low tax” country when compared to other developed countries. Progressive tax- a tax that takes a larger percentage of higher incomes than of lower incomes. Examples: Income, Inheritance, Luxury, Property Impact of Taxes on Income % of Income 50% 20% 10% 0 $1,000 $10,000 $100,000 Income ($) Regressive tax- A tax that takes a larger percentage of lower incomes than of higher incomes. Examples: Sales, Licenses and Fees, Excise, Social Security Impact of Taxes on Income % of Income 40% 20% 5% 0 $1,000 $10,000 $100,000 Income ($) Proportional Tax- A tax that takes the same percentage of income from all workers. Examples: Flat tax proposal for the income tax Impact of Taxes on Income % of Income 20% 0 $1,000 $10,000 $100,000 Income ($) 13. Benefits Received Principle- The people who pay the tax are the ones who directly receive the benefits. Examples: Licenses and Fees, Most Excise Taxes, Social Security 14. Ability to Pay Principle- The amount of tax a person pays is based on how much they can afford to pay. Two types: 1. Based on Wealth- Value of your assets(what you own). Examples: Property, Inheritance 2. Based on Income- How much money you earn now. Examples: Personal Income, Luxury Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad Economic Statistics- Expansionary Policy 3% CPI Increase/ Inflation Rate -2% Growth in RGDP 10% Unemployment Rate What is the problem with the economy? Recession! How do you know this? Unemployment is at a very high rate, higher than it’s normal range of 3-5%. The economy is also shrinking, since the RGDP is negative. Economic Statistics- Expansionary Policy 3% CPI Increase/ Inflation Rate -2% Growth in RGDP 10% Unemployment Rate What can the Congress and the President do to solve/ help this situation? Increase the amount of income for people! This will put more money into the economy and get it expanding again. “Murphy's Law of Economic Policy” ''Economists have the least influence on policy where they know the most and are most agreed; they have the most influence on policy where they know the least and disagree most vehemently.'' Economist Alan Blinder, former vice chair of the Federal Reserve 15. Fiscal Policy- Using Taxes and Government Spending to achieve specific economic goals. 16. Expansionary Fiscal Policy- Efforts by Congress and the President to stimulate the economy and get it expanding. Used during a recession. Tries to increase aggregate demand. 3 “Tools” of Fiscal Policy: 1. Taxes- Decrease 2. Government Spending- Increase 3. Transfer Payments- Increase AD/ AS Graph PL LRAS SRAS0 AD/AS GraphExpansionary Fiscal Policy PL1 John Maynard Keynes PL0 AD0 FE 0 Y0 Y1 AD1 RGDP=Y The economy is below FE at an output of Y0. Congress and the President can: 1. ↑ G 2. ↑ TP 3. ↓ T Expansionary Fiscal Policy pushes AD from AD0 to AD1; PL ↑ from PL0 to PL1, RGDP ↑ from Y0 to Y1. U ↓ because economy has risen to FE. But…Demand-Pull Inflation! Expansionary Fiscal Policy Full $20 Billion Increase in Aggregate Demand Price Level $5 Billion Additional Spending AS Recessions Decrease Aggregate Demand P1 AD1 AD2 $490 $510 Real Domestic Output, GDP Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What is the problem with the economy? Inflation! How do you know this? CPI is going up at a very high rate. Higher than it’s normal range of 2-3%. Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What can the Congress and the President do to solve/ help this situation? Decrease the amount of income for people! This will put less money into the economy and get it to slow down or contract. 17. Contractionary Fiscal Policy- Efforts by Congress and the President to constrict the economy and get it contracting. Used during an expansion with high inflation. Tries to decrease aggregate demand. 3 “Tools” of Fiscal Policy: 1. Taxes- Increase 2. Government Spending- Decrease 3. Transfer Payments- Decrease AD/ AS Graph PL LRAS SRAS0 PL0 PL1 AD/AS GraphContractionary/ Restrictive Fiscal Policy AD0 AD1 FE 0 Y1 Y0 RGDP=Y The economy is above FE at an output of Y0. Congress and the President can: 1. ↓ G 2. ↓TP 3. ↑ T Contractionary Fiscal Policy pushes AD from AD0 to AD1; PL ↓ from PL0 to PL1, RGDP ↓ from Y0 to Y1. U ↑ because economy has decreased to FE. Contractionary Fiscal Policy Recessions Decrease Aggregate Demand $5 Billion Initial Decrease In Spending Price Level AS Full $20 Billion Decrease in Aggregate Demand P1 AD4 AD3 $510 $522 Real Domestic Output, GDP 18. Discretionary Stabilizers- Fiscal policy tools that require Congress and the President to take some action. Examplesincrease or decrease taxes, create or eliminate a tax break, Spend more on infrastructure, weapons, education, NASA, FBI, National Parks 19. Automatic Stabilizers- Fiscal policy tools that do not require Congress and the President to take some action. Examples- Welfare, food stamps, AHCCS, section 8 housing vouchers, other programs based on income, unemployment compensation. U.S. Income-Maintenance System Entitlement Programs Social Security Earned-Income Tax Credit (EITC) Medicare and Medicaid Unemployment Compensation Public Assistance “Welfare” Supplemental Security Income (SSI) Program Temporary Assistance for Needy Families (TANF) Food-Stamp Program Section 8 Housing Vouchers 2009 Stimulus Package by category- Link to larger graphic Problems, Criticisms, and Complications of Fiscal Policy Problems of Timing Political Considerations Recognition Lag Administrative Lag Operational Lag Political Business Cycle Future Policy Reversals Offsetting State and Local Finance Crowding-Out Effect Current Thinking on Fiscal Policy O 11.2 2009 Stimulus Package by year in which money is spent- Link to larger graphic. 20. Barter- Trading of goods and services without the use of money. Not very efficient! It lacks a “coincidence of wants”. Trueques (barter markets) of Argentina Baseball cards! Pogs! Marbles! Sources of Money’s Value Commodity Money- The item used as money has value of it’s own. Ex: Silver, Gold, Gems, Salt, tobacco, furs, shells Sources of Money’s Value Representative Money- The item used as money has value because it can be exchanged for something valuable. Gold and Silver Certificates Sources of Money’s Value Fiat Money- The item used as money has value because the government says it is money AND the citizens accept it is money. Almost all coins and currency today 21. Functions of money 1. Medium of exchange Accepted in trade for G & S 2. Store of value Can be saved for use at a later date 21. Functions of money3. Unit of Account/ Measure of value Easy to judge the worth of different products 4. Standard of Deferred Payment Used as a standard benchmark for specifying future payments for current purchases, that is, buying now and paying later. 22. Characteristics of money- Why do we use certain items as money? 1. Divisibility Easy to break into smaller units 2. Portability Easy to carry or transport 3. Durability Lasts a long time 4. Stability in value Holds its value over time (no/ low inflation!) 23. M1- Measure of the supply of money in circulation. Used by the Federal Reserve and others to measure the growth of money in circulation. Includes the following: 1. Coins and Currency 2. Demand Deposits/ Checking Accounts 3. Traveler’s Checks 24. M2- Another measure of the supply of money. Used for the same reason as M1. Many economists feel it more accurately reflects the "readily available" supply of money(the money that can relatively quickly be turned into cash). M2 includes everything in M1 plus the following major components : 1. Savings Accounts 2. Money Market Accounts (MMA’s) 3. Certificates of Deposit (CD’s) 4. Eurodollars (U.S. $ in Euro banks) 25. M3 = M2 + Large Time Deposits Broadest definition of the money supply M1 M2 Currency + 54% M1 Checkable Deposits + 46% 20% February 2006 Small Time Deposits + 15% Money Market Mutual Funds Held By Individuals + (MMMF) 11% Savings Deposits Including Money Market + Deposit Accounts (MMDA) 54% Totals $1,375 Billion $6,758 Billion The Global Greenback U.S. Currency Circulating Abroad Russians $40 Billion Argentineans $7 Billion Polish $6 Billion U.S. Profits from Dollars Leaving Black Markets and Illegal Activities Seeking Stable Purchasing Power Soviet Union Collapse Brazil Inflation Issues Asian Market Exchanges 26. The Monetary Equation of Exchange MxV = P x Q Money X Velocity = Price Level X Quantity M = M1 Velocity = The number of times a dollar is spent Price Level = The rate of inflation (GDP Price Deflator) Quantity = Real GDP Real GDP (Q) x Price Level (P) = Nominal GDP 27. Money Multiplier = 1/ Reserve Requirement X Initial Deposit Example: If the Fed has a Reserve Requirement of 20% this means 1 ÷ .2 = 5 5 is the money multiplier $1000 initial deposit $800 (80%) in excess reserves and $200 (20%) in required reserves $1000 x 5 = $5000 of money in circulation $800 x 5 = $4000 new money created by the banking SYSTEM (not by 1 bank) $1000 initial deposit + $4000 new money = $5000 in circulation Refer to Money Creation Simulation for more examples Bank (1) Acquired Reserves and Deposits Bank A $100.00 Bank B 80.00 Bank C 64.00 Bank D 51.20 Bank E 40.96 Bank F 32.77 Bank G 26.21 Bank H 20.97 Bank I 16.78 Bank J 13.42 Bank K 10.74 Bank L 8.59 Bank M 6.87 Bank N 5.50 Other Banks 21.99 (2) Required Reserves (Reserve Ratio = .2) (3) Excess Reserves (1)-(2) $20.00 16.00 12.80 10.24 8.19 6.55 5.24 4.20 3.36 2.68 2.15 1.72 1.37 1.10 4.40 $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 (4) Amount Bank Can Lend; New Money Created = (3) $80.00 64.00 51.20 40.96 32.77 26.21 20.97 16.78 13.42 10.74 8.59 6.87 5.50 4.40 17.59 $400.00 Monetary Multiplier or Checkable-Deposit Multiplier Monetary Multiplier = or in Symbols… Graphic Example 1 Required Reserve Ratio 1 m = New Reserves $100 $80 Excess Reserves $400 Bank System Lending Money Created R $20 Required Reserves $100 Initial Deposit The Monetary Multiplier W 13.2 Reversibility Making Loans Creates Money Loan Repayment Destroys Money Multiple Step Money Expansion Multiple Step Destruction of Money AP Macro Exam Tip An injection of $100 of new money to the system when the reserve requirement is 10% will change the money supply by $1000. BUT the banking system increases the money supply by $900 (the $100 difference being the action of the depositor). Students have to be very careful to read the question carefully and understand the two possible answers for the change in the money supply. A third possibility to the $100 of new deposits to the system is "how much can this previously fully loaned out bank immediately increase their loans?" Well now, I might not have the wording that the College Board would use after a two year period crafting the question, but a $100 deposit with a reserve requirement of 10% allows the bank to make a loan of $90. 28. The Federal Reserve(The Fed)- Central bank of the U.S. Privately owned and financed by member banks in the U.S. Very important and powerful. The Fed is given power by law to conduct the following major functions: 1. Check clearing- Clears checks written under one bank and then deposited in another bank. 2. Bank Regulation- Keeps banks honest and depositors' money safe from banks misuse. 3. Providing Currency- Issues, but does not print, new money when banks turn in old, worn out currency. 4. Regulating the money supply(using the 3 tools)Increase or decrease the money supply to fight inflation and / or prevent the economy from entering a recession. 29. Structure of the Fed (Major parts)1. Regional Banks- 12 regional banks; AZ in the 12th district; San Francisco HQ of 12th district; New York most important district. Regional banks are in charge of the 1st 3 functions listed above. 29. Structure of the Fed (Major parts)2. Board of Governors- 7 members, appointed to 14 year terms by the President and confirmed by the Senate. Oversee all operations of the Fed. B of G Building Chairman-Benjamin Bernanke, appointed in 2005 by G. W. Bush, confirmed by Senate 1/31/2006 29. Structure of the Fed (Major parts)3. Federal Open Market Committee (FOMC)- 12 members (7 BofG's and 5 district bank presidents) Decides monetary policy (see below). 7 members, appointed by president, confirmed by the Senate 12 regional bank presidents All 7 of B of G serve on FOMC 5 of the branch presidents serve on the FOMC too, 1 of 5 is always from NY branch Framework of the Federal Reserve System and the Relationship to the Public Board of Governors Federal Open Market Committee 12 Federal Reserve Banks Commercial Banks Thrift Institutions (Savings and Loan Associations, Mutual Savings Banks, Credit Unions) The Public (Households and Businesses) GLOBAL PERSPECTIVE Central Banks, Selected Nations Australia: Canada: Euro Zone: Japan: Mexico: Russia Sweden: United Kingdom: United States: Reserve Bank of Australia (RBA) Bank of Canada Central Bank of Europe (CBE) Bank of Japan (BOJ) Banco de Mexico (Mex Bank) Central Bank of Russia Sveriges Riksbank Bank of England Federal Reserve System (the “Fed”) (12 Regional Federal Reserve Banks) Fed Salary Facts Fed Chairman Makes $191,300 All other members make $172,200. Salaries are not very high when compared to what a private banker could make These numbers are as of January 2008. 30. Monetary Policy- The control of the supply of money by the Fed to achieve specific economic goals. Changing the money supply will cause the aggregate demand curve to shift! 31. The Three (3) Tools of Monetary Policy 1. Open Market Operations (OMO)- Sets the Federal Funds Rate = IR Banks charge Banks Buying and Selling Government Bonds (Securities) Fed Buys bonds Decrease in Fed Funds Rate Increase in $ supply Fed Sells bonds Increase in Fed Funds Rate Decrease in $ supply Buy Bigger, Sell Smaller Tools of Monetary Policy Fed Buys $1,000 Bond from a Commercial Bank New Reserves $1000 $1000 Excess Reserves $5000 Bank System Lending Total Increase in the Money Supply, ($5,000) Tools of Monetary Policy Fed Buys $1,000 Bond from the Public Check is Deposited New Reserves $1000 $800 Excess Reserves $4000 Bank System Lending $200 Required Reserves $1000 Initial Checkable Deposit Total Increase in the Money Supply, ($5000) Federal Funds Rate, Percent Using Open Market Operations To Set The Federal Funds Rate 4.5 Sf3 4.0 Sf1 3.5 Sf2 Df Qf3 Qf1 Qf2 Quantity of Reserves How the Fed’s actions affect all of the participants in the economy 2. Discount Rate (DR)- IR Fed charges Banks Fed decreases DR Banks borrow more $ Banks lend out more $ Increase in $ Supply Fed increases DR Banks borrow less $ Banks lend out less $ decrease in $ Supply Many days, there is less than $100 million in discountwindow loans outstanding. That leapt to almost $46 billion after the Sept. 11, 2001, terrorist attacks on the U.S. disrupted the money markets. Link to change in FFR and DR rates 3. Reserve Requirements (RR)- Fed decreases RR Banks Lend out more $ Increase in $ Supply Fed increases RR Banks Lend out less $ Decrease in $ Supply Link to use of technology to reduce required reserves Money Market- The market for short term lending. Nominal Interest Rate (i) Money Market i0 Money Market GraphMoney Demand Curve i1 MD 0 QM0 QM1 Quantity of Money (QM) The nominal interest rate is the opportunity cost of holding money. As i ↓ ↑ Quantity of MD, ∆ QMD As i ↑ ↓ Quantity of MD, ∆ QMD Money Market Graph The supply of money (MS) is determined by the Fed so it is a fixed amount (perfectly inelastic) Money Market Nominal Interest Rate (i) MS i0 MD 0 QM0 Money demand (MD) slopes downward for 4 reasons: Quantity of Money Transaction Demand- Need to keep money for daily purchases Asset Demand- Need to hold money as an asset, for its liquidity and low risk Speculative Demand- Change the amount of money you hold because you think interest rates will change Precautionary Demand- Need to keep $ to pay for emergencies Demand for Money and the Money Market (a) Transactions Demand for Money, Dt (b) Asset Demand for Money, Da (c) Total Demand for Money, Dm And Supply Rate of Interest, I percent 10 Sm 7.5 = + 5 5 2.5 0 Dt 50 100 Da 150 200 Amount of Money Demanded (Billions of Dollars) 50 100 150 200 Amount of Money Demanded (Billions of Dollars) Dm 50 100 150 200 250 Amount of Money Demanded and Supplied (Billions of Dollars) 300 Interest Rates G 14.1 Equilibrium Interest Rate Interest Rates and Bond Prices Bond Prices Fall When Interest Rates Rise Bond Prices Rise When Interest Rates Fall Inverse Relationship Between Interest Rates and Bond Prices W 14.2 Money Market Money Market Graph∆ MS (shift in MS) An ↑ in MS from MS0 to MS1 → ↓ i from i0 to i1; ↑ QM from QM0 to QM1 A ↓ in MS from MS0 to MS2 → ↑ i from i0 to i2 ↓ QM from QM0 to QM2 Nominal Interest Rate (i) MS2 MS0 MS1 i2 i0 i1 MD 0 QM2 QM0 QM1 Quantity of Money (QM) Money Market Graph- ∆ MD (shift in MD) An ↑ money demand from MD0 to MD1 → ↑ i from i0 to i1 A ↓ money demand from MD0 to MD2 → ↓ i from i0 to i2 Money Market Nominal Interest Rate (i) MS0 i1 i0 i2 MD1 MD2 0 What happens to Quantity of Money? QM0 MD0 Quantity of Money (QM) Money Market Graph Different elasticities of MD Money Market Nominal Interest Rate (i) Country A has a relatively elastic MD. Country B has a relatively inelastic MD. MS0 MS1 i0 i1 MD- Country A i2 MD- Country B 0 QM0 QM1 Quantity of Money Country A (Bolivia)- An ↑ in MS from MS0 to MS1will cause a relatively small ↓ in i from i0 to i1. Country A’s MD is relatively insensitive to ∆ in i. Countries with less developed countries/ economies (LDC’s). Country B (USA)- An ↑in MS from MS0 to MS1will cause a relatively large ↓ in i from i0 to i2. Country B’s MD is relatively sensitive to ∆ in i. Countries with more developed countries/ economies (MDC’s). Different Elasticities of Investment Demand Money Market Nominal Interest Rate (i) MS0 Investment Demand MS1 Nominal Interest Rate (i) Country A i0 i1 Country B IDE MD 0 QM0 QM1 Quantity of Money IDI QI0 QII QIE Quantity of Investment The ↓ in i from i0 to i1 ↑ investment a little in the country A but a lot in country B. A country would rather have an elastic investment D curve, sensitive to changes in i. These would tend to be more developed countries/ economies (MDC’s). Different Elasticities of Money Demand and Investment Demand Money Market Nominal Interest Rate (i) MS0 Nominal Interest Rate (i) MS1 Investment Demand i0 IDE i1 MDI 0 QM0 QM1 Quantity of Money QI0 QIE Quantity of Investment A country would rather have an inelastic (insensitive) money demand curve and an elastic (sensitive) investment demand curve. These would tend to be more developed countries/ economies (MDC’s) Economic Statistics Rules of Thumb aka “The Economic Sweet Spot” Good 1-3% Inflation Bad Bad 3-4% Growth (RGDP) Good Good 4-6% Unemployment Bad Economic Statistics- Expansionary Policy 3% CPI Increase/ Inflation Rate -2% Growth in RGDP 10% Unemployment Rate What is the problem with the economy? Recession! How do you know this? Unemployment is at a very high rate, higher than it’s normal range of 4-6%. The economy is also shrinking, since the RGDP is negative. Economic Statistics- Expansionary Policy 3% Inflation -2% Growth (RGDP) 10% Unemployment What can the Federal Reserve do to solve/ help this situation? Increase the money supply! This will put more money into the economy and get it expanding again. 32. Expansionary Monetary Policy (Easy money) Efforts by the Fed to stimulate the economy and get it expanding. Used during a recession. Tries to increase aggregate demand. 3 “Tools” of Monetary Policy: 1. Open Market Operations (OMO) Fed Buys bonds/ Decreases Fed Funds Rate 2. Discount Rate (DR) Fed decreases DR 3. Reserve Requirements (RR)Fed decreases RR Expansionary Monetary Policy CAUSE-EFFECT CHAIN Problem: Unemployment and Recession Fed Buys Bonds, Lowers Reserve Ratio, or Lowers the Discount Rate Excess Reserves Increase Federal Funds Rate Falls Money Supply Rises Interest Rate Falls Investment Spending Increases Aggregate Demand Increases Real GDP Rises Expansionary Monetary Policy Investment Demand Graph Money Market Graph Nominal Interest Rate (i) MS0 Nominal Interest Rate (i) MS1 i0 i1 MD 0 QM0 QM1 Quantity of Money Money Market- MS ↑ from MS0 to MS1. This ↓ nominal interest rates (i) from i0 to i1 and quantity ↑ from QM0 to QM1 ID QI0 QI1 Quantity of Investment Investment Demand- ↓ i from i0 to i1 → ↑ I from QI0 to QI1. ↑ I → ↑ AD. AD/ AS Graph PL LRAS SRAS0 AD/AS GraphExpansionary Monetary Policy PL1 PL0 AD0 FE 0 Y0 Y1 AD1 RGDP=Y The economy is below FE at an output of Y0. The Fed can: 1. Buy Bonds, ↓ federal funds rate 2. ↓ Discount Rate ↑MS→ ↓IR → ↑C, I → ↑AD 3. ↓ Reserve Requirements Expansionary Monetary Policy pushes AD from AD0 to AD1; PL ↑ from PL0 to PL1, RGDP ↑ from Y0 to Y1. U ↓ because economy has risen to FE. But…Demand-Pull Inflation! Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What is the problem with the economy? Inflation! How do you know this? CPI is going up at a very high rate. Higher than it’s normal range of 1-3%. Economic Statistics- Contractionary Policy 15% CPI Increase/ Inflation Rate 5% Growth in RGDP 4% Unemployment Rate What can the Federal Reserve do to solve/ help this situation? Decrease the money supply! This will put less money into the economy and get it to slow down or contract. 33. Contractionary Monetary Policy (Tight money) - Efforts by the Fed to constrict the economy and slow it down. Used during an expansion with high inflation. Tries to decrease aggregate demand. 3 “Tools” of Monetary Policy: 1. Open Market Operations (OMO) Fed Sells bonds/ Increases Fed Funds Rate 2. Discount Rate (DR) Fed increases DR 3. Reserve Requirements (RR)Fed increases RR Restrictive Monetary Policy CAUSE-EFFECT CHAIN Problem: Inflation Fed Sells Bonds, Increases Reserve Ratio, or Increases the Discount Rate Excess Reserves Decrease Federal Funds Rate Rises Money Supply Falls Interest Rate Rises Investment Spending Decreases Aggregate Demand Decreases Inflation Declines Bank Panics of 1930-1933 Series of Bank Panics Before Deposit Insurance Mass Withdrawals From Fear Move to Cash Reduced Money Supply Through Reduction in Loans Multiple Contraction Slowed Lending and the Economy 1933 National Bank Holiday for One Week Resulted in FDIC and 25% Drop in Money Supply Contributed to the Great Depression Regulation Protects the System Today Contractionary Monetary Policy Investment Demand Graph Money Market Graph Nominal Interest Rate (i) MS1 Nominal Interest Rate (i) MS0 i1 i0 MD 0 QM1 QM0 Quantity of Money Money Market- MS ↓ from MS0 to MS1. This ↑ nominal interest rates (i) from i0 to i1 and quantity ↓ from Q0 to Q1 ID QI1 QI0 Quantity of Investment Investment Demand- ↑ i from i0 to i1 → ↓ I from QI0 to QI1. AD/ AS Graph PL LRAS SRAS0 PL0 PL1 AD0 AD1 FE 0 Y1 AD/AS GraphContractionary/ Restrictive Monetary Policy Y0 RGDP=Y The economy is above FE at an output of Y0. The Fed can: 1. Sell Bonds, ↑ federal funds rate 2. ↑ Discount Rate ↓ MS→ ↑ IR → ↓ C, I → ↓ AD 3. ↑ Reserve Requirements Contractionary Monetary Policy pushes AD from AD0 to AD1; PL ↓ from PL0 to PL1, RGDP ↓ from Y0 to Y1. U ↑ because economy has decreased to FE. Monetary Policy and Equilibrium GDP (a) The Market For Money Sm2 (c) Equilibrium Real GDP and the Price Level Sm3 AS 10 P3 Price Level Rate of Interest, i (Percent) Sm1 (b) Investment Demand 8 6 Dm AD3 I=$25 P2 AD2 I=$20 ID 0 AD1 I=$15 $125 $150 $175 Amount of Money Demanded and Supplied (Billions of Dollars) $15 $20 $25 Amount of Investment, I (Billions of Dollars) Q1 Qf Q3 Real Domestic Product, GDP (Billions of Dollars) Monetary Policy Evaluation and Issues Speed and Flexibility Isolation From Political Pressure Recent U.S. Monetary Policy Problems and Complications Recognition Lag Administrative Lag Operational Lag AD-AS Theory of Price Level - Real Output and Stabilization Policy Input Resources With Prices Productivity Sources LegalInstitutional Environment Consumption (Cd) Aggregate Supply Levels of Output, Employment, Income, and Prices Aggregate Demand Investment (Ig) Net Export Spending (Xn) Government Spending (G) Loanable Funds Market Real Interest Rate (r) Loanable Funds MarketPrimarily, this is the market where lenders make money available to business borrowers to expand their investment in capital. Loanable Funds Market SLF r0 DLF 0 QLF0 Quantity of Loanable Funds Loanable Funds Market Supply of Loanable FundsThe income people have chosen to save or lend out rather than use for consumption. A ∆ savings decisions will shift SLF. Demand for Loanable FundsThe money households and businesses want to borrow. A ∆ investment or consumption decisions will shift DLF. Real Interest Rate (r) Loanable Funds Market SLF r0 DLF 0 QLF0 Quantity of Loanable Funds Loanable Funds Market Determinants of Supply of LF 1.Domestic Saving by Individuals and Business Real Interest Rate (r) Loanable Funds Market SLF 2.Government Budget Surpluses: G<T r0 3. International Savers/ Investors Determinants of Demand of LF 1.Domestic Borrowers, both individuals and business 2.Government Budget Deficit: G > T 3.International Borrowers DLF 0 QLF0 Quantity of Loanable Funds 34. Prime rate- The interest rate that the biggest banks charge their biggest and best customers. When the Fed increases Discount and/ or Federal Funds rate banks raise their Prime rate which causes other rates(car, home loans, etc.) to increase. If the Fed decreases its rates banks do the same with their prime and other rates. Fed ↑ Money Supply Banks borrow more Banks lend/ create more ↓ Prime rate ↓ rates for homes, cars, education ↑ C, I ↑ AD. 35. Budget Deficit- When government spending exceeds government revenue. When the government spends more than it makes. To make up the deficit the government is forced to borrow money. Currently 407 billion (FY2008). A yearly total. Maybe $1.6 Trillion for 2009 Budget Deficit vs. Budget Surplus A deficit exists when Government Spending is > Tax Revenue. So: G > T A surplus exists when Government Spending is < Tax Revenue. So: G < T A balanced budget exists when: Government Spending = Tax Revenue. So: G = T Federal Deficits and Surpluses – 1990 - 2005 as a Percentage of Potential GDP (1) Year (2) Actual Deficit (-) or Surplus (+) (3) Standardized Deficit (-) or Surplus (+) 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 -3.9% -4.4% -4.5% -3.8% -2.9% -2.2% -1.4% -0.3% +0.8% +1.4% +2.5% +1.3% -1.5% -3.4% -3.5% -2.6% -2.2% -2.5% -2.9% -2.9% -2.1% -2.0% -1.2% -1.0% -0.4% +0.1% +1.1% +1.1% -1.1% -2.7% -2.4% -1.8% Source: Congressional Budget Office Federal Budget Deficits and Surpluses Actual and Projected, Fiscal 1992-2012 Actual Projected (as of March 2006) Budget Deficit (-) or Surplus, Billions $300 200 100 0 -100 -200 -300 -400 -500 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 Source: Congressional Budget Office 36. National Debt- The sum of all past budget deficits. Currently $10.6 trillion (November, 2008). Who do we owe the debt to? As of November 2007, Japan ($580 billion), China ($390 billon) and the United Kingdom ($320 bilion) are the biggest foreign holders of our Debt. Debt Held by the Public as a Percent of GDP 1980-2007 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002 2004 2006 Source: Congressional Budget Office, January 2008 118 Percent of Debt Held by the Public Owned by Foreigners (1980-2006) 50% 45% 40% 35% 30% 25% 20% 15% 10% 5% 0% 1987 1990 1993 1996 1999 2002 2005 Source: United States Treasury Department GLOBAL PERSPECTIVE Publicly Held Debt: International Comparisons As a Percentage of GDP - 2005 0 Italy Belgium Japan Germany France United States Hungary Netherlands United Kingdom Spain Canada Poland 20 40 60 80 100 101.3 86.3 80.9 58.8 46.5 45.7 39.6 39.3 39.1 28.7 26.4 17.0 Source: Organization for Economic Cooperation and Development 37. Discretionary Spending- Spending that is not required by law. Examples: ∆Taxes/ Tax deductions, Defense, NASA , Education 38. Entitlement Spending- Spending programs required by law to be paid to anyone who meets criteria set by law. Examples: Social Security, Welfare, Stud. Loans, Food Stamps Growth of programs for baby boomers is a real concern for the future- S.S., Medicare, Medicaid, Prescription Drug Benefit 39. Mandatory Spending = Entitlements + Net Interest on the Debt. Both are required by law. Both growing dramatically because of: 1. ↑ in the deficit more debt 2. Aging Population more spending on Social Security, Medicare, and Medicaid This then puts a squeeze on discretionary spending such as defense, NASA, national parks, law enforcement, education, etc. 40. Transfer payments- Payments made to individuals/ households by the government. Examples: S.S, Welfare, Stud. Loans, Food Stamps Composition of Actual FY 2007 Federal Government Revenues and Outlays (Deficit: $163 Billion) 2,750 2,500 Billions of Dollars 2,250 Interest 238 Domestic* 493 Defense 549 26 138 1,500 1,250 Other Entitlements 309 Medicare & Medicaid 561 Other Taxes 370 Corporate Taxes 870 Social Insurance Taxes 2,000 1,750 Estate & Gift Taxes 1,000 750 1163 500 250 Social Security Individual Income Taxes 581 0 Outlays: $2.73 trillion Revenue: $2.57 trillion *Includes all appropriated domestic spending such as education, transportation, homeland security, housing assistance, and foreign aid. Source: CBO 2008. Percentage of Population Aged 65 and Over America’s Population is Aging Population age 65 and Over 25% 20% 15% 10% 5% 0% 2007 2012 2017 2022 2027 Year Source: Social Security and Medicare Trustees’ Report, April 2007 2032 2037 2042 2047 Americans are living longer and having fewer children Consequently, fewer workers are available to support each Social Security recipient 1960: 5.1 to 1 Today: 3.3 to 1 2040: 2.1 to 1 Source: Social Security Administration, April 2007 130 Medicare Costs Soar in the Coming Decades 12 10 8 6 4 2 0 2007 2010 2020 2030 2040 2050 2060 2070 2080 Calendar Year General Revenues required to fund the program Income from dedicated taxes, premiums, and state transfers Source: Medicare Trustees’ Report, 2008 131 Mandatory spending is consuming a growing share of the budget 1967 1987 26% 68% 44% 2007 42% 38% 53% 7% 14% Mandatory Net Interest 9% Discretionary Source: Congressional Budget Office, January 2008 NOTE: Numbers may not add up due to rounding. Social Security, Medicare, & Medicaid as a Percentage of the Federal Budget All other Federal Spending Social Security, Medicare and Medicaid $1.6 Trillion $1.1 Trillion 58% 42% Source: Congressional Budget Office, January 2008. Outlays of Select Mandatory Spending Programs (FY 2008 Projected) $700 $600 $ Billions $500 $400 $300 $200 $100 $0 Social Medicare Medicaid Federal Unemploy- Earned Security Retirement ment Income & & Disability Comp. Child Tax Credits Food Stamps Family Support Child Nutrition Source: Congressional Budget Office, January 2008 Change in Composition of Discretionary Spending 1967 1987 32% 36% 68% 64% Defense 2007 47% 53% Non-defense Source: Congressional Budget Office, January 2008 135 Defense Discretionary Spending as a Percentage of GDP 10.0 As a Percentage of GDP 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1965 1968 1971 1974 1977 1980 1983 1986 1989 1992 1995 1998 2001 2004 2007 Source: Congressional Budget Office, January 2008 136 Outlays of Select Discretionary Non-Defense Programs (FY 2008 Projected) $90 $80 $70 $ Billions $60 $50 $40 $30 $20 $10 $0 Education Transportation *includes ground, air, and water Income Security Natural Resources & Env. Veterans Foreign Aid Homeland Security Science, Space, & Technology Source: Congressional Budget Office, January 2008 137 Automatic Growth in the Big Three Entitlements Swamps Growth of Appropriations 10 Year Growth in Social Security, Medicare and Medicaid Increase Over 2007 Level of Funding In Billions of Dollars $1,250 $1,000 $750 $500 $250 $0 2008 2009 2010 2011 2012 2013 2014 2015 Year 2016 2017 2009-2018 Spending for Social Security, Medicare and Medicaid. $5.9 trillion Discretionary Spending $1.9 trillion Source: Congressional Budget Office, January 2008. 2018 Current fiscal policy is on an unsustainable path Interest All Other Medicaid Average tax revenue Medicare Social Security Source: Government Accountability Office, March 2008 Social Security, Medicare, Medicaid and Interest Consume All Federal Revenues in Less Than 20 Years Percentage of Revenues 125% 100% 75% 50% 25% 0% 2003 2008 2013 Year 2018 Social Security, Medicare and Medicaid Source: GAO. 2008. 2023 2028 Interest Balanced Budget There are good economic reasons (crowding out) for a balanced budget. A balanced budget exists when: Government Spending is = Tax Revenue. So: G = T Balanced Budget A deficit exists when Government Spending is > Tax Revenue. So: G > T So, to have a balanced budget the government must: ↓ G or ↑ T or ↓ Transfer payments Crowding Out Illustrated Federal Government engages in expansionary fiscal policy to close the recessionary gap. ↑TP, ↓ T → ↑ DPI → ↑ C, I → ↑ AD AD/AS Graph PL LRAS SRAS0 ↑ G → ↑ AD PL ↑ from PL0 to PL1 RGDP ↑ from Y0 to Y1 PL1 PL0 AD0 FE 0 Y0 R Gap Y1 AD1 RGDP=Y U ↓ because the economy has moved up to FE. The recessionary gap is gone! 41. Crowding Out effect- Federal government spends more than it makes (taxes) It must borrow the rest. The rise in interest rates caused by increased borrowing by the federal government. Since the Gov is borrowing more the D for loanable funds ↑ from DLF0 to DLF1 and real interest rates increase from r0 to r1. Q of loanable funds ↑ from Q0 to Q1. Loanable Funds Market Real Interest Rate (r) SLF r1 r0 DLF1 (Private + Public Debt) DLF0 (Private Debt) 0 QPrivate Q 0 Q1 Quantity of Loanable Funds Because of the ↑ in r the Qd of loanable funds available for private borrowing ↓ from Q0 to QPrivate. Crowding Out effect- Loanable Funds and Investment Demand Loanable Funds Market Real Interest Rate (r) SLF Real Interest Rate (r) Investment Demand r1 r0 DLF1 DLF0 0 QLF0 QLF1 Quantity of Loanable Funds ID0 QI1 QI0 Quantity of Investment Demand D for loanable funds has ↑ from The ↑ in real interest rates will DLF0 to DLF1 and real interest cause the Q of Investment rates have ↑ from r0 to r 1. demand to ↓ from QI0 to QI1. Crowding Out effect- Money Market and Investment Demand Money Market Nominal Interest Rate (i) Nominal Interest Rate (i) MS0 Investment Demand i1 i0 MD1 ID MD0 0 QM0 Quantity of Money MD has ↑ from MD0 to MD1 and nominal interest rates have ↑ from i0 to i1. QI1 QI0 Quantity of Investment Demand The ↑ in nominal interest rates will cause the Q of Investment Demand to ↓ from QI0 to QI1. Effect of crowding out on the economy Because of the↑ r → ↓ I AD/ AS Graph PL LRAS SRAS0 → ↓ AD from AD1 to AD2 PL ↓ from PL1 to PL2 PL1 PL2 RGDP ↓ from Y1 to Y2 PL0 AD0 FE 0 Y0 Y2 Y1 AD2 AD1 RGDP=Y Recessionary gap is partially restored U ↑ because you have moved back below FE The Investment Demand Curve and the Crowding-Out Effect A Large Public Debt to Finance Public Investment Will Cause… 16 If Public Spending Spurs More Private Investment Will Increase to ID2 Real Interest Rate (Percent) 14 12 b 10 c 8 a 6 Interest Rate Rise Will 4 Decrease 2 Investment a to b 0 5 10 CrowdingOut Effect ID2 ID1 15 20 25 30 35 Investment Demand (Billions of Dollars) 40 42. Crowding In effect- The decrease in interest rates caused by decreased borrowing by the federal government. Federal government spends less and raises taxes. It needs to borrow less OR if Tax revenue > spending (A budget surplus) it does not need to borrow at all. Real Interest Rate (r) Loanable Funds Market SLF r0 r1 Since the Gov is borrowing less the D for loanable funds ↓ from DLF0 to DLF1 and real interest rates decrease from r0 to r1. DLF0 DLF1 0 Q1 Q0 Quantity of Loanable Funds ↓ r means I ↑ so AD ↑ and RGDP ↑. Phillips Curve (Short run) Phillips Curve Inflation Rate Tradeoff between inflation and unemployment Fiscal policy- ↓ T, ↑ TP or G ↓ Unemployment from U0 to U1→ ↑ Inflation from I0 to I1 PL I1 I0 AD/ AS Graph LRAS SRAS0 SRPC 0 PL1 PL0 AD0 FE 0 Y0 Y1 R Gap AD1 RGDP=Y U1 U0 Unemployment Rate Same as ↑ in AD on AD/AS graph 1930’s-1970’s: Keynesian theory reigns supreme 1970’s-2000’s: Classical theory rebounds with: Monetarism and Rational Expectations Theory (RET) but…. Crisis of 20082009: New Keynesians rebound April 13 (Bloomberg) -- Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money. Bernanke’s gamble that the highest jobless rate in 25 years and the most idle factory capacity on record will hold down inflation is straight out of the late British economist Keynes. Should late Nobel-prize-winner Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” prove right, the $1 trillion or more in liquidity Bernanke has pumped into the financial system by expanding the Fed’s balance sheet may leave him to cope with surging consumer prices. So far, investors and economic data both back up the BernankeKeynes view. The market in Treasury Inflation-Protected Securities as of April 6 indicated long-term inflation expectations of 2.5 percent, below the 2.8 percent average inflation rate of the past 10 years. Helicopter Ben Central Bank rate cuts are occurring worldwide October , 2008 Animated Phillips Curve SRAS1 PL LRAS1 LRAS0 SRAS0 PL1 PL0 AD FE1 0 Y1 FE0 Y0 RGDP=Y Supply Shock An unexpected shock to the economic system such as a ↓ in availability of oil or food supplies causes LRAS/SRAS to ↓, PL ↑, RGDP ↓, U Rate ↑. What’s the problem? High prices and high unemployment at the same time! The worst of all economic worlds. This tends to then lead to an ↑ in inflationary expectations which causes us to demand ↑wages which ↑costs of production but… → ? More stagflation! Phillips Curve (short run) Inflation Rate Phillips Curve Tradeoff between inflation and Unemployment ↑ in SRPC from SRPC0 to SRPC1 caused by stagflation (↓ in LRAS/ SRAS) SRPC1 Unemployment AND Inflation both ↑ SRPC0 SRPC2 0 ↓ in SRPC from SRPC0 to SRPC2 caused by ↑ in technology or other LRAS determinants (↑ in LRAS/ SRAS) Unemployment AND Inflation both ↓ Unemployment Rate Phillips Curve Phillips Curve (long run) Inflation Rate LRPC Phelps- Friedman hypothesis- There is a “natural rate of unemployment (NAIRU!) that the economy will always return to. C B Exp Fiscal Policy can ↓ U temporarily, from A to B. However, according to the theory of NAIRU, this is a short-run tradeoff b/c it will ↑ inflation expectations, shifting SRPC0 to SRPC1 and moving equilibrium from B to C. ↓ in U below the "Natural Rate" will be temporary, and lead only to higher inflation in the long run. SRPC1 A SRPC0 0 NAIRU Unemployment Rate Movement along the SRPC (from A to B) is caused by AD shift A shift in the SRPC (SRPC0 to SRPC1) is caused by AS shift The Long-Run Vertical Phillips Curve PCLR Annual Rate of Inflation (Percent) 15 PC3 12 b3 PC2 9 a3 b2 PC1 6 a2 c3 a1 c2 b1 3 0 3 4 5 Unemployment Rate (Percent) 6 AD/ AS Graph PL SRAS1 LRAS PL2 SRAS0 C AD/AS GraphPhillips curve equivalent B PL1 A PL0 FE 0 Y0 AD0 Y1 AD1 RGDP=Y Expansionary Fiscal/ Monetary Policy pushes AD from AD0 to AD1; PL ↑ from PL0 to PL1, RGDP ↑ from Y0 to Y1. Move from A to B → Demand-Pull Inflation! Real wages decrease! Inflation causes resource prices to ↑ (nominal wages ↑ so real wages go back ↑), which shifts SRAS from SRAS0 to SRAS1. The economy ↓ to LRE/ FE at Y0 but at a ↑ PL, PL2. Move from B to C → Cost-Push Inflation! Taxation and Aggregate Supply Supply-Side Economics- attempts to ↑LRAS/SRAS Δ Tax Incentives to encourage Work Δ Tax Incentives to encourage Saving and Investing to provide more $$$ for R & D, infrastructure, capital projects The Laffer Curve 100 Tax Rate (Percent) n Laffer Curve m m l Maximum Tax Revenue 0 Tax Revenue (Dollars) Taxation and Aggregate Supply Criticisms of The Laffer Curve Taxes, Incentives, and Time Inflation and Higher Real Interest Rates Position on the Curve From Short Run To Long Run Demand-Pull Inflation in the Extended AD-AS Model AS2 Price Level ASLR AS1 b P3 c P2 a P1 AD2 AD1 Qf Real Domestic Output From Short Run To Long Run Cost-Push Inflation in the Extended AD-AS Model If Government Counters Recession With Spending… If Government Ignores Recession… Price Level ASLR AS1 c P3 P2 AS2 b a P1 AD2 AD1 Qf Real Domestic Output From Short Run To Long Run Recession in the Extended AD-AS Model Price Level ASLR AS2 a P1 P2 AS1 b c P3 AD1 AD2 Q1 Qf Real Domestic Output Intentionally Blank AD/ AS Graph SRAS0 PL LRAS PL0 SRAS1 A AD/AS GraphPhillips curve equivalent B PL1 C PL2 AD0 FE 0 Y1 Y0 AD1 RGDP=Y Contractionary Fiscal/Monetary Policy pushes AD from AD0 to AD1; PL ↓ from PL0 to PL1, RGDP ↓ from Y0 to Y1. Move from A to B. Real wages increase! ↓ PL causes resource prices to ↓ (nominal wages ↓ so real wages go back ↓), which shifts SRAS from SRAS0 to SRAS1. The economy ↑ to LRE/ FE at Y0 but at a ↓ PL, PL2. Move from B to C Does the Economy Self-Correct? O 17.3 New Classical View of SelfCorrection Rational Expectations Theory New Classical Economics Speed of Adjustment Unanticipated Price-Level Changes Price-Level Surprises Fully Anticipated Price-Level Changes G 17.1 Does the Economy Self-Correct? New Classical View of Self-Correction ASLR AS2 Price Level AS1 c P3 b P2 P1 a AD2 AD1 Q1 Q2 Real Domestic Output Does the Economy Self-Correct? New Classical View of Self-Correction ASLR Price Level AS1 AS3 P1 P4 f a d P5 e AD1 AD3 Q4 Q3 Q1 Real Domestic Output Does the Economy Self-Correct? Mainstream View of Self-Correction Downward Wage Inflexibility Efficiency Wage Theory Greater Work Effort Lower Supervision Costs Reduced Job Turnover Insider-Outsider Relationships Insider-Outsider Theory O 17.4 AD/ AS Graph PL SRAS1 LRAS PL2 SRAS0 New Classical/ RET View of ↑ in AD C B PL1 RET= Rational Expectations Theory A PL0 FE 0 Y0 AD0 Y1 AD1 RGDP=Y New Classical View- Because of wage and price flexibility, Unanticipated ↑ in AD Demand-Pull Inflation from Pt. A to B Cost-Push Inflation from B to C, self-correction happens very fast b/c info is very accessible so behavior changes fast! Anticipated ↑ in AD leads from A to C immediately. AS is a vertical line at LRAS. Since economy self-corrects then government should keep out! AD/ AS Graph RET= Rational Expectations Theory PL SRAS1 LRAS F PL2 SRAS0 A D PL3 New Classical/ RET v. Mainstream/ Keynesian View B PL1 A PL0 FE 0 Y2 Y3 Y0 AD1 Y1 AD0 RGDP=Y New Classical View- Because of wage and price flexibility, Demand-Pull Inflation from Pt. A to B Cost-Push Inflation from B to C, self-correction happens very fast b/c info is very accessible so behavior changes fast! Mainstream view- If prices are inflexible (“Sticky”) the PL stays at PL2 and RGDP/output falls to Y2 ( Pt. F) OR Mainstream view- If PL eventually ↓to PL3 RGDP/output still falls (to Y3) b/c wage inflexibility prevents SRAS from ↓