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Introduction to Economics The US Economy Economics in the News Los Angeles Times October 29, 2002 Page A-1 California State Budget and the UC Budget, Lecture Nine Wall Street Journal October 30, 2002 Page Chapter 25 • Keynesian Economics Determining GDP • GDP is determined where the C + I line intersects the 45line. • At that level of output, y*, desired spending equals output. Chapter 30 • The Dynamics of Inflation and Unemployment Money Growth, Inflation, and Interest Rates • When the public holds expectations of inflation, real and nominal rates of interest will differ. Nominal rate of interest Real rate of = interest + Expected rate of inflation • In the long run, changes in the money supply do not affect real variables, including the real interest rate. But nominal rates, which depend on the rate of inflation, will be affected by the growth of the money supply. The Quantity Equation • The equation of exchange, or quantity equation, links the money supply and velocity to nominal GDP: money supply x velocity nominal GDP MxV Pxy • If velocity is predictable, we can use the quantity equation and the supply of money to predict nominal GDP, or the value of spending, on the right side of the equation. Chapter 27 • Money, the Banking System and the Fed The Role of the Federal Reserve in the Money Creation Process • Open market purchases: The Fed’s purchase of government bonds, which increases the money supply. • Open market sales: The Fed’s sales of government bonds to the public, which decreases the money supply. Using Concepts to Illustrate the US Economy in Fall 2002 • Production Possibility Frontier Tool: Illustrate the War on Terrorism – Lecture Eight Guns or Butter War Front: “Guns” This year Last Year Production Possibility Frontier: Real GDP Govt.: Tax it away or borrow to buy it away Opportunity cost of war in“butter” Home Front: “Butter” Using Concepts to Illustrate the US Economy in Fall 2002 • Production Possibility Frontier Tool: Illustrate that the Government wants more guns and butter, and spends on both increasing nominal GDP faster then real GDP – Lecture Eight Guns or Butter War Front: “Guns” Government. Wish Nominal GDP Production Possibility Frontier: Real GDP Govt.: Tax it away or borrow to buy it away Home Front: “Butter” Is Inflation on the Way? • Measure GDP in current (nominal) $ • But how much of the change from year to year is a change in output and how much is a change in prices? • GDP(nominal) = GDP Deflator x GDP(real) GDP Deflator: Percentage Change Source: http://www.yardeni.com Lecture Eight Lecture 5 Inflation Http://stats.bls.gov/eag/eag.us.htm Using Concepts to Illustrate the US Economy in Fall 2002 • Production Possibility Frontier: Real GDP Could be Getting Ready to Decline-Double Dip Recession? Less Guns and Butter? War Front: “Guns” Production Possibility Frontier: Real GDP Home Front: “Butter” Lab Five: Http://www.economagic.com Using Concepts to Illustrate the US Economy in Fall 2002 • What are the Policy Options to Fight Recession – Fiscal Policy: Lecture Seven Bust Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I +G Total Expenditure GDP Line Aggregate Expenditure Unemployment Rate Oct. 2000 = 3.9% 45 0 Unemployment Rate Sept 2001 = 4.9 % GDP = Y National Income, Y Bust Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I +G Total Expenditure GDP Line Aggregate Expenditure 45 0 GDP = Y Lecture Seven National Income, Y National Income and Product Accounts (NIPA)-Ch. 20 Percent Change in Real (Constant $) GDP with Component 01 II 01 III 01 IV 02 I 02 II Consumption 1.4 1.5 6.0 3.1 1.8 Investment -17.6 -5.2 -17.3 18.2 7.9 Government 5.6 -1.1 10.5 5.6 1.4 Net Exports - Total: GDP -1.6 -0.3 2.7 5.0 1.3 Federal Government Spending Source: http://www.yardeni.com Federal Government Surplus or Deficit in Billions of $ 300 200 Billions of $ 100 0 1965 1970 1975 1980 1985 -100 -200 -300 -400 Year 1990 1995 2000 2005 Personal Savings Rate: Income = Consumption + Savings Source: http://www.yardeni.com Retail Sales in Trillions of Dollars Source: http://www.yardeni.com Policy Option: Reassure the Public “The only thing we have to fear is fear itself” Franklin Delano Roosevelt Lecture Seven Bust Consumption, C Investment, I GDP Income = expenditure I.e. Y = GDP GDP = C + I +G Total Expenditure GDP Line Aggregate Expenditure Unemployment Rate Oct. 2000 = 3.9% 45 0 Unemployment Rate Sept 2001 = 4.9 % GDP = Y Lecture Seven National Income, Y Using Concepts to Illustrate the US Economy in Fall 2002 • What are the Policy Options to Fight Recession – Monetary Policy: Lecture Nine The Federal Reserve System: Purposes & Functions http://www.bog.frb.fed.us/ PDF format: Adobe Acrobat The Federal Reserve System: Purposes & Functions http://www.bog.frb.fed.us/ PDF format: Adobe Acrobat Impact of the Supply of Reserves on the Federal Funds Rate FFR, price of reserves Demand for Reserves by Banks Supply of Reserves: Fed quantity of reserves Fed: Lender of Last Resort to Banks at Discount Rate, 00-02 Source: Federal Reserve Bank of Minneapolis The Federal Reserve • Maintaining Liquidity: The Growth of the Money Supply The Annual Rate of Growth of M1 Source: http://www.yardeni.com Definitions of Money • M1(a measure of media of exchange) = – currency held by the public, outside of banks – checkable deposits • demand deposits • NOW (negotiable order of withdrawal) accounts – savings & loans, mutual savings banks – traveler’s checks • M2 = M1 + Lecture Nine – money market accounts at banks – money market mutual fund accounts – certificates of deposit, CD’s, less than $100,000 • M3 = M2 + CD’s over $100,000 Consumer Credit Outstanding as a % of Disposable Personal Income (Ch. 25) Source: http://www.yardeni.com Using Concepts to Illustrate the US Economy in Fall 2002 • What has been the economic impact of the “War on America”? – Destruction of income (flow) – Destruction of wealth (stock) The Direct Loss of Income • 3000 fatalities • @ $100,000 per year income • $ 0.3 billion The Indirect Loss of Income: Potential GDP • Full employment of labor • Full employment of capital Lab Three: National Income and Product Accounts (NIPA)-Ch. 20 Billions of Current $, Seasonally Adjusted at Annual Rates 01 III 01 IV 02 I 02 II Consumption 6983.7 7099.9 7174.2 7254.7 Investment 1574.9 1500.7 1559.4 1588.0 Government 1851.7 1896.8 1939.5 1959.8 Net Exports -312.6 -344.5 -425.6 Total: GDP 10097.7 10152.9 10313.1 -360.1 10376.9 GDP is Gross Domestic Product The Indirect Loss of Income: Potential GDP • Full employment of labor – unemployment rate has gone from 4 % to 5% – Say we lost 1 % of national income, 2002II $10377 billion, would be $104 billion • Full employment of capital Capacity Utilization Source: http://www.yardeni.com How Much of the Loss is Attributable to the Attack • As of August 22, the Survey of Professional Forecasters were still relatively optimistic – Calling for a growth rate in real GDP of 2.4% in 2002QIII – calling for a growth rate in real GDP of 2.6% in 2002 QIV Survey of Professional Forecasters 2002 Q3 2002 Q4 2003 Q1 Growth Rate Real GDP Inflation Rate CPI Unemployment Rate 2.4% 2.6% 3.4% 2.0% 2.1% 2.3% 6.0% 6.0% 5.8% http://www.phil.frb.org/ Survey of Consumer Confidence • For October 79.4, down 14.3 point dive in one month (1985 =100). Lowest index in nine years Index of Consumer Confidence Lecture Six, updated Midterms • Essay Questions Midterm Study Question • Economists are expecting a decline in GDP for the 3rd quarter of 2001, with perhaps continuing decline in GDP for the fourth quarter. – What are some of the similarities in the decline of expenditure components now and in the 1930’s? – What is a major difference in the behavior of expenditure components now and in the great depression? – How do economic policies differ between the two periods? Lecture Seven 1998 Midterm Part IV ( 28 points) Answer both essay questions. 1. One reason for the Great Depression was a sharp drop in consumer spending. a. Assuming the economy was initially at the full employment level of output, describe the effect of a drop in consumer spending. b. What was Keynes’ policy recommendation for escaping from the Great Depression? 2. Opinions about the US economy have been quite changeable this Fall quarter. At the moment, the rate of growth of the economy is slowing, but growth is still positive. How would you satisfy yourself whether a recession might be coming or not? How would you assess whether the likelihood of a recession in 1999 is low? or high? a. What conceptual framework would you use to answer this question about a prospective recession? b. What data and which economic measures or statistics would you look at? c. How would you deal with the fact that you need a “crystal ball” to see into 1999 and the future? Midterms • Graphical Questions Part III (20 points) Answer both questions. 1. This is a Keynesian economics diagram of the determination of equilibrium GDP. Aggregate Expenditures 45 degrees Full Employment Income Aggregate Income a. Label the aggregate expenditures line b. Label the equilibrium condition line, for which aggregate expenditures equals aggregate income, i.e. GDP = Y. c. On this diagram, indicate the equilibrium level of aggregate income, Yeq . d. Is this equilibrium level of income higher or lower than the full employment level of income? ________________. e. Given your answer to part d, does this indicate a recession or an inflationary boom? ____________________. 2. This diagram illustrates the market for reserves and the determination of the federal funds rate. This is the rate which commercial banks charge one another for borrowing, usually overnight. Federal Funds Rate Quantity of Reserves a. Label the demand curve for reserves. b. Which institution(s) demand(s) reserves?______________ c. Label the supply curve for reserves. d. Which institution(s) affect(s) the supply curve for reserves?_______________ e. If the Federal Reserve raises the ratio of required reserves to deposits, which curve will shift to the right, resulting in a _______________ federal funds rate? ____________.. Wall Street Journal October 30, 2002 Page