Download Lecture9 - UCSB Economics

Introduction to Economics
Macroeconomics
The US Economy
Llad Phillips
1
Quiz: Median = 32
Score
39-40
37-38
35-36
33-34
30-32
27-29
24-26
21-23
-20
Grade
A
AB+
B
BC+
C
CD+
Number
8
12
18
21
31
16
14
8
3
Outline
Economics in the News
 Review of Chapters 20, 21, and 24
 The banking system and the Federal Reserve
 Monetary Policy: Does the Fed get the timing
right?

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Conference Board
Index of Consumer Confidence falls 14.3
points in September to lowest level since
1993!
 Index is at 79.3 (1985=100)
 Is consumer spending going to collapse?
 Is it going to be a rough Christmas for
retailers?

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Impact of the Business Cycle on
the Public Sector

The University of California
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California State Budget

Governor Davis Warns of a 15% Budget Cut
for 2002-2003
 Daily

Nexus, Thursday October 13, 2001
Policy Implications: Raising Student Fees?
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UC Budget, General Fund Component, Millions of Nominal $
4000
3500
3000
2000
1500
1000
500
0
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
$
2500
Fiscal Year
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How has UC Fared Over Time?
Does UC get a fair share of state money?
 UC Budget Share = UC Budget/CA Gen Fund

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UC Share of CA General Fund Budget
8.00%
7.00%
6.00%
4.00%
3.00%
2.00%
1.00%
0.00%
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
Percent
5.00%
Fiscal Year
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Trends in California Government
Proposition 13 (1970’s): limited local
property tax, shifted fiscal power to the state
 Gann Initiative(1970’s): tried to limit state
government to constant real expenditures
per person, ie limit the size of government
 Relative Size of Government = CA Gen
Fund Expenditures/ CA Personal Income

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CA General Fund Expenditures As a % of CA Personal Income
8.00%
7.00%
6.00%
4.00%
3.00%
2.00%
1.00%
0.00%
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
Percent
5.00%
Fiscal Year
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UC Budget Forecast for 2002-2003
UC Budget, GEN FUND = UC Budget Share x Relative Size
of Government x CA Personal Income
UC Budget = (UC Budget/CA Gen Fund) x ( CA Gen Fund/
CA Personal Income) x CA Personal Income
UC Budget, GEN Fund = 0.045 x 0.07 x CA Personal Income
68
-6
9
70
-7
1
72
-7
3
74
-7
5
76
-7
7
78
-7
9
80
-8
1
82
-8
3
84
-8
5
86
-8
7
88
-8
9
90
-9
1
92
-9
3
94
-9
5
96
-9
7
98
-9
9
00
-0
1
00
-0
3
Billions $
CA Personal Income, Billions of Nominal $
1200
1000
800
600
400
200
0
Fiscal Year
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Chapter 20
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Production, Income,
and the Circular Flow

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The circular flow
diagram shows how
production of goods
and services
generates income
for households and
how households
purchase goods and
services produced
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by firms.
U.S. Real GDP
1930-2000
• Real GDP has
grown
substantially
over this period.
Consumption Expenditures

Consumption expenditures are purchases of
newly produced goods and services by
households. Consumption is broken down into:
• Durable goods that last for a long time.
• Nondurable goods that last for a short time.
• Services that reflect work done in which
people play a prominent role in the delivery.
• Consumption comprises 67% of total purchases.
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U.S. Trade Balance as a Share of
GDP, 1960 - 2000
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Who Gets the Income?
Composition of U.S. National Income, Second
Quarter 2000 (billions of dollars)
National income
7,983
Compensation of employees
5,603
Corporate profits
964
Rental income
141
Proprietor’s income
709
Net interest
566
• Approximately 70% of all national income goes
to workers in the form of wages and benefits.
GDP as a Measure of Welfare

GDP is our best measure of the value of
output produced, but not a perfect measure.
There are several recognized flaws in the
construction of GDP:
3) GDP ignores the underground economy,
where transactions are not reported to
official authorities.
4) Finally, GDP does not value changes in the
environment that arise from the production
of output.
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Chapter 21
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Definitions

The unemployment rate is the percentage of
people in the labor force who are
unemployed.
• The labor force participation rate is the
fraction of the population that is over 16 years
of age that is in the labor force.
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U.S. Inflation Rate, 1950-2000,
Based on Chain Price Index
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Chapter 24
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Business Cycles
and Economic Fluctuations

A recession is a period when real GDP falls
for two consecutive quarters. It starts at the
peak of an increase in output, and ends at a
trough, the time at which output stops
falling in a recession.
• A depression is a prolonged period of decline
in output, or a severe recession. During the
Great Depression, 1929 through 1933, real
GDP fell by over 33%, and unemployment
rose to 25%.
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The 1990 Recession
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Nine Postwar Recessions
Peak
November 1948
July 1953
August 1957
April 1960
December 1969
November 1973
January 1980
July 1981
July 1990
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Trough
October 1949
May 1954
April 1958
February 1961
November 1970
March 1975
July 1980
November 1982
March 1991
Percent Decline
in Real GDP
1.5
3.2
3.3
1.2
1.0
4.9
2.5
3.0
1.4
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The Unemployment Rate
During Recessions

During periods
of recession,
marked by the
shaded bars,
unemployment
rises sharply.
Money, the Banking System and
the Federal Reserve

What is money?
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The Functions of Money

medium of exchange
 instead
of barter, i.e. exchange of goods &
services for goods and services, we can
exchange goods & services for money and vice
versa
 eliminates
the search costs & inconvenience of
barter

store of value
 we
can hold money as an asset
 because
it is a medium of exchange, it is liquid, i.e.
we can convert money into goods & assets quickly

unit of account
measure of value, “ a dollar’s worth of ...”

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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 +
 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
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Summary of Monetary Policy
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The Federal Reserve System: Purposes & Functions
http://www.bog.frb.fed.us/
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PDF format: Adobe Acrobat
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The Federal Reserve System: Purposes & Functions
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http://www.bog.frb.fed.us/
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PDF format: Adobe Acrobat
How Effective Has the Fed Been?

Fed Goals: A Stable Economy
 maximum
employment
 stable prices
 moderate long-term interest rates

Fed Objectives or Targets
 quantity
of reserves
 price of reserves: Federal Funds Rate
 federal
funds rate, FFR, is the interest rate banks
charge one another for borrowing reserves for a day
or so; mostly large urban banks borrowing from
small suburban and rural banks
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Misery Index = Unemployment Rate + Inflation Rate
Misery Index: 1929-1996 .
25
20
Index
15
10
5
Hoover
Roosevelt
Truman
Ike
Year
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
29
0
LBJ Nixon/
Reagan Bush
JFK
Clinton
Ford Carter
How Effective Has the Fed Been?
 Fed
Objectives or Targets
quantity
of reserves
price of reserves: Federal Funds Rate
 federal
funds rate, FFR, is the interest rate
banks charge one another for borrowing
reserves for a day or so; mostly large urban
banks borrowing from small suburban and
rural banks
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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
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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
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Fed: Lender of Last Resort to Banks at Discount Rate, 00-02
Source: Federal Reserve Bank of Minneapolis
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Nation’s Commercial Banks, 10/22/01
Assets $B
Liabilities
Com Loans
1050.1 Trans Dep 634.4
Pers Loans
559.1 Sav Dep
3530.2
Real Estate L 1723.3 Dep>$100K 970.2
Home Equity L 148.6
US Gov Sec
817.4
Other Sec
649.2
Total
4947.7
Bank Loans (credit) = $3928.8 B, WSJ 10/22/2001, p. C 2
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What is at stake?
US Postwar Expansions
Trough - Peak
Duration, Months
Oct. ‘45 - Nov. ‘48
37
Oct. ‘49 - July ‘53
45
May ‘54 - Aug. ‘57
39
April ‘58 - April ‘60
24
Feb. ‘61 - Dec. ‘69
106
Nov. 70 - Nov. ‘73
36
March ‘75 - Jan. ‘80
58
July’80 - July ‘81
12
Nov. ‘82 - July ‘90
92
March ‘91 – April ‘01
121
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Monetary Policy Tradeoff
Is the Fed too Inflation Oriented?
 Note: the CPI inflation rate tends to
decrease during and after recessions

 to
control inflation, the Fed may be tempted
into policies that precipitate recessions and/or
make them more severe

Note: the unemployment rate tends to
increase during and after recessions
 some
critics in Congress think the Fed is too
restrictive, i.e. not sufficiently expansionary in
policy
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Other Measures of Fed Effectiveness

Reserve Aggregates
 Excess
Reserves
 Free Reserves
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Definitions
Total Bank Reserves = Vault Cash +
Deposits with Fed + Loans from Fed
 Required Bank Reserves = Deposits x
Required Reserve Ratio
 Excess Reserves = Total Reserves Required Reserves

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Consumers, Firms, Banks, and the Fed Determine Reserve Aggregates
Banks
Banks
Fed
Deposits with Fed
Loans from Fed,(OMO)
x
+
Bank Vault Cash
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Fed
Reserve ratios
=
=
Total Reserves
Consumers
Businesses
Bank Deposits
-
Required Reserves
=
Excess
Reserves
48
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Fed Sets Ratio of Minimum
Bank Reserves to Bank Deposits
 Helps
Prevent Liquidity Crises
 For Example: Dec 1999
deposits
of 0-$44.3 M (small banks)
 required
deposits
minimum reserve ratio: 3%
of $44.3 + M (large banks)
 required
minimum reserve ratio: 10%
Cutoff: $44.3 M as of 2000
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Did the Fed Run too tight a
monetary policy before 1980?
Kept excess reserves too low in the banking
system
 This forced banks to borrow reserves from
the Fed at the discount window
 In the 1980’s and 1990’s, the Fed allowed
more excess reserves, there was less
borrowing at the discount window
 Much longer expansions ( boom times)
resulted

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Fed Policy Record, 48.01-97.07
10000
8000
6000
4000
2000
0
50
Source: Survey
of Current Business,
January, 1995
55
60
65
Fed Loans
70
75
80
85
90
Excess Reserves
95
Fed Monetary Policy:
Insufficient Excess Reserves?

Expansionary Policy
 ease
credit
 provide positive free reserves

Contractionary Policy
 tighten
credit
 force banks to borrow at discount window,
causing negative free reserves
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Bank Reserve Aggregates, 10-19-01
Total Reserves( cash in Bank Vaults
& Deposits with Fed)
Nonborrowed Reserves
$44.1 B
Required Reserves
$43.0B
Excess Reserves*
$1.1 B
Free Reserves**
$1.0 B
$44.0 B
* Excess Reserves = Total Reserves - Required Reserves
** Free Reserves = Excess Reserves - Borrowed Reserves
Source: The Wall Street Journal, 10/19/2001, p.C13
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Before the 1980”s
Did the Fed dry up “free reserves” too much
with tight monetary policy?
 Free Reserves = Excess Reserves Borrowed reserves
 If banks are forced to the discount window,
borrowed reserves may dominate excess
reserves

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Fed Policy Record, 48.01-97.07
10000
8000
6000
4000
2000
0
50
Source: Survey
of Current Business,
January, 1995
55
60
65
Fed Loans
70
75
80
85
90
Excess Reserves
95
Fed Policy: 48.01-97.07
2000
0
-2000
-4000
-6000
-8000
50
55
60
65
70
75
80
Free Reserves
85
90
95
Fed Loans of Reserves to Banks
Before each recession, Fed loans peak and
exceed excess reserves
 As a consequence, free reserves are negative
before each recession

 recall:
free reserves = excess reserves - Fed loans
 negative free reserves are called “net borrowed
reserves”
 they
are an index of the Fed trying to tighten credit
 evidently the Fed was tightening credit sufficiently to
contribute to the recession

Note: Fed keeps excess reserves low during
inflationary 70’s; opposite policy in the 90’s
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Summary of Monetary Policy

Federal Reserve Needs to Avoid Bank
Panics and Bank Failure
 tool:
FDIC
 tool: Bank Supervision & Education

Federal Reserve Needs to Keep the
Economy Healthy: Low Unemployment &
Inflation Rates
 tool:
Open Market Policy: Fed Sells Securities
to Decrease Commercial Bank Deposits and
Tighten Credit
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More Review Material
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Review: Lecture Nine

Macroeconomic Policy
 fiscal
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policy
61
Fiscal Policy

Preventing Depressions
 role
for autonomous federal spending: the
federal government as spender of last resort
 Keynesian

model
Automatic Stabilizers in Federal Budget
 counter-cyclical
 progressive

effect
income tax
Limit to Fiscal Policy from 1980 to 1998
 the
federal deficit
 federal
government income-expense statement
• surplus(deficit) = receipts - expenditures
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Less than Full Employment Equilibrium
GDP= C+I+G
Consumption, C
Investment, I
GDP
GDP = C + I
C = C0 + mpc* Y
I
45
0
GDP = Y
YFE
Income, Y
Full Employment Income
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Source: Lecture Six
63
Less than Full Employment Equilibrium
GDP= C+I+G
Consumption, C
Investment, I
GDP
GDP = C + I
GDP+ C+I
C = C0 + mpc* Y
C= C0 +mpc*Y
I
I
45
0
GDP = Y
YFE
Income, Y
Full Employment Income
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Source: Lecture Six
64
Automatic Stabilizers

Progressive Income Tax Rates
 as
personal incomes rise
 many
move to a higher tax bracket
• disposable income does not grow as fast as income
because income taxes take a larger bite
 as
personal incomes fall
 many
move to a lower tax bracket
• taxes take a smaller fraction of income and dispoable
income does not fall as fast as personal income

Transfer Payments may grow in recession
 entitlement
program payments
 unemployment
insurance
 Aid to Families with Dependent Children(AFDC)
Llad Phillips Social Security Pensions
65
Federal Surplus (Deficit) $ Millions
150000
100000
50000
Millions
0
1880
-50000
1900
1920
1940
1960
1980
2000
2020
-100000
-150000
-200000
-250000
-300000
-350000
Fiscal Year
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Perspective:Is the economy growing less
rapidly in the decade of the Nineties?

Growth in real GDP over time
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Real GDP Billions 96$, 1929-1999
12000
10000
GDP
8000
Real GDP Billions 96$
exponential trendline
6000
4000
y = 8E-29e0.0369x
R2 = 0.9767
2000
0
1920
1930
1940
1950
1960
1970
1980
1990
2000
2010
year
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Midterm Review

O’Sullivan and Sheffrin
 Ch.
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20, 21, 24, 25 , 27, 28, 30
69
20: The Big Ideas in Macro

Circular Flow
 Labor
Market
 Goods Market

Measuring the Output of the Economy
 GDP
 National

Income
GDP: Is it a measure of welfare?
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Measuring a Nation’s Production and
Income

GDP: Expenditure Perspective
 Consumption
 Gross
Private Investment
 Government Purchases
 Net Exports
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21: Unemployment and Inflation
What is Unemployment
 Consumer Price Index (CPI)
 Percentage Rate of Change of CPI: Inflation

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Review Part II: Chapter Three

Conceptual Framework: Circular Flow
Firms
Income
Firms
Labor
Supply
Goods
Demand
Goods
Households
Households
Income Perspective
Expenditure Perspective
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Expenditure Perspective: Open
Firms
Exports
(Sales)
Supply
Goods
Demand
Goods
Imports
(puchases)
Households
Government
Households: Consumption of Goods and Services
Firms: Investment in Plant and Equipment
Government: Purchase of Goods and Services
All Three: Exports - Imports = Net Exports
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21: Behind the Economic Statistics

Is a recession coming?
 how
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would you figure that out?
75
21: Behind the Economic Statistics

Expenditure Perspective: GDP
 Consumption
 Gross
Private Investment
 Government Purchases
 Net Exports

Inflation
 what
is it?
 how do we measure it?
 why is it a problem?
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76
The Inflation Rate Since 1980
Source: http://www.yardeni.com
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21: Behind the Economic Statistics

Expenditure Perspective: GDP
 Consumption
 Gross
Private Investment
 Government Purchases
 Net Exports

Inflation
 what
is it?
 how do we measure it?
 why is it a problem?

Unemployment
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Unemployed Persons, Millions, 1929-1997
.
14
1933 trough
1982 trough
12
1938 trough
1991 trough
8
6
4
2
1945 trough
Year
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97
93
89
85
81
77
73
69
65
61
57
53
49
45
41
37
33
0
29
Millions
10
Unemployment Rate: unemployed/ (employed + unemployed)
Unemployment Rate: unemployed/ (labor force)
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24: Coordinating Economic Activity
If nominal GDP grows faster than real GDP,
what happens?
 If real GDP stops growing or declines, what
happens?

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81
25: Keynesian Economics and Fiscal Policy
The Keynesian Cross
 The Basic Ideas

 GDP =
National Income (equilibrium)
 equilibrium GDP can differ from full
employment GDP

What Should We Do IF We Slip Into
Depression?
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Less than Full Employment Equilibrium
Consumption, C
GDP = C + I
Investment, I
GDP
C = C0 + mpc* Y
I
45
0
GDP = Y
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Full Employment Income
YFE
Income, Y
83
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?
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84
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?
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85
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
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a. Label the aggregate expenditures line
86
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? ____________________.
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87
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.
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88
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? ____________..
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