Download x 2b

ECO 154/254
Intermediate
Macroeconomics
Prof. Michael B. McElroy
Multimedia by: Mannig J. Simidian
x2
x2a
x2b
x1a x2b x1
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The Scarcity Story
The Production Function
The Production Possibilities Frontier
Opportunity Cost
Dymamics of the PPF: Economic Growth
Choice: Investment or Consumption?
Public vs. Private Spending
Summary & Exercises
The Scarcity Story...
“Scarcityman” (as he’s nicknamed) loves pondering the economic phenomenon, scarcity. He claims that
scarcity is simply an inherent condition in nature, that we all must endure. He implies that we can’t just
have or produce everything. Opportunity costs exist and we must constantly make choices. Decisions
will always be about “this or that”, not “this and that” and “now or later” not “now and later.”
Scarcity
Rules!
Scarcityman won’t have to remind us to take our bitter pill, scarcity, we will constantly run into it as we
further our study of Macroeconomics. We will come to realize that scarcity exists for everyone, rich or
poor.
For the richer country, scarcity forces people to work instead of play. If
resources were not scarce, the people would pursue more leisure
activities like vacation.
For the poorer country, poverty and appalling
living conditions make scarcity a matter of life
and death.
The Production Function
The production function is a process of transforming inputs (labor (n),
capital (k), institutional structure (inst) ) into outputs (final goods
and services for a certain time period).
The algebraic representation is:
y = F ( n, k, inst)
output
is
some function of
our given inputs
The Production Possibilities Frontier
(The PPF)
• Our goal in working with the PPF is to see the most output that can be produced given a certain amount
of inputs.
• So, first assume that as a nation, our inputs (n,k,inst) are fixed and we produce 2 goods, x1 and x2. In
other words, right now, we only have a certain amount of workers, and capital to work with and a certain
level of institutional efficiency within our society.
• Next, we’d like to determine what combinations of our 2 goods we could produce…so here we go.
Let’s say you decide to
produce this amount of goods x2 and x1.
x2
x2a
Remember that points
that lie outside the PPF,
are unattainable.
x2b
Remember
that points
that lie
inside the
PPF are
attainable,
but not
desirable.
x1a x1b x1
Or you could cut back on x2 and
increase your production of x1.
Opportunity Cost
The downward slope of the PPF depicts that the opportunity cost of producing more of one good is the amount
of the other good that must be sacrificed.
x2
10
units
A
Let’s say you are at point A, producing only good x2.
Suddenly you decide to produce some of good x1 without
reducing the production of good x2.
B
Uh oh…this is outside the
PPF, so you must reduce production of x2.
7
units
Notice that in order to gain 8 units of x1, you had
to give up 3 units (10-7) of good x2.
0 units
8 units
x1
Dynamics of the PPF: Economic Growth
Now, let’s suppose we can increase our inputs (n,k,inst). This
will shift out our PPF, making it possible to produce at a
higher PPF.
x2
PPF
This action is called
PPF
Remember that any points
that lie beyond even the higher PPF...
are still unattainable!!!
x1
9
measured in millions of dollars
Investment
Choice:
Consumption
or Investment?
A nation at point A is choosing “zero-growth”, that is, they
would rather consume right now, than invest and consume
more later.
C
B
6
0
A nation choosing point B shows more willingness to invest.
By investing more, the nation can increase its capital stock
and therefore experience an increase in their PPF in the future.
A
5
Consumption
measured in millions of dollars
8
10
A nation choosing point C is
investing even more and will see an even larger increase in their
PPF.
Consumption or investment?
There is no “better” choice, it just depends on whether one places a higher value on current consumption, than on
growth. Keep in mind that investment implies future consumption, so the decision is really about
when to consume.
measured in millions of dollars
Investment
9
C
A nation choosing point C, is said to have a
Low Rate of Time Preference.
B
6
5
Consumption
measured in millions of dollars
8
A nation choosing point B, is said to have
a High Rate of Time Preference.
Public vs. Private Spending
Public Output
The issue of Public and Private spending must also run into the boundaries set by scarcity. There is an
opportunity cost whereby more government output means less private output.
B
gB
gA
+Dg
Starting at point A, if the government decides
to increase public spending...
It must diminish private spending
and land at point B.
A
-D(c+i)
(c+i)B (c+i)A
Private Output
This is known as
Copyright 1997 Dead Economists Society
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Historical Background
A Glimpse of Adam Smith
Market Clearing
Quantity Theory of Money
Classical AS* Curve
Classical AD Curve
Conclusions on the Classical Model
Historical Background
The Classical model of economics relates the standard supply-demand
analysis to the macroeconomy. It holds that wages and prices will be
“flexible” as opposed to “sticky.” Adam Smith’s Wealth of Nations
(1776) suggested that the economy was controlled by the “invisible
hand” whereby the market system, instead of government would be
the best mechanism for a healthy economy.
A Glimpse of
Adam Smith
The central thesis of The Wealth of Nations is that capital is best employed for the production and distribution of wealth
under conditions of governmental noninterference, or laissez-faire, and free trade. In Smith's view, the production and
exchange of goods can be stimulated, and a consequent rise in the general standard of living attained, only through the
efficient operations of private industrial and commercial entrepreneurs acting with a minimum of regulation and control by
governments. To explain this concept of government maintaining a laissez-faire attitude toward commercial endeavors,
Smith proclaimed the principle of the “invisible hand”: Every individual in pursuing his or her own good is led, as if by an
invisible hand, to achieve the best good for all. Therefore any interference with free competition by government is almost
certain to be injurious.
"Smith, Adam," Microsoft® Encarta® 96 Encyclopedia. © 1993-1995 Microsoft Corporation. All rights reserved. © Funk & Wagnalls Corporation. All rights reserved.
Market Clearing
Market clearing is an alignment process whereby decisions between suppliers and demanders reach an equilibrium.
Here’s how it works...
Let’s say you begin with an initial demand and supply curve for CDs.
Remember that the demand curve slopes downward meaning that as you increase the price (by moving along the demand curve), the quantity
demanded decreases. Conversely, the supply curve slopes upward implying that as the price increases (by moving along the supply curve), the
amount supplied will increase.
P
P´
P*
D
D´
S
The center point A is the place where
market decisions reach an equilibrium.
Now, suppose that there is a sudden
increase in the demand for CDs.
Demand will shift from D to D´.
B
A
Q* Q´
Q
The increase in demand places upward pressure
on the price to point B
since the original price,
P* no longer clears the market.
LMp0
LMp1
IS
r
A
ro
rshortrun
rlongrun
Module 4:
Dymanics of IS-LM
B
c

y
ASLR
p
B A 
plongrun
c

AD
AD’
y
Steps to doing the “IS-LM”
• Step 1:Determine which term will be changed
for example, +DX0 (increase in autonomous
net exports)
• Step 2: Determine which equation (IS or LM) will
be affected.
• Step 3: Preform the neccisary movements within
the IS-LM framework.
• Step 4: Determine the affects on the other variables
by either reading it directly off the diagram, or using
equations 1-10.
Given these
Equations...
1) Y= c + i + x + g
2) c= co + ci (y-t)
3) t= to + ti y
4) i= io - i2 r
5) x = xo - xiy -x2 r
6) g = go
7) L/P=M/P
8) L/P=j0+j1y-j2r
9) M=M0
10SR) P=P0
10LR) y*=F(n*,K0,I0nst)
IS
Aggregate
Demand
(Equ. 1-9)
LM
Aggregate
Supply
What happens if
there is a
+ Dx0?
What is the impact on other variables in the
economy: y,p,r,c,i,x,b?
Steps to the “IS-LM”
• Since we want to examine how+Dx will affect
other variables in the economy. we must see which
equation, IS or LM will be affected.
• Then we must determine if the variable causes a
movement along, or an entire shift of the
appropriate line.
IS
y   z 0  g 0  c1t 0)   (i 2  x 2)r
  1 / (1  c1  c1t 1  x1)
z 0  c0  i 0  x 0
y

LM
( M 0/ P 0)  j 0
j2
 j1 r
j1
y= (M0/P0) - j0 + j2 r
r
IS
IS’
LMp2
LMp0
C

B
A
p
p2
p0
y
ASLR
C 
A
ASSR
 B 
AD
AD’
y
1) +Dx causes IS
curve to shift right
to IS’.
2) This leads to a
rightward shift in AD to AD’.
Short Run:
Move from A to B.
Long Run:
Market clears at p0 to p2
from B to C.
3) +Dp causes LMp0
to shift leftward to
LMp2.
r
IS
IS’
LMp2
LMp0
C

B
Short
Run:
A
p
p2
p0
y
ASLR
C 
A
ASSR
 B 
AD
AD’
y
y
p
r
c
I
x
b
+
0
+
+
?
-
Long
Run:
0
+
++
0
-+
0
Module 5:
A Look at the Depression
i
Unemployment Lines, 1930s
The Wall Street stock-market crash of 1929 precipitated the Great Depression, the worst economic downturn in
the history of the United States. The depression lasted over a decade, with hundreds of thousands of
Americans losing their jobs, businesses failing, and financial institutions collapsing. Of the 6000 people
hoping to get jobs on this day in New York, 135 were hired.
Module 6:
Fiscal Policy
What is Fiscal Policy?
• Choices about public spending and how to finance that spending.
• It is a system for transfering reserces from the private to public
sector.
“Private vs. Public Choice”
“It Depends” Questions
• What is the impact of a +Dg on the
macroeconomy?
• What is the size of the national debt and the
deficit?
• What is the impact of continued b>0 on
y,p,r,c,i,x etc..?
• Are continued gov’t defecits sistainable?
What is the impact of a +Dg on the
macroeconomy?
• “It depends” on how the government finances its spending.
• It has three options:
(+Dg= +Dt0) Theft (taxes: coercion now), (+Dg= +Db)
Borrowing (bonds: coersion later), (+Dg= +DM0)
Counterfeiting (Printing money).
Tax-Financed Increase in
Government Spending
(+Dg0=+Dt0)
Tax-Financed
Increase in
Government
Spending
(+Dg0=+Dt0)
r
IS
IS’
IS’’
LMp0
LMp0
E 
Result:
B
A
Given our IS equation:
y=(z0+g0-c1t0)-(i2+x2)r
+Dg shifts IS to IS’.
But, +Dt shifts IS back to the left
(to IS ’’). Note: the shift leftward
from IS’ to IS ’’ is less than the
original rightward shift becausepE
the tax-multiplier (-c1t0) is less
than the expenditure multiplier
0
().
p
p
y
ASLR
E
A

ASSR
B 
AD
AD’
y
A small rightward
shift in both IS (IS to
IS’) and AD (AD to
AD’’) and a movement
along ASSR . As the
market clears, the
rising price level
contracts LM and the
economy moves to E.
Bond-Financed Increase in
Government Spending
(+Dg0=+Db)
Bond-Financed
Increase in
Government
Spending
(+Dg0=+Db)
r
IS
IS’
IS’’
LMp0
LMp0
E 
Result:
B
A
Given our IS equation:
y=(z0+g0-c1t0)-(i2+x2)r
+Dg shifts IS to IS’. But, +Dt
shifts IS back to the left (to IS ’’).
Note: the shift leftward from IS’
to IS ’’ is less than the original
rightward shift because the tax-pE
multiplier (-c1t0) is less than the
expenditure multiplier ().
p
p0
y
ASLR
E
A

ASSR
B 
AD
AD’
y
A small rightward
shift in both IS (IS to
IS’) and AD (AD to
AD’’) and a movement
along ASSR . As the
market clears, the
rising price level
contracts LM and the
economy moves to E.
Money-Financed Increase in
Government Spending
(+Dg0 =+DM0)
?
What is the size of the national
debt and the deficit?
Annual Deficit (1997)
Annual Deficit (1996)
Annual Deficit (1995)
…….
…...
National
Debt
A meaningful deficit...
• Exclude funds borrowed from federal agencies.
• Include the deficits of local and stage governments.
• Modify the real value of outstanding public debt. to reflect current
inflation.
• Include hidden liabilities that currently escape detection in
accounting system.
The Cyclical Deficit
• Changes in the cash flow deficit arise purely
from fluctuations of real output (y) around its
full employment level.
• For example: A recession causes a lower tax
base and therefore decreases the government
collections.
t=t0+t1y
b=g-t
Structural Deficit
• Reflects one or more changes in the fiscal policy instruments Dg0,
Dt0, or Dt1 and results in a shift in the IS and AD curves.
Dg0, Dt0, or Dt1
Myopic Consumers
• Short-sighted consumers see a decrease in taxes in such a way that
their current consumption might increase because of this new
“wealth.”
Their response according to our IS equation is
 ( z0 + g0 - c1 t0) - (x2 + i2) r
This t0 induces them to increase Z0.
Tax-discounters
• Tax-discounters’ perceive that lower tax cuts now, means higher
future taxes later, leaving consumption unchanged. “Tax cuts are tax
postponements.”
• Previously, we looked at (+Dg0=+Db)
we measured the effect of +Dg only, because the variable b was not
in any of our 10 equations.
• Tax discounters treat deficits just the same as taxes when making
consumption decisions.
They see (+Dg0=+Db) as (+Dg0=+Dt0) !!!
Government Deficits and Current Economic
Activity
• Measurement discrepancies
• Impact of fiscal policy
(expansionary, contractionary or
nuetrat) depends on the CHANGE
in the deficit from the precious
year.
• Cyclical vs. Structural Deficits
• Tax-discounting view
Module 7:
Monetary Policy
Money
Commodity
Symbol
Invention
Without Money
Self-suffiency
Barter
Functions of Money
•
•
•
•
Make Transactions
Store Purchasing Power
Measure Economic Performance
Measure fullfillment of contracts
Here’s what Money Does...
Monetezation brings effeciency...
PPF1
PPF2
nst
Di )
The better the money, the farther out the PPF.
How does money do this?
Fiat money:
A declaration of legal tender.
Back to Classical Model: Quantity Theory of
Money
• MV=Py
• Take the logs:
ln M + ln V = ln P + ln y
• Next solve for ln P:
ln M +ln V - ln y = ln P
• Then, take the derivative of
the logs to get the percent
changes:
d ln M
dt
+
d ln V d ln y d ln P
=
dt
dt
dt
%DM + %DV - %Dy* = %DP = P
Growth of Money Supply + Growth of Money Demand - Growth of
output = Inflation (P )
%DM = %Dy* - %DV
Non-inflationary condition
for Monetary Policy.
How does the Fed Control the Money
Supply?
• To expand the Money Supply:
They buy ___________ and pay for it with new money.
• To reduce the Money Supply:
They sell ___________ and receive the existing dollars and then
destroy it.
But this is difficult to do…
The criteria for choosing__________.
1. Storage Cost
2. Equity
U.S. Treasury Bonds
•To expand the Money Supply:
They buy U.S. Treasury Bonds and pay for it with new money.
•To reduce the Money Supply:
They sell U.S. Treasury Bonds and receive the existing dollars
and then destroy it.
The Fed Controls the Money Supply
through...
1) Open Market Operations (buying and
selling U.S. Treasury bonds).
2) D Reserve Requirements (never really
used).
3) D Discount rate which member banks
can borrow from the Fed (not meeting
the reserave requirements).
What impact does DM have on y, p, r….?
• Whether y=y*, or y<y*.
• Whether SR or LR.
• Continued +DM or one shot
+DM.
• Depends on Interest Rates
(nominal or real).
Fisher Equation: R = r + Pe
Actual (Market)
Nominal rate of
interest
Real rate
of interest
Inflation
One shot +DM
+DM
SR -Dr +Dy -DR
r
IS
+DLM, +DAD
.
A
In the short-run, prices are stickey, so inflation is zero. (Point
A to B.)
Plug in the latter effects of the AD/AS diagram into the fisher
equation to see the effect on the Nomonal interest rate (R).
e
0
R=
r+
P
 
In the long-run, prices will adjust so quickly
to point c, that the market will not incur any
inflation, despite the new price level P1.
LR Dr =DR =Dy=0
LM
P
P1
P0
LM’
.
B
.
. .
y
C
A
B
AD
y
AD’
Continuous +DM (Increasing rate of gr wth of the
money suppy)
SR: The AD/AS diagram
+DM
tells us....-Dr +Dy
LR: Prices adjust, shifting LM back leftward, Dr =0, but
with +DP. The fisher equation tells us +DPe
+DR (R=0r+Pe)
In the LR, prices will adjust and the Nominal Interest Rate (R) will rise. Any
attempts to -Dr, at y* will only increase the price level and R.
Money Neutrality: “You can’t print your way
to prosperity.”
Changes in Monetary Policies
have no lasting effect on r, but
changes in Fiscal Policies do.
Distinction between Short-term and Long-term
Interest Rates on Bonds
(3 mos.) RST= r + Pe
(10 yr.) RLT= r + Pe
How will the bond market react to a sudden
+DM, what happens to R?
+DM
SR -Dr  DRST
LR Dr =0 + DPe
You would be quite rich if you predict interest
rates.
Effecient Market Hypthesis
• Good Prediction
• Unique
Random Walk Hypthesis
• Given that there are so many people in the
market, you select the stocks randomly.
Why doesn’t the central bank do a better job
of stabilizing the economy?
• What’s the goal?
• Policy Lag: Long &Variable lag
between +DM and Dy?
• Which money supply?
Module 8:
Suppose you were Chairman...
Module 9: International Trade
World Trade Center, New York City
Manhattan, one of the boroughs of New York City, is the headquarters for much of the world’s foreign trade. The twin towers of the 110-story World Trade Center are
seen in this photograph, with the Statue of Liberty in the foreground.
New York Conv. & Vis. Bureau
Scarcity:
A bitter pill
for rich or poor nations
For the richer country, scarcity
rears its ugly head by forcing
people to work instead of play.
If resources were not scarce,
the people would pursue more
leisure activities like vacation.
For the poorer country,
poverty and
appalling living conditions
make scarcity a matter of life
and dealth.
The PPF
• Our goal in working with the PPF is to see the most output that can be produced given
a certain amount of inputs.
• So, first assume that as a nation, our inputs (n,k,inst) are fixed and we produce 2 goods,
x1 and x2. In other words, right now, we only have a certain amount of workers, and
capital to work with and a certain level of institutional efficiency to work with.
• Next, we’d like to determine what combinations of our 2 goods we could produce…so
here we go.