Download 1 Macroeconomics Final Chapter 13: Fiscal policy – consists of

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Macroeconomics Final
Chapter 13:
Fiscal policy – consists of deliberate changes in government spending and tax collections designed to
achieve full employment, price-level stability and encourage economic growth

Requires increases in government spending, decreases in taxes, or both –a budget deficit – to
increase aggregate demand and push an economy from a recession

Decreases in government spending, increases in taxes, or both –a budget surplus—are
appropriate fiscal policy for decreasing aggregate demand to try to slow or halt demand-pull
inflation
Council of Economic Advisors (CEA) – a group of three economists appointed by the president to provide
expertise and assistance on economic matters
Expansionary fiscal policy – uses increases in government spending or tax cuts to push the economy out
of recession

Recession

Raise GDP, shift AD to right
Federal Government should stimulate:



Increase government spending
Reduce taxes
Some combination of the two
Budget deficit – government spending in excess of tax returns
Contractionary fiscal policy – decreases in government spending, increases in taxes, or both to reduce
demand-pull inflation

Demand-pull inflation –increase in aggregate demand which increases price level and real
output
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
o
Move AD left: should move toward a budget surplus (tax revenues in excess of
government spending)
o
Inflationary gap  difference between real output and real output at full employment
o
Reasons for sticky prices: price war (increase total revenue, more customers), menu
costs, wages (contracts, minimum wage, morale)
Government eliminate the inflationary GDP gap
o Decrease government spending
o Raise taxes
o Some combination of the two policies
Budget surplus – tax revenues in excess of government spending
Built-in stabilizer – anything that increases the government’s budget deficit during a recession and
increases its budget surplus during an expansion without requiring explicit action by policymakers

Taxes collected at every level of GDP; transfer payments – “negative taxes”
o

Arise from net tax revenues, which vary directly with the level of GDP
o

Doesn’t require any action on the part of policymakers given a tax rate
During recession, the Federal budget automatically moves toward a stabilizing deficit;
during expansion, the budget automatically moves toward an anti-inflationary surplus
Lessens, but does not fully correct, undesired changes in real GDP
(graph)
Economic importance of relationship between tax receipts and GDP:

Taxes reduce spending and aggregate demand
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
Reductions in spending are desirable when the economy is moving toward inflation, whereas
increases in spending are desirable when economy is slumping
Progressive tax system – average tax rate increase as the taxpayer’s income increases and decreases as
the taxpayer’s income decreases

Tax revenue / GDP
Proportional tax system – average tax rate remains constant as the taxpayer’s income increases or
decreases
Regressive tax system – average tax rate falls as GDP rises
*the more progressive the tax system, the greater the economy’s built-in stability
Cyclically adjusted budget – a comparison of the government expenditures and tax collections that
would occur if the economy operated at full employment throughout the year; full employment budget

Cyclically adjusted budget
o
Government spending: $595 billion
o
Government revenue: $505 billion
Cyclically adjusted
Non-cyclically adjusted
$555-550 = $5 billion deficit
$595-505 = $90 billion deficit

The cyclically adjusted budget removes cyclical deficits from the budget and therefore measures
the budget deficit or surplus that would occur if the economy operated at its full-employment
output throughout the year

Cyclical deficit – a federal budget deficit that is caused by a recession and the consequent
decline in tax revenues
o
Deficits caused by changes in GDP
o
Changes in the cyclical-budget deficit or surplus provide meaningful information as to
whether the government’s fiscal policy is expansionary, neutral, or contractionary

Changes in the actual budget deficit or surplus do not, since such deficits or
surpluses can include cyclical deficits or surpluses
Problems of timing in connection with fiscal policy:

Recognition lag – time between the beginning of recession or inflation and the certain
awareness that it is actually happening

Administrative lag – time between the need for fiscal action is recognized and the time action is
taken

Operational lag – time between fiscal action is taken and the time that action affects output,
employment, or the price level
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Problems that complicate the enactment and implementation of fiscal policy

Potential for misuse of fiscal policy for political rather than economic purposes
o
Political business cycles – swings in overall economic activity and real GDP resulting
from election-motivated fiscal policy, rather than from inherent instability in the private
sector

The fact that state and local finances tend to be pro-cyclical

Potential ineffectiveness if households expect future policy reversals

The possibility of fiscal policy crowding out private investment
Crowding-out effect – an expansionary fiscal policy (deficit spending) may increase the interest rate and
reduce investment spending, thereby weakening or canceling the stimulus of the expansionary policy

Rising interest rate might also potentially crowd out interest-sensitive consumption spending

Attention on investment and whether the stimulus provided by deficit spending may be partly
or even fully neutralized by an offsetting reduction in investment spending
U.S. Securities – financial instruments issued by the Federal government to borrow money to finance
expenditures that exceed tax revenues

(1) treasury bills (short-term securities)

(2) treasury notes (medium-term securities)

(3) treasury bonds (long-term securities)

U.S. savings bonds (long-term, nonmarketable bonds)
External public debt – the portion of the public debt owed to foreign citizens, firms, and institutions


Total accumulation of all past Federal government deficits and surpluses and consists of
Treasury bills, Treasury notes, Treasury bonds, and U.S. savings bonds
o
“Public”: includes banks, state and local governments = 57%
o
Federal Reserve and Federal agencies = 43%
Public debt cannot bankrupt the U.S. government
o
The debt needs only to be refinanced rather than refunded
o
The Federal government has the power to increase taxes to make interest payments on
the debt

Not a vehicle for shifting economic burdens to future generations; Americans inherit not only
most of the public debt (a liability) but also most of the U.S. securities (an asset) that finance the
debt

Substantive problems associated with public debt:
o
Payment of interest on the debt may increase income inequality
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o
Interest payments on the debt require higher taxes, which may impair incentives
o
Paying interest or principal on the portion of the debt held by foreigners means a
transfer of real output abroad
o
Government borrowing to refinance or pay interest on the debt may increase interest
rates and crowd out private investment spending, leaving future generations with a
smaller stock of capital than they would have had otherwise
Public investments – government expenditures on public capital (roads, bridges, electric power facilities)
and on human capital (education, training, health)

May partly or wholly offset the crowding-out effect of the public debt on private investment

Added public investment may stimulate private investment, where the two are complements
Chapter 14:
Functions of money:

Medium of exchange – any item sellers generally accept and buyers generally use to pay for a
good or service

Unit of account – standard unit in which prices can be stated and the value of goods and
services can be compares

Store of value – an asset set aside for future use
Advantages of money:

Store wealth – stocks, bonds, gold, real estate

Liquid asset (liquidity) – ease in which an asset can be converted quickly into the most widely
accepted and easily spend for of money, case, with little or no loss of purchasing power
M1 Money Supply:

Currency in circulation in the hands of the public
o

US: coins, paper money
All checkable deposits
o
Checks, debit cards
Federal Reserve Notes – paper money issued by the Federal Reserve Banks
Token money – face value of any piece of currency is unrelated to its intrinsic value

Value of the physical material (metal or paper and ink) out of which that piece of currency is
constructed
Checkable deposits – any deposit in a commercial bank or thrift institution against which a check may be
written
Commercial banks – a firm that engages in the business of banking (accepts deposits, offers checking
accounts, and makes loans)
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Thrift institution – a savings and loan association, mutual savings bank, or credit union

Money represents the debts of government and institutions offering checkable deposits and has
value because of the goods, services, and resources it will command in the market
o
Maintaining the purchasing power of money depends largely on the government’s
effectiveness in managing the money supply
“Near Monies” – certain highly liquid financial assets that do not function directly or fully as a medium
of exchange but can be readily converted into currency or checkable deposits
M2 Money Supply:


Savings deposits, including money market deposit accounts
o
Savings deposit: a deposit that is interest-bearing and that the depositor can normally
withdraw at any time
o
Money market deposit account (MMDA): interest-bearing account containing a variety
of interest-bearing short-term securities
Small-denominated (<$100,000) time deposits
o

Time deposits: an interest-earning deposit in a commercial bank or thrift institution that
the depositor can withdraw without penalty after the end of a specific period
Money market mutual funds held by individuals
o
Money market mutual fund (MMMF): interest-bearing accounts offered by investment
companies, which pool depositors’ funds for the purchase of short-term securities
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What “backs” the money supply?

“backed” by government’s ability to keep money value stable

Management of money supply – no “gold standard”

Paper money is the circulating debt of the Federal Reserve Banks
Legal tender – a nation’s official currency (bills/coins); payment of debts must be accepted in this
monetary unit, but creditors can specify the form of payment
Purchasing power of the dollar - $V = 1/P
Federal Reserve System – the US central bank, consisting of the Board of Governors of the Federal
reserve and the 12 Federal Reserve Banks, which controls the lending activity of the nation’s banks and
thrifts and thus the money supply, also some 6,800 commercial banks, and 8,700 thrift institutions
(mainly credit unions)

Created early 20th century
o
Centralized: money mismanagement, banking crisis, different private bank notes used as
currency

Board of Governors: basic policymaking body for the entire banking system

Directive of the Board and the Federal Open Market Committee (FOMC) are made effective
through the 12 Federal Reserve Banks, which are simultaneously (a) central banks, (b) quasipublic banks, and (c) bankers’ banks
(graph)
Federal Reserve functions:

Issue Federal Reserve Notes (currency)

Set reserve requirements and hold reserves deposited by banks and thrifts
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
Lend money to financial institutions and serve as the lender of last resort in national financial
emergencies

Provide for the rapid collection of checks

Act as the fiscal agent for the Federal government

Supervise the operations of the banks

Regulate the supply of money in the best interests of the economy

Essentially an independent institution, controlled neither by the president of the United States
nor by Congress
o
Shield Fed from political pressure and allows it to raise and lower interest rates (via
changes in the money supply) as needed to promote full employment, price stability,
and economic growth
Financial Crisis of 2007-2008:


Rise in mortgage loan defaults, the collapse of near-collapse of several major financial
institutions, and the generalized freezing up of credit availability
o
Subprime mortgage loans – high-interest rate loans to home buyers with above-average
credit risk
o
Mortgage-back securities – bonds backed by mortgage payments
o
Securitization – the process of slicing up and bundling groups of loans, mortgages,
corporate bonds, or other financial debts into distinct new securities
o
Resulted from bad mortgage loans together with declining real estate prices
o
Resulted from underestimation of risk by holders of mortgage-back securities and faulty
insurance securities designed to protect holders of mortgage-back securities from the
risk of default
2008: Troubled Asset Relief Program (TARP): authorized US Treasury to spend up to $700 billion
to make emergency loans and guarantees to failing financial firms
o
Aided by lender-of-last-resort loans provided by the Federal reserve to financial
institutions through a series of newly established Fed facilities

Intensified the moral hazard problem: tendency of financial investors and
financial firms to take on greater risk when they assume they are at least
partially insured against loss
Fed’s lender-of-last-resort responses:

Primary Dealer Credit Facility (PDCF)

Term Securities Lending Facility (TSLF)

Asset-Back Commercial Paper Money Market Mutual Fund Liquidity Facility

Commercial Paper Funding Facility (CPFF)
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
Money Market Investor Funding Facility (MMIIFF)

Term Asset-Backed Securities Loan Facility (TALF)

Interest Payments on Reserves
Financial services industry – commercial banks, thrifts, insurance companies, mutual fund companies,
pension funds, security firms, and investment banks
Wall Street Reform and Consumer Protection Act of 2010:

A law that gave authority to the Federal reserve System to regulate all large financial
institutions, created an oversight council to look for growing risk to the financial system,
established a process for the Federal government to sell off the assets of large failing financial
institutions, provided Federal regulatory oversight of asset-back securities, and created a
financial consumer protection bureau within the Fed
Chapter 15:
Fractional reserve banking system – only a portion (fraction) of checkable deposits are backed up by
reserves of currency in bank vaults or deposits at the central bank
Balance sheet – statement of assets: things owned by the bank or owed to the bank, and claims on
those assets

Assets = liabilities + net worth
Required reserves – an amount of funds equal to a specified percentage of the bank’s own deposit
liabilities

Required reserves = (required reserves/checkable deposits)
o

Protect deposits  allows Fed to control lending ability of commercial bank (i.e. their
ability to prove credit)
Reserve ratio: ratio of required reserves the commercial bank must keep to the bank’s own
outstanding checkable-deposits liabilities
o
reserve ratio = (commercial bank’s required reserves / commercial bank’s checkabledeposits liabilities)
Excess reserves – the amount by which a bank’s or thrift’s actual reserve exceed its require reserve

= actual reserve – required reserve

Banks lose both reserves and checkable-deposits when checks are drawn against them
Actual reserves – the funds that a bank has on deposit at the Federal Reserve Bank of its district (plus its
vault cash)
Commercial banks:

Create money – checkable deposits, or checkable-deposit money – when they make loans
o
Convert IOUs, which are not money, into checkable-deposits, which are money
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

Can lend only an amount equal to its excess reserves
o

Money creation is thus limited because checks drawn by borrowers will be deposited in
other banks, causing a loss of reserves and deposits to the lending bank equal to the
amount of money that it has lent
Banks may decide to use excess reserves to buy bonds from the public: in doing so, banks
merely credit the checkable-deposit accounts of the bond sellers, thus creating checkabledeposit money
o

Money is destroyed when lenders repay bank loans
Money vanishes when banks sell bonds to the public because bond buyers must draw
down their checkable-deposit balances to pay for the bonds
Banks earn interest by making loans and by purchasing bonds; they maintain liquidity by holding
cash and excess reserves (Fed: pays interest on excess reserves)
o
Banks often can obtain higher interest rates by lending out excess reserves on an
overnight basis to banks that are short of required serves
o
These loans are made in the Federal funds market, and the interest paid on the loans is
called the Federal funds rate
Federal funds rate – interest rate banks and other depository institutions charge one another on
overnight loans made out of their excess reserves
Monetary multiplier – defines the relationship between any new excess reserves in the banking system
and the magnified creation of new checkable-deposit money by banks as a group

Commercial banking system as a whole can lend by a multiple of its excess reserves because the
system as a whole cannot lose reserve
o

Individual banks can lose reserves to other banks in the system
The multiple by which the banking system can lend on the basis of each dollar of excess reserves
is the reciprocal of the reserve ratio
o
Multiple credit expansion process is reversible

Monetary multiple = (1/required reserve ratio) or m = (1/R)

Maximum checkable deposit creation = excess reserves x monetary multiplier (D = E x m)
Ex. Fed sets reserve ratio to 10%, bank collectively has $2 billion in excess

M = (1/R)  M = (1/.1)

10 x 2 = $20 billion in new checkable deposits
Ex. $30 billion new loans, $50 billion paid off

Amount of loans decrease by $20 billion

Money supply: decrease
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Chapter 16:
Transactions demand – demand for money as a medium of exchange
Asset demand: hold money as a store of value; corporate stocks, corporate or government bonds, or
money

Hold onto cash  doesn’t collect interest
Total demand for money – by horizontally adding the asset demand to the transaction demand

The amount of money demanded for transactions varies directly with the nominal GDP; the
amount of money demanded as an asset varies inversely with the interest rate
o
The market for money combines the total demand for money with the money supply to
determine equilibrium interest rates
Transaction demand for
asset demand for money
money, Dt
total demand for money
Dm = Dt + Da and supply of money Sm
Ex. Bond prices

$1,000 future value, $50 interest, interest yield 5%

Interest rate rises 7.5%  now $1,000, $75 paid

Older bonds that pay $50  not competitive (price must decline so interest yield comes out to
7.5%
o
0.75 = 75/667
Four main instruments of monetary policy:
1. Open market operations – consist of buying government bonds (US securities) from or selling
government bonds to commercial banks and the general public

Increase the money supply = Fed buys bonds

Decrease the money supply = Fed sells bonds
2. Reserve ratio – the fraction of checkable deposits that a bank must hold as reserves in a Federal
Reserve Bank or in its own bank vault, also called, reserve requirement
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3. Discount rate – the interest rate that the Federal Reserve Banks charge on the loans they make to
commercial banks and thrift institutions
4. Term auction facility – the monetary policy procedure used by the Federal reserves in which
commercial banks anonymously bid to obtain loans being made available by the Fed as a way to expand
reserves in the banking system
Federal funds rate- the interest rate banks and other depository institutions charge one another on
overnight loans made out of their excess reserves

Adjusted by the Red to a level appropriate for economic conditions

Expansionary monetary policy: purchases securities from commercial banks and the general
public to inject reserves into the banking system
o

Lowers the Federal funds rate to the targeted level and also reduces other interest rates
(such as the prime rate)
Restrictive monetary policy: Fed sells securities to commercial banks and the general public via
open-market operations
o
Reserves are removed from the banking system, and the Federal funds rate and other
interest rates rise
(graph)
Expansionary monetary policy – Federal Reserve System actions to increase the money supply, lower
interest rates, and expand real GDP

Lower the interest rate to bolster borrowing and spending, which will increase aggregate
demand and expand real output
o

Achieve lower rate, buy bonds
Prime interest rate – the benchmark interest rate used by banks as a reference point for a wide
range of interest rates charged on loans to businesses and individuals
Restrictive monetary policy – Federal Reserve System actions to reduce the money supply, increase
interest rates, and reduce inflation

Increase the interest rate to reduce borrowing and spending, which will curtail the expansion of
aggregate demand and hold down price-level increases (sell bonds)
Taylor Rule – a modern monetary rule propose by economist John Taylor that would stipulate exactly
how much the Federal Reserve should change real interest rates in response to divergences of real GDP
from potential GDP and divergences of actual rates of inflation from a target rate of inflation
Monetary policy’s complex cause-effect chain:
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
(a) policy decisions affect commercial bank reserves

(b) changes in reserves affect the money supply

(c) changes in the money supply alter the interest rate

(d) changes in the interest rate affect investment

(e) changes in investment affect aggregate demand

(f) changes in aggregate demand affect the equilibrium real GDP and the price level
Monetary policy advantages over fiscal policy:

Speed and flexibility

Isolation from political pressure

Fed has used monetary policy to keep inflation low while helping limit the depth of the
recession of 2001, to boost the economy as it recovered from that recession, to help stabilize
the banking sector in the wake of the mortgage debt crisis, and to promote recovery from the
severe recession of 2007-2009
Cyclical asymmetry – the idea that monetary policy may be more successful in slowing expansions and
controlling inflation than in extracting the economy from severe recession
Monetary policy major limitations and potential problems:

(a) recognition and operation lags complicate the timing of monetary policy

(b) in a severe recession, the reluctance of banks lend excess reserves and firms to borrow
money to spend on capital goods may contribute to a liquidity trap that limits the effectiveness
of an expansionary monetary policy
o
Liquidity trap – adding more liquidity to banks has little or no additional positive effect
on lending, borrowing, investment or aggregate demand

Situation in a severe recession in which the Fed’s injection of additional reserves
into the banking system has little or no additional positive impact on lending,
borrowing, investment, or aggregate demand
Chapter 18:
Short-run aggregate and long-run aggregate supply:

Short-run is a period in which nominal wages do not respond to changes in the price level

Curve is up sloping, because nominal wages are unresponsive to price-level changes, increases
in the price level (prices received by firms) increase profits and real output
o
Price level rises  unemployment falls … firms encourage workers to come to market,
keep up with output
o
Price level falls  unemployment rises … less output creates a need for less workers in
the economy
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(graph)
Equilibrium in the long-run AD-AS model:

Long-run equilibrium GDP and price level occur at the intersection of the aggregate demand
curve, the long-run aggregate supply curve, and the short-run aggregate supply curve
o
Nominal wages fully respond to changes in the price level

o
Vertical, with sufficient time for adjustment, nominal wages rise and fall with
the price level, moving the economy along a vertical aggregate supply curve at
the economy’s full-employment output
Long-run equilibrium, economy achieves its natural rate of unemployment and its fullpotential real output
(graph)
Demand-pull inflation in the extended AD-AS model:

Increase in aggregate demand from AD1 to AD2 drives up the price level and increases real
output in the short run. In the long-run, nominal wages rise and the short-run aggregate supply
curve shifts leftward
o

(graph)
Once nominal wages rise to match the increase in price level, the temporary increase in
real output is reversed
Real output returns to prior level, and price level rises even more
15
Cost-pull inflation in the extended AD-AS model:

Short-run aggregate supply curve shifts left from AS1 to AS2 if government counters the decline
in real output by increasing aggregate demand to the broken line, price level rises even more

If government allows a recession to occur, nominal wages eventually fall and aggregate supply
curve shifts back rightward to original location

Unless the government expands aggregate demand, nominal wages will eventually decline
under conditions of recession and the short-run aggregate supply curve will shift back to its
initial locations
o
Prices and real output will eventually return to their original levels
(graph)
Recession in the extended AD-AS model:
(graph)
Production possibilities and long-run aggregate supply:

(graph)
Economic growth driven by supply factors shifts an economy’s production possibilities curve
outward and the long-run aggregate supply curve to the right
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Depicting US growth via the extended AD-AS model:

Under normal circumstances, there is a short-run trade-off between the rate of inflation and the
rate of unemployment

Aggregate supply shocks can cause both higher rates of inflation and higher rates of
unemployment

No significant trade-off between inflation and unemployment over long periods of time

If prices and wages are flexible downward, a decline in aggregate demand will lower output and
the price level; the decline in the price level will eventually lower nominal wages and shift the
short-run aggregate supply curve right-ward. Full employment output will thus be restored

One-time changes in AD and AS can only cause limited bouts of inflation. Ongoing mild inflation
occurs because the Fed purposely increases AD slightly faster than the expansion of long-run AS
(driven by supply factors of economic growth)
(graph)
Phillips Curve – curve showing the relationship between the unemployment rate (horizontal axis) and
the annual rate of increase in the price-level (vertical axis)

Assuming a stable, up-sloping short-run aggregate supply curve, rightward shifts of the
aggregate demand curve of various sizes yield the generalization that high rates of inflation are
associated with low rates of unemployment, and vice versa.
*In the 1970s and early 1980s the Phillips Curve apparently shifted rightward, reflecting stagflation—
simultaneously rising inflation rates and unemployment rates. The higher unemployment rates and
inflation rates resulted mainly from huge oil price increases that cause large leftward shifts in the shortrun aggregate supply curve (so-called aggregate supply shocks). The Phillips Curve shifted inward toward
its original position in the 1980s. By 1989 stagflation had subsided, and the data points for the late
1990s and first half of the first decade of the 2000s were similar to those of the 1960s. The new pattern
continued until 2009, when the unemployment rate jumped to 9.3% and the inflation rate rose on a
December-to-December basis to 2.7%.

Although there is a short-run trade-off between inflation and unemployment, there is no longrun trade-off. Workers will adapt their expectations to new inflation realities, and when they do,
the unemployment rate will return to the natural rate. So the long-run Phillips Curve is vertical
at the natural rate, meaning that higher rates of inflation do not permanently “buy” the
economy less unemployment
Stagflation – inflation accompanied by stagnation in the rate of growth of output and an increase in
unemployment in the economy; simultaneous increases in the inflation rate and the unemployment rate
17
Aggregate supply shocks – sudden, large increases in resource costs that jolt an economy’s short-run
aggregate supply curve leftward
Long-run vertical Phillips curve – Phillips curve after all nominal wages have adjusted to changes in the
rate of inflation; a line emanating straight upward at the economy’s natural rate of unemployment
Disinflation – reductions in the inflation rate from year to year
Supply-side economics – stress that changes in aggregate supply are an active force in determining the
levels of inflation, unemployment, and economic growth

Government policies can either impede or promote rightward shifts of the short-run and longrun aggregate supply curves

Supply-side economists focus attention on government policies, such as high taxation, that
impede the expansion of aggregate supply
Laffer Curve – a curve relating government tax rates and tax revenues and on which a particular tax rate
(between zero and 100 percent) maximizes tax revenues

Relates tax rates to levels of tax revenues and suggests that under some circumstances, cuts in
tax rates will expand the tax base (output and income) and increase tax revenues.
o
Most economists, however, believe that the US is currently operating in the range of the
Laffer Curve where tax rates and tax revenues move in the same, not opposite,
directions

1980s: US tax rate was so high that production was discouraged  lowering tax rate lead to
increases, decreases, or same tax revenues

Reagan tax cuts worked as intended
o

Boosted AD, returned GDP to full employment output and normal growth path
Economy expanded, tax revenues expanded (despite lower tax rates)  didn’t shift AS out to an
extraordinary extent
Ex. Over 20 years, a country’s price level went from 100 to 150. Its real GDP went from $3 trillion to $6
trillion. What’s the real economic growth? Rate of growth?

($6 trillion – 3 trillion)/3 = 100% growth

Annual rate of growth? = (growth/number of years) = (1/20) = 5%

Experience inflation? Price level changes?
o
Inflation for 20 years: (150-100)/100 = 50%
o
Annual inflation: (.5/20)= 2.5%
Chapter 20:
Economic basis for trade:

Distribution of natural, human, and capital resources among nations is uneven; nations differ in
their endowments of economic resources
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
Efficient production of various goods requires different technologies, and not all nations have
the same level of technological expertise

Products are differentiated as to quality and other attributes, and some people may prefer
certain goods imported from abroad rather than similar goods produced domestically
United States leads the world in combined volume of exports and imports

Other major trading nations: Germany, Japan, the western European nations, and the Asian
economies of China, South Korea, Taiwan, and Singapore

US’s principle exports include chemicals, agricultural products, consumer durables,
semiconductors, and aircraft; principle imports: petroleum, automobiles, metals, household
appliances, and computers
Labor-intensive goods – product requiring relatively large amounts of labor to produce

Textiles, electronics, apparel, toys, and sporting goods
Land-intensive goods – products requiring relatively large amounts of land to produce

Beef, wool, and meat
Capital-intensive goods – products requiring relatively large amounts of capital to produce

Airplanes, automobiles, agricultural equipment, machinery, chemicals
Absolute advantage – if a country is the most efficient producer of that product (by which we mean that
it can produce more output of that product from any given amount of resource inputs than can any
other producer)
Competitive advantage – if a country can produce the product at a lower opportunity cost (by which we
mean that it must forgo less output of alternative products when allocating productive resources to
producing the product in question)
Realities relating to production possibilities curve:

Constant costs

Different costs

US absolute advantage in both
Opportunity-cost ratio – an equivalency showing the number of units of two products that can be
produced with the same resources

Mutually advantageous specialization and trade are possible between any two nations if they
have different domestic opportunity-cost ratios for any two products
Principle of comparative advantage – total output will be greatest when each good is produced by the
nation that has the lowest domestic opportunity cost for producing that good

By specializing on the basis of comparative advantage, nations can obtain larger real incomes
with fixed amount of resources
19
Terms of trade – the rate at which units of one product can be exchanges for units of another product;
the price of a good or service; the amount of one good or service that must be given up to obtain 1 unit
of another good or service

Determine how this increase in world output is shared by the trading nations; increasing (rather
than constant) opportunity costs limit specialization and trade
Trading possibilities line – shows the amounts of the two products that a nation can obtain by
specializing in one product and trading for the other
Gains from trade – the extra output that trading partners obtain through specialization of production
and exchange of goods and services
World price – the price that equates the quantities supplied and demanded globally
Domestic price – the price that would prevail in a closed economy that does not engage in international
trade
Export supply curve – an upward-sloping curve that shows the amount of a product that domestic firms
will export at each world price that is above the domestic price
Import demand curve – a down-sloping curve showing the amount of a product that an economy will
import at each world price below the domestic price
Equilibrium world price – the price of an internationally traded product that equates the quantity of the
product demanded by importers with the quantity of the product supplied by exporters

The price determined at the intersection of the export supply curve and the import demand
curve

A nation will export a particular product if the world price exceeds the domestic price; it will
import the product if the world price is less than the domestic price; the country with the lower
costs of production will be the exporter and the country with the higher costs of production will
be the importer
Tariffs – excise taxes of “duties” on the dollar values of physical quantities of imported goods
Revenue tariff – usually applied to a product that is not being produced domestically
Protective tariff – implemented to shield domestic producers from foreign competition

Impede free trade by increasing the prices of imported goods and therefore shifting sales
toward domestic producers

Supply and demand analysis demonstrates that protective tariffs and quotas increase the prices
and reduce the quantities demanded of the affected goods

Sales by foreign exporters diminish; domestic producers, however, gain higher prices and
enlarged sales; consumer losses from trade restrictions greatly exceed producer and
government gains, creating an efficiency loss to society
*strongest arguments for protection are the infant industry and military self-sufficiency arguments
20

Most other arguments for protection are interest-group appeals or reasoning fallacies that
emphasize producer interests over consumer interests or stress the immediate effects of trade
barriers while ignoring long-run consequences
Import quota – limit on the quantities or total values of specific items that are imported in some period
Nontariff Barrier (NTB) – includes onerous licensing requirements, unreasonable standards pertaining to
product quality, or simply bureaucratic hurdles and delays in customs procedures
Voluntary Export Restriction (VER) – trade barrier by which foreign firms “voluntarily” limit the amount
of their exports to a particular country
Export subsidy – consists of a government payment to a domestic producer of export goods and is
designed to aid that producer
Direct effects of tariffs:

Decline in consumption

Increased domestic production

Decline in imports

Tariff revenue
Dumping – sale of a product in a foreign country at prices either below cost or below the prices
commonly charged at home

Cheap foreign labor argument for protection fails because it focuses on labor costs per hour
rather than on what really matters, labor costs per unit of output
o
Due to higher productivity, firms in high-wage countries like the US can have lower
wage costs per unit of output than competitors in low-wage countries

Whether they do will depend on how their particular wage and productivity
levels compare with those of their competitors in low-wage countries
Smoot Hawley Tariff Act – legislation passed in 1930 that established very high tariffs its objective was to
reduce imports and stimulate the domestic economy, but it resulted only in retaliatory tariffs by other
nations
General Agreement on Tariff and Trade (GATT) – (1) equal, nondiscriminatory trade treatment for all
member nation; (2) the reduction of tariffs by multilateral negotiation; (3) the elimination of import
quotas

Formed 1947

The Uruguay Round of GATT negotiations (1993) reduced tariffs and quotas, liberalized trade in
services, reduced agricultural subsidies, reduced pirating of intellectual property, and phased
out quotas on textiles
World Trade Organization – oversees trade agreements reaches by the member nations, and rules on
trade disputes among them
21

153 member nations (as of 2010); implements WTO agreements, rules on trade disputes
between members, and provides forums for continued discussions on trade liberalizaiton
Doha Development Agenda – the latest, uncompleted sequence of trade negotiations by members of
the World Trade Organization; named after Doha, Qatar, where negotiations began

Began in late 2001, as of 2010 was still in progress
European Union (EU) – an association of 27 European nations (as of 2010) that has eliminated tariffs and
quotas among them, established common tariffs for imported goods from outside the member nations,
eliminated barriers to the free movement of capital, and created other common economic policies
Euro Zone – the 16 nations (as of 2010) of the 25-member European Union that use the Euro as the
common currency
North American Free Trade Agreement (NAFTA) – established a free trade area that has about the same
combined output as the EU but encompasses a much larger geographical area
Trade Adjustment Assistance Act – a US law passed in 2002 that provides cash assistance, education and
training benefits, health care subsidies, and wage subsidies to workers displaced by imports or
relocations of US plants to other countries

Recognizes that trade liberalization and increased international trade can create job loss for
many workers
Offshoring – shifting work previously done by American workers to workers located in other nations

Although it reduces some US jobs, it lowers production costs, expands sales, and therefore may
create other US jobs

Less than 4% of all job losses in the US each year are caused by imports, offshoring, and plant
relocation
Economic basis for trade:

Different resource endowments

Different levels of technology

Product differentiation
David Ricardo (1817) – international specialization will benefit a nation

Countries benefit from specializing in the production and export of the goods it can produce at
relatively low cost
Free trade expands consumption options:
(graph)
22
Chapter 8:
Economic growth – an increase in real GDP occurring over some time period; an increase in real GDP per
capita occurring over some time period
Real GDP per capita – amount of real output per person in a country

= (real GDP/population)
Rule of 70 – provides a quantitative grasp of the effect of economic growth

Approx number of years required to double real GDP = (70/annual percentage rate of growth)
Modern economic growth – characterized by sustained and ongoing increases in living standards that
can cause dramatic increases in the standard of living within less than a single human lifetime

Sustained, ongoing increases in standard of living

Provides more time for leisure, encourages social development (e.g. universal education,
protects rights), and typically leads to democratic systems of government

Improvements in health mean that (generally) people can expect to live longer
Eisenhower years (1950s):

Economic boom following WWII; standard of living increased greatly for many in US

Moderate Republicanism: lead to US “down the middle of the road between the unfettered
power of concentrated wealth… and the unbridled power of statism or partisan interests”

Expanded Social Security, increased minimum wage, and created the Department of Health,
Education, and Welfare

Improved infrastructure: interstate highway system

St. Lawrence Seaway

Low unemployment, low inflation

High priority: balancing budget
Civil Rights (1950s):

Brown vs Board of Education (1954)
“Leader” countries – more industrially/technologically advanced, so they grow more slowly

Typically grow by an average annual rate of just 2 or 3 percent per year
“Follower” countries – have potential for much higher growth rates because they can adopt existing
technologies from the leader countries
23

Once they are also rich and using the latest technology, their growth rates are limited by the
rate at which new technology can be invented and applie

Ex. leader – GDP $40,000; growth rate 0%
Follower – GDP $20,000; growth rate 7%

How many years will it take for follower country to catch up to the living standard of the leader
country?
o
(70/7) = 10 years to double
o
10 years for $20,000 to double to $40,000
Institutional structures to promote economic growth:

Property rights

Patents and copyrights: constant flow of innovative new technologies and sophisticated new
ideas

Efficient financial institutions – channel the savings generated by households toward the
businesses, entrepreneurs, and inventors that do most of society’s investing and inventing

Literacy and widespread education – needed for the development of new technologies

Free trade – allows countries to specialize so that different types of output can be produced in
the countries where they can be made most efficiently

Competitive markets (different degrees of regulation)
Determinants of growth (supply side) – relate to the economy’s physical ability to expand

Increases in quantity/quality of natural resources

Increases in quantity/quality of human resources

Increases in the supply (or stock) of capital goods

Improvements in technology

Supply factors – changes in the physical and technical agents of production; enable an economy
to expand its potential GDP
Determinants of growth (demand side) – demand factors: to achieve the higher production potential
created by the supply factors, households, businesses, and government must purchase the economy’s
expanding output of goods and services
Determinant of growth (economy efficiency) – efficiency factor: to reach its full production potential, an
economy must achieve economic efficiency as well as full employment

Productive efficiency

Allocative efficiency

Full-employment
24

Supply factors that shift PPF out
o
Demand factor and efficiency factor move the economy from points such as a and c to
the optimal output, point b
(graph)
Labor-force participation rate – the percentage of the working-age population actually in the labor force

Labor inputs (hours of work) x labor productivity (average output per hour) = real GDP
o
Labor inputs: size of employed labor force; average hours of work
o
Labor productivity: technological advances; quantity of capital; education and training;
allocative efficiency
Growth accounting – assess the relative importance of the supply-side elements that contribute to
changes in real GDP

Increases in hours of work

Increases in labor productivity
Changes in productivity growth rates – technological advances

Accounts for 40% of productivity growth

Includes techniques, management methods, innovations in business organization

Often embodied within new capital; promotes investment in machinery, equipment
Changes in productivity growth rates – quantity of capital

Accounts of approximately 30% of productivity growth

More and better plants, equipment, machinery, make labor more productive

Complemented by infrastructure improvements
Changes in productivity growth rates – education and training

Human capital: the knowledge and skills that make a worker productive
Changes in productivity growth rates – economic of scale and resource allocation

Together, explain approximately 15% of productivity growth
25

Economies of scale: reductions in per-unit production costs that result from increases in output
levels

Improved, resource allocation: shift to high productive industries
Increasing rate of average productivity growth:

Wave of technological advancements

Increasing returns to scale

Global competition
o
Economy’s labor productivity determines its average real hourly wage

Income per hour = output per hour

Productivity growth is the economy’s main route for improving workers’ living
standards
Fixed  AFC = (FC/q)
Per unit ATC = (TC/q)

100,000 + 100(.5) = $100,050/100 = $1,000.50
Information technology – new and more efficient methods of delivering and receiving information
through the use of computers, fax machines, wireless phones, and the Internet

The combination of the computer, fiber-optic cable, wireless technology, and the Internet
constitutes a spectacular advance in IT  used to connect all parts of the world
Start-up firms – a new firm focused on creating and introducing a particular new product or employing a
specific new production or distribution method

Increasing returns – a situation in which a given percentage increase in the amount of inputs a
firm uses leads to an even larger percentage increase in the amount of output the firm produces

More specialized inputs

Spreading of development costs

Simultaneous consumption

Network effects – increases in the value of a product to each user, including existing users, as
the total number of users rises

Learning by doing – achieving greater productivity and lower average total cost through gains in
knowledge and skill that accompany repetition of a task; a source of economies of scale
Critics of rapid growth – say that it adds to environmental degradation, increases human stress, and
exhausts the earth’s finite supply of natural resources
Defenders of rapid growth – say that it is the primary path to the rising living standards nearly
universally desired by people, that it need not debase the environment, and that there are no
indications that we are running out of resources
26
*Growth is based on the expansion and application of human knowledge, which is limited only by
human imagination
Chapter 21:
Paths to economic growth:

Use existing supplies of resources more efficiently: eliminate unemployment and
underemployment, achieve productive and allocative efficiency

Expand available supplies of resources, and advance technological knowledge to push PPF
outward
Issues – natural resources

Uneven distribution of natural resources

Control of natural resources in the hands of multinational corporations

Price fluctuations of farm products, raw materials

Climate change
Issues – human resources

Large populations

High rates of unemployment, underemployment

Low rates of educational attainment

Low labor productivity
o
Population growth?

Less housing savings  less investment

Lower productivity as a result of less available capital

Overuse of land

Urban problems

Demographic transition
1950-2010: average years of schooling in developing countries rose from 2.1 to 7.1 years

In industrially advanced nations, 6.2 to 11 years
Issues – capital accumulation

Workers need access to physical capital (machinery, equipment) to become more productive

More productive workers generate more output, income

Obstacles to investment: low savings rates, lack of investors, lack of entrepreneurs
o
Infrastructure issues may prevent foreign investment
27
Issues – technological advancement

Technological borrowing may be hampered by very different resource endowments
Issues – sociocultural and institutional factors

Social factors

Religious, cultural beliefs

Political conflict

Government problems
Role of government:

Rule of law

Infrastructure

Free trade

Human capital development

Innovation and entrepreneurship

Credit systems

Population growth

Peace
Rule of other nations:

Lowered trade barriers  good and bad

Temporary migration

Prevent arms sales

Foreign aid
Private capital flows – international corporations, banks, and financial investment companies send
private capital to developing countries

Build plants

“Emerging market funds”

Usually focused on a few middle income countries (e.g. Mexico, China, India) rather than the
poorest countries
28