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Principles of Macroeconomics Winter 2012 Instructor : Phone : E-Mail: Office Hours: John Winstandley ( 651) 503-4347 [email protected] Before Class ( 12:30- 1:00), After Class ( 4:30-5:00) Additional Office Hours : SA Jan. 28 SA Feb. 11 SA Mar. 17 SA Mar. 24 (11:45 am – 1:15 pm) (11:45 am – 1:15 pm) (11:45 am – 1:15 pm) (11:45 am – 1:15 pm) Course Text ( recommended, not required ): Macroeconomics: Principles and Policy ( 11th edition), by Baumol and Blinder Exams: There will be 2 exams. The second exam will not be cumulative. The exam schedule is as follows: EXAM 1 2 DATE AND TIME % of the Final Grade SU Feb. 12 , 3:00 pm – 4:30 pm SU Mar. 25 30 % 40 % Problem Sets: There will be 2 homework assignments. These assignments will include problems based on the material presented in lecture/ online. Homeworks are due at 3:30 pm on their due date. Late homeworks will be accepted ( before midnight on March 31), but at a loss of 25 % of the points on that problem set. The homework due date schedule is as follows: HW 1 2 DUE DATE Jan. 29 Mar. 18 % of the Final Grade 10 % 20 % Course Grading: If necessary, I will base a curve around a target distribution on each exam. If the actual distribution is below the target, points will be added to each student’s score. After this curve is put into place, grades are as follows: 93 + : A 90 – 92 : A – 87 – 89 : B + 83 – 86 : B 80 – 82 : B 73 - 79 : C + 66 – 72 : C 60 – 65 : C 55 – 59 : D + 50 – 54 : D 0 – 49 : F Tentative Course Schedule: DATE WEB NOTES TOPICS - Gross Domestic Product - Potential GDP - Unemployment - Inflation - Components of Aggregate Demand Jan. 8 - The Consumption Function Investment Net Exports Equilibrium GDP Jan. 15 - The Multiplier The AD Curve The AS Curve Equilibrium of AS and AD Jan. 29 - Equilibrium of AS and AD - Recessionary and Inflationary Gaps Feb. 12 - Fiscal Policy - The Banking System EXAM 1, 3:00 pm – 4:30 pm WEB NOTES - The Banking System Feb. 26 - Monetary Policy Exchange Rates International Macroeconomics Mar. 18 - International Macroeconomics Mar. 25 EXAM 2, 1:00 pm – 4:30 pm Mar. 26 – Mar. 31 Final Week TEXT READINGS 87 - 91 108 - 109 113- 115 120 -121; 122- 124; 127 -129 154 – 157 157 - 163 164 – 165 165 – 166 176- 177; 193-194 185 – 190 180 200 - 203 203 - 205 203 - 205 205 – 211 221; 223 – 225; 226- 228 248 – 251 248 - 259 265 - 274 362 – 365 380 – 386 362- 365; 369 – 370 ; 380 – 386 Before the First Class: directly in class): you should have read the notes that follow ( we will NOT cover this material Nominal vs. Real GDP Gross Domestic Product (GDP) : the sum of the money value of all new final goods and services produced in the domestic economy ( and sold in a market) during a specified period of time - the period of time is often 3 months ( a “ quarter”) Nominal GDP : value each good produced at its current price One use of GDP : to track the economy’s health over time - e.g., are we producing more now than we did 10 years ago? Nominal GDP is not well suited for this task Problem: increases in prices will lead to an increase in Nominal GDP - e.g., output and price for a certain car model: Year 0 1 Q 10 8 P $ 10,000 $ 20,000 Nominal Value ( = P x Q) $ 100,000 $ 160,000 - in the above case, Nominal GDP increased even though output actually fell - so, using Nominal GDP might fool us into believing that the economy is growing ( or ,above, that the production of cars is increasing) To solve the problem…………… - Measure the value of production by the price that prevailed in some “base year” - doing this results in the calculation of Real GDP - e.g., if the base year = Year 0: Year 0 1 Q 10 8 Value ( = Price In Year 0 ) $ 10,000 $ 10,000 Real Value $ 100,000 $ 80,000 - In that case, the decrease in production leads to a decrease in Real GDP - i.e., Real GDP will only increase if output actually increases Intermediate Goods - GDP only includes sales of final goods and services : those purchased by their ultimate users - in contrast, an intermediate good is a good purchased for use in the production of another product - these are not included in GDP - e.g., if a car company buys the engines from another company . these purchases are not included in GDP, to avoid “ double counting” - when the car company sells the car to a consumer, part of the price includes the cost of the engine - so the engine’s value is included in GDP then - if it was counted when the car company bought it, it would be counted twice The Economic Costs of Unemployment 1) Unemployment implies loss of the goods and services that the workers could have produced - which means less output for the economy’s residents to consume - i.e., in the present, we lose output but, even when the workers resume working, the costs of unemployment linger… 2) Unemployment implies workers don’t gain new skills, or that the skills they had previously will begin to deteriorate - so, unemployment today implies that workers will be less productive in the future Counting the Unemployed - monthly survey by the government - places those questioned into 1 of 3 categories: 1) Employed – anyone currently working in the market ( including part-time) 2 ) Unemployed – anyone not working who - expects to return to a previous job - e.g., a factory temporarily shuts down or - has looked for work in the last month 3 ) Out of the Labor Force - anyone not working who is not looking for work - such individuals don’t factor into the unemployment rate at all UNEMPLOYMENT RATE ( UR) = Unemployed Employed + Unemployed The Unemployment Rate probably understates the true size of an economy’s problem in matching workers with jobs e.g., if the UR = 10%, there are 10% who want to work but can’t find a job - in that case, clearly a lack of a good “ job match” other mismatches that won’t show up in the UR: “ Underemployed” - those who work part-time but would like to work full-time - they count as Employed, so the UR doesn’t detail this problem - but, there not “matched” with the right job “ Discouraged Workers” – those not working who have given up looking for work - they’re not counted as Unemployed - this lead to a quirk of the UR: the UR falls as workers give up hope of finding a job - this often happens during recessions ( a recent example: it happened in the U.S. in 2009): - the recession implies that the economy’s output is falling - which means fewer jobs are available - which leads to more “ discouraged workers” - which may mean that the UR will decrease - this could fool one into thinking the labor market is getting better, when it’s actually a sign that it’s so bad that people are giving up the pursuit of a new job Types of Unemployment - to lead to a definition of “fully employed”……… 1) Frictional - “normal” labor market turnover - e.g., temporarily between jobs 2 ) Structural - caused by changes in the economy that imply a permanent decrease in a certain type of skill - e.g., machines/ software replacing people loss of jobs in industries in which demand for the product has permanently fallen 3 ) Cyclical - unemployment due to a general, temporary downturn in the economy ( i.e., a recession ) “ Full Employment” doesn’t mean everyone is working - it means that there is no unemployment that simply wastes resources - Frictional Unemployment can be good in the long-run : people look for better jobs or for jobs for which they are more qualified - Structural Unemployment means workers move from industries in decline to industries making products more in demand by society - Only Cyclical Unemployment is clearly a waste - workers are laid off in a recession; they go back to that job as the economy improves - So, “Full Employment” is the absence of “wasteful” unemployment - thus, “Full Employment” is when there is no Cyclical Unemployment - so, “Full Employment” does NOT mean that the UR = 0 % The Natural Rate - the “Natural Rate of Unemployment” is this “normal” rate of unemployment, when there is no Cyclical Unemployment, and “average” levels of Frictional and Structural - estimates : the “Natural Rate” in the U.S. is around 5% or 6% Suppose the Natural UR = 5.5 % - thus, 94.5% of the labor force are employed, helping to produce output ( which we calculate as Real GDP) - this level of output, produced when the economy is operating with no cyclical unemployment , is also called the “Natural Rate of Output” - Note : the “Natural Rate of Output” is equivalent to “Potential GDP” - this connection is important: - higher output implies less unemployment and - less output implies more unemployment - we will assume this later, when we build a supply/demand model Suppose Real GDP is currently below the “Natural Rate of Output” - e.g., the economy is in a recession - then, the UR will be above its natural rate - as an example, say the current UR = 6.5% - this implies that the level of Cyclical Unemployment = 6.5 – 5.5 = 1.0% Economic Policymakers will often work to eliminate Cyclical Unemployment , by attempting to get the economy back to its Natural Rate ( or equivalently, back to Potential GDP) But they won’t try to drive the UR to 0%, because they believe that Frictional and Structural Unemployment is useful in the long-run Inflation One of the two main macroeconomic variables Inflation - an increase in the general level of prices Purchasing Power - the volume of goods and services a given amount of money will buy Inflation implies a decrease in the purchasing power of a given level of income - e.g., after inflation, $1 buys less than it did before However, wages often increase as price do - which means that , even during inflationary times, the average purchasing power of workers may not fall - i.e., each $1 earned is worth less, but more $ are earned - in fact, many economists believe that higher wages CAUSE higher prices - more discussion in future chapters, but the basic idea: - wage increases mean the cost of production increases, so companies pass this increase in costs on to their customers - so, if wages increase by 5%, causing 5% inflation, then average purchasing power didn’t change Real Wage Rate - the wage rate adjusted for inflation - it measures how much one can buy with one’s wages - Formula : The % Change in Real Wage = % Change in Nominal Wage % Change in Prices ( i.e., the inflation rate) - e.g., suppose a worker receives a 7% Nominal Wage increase during a year when inflation = 5% - then, the change in the real wage = 7 -5 = 2 % Economic Policymakers are concerned with fighting inflation ( as we’ll see more in future chapters) But why? The above implies that inflation may not affect purchasing power at all Reasons Economic Policymakers Try to Fight Inflation: 1) Consumers believe that inflation robs them of purchasing power - e.g., the worker above thinks that they earned a 7% real wage increase - then, as prices increase over the year, they feel that their raise has been stolen by inflation - so, maybe workers/consumers/ voters demand that policymakers fight inflation - however, if higher wages cause inflation, the only way to avoid inflation is if nominal wages don’t increase in the first place 2) Uncertainty over future inflation hurts the economy - to see this, we discuss - Inflation and Borrowing/Lending - lenders are hurt by inflation; borrowers gain from inflation - e.g., Bob loans Ann $ 1000, to be paid back next year - suppose Bob wants 5% interest - so Ann agrees to pay back $ 1050 next year - Bob really wants $ 1050 in purchasing power next year - i.e, to be able to buy next year what he could have bought with $ 1050 today - but, if inflation is , say, 10%, the $1050 he receives next year is worth less than the $ 1000 he loaned today - Ann gains since the $1050 she pays back next year is worth less than the $ 1000 she receives today How could Bob solve the problem? - he could charge Ann 15% interest : 10% to compensate for inflation , plus the 5% interest that he wanted - this 5% rate would be the Real Interest Rate – the % increase in purchasing power that the borrower pays to the lender - in this case, 15% in the Nominal Interest Rate Nominal Interest Rate = Real Interest Rate + Expected Inflation Rate As long as they agree on the expected inflation rate , then inflation has no effect - i.e., they agree that the “price” of money should be 5% - both think that inflation will be 10% - so, Ann doesn’t mind paying 15% - maybe she’s going to invest in a business whose prices will increase by 10% The problem comes if they don’t agree on the expectation Uncertainty over future inflation rates can prevent economic transactions from taking place: - e.g., suppose Ann and Bob agree that a 5% real interest rate is fair - yet Bob believes inflation will be 11% , but Ann believes it will be 9% - so Bob wants 5 + 11 = 16% interest, but Ann is willing to pay only 5 + 9 + 14% - so they can’t agree on a deal - even though they’ve really agreed on a price ; generally ,when the two sides agree on a price , the transaction will take place, and both sides are better off - but not in this case, which hurts the economy : maybe Ann wants to start a business, and thus add output to the economy; but , in this case, that output is lost, because she never receives the capital in the first place To prevent this problem, policymakers may target 0% inflation Although, all the policymakers really need is constant/predictable inflation - e.g., if it’s always 10% per year, Ann and Bob will agree Calculating the Inflation Rate Index Numbers - numbers expressing the cost of a market basket of goods, relative to its cost in some “base period” Example : - Consumer Price Index ( CPI) - measure of the average level of prices of a “basket” of goods and services consumed by a typical urban family in a given year - this is the most widely quoted measure of inflation - e.g., if the basket costs $ 4500 now, but cost $ 3000 in the base year : CPI( now) = Cost of Basket Now Cost of Basket in the Base Year = $ 4500 $ 3000 X 100 X 100 = 150 Note : CPI( base year ) = 100 So, CPI( now) – 100 = % change in prices since the base year - e.g., in the above example, prices have increased by 150 – 100 = 50% since the base year Deflating - the process of finding the real value of some nominal value, by dividing by some price index - this allows us to track an economic value over time e.g., suppose Cathy earns $ 10/ hour in the base year ( Year 0), but she earns $ 12 / hour in Year 1 Suppose CPI( Year 1) = 125 Then, Cathy’s Real Wage in Year 1 =Nominal Wage in Year 1 X 100 CPI = $12 X 100 125 = $ 9.60 - this means that, in “Year 0 dollars”, Cathy earns $ 9.60 an hour in Year 1 “ 100” is the “deflator” = value of each Year 1 dollar, in terms of the base year CPI - here, it equals 100/ 125 = .8 which means that each Year 1 dollar buys what $ .80 would have bought in the base year so ,we “deflate” each Year 1 dollar by multiplying it by .8 In general, real value = nominal value X 100/(Price Index) Components of Aggregate Demand Aggregate Demand (AD) : the total amount that all consumers, business firms, and government agencies are willing to spend on the final goods and services of a particular economy Important note : how much they’ll spend at a particular price level The Components of AD: Consumption (C) : total amount spent by consumers on newly purchased goods and services ( except new homes) Investment (I) : spending by businesses on new factories/ offices and new equipment, plus purchases of new homes by consumers Why new homes here? Because, like the decision to invest in factories/ equipment, the amount of new homes will be affected by Interest Rates Government Purchases of Goods and Services (G) Net Exports (NX ) = Exports (X) – Imports (IM) To create an accurate measure of spending on goods and services produced in a given economy ( say, the U.S. ), we need to : Add purchases of U.S. products by those in other countries ( these are exports ) AND Subtract purchases of foreign goods by those in the U.S. ( these are imports) , because these purchases would have counted in C, I, or G already -e.g., if a U.S. consumer buys a Japanese-made car, it is counted as part of C for the U.S.( since it’s consumption by a U.S. resident) But it shouldn’t be counted as AD for U.S. products So, it’s subtracted as part of IM ( maybe the car costs $ 20,000: $ 20,000 is added in C, then$ 20,000 is subtracted in IM, so that, overall , it has no effect on the count of AD for U.S. goods) AD is the sum of these 4 components: AD = C + I + G + NX ( or, AD = C + I + G + ( X – IM) ) Let’s follow this demand ( i.e., money) around the economy …….. For now, we assume that firms produce enough to meet this demand ( later , we won’t assume this: maybe firms don’t want to produce as much as we want to buy, at the prices we ( the buyers) are willing to pay) This production is , by definition , = GDP So, AD = GDP Note: since AD represents a spending level, firms have now earned revenue = AD ( or, = GDP) Firms distribute this revenue : - Pay workers Pay debts Pay rents Some is kept as profit for the owners These are all of the sources of income in the economy They add up to National Income ( NI) : aggregate income of everyone in the economy ( before taxes and/or government benefits) So, AD = NI Or, GDP = NI Before NI reaches consumers, some is taken away as Taxes ( Tx) Also, the government provide benefits ( a source of income for recipients) These are called “Transfer Payments” ( Tr) So, income that reaches consumers is = NI - Tx + Tr This is called “Disposable Income” ( DI) So, DI = NI - Tx + Tr ( Note : we’re back at the beginning : we use this DI to buy the goods/services that we want Thus, this becomes Consumption, which means more demand “flows” toward the producers of goods/services….. They then use the revenue thus earned to pay workers/owners Which then becomes another round of DI ………….etc. The money circles around the economy) Note : Since AD = C + I + G + NX And AD = GDP , Then GDP = C + I + G + NX ( i.e., if you want to know how much is produced, you can break it down by the 4 components of spending) The following 6 questions, based on the notes above, will be included on Homework 1 . So you could work on these before the first day of class. However, they are NOT due on the first day ( they will be due, with the rest of HW 1, on January 29). 1. For the following parts, state how much the given action would change GDP ( consider each part independently) : a.) Agnes pays $100 for vegetables at a farmer’s market. b.) A vegetable producer pays $ 10 for seeds to grow vegetables which are then sold to Agnes for $ 100. c.) Agnes pays $ 5 for a packet of seeds and then uses them to grow vegetables that would be worth $ 100, although Agnes actually eats them herself. d.) Agnes uses her own seeds to grow vegetables that would be worth $ 100, although Agnes actually eats them herself. e.) Bob buys a new bike for $ 200. f.) Bob buys a used bike at a garage sale for $ 20. 2. The statistical office of Shelbyville surveys the employment condition of the residents on a monthly basis. For March and August, they found the following statistics: Worked Full-Time for Pay Number of Residents in that Category in March August 11,250 11,300 Worked Part-Time for Pay 250 250 Did not work for pay, but looked for work 1000 1,250 Did not work for pay because they thought jobs were not available 700 400 Did not work for pay because they did not want to 500 500 a.) How many of Shelbyville’s residents were officially considered to be employed in March? b.) How many of Shelbyville’s residents were officially considered to be unemployed in March? c.) How many of Shelbyville’s residents could be considered to be “discouraged workers” during March? d.) Solve for Shelbyville’s unemployment rate in March. Show your work. e.) Solve for Shelbyville’s unemployment rate in August. Show your work (round to the nearest tenth of a percent. As an example, if your calculation = 4.368%, you’d round to 4.4%). f.) Note that there are more workers in August than March; yet your answers to d.) and e.) should imply that there is a HIGHER unemployment rate in August. Explain how this occurred ( give an intuitive answer, based on the scenario above, rather than a strictly numerical answer). 3. Cate lends Dave $ 300, with an agreement that he will pay her $ 315 next year. a.) What is the nominal rate of interest on this transaction? b.) Suppose that Cate only wants a 3.75 % real interest rate. What is the inflation rate that Cate expects? c.) Suppose that the actual inflation rate = 1.5 %. Of the two, who gains unexpectedly? Explain why. 4. Erin, having recently graduated from college, is looking to work for 2 years before she enters graduate school. She has received 2 job offers with the following salary structures: JOB A : pays $ 30,000 in 2012 and $30,750 in 2013 JOB B : pays $ 30,000 in 2012; 2013’s salary will be equal to $30,000 plus a cost of living adjustment ( i.e., a raise equal to the inflation rate in 2013) Suppose that Erin has no preference for either job, other than the highest salary. Suppose that the inflation rate in 2013 equals 3 % . a.) Solve for the % increase in nominal salary from 2012 to 2013 for Job A. b.) What is the % increase in real salary from 2012 to 2013 in Job A ( with inflation in 2013 = 3 %)? c.) What is the % increase in real salary from 2012 to 2013 for Job B ( with inflation in 2013= 3 %)? d.) With inflation equal to 3 % for 2013, which job should Erin take? e.) Suppose that the CPI for 2012 is 100, while the CPI for 2013 is 103. Deflate the 2013 salary for Job A to determine how much the 2013 salary is worth in terms of 2012 dollars ( you may need to round to the nearest cent). f.) How much is the 2013 salary for Job B worth ( in 2012 dollars)? 5. Suppose the following data is true: Year 2008 2009 Cost of the “basket” used to Calculate the CPI $ 15,000 $ 15,150 CPI that year 100 ? a.) Calculate the CPI in 2009. b.) Calculate the inflation rate in 2009. c.) Suppose Fred received a 6 % nominal wage increase in 2009. Solve for Fred’s real wage increase ( in percentage terms) in 2009. 6. Consider a particular macroeconomy. You have the following data ( in billions): National Income $ 6,500 Taxes $ 2,000 Transfer Payments $ 1,500 Consumption $ 4,000 Investment $ 400 Govt. Spending $ 1,800 Exports $ 600 Solve for the following values: a.) Disposable Income b.) Gross Domestic Product c.) Imports