102 Econ 1-9-08
Chapter 5
Introduction to Macroeconomics
Economy: the structure of economic activity in a community, a region, a country, a group of countries, or the world. Gross Domestic Product: the market value of all final goods and services produced in the nation during a particular period- usually a year. Flow Variable: A variable that measures something over an interval of time, such as your income per week. Stock Variable: A variable that measures something at a particular point in time, such as the amount of money you have with you right now. Mercantilism: the incorrect theory that a nation`s economic goals should be to accumulate precious metals in the public treasury; this theory prompted trade barriers to reduce imports, but other countries retaliated in, reducing trade and the gains from specialization. Mercantilism taught that colonies existed to benefit the mother country. [17th and 18th century Britain and France] Economic fluctuations: the rise and fall of economic activity relative to the long-term growth trend of the economy; also called business cycles. Depression: A sharp reduction in an economy`s total output accompanied by high unemployment lasting more than a year; severe economic contraction. Recession: a decline in the economy`s total output lasting at last two consecutive quarters, or six months; an economic contraction. Inflation: an increase in the economy`s average price level. Expansion: a phase of economic activity during which the economy`s output increases.
Case study: the Global Economy.... Pg. 94-95
Business Cycles o o Are not perfectly synced but across countries Often show apparent links
U.S. and U.K.
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Both economies went into a recession in the early 80`s, then grew well for the rest of the decade Entered another recessions in 1991, then recovered for the rest of the 90`s Slowed in 2001, only to pick up again in 2004
Problems with connected business cycles o A slump in one country could worsen another country who is already in a recession A fear among economists in 2001 was that the terrorist attacks would cause a major collapse. They feared that the struggling stock prices, airline tickets, ect. Would affect other countries, again coming back and hurting the US, ultimately causing the connected economies to feed into each other until there was a collapse.
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Leading economic indicators: variables that predict, or lead to, a recession or recovery; examples include; consumer confidence, stock market prices, business investment, and bigticket purchases, such as automobiles and homes. 1-11-08 Coincident economic indicators: variables that reflect peaks and trough as they occur, examples include employment, personal income, and industrial production. Lagging Economic indicators: variables that follow, or trail, changes in overall economic activity; examples include the interest rate and the average duration of unemployment. Aggregate output: a composite measure of all final goods and services produced in an economy during a given period, real GDP. Aggregate demand: the relationship between the economy`s price level and the quantity of aggregate (total) output demanded (other things constant) Price Level: a composite measure reflecting the prices of all goods and services in the economy relative to prices in a base year. Real gross domestic product (real GDP): the economy`s aggregate output measured in dollars of constant purchasing power. Aggregate demand curve: a curve representing the relationship between the economy`s price level and real GDP demanded per period (other things constant) [Graph] exhibit 4 lower prices more demand
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Aggregate supply curve: a curve representing the relationship between the economy`s price level and real GDP supplied per period (other things constant) [Graph] shoot for somewhere in the middle of both curves. Equilibrium point: 10.4 trillion measured in dollars of purchasing power at 106 in 2003. Represents a 6% increase since 2000] Higher level of GDP = 1. More goods and services in the economy 2. More people probably employed. The great depression and before 1873 1879 Hard Times o o 80 railroads went bankrupt This hurt the steel companies, now new track to lay
1890's Depression o 18% unemployment rate
Stock market crash of 1929 1930's (into WWII) Great Depression o Up to 25% unemployed A leftward shift of the aggregate demand curve (exhibit 6)
Prior to the Great Depression, Adam Smith's Laissez-faire ruled
The age of John Maynard Keynes: Post WWII/Early 1970's
The General Theory of Employment, Interest and Money
Government intervention through fiscal and monetary policies, fiscal tend to be raising and lowering taxes. Spoke of Business pessimism; instability of aggregate demand Investment dropped 80% between 1929-1933 [Graph] shrinking GDP 1-14-08 3
Government Intervention necessary: gov`t must increase aggregate demand Federal budget: a plan for federal government outlays and revenues of a specific period, usually a year. Federal budget deficit: a flow variable that measures the amount by which federal government outlays exceed federal government revenues in a particular period, usually a year. Demand-side economics: macroeconomic policy that focuses on shifting the aggregate demand curve as a way of promoting full employment and price stability. Keynes policy Fiscal policies: (government spending and taxes) and monetary policies. - Government needed to shock economy out of depression. Enter WWII. - 1960`s Golden age of Keynesian economics. -world economic boom The Great Stagflation: 1973-1980 Inflation Crop Failures Oil shortage, 1973 Huge Cost of War Stagflation: a contraction, or stagnation of a nation`s output accompanied by inflation in the price level. [graph] Rising prices and unemployment and rising interest rates by the fed. Peaked at 20% Experience since 1980's Supply-side economics: (Reagan) macroeconomic policy that focuses on a rightward shift of the aggregate supply curve through tax cuts or other changes that increase production incentives. - President Reagan - Tax cuts to stimulate economy (23% over three years). - Before tax cuts went into effect, another recession 1981-82; then longest peacetime expansion of economy on record to that date took place. Fed. Deficit persisted. National defense.
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- President Clinton; raised Taxes Republican Congress: Cut Federal Spending. 1998: Federal Budget Surplus. - Late 2000, economy slowing. Attack on US. President Bush: Tax cuts in 2003. Helped, but deficit grew again (with war costs as well) well fair wasn`t working.
Case study: Over Seven Decades of Real GDP...Pg. 104-105
Growth from 1929 2003 o Twelve fold from 0.9 trillion to 10.4 trillion GDP
Job Growth form 1929 2003 o o 47 million jobs to 138 million jobs, or a 194% job increase. Population only grew 139% According to the book the US has been an impressive job machine
Education increased as the workers increased Real DGP is important, but th best measure of the average standard of lifing is an economies Real GDP per Capita o o 1-16-08 [Graph] exhibit 8 This tells us how much an economy produces on average per resident. The US is leader in output per capita
Chapter 6
Productivity and Growth
Growth and the production possibility frontier
Economic growth Role of technology/new or improved resources Productivity: the ratio of a specific measure of output such as real GDP, to a specific measure of input such as labor; in this case, productivity measures real GDP per hour of labor. Human capital: accumulated knowledge, skill, and experience, of the labor force. 5
Physical capital: machines, buildings, roads, modes of transportation, and other manufactured creations used to produce goods and services. 1-18-08 Labor productivity: Output per unit of labor; measured as real GDP divided by the hours of labor employed to the produce the output Per worker production function: The relationship between the amount of capital per worker in the economy and average output per worker Capital Deepening: An increase in the amount of capital per worker; one source of rising labor productivity Two kinds of change improve worker productivity: 1. An increase in the quantity of capital per worker 2. An improvement in the quality of capital per worker Rules of the game: The formal and informal institutions that promote economic activity; the laws customs, convention, and other institutional elements that determine transaction costs and thereby affect people`s incentive to undertake production and exchange
Productivity in Growth and Practice
Industrial Market Countries (Developed Nations): Economically advanced capitalist countries of Western Europe, North America, Australia, New Zealand, and Japan, plus the newly industrialized Asian economies of Taiwan, South Korea, Hong Kong, and Singapore Developing countries: Countries with a low living standard because of little human and physical capital per worker.
Case Study: Computers and Productivity Growth
Computer background o o First microprocessor, the Intel 4004, hit the market in 1971 IBM`s first PC hit market in 1981 This fueled boom in computer use Advances in computing power There are no 65 computers for every 100 people in the US today, that is more computers then cars. 6
Federal Reserve System Study o Computers boost productivity through o Efficiency gains in the production of computers and semiconductors Greater computer use by industry
The use of computers has quickened enough since 1996 to boost overall productivity in the US American businesses invested more, and earlier on, then many other big economies This is why economic benefits should/did show up first
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From 2002 first half of 2004 labor productivity grew at the fastest rate for consecutive years in more then 50 years. This high labor productivity can easily make up for lost output that took lace during long recessions
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Cumulative power of productivity growth is why economist now pay less attention to short term fluctuations in output and more to long term growth
Basic Research: The search for knowledge without regard to how that knowledge will not be used Applied Research: Research that seek answers to particular questions or to apply scientific discoveries to develop specific products Convergence Theory: A theory that predicting that the standard of living in economies around the world will grow more similar over time, with poorer countries eventually catching up with the richer ones. 1-23-08 Industrial policy: the view the government - using taxes, subsides, and regulations should nurture the industries and technologies of the future, thereby giving these domestic industries an advantage over foreign competition. Infant industry argument - Alexander Hamilton. Case study: Picking Technological Winners... Pg. 126 President Clinton proposed that the US should shift from military to civilian focus.
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Economist have realized that firms in some industries gain performance advantage by clustering o o Clustering locating in an area already thick with firms in the same industry The flow of information and healthy competition help to facilitate this boost in performance Firms that do this can also tap into established markets for specialized labor and other inputs.
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Skeptics have pointed out that the government in other countries do not help spur great advancement in technology but actually hurt it. This is why most economists would prefer to let Microsoft, GE, or some startup, bet on important technologies of the future.
Chapter 7
Measuring the Economy and the circular Flow
Expenditure approach to GDP: a method of calculating GDP by adding spending on all final goods and services produced in the nation during the year. Income Approach to GDP: a method of calculating GDP by adding all payments for resources used to produce output in the nation during the year. Final goods and services: Goods and services sold to final, or end, users. Intermediate goods and services: goods and services purchased by firms for further reprocessing and resale. Double counting: the mistake of including the value of intermediate goods plus the value of final goods in gross domestic product; counting the same good more than once. Consumption: household purchases of final goods and services, except for new residences, which count as investments. Investments: the purchase of new plants, new equipment, new buildings, and new residents. Plus net additions to inventories. Physical capital: manufactured items used to produce goods and services; includes new plants and new equipment. Residential construction: building new homes or dwelling places. 1-28-08
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Inventories: producers` stocks of finished and in-process goods. Government purchases: spending for goods and services by all levels of government; outlays minus transfer payments. Net exports: the value of a country`s exports minus the value of imports. Aggregate expenditure: total spending on final goods and services during a given period, usually a year. [C + I + G (X - M) = aggregate expenditure = GDP] Aggregate income: the sum of all income earned by resource suppliers in an economy during a given period. Value added: the difference at each stage of production between the selling price of a product and the cost of intermediate goods purchased from other firms. Disposable income (DI): the income households have available to spend or to save after paying taxes and receiving transfer payments. Net taxes (NT): taxes minus transfer payments. Financial markets: banks and other financial institutions that facilitate the flow of funds from savers to borrowers. Leakage: any diversion of income from the domestic spending stream; includes savings, taxes, and imports. Injection: any spending other than by households or any income other than from resource earnings, includes investment, government purchases, exports, and transfer payments. Depreciation: the value of capital stock used up to produce GDP or that becomes obsolute during a year. Net domestic production: gross domestic product minus depreciation. Case Study: Tracking a $12 Trillion Economy... pg139 Article one of the constitution requires a decennial population census o The government has broken that responsibility down into three parts Census Bureau Commerce Departments` Bureau of Economic Analysis Bureau of Labor Statistics
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Since 1980, Real GDP has more than doubled, Employment has increased more than 40 Million and Real Foreign Trade has more than tripled o o Yet the federal budget has declined in real terms Only .2% of the federal budget goes toward keeping track of the nations economy
Budget Cuts o Have eliminated some data collection while others have slowed Has many as half the imports accounted for reflect carry over from the previous months
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Forced some agencies to do more with the same amount of staff The census bureau proposed data collection on the internet, but was quickly refused by congress
Monitoring economic activity was developed back in the 30`s and 40`s o o o o It was geared more towards measuring the tangible, or manufacturing sector Services are intangible, like medical car, online services, ect The data collection for intangible tends to be less accurate now Researchers also found that after 95, labor productivity in the service sector grew faster then in the goods sector
In short, you cannot effectively realize the increase in efficiency of service because of the data collection style that we currently use. Nominal GDP: GDP based on prices prevailing at the time of the transaction; current dollar GDP. Base year: the year which other years are compared when construction an index; the index equals 100 in the base year Price index: a number that shows the average price of goods, changes in a price index over time show changes in the economy`s average price level. Consumer price index, or CPI: a measure of inflation based on the cost of a foxed market basket of goods and services. GDP price index: a comprehensive price index of all goods and services included in the gross domestic product. 10
Chain-weighted system: an index that adjusts the weights from year to year in calculating a price index, thereby getting rid of much of the bias caused by a fixed-price weighting system. Case study: Prices and GDP Estimation Economist used to believe that the recovery that began in 1991 was spurred by investment spending, especially on the computer sector, this case study reconsiders the role of computer production as a stimulus to that recovery. Computer prices have fallen an average of 13% per year since 1982. It is from the exaggeration in the value of computer production in 1991 that led to the incorrect beliefe that the recovery resulted primarily from a jump in investment spending Chain-Weighted measure adjusts for some distortion that comes from using the 1987fixed price. o According to this method investment grew less during the recovery than during the four previous recoveries This means that investments did not turn out to be such a factor in stimulating economic expansion than it had been in the past. Although the chain weighted system is more complicated provides more reliable year-to-year changes in real output
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Chapter 8
Unemployment and Inflation
Labor force: those 16 years of age and older who are either working or looking for work. Unemployment rate: the number of unemployed as a percentage of the labor force. Discouraged workers: those who drop out of the labor force in frustration because they can`t find work. Labor force participation rate: the labor force as a percentage of the adult population. Case Study: Poor King Coal West Virginia Coal workers, good money, steel overseas took away business form this small but wealthy city making them have to pack up shop and move on out. 40% out of work all of the sudden. The county tried to bring nuclear waste to the old mines, and the terrain was not beneficial for them. Mining jobs went from 7200 to 700, and population dropped to nearly half, because of the lost business. 11
McDowell County, West Virginia prospered by supplying coal that fired the nations steel mills. o o o In 1980, mining jobs accounted for more then half of the jobs in the county Average pay was above $80,000yr (in today`s value) More then half of those over the age of 25 were high school dropouts
Two things came up that hurt McDowell County`s local industry o o The value of the dollar rose relative to foreign currency Steel became cheaper elsewhere and the demand for the production went down in the US
This really hurt the overall economy of the County because they did not really haveany other industry but steel. o They tried to attract other sources of job, o o Even considered a nuclear waste dump Using abandoned mines as possible fish farms
Population dropped nearly half over the next 20 years They are now relying on new highways to provide potential jobs
Frictional unemployment: unemployment that occurs because job seekers and employment need time to find each other. 2/1/08 Seasonal Unemployment: unemployment caused by seasonal changes in the demand for certain kinds of labor. Structural Unemployment: unemployment because 1) the skills in demand do not match those of the unemployed, or 2) the unemployed do not live where the jobs are. Cyclical Unemployment: unemployment that fluctuates with the business cycle, increasing during contractions and decreasing during expansions. Full Employment: Employment level when there is no cyclical unemployment Unemployment Benefits: Cash transfers for those who lose their jobs and actively seek employment.
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Underemployment: workers are overqualified for their jobs or work fewer hours then they would prefer. Case Study: Hyperinflation in Brazil Inflation over a six year period meant that in 1994, the price level was 3.6 million times higher then in 1988 Workers insisted on getting paid daily, often spending all of it as fast as possible The Finance Minister was considered a national hero when he managed to tame inflation, he was elected president in 94 and 98 Interest Rate: interest per year as a percentage of the amount loaned. Nominal Interest rate: the interest rate expressed in current dollars as a percentage of the amount loaned; the interest rate on the loan agreement. Real Interest rate: the interest rate expressed in dollars of constant purchasing pwer as a percentage of the amount loaned; the nominal interest rate minus the inflation rate. COLA: cost-of living adjustments; the increased in a transfer payment r wage that reflects the increase in the price level. Case Study: hyperinflation in Brazil Hyperinflation: a very high rate of inflation Disinflation: a reduction in the rate of inflation Demand-Pull Inflation: a sustained rise in the price level caused by a leftward shift of the aggregate supply curve [Graphs] Exhibit 6 Interest: the dollar amount paid by borrowers to lenders Interest Rate: Nominal Interest Rate: the interest rate expressed in current dollars as a percentage of the amount loaned; the interest rate on the loan Real Interest Rate: the interest rate expressed in dollars of constant purchasing power as a percentage of the amount loaned; the nominal interest rate minus the inflation rate. [Graphs] Exhibit 7
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Exam 1: Wed, 2/4/08 55-60 question, A-D Multiple choice, case studies, 1-3 questions each definitions
Look at graphs, know what they are doing be here at 10! Know the people, Johon Meynard Keynes
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2-8-08
Chapter 9
Aggregate Expenditure Components
Consumption function: the relationship between consumption and income other things constant Marginal Propensity to Consume: (MPC) the fraction of a change in income that is spent on consumption; the change in consumption divided by the change in income that caused it. [Graph] Exhibit 1, interest rates were high, [Graph] Exhibit 4a Marginal Propensity to Save: (MPS) the fraction of a change in income that is saved; the change in saving divided by the change in income that caused it Saving Function: the relationship between saving and income other things constant Net Wealth: the value of assets minus liabilities [Graph] Exhibit 5 Case Study: The Life-Cycle Hypothesis pg. 183 Do people with higher incomes save a larger fraction of their income than those with low income? o According to both evidence and theory, YES
John Maynard Keynes o
The General Theory of Employment, Interest, and Money, -1936
Expressed that richer economies save a larger fraction of disposable income as they grow This was later proved wrong by economist
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Economist later found that the fraction of disposable income saved in an economy seems to stay constant as the economy grows
Life-Cycle model of consumption and saving o o Young people tend to borrow to finance education and home purchases Middle age people begin getting these things paid off and begin saving more 15
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In old age they begin drawing out of savings or dissaving
The life-cycle hypothesis suggests that the saving rate for an economy as a whole depends on, among other things, the relative number of savers and dissavers in the population o Other factors o Tax treatment of interest Convenience and reliability National customs Relative costs of a households major purchase, housing
Japan example Consider it shameful to borrow, meaning more likely to save Require a higher percentage of down payment on housing Housing is more expensive Save on average 13% disposable income, compared to our 4%
Life-Cycle Model of Consumption and Saving: young people borrow, middle age payoff debts, older people make withdraws on their savings, on average net savings over their liftime is small Case Study: Investment Varies Much More than Consumption pg. 188 Consumption makes up roughly 2/3 of GDP and investment varies from year to year, averaging about 1/6 of GDP over a decade [Graph] Exhibit 9 o o Investment fluctuates with much more than consumption or GDP Fluctuations in consumption and in GDP appear to entwined, but consumption varies less then GDP because consumption depends on disposable income, and disposable income varies less then GDP
While consumption is the largest spending component, investment varies much more that consumption and accounts for nearly all the year-to-year variability in real GDP. o Economic forecasters pay close attention to business expenditures and investment plans
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Investment Function: the relationship between the amount businesses plan to invest and the economy`s income, other things constant Autonomous: a term that means independent; for example, autonomous investment is independent of income Government Purchase Function: The relationship between government purchases and the economy`s income, other things constant Net Exports: the relationship between net exports and the economy`s income other things constant Look at pgs 184-185, some simple golf cart story
Chapter 10
Aggregate Supply
Planned Investment: the amount of investment tat firms plan to undertake during a year Actual Investment: the amount of investment actually undertaken; equals planned investment plus unplanned changes in inventories Aggregate Expenditure Line: a relationship showing, for a given price level, planned spending at each income, or real GDP; the total of C+I+G+(X-M) at each income, or real GDP Income-Expenditure Model: a relationship between aggregate income and aggregate spending that determines, for a given price level where amount people plan to spend equals the amount produced. Look at pg 203-204, [Graph] Exhibit 3 Case Study: Fear of Flying pg. 206 What did the World Trade Center Catastrophe do to the Airline Industry? o Already slumping demand had a multiplier effect on aggregate expenditure throughout the US
9/11 effects on the Airline Industry o When aviation regulators knew that a number of planes had been hijacked they Immediately grounded all non-military planes
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They remained grounded for one week costing the industry millions of dollars a day.
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The media Played the horrendous video og the second plane hitin the second tower repeatedly burning the fear consumers into This heightened the concerns about airline safety
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New Regulations Caused longer waits at airports More strict regulations of the items permitted on board the aircrafts This discouraged air travel for many simply because of the inconveniences
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Airline Statistics after 9/11 Airlines were operating at only 75% of number of flights Those reductions in flights meant that a sum 900+ planes would sit on the tarmac, getting no use Of those operating flights, occupancy was only 30% vs. the usual 75% Airlines requested Federal Aid, claiming they would go under without them The government put a 15 billion dollar package together The airlines were still forced to lay off some 20% or 85,000 of its workers The reduction in use of airplanes meant reduced sales of new airplanes This triggered more than 30,000 people to be laid off from the Boeing company and trickled throughout other parts of the airline manufacturing industry Rockwell had to cut 15% of their employees Skycheff laid off some 4,800 of 16,000 employees Airports began rethinking their growth strategies Honolulu suspended their plans on increasing the number of gates and the renovation of over seas terminals 18
Within 3 Weeks Job cuts had exceeded 150,000 o This was only the first round of job cuts caused by 9/11
The economy was already almost in a recession in the weeks before the attacks, so after it was no surprise that we experience a recession o In short, the reduction of jobs in the airline industry had a multiplier effect on a much greater portion of the economy then what was directly involved
Airlines are only a part of the Travel industry o The attacks affected: hotels, restaurants, tourist attractions, car rentals, taxi rides, ect.
The attacks also shook consumer confidence Within 10 days of the attacks the number of people who filed for unemployment benefits went to a 9-year high These early job losses could be viewed as just a part of the first round of reduced aggregate expenditure The second round would occur when people who lost their jobs or feared loosing their jobs would start to spend less The US continued to loose jobs for the next two years Simple Spending Multiplier: the ratio of a change in real GDP demanded to the initial change in spending that brought it about; the numerical value of the simple spending multiplier is 1(1-MPC); call simple because only consumption varies with income Case Study: Falling consumption triggers Japan`s recession pg. 211 Consumer spending is the largest component of aggregate expenditure, accounting for some 2/3 of the total o o Consumption depends primarily on disposable income BUT, depends also on several other factors, including household wealth interest rate, consumer expenditures
Japan`s Stock Market Real Estate and household Wealth
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The sharp reduction in and erosion of consumer confidence in the economy prompted its people to spend less and save more The drop in consumption reduced aggregate expenditure and shifted the aggregate demand curve to the left This decline resulted in Japans` longest economic downturn in over 50 years, with unemployment doubling between 1990 and 2003 Japan`s economy is 2nd largest next to the US The decline in consumption had global implications but by 2004 was beginning to show some signs of life.
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[Graph] Exhibit 5 [Graph] Exhibit 6
Chapter 11
Aggregate Supply
Nominal Wage: the wage measured in current dollars; the dollar amount on a paycheck Real Wage: the wage measured in dollars of constant purchasing power; the wage measured in terms of the quantity of goods and services it will buy Potential Output: the economy`s maximum sustainable output, given the supple of resources, technology and productions incentives; the output level when there are no surprises about the price level Natural Rate of Unemployment: the unemployment rate when the economy produces its potential output Nominal Wage: the wage measured in current dollars; the dollar amount on a paycheck Real wage: the wage measured in dollars of constant purchasing power, the wage measured in terms of the quantity of goods and services it will buy Short run: in macroeconomics, a period during which some resource prices, especially those of labor, are fixed by explicit or implicit agreements. Self described. A shorter amount of time in which prices, unemployment, or supply and demand moves back and forth. Short-run aggregate supply curve (SRAS): (pg225) a curve that shows a direct relationship between the price level and real GDP supplied in the short run (o.t.c.) Short-run equilibrium: the price level and real GD that occur when the aggregate demand curve intersects the short-run aggregate supply curve. 20
Expansionary Gap: the amount by which output in the short run exceeds the economy`s potential output. Long run: in macroeconomics, a period during which wage contracts and resource price agreements can be renegotiated; there are no surprises about the economy`s actual price level. Long-run equilibrium: (actual = expected) the price level and real GDP that occurs when (1) the actual price level equals the expected price level equals the expected price level (2) real GDP supplied equals potential output and (3) real GDP supplied equals real GDP demanded. Contractionary gap: the amount by which actual output in the short run falls short of the economy`s potential output. Long-run aggregate supply (LRAS) curve: a vertical line at the economy`s potential output; aggregate supply when there are no surprises about the price level and all resource contracts can be renegotiated.
Case Study: US Output Gaps and Wage Flexibility
When actual output exceeds potential output, the output gap is positive and the economy has an expansionary gap. o When output in 2000 was 2.2 percent above potential output, this amounted to an expansionary gap of some 200 billion dollars (in 2000),
When actual output falls short of potential output, the output gap is negative and the economy suffers a contractionary gap o Actual output in 2003 was 1.4 percent below potential output, this amounted to a contractionary gap of 150 billion dollars (in 2000 cash) The economy does not have to be in a recession for actual output to fall short of potential output
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From 1992 1995 and from 2002 2004, the economy expanded even though actual output was less than potential output As long as unemployment exceeds its natural rate, the economy will suffer a contractionary gap
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It goes without saying that both employers and employees would be better off if these contractionary gaps had been reduced or eliminated o The more workers employed the more goods produced raises standard of living
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Coordination failure: a situation in which workers and employers fail to achieve an outcome that all would prefer. If employers and employees can increase output and employment by agreeing to lower nominal wages, why doesn`t this agreement come quickly? o o Negotiating contracts is timely and expensive Often long term, because of this
Why do employers lay-off employees when demand is slack, instead of cut wages? o Employers think that pay cuts damage the moral of their workers o Lower morals, lower output
Even in the worst recessions 9 in 10, keep their jobs or find replacement jobs quickly
Another reason employees may be reluctant to take a pay cut is because they may be able to collect more in unemployment benefits then the wages they would receive for actually working. Supply shocks: unexpected events that affect aggregate supply, sometimes only temporarily. Beneficial supply shocks: unexpected events that increase aggregate supply, sometimes only temporarily. Adverse supply shocks: unexpected events that reduce aggregate supply, sometimes only temporarily.
Case Study: Why is Unemployment so HIGH in Europe?
Between WWII and the mid-1970`s, unemployment in Western Europe was low o Form 1960-1974, unemployment never even got to 4% in France
Worldwide recession of the mid 70`s caused unemployment everywhere to surge up, but unemployment in Europe continued to climb long after the recession ended o Unemployment in France and Italy remained above 10% during the 80`s and again in the 90`s In 2004, Italy`s unemployment rate was 8%, Germany and France had 10%, Spain with 11%, and Belgium with 12% Today some claim that the natural rate of unemployment in these countries has increased 22
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Hysteresis: the theory that the natural rate of unemployment depends in part on the recent history of unemployment depends in part on the recent history of unemployment rate increase the natural rate of unemployment. o
The longer that the actual unemployment rate stays above what had been the natural rate, the more the natural rate itself will increase
Some European countries also offer generous unemployment benefits, some people have managed to collect over a decade Other factors have lead to companies being reluctant to hire new employees because it is very costly to let employees go
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Unemployment it higher in continental Europe especially among young workers, few private sector jobs have been created there, if they had the same unemployment rate as the US, and same labor participation rate, they would have about 30 million more people would be working 2/18/08 Wage Agreement: can be explicit or implicit
Chapter 12
Fiscal Policy
Automatic Stabilizers: structural features of government spending and taxation that reduce fluctuations in disposable income and thus consumptions, over the business cycle Discretionary Fiscal Policy: the deliberate manipulation of government purchase, taxation, and transfer payments to promote macroeconomic goals, such as full employment price stability and economic growth. [Exhibit 1] [Exhibit 2] Simple tax Multiplier: the ratio of a change in real GDP demanded to the initial change in autonomous net taxes that brought it about; the numerical value of the simple tax multiplier is MPC/(1 MPC) Expansionary fiscal policy Classical Economics: A group of 18th and 19th century economists who believed that economic downturns were short-run phenomena that corrected themselves through natural market forces; thus, the believed the economy was a self-correcting and needed no government intervention. 23
The evolution of Fiscal Policy... Prior to the 1930s, discretionary fiscal policy was seldom used as an instrument of macroeconomic policy. 1929 stock market crash 1930 and beyond the great Depression - At it`s height, 25% of the working population was unemployed - Although unemployment dropped, the invisible hand was no where to be found - 1936 John Maynard Keynes (UK) The general Theory of Employment interest and money 2-25-08 Key findings... prices and wages inflexible in a downward direction...natural market forces were not correcting the situation. Even with lower interest rates, bleak business expectations ( too conservative) Three developments bolstered the use of discretionary fiscal policy in the US: 1. With the economy operation below its potential, the government needed to increase aggregate demand to boost output and employment. 2. WWII lifted US out of the depression 3. Employment Act of 1946 - gave the federal government responsibility for promoting fill employment and price stability, Overall impact of fiscal policy: don`t worry about a balanced budget, promote full employment and price stability. Automatic Stabilizers: Automatic stabilizers smooth out fluctuations in disposable income over the business cycle, thereby stimulating aggregate demand during recessions and dampening aggregate demand during expansions. Progressive Income Tax: during economic expansion and recession. Unemployment Insurance: during economic expansion, the system automatically increases the flow of unemployment insurance taxes from the income stream into the unemployment insurance fund, moderating aggregate demand. During downward economic downturns, transfer payments increase.
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Because of automatic stabilizers, GDP fluctuates less than it otherwise would, and disposable income varies proportionately less than does GDP [ consumptions also fluctuates less than GDP] Golden Age to Stagflation: 1960s: Golden Age of Keynesian Economics President Kennedy: proposed a federal budget deficit. President Johnson: cut taxes.
Discretionary fiscal policy is a demand-management policy; the objective is to increase or decrease aggregate demand to smooth economic fluctuations.
1970s: Stagflation High unemployment, high inflation resulting from a decrease in aggregate supply. [crop failures, oil shocks, and war costs] Demand management policies weren`t working. 2/27/08 1980's: the Supply Side Experiment President: -23% tax cut (over three years) -Gov. Spending. [7.1% to 6.3%] -The stimulus from the tax cut helped sustain a continued expansion during the 1980`s-The longest peacetime expansion to that point in the nations history -The national debt strongly increased 1990's: Discretionary Fiscal Policy and Presidential Elections -Errors of judgment and reasoning -President Clinton: -1993: substantially increased taxes on high-income households -1994: republican Congress: more discipline on Federal Spending Economy recovered: growing consumer spending, rising business optimism (tech) -1996 welfare reform Globalization, and the bull market [8.3% to 3.2%] 25
By early 2001 the economy was in recession
Chapter 13
Money and the Financial System
Double Coincidence of wants: two traders are willing to exchange their products directly
Transition from Barter to Money
Money: anything that is generally accepted in exchange for goods and services. (money fulfills three important functions: a medium of exchange, a unit of account, and a store of value.) Medium of Exchange: anything that facilitates trade by being generally accepted by all parties in payment for goods or services Commodity Money: anything that serves both as money and as a commodity; money that has intrinsic value. Unit of Account: a common unit for measuring the value of each good or service Store of Value: anything that retinas it`s purchasing power over time Gresham's Law: People tend to trade away inferior money and hoard the best. [Bad money drives out good--debasing the coinage] Money should maintain a relatively stable value Seigniorage: The difference between the face value of money and the cost of supplying it; the profit` from issuing money US coin production: 25 cents/3 cents: US Mint = $500 million a year in seigniorage Token Money: money whose face value exceeds its cost of production Check: a written order instructing the bank to pay someone from an amount deposited FRACTIONAL RESERVE BANKING SYSTEM: only a portion of bank deposits is backed by reserves Bank Notes: originally, papers promising a specific amount of gold and silver to anyone who presented them to issuing banks for redemption; today, Federal Reserve notes are mere paper money Representative money: bank notes that exchange for a specific commodity, such as gold.
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Fiat Money: Money not redeemable for any commodity; its status as money is conferred initially by the government but eventually by common experience. Legal Tender: U.S. currency that constitutes a valid and legal offer of payment of debt. Depository Institutions: commercial banks and thrift institutions; financial institutions that accept deposits from the public Commercial Banks: depository institutions that historically make short-term loans primarily to business Thrift Institutions (THRIFTS): savings banks and credit unions; depository institutions that historically lent money to households 3/7/08 [When Monetary Systems in breakdown]
financial Institutions in the US
Financial Intermediaries: Institutions that serve as go-betweens, accepting funds from savers and lending them to borrowers. Depository Institutions: commercial banks and thrift institutions; financial institutions that accept deposits from public Commercial Banks: depository institutions that historically make short-term loans primarily to business
Birth of the FED
Before 1863, banks were chartered by the states in which they operated, thus known as State Banks o Each Bank issued notes and they were redeemable for gold
National Banking Act of 1863 and later amendments created a new system of federally chartered banks called National Banks o o o o o They issued notes They were regulated by the Comptroller of the Currency State notes taxed out of existence State banks survived by creating checking accounts Thus we have the dual banking system today:
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State and federal
19th Century: panic runs on Banks 1907: Knickerbocker Trust Company (NYC) Failed. This all led to the creation of the Federal Reserve System in 1913 Federal Reserve System (The FED): the central bank and monetary authority of the US o o o o o o o o To serve as the central bank and monetary authority of the US All banks joined the FED (except state banks) It now issued all notes OTHER POWERS To buy and sell government securities To extend loans to member banks To clear checks To require that member banks hold reserves equal to at least some specified fraction of their deposits
The Reserve banks hold deposits of member banks, and extend loans to member banks Reserves: Funds that banks use to satisfy the cash demands of their customers and the reserve requirements of the FED; reserves consist of cash held by banks plus at the FED Reserve banks were also authorized to lend banks in need of reserves; the interest rate charged is called the discount rate Any profit additional earned by the reserve banks is turned over to the US treasury Banking During the Great Depression 1913-1929 FED performed up to expectations 1930-1933 FED practiced conservative monetary policies. o 1/3 of banks FAILED
1933 FDR: Banking Holiday Banking Acts of 1933 and 1935: regulated the banking system and centralized power with the FED 28
The board of Governors: responsible for setting and implementing the nation`s monetary policy 12 reserve banks moved under the board of Governors (7 board appointed by president and confirmed by the senate) [Exhibit 3] Each member serves a 14 year nonrenewable term (staggered appointment; one every two year),(designed to protect the board from political pressure) One governor is pointed to chair the Board of Governors--a four year renewable term FEDERAL OPEN MARKET COMMITTEE (FOMC): The 12-member group that makes decisions about the open-market operations--purchases and sales of U.S. government securities by the FED that affect the money supply and interest rates; consists of the 7 Board governors plus 5 of the 12 presidents of the reserve banks. OPEN-MARKET OPERATIONS: Purchases and sales of government securities by the Federal Reserve in a n effort to influence the money supply.
Objectives of the FED:
1. 2. 3. 4. 5. 6. A high level of employment in the economy Economic growth Price stability Interest rate stability Financial market stability Exchange rate stability
1972- Merrill Lynch MONEY MARKET MUTUAL FUND: A collection of short-term interest-earning assets purchased with funds collected from many shareholders. (Limited check writing privileges) (Competition for banks) Bank Deregulation: Deregulation and deposit insurance created moral hazard. S and L Collapse Congress 1989 $250 billion dollar bailout 29
BANK BRANCHES: A bank`s additional offices that carries out banking operations. BANK HOLDING COMPANY: A corporation that owns banks. National banks are the wave of the future. Merger upon Merger taking place. Exhibit 8. [Banking Troubles in Japan]
Chapter 14:
Banking and the Money Supply
Checkable Deposits: Deposits in financial institutions against which checks can be written and ATM or debit cards can be applied. Money Aggregates: Measures of the economy`s money supply
M1: The narrowest measure of the money supply, consisting of currency and coins held by the non-banking public, checkable deposits, and traveler`s checks. [Faking It] Savings Deposits: Deposits that earn interest but have no specific maturity date. Time Deposits: Deposits that earn a fixed rate of interest if held for the specified period, which can range from several months to several years; also called certificates of deposits (CD`s) M2: A money aggregate consisting of M1 plus savings deposits, small denomination, time deposits, and money market mutual funds. M3: A money aggregate consisting of M2 plus large-denomination time deposits. Debit Card: Cards that tap directly into the depositor`s bank account to fund purchases; also called a check card, and usually doubles as an ATM card. Asymmetric Information: A situation in which one side of the market has more reliable information than the other side. Net Worth: Assets minus liabilities. Balance Sheet: A financial statement that shows assets, liabilities, and net worth at a given point in time; all these are stock measures; because assets must equal liabilities plus net worth, the statement is in balance. Asset: Anything of value that is owned. Liability: Anything that is owed to another individual or institution. 30
Required Reserves: The dollar amount of reserves a bank is obligated by regulation to hold. Required Reserve Ratio: The ratio of reserves to deposits that banks are obligated by regulation to hold. Excess Reserves: Bank reserves exceeding required reserves. Liquidity: A measure of the ease with which an asset can be converted into money without a significant loss of value. Federal Funds Market: A market for overnight lending and borrowing of reserves among banks; the market for reserves on account at the FED. Federal Funds Rate: The interest rate charged in the federal funds market; the interest rate banks charge one another for overnight borrowing; the FED`s target interest rate. Money Multiplier: The multiple by which the money supply increases as a result of an increase in fresh reserves in the banking system. Simple Money Multiplier: The reciprocal of the required reserve ratio, or 1/r; the maximum multiple of fresh reserves by which the money supply can increase. [Banking on the Net] Electronic Banking, or E-Banking: Conducting banking transactions over the Internet. Open-Market Purchase: The purchase of U.S. government bonds by the FED to increase the money supply. Open-Market Sale: The sale of U.S. government bonds by the FED to reduce the money supply. Discount Rate: The interest rates the FED charges banks that borrow reserves.
Chapter: 15
Fiscal and Monetary Policy
The Demand and Supply of Money Stock of money: How much you have right now. Flow: How much you earn per period. (w/m/y). Demand for Money: The relationship between how much money people want to hold and the interest rate. 31
People demand money to carry out market transactions
Money allows people to carry out economic transactions more easily and more efficiently. The more active the economy is--that is, the more goods and services exchanged reflected by real output--the more money demanded. Rule: The higher the economy`s price level, the greater the demand for money. Bonds: a store of value. Earn interest for loaning your money. Problem: Liquidity The quantity of money demanded varies inversely with the interest rate. (low/high interest rate). [Money Demand Curve]
The Supply of Money and the Equilibrium Interest Rate
The Supply of Money is determined in the end by... THE FED. [Exhibit 2] Equilibrium moves from point a to point b. For a given money demand curve, an increase in the supply of money drives down the market interest rate, and a decrease in the supply of money drives up the market interest rate.
Money and Aggregate Demand in the Short Run
Monetary policy influences the market interest rate, which intern affects the level of planned investment, a component of aggregate demand.
Interest Rates and Planned Investment
[Exhibit 3] To increase money supply, the FED uses open-market purchases of US government securities as its primary tool. Summary of events: M i I AD Y
Adding short-Run Aggregate Supply Rule: For a given shift of the aggregate demand curve, the steeper the short-run aggregate supply curve, the smaller the increase in real GDP and the larger the increase in the price level.
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[Exhibit 4] Short Run Equilibrium. Why? At point a, real wages are higher than had been negotiated and many people are looking for jobs. The FED could wait to see if the economy recoups on its own. Renegotiation of nominal wages could take place. (Lower production costs push the supply curve rightward, closing the contractionary gap. The FED could also lower the interest rate. [Gamble: could trigger expansionary gap as well] NOTE: Lowering interest rates many not always stimulate demand leading to increased demand! A gamble.
[Targeting the Federal Funds Rate]
Money and Aggregate Demand in the Long Run
Equation of Exchange: The quantity of money, M, multiplied by its velocity, V equals nominal GDP, which is the product of the price level, P, and real GDP, Y
M[oney] x V[elocity] = P[rice] x Y[GDP]
Velocity of Money: the average number of times per year each dollar is used to purchase final goods and services.
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2003: nominal GDP: $11 trillion. Money Stock (M1): 1.3 trillion Velocity was $11 trillion divided by $1.3 million, or 8.5. Given the GDP and the money supply, each dollar must have been spent about 8 times on average to pay for final goods and services. Velocity only measures spending on final goods and services. (a conservative estimate). The Quantity Theory of Money: If the velocity of money is stable, or at least predictable, changes in the money supply have predictable effects on nominal GDP.
If M increases 5% and V remains constant, then P x Y or nominal GDP must also increase 5%.
Increase in the money supply = more spending (long run) which leads to a higher nominal GDP.
[Inflation is often triggered by expansionary policies] [Exhibit 6] Velocity of Money has increased due to technology. Cards; pay checks, etc. Money as a store of value; the great the store power, the lower the velocity.
[Money Supply and Inflation Around the World] [Exhibit 9]
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