~The 3.1 Productions Possibilities Frontier: Macroeconomic applications PPF (Production possibilities frontier) shows all possible combinations of goods & services that is possible to produce in this economy given its resources & technology (the line- shows maximum) Will show u the max amount of good the economy can produce Macro uses aggregate goods (a group of economic units acting as a whole) Consumption good = a good that provides immediate satisfaction (ex: clothing or food or entertainment or medical care horizontal axis not a specific good just an aggregate measure of consumer goods- representation) Investment good= a good used to produce other goods (ex: capital or goods that produce other goods like a sewing machine or factory) Investment = business spending Product Possibilities schedule= table of data that shows; the maximum quantity of consumer goods that can be produced for any given quantity of investment goods produced Increasing opportunity costs occurs b/c some resources are better suited to the production of consumption goods, while other resources are better suited to the production of investment goods Points above the PPF are not achievable given resources and tech indicates the reality of scarcity ; points under the PPF represent underemployment or unemployment The downward slope reminds us of opportunity costs there are trade offs The cure gets steeperas we move down it b/c slope of curve reps opportunity costs; steeper it gets =larger the opportunity costs are getting Slope = rise (change in investment goods) Run ( change in consumption goods) Outward bowed shape of PPF indicates increasing opp. Costs
If any variables that were previously held constant changes the whole curve must be redrawn Ex: improvement in tech. increase the production of investment goods Economic growth results from the accumulation of resources which improves overall production Changes in PPF War= overall output would be reduced b/c resources are being occupied or destroyed An increase in immigration= overall output would increase because of an increase in labor An improvement in technology for consumption goods= this improvement in technology increases the production of consumption goods
Circular Flow Model Every time you spend money you create income for someone else Spending=Income Circular flow model= diagram illustrating the flow of spending & income in an economy Includes: Households (purchases- consumption; acquire $ by selling their resources like labor, land, etc) Firms (businesses; pay for factors of production w/money which becomes households income) Factors of Production: Households supply resourcesland, labor, & capital flow into the factor markets Factor markets land, labor, & capital is hired by firms Firms puts resources to work to produce goods & services Goods & services are provided by firms & enjoyed by households Flow is clockwise starting with households/resources Money flow is counter-clockwise starting w/ firms b/c this is a closed system-spending must equal income When Other players get involvedGov. buys goods & services & hires factors of production OR the rest of the world (ppl from other countries n stuff)
Imports= foreign goods brought into the economy for domestic sale Exports= domestics goods shipped abroad for foreign sale
Factorsofproductionaretheinputsintheproduction process. Inacircularflowmodel,firmssupplyproductsand demandresources. Inthecircularflowmodel,equilibriumoccurswhenall thespendingofhouseholdsandfirmsequalstheincome receivedbythefactorsandgoodsandservicesmarkets.
RealGDP(grossdomesticproduct)3.1.3 Talksaboutproductioninaneconomy
Grossdomesticproduct=themarketvalueofall finalgoods&servicesproducedwithinacountryin agivenperiodoftime
Working through deff. Market value valued at market prices (selling at car for 20,000 adds 20,000 to gdp) Final means not intermediate (GDP includes the market values of the car sold to the consumer who is the final user GDP does not include parts purchased by the care company as intermediate goods used for producing the car GDP includes both goods & services to measure the output in an economy Efforts made to include all economic activity in GDP
GDP= is an output produced within a country regardless of the nationality of people engaged in production GNP (gross national product) = output by citizens of a country, regardless of their location (ex: Dell producing computers in China would be part of GNP not GDP; Hondas production of cars in Tennessee would be part of GDP but not GNP The production of goods and services in an economy is like the flow of water through a pipe we have to measure per period of time for the # to make sense Measures GDP per year (ex: if you hear US GDP is 13 trillion dollarsthat means that there are 13 trillion dollars worth of final goods & services at market prices produced within the US in a year Nominal GDP (things measures in terms of money or actual dollar value) Real GDP (measure of output in terms of physical goods & services) Calculating Nominal GDP
Year 1=Total market value of apples + total market value of bananas = $ Nominal GDP
(which is the quantity times cost of apples) Nominal GDP changes due to prices & quantities Calculating REAL GDP
Real GDP = [(Nominal GDP)/(GDP deflator)] x 100
Must hold prices constant Same formula as nominal except you dont change Nominal GDP has increased more than REAL GDP b/c the former includes the effect of rises in prices & quantities while the latter includes only rises in quantities GDP Deflator =(take nominal GDP divided by Real GDP times 100) (This tells u the rate by which prices have increased from the base year)
Calculate rate of inflation Rate of inflation = GDP Deflator of year ur interested in GDP deflator from previous year then divide by the GDP deflator from previous year The New BEA Procedure for Calculating Real GDP Suppose you work for a moving company $50/day You get a raise. $100/day So to get ur % increase 100-50/50 x 100 = 100% increase Then you get a pay cut....so you get aid $40/day 40-100/100 x 100= 60% decrease % changes depends entirely on where you startthe base with which you calculate with determines change The Bureau of Economic Analysis (BEA) establishes a weighted average to calculate real GDP to correct this problem *Use an in-between price Limitation of GDP & Alternative Indexes Factors LEFT OUT WHEN CALUCULATING GDP 1. Value of leisure (harder ppl work less time they have to chill) 2. Environment (ppl want to enjoy & feel safe about their environment) 3. Value of household production (cooking cleaning) 4. Quality of goods (high vs. low) 5. The underground economy (trading things under the radar without a trace) 6. Crime & safety (higher crime less quilty of life) 7. Health/welfare 8. Distribution of income Alternatives so we can have a wider measure
Human Development Index (includes life expectancy at birth, adult literacy, school enrollments & GDP per capita) Genuine Process Indicator (an indicator constructed by a group called Redefining Progress that measures well-being by considering both the distribution and the quality of economic growth in terms of the value of housework, caring for children & the elderly, volunteerism & the hours spent on free time or family & community activities.) has bee flat in relative years compared to GDP 3.1.6 Hot Topic: Feminist Economics & the Measurement of GDP Housework is not included in the GDP b/c it is not transacted in markets 70% of housework is done by women Feminist economics= the study of the economy under feminist beliefs Feminist economics seeks to bring about more accurate measures of the value created by housework to the GDP What would happen to the GDP if a value was put on housework? If you calculate it done from the 1940s through the 1980s & put a market value on it, it would add about 20% to the GDP According to the UN report on human development, about 40% of all value in the world economy is created by housework not reported by governments Labor force= the total number of workers including employed & unemployed Feminist economist want to see the market value added to housework How do we get more accurate measures of the value created in our economy by housework?...figure out how much you would have to pay an outside service to do the work; use the governments system to approximate the rental value of permanent residents.why hasnt this happened? Until recently there has not been a constituency to bring about this change B/c feminist economics has raised awareness of the inaccurate measurement of the value that it has create by housework, weve started thinking about it more 3.1.7 Hot Topic: Off the Books: The Underground Economy Any economic activity that takes place outside of government supervision (to avoid the law or paying taxes)
Illegal trade: drug trafficking & transporting illegal immigrants across boarders Tax evasion: working for cash & not reporting income to the IRS Barter: exchange of goods or services between individuals without reporting value to the IRS (I paint your garage if you mow my lawn) Costs -Taxes are being avoided -Resources are tied up in enforcing tax laws (there will be less money available to finance public goods) - Organized crime will increase (people will begin to form their own laws around underground transactions as happened w/ alcohol & narcotics today Benefits Innovation will occurs (ppl who dont have the resource to deal with gov. regulations can get a chance to make a living ex: going out and mowing neighbors lawns) What can we do about this money being lost? Increase enforcement= the gov. could increase its law enforcement officers to go after the people involved in underground activities Legalize underground activities= legalization would bring these activities under government regulation so that they may be taxed. An example of this is the legalization of alcohol 3.2.1 The Expenditures Approach (adding all things up to get GDP) Every transaction involves a buyer and sellerbuyers perspective (the transaction represents spending) & sellers perspective (the transaction represents income) the income approach adds up all the income received by sellers) The total GDP of the U.S. economy in 2005 was 12.8 trillion -Consumption (households) 70% (8.9 trillion) -Investment (businesses) 17% (2.2 trillion) - Spending by the Government (on goods & services, new roads, bridges, etc) - Net exports (NX) ADD ALL FOR AMOUNTS FROM EACH Category TO GET TOTAL GDP Investment the spending by business on capital goods
Gross vs. Net investment spending Gross= total spending on investment goods; deprecation some of the machines wear out or become obsolete Net investment= Gross Investment Deprecation Transfer payments: payments made to individuals that are not compensation for a good or service, such as welfare or unemployment compensation Exports: domestic goods shipped abroad for foreign sale Imports: Foreign goods brought into an economy for domestic sale 3.2.2 The Income Approach the measurement of GDP as total income created when buyers purchase goods & services income approach=expenditure approach total personal income = disposable income + personal income tax subtract transfer payments ($ gov. gives you like unemployment & welfare) add back in money given to the gov. (like ss, corporate income taxes) add undistributed corporate profits = NI (National income which is the total amount of money received in a country by factors of production) Components of NI 1. employee compensation 2. proprietors income (profit) 3. rent for land 4. interest payments 5. corporate profits + indirect businesses taxes (sales & excise taxes, taffs) + depreciation (tools worn out from use) + net foreign factor income (money paid to foreign factors operating in the US) Calculations Y (output; income & spending) depreciated capital = Net Domestic Product (NDP)
NI Social Security Contributions Corporate taxes Undistributed Corporate profits + Transfer payments = Personal Income (PI) NDP- Foreign factors Indirect Business taxes = National Income (NI) Personal income Personal income taxes =Disposable income 3.2. Hot Topic: Impact of E-commerce on the Economy Advantages of e-commerce = tax free, competition ( you have options), convenience Disadvantages of e-commerce= no inspection of goods & services, no personal interaction, no atmosphere Advantages of the store= inspect food, read labels, interactions w/ others, special service request Electronic commerce (e-commerce) = buying & selling of goods & services over the internet 3.3 Costs of living Changes in the Cost of Living and the CPI Prices do not rise uniformly across all goods & services Consumer Price Index = a monthly measure of the prices of goods & services purchased by a typical household BLS (Bureau of Labor Statistics constructs the CPI by using a market basket of goods & services, designed to represent the typical purchases of a household Basket includes: housing (biggest %), medical care (4th biggest %), food(2ns biggest %), entertainment, clothing, education, transportation(3rd biggest%), other CPI represents changes in the households cost of living and is used as the most reliable measure of whats happening to inflation from the point of view of households/consumers
comparesthecostofabasketofgoodsconsumedinthebase yeartothecostofthesamebasketinanotheryear.
Uses of CPI Wage contracts: labor unions negotiates wage contracts based on CPI Costs of living adjustments: the gov. uses the CPI to make costs of living adjustments to Social Security & other programs
Inflation indexed bonds: the treasury uses the CPI to calculate payments on inflation-indexed Treasury bonds Real Interest rate: the CPI is used to calculate real interest rates
Real interest Rates The inflation-adjusted return on savings measured in terms of purchasing power Real interest rate= nominal interest rate inflation rate If nominal interest rate is 5% & the inflation rate is 5%, the real interest rate is 0%, as there is no increase in purchasing power Producer Price Index Monthly measure of the prices of goods & services purchased by a typical business Based on a basket of goods designed to represent the price level relevant to the average business Includes RAW goods you may never use like pig iron & raw aluminum Changes in prices in the PPI foreshadows whats going to happen in the CPI (consumer price index)---ex: if raw materials prices increasebusinesses will pass rising costs on to the consumer in the form of higher prices for final goods & services
Borrowerslosewheninflationislowerthanexpectedbecauselenders buildtheexpectedrateintotheirinterestrates Whichofthefollowingchangesinpriceindexesshowsthegreatest rateofinflation:100to120,150to180,or190to228? Calculatetheratesofchange:[(120100)/100]x100=20%; [(180150)/150]x100=20%;[(228190)/190]x100=20%. Top 10 leading economic indicators 1. avg. weekly hours worked in manufacturing 2. unemployment insurance claims 3. new manufacturing orders for consumer goods 4. vender delivery performance 5. new manufacturing orders for capital goods 6. new building permits 7. stock prices 8. money supply 9. short-term vs. long-term interest rates 10.consumer expectations
Index of Leading Economic Indicators Weighted average used to forecast economic conditions 3.3.3 Calculating the rate of inflation CPI uses narrower basket of goods & services while the GDP deflator is based on ALL prices in the economy Real GDP current years quantities but prices from some base year To calculate CPI, we need to fix a market basket to weight the change in prices, may include imported goods & considers only the subset of goods and services that are in the market basket of typical household The CPI measures the change in the price of a fixed basket of goods & services (base year always x100)
GDP deflator Considers all final goods & services produced in an economy Only considers goods produced domestically Uses quantities produced in the current year for weighing prices CPI Considers only a specific market basket purchased by typical households Might include imports Uses fixed quantities from a base year when market basket s defined for weighting prices
3.3.4 Comparing the CPI and the GDP Deflator Inflation= a general increase in all prices across the economy If you want to measure inflation, which method should you use? Use the CPI to calculate cost of living adjustments Use the GDP deflator to measure the rate of inflation CPI overstates the general rate of inflation for these reasons: -Not comprehensive b/c it only considers only the bundle of goods and services that households typical buy; GDP deflator broader measure & better for finding out inflation
-CPI has substitution price bias it assumes ppl always buy the same basket of goods & services as prices change; doesnt account for substitute goods; GDP deflator is a broad measure that allows room for substitution Excludes new products new products are not included in the old basket Excludes quality changes (higher prices may be a reflection of improved quality as well as increased cost of living) Excludes shopping pattern changes (new, lower priced outlets (i.e. superstores, online retail) are not reflected in the CPI May over state 1-1.5 % Federal reserve look more at the GDP deflator b/c its a better indicator of the overall rate of inflation
3.4 The Business Cycle Recessions, Depressions, & Booms Trend line represents the avg. rate of growththe economy will fluctuate around it which is called the business cycle Business the cycle: fluctuation of economic activity over a period of time Booms when expansion are particularly significant or prolonged Recessions when contractions are particularly significant or prolonged they are called recessions Extremely severe recessions are called depressions Contractions are periods when the real GDP grows slower than the trend
Atroughoccursattheendofaperiodofcontractioninthe businesscycle,abottomingoutofthecontraction(belowthe line) Peak=highestpointaboveline Contraction=online
3.4.2 Theoretical Explanations for Cycles Why does the business cycle occur? Karl Marx believe fluctuations occurs in the business cycle due to class conflict between labor & capital; felt capitalists
overproduction of goods caused periods of excess supply followed by periods of shortage, thus hurting workers; sever changes in the business cycle were due to unplanned economy; SOLUTION: MORE GOV. PLANNING Joseph Schumpeter - his view focused on technology & how the economy is driven by creative destruction; new tech. replaced old tech. causing disorder & chaos; believes business cycle is byproduct of tech. the stops in the line are b/c ppl are trying to adjust; no solution John Maynard Keynes believes the business cycle was caused by fluctuations in spending; believe the gov. should spending money on public goods (road, bridges & schools) to equal out consumer saving; believes economy is driven by demand & if ppl dont demand enough make them Stagflation = a period which prices are increasing at the same time real GDP is stagnant or decreasing New Classical View = believes the business cycle is a naturally occurring phenomenon & no one should intervene; lets the business cycle happens the way it want to let the law of the jungle rule; believes the gov. should focus its attention on the market failures & assure that such things as education & public goods are provided Real Business Cycles = economy is being driven by real factors like the price of oil; changes in natural resources & technology (supply) are the origins of fluctuations in the business cycle; says the real effect is the natural course of things; driven by fundamentals of economy; no solution The Monetarist Explanation= believes business cycles are caused or worsen by prob. w/ money supply gov. makes credit easy to get a boom happens interest rates go up- prices fall again; poor management of monetary policy; believes if money is allowed to be used smoothly and grow that the business cycle will be less severe Mainstream = synthesis of several of the above
3.5.1 Measuring the Labor Force and Unemployment The unemployment rate is a summary measure of the health of the labor market. Relatively high = may take longer to find job you want Relatively low = shows tight labor market and easier for you to find job
Each month the Bureau of Labor Statistics (BLS) conducts the Current Population Survey (CPS) of 60,000 households to obtain measures of the features of the labor marketdivides into 3 groups: ppl who are working (biggest section), ppl who are not working but looking for a job, ppl who are not working & NOT looking for a job The adult population doesnt include institutionalized people (i.e. ppl in schools, prisons, & hospitals arent included) Labor force= the total number of non-institutionalized adults who are either working (employed0 or looking for work (unemployed) Unemployment rate = Number of unemployed/labor force
The unemployment rate has limitations 1. Doesnt tell us about ppl who are underemployed (working in jobs below their capability or fewer hours they desire) 2. Doesnt tell us about duration (how long has the unemployed been that wayare they moving between jobs or is it chronic unemployment) 3. Concern of discouraged workers (ppl who have left the labor market all together) Labor force participation rate= Labor force/ Adult population x100 Look at labor participation rate for distinct groups in society (diff. demographic groups) Discouragedworkersarethoseindividualswhohavelookedforwork,become discouraged,andhaveceasedlooking.TheBureaudoesnotcountthesepeopleaspartof thelaborforceeventhoughtheywouldworkiftheycouldfindajob.Thiseffectprobably understatestheunemploymentrate. Supposeastatehasanadultpopulationof10millionpeople,andthelaborforce participationrateis80%.Thenumberofpeopleinthestatewithjobsis7,280,000.The unemploymentrateinthisstateis_____ Theunemploymentrateisthenumberofunemployeddividedbythelaborforce.To calculatethetotallaborforcemultiplytheadultpopulationof10,000,000xthelabor forceparticipationrateof.80=8,000,000.Because7,280,000peopleinthelaborforce
havejobs,720,000peopleinthelaborforceareoutofwork.Divide720,000by8,000,000 andmultiplyby100tocalculateanunemploymentrateof9%. 3.5.2 Types of Unemployment Frictional unemployment sign of healthy economy; refers to unemployment caused by ppl moving between jobs, careers, & locations; seasonal unemployment Structural unemployment results from compositional changes in the economy due to technological changes, competition from abroad or changes in regulations; someone who develops skills for a particular industry will be structurally unemployed if their factory leaves the job market Cyclical unemployment results from busts in the economic cycle (recessions & contractions); caused by downturns in business cycle slowing of economic activity was correlated with spikes in unemployment; as recessions end, we see decreases in unemployment Date show that unemployment rates: do not vary much w/ gender; vary quite a bit across ethnic groups (minorities have higher unemployment rates); vary greatly w/ age; teenagers have much higher rates of unemployment The unemployment rate is one simple number that cover a more complex story
3.6 Understanding the Natural Rate of Unemployment The natural rate of unemployment= the rate of unemployment that remain after the cyclical component of unemployment has been removed -even if there were no variations in the business cycle; It is a measure of the frictional and structural unemployment at which the economy operates efficiently Factors affecting the Natural Rate Demographics Older workers tend to keep their jobs longer; as the population grows frictional unemployment goes down & the natural rate of unemployment decreases Policies pertaining to job training & unemployment insurance
More job training leads ppl to new jobs sooner, & so decreases the natural rate & there is less structural unemployment; more unemployment insurance decreases an individuals cost of being unemployed & raises the natural rate of unemployment Policies that discourage firms form hiring quickly (if regulations make it harder for firms to hire, the natural rate of unemployment increases) Structural changes (changes in the structure or composition of the economy can also affect the natural rate of unemployment)
Over time, the natural rate over time economist isolates factors due to change in the business cycle Reasons for the decrease in the natural rate of unemployment: Aging baby boomers= the population is older due to aging baby boomers & as older ppl switch jobs less frequently, the natural rate has declined; less frictional unemployment High incarceration rates for young ppl= w/ historically high rates, the labor force is older & so the natural rate has decreased Issue of government support = changes in the nature of gov. support policies also have change the natural rate Structural changes = as the economy has moved from manufacturing to white-collar service jobs, there is less frictional & structural unemployment & hence a decrease in the natural rate 3.7 Causes of Unemployment Minimum Wage Laws The lowest price employers can pay for labor When Wages increase, firms demand fewer workers & either replace then with machines or scale, back business When Wages are higher, households will supply a larger quantity of labor Diff. between the number of ppl who want to find jobs at w bar and the number of jobs offered = surplus of labor or unemployment
Problems with the minimum wage = a min. wage can create unemployment by encouraging more workers to enter the job market than are demanded by employers; it can put unskilled workers at a disadvantage by making tem less competitive with skilled workers
Theminimumwageisalegalminimumbelowwhichanemployer cannotpay.Itactsasapricefloorinthelabormarket
Middle class teens are most likely to suffer unemployment when a minimum wage is imposed Over 40 yr. old primary income providers Although minimum wage affects younger workers, it probably does not after the working poor
An Analysis of Labor Union & Unemployment Labor union=A organization of workers within a particular industry that bargains collectively with firms about wages & working conditions Collective bargaining= negotiations between representatives of the labor union and management; result is usually a contract that is enforced for 1-3 yrs. Strike= stoppage of work when workers terms are not met In a free market, the supply of labor reflects the passive response of workers to higher or lower wages The demand curve represents the firms profit maximizing choices in response to higher & lower wages Unions at time will hold out for higher wages; this higher wage will cause the firm to hire less workers The union may require as part of its demands that the firm not only pays the higher wage, but also continues to employ the same number of workers. This shift the demand curve outwards. & the firm is not able to make a profit-maximizing decision Labor cartels may cause the company to operate at an inefficient but unemployment is reduced Union have the right to form law. Their activities are overseen by the National Labor Relations Board
Disadvantage of Unions to Unskilled labor: unskilled workers are disadvantaged when unions advocate for high minimum wages. Firms will be less inclined to hire unskilled labors if wages are higher To protect unskilled labor some states have right-to-work laws Labor unions are like cartels: they protect workers by giving them power to meet power of management
3.8 Theory of Efficiency Wages When wage is above equilibrium there is unemployment Gov. require of min wage about equilibrium level = unemployment Labor union demand higher wages = unemployment Firms pat the efficiency wage = the wage above equilibrium that firms voluntarily pay to increase productivity & profits Ways the efficiency wage affects the market: 1. Quantity of labor a firm would wire 2. Quality of labor a firm would hire When a firm pays above the equilibrium wage, more ppl will apply for jobs than the firm will hire, causing unemployment Reason a firm would pay higher than the equilibrium 1. Motivates workers (they wanna work hard to keep the job they have b/c they will make less $ somewhere else) 2. Happy healthy workers are more productive increases worker morale & productivity (pay them more so they can be happier) 3. At higher wages, the company is able to attract the more talented & skilled workers Problem of asymmetric information= unequal distribution of knowledge; some workers are more productive than other but you can tell in an assembly line Adverse selection= selection of a lower quality product because of asymmetric info 4. To reduce employee turn over Non-price rationing= using alternate methods of distinguishing price/wage mechanism 3.7.5Unemployment Insurance Unemployment Insurance & the job search
- Unemployment insurance helps an unemployed individual financially- most ppl who are unemployed are entitled to collect up to 50% of their previous salary for up to 26 weeks - Employment efforts are influenced by weighting how one thrives without work versus how one thrives w/ work - Unemployment insurance may delay the job search & promote moral hazard Moral hazard: one party to a transaction takes some unobservable action afterwards; any time a person is insured they exert less effort Proposed solution: A two-tiered system that distinguishes between short-term & long-term unemployment Short-term gives the unemployed support long enough for them to find a job Long-term the structurally unemployed need more time to learn new skills 3.9 Inflation Inflation, deflation, Stagflation, & Hyperflation Inflation = a general increase in the average level of price in an economy most experience as a slow increase in prices over time; when prices rise value of dollar shrinks Deflation = when prices in the economy is generally falling, rare & dangerous for an economy; Great Depression; when prices fall you think y buy today so ppl dont spend $ and there is too much on the shelves Stagflation = results from supply shocks like high international oil prices; an increase in the average price level at the real GDP is either stagnant or declining; combination of inflation & economic stagnation Hyperinflation = extraordinarily rapid rise in prices; very rare & typically caused by the government printing money to meet debt or deal with some economic crisis; after WWI in Germany; ppl in the country may resort to barer or use another currency to avoid carrying money that is rapidly losing value; dangerous for economy leading to ppl not using $ at all Inflation and Purchasing Power When prices are rise you can buy less with a given amount of $ Prices & purchases have a reciprocal relationship
When there is inflation in the economy the value of the dollar is shrinking purchasing power goes from being able to buy a lot to a little
Purchasing power of a dollar= 1/ price level 1 __ 1/20 = 20 During periods of deflation, as price levels decrease, purchasing power increases at the same rate During periods of hyperinflation, ppl may be unwilling to accept money & the economy may revert to barter
Short-run Causes: Demand-Pull and Cost-push inflations In the short run inflation results from: A. Demand-pull is associated with a booming economy & an increase in the real GDP B. Cost-pushinvolves rising prices that are correlated with a shrinking economy & a reduction in real GDP (activity on the supply side) Demand-pull Beings when consumers, businesses, the gov. & or foreigners decide to increase their spending & do more shopping Factories have to increase their output to keep up sooooas demand goes up factories must increase output Production costs rise: as GDP rises factories need more raw materials & workers & higher wages NAIRU Non-accelerating inflation rate of unemployment; the lowest rate of unemployment that does not create inflationary concern Prices rise: as production costs rise, producers must raise prices; higher prices may make employees ask for higher wages to compete with an increase in the cost of living Wage-price spiral up; Demand-pull inflation is associated w/ and expanding economy Cost-push inflation -Beings with companies deciding they have to raise prices Prices go upreal GDP does down Exogenous originating outside an organism or in this case a system A stable economy is suddenly hit by a supply shock-cost of doing business increases producers raise prices but may decide costs are too high to remain profitable
GDP decrease: workers get laid off, companies produced less, consumers purchase less (employees have less to spend) Prices may continue to rise Cost- push inflation is usually occurs in a recessionary economy; stagflation (shrinking economy)
The wage-price spiral is difficult to break b.c contractual agreements, like costs of living adjustments & social security payments, automatically increase wages In an inflationary economy, ppl are inclined to spend today rather than save for tomorrow. The worsens the demand-pull, pushing prices up further
3.8.2 The Quantity Theory of Money
The quantity of money available determines the price level & the growth rate of the quantity of money determines the inflation rate Purchasing goods & services requires money. Therefore, the economy depends on the amount of money available
Quantity equation
M x V= P x Y (output/ quantity goods & services) (money supply/currency, checks) (velocity-hold constant) (Prices ppl pay) Velocity = the average number of times money changes Any change in the money supplyhas to show up as a change in GDP (either a change in price, output, or both) Increase in money supply may increase credit & loan opportunities & business may expand, producing more output Classical view of money- in the long run where V is stable & y if fixed, changes in M (a nominal variable) only affect the price level (P) ( a nominal variable) Inflation tax= an implicit tax imposed on goods & services to pay for the gov. spending
The Cost of Inflation
1. Redistribution of wealth = when the inflation rate is rising, lenders will receive less purchasing power in terms of money paid back from borrowers Lend 10% Actual inflation rate is 15% > expected inflation rate 5% = loss of lenders purchasing power Wealth is redistributed to borrowers, making it easier to pay back loans 2. Effects on fixed income (rising inflation rates will shrink the purchasing power of those receiving fixed income which are equal payments in each time period from a bond or annuity with a non-variable interest rate Those on fixed income may receive: annuities (bonds), pensions (retirement savings), Social security (government assistance) Some public assistance programs like ss, rise w/ inflation, but most fixed income does not adjust for higher costs of living 3. Inflation tax= during periods of inflation, the government may impose an inflation tax; when the gov. spends more, costs are passed along to the taxplayer