8, February 2011
Macro
Labor Force (not the entire population) All individuals 16 years of age and older who are noninstitutionalized and are either currently employed or unemployed and actively seeking employment
Unemployment
Unemployment rate = the number of people who are unemployed / labor force
Involuntarily unemployed they are not out of a job due to their own decision. You are willing
able to work at the going wage but no jobs are available
Voluntary unemployed there are plenty of jobs to go around, but this particular person
refuses to work at the going wage
4 types of unemployment
1. Structural unemployment exists when a person finds they are unemployed because the
economy no longer has the need for someone of these skills (blacksmith)
2. Seasonal unemployment when you are unable to pursue your occupation because of the
season (construction)
3. Frictional unemployment there are plenty of jobs to go around, but because of frictions in the
labor market, people dont know instantaneously where the job openings are and firms
instantaneously dont know who is available so they cannot instantaneously find a job
4. Cyclical Unemployment unemployment which occurs because of recessionary and
depressive phases of the business cycle
Discourage Worker Phenomena you become discourage from getting a job because of the
rejection
They drop out of the labor force and are no longer counted as unemployed because they are
not actively seeking a job
Costs to Unemployment
Economic Costs
o The Goods and Services that could be produced but are not being produced because of
the unemployment
o Left with smaller capital stock in the future than you would have had and therefore lower
productive capability in the future
o Loss in skill
Social Costs
o Psychological problems begin to emerge when an individual looks for a job for 1,2,3
years, they lose their social image can even affect the family
o As unemployment lasts for longer periods of time, people may begin to resort to illegal
activities (stealing medicine for a sick child, etc)
o Political Unrest attitude becomes the politicians are doing okay, what about us? They
are the ones that should be helping us
Inflation the continuing increase in the overall price level of goods and services
Borrower/Lender relationship I want to borrow $1000 a year, but the lender has to give up
that money for the goods he wants. Make a deal give interest so you can buy 5% more
goods when he gives you the money.
o You loan the $1000 and agree on 5%, but one year later, there is 6% inflation. Thus you
are at a loss as you need to meet the inflation
o You expect inflation so you agree on 11% interest rate. If there is inflation, you meet the
increase and get your 5%. If there is not, you gain the 11% and the borrower loses.
*Classical School of Thought predominant field of view in WW2 era (the economy is always in
equilibrium)
Circular Flow Model (on 2/8 notes sheet)
Says Law states supply creates its own demand
Problem = Households can save their money
First Pillar of School of thought dont have to worry because of interest (rate of savings = rate
of investment)
o People are saving because of the rate of interest. The higher the rate of interest, the
more they are willing to save
o The rate of interest would guarantee that what is leaking with the household savings
would be made up by investment spending (leakage=injection)
o Leakage any amount of money that is saved by households that is not spend on
goods and services
o Injection any spending on goods and services which is not coming directly from the
household income
Counter What if the rate of interest is above equilibrium?
Second Pillar of School of Thought Even if savings does not = investment spending, you are
still going to have full employment because all prices and wages are perfectly flexible
o To meet the low supply, the price of goods goes down. As this goes down, quantity
demanded goes up
o Thus labor wages go down they are okay with it because it meets the reduction in the
prices of goods and services they consume
February 10, 2011
Keynes attacks classical school of thought during the Great Depression in 1935 (case of high
employment)
Points out that savings and investment are undertaken by 2 different groups with 2 different
reasons.
o Says households save so they have something to retire with (reasons have nothing to do
with rate of interest)
o MEI Marginal Efficiency of Investment (2/10/11 Notes 1)
Keynes says that the MEI curve is not always constant like it was assumed before
(can shift through changing maintenance costs, quantity changes, etc)
Classical economists would argue with the idea that prices and wages are perfectly
flexible (pillar 2)
Points out that prices and wages are not as flexible as the classical economists thought they were
(because of monopolistic firms)
o Reason 1 Individuals are concerned with not just their absolute wage but their relative
wage (wage relative to other individuals)
If you cut your wage relative to others, you look poorer relative to everyone else
thus people resist a decrease in wage
o Reason 2 there are cases where the wage is set by an agreement between the workers
and employers which can be set up for a specific time frame
o Reason 3 A firm has earned a reputation of being a good employer. Once this has been
met, they wont want to lose it they dont want to lower the wage.
Once they start firing employees for those who work cheaper, they will not be able to
hire employees in the future that will meet their needs
Will combat this through alternate methods, such as lowering work hours
Since prices and wages are not as flexible as the economists assume, Keynes points out that you
may have unemployment in the economy
o The classical economists argue that the prices and wages will eventually become flexible in
the long run, and in the long run the unemployment will disappear.
Keynes concerned with the short run responds with yes, but in the long run we
are all dead
How long must you wait for this unemployment to disappear?
Classical School of Thought
o They were not concerned with nominal income; they were concerned with real income.
Real economic variables.
1. Notion of all markets will eventually reach equilibrium
2. Focus is on real variables, real wage, real income, not nominal variables (2/10/11 Notes 2)
3. The only reason why production takes place is that individuals go to work, produce goods
to earn an income, and buy the goods they want
February 15. 2011
(2/15/11 Notes 1)
Classical School of Thought
o Supply curve is always vertical
o Makes no difference what the price level is, the wage that is paid will change
accordingly
Aggregate Supply Curve shows the overall volume of goods and services produced at the
different price levels in the economy (2/15/11 Notes 2)
Once you have a perfectly vertical supply curve, the demand for that item has no effect on the
level of production
Aggregate Demand Curve shows the overall goods and services demanded at the various
price levels (negative slope)
o Wealth Effect When wealth goes down, people cut down in their demand of goods
and services (Prices go up and real income goes down)
Net Taxes = total taxes that government collects transfer payments
o Counts as leakage (along with savings) households cannot contribute this money to
the economy
Government Spending purchase of goods and services that is not coming directly from
household income
o Counts as injection (along with investment spending)
According to Classical Economists:
o Fiscal Policy doesnt shift the aggregate demand curve
Even if you could shift it, it would not have any effect because the supply curve is
perfectly vertical
A change in money supply is the only thing that would shift the demand curve
(determined the overall price level in the economy)
Quantity Theory of Money
People can hold their wealth in the form of land, a house, a car Why hold wealth with
money?
o People want to hold some of their wealth in the form of money because money is a
means of making a payment
o People spending on goods and services is generally proportional to their income
Thus the amount of money people want to save is proportional to their nominal
income
MD=k(py) so at equilibrium MS=k(py)
February 22, 2011
Aggregate Expenditure / Aggregate Output approach
Aggregate expenditure approach is not the aggregate demand curve
o Shows overall spending at different income levels in the economy
Aggregate output is not the same as aggregate supply curve
o Shows overall volume of goods and services produced in the economy at different
income levels in the economy
The major determinate of consumer spending is disposable income [y D = (y-t)] [C = f(yD)]
C
AO
S
C = a + b(yD) -> b = MPC = delta C / delta yD
S
$9000
C = 1000 + .8yD
{C} = AE
E
yD = 0 ; C = 1000 + .8(0) = $1000 $5000
10000 Y
E
$1000
5000
yD = 5000 ; C = 1000 + .8(5000) = $5000
-1000
yD = 10000 ; C = 1000 + .8(10000) = $9000
Y
5000 10000
S = yD C
S = yD (1000 + .8yD) => S = yD -1000 - .2yD (.2 = marginal propensity to save = delta S / delta
yD)
Desired Investment Spending amount of investment which firms wish to undertake
Actual (realized) Investment investment which actually occurs
o Increases in investment of machine, tools, factories that actually occurs
o Increases in inventory that actually occurs
Could increase because the firms wanted them to
Could even increase when the firm doesnt want it to (people dont buy the
merchandise)
Autonomous the level of investment desired by firms does not change with changes in
income
Savings will always equal actual investment will only have equilibrium when actual investment =
desired investment
Savings can exceed investment as long as the government imposes taxes of that same magnitude
Injection = Leakage => (I+G) = (S+T)
AE = AO
Simple Multiplier the change in equilibrium income is a multiple of the change in investment
spending which causes it
Simple Muilt. (AE Mult.) = yE / AE => 1 / (1 MPC) or 1 / MPS
February 24, 2011
ID
10 Bil.
10 Bil.
MPC = .8
Y
10 Bil.
+ 8 Bil.
+ 6.4
C
8 Bil.
+ 6 Bil.
S
2 Bil.
+ 1.6
0
0
0
50 Bil.
40 Bil.
10 Bil.
Simple Mult = 1/(1-.8) = 1/.2 = 5 ID = 10Bil. Y = (5)(10Bil) = 50 Bil
Derive Simple Multiplier
yE = C + ID + G
->
C = a + b(yD) [b = MPC)
->
yD = (y-t)
y = a + b(y-t) + ID + G
->
y = a + by bt + TD + G ->
y by={a bt _ TD
+ G}
y(1-b) = {a bT + ID + G} ->
y = (1/[1-b]){a bt + ID + G}
Given MPC = .8
Simple Mult = YE/ME = 1/(1-.8) = 5
Investment = YE/ID = 1/(1-.8) = 5
Government Spending = YE/G = 5
Tax Multiplier = -b/(1-b) = -.8/.2 = -4
o Negative because lowered taxes increases after tax income. When this income
increases, the surplus of money leaks into savings.
Balance Budget Multiplier Multiplier that results from a balanced change in the governments
budget
o They have increased taxes by the same amount as they increased spending
o Y = 1/(1-b){-bT + G} -> T = G = BB
Y/BB = (1-b)/(1-b) = n
Assuming the following
nothing has changed in the firms outlook for the future
nothing has changed in government spending
imports/exports levels are the same
Price level goes up instead
o When the shift in the aggregate expenditure curve is the result of the change in the
price level of the economy, there is a shift along the aggregate demand curve
Exports, Desired Investment, Government Spending = Injection
Imports, Savings, Tax = Leakage
A change in fiscal policy / investment spending / government spending will cause the aggregate
demand curve to shift
Classical Economists say it doesnt matter if the aggregate demand curve shifts because the
aggregate supply curve is perfectly vertical there will be no change in production or
employment
Keynes Argument
o In long run yes there is a vertical supply curve and prices and wages are flexible but...
o In short run not all prices and wages are perfectly flexible so the supply curve has a
positive slope
Thus a shift in demand will cause a change in production
March 1, 2011
Part 3
Potential output Total GDP that could be produced by the economy if all its resources are
fully employed
National rate of unemployment rate of unemployment that occurs when your economy is
producing at its potential output
If price level which actually materializes is exactly equal to what everybody expected it to be,
the economy will be producing at its potential level of output and rate of unemployment =
national unemployment
o If price level that exists is greater than everyone expected it to be, the economy will be
able to produce above its potential level of output
o If price level that exists is less than the expected, firms will have to cut back on
production
o Connect points and have positive slope aggregate average supply curve (Fig 3.1)
Fiscal Policy government spending and taxing policies to bring about a change in economic
activity (Fig 3.4)
o Contractionary gap unemployment
To remove a contractionary gap, we would use an expansionary fiscal policy
(designed to expand production in the economy)
Increase government spending and/or decrease in taxes
o Expansionary Gap inflation
March 3, 2011
Functions of Money
M1 = coins + currency + checking accounts + travelers tax
o Very close relationship between money supply and available credit
Goldsmith Principle
Fractional Reserve Banking System
Federal Reserve System a bankers bank
o The only ones that can do business with this are bank (Chase, Bank of America, etc)
o Board of Government 7 members
14 year term, Stagnant so every 2 years ones office term expires
o 12 Federal Reserve Banks
o Member Banks banks we do business with Chase, Citicorp, etc
They do not need bank every to join
The Reserve has large banks already as members
The Reserve is so big that it can impose rules to require membership
Any bank which is a member of the federal reserve must go to the FDIC for
insurance
If a bank becomes a member, they need to subscribe to a certain number of
stock
Banks who are members have the phrase National Association
o Required Reserve Ratio percentage of deposit which the bank must hold in reserve
Determined by the federal reserve bank
In what form can the bank hold these reserves?
Actual cash in the banks vaults itself readily available
Deposits with the Federal Reserve Bank
o Cannot take any reserves and put them in a depositing account in
another bank (ie down the street)
o Run on a Bank when everyone goes to the bank and tries to pull as much cash out as
they can
o Fed Open Market Committee consists of 12 members
The 7 board of Governors
5 of the presidents of the Fed Reserve Banks
Take concrete step to increase or decrease money supply
Assets Liability = Net Worth
Assets = Liability + Net Worth
Bank
o Asset
Legal Reserves
Those that you are Required to be holding onto
Those Excess to the required
Loans
o Liability + Net Worth
Checking Account
Net Worth
Money Multiplier = 1/RQR
In the multiple bank system like we have, no one bank will ever loan out more than its excess
reserves, however those excess reserves will work their way through the banking system and
in the end we will receive the same
March 22, 2011
Banks always carry a buffer in their excess reserves
Fed funds market when the banks start loaning their excess reserves overnight to other
banks
o Fed fund rate exchange rate that is charged to borrow those excess reserves
overnight
o If fed wants to increase or decrease the exchange rate, they will use one of the three
tools
Reserve ratio
Discount rate
Open market operation
The three tools are known as major controls or quantitative controls
Other tools = qualitative controls
o Moral suasion youve convinced someone to see things your way
The federal reserve has been able to get the banks to change the money
supply the way that they would like it without having to use the three tools
o Marginal requirement if you borrow money from a bank or brokerage to buy a
stock, you must pay the marginal requirement for the stock and the bank will pay the
rest
The bank controls the stock as collateral
Margin call when the value of the stock has gone down and the bank wants
you to pay what you borrowed you cant so the bank sells your stock
Monetary policy trying to bring about changes in the level of economic activity through
changing the money supply
Liquidity reference approach Keynesian approach
o The demand for money is nothing more than the demand of liquidity
o Money is most liquid of all assests
Three basic motives for holding on to money
o Transactions demand for money demand for money so you can engage in your
transactions between paydays
o Precautionary motive a demand for money so that you can engage in transactions
which you have not previously planned on
o Speculative motive hold on to money and speculate, at a higher interest rate = give
money to bond market. By connecting these points you get a negative sloped curve
To remove a contractionary gap, change in expansionary fiscal (increase in government
spending and/or taxes) and increase in monetary supply
To remove an expansionary gap, change in contractionary fiscal (decrease in government
spending and/or taxes) and decrease in monetary supply
March 24, 2011
Liquidity trap if entered, you can increase the money supply all you want, but investment
spending does not go down (no change)
o Need to rely on fiscal policy
Heavy emphasis on fiscal policy because at the time, monetary policy would not work
What did the classical say about fiscal policy?
o Fiscal policy would not shift the aggregate demand curve
The rate of interest would go up, therefore if they are spending more, they are
spending less
Even if you could shift it, the classical economists would say it does not matter
because the aggregate supply curve is perfectly vertical
What did the classical say about monetary policy?
o A change in the money supply would shift the aggregate demand curve
It will have no impact on level of production or employment because supply curve
is perfectly vertical
o The demand for money was a constant proportion of nominal income
The monetarists agreed with Keynesians about the short run average supply curve having a
positive slope
According to Keynesian, the aggregate demand curve is shifting about in the economy
because of the instability of investment spending by firms
March 29, 2011
Monetarist School of Thought claims that the instability in the economy is not the large and
sudden changes in investment spending, but because the government changes money supply
by the wrong amount
o In short run, the aggregate supply curve has a positive slope
o Fiscal policy will have no effect on the economy. Only monetary policy (opposite of what
Keynes would say during a depression)
Monetarists believed that the demand curve was perfectly vertical; investment curve was
extremely horizontal
Fiscal Policy wouldnt work in the end.
o Increase in investment spending will cancel out any increase in government spending
According to Monetarists monetary policy effects the economy, not fiscal
A rule should be use to change the money supply
Why did Keynes think that during the depression, monetary policy would not be very effective
because demand for money was horizontal and investment curve was fairly vertical?
o If interest rate is already low, no one is going to take money and use it to buy corporate
bonds.
If you increase government spending according to the classical, the demand curve for local
funds would shift to the right
o Interest rate went up, consumer spending went down (they would save more money)
March 31, 2011
New Classical School of Thought any policy is useless
o Referred to as policy ineffectiveness no policy (monetary or fiscal) would have any
effect in the economy
Past behavior of prices used to construct what the future prices will be
Rational expectations assuming that individuals understand how an increase in government
spending/ change in money supply/ investment spending interact with one another and
therefore what a change in them would cause in the price level
Demand-pull inflation chasing too many dollars with too few goods
Cost-push inflation inflation in conjuncture with unemployment
o If labor gets a raise which is greater than its increase in productivity, aggregate supply
curve shifts to the left
Stagflation unemployment and inflation at the same time
April 5, 2011
Philips Curve shows the relationship between the rate of unemployment and the rate of
inflation
Equation of Exchange
o M = Money supply
MV [Total Spending] = PY [Real Output]
o V =Velocity of money
V = (PY)/M
o P = Price Level
o Y = Real Output
Quantity Theory of Money [MV=PY]
o V = constant or stable = Vbar
o MVbar = PY
increase in M = increase in PY
Velocity of money determined by various institutions in the economy
o Technology
o Use of credit cards/charge cards
o Frequency of payments
o Money as a stored value
In Keynesian economics, the velocity of money is not constant
In classical theory velocity of money is not constant
Starting from 1980s, the velocity of money increased rapidly
Equation of exchange it not concrete solution anymore; it is usually referred to as a general
guide
Hyperinflation the velocity of money is picking up price level is increasing, people are
losing faith in money and want to spend it as soon as possible to obtain goods and services
Net exports (exports [leakages] imports[injection])
Shocks in one economy can be transmitted to another economy in the world through the notion
of an open-economy
Exchange Rate the price of one countrys currency in terms of another countrys currency
Depreciation of Currency the value of the dollar has gone down
Appreciation of Currency the value of the dollar has gone up
The demand curve of any foreign currency is a result of the US residents demand for a foreign
countrys goods or services
o What causes demand to shift?
Change in income of US residents (increase in Y = increase in foreign demand)
Change in price in other country relative to US (increase in price level = decrease
in demand)
o What causes supply to shift?
Change in income in the US (increase in foreign income = increase in supply)
Change in relative price in the other country relative to the US (increase in price
level in US = increase in supply)
April 7, 2011
Balance of payments official record in which a country tries to record all of the payments that
flow into it in a year with all the payments that flow out of the country in a year
o When payments that flow in and those that flow out are equal, the balance of payment
is in equilibrium
o Surplus of balance of payments when the total payments that flow into the country
exceeds the payments that flow out of the county viewed as a disequilibrium situation
o If total payments that flow out of the country is greater than the payments that flow in,
there is a deficit also a disequilibrium situation
When you have a flexible exchange rate, the balance of equilibrium is always in equilibrium
Flexible Sales Rate Regime the government ..
Fixed Exchange Rate Regime
Current Account
o Import and export of goods and services
Imported Goods and Services (-)
M
= (X-M) [Net Exports]
Export of Goods and Services (+)
X
o Income on assets
Income received on US assets abroad (+)
Payments for the use of foreign assets (-)
o Unilateral Transfers
Outflow (-)
Inflow (+)
o Net Exports (-490.2) + Income (16.6) + Transfers (-68.3) = -541.8 [2003 Spencer 268]
Financial Accounts include such things as will you decide to open a bank account in the UK
o If you decided to buy a bond from the UK
Capital Account includes when a person is coming into your country and they have some
capital assets in them
Exam Review
Know flowchart he put on board
Functions of money supply (just what he went through)
Two moral controls
April 14, 2011
Shocks from the decrease in the level of income/investment results in transfers to another
country, affecting the net exports (x-m)
o If income goes down for nation A, aggregate expenditure goes down and so the
aggregate demand can shift to the left, which moves away from equilibrium, causing
unemployment and lower price levels
o Thus, if income goes down for nation A, imports for down which lowers aggregate
expenditure for nation B, causing
o Flexible interest rates act as a buffer for shocks, thereby not transferring shocks to other
countries
The gold standard is a fixed exchange rate regime
o Rules:
Every country had to define its currency in terms of gold
Each country had to passively allow gold to flow in and flow out of their economy
Each nation had to change their money supply as a result of gold flowing in or
out
If gold flowed into your country, you had to expand your money supply
If gold flowed out of your country, you had to reduce money supply
Each nation had to make sure they maintain wage and price flexibility
Mint parity rate
Per capita GDP method used to measure a countrys standard of living
Three Reasons for impact on growth
o There is an increase in the volume or quality of resources
o Technological improvements
o Improvement in the economic environment
Set of rules governing commerce, customs, property rights, tax laws
Production is the process which converts or transforms your resources (factors of production)
into final goods and services
The greater the productivity, the more you can produce with the same amount of resources
Productivity = total output relative to a specific amount of an input
o The most commonly used method of measuring productivity is labor productivity
Total output / total number of hours of labor used = labor productivity
Labor accounts for roughly 70% of all costs of production
Labor productivity is more easily measured
Human capital accumulated knowledge, skill, and experience of workforce
April 21, 2011
Exam Review
What monetarists have to say about the effectiveness of monetary policy over fiscal policy
New classical take of rational expectations
If your imports of other countries has an effect on the multipliers
How the supply and demand curve comes about in the equilibrium exchange rate
How under a flexible exchange rate, a shock in one economy can effect another
Why an increase in government spending does not shift the aggregate demand curve to the
right?
Monetary policy would shift the curve.
Aggregate supply curve perfectly vertical as a result of perfectly flexible prices and wages
classical
Keynes says both monetary and fiscal policy would shift the aggregate demand curve
Monetary policy if you wanted to expand production increase money supply which can
decrease in the rate of interest which would cause the aggregate demand curve to shift to the
right unemployment reduced
Liquidity Trap Keynes pointed out that to him that it was quite conceivable that in a time like
the Great Depression, production can only go up
o Demand curve for money perfectly horizontal
Asset demand for money = speculative demand for money
Monetarists believe that the demand curve for money is extremely vertical
o Investment spending is extremely sensitive to changes in interest rates
New Classical Rational Expectations
Balance of Payments current account consists of
o Imports and exports of goods and services
o Unilateral Transfer
o Payments for capital abroad and in US