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Chapter 1 Economics: The Core Issues

I. What is Economics?

The study of economics is based on a single reality: the wants of individuals, firms, and society are virtually unlimited, but resources are limited. This problem is known as scarcity. Due to scarcity we have to make choices, weighing the benefits and costs of each choice. This is economics. So Mick Jagger was quite the economist when he sang, "You can't always get what you want."

Any economic system will have to answer the following questions:

1. What to produce, given resources are limited (so we cannot produce everything we want)

2. How to produce the goods and services that we decide to produce in #1?

3. For whom is this stuff produced?

4. Who gets to decide #1-3?

In the United States a combination of both the government (and thus voters) and buyers and sellers in the marketplace answer these questions. In the former Soviet Union, central planning commissions made these decisions (and not very well, I might add).

For example, consider the decision to produce a Lexus.

What to produce? Toyota designs a luxury car that it believes buyers will want. Toyota decides how many it is willing to make given the price and their own costs, and U.S. buyers decide how many they will buy, based on the price, their preferences for the luxury car, among other factors.add). For example, consider the decision to produce a Lexus. How to produce? Toyota designs a

How to produce? Toyota designs a factory and machines and hires workers to make the Lexus at a low cost, but high quality. The government (of Japan and the United States) restricts Toyota's production techniques: there are pollution and safety regulations that Toyota must follow. There are minimum wage and overtime laws that Toyota must follow in compensating workers.their preferences for the luxury car, among other factors. Who gets a Lexus? If you've got

Who gets a Lexus? If you've got $50,000 and your willing to give it to Toyota, then you get a Lexus. If not, too bad. In other words, in the marketplace, the PRICE of the Lexus rations out the car. If everyone could just go pick one up for free, we would very quickly run out of Lexuses, and Toyota would not be able to make them fast enough. The price determines who will get scarce resources.laws that Toyota must follow in compensating workers. Who decided 1-3? For the most part, Toyota

Who decided 1-3? For the most part, Toyota and potential car buyers determine the design, quantity and price of the Lexus. However the government also had a say in how a Lexus is produced through certain regulationsenough. The price determines who will get scarce resources. II. A Closer Look at Scarcity and

II. A Closer Look at Scarcity and Choices

Scarce resources may be placed in one of four categories, also known as factors of production: land, labor, capital, and entrepreneurship.

Land refers to all natural resources, such as timber, oil, or water. refers to all natural resources, such as timber, oil, or water.

Labor refers to the number of workers in an economy, the time available to work, as refers to the number of workers in an economy, the time available to work, as well as how skilled those workers are.

Capital is NOT money in this context, but refers to goods that are used to produce is NOT money in this context, but refers to goods that are used to produce other goods and services, like the factories and tools that convert wood to paper, or the copy machine that converts paper to a book.

Entrepreneurship is the ability to use land, labor and capital in increasing new and better ways is the ability to use land, labor and capital in increasing new and better ways that maximize the quantity and quality of production from scarce resources. Entrepreneurship means that we now listen to music on CDs and MP3 and not vinyl record albums.

With scarcity comes choices. We cannot have everything so now we must choose. You and I face scarcity through our budget constraints (which explains why I drive a Saturn and not a Lexus). The State Assembly in

why I drive a Saturn and not a Lexus). The State Assembly in Virgilio Devonaire Marco
why I drive a Saturn and not a Lexus). The State Assembly in Virgilio Devonaire Marco

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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M A C R O E C O N O M I C S P a

New York must choose how to allocate tax dollars among competing uses (although they take their time doing it).

Scarcity means choices and choices mean costs.

Everytime we make a choice we give up the opportunity to use the resource in another way. This forgone option in known as the opportunity cost. In economics there is a saying: "There's no such thing as a free lunch" This does not mean that economists are too cheap to pick up their share of the tab

(although some are

"free" because we are using resources that could have been used for something else.

).

It means that nothing is truly

III. A Model of Scarcity and Choice: The Production Possibilities Curve

We can illustrate choices and opportunity costs through constructing a production possibilities curve for two hypothetical goods. Your book shows and example using shoes and TVs. I will go through another example here.

Suppose the nation of North Korea is making a decision about allocating resources. Let's assume they must choose between producing two goods: laptop computers and tanks. Given that their resources are scarce, they must choose how to allocate them between laptops and tanks. Suppose the tradeoff between laptops and tanks per month is given by the table below:

 

laptops

tanks

A

800

0

B

600

35

C

400

65

D

200

85

E

0

100

So if N. Korea produces only tanks, it can make 100 per month. If N. Korea gives up 15 tanks, it can produce 200 laptops. In other words, the opportunity cost of the first 200 laptops is 15 tanks. If N. Korea wants another 200 laptops, for a total of 400, it must give up another 20 tanks. To go up to 600 laptops, another 30 tanks. The opportunity cost of producing more and more laptops is rising.

Why do opportunity costs increase? Because resources are not perfectly substitutable between producing laptops and producing tanks. The two processes use different mixes of machines, raw materials, and labor skills. So if we start with 0 laptops and go to 200, we divert the best-suited resources first, giving up only 15 tanks. As N. Korea makes more and more laptops, the resources being diverted from tank production are less and less suitable, so N. Korea must give up more and more tanks. This difficulty in transferring resources would come up in almost any example.

We can plot the relationship above on a graph, known as a production possibilities curve. It gives us a picture of the tradeoff.

possibilities curve. It gives us a picture of the tradeoff. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
possibilities curve. It gives us a picture of the tradeoff. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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This graph illustrates the tradeoff between laptops and tanks. Note the shape of the curve--it is concave, which is due to the increasing opportunity costs. In addition to the tradeoff, the production possibilities curve shows us, for the North Korean economy, which combinations of laptop/tank production are doable, given current resources:

Points ON the curve (points A, B, C, D, and E) are all possible, and the are all efficient , i.e. they use all available resources. Which point is better? that depends on efficient, i.e. they use all available resources. Which point is better? that depends on your opinion on laptops vs. tanks. Today, N. Korea clearly prefers tanks.

Points INSIDE the curve are possible, but they are also inefficient . At point X, N. Korea could increase laptop production without sacrificing any tanks, inefficient. At point X, N. Korea could increase laptop production without sacrificing any tanks, or increase tanks without giving up laptops.

Points OUTSIDE the curve, like point Z, would be nice, but right now they are unattainable. There are not enough resources right now for N. Korea to make BOTH 650 laptops and 55 tanks. Point Z may be possible in the future if N. Korea experiences economic growth through discovering more resources or using them better. Economic growth shifts the curve outward as show below:any tanks, or increase tanks without giving up laptops. IV. Who makes the choices? In the

Economic growth shifts the curve outward as show below: IV. Who makes the choices? In the

IV. Who makes the choices?

In the North Korean economy, the government makes all choices since it owns all of the resources, and since the government is a dictatorship, only a handful of people direct the economy. This is known as a command economy.

In the absence of government control, decisions about what, how, and for whom to produce are made by the interaction of buyers and sellers in the market for each good and service. The prices of goods and services ration them to buyers who are able and willing to pay and also sends a signal to producers about what production is profitable. This profit motive also ensures that producers seek out the lowest-cost production methods. This is known as capitalism, or a free market economy

This is known as capitalism, or a free market economy Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
This is known as capitalism, or a free market economy Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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In the United States free markets play a large role in the economy, but there is also government involvement. The government produces some goods and services: national defense, education, highway building. And the government regulates how we produce with environmental and safety regulations. The result is what is known as a mixed economy.

In the United States and in many other countries there is an ongoing debate about the appropriate mix of private markets and government intervention. Conservatives argue for a laissez-faire (meaning "leave it alone") policy of limiting the role of government and letting markets determine economic outcomes. Liberals argue that market outcomes often have undesirable consequences, such as pollution, or poor working conditions, and that government has a legitimate role in tempering the excesses of capitalism.

Arguments about the role of government in the economy come up in many areas, and we will hear many of them in the months leading up to the November 2000 elections. Should the government provide public school vouchers? Should Social Security be privatized? Should the Federal Reserve raise interest rates?

V. What is economics?, revisited

This semester we are studying Macroeconomics, which means we will be more concerned with the economy as a whole than specific pieces. Consumer spending as a whole, the general level of prices and inflation in the economy, the causes and remedies for a recession are issues that interest macroeconomists. Microeconomics, on the other hand, is interested in parts of the economy, such as individual consumer behavior, how a firm determines how many workers to hire, how the market for healthcare differs from, say, the market for Diet Coke.

There are two tools used frequently by economists and in this course: models and graphs. Models are a simplification of reality that helps us understands how something works. Models start with simplifying assumptions, apply them to a theory about how the economy works, and come up with some results or implications. With any model there is a tradeoff: if the model is very simple, it is easy too understand, BUT may not be realistic. However, if the model is too realistic, it may be too complicated to be of any use. In this class we will build models of markets and the economy as a whole and compare the model implications to the reality of the U.S. economy.

Graphs are a convenient way to look at a model. They give us a picture of the state of the economy and/or the effects of changes in the economy. It may be tempting to overlook the graphs, but they are an important part of understanding economics, so take the time to understand them.

economics, so take the time to understand them. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
economics, so take the time to understand them. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Chapter 2 The U.S. Economy: A Global View

The U.S. economy, like any economy must answer the questions about what, how, and for whom to produce. As mentioned in chapter 1, these decisions are made in the U.S. through a combination of private markets and government intervention.

I. What America Produces

The short answer to this question is "a whole lot," but this answer is not particularly informative. For a more specific answer we need to measure output. This measure is known as Gross Domestic Product or GDP which is the total market value of all goods and services produced in the United States in a given year. In other words, it is each thing we produce, multiplied by the price and then added up. The bar graph on page 27 shows very clearly how the United States produces WAY more than any other country in the world. In fact, California by itself has a GDP larger than all but 6 countries in the world. In addition to GDP itself, we are also interested in

GDP per capita. This divides GDP by the population of the country. Again, the U.S. per capita GDP is the largest among the countries listed on page 28. GDP per capita is a measure of standard of living: rich nations have high per capita GDPs and poor nations have low per capita GDPs. Just looking at GDP alone can be misleading: note how China has the second largest GDP in the world, but its GDP per capita is below the world average. Why? because there are so many people in China sharing that production.

GDP growth. The standard of living you enjoy today is higher than the standard of living of your grandparents. Why? Because GDP has growth over time AND has grown faster than the U.S. population so that GDP per capita has grown over time. Economic growth is essential if we hope for a better standard of living for our children. On average, the U.S. economy has grown about 3% per year. Between 1996 and 1999 GDP growth has averaged over 4% per year. Recall that GDP growth shifts out the production possibilities curve over time.

GDP is often synonymous with the economy. GDP measures the size of the economy. A growing GDP indicates an economic expansion, while falling GDP indicates a recession.

So what is all of this stuff we are producing? In the U.S. today, most of what we produce (over 75%) are services, not actual goods. This has changed from 100 years ago, when most of our output consisted of agricultural and manufacturing good (See figures 2.2 and 2.3, p. 30-31). This trend toward a service-based economy is expected to continue. High growth is expected in retail services, medical services, and financial services.

These goods and services produced in the U.S. go to four areas: consumers, firms, government, and other countries. Of these four areas, the consumer is king. Consumer goods and services account for 67% of the U.S. GDP. This is why economists are always concerned about consumer confidence and why holiday retail sales are followed so closely. If consumer do not buy, GDP will fall.

II. How America Produces

"Very well, thank you." Seriously, behind the huge GDP of the United States is the abundance of high quality resources, and the efficient use of resources. Many countries match the U.S. in natural resources but NOT in GDP. Why is the U.S. able to squeeze so much output out of its factors of production?

Workers in the United States are highly educated and very productive. U.S. workers are able to produce more output per worker than workers in other countries. This is due to their skills, formal schooling (like college), and

The United States has a large capital stock. This means we have many buildings, factories, machinery, computers. We also have a highly developed infrastructure. This refers to structures that make communication and transportation possible: electricity wiring, fiber optics networks, paved roads, bridges, railroads, oil and gas pipelines, etc. This capital stock makes our skilled labor force more productive than other countries where workers may be just as skilled, but do not have networked computers or even reliable phone service.

In the United States, the factors of production are privately-owned. Companies and their machinery are owned by the stock holders. We own our labor, and sell it, in the form of wages, to the highest bidder. This private ownership creates a powerful incentive, known as the profit motive. If people get to keep the fruits of their labor, they will work harder, and/or produce a product as cheaply as possible.

harder, and/or produce a product as cheaply as possible. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
harder, and/or produce a product as cheaply as possible. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Business firms come in 3 types: Corporations, partnerships, proprietorships. Corporations are owned by many shareholders (or stockholders). Proprietorships have one owner, while partnerships have a small number of owners. The principle distinction with a corporation is the principle of limited liability: shareholders are not individually liable for corporation debts. If I own shares of the company Etoys, and they go bankrupt, I lose only the value of my stock--the lenders to Etoys cannot go after my house or my checking account. About 20% of firms are corporations, but they are the large firms, so they account for 84% of all firm assets. (See figure 2.5, page 36).

In the United States, private property rights are protected. My right to own my own home means nothing if somebody can just stop by and take it. By setting and enforcing the law, the government establishes the rules of the game that allow markets to function. In fact, many historians argue that the foundation of U.S. law, the Constitution, reflects the desire of wealth landowners to protect their property and their wealth. The growth of crime is a major obstacle to economic growth in Russia.

III. For Whom America Produces

For the most part, income determines who gets what, although the government does have many programs that assist the poor in obtaining essentials goods and services like housing, food, and medical care.

The result of the market system is huge inequality--large gaps between the rich and the poor. This is probably the biggest criticism of capitalism. The profit motive gives us efficiently but there is no guarantee of equality. Table 2.2 demonstrates the income inequality that exists in the United States.

Even though the United States has a great deal of income inequality, this does not mean a market economy is

a bad thing. Market economies have built-in incentives for efficiency and entrepreneurship that lead to economic growth, and this growth can make everyone better off, whether rich or poor. This is what Republicans mean when they argue that "a rising tide lifts all boats."

If we think of the U.S. economy as a pie, then our economy is the biggest pie in the world, and it is growing in

size over time. Because our pie is so big, a small piece of the U.S. pie may actually be larger than a big piece of pie in, say, Bangladesh.

Other industrialized countries seem to place a greater value on economic security and equality, such a France, Germany, and Canada. Americans place more emphasis on equality of opportunity rather than equality of result.

on equality of opportunity rather than equality of result. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
on equality of opportunity rather than equality of result. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Chapter 3 Supply and Demand

I. Demand

In this chapter we take a closer look at the market mechanism by building a model that shows us how the price

and amount of a specific good or service are determined. This model involves the behavior of buyers and sellers interacting to maximize profits and well-being. I have subdivided chapter 3 into 3 parts: Demand, Supply, and Market Equilibrium. I believe this subdivision makes the online lecture easier to follow.

There are two types of markets. Product markets involve the buying and selling of final goods and services. So the buyer is a consumer and the seller is a firm. For example, consider the market for toothbrushes. You and I are buyers, and Oral B or Proctor & Gamble are sellers.

A market is any situation where buyers and sellers interact, exchanging dollars for goods, services, or factors of production. It does not necessary have to be in the same physical location.

Factor markets involve the buying and selling of the factors of production, like labor, raw materials, machinery. The buyer is the firm and the seller is the owner of the factor. I sell my labor to SUNY Oswego, and SUNY Oswego is the buyer.

What is Demand?

Demand is a model of the behavior of buyers. Buyers are those willing and able to pay for a good or service. Let's consider a specific good that is the salvation of many a working mother: A large pizza, delivered. We also need to carefully measure the good, so let's consider the good to be large pizzas delivered per week in Oswego, NY.

To begin to build a model of buyers choice, we start with a simplifying assumption: Let's first look at the relationship between the amount of pizzas delivered per week in Oswego and price of delivery pizzas AND NOTHING ELSE. We hold all of the other factors that might impact the demand for pizzas constant. This assumption is known as ceteris paribus, or "other things remaining equal." (Economists love Latin terms). We will relax this assumption later, but for now we are concerned only with price and quantity. Suppose the relationship between price and pizza delivered is defined by the table below. This is known as a demand schedule.

 

Price of large pizza

Quantity of pizzas demanded (per week in Oswego)

A

$25

100

B

$20

210

C

$15

300

D

$10

500

E

$ 5

650

Note how when the price of pizza falls, the quantity of pizza demanded rises, ceteris paribus. This is known as the law of demand. The law of demand exists for two reasons. First, as the price of pizza rises, consumers will substitute cheaper goods. Second, as the price rises, consumers feel poorer in terms of what goods they are able to afford, causing them to cut back on expenditures.

able to afford, causing them to cut back on expenditures. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
able to afford, causing them to cut back on expenditures. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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M A C R O E C O N O M I C S P a

Now lets plot the table above to get a picture of the demand for pizza. This is known as a demand curve.

The law of demand results in a demand curve with a negative slope. Changes in the price move us along the demand curve, from point A to B as the price falls, or point C to B at the price rises. A price decrease will increase quantity demanded, while a price increase will decrease quantity demanded.

Changes in Demand

Now lets revisited our assumption of ceteris paribus. If we allow other factors affecting pizza demand to change, this will shift us to an entirely new demand curve. In reality the amount of large pizzas people want to buy depends on many things, including

taste or preference for pizza: pizza may be a popular takeout choice, or the community may prefer Chinese food or subs.

income of households: if we live in a poorer area, people may not order food as often as a middle class area.

price and availability of substitute goods: A substitute good is one that could be purchased instead of pizza. Is pizza the only deliviery option, or can people get chinese? subs? salads? If Chinese food falls in price, then the demand for pizza will fall if people substitute the cheaper Chinese delivery for pizza delivery.

price and availability of complement goods: A complement good is one that is consumed with pizza, like soda or parmesan cheese. If the price of soda or parmesan rises, this affects the demand for pizza.

expectations about future prices, income: If a family expects a layoff or big expenses in the future, they might save money now by not ordering food.

the size and composition of the population: Of course more people in Oswego means more pizza ordered, but the composition of the population matters too. A community of retired people will not order as much pizza as, say, college students.

A change in any of the 6 factors above will shift the entire demand curve to the left or right. A shift left is a decrease in demand, while a shift right is an increase in demand. In our example, the following changes would INCREASE the demand for pizza:

rising preferences for pizza over other foods

rising household income which makes pizza more affordable

an increase in the prices of other takeout food relative to the price of pizza

a decrease in the price of soda and/or parmesan cheese

an expected increase in household income

an increase in enrollment at SUNY Oswego

in household income an increase in enrollment at SUNY Oswego Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
in household income an increase in enrollment at SUNY Oswego Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Consider an increase in enrolment at SUNY Oswego. With more students ordered pizza at any price, the entire demand curve shifts to the right as seen below:

the entire demand curve shifts to the right as seen below: Now consider instead a decrease

Now consider instead a decrease in household income in Oswego due to massive layoffs by a large employer. Households cut back on luxuries like eating out (or ordering in). Demand falls, or shifts to the left as seen below:

in). Demand falls, or shifts to the left as seen below: Note there is a very

Note there is a very important difference between a change in quantity demanded and a change in demand.

A change in quantity demanded is caused by a change in price, and is represented by movement along the demand curve.

A change in demand is caused by one of the other factors affecting demand, and is represented by a shift to a new demand curve.

This distinction is a common source of confusion for economics students, so be careful!

source of confusion for economics students, so be careful! Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
source of confusion for economics students, so be careful! Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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II. Supply

In part one we modeled the behavior of buyers. In part two we model the behavior of sellers.

What is Supply?

Supply is a model of the behavior of sellers. Let's return to our example of pizza delivered in Oswego during a week. The sellers here are the various pizza places that deliver. Again we first consider the relationship between the price of pizza and the amount of delivered pizzas that restaurants are willing to supply, ceteris paribus.

The supply schedule is as follows:

 

Price of pizza

Quantity of pizza supplied (per week in Oswego)

a

$25

800

b

$20

700

c

$15

625

d

$10

500

e

$5

300

Note that as the price of pizza falls, the quantity of pizzas supplied also falls, ceteris paribus. This is relationship is known as the law of supply. Why do we see this relationship? Remember that costs of making pizzas is held constant here. This means that as the price of pizzas rise, the profits are rising too, so suppliers are willing to make more.

We illustrate the supply relationship with the supply curve

We illustrate the supply relationship with the supply curve The supply curve has an upward slope

The supply curve has an upward slope due to the law of supply. Sellers are willing to produce more at higher prices. A change in price will result in movement along the supply curve, like from a to c as prices fall, or from e to d as prices rise.

Changes in Supply

Now let’s revisit our assumption of ceteris paribus. If we allow other factors affecting pizza supply to change, this will shift us to an entirely new supply curve. In reality the amount of large pizzas producers are willing to sell depends on many things, including

costs of production: The cost of labour, cheese, gasoline for the delivery cars, etc. all impact how many pizzas will be supplied at any given price

impact how many pizzas will be supplied at any given price Virgilio Devonaire Marco Umipig/BS ECONOMICS
impact how many pizzas will be supplied at any given price Virgilio Devonaire Marco Umipig/BS ECONOMICS

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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technology: Machines affect the time it takes to make a pizza, or how many inputs are required

profitability of producing other things: Is the pizza business as profitable as the sub shop business?

expectations: Do sellers expect the pizza delivery business to be profitable in the future?

the number of sellers: How many pizza places are in Oswego?

A change in any of the 5 factors above will shift the entire supply curve to the left or right. A shift left is a decrease in supply while a shift right is an increase in supply. In our example, the following changes would INCREASE the supply of pizza:

falling cheese, tomato, or gasoline prices

the invention of a better pizza oven or cheese grater

a decrease in the profitability of sub shops

two new pizza places open in downtown Oswego

Consider a big decrease in the price of cheese. This will shift the supply curve to the right as illustrated below:

shift the supply curve to the right as illustrated below: Suppose instead that rising gasoline prices

Suppose instead that rising gasoline prices make delivery more expensive. Then supply decreases, or shifts to the left as below:

Then supply decreases, or shifts to the left as below: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
Then supply decreases, or shifts to the left as below: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
Then supply decreases, or shifts to the left as below: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Note there is a very important difference between a change in quantity supplied and a change in supply.

A change in quantity supplied is caused by a change in price, and is represented by movement along the supply curve.

A change in supply is caused by one of the other factors affecting supply, and is represented by a shift to a new supply curve.

This distinction is a common source of confusion for economics students, so be careful!

III. Market Equilibrium

Now we put together the behavior of buyers (part one) and the behavior of sellers (part two) to have a model of the whole market for pizza.

Market Equilibrium

Recall the demand and supply schedules for pizza delivered in Oswego in a week:

Price of pizza

Quantity of pizza demanded (per week in Oswego)

Quantity of pizza supplied (per week in Oswego)

$25

100

800

$20

210

700

$15

300

625

$10

500

500

$5

650

300

Note that at a price of $10, the quantity supplied = the quantity demanded = 500. If we plot the supply and demand curves on the same set of axes, we get the following illustration of the pizza market:

axes, we get the following illustration of the pizza market: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
axes, we get the following illustration of the pizza market: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
axes, we get the following illustration of the pizza market: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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The supply and demand curves intersect at the point where quantity supplied = quantity demanded. This intersection is what we call an equilibrium price. This is the price where the intentions of both the buyer and seller are compatible: Buyers want to buy the exact amount the sellers want to sell.

Why is (500, $10) an equilibrium? To understand why, let's think about what would happen if the price was greater than or less than $10.

If the price is greater than $10, say $20, the quantity demanded = 210 and the quantity supplied = 700. The result would be a huge surplus of 490 pizzas produced, with no one willing to buy them for $20. This surplus would force prices to fall, causing pizza supplies to cut back production and pizza buyers would be willing to buy more pizzas as the price falls, until the price reaches $10.

If the price is less than $10, say $5, the quantity demanded = 650 and the quantity supplied = 300. The result would be a shortage of 350 pizzas. This shortage would force prices up, causing pizza suppliers to produce more and consumers to buy less, until the price reaches $10.

So an equilibrium point is a point of rest, where there is no incentive for buyers or sellers to change their decisions. However, if one of the other factors affecting demand and supply change, then the demand and/or supply curves will shift, and a new equilibrium will result. Let's consider a few examples

Changes in Equilibrium

Let's consider a few examples.

Example 1: Suppose that the price of Chinese food delivery rises. What happens to the market for pizza? Let's figure this out with a 3 step approach:

Step 1: Will this affect the demand or supply curve? Chinese food is a substitute for pizza, so the price of chinese food affects the demand curve

Step 2: In what direction will the affected curve move? The price of chinese food, a substitute, INCREASES, so the demand for pizza INCREASES, or the demand curve shifts right.

Step 3: What is the resulting impact on the equilibrium price and quantity? This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price and larger quantity. An increase in demand results in an increase in price and quantity.

in demand results in an increase in price and quantity. Example 2: Suppose instead that the

Example 2: Suppose instead that the Chinese food business is incredibly popular and profitable. What happens to the market for pizza? Again, we use the same three step approach:

Step 1: Will this affect the demand or supply curve? The chinese food business is an alternative to the pizza business, affecting the supply curve

to the pizza business, affecting the supply curve Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
to the pizza business, affecting the supply curve Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Step 2: In what direction will the affected curve move? The profitability of chinese food means that some pizza places will switch to chinese food places, so the supply of pizza DECREASES, or the supply curve shifts left.

Step 3: What is the resulting impact on the equilibrium price and quantity? This is easiest to answer with a graph. If you look at the graph below you will see that the new equilibrium has a higher price and smaller quantity. An decrease in supply results in an increase in price and a decrease in quantity.

results in an increase in price and a decrease in quantity. Example 3 : Now lets

Example 3: Now lets combine examples 1 and 2 so that the demand for pizza increases AND the supply of pizza decreases. What happens to the market for pizza?

we know an increase in demand will increase equilibrium price and increase quantity.

we know a decrease in supply will increase equilibrium price and decrease quantity.

put both together the equilibrium price will increase but the affect on quantity is uncertain, and depends on whether the shift in demand is smaller or larger than the shift in supply. As I have draw the graph below, there is no change in quantity.

I have draw the graph below, there is no change in quantity. Virgilio Devonaire Marco Umipig/BS
I have draw the graph below, there is no change in quantity. Virgilio Devonaire Marco Umipig/BS
I have draw the graph below, there is no change in quantity. Virgilio Devonaire Marco Umipig/BS

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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The table below summarizes how changes in demand and supply affect equilibrium price (P) and quantity (Q).

no change in demand (no shift) increase in demand (shift right) decrease in demand (shift
no change in demand
(no shift)
increase in demand
(shift right)
decrease in demand
(shift left)
no change in supply
(no shift)
no change in P
no change in Q
P
increases
P
decreases
Q
increases
Q
decreases
increase in supply
(shift right)
P
decreases
P ?
P
decreases
Q increases
Q
increases
Q ?
decrease in supply
(shift left)
P increases
P
increases
P?
Q decreases
Q?
Q
decreases

Worksheet on Supply and Demand, Chapter 3

Example 1: The Market for Leather Sandals

Let's look at how different factors will affect the price and quantity of leather sandals in central New York.

A. Mad cow disease requires the total destruction (and no use) of 20% of the worlds cows.

total destruction (and no use) of 20% of the worlds cows. B. Global warming leads to

B. Global warming leads to longer and hotter summers.

cows. B. Global warming leads to longer and hotter summers. C. PETA (an animal rights group)

C. PETA (an animal rights group) launches an advertising campaign against the use of animal products.

an advertising campaign against the use of animal products. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
an advertising campaign against the use of animal products. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
an advertising campaign against the use of animal products. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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D. The production of leather wallets and handbags declines in profitability.

of leather wallets and handbags declines in profitability. Example 2: The Market for Natural Gas From

Example 2: The Market for Natural Gas

From January 2000 to January 2001, the price of natural gas has risen from $2.00 per BTU to over $10.00 per BTU. We are going to examine why.

Using the diagram below, what changes in supply and/or demand are consistent with an increase in the price of natural gas?

are consistent with an increase in the price of natural gas? What factors may have affected

What factors may have affected the supply of natural gas this winter?

What factors may have affected the demand for natural gas this winter?

may have affected the demand for natural gas this winter? Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
may have affected the demand for natural gas this winter? Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 4 The Public Sector

As we discussed in chapter 1, the United States is a mixed market economy, combining private markets for goods and services with government regulation and provision of goods and services. In this chapter we look at the circumstances under which private markets fail and government must step in, the optimal amount of government intervention, and the potential drawbacks to government intervention.

Very few people in the world argue for zero government intervention, and very few people argue for 100% government control of the economy. In the United States, popular opinion about the right level of government intervention is closer to zero than in any other industrialized country. This goes back to the birth of our country-- a revolt by tax-paying landowners who were not too thrilled with the interference of Britain's King George III. We begin by examining the case for government intervention in certain situations.

I. Market Failure

In providing most goods and services, the market mechanism of supply and demand results in an optimal outcome; i.e. scarce resources are directed to their most desired uses. This results automatically from individuals maximizing their own well-being and from firms maximizing profits. In other words, the market mechanism chooses a point on the production possibilities curve. However, for certain goods and services the market outcome is not optimal: either too much or too little of the good or service is produced. This situation is known as market failure. When there is a market failure there is a case for government intervention. The government can guide resources to their best uses.

When do market failures occur? There are several sources of market failure

Public goods

These goods are characterized by joint consumption. That is, the consumption of the good by one person does not prevent another person from consuming the good as well. A candy bar is a private good. If I eat it, you cannot. National defense is a public good. If I buy a missile defense system to protect Baldwinsville, NY from nuclear attack, then my next-door neighbor also consumes the defense system. It does not make my protection any less effective, and I cannot prevent my neighbor from benefiting from the missile shield.

So why are public goods a problem? Since the benefits are shared, I have an incentive to not buy the missile shield (because those things are pretty expensive) and hope that my neighbor does. This is known as the free rider problem. Everyone in Baldwinsville hopes that someone else will buy the missile shield, so no one buys the missile shield. As a result, there is no missile shield, even though society values and wants one. Thus, the market fails to provide a missile shield.

Most of you are already familiar with the free rider. That's the "friend" who wants to copy your homework 5 minutes before class.

What's the solution? Have the government force people to pay taxes and use that revenue to fund the production of the public goods. Otherwise, the market will fail to produce valuable public goods and society will be worse off.

examples of other public goods: law enforcement, road construction, flood control, fire protection

Externalities

The consumption or production of goods always results in benefits and costs borne by the buyer and seller. However, the consumption and production some goods yield costs and benefits to third parties other than the buyer or seller. These third party cost and benefits are known as externalities. When externalities exist, markets underestimate either the benefits or costs of consumption or production. As a result either too much or too little of the good is produced. Huh? Let's look at a couple of examples:

One example of a good whose consumption results in external benefits is the polio vaccine. If I buy a polio vaccine for myself I clearly benefit: I am now immune from polio. But others also benefit, because their potential for exposure to polio has decreased now that one less person is susceptible to polio. Also, since I will not get the crippling disease, I will not consume the scarce medical resources used to treat the disease.

So what is the problem here? When deciding whether or not to buy the vaccine, I consider only my benefits, not yours. As a result I and others like me underestimate the benefits of polio vaccination and not enough

the benefits of polio vaccination and not enough Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
the benefits of polio vaccination and not enough Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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people get vaccinated. When goods have external benefits, the market will fail by underproducing the good. The solution is typically government subsidies that encourage greater consumption.

other goods with external benefits: education, antilock brakes, landscaping (Why?)

An example of a good whose production results in external costs is coal-generated electricity. The production of electricity has some pretty obvious benefits in terms of profits for the utility company. But there are third party costs: burning coal causes a huge amount of air pollution that can trigger asthma attacks, lung disease, acid rain, and global warming.

In the absence of any pollution regulations, electricity costs reflect only production costs not pollution costs. Electricity will be too cheap, and too much will be produced. When goods have external costs, the market will fail by overproducing the good. The solution is government regulation that increases the cost of production or consumption.

other goods with external costs: cigarette consumption, listening to loud music, any production that results in pollution.

Market Power

A firm has market power when it is able to influence the price of a good or service through its large market share. An extreme example of market power is a monopoly, where only one firm supplies a good or service. A firm with market power is able to restrict output and inflate the price of a good in order to maximize profits. As a result, the market fails by underproducing a good or service. By excluding competition, a firm with market power will have less incentive to improve the quality of its products, hurting consumers.

The government combats market power through enforcing antitrust laws. These laws do not outlaw market power but regulate the behavior of firms with market power. The antitrust case against Microsoft was about its behavior not its size.

Not all monopolies are bad. Sometimes it is efficient to have only one producer, such as in the distribution of phone service or electricity over power lines. These are known as natural monopolies. Also, sometimes the government creates a monopoly by granting patents. Pfizer has a patent for Viagra, which gives it a legal monopoly. Without the patent, Pfizer would not recoup its research costs and there would be no incentive for pharmaceutical companies to undertake medical research.

Inequity

The market may result in an efficient allocation of resources, but as we discussed in chapter 2, not everyone gets an equal slice of the pie. People with more money go to better schools, drive better cars, living in nicer houses, etc. The question is should the government redistribute income by taxing those with "too much" and giving it to those with "too little." This type of redistribution is not especially popular in the United States. Observe the unpopularity of taxes and the popularity of welfare reform.

Eliminating poverty does have external benefits. Poverty has consequences for crime and child poverty has consequences for future economic growth. The negative effects of poverty spill over to those not in poverty. However, the benefits of reducing poverty need to be balanced with the costs of redistributing income. Too much taxation reduces incentives for profits and entrepreneurship, which reduces economic growth.

Europe's economic growth has lagged behind U.S. growth, and some economists argue that a heavy tax burden in Europe is one explanation. In an election year you hear a lot of talk about U.S. taxes being too high, but keep in mind that they are much lower than taxes in many other industrialized countries like France, Germany or Canada.

Keep in mind that those who support greater equity are not necessarily making economic arguments, but instead are making moral arguments.

Instability

Historically, market economies go through periods of inflation or unemployment. Some economists argue that the government needs to intervene to keep inflation and unemployment at a minimum. In fact, the are federal laws that require Congress and the President to do just that. Other economists argue that the government does not have the ability to intervene correctly and only makes things worse. We take a close look at this debate in module 3.

worse. We take a close look at this debate in module 3. Virgilio Devonaire Marco Umipig/BS
worse. We take a close look at this debate in module 3. Virgilio Devonaire Marco Umipig/BS

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II. The Size of Government

We have established that there are cases that merit government intervention. Even the most conservative legislators would agree (especially since the government pays their salaries). How involved is the government in the U.S. economy?

government spending in the U.S. accounts for about 16% of GDP, lower than our neighbor Canda (20%) but higher than Japan (10%)

The largest federal expenditures include, Social Security, Medicare/Medicaid, and interest on the national debt; state and local governments spend most of their funds on education and welfare

III. Taxation

Taxation takes resources used for private consumption and diverts them to the public sector. Taxes are used to fund public goods, and tax law is often used to encourage or discourage certain activities. For example gasoline taxes are used to fund highway construction, a public good, as well as encourage energy conservation.

The 3 largest sources of federal revenue are income taxes, social security taxes (that FICA box on your paycheck), and corporate income taxes.

Income taxes are progressive: larger incomes are taxed at a higher rate. The incredibly compicated income tax law is also designed to affect behavior. There are special tax breaks for children, for saving for retirement college, for owning a home, for building low-cost housing, for conducting medical research into rare diseases.

Social security or payroll taxes are regressive: larger incomes are taxed at a lower rate, due to the cap on how much earnings are subject to the social security tax (about $75,000). So someone who makes $45,000 has all of her earnings taxed. Someone who earns $100,000 has only 75% of her earnings taxed. A typical working family pays more in Social Security taxes than in income taxes.

For state and local governments, the 3 largest sources of revenue are sales, property and income taxes

Sales taxes are regressive, since poorer consumers spend almost all of their money on goods and services, while higher income households save more of their income. For this reason many states exempt food and clothing from the sales tax.

Property taxes are also regressive since lower-income households spend a larger share of their income on housing. Although renters do not directly pay a property tax, these costs are reflected in their monthly rent payments.

State income taxes have the same progressive structure as federal income taxes. Some states, like Texas and Tennessee, do not have an income tax.

IV. Government Failure

While government intervention is advisable in the case of market failure, it is also true that government intervention with fail to improve, or even worsen economic outcomes. This notion of government waste involves several issues

The government wastes resources by not using them efficiently. This is a problem in the public sector where the profit incentive does not exist. The Department of Motor Vehicles does not get bonuses based on its customer service.

The government is performing functions that could be performed better in the private sector. The main argument behind school vouchers is that private education is superior to public education. Many support contracting out welfare services to private agencies, like Catholic Charities or the Salvation Army. Should health insurance remain in the private sector or should the government take over like in Canada?

What is the opportunity cost of government services? Do the benefits of controling air pollution justify the higher costs for gasoline and electricity? What is the opportunity of building more prisons? Measuring the benefits and costs of public goods is tricky: how do you quantify the benefits of saving the Spotted Owl from extinction?

The appropriate role of government is an ongoing debate in both microeconomics and macroeconomics.

an ongoing debate in both microeconomics and macroeconomics. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
an ongoing debate in both microeconomics and macroeconomics. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 5 National Income Accounting (Measuring Output)

I. Gross Domestic Product (GDP)

Macroeconomists are interested in total production in the economy, so it is essential that we create a measure of total output. This measure is called GDP. GDP is the total market value of all final goods and sevices produced in a country in a given year. Three things to note about this definition of GDP:

total market value. We add up the dollar value of all the stuff produced in the United States. We add up the dollar value of all the stuff produced in the United States. This is because producing a car is way different that producing a haircut or a can of soup, but by converting everything to its dollar value we have a uniform measure.

final goods and services. We only count final products ready to be consumed, NOT products used to make . We only count final products ready to be consumed, NOT products used to make other products. So a car will be counted in the GDP but the steel used to make the car is not counted separately. Why? Because the value of the car already reflects the value of the steel, rubber, plastic,etc. that goes into it.

produced in a country. The U.S. GDP counts only those goods and services produced in the physical borders of The U.S. GDP counts only those goods and services produced in the physical borders of the United States. So Toyotas made in Ohio are counted, even though Toyota is a Japanese company. However, minivans made by General Motors in Mexico do NOT count in GDP, even though GM is a U.S. company. Where the good or service is produced is important.

Example. Suppose our imaginary economy produces 3 goods: apples, computers, pizza. The table below shows
Example. Suppose our imaginary economy produces 3 goods: apples, computers, pizza. The table below shows
production and prices for 1999:
year
apples
computers
pizza
price
quantity
price
quantity
price
quantity
1999
$0.50
500
$1000
100
$9
400

To caluculate GDP, we simple multiply the price and quanitity of each good to get the dollar value, then add up all three values:

GDP = value of apples + value of computers + value of pizza GDP = ($.50)(500) + ($1000)(100) + ($9)(400) = $250 + $100,000 + $3600 = $103,850

With millions of goods and services in the United States, the process is a bit more complicated, but the principle is the same.

The measurement of GDP and its components is known as national income accounting. The U.S. Department of Commerce is in charge of measuring U.S. GDP and measures it quarterly, or 4 times per year.

II. Nominal GDP vs. Real GDP

In measuring GDP, we use prices to measure the value of good and services produced. Using the current prices to value current production is known as nominal GDP. The problem with nominal GDP is that a change in nominal GDP can be due to either (1) a change in the production of goods and services, or (2) a change in the prices of those goods and services. So an increase in prices will cause nominal GDP to rise, even if production has not changed at all. This gives a misleading picture of how well our economy is doing. It also makes it difficult to compare production from year to year, since prices change every year.

from year to year, since prices change every year. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
from year to year, since prices change every year. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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To address the price problem, we also construct a measure of GDP that takes price changes into account. Real GDP values goods and services in any given year by using the prices of a set base period. By holding prices constant, real GDP measures only the changes in production from year to year. Changes in real GDP are used to measure economic growth.

Example. Lets continue our example above. The table below has the prices and production of apples, computers and pizza for three years:

year apples computers pizza price quantity price quantity price quantity 1997 $0.45 475 $1100 70
year
apples
computers
pizza
price
quantity
price
quantity
price
quantity
1997
$0.45
475
$1100
70
$7
380
1998
$0.48
510
$1050
85
$8
390
1999
$0.50
500
$1000
100
$9
400

First, let's calcuate nominal GDP for each year. This means we take the price for that year times the quantity for that year.

nominal GDP 1997 = (.45)(475) + (1100)(70) + (7)(380) = $ 79,873.75 nominal GDP 1998 = (.48)(510) + (1050)(85) + (8)(390) = $ 92,614.80 nominal GDP 1999 = (.50)(500) + (1000)(100) + (9)(400) = $103,850

From 1997 to 1999 nominal GDP has increased by

= $103,850 From 1997 to 1999 nominal GDP has increased by but this increase includes changes

but this increase includes changes in BOTH price and production

Now let's calculate real GDP, using 1998 as the base year. This means for each year we will value output using 1998 prices.

real GDP 1997 = (.48)(475) + (1050)(70) + (8)(380) = $ 76,786 real GDP 1998 = (.48)(510) + (1050)(85) + (8)(390) = $ 92,614.80 real GDP 1999 = (.48)(500) + (1050)(100) + (8)(400) = $108,440

From 1997 to 1999 real GDP has increased by

(400) = $108,440 From 1997 to 1999 real GDP has increased by but this increase includes

but this increase includes ONLYchanges in production, because prices are held constant at their 1998 levels. Note how the real GDP increase is greater. This is because in calculating nominal GDP, computer prices are falling over time even though computer production is increasing.

Note that real GDP = nominal GDP in the base year, since both measures use the same prices and same production.

since both measures use the same prices and same production. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
since both measures use the same prices and same production. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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When the U.S. Department of Commerce calcuates real GDP they use an average of prices in previous years, not just the prices of a single year. This is known as a chain-weighted price adjustment.

Figure 5.1 (page 95) measures real vs. nominal GDP from 1975 to 1996, using 1992 as the base year. Given that prices on average increase over time in the U.S., the real GDP is greater than the nominal GDP before 1992, and less than nominal GDP after 1992.

Real and nominal GDP are used to form a price index, something we discuss in Chapter 7.

III. U.S. GDP Over Time

The graph below shows the post WWII path of real and nominal GDP in the United States, using 1996 as a base year.

nominal GDP in the United States, using 1996 as a base year. Given that prices on

Given that prices on average increase over time in the U.S., the real GDP is greater than the nominal GDP before 1996, and less than nominal GDP after 1996. Note that even after adjusting for inflation, production in the United States has risen dramatically in the past 50 years, from $1.5 trillion to over $9 trillion.

Typically economists are more interested in the CHANGE in real GDP rather than the LEVEL of real GDP:

in the CHANGE in real GDP rather than the LEVEL of real GDP: The negative percent

The negative percent changes in real GDP indicate recessions.

Real and nominal GDP are used to form a price index, something we discuss in Chapter 7.

to form a price index, something we discuss in Chapter 7. Virgilio Devonaire Marco Umipig/BS ECONOMICS
to form a price index, something we discuss in Chapter 7. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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IV. Measuring GDP: The Expenditure Approach

So how does the U.S. government go about measuring such a huge quantity? One approach is to add up expenditures on goods and services in each sector of the economy:

Consumption (C). As mentioned in chapter two, this accounts for about 2/3 of GDP. As mentioned in chapter two, this accounts for about 2/3 of GDP.

Investment (I). Plants, equipment and inventory of businesses. This is one of the most volatile components . Plants, equipment and inventory of businesses. This is one of the most volatile components of GDP.

Government Spending (G): Federal, state, and local government purchases of goods and services are counted here. This : Federal, state, and local government purchases of goods and services are counted here. This does NOT count transfer payments, such as welfare, since this just transfers income and does not represent production of goods and services.

Net Exports (X - IM). Net exports is exports minus imports. So we add in those goods and services . Net exports is exports minus imports. So we add in those goods and services produced in the U.S. and sold abroad but we substract the good and services purchased by consumers, businesses, and governments that were not made in the United States. Since the 1970s, the U.S. has imported more than it has exported, so net exports are negative.

Putting all of the expenditures together we have the identity

GDP = C + I + G + X - IM

V. Measuring GDP: The Income Approach

The second approach to measuring GDP is to look at income instead of expenditures. If someone bought it, then someone is being paid to make it. The income components include

Wages and salariesis being paid to make it. The income components include Corporate profits Proprietors income (the profits

Corporate profitsto make it. The income components include Wages and salaries Proprietors income (the profits of partnerships

Proprietors income (the profits of partnerships and soley owned businesses, like a family restaurant)components include Wages and salaries Corporate profits Farm income Rent Interest Sales taxes Depreciation (the

Farm incomeand soley owned businesses, like a family restaurant) Rent Interest Sales taxes Depreciation (the amount of

Rentowned businesses, like a family restaurant) Farm income Interest Sales taxes Depreciation (the amount of capital

Interestowned businesses, like a family restaurant) Farm income Rent Sales taxes Depreciation (the amount of capital

Sales taxeslike a family restaurant) Farm income Rent Interest Depreciation (the amount of capital that has worn

Depreciation (the amount of capital that has worn out during the year)a family restaurant) Farm income Rent Interest Sales taxes Tables 5.5 and 5.6 (pages 98, 99)

Tables 5.5 and 5.6 (pages 98, 99) show the relationship between the income and expenditure approaches. The expenditure and income approaches should, in theory, give us the same answer. In reality they are slightly different due to some measurement error. But spending and income are related in a circular flow: spending by someone becomes income for someone else. For example, when my family goes out to eat, the meal we purchase represents income for the waiter, the restaurant owner, the suppliers, and the sales tax on the meal is income for the government. So to calculate GDP we can either add up expenditures or add up income. The flow between income and spending is demonstrated in figure 5.3 (page 101).

VI. What does GDP NOT measure?

So GDP is an important measure of the economic power and health of a nation. But GDP does not tell the whole story in terms of the well being of a nation. Here are a few things GDP leaves out:

Other social indicators. These include crime, illiteracy, life expectancy, infant mortality. Although these things are related to . These include crime, illiteracy, life expectancy, infant mortality. Although these things are related to GDP, the connection is not perfect: The U.S. has a larger GDP per capita than Canada or Japan, but also has a higher rate of crime, illiteracy, and infant mortality.

Equity. A large GDP per capita does not mean that the wealth of a nation . A large GDP per capita does not mean that the wealth of a nation is shared equally. In some nations, the GDP is distributed for the most part among a small elite class, leaving the rest of the nation in poverty.

elite class, leaving the rest of the nation in poverty. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
elite class, leaving the rest of the nation in poverty. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Environmental issues. A high rate of production may have disasterous environmental consequences. Brazil may increase its GDP A high rate of production may have disasterous environmental consequences. Brazil may increase its GDP by cutting down rain forests for the timber, but very few of us would say that is a good thing.

The underground economy. The GDP actually measured will fail to capture any goods and services that are . The GDP actually measured will fail to capture any goods and services that are not reported to the government. These include illegal activities, like marijuana cultivation, cocaine sales, and tax evasion, such as under-reporting tip income, or cash-paid babysitting. The underground economy is estimated to be as large as 10% of the measured GDP in the United States(see page 91). The underground economy in Mexico is relatively larger due to drug smuggling. Canada's underground economy is estimated to be as high as 20% due to the higher taxes there.

Nonmarket work. This includes transactions for which people are not paid. When I do my family's . This includes transactions for which people are not paid. When I do my family's laundry, that is not counted in GDP. But if I paid someone to do my laundry, it would count in GDP. The exclusion of homemaking really understates the services produced in the United States.

So while GDP is a crucial measure of the size and health of an economy, keep in mind it is not the ONLY measure of well-being.

keep in mind it is not the ONLY measure of well-being. Virgilio Devonaire Marco Umipig/BS ECONOMICS
keep in mind it is not the ONLY measure of well-being. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Chapter 6: Unemployment

In this chapter we take a closer look at the problem of unemployment. Of all macroeconomic problems, chronic unemployment probably extracts the highest personal cost: it destroys marriages, it leads to depression, drug abuse, and even suicide. But the costs of unemployment are borne by the entire economy, not just the unemployed. In this chapter we look at the measurement of unemployment, the costs of unemployment, and what constitutes a "good" level of unemployment in our economy.

I. Measuring Unemployment

In measuring unemployment, it is first necessary to measure who is in the labor force; i.e. who is working for pay or actively looking for work for pay. In other words, we do not want to just look at the population because we do not want to count children as unemployed, or homemakers as unemployed, or retirees or the severely disabled. That would give us a misleading picture of the labor market.

The percentage of the civilian population that is over 16 and in the labor force is known as the labor force participation (LFP) rate. Below is figure 6.2 from your textbook showing the labor force participation rate from 1950 to 1998

Year

Men

Women

Married Women w/ children under 6

1950

86.4%

33.9%

-

1960

83.3%

37.7%

19%

1970

79.7%

43.3%

-

1980

77.4%

51.5%

-

1990

76.1%

57.5%

-

1998

74.9%

59.8%

64%

Note how the LFP rate has fallen for men. This is due to earlier retirement made possible by Social Security and private pensions. The LFP rate for women has almost doubled since 1950 as more homemakers have entered the labor force. The most dramatic increase in LFP has occurred among married women with small children.

So to measure unemployment we measure the number of people not employed AND actively looking for work. The unemployment rate is the percentage of the labor force that is unemployed.

Unemployment rate =

of the labor force that is unemployed. Unemployment rate = The unemployment rate is calculated monthly

The unemployment rate is calculated monthly by the Bureau of Labor Statistics. The unemployment rate as of June 1999 was 4%, which is very low by historical standards.

June 1999 was 4%, which is very low by historical standards. Virgilio Devonaire Marco Umipig/BS ECONOMICS
June 1999 was 4%, which is very low by historical standards. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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This 4% however is a national average and varies substantially by age, race, sex, education, region, and marital status. Figure 6.4 (page 110) shows how unemployment rate varies by these categories in 1998. This pattern persists over time:

Unemployment rates are highest for younger workers (age 16-19)these categories in 1998. This pattern persists over time: Unemployment rates are highest for high school

Unemployment rates are highest for high school dropouts, lowest for college graduates.rates are highest for younger workers (age 16-19) Unemployment rates are lower for white workers and

Unemployment rates are lower for white workers and higher for black and hispanic workers.for high school dropouts, lowest for college graduates. Unemployment rates are lower for married men vs.

Unemployment rates are lower for married men vs. single men.for white workers and higher for black and hispanic workers. Unemployment rates are lower in urban

Unemployment rates are lower in urban areas vs. rural areas.Unemployment rates are lower for married men vs. single men. We are also interested in how

We are also interested in how long people are jobless, or the duration of unemployment. The vast majority of people who become unemployed are unemployed for less that 14 weeks (January 2001).

are unemployed for less that 14 weeks (January 2001). The unemployment rate and the duration of

The unemployment rate and the duration of unemployment are useful economic indicators but they do not tell the whole story. The unemployment rate fails to consider several things:

Discouraged workers. If someone has "given up" trying to find work and is sitting on the . If someone has "given up" trying to find work and is sitting on the couch eating cheetos and watching Jerry Springer, they are not counted in the labor force. This means these people do not show up in the unemployed statistics. This is more of a problem during recessions.

Underemployment. Sometimes people are forced to take jobs that are not a good match to . Sometimes people are forced to take jobs that are not a good match to their job skills. However these people are still counted as employed, even though they are not utilizing all of their job skills. For example, if SUNY Oswego fires me, and I take a job as a cashier at Wegman's, I am not unemployed, but I am underemployed. The same is true for part-time workers who really want a full-time job.

Phantom unemployment. Some people report that they are looking for work, when in fact they are not. Some people report that they are looking for work, when in fact they are not. This is done to satisfy the job-seeking requirements of welfare reform, or the requirements for receiving unemployment benefits. These people are reported as unemployed, when the truth is they are not in the labor force.

Despite these problems, the unemployment rate is a key economic indicator.

II. The Costs of Unemployment

We know that high unemployment is not a good thing, but you may not be aware of all of the reasons. Unemployment clearly has costs for the person who is jobless, but the true costs extend beyond the individual or the family affected.

costs extend beyond the individual or the family affected. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
costs extend beyond the individual or the family affected. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Unemployment costs the economy as a whole. If we are experiencing unemployment, then we are not using all of our labor resources. This means we are at a point INSIDE the production possibilities curve. This lost output is gone forever. The relationship between unemployment and production is known as Okun's Law: An increase of unemployment by 1 percentage point will cause real GDP to decrease by 2 percentage points.

Unemployment has a domino effect as well: As people lose their jobs, they cut back on spending, which causes other workers to lose their jobs. Unemployed people will likely postpone the purchase of a new car, and not go out to eat. This may cause auto workers and waiters to lose their jobs as well.

Unemployment increases government expenditures on unemployment benefits, food stamps, etc., while decreasing income tax revenue, potentially creating a budget deficit.

Probably the most serious and most difficult to quantify are the personal costs. Higher unemployment is associated with increasing rates of suicide, domestic violence, drug abuse, and health problems.

III. What Should be our Goals for Unemployment?

We should first start by noting that the goal for unemployment is NOT zero. Some unemployment is inevitable and even desireable. If unemployment is too low, firms cannot find workers, resulting in output loss.

One of our basic macroeconomic goals is something called full employment. Full employment does NOT mean zero unemployment. To understand what full employment means, lets look at 3 types of unemployment:

Frictional unemployment is the unemployment that results from people switching jobs or entering the labor market. The is the unemployment that results from people switching jobs or entering the labor market. The job search takes time, so this type of unemployment is inevitable. Frictional unemployment is temporary because the jobs and workers are there, they just have to find each other. Recent college graduates who take a couple of months to land a job are an example of frictional unemployment. Employment agencies, classified ads, the internet all reduce the time is takes to match job offers to job seekers but some frictional employment will always exist.

Structural unemployment is more serious. This type of unemployment is caused by a mismatch between job skills is more serious. This type of unemployment is caused by a mismatch between job skills needed and jobs skills possessed by job seekers, or a mismatch in the location of jobs and job seekers. Although the jobs are out there, the job seekers are not qualitfied for them or have to move to find them, making structural unemployment more long-term as people retrain or relocate. For example, many garment workers have lost their jobs in the U.S. as factories move overseas, but they are not qualified to fill job openings for computer programmers and web developers. With the rapid pace of technological change and growth of global markets, structural unemployment is also inevitable.

Cyclical unemployment occurs when there are too few jobs available due to an economic slowdown. Due to occurs when there are too few jobs available due to an economic slowdown. Due to low demand for goods and services, the number of workers demands is less than the number of workers available in the labor force. Cyclical unemployment corresponds to recessions.

Back to full employment. What is it? Since 1946, the federal goverment is required to pursue the goal of full employment, but does not specify exactly what it is. Full employment occurs when cyclical unemployment is zero, and structural and frictional unemployment are at a minimum. When unemployment is higher, resources are not being used efficiently. When the unemployment rate is lower, the shortage of workers will cause wages and prices to rise, triggering inflation.

So the goal of full employment is defined as the lowest unemployment rate consistent with stable prices. The Full Employment and Balanced Growth Act of 1978 gets more specific with goals of 4% for the unemployment rate and 3% for inflation.

goals of 4% for the unemployment rate and 3% for inflation. Virgilio Devonaire Marco Umipig/BS ECONOMICS
goals of 4% for the unemployment rate and 3% for inflation. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Most economists believe we are at full employment when the unemployment rate is between 4 and 6%. This is known as the natural rate of unemployment. This rate changes over time as changes in our economy affect structural unemployment levels.

The unemployment rate for post WWII is plotted below:

The unemployment rate for post WWII is plotted below: There are are couple of things to

There are are couple of things to note from the graph above.

The unemployment rate we are experiencing currently is the lowest in about 30 years.There are are couple of things to note from the graph above. Note how we often

Note how we often fail to achieve the goal of full employment. Why? We will discuss the causes of unemployment as well as potential remedies in more detail in later chapters.are experiencing currently is the lowest in about 30 years. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

well as potential remedies in more detail in later chapters. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
well as potential remedies in more detail in later chapters. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 7: Inflation

In the final chapter of this module we look at inflation. In macroeconomics we are interested in the average level of prices in the economy, not the price of any particular good or service. Inflation is defined as an increase in the average level of prices in the economy, while deflation would be a decrease in the average level of prices. We focus on inflation because for the past 60 years in the U.S., average prices have risen, not fallen, so deflation is actually rare. In this chapter we ask

why is inflation a problem?so deflation is actually rare. In this chapter we ask how do we measure inflation? what

how do we measure inflation?rare. In this chapter we ask why is inflation a problem? what are the basic causes

what are the basic causes of inflation?ask why is inflation a problem? how do we measure inflation? what kind of goals should

what kind of goals should we set for inflation?measure inflation? what are the basic causes of inflation? I. Why is inflation a problem? Not

I. Why is inflation a problem?

Not for the reasons most people think. It may be tempting to say, "because everything is more expensive," but that is not it. Deflation can actually be just as damaging as inflation. The problem with inflation is one of redistribution: inflation makes some people worse off, but it makes others better off. This redistribution is due to three effects:

Price effects. As the average level of prices increase, some prices increase faster than others, so . As the average level of prices increase, some prices increase faster than others, so some people are more affected than others. The increase in gasoline prices in the summer of 2000 hurt truckers a lot, but barely affected people who live close to work and drive economy cars. College tuition has risen almost twice as fast as average prices over the past 20 years, which hurts you a lot, but may have little impact on a married couple with no children.

Income effects. Prices for goods and services mean incomes for someone else. So as some prices . Prices for goods and services mean incomes for someone else. So as some prices increase faster than others, some incomes increase faster than others. Oil companies posted record profits in the summer of 2000.

Wealth effects. Inflation redistributes income between borrowers and lenders. Suppose you borrow $100,000 for a 30-year . Inflation redistributes income between borrowers and lenders. Suppose you borrow $100,000 for a 30-year mortgage at 7% interest, giving you a monthly housepayment of about $665. During the next 30 years, as prices rise, that $665 buys less and less. So as a borrower, the real value of your housepayment declines. Thus a borrower may gain from high inflation. The lender however, receives $665 per month, so the lender loses. If inflation is high enough the $239,400 the lender receives in loan and interest repayment over the next 30 years ($665 x 12 months x 30 years) will be worth LESS in real terms than the $100,000 the borrower receives today. Inflation hurts lenders but benefits borrowers, especially if it is unexpected. So the Wall Street banker is much more worried about inflation than Joe Average with a mortgage and a car payment.

The costs of inflation go beyond redistribution, and have negative implications for the economy as a whole. If inflation is low, the effects may be small. But in periods of high inflation, known as hyperinflation, the negative effects will cripple an economy. What are the macro implications for inflation?

Uncertainty. Future prices are unknown, making it difficult to plan investment and consumption decisions. This means Future prices are unknown, making it difficult to plan investment and consumption decisions. This means that some production will not be undertaken because firms are not certain about profitability.

Shorter time horizons. Due to uncertainty over prices, firms and consumers are less willing to commit to long-term Due to uncertainty over prices, firms and consumers are less willing to commit to long-term plans, like a 30-year mortgage, or building a new housing development over 10 years. Again, production falls due to uncertainty.

over 10 years. Again, production falls due to uncertainty. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
over 10 years. Again, production falls due to uncertainty. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Diverting resources from production. When inflation gets to be very high, firms and consumers spend more time and resources When inflation gets to be very high, firms and consumers spend more time and resources trying to avoid inflation, and less time on productive activities. For example, in Germany in 1923, prices doubled every week. Workers would be paid several times a day, and would immediately rush out and spend their wages. People had to bring wheelbarrows full of money to buy one loaf of bread. All of this results in time and resources being devoted to inflation-related activities instead of the production of goods and services.

So inflation not only redistributes income, it also reduces the growth of real GDP which has negative implications for employment and standard of living for everyone.

II. Measuring Inflation

Inflation is measured as the percentage change in a price index. A price index measures the average price level for a set of goods and services, relative to a base year. We will discuss three commonly used price indices.

The Consumer Price Index (CPI) is the most commonly used index for measuring inflation. It is designed to measure changes in the prices of goods and services typically purchased by an urban consumer, so it is also known as a cost-of-living index. So the price of gasoline or milk is included in the CPI, but the price of a forklift is not. To calculate the CPI the Bureau of Labor Statistics

identifies a "market basket" of goods and services the typical consumer buys, about 184 items.is not. To calculate the CPI the Bureau of Labor Statistics assigns a weight to each

assigns a weight to each category based on how much of a consumer's budget that item takes. Figure 7.2 shows that housing costs account for almost 40% of consumer expenditure, while clothing only accounts for 5%. The BLS surveys families every year to come up with the items and weights in a market basket.and services the typical consumer buys, about 184 items. shops for the items in 85 cities

shops for the items in 85 cities across the country every month to measure the price changes of items in the market basket.to come up with the items and weights in a market basket. compares the price of

compares the price of the market basket to its price in a base year.to measure the price changes of items in the market basket. Example: The price of the

Example: The price of the market basket between 1996-1999 is listed in the table below

Year

Cost of the market basket

1996

$10, 640

1997

$10, 780

1998

$10, 810

1999

$10, 900

To calculate the CPI for each year we compute

$10, 900 To calculate the CPI for each year we compute Suppose we choose 1997 as

Suppose we choose 1997 as our base year. Now we can calculate the CPI for each year:

our base year. Now we can calculate the CPI for each year: Virgilio Devonaire Marco Umipig/BS
our base year. Now we can calculate the CPI for each year: Virgilio Devonaire Marco Umipig/BS

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M A C R O E C O N O M I C S P a

The CPI rises over time because the price of the market basket has risen over time. To get the inflation rate for each year, we measure the percentage increase in the CPI:

each year, we measure the percentage increase in the CPI: Note that for the base year,

Note that for the base year, the price index = 100. This is true for any index.

The CPI is used to calculate cost-of-living adjustments (COLAs) under many union contracts, for Social Security recipients, for federal employees, and to adjust federal tax brackets for inflation. Therefore, it is important that this measure be accurate. However there are a couple of problems with the CPI that cause it to OVERSTATE inflation:

The CPI does not allow for a substitution effect. When the price of soda rises, consumers will cut back on soda and drink . When the price of soda rises, consumers will cut back on soda and drink water, or Snapple, or milk. The CPI market basket is fixed, so it misses this substitution effect.

The CPI does not measure quality changes. Cars are more expensive today than in 1980, but they are also safer, more . Cars are more expensive today than in 1980, but they are also safer, more mechanically reliable, pollute less and use less gasoline. The CPI attempts to adjust for quality changes but does so imperfectly, and with a time lag.

Also, the CPI market basket changes over time, making comparisons difficult. For example, a 1970 market basket would not include a VCR, computer, or cellular phone.

The mismeasurement of inflation by the CPI causes COLAs to be higher that actual inflation, which means larger raises for some workers, but higher costs to the federal government and thus taxpayers. A 1996 report suggested this overstatement of inflation to be between .8 and 1.6 percentage points annually.

The Producer's Price Indexes (PPI) are similar to the CPI, except that they measure the prices of raw materials, intermediate goods, or final goods used by producers instead of consumers. Increases in the PPI often precede increases in the CPI, as producers pass price increases along to consumers.

The GDP Deflator is the broadest price index, measuring the average price level of all goods and services included in the GDP. The deflator is simply the ratio of nominal GDP to real GDP. Or in other words, this index deflates nominal GDP to an inflation-adjusted output, real GDP. The GDP deflator differs from the two previous indexes in that

GDP deflator differs from the two previous indexes in that Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
GDP deflator differs from the two previous indexes in that Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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It does not have a fixed market basket, but looks at all goods and services produced in the United States.M A C R O E C O N O M I C S P a

It does not include imports (which are not in the GDP), so it may understate inflation, especially when the price of oil increases, since most oil is imported.at all goods and services produced in the United States. III. Real vs. Nominal Quantities Using

III. Real vs. Nominal Quantities

Using the appropriate price index, we can convert any nominal quanitity (measured in current dollars) to a real quantity (adjusted for inflation):

dollars) to a real quantity (adjusted for inflation): Let's consider an example using the minimum wage.

Let's consider an example using the minimum wage. Consider the following table of the federal minimum wage between 1980-1998 and the CPI for the same years:

Year

minimum wage

CPI

1980

$3.10

82.5

1982

$3.35

97

1984

$3.35

103.7

1986

$3.35

109.4

1988

$3.35

118.1

1990

$3.80

130

1992

$4.25

140.2

1994

$4.25

148

1996

$4.75

156.8

1998

$5.15

163

148 1996 $4.75 156.8 1998 $5.15 163 Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
148 1996 $4.75 156.8 1998 $5.15 163 Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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So the minimum wage has risen $2.05 or 66% over 18 years, but prices have risen as well. Using the formula above we can calculate the real minimum wage, i.e. the actual purchasing power of the minimum wage.

Year

minimum wage

CPI

real minimum wage

1980

$3.10

82.5

$3.76

1982

$3.35

97

$3.45

1984

$3.35

103.7

$3.23

1986

$3.35

109.4

$3.06

1988

$3.35

118.1

$2.84

1990

$3.80

130

$2.92

1992

$4.25

140.2

$3.03

1994

$4.25

148

$2.87

1996

$4.75

156.8

$3.03

1998

$5.15

163

$3.16

Looking at the real minimum wage, we see that it actually peaked in 1980. So someone working for minimum wage is actually worse off, even though the nominal wage has risen, it has not kept up with inflation.

IV. The Goal of Price Stability

Price stability is synonymous will low inflation (or low deflation). What is an appropriate goal for price stability? We know inflation is costly. Does it follow that our goal should be for zero inflation? If so, we are doing a pretty lousy job!

Recall that according to the Full Employment and Balanced Growth Act of 1978 the goal of economic policy should be an inflation rate of less than 3%. Why not zero? An inflation rate of 0% may require spending cuts that could decrease real GDP and increase unemployment (we discuss this tradeoff later in chapter 16). Also, given that the CPI overstates inflation, a 3% measured inflation rate is actually less than 3%.

Looking at the percentage change in the CPI below (the red line) we see that inflation has frequently risen above 3%. Right after WWII, inflation spikes as consumers rush to buy all of the consumer goods not available during wartime. Throughout the 1950s inflation is fairly tame, but it begins to increase steadily in the 1960s. Inflation was especially a problem between 1973-1982. However, inflation stayed below 3% during most of the

However, inflation stayed below 3% during most of the Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
However, inflation stayed below 3% during most of the Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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1990s

M A C R O E C O N O M I C S P a

V. What causes inflation?

Inflation can come from two sources: the economy supply curve or the economy demand curve. Cost-push inflation comes from the supply side. Basically, a large increase in the price of a very important input causes suppliers to pass along those increases and prices rise. Examples of cost-push inflation include OPEC oil price hikes in the 1970s, a bad drought the decreases food production, or labor union wage demands. Cost-push inflation results in one-time price hikes, but not persistent inflation.

Persistent inflation comes from the demand side. Demand-pull inflation occurs when the economy cannot produce fast enough to satisfy demands of consumers. In the first half of 2000, economists have been concerned about the emergence of demand-pull inflation as a booming economy and stock market motivate wealthy consumers to spend, spend, spend. Those concerns have decreased in the latter part of 2000, as the stock market ended the year down, GDP growth slowed down, and the unemployment rate inched up slightly. Holiday retail sales, an important spending indicator, were flat relative to 1999.

Most economists agree that persistent inflation is a demand phenomenon: "Too many dollars chasing too few goods." The link between inflation and money is explored later in chapter 15.

between inflation and money is explored later in chapter 15. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
between inflation and money is explored later in chapter 15. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 8 The Business Cycle, Part One

In this chapter we begin to build a model of our economy that will explain and predict changes in GDP, unemployment, and prices.

We first turn our attention to changes in GDP. We know that both real and nominal GDP have grown over time, but it is also true that GDP exhibits cyclical behavior: it rises for a period of time then falls for a period time. This cycle of alternating growth and contraction in GDP is known as the business cycle.

Business cycles are a powerful thing. The Great Depression of the 1930s shaped the attitudes and behaviors of

a generation of Americans. The contraction in GDP in 1990-91 most likely cost George Bush re-election. Do you remember the slogan of President Clinton's successful 1992 campaign? "It's the economy, stupid."

Even in the 2000 election, some were baffled that the economic expansion of the 1990s did not give Al Gore a victory.

Business cycles are also a controversial thing. There is substantial disagreement among macroeconomists about the causes of business cycles and what, if anything, should be done about them.

All About Business Cycles

We measure a business cycle by changes in real GDP, so we are focusing only on changes in output. The business cycle has four parts: peak, contraction, trough, expansion.

A peaks are high points for real GDP, while the troughs are low points. The period between a peak and a

trough is known as a contraction, or also a recession. Officially recessions are periods of declining real GDP that lasts at least 6 consecutive months (two quarters). Very serious recessions are called depressions. The period between a trough and a peak is known as an expansion, which is characterized by increased real GDP. As of November 2000, the United States economy has been in an expansion since March 1991, or 117 months, the longest expansion on record. The last recession ran from July 1990 to March 1991 or 8 months.

The graph below shows the history of U.S. business cycles since 1930.

below shows the history of U.S. business cycles since 1930. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
below shows the history of U.S. business cycles since 1930. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
below shows the history of U.S. business cycles since 1930. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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There are a few interesting things to note;

The 1930s saw the worst contraction in GDP of almost 30%. This is known as the Great Depression and was experienced by most of the world.P a g e | 36 There are a few interesting things to note; Wartime increases

Wartime increases the demand for goods and services by the military, causing economic expansion. Note the growth in real GDP that occurs in WWII, the Korean War, and the Vietnam War.Great Depression and was experienced by most of the world. Even during times of economic expansion,

Even during times of economic expansion, real GDP may grow only very slowly, below the long-run U.S. average of 3% per year. These are known as growth recessions . For example, even though our most recent recession ended in March 1991, growth recessions. For example, even though our most recent recession ended in March 1991, Americans did not feel better about the economy at first, voting George Bush out of office in November 1992. This lack of consumer confidence can be attributed to the slow growth of GDP in the early 1990s. Some economics are predicting a growth recession for 2001.

Prior to 1930s, many economists, known as the classical economists, argued that the market economy was inherently stable, and that business cycles were nothing to be concerned about--just short and temporary inconveniences. The market economy would always return itself to growth and prosperity, or "self-correct." Why? Because wages and prices would adjust to keep us at equilibrium. If people were unemployed, then wages would quickly fall, and people would again be hired. If inventories piled up, prices would fall and consumers would buy more.

The Great Depression sort of blew that theory right out of the water. From 1930-33, output fell 30% and unemployment rose to 25%, hardly a minor inconvenience. John M. Keynes criticized the classical economists in his famous book, The General Theory, arguing that market economies are naturally unstable and that waiting for the economy to self-adjust is a mistake. Keynes argued that wages and prices are not flexible, causing long periods of unemployment. His solution? The government should intervene during business cycle downturns to ease the pain of unemployment. Keynes has had a huge influence on macroeconomics and economic policy, with Keynesian economics forming the foundation for most college economics textbooks.

If we want to understand why business cycles occur and what possible remedies exist, we need a model of how the economy works.

I. A Model of the Macro Economy

To understand why business cycles occur, and what, if anything, should be done about them, we need a model of the economy. Our model, like any model, is a simplification, where we take some inputs, put them in a framework, and get some outputs.

The outputs of our model should be the macroeconomic variables of interest, namely:

real GDPshould be the macroeconomic variables of interest, namely: prices employment economic growth international variables

pricesbe the macroeconomic variables of interest, namely: real GDP employment economic growth international variables (exchange

employmentmacroeconomic variables of interest, namely: real GDP prices economic growth international variables (exchange rates,

economic growthvariables of interest, namely: real GDP prices employment international variables (exchange rates, trade balance) The

international variables (exchange rates, trade balance)interest, namely: real GDP prices employment economic growth The inputs into our model are the various

The inputs into our model are the various events/forces/influence that will impact the economy:

internal market forces: population growth, technological innovation, consumer behaviorevents/forces/influence that will impact the economy: external shocks: wars, weather, other international trade

external shocks: wars, weather, other international trade disputesgrowth, technological innovation, consumer behavior political: tax laws, government spending, regulation of

political: tax laws, government spending, regulation of money and creditshocks: wars, weather, other international trade disputes Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

laws, government spending, regulation of money and credit Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
laws, government spending, regulation of money and credit Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Any influence on a macroeconomic variable in a market economy must happen by affecting either the supply or the demand of goods and services. To capture this, we will build a model of demand for ALL goods and services, and supply of ALL goods and services, known as aggregate demand and aggregate supply.

Aggregate Demand

Aggregate demand (AD) in the relationship between the amount of total output demanded and the average price level. As shown here and in figure 8.5 (page 154), the AD curve is downward sloping.

in figure 8.5 (page 154), the AD curve is downward sloping. The total demand curve is

The total demand curve is downward sloping for 3 reasons:

The real balance effect. Consider consumers with $1000 to spend. At lower price levels, consumers can buy more with $1000 than at higher price levels. So when prices are low, the real value of their money is higher.The total demand curve is downward sloping for 3 reasons: The foreign trade effect. As prices

The foreign trade effect. As prices rise in the U.S., imports will become relatively cheaper, causing consumers to buy fewer U.S. goods and services.prices are low, the real value of their money is higher. The interest rate effect. Lower

The interest rate effect. Lower prices coexist with lower interest rates, which encourages borrowing to purchase goods and services.causing consumers to buy fewer U.S. goods and services. In each case above, lower prices are

In each case above, lower prices are associated with buying more goods and services, higher prices are associated with fewer purchases, ceteris paribus. This gives the AD curve it's downward slope.

Aggregate Supply

The aggregate supply curve represents how much firms are willing to produce at each price level, ceteris paribus. The aggregate supply curve (AS) is upward sloping, but with a changing slope. The AS curve is flatter at lower levels of output and steeper at higher levels of output. Giving us the curve below (figure 8.6, p.156).

of output. Giving us the curve below (figure 8.6, p.156). First let's consider why the AS

First let's consider why the AS is upward sloping. The reason lies in profits. In the short-run many costs are fixed: rent, salaries, supplier contracts. If prices rise, then suppliers get an increase in the price they receive, but their costs do not increase by the same amount. This causes profits to rise, so suppliers increase output. If prices fall, profits fall, and suppliers decrease output.

If prices fall, profits fall, and suppliers decrease output. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
If prices fall, profits fall, and suppliers decrease output. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Next, let's examine the changing slope of the AS curve. At lower levels of real GDP, changing prices result in large changes in output supplied. At higher levels of real GDP, changing prices result in only small changes in output supplied. Why the difference? At low levels of GDP there is a lot of excess capacity in the economy:

workers are easy to find, materials are easy to get. This enables produces to increase output without paying much more in costs. At higher levels of GDP, the economy will be close to its capacity (at a point of the production possibilities curve). As a result, producers will have a hard time finding the workers and materials without paying more for them. As costs increase, the incentive to produce more decreases.

So, in summary, producers supply more goods and services at higher prices, giving us an upward sloping AS curve. However, at a higher level of real GDP, a price increase causes real GDP supplied to increase only a little. So the AS curve is affected by both profits and costs.

II. Macro Equilibrium

At a given point in time, the state of our macroeconomy is summarized by the intersection of the AD and AS curves:

is summarized by the intersection of the AD and AS curves: In the graph above, Qe

In the graph above, Qe is the level of real GDP in our economy, and Pe is the average price level. This is a macro equilbrium--the unique combination of prices and output where the quantity of all goods and services produced is equal to the quantity purchased. Even though the equilibrium is stable, there are two potential problems with the economy here.

The macro equilibrium may not be desirable. The output and price combination may not be consistent with our macreconomic goals. The output Qe may be consistent with an unemployment rate of 9%, which means that real GDP is below its full employment level . Or the price level Pe may be 10% higher than the full employment level. Or the price level Pe may be 10% higher than the year before, representing an unacceptable rate of inflation.

Even if the macro equilibrium is desirable, there is no guarantee that outside forces will not shift the AD or AS curves to a new, undesirable macro equilibrium. For example, rising gasoline prices increases costs for almost all producers, shifting the AS curve left. This causes real GDP to fall, prices to rise, and unemployment to rise.year before, representing an unacceptable rate of inflation. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

real GDP to fall, prices to rise, and unemployment to rise. Virgilio Devonaire Marco Umipig/BS ECONOMICS
real GDP to fall, prices to rise, and unemployment to rise. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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So macro equilibria are not all "good" and they can change for many reasons.

III. What Causes Macro Instability? A Preview

Again, this is a big area of disagreement, and the AD/AS model does not solve the disagreement. Economists disagree about (1) the shape of the AS curve, (2) how likely is it the AD or AS will shift.

Stability is discussed more in module 4, but here is an introduction to the debate. Instability can come from one of two sources: either the AD shifts or the AS shifts, which changes macro equilibrium.

Keynes argued that AD shifts were responsible for instability. AD that is too low (too far to the left) would cause output to be too low and thus unemployment to be too high. Keynesians want the government to intervene to move the AD curve to a desirable position.

Both Keynesians and monetarists argue that when AD that is too high (too far to the right) causes inflation. They differ in that Keynesians want the government to intervene and move the AD curve to a desirable position, while monetarists feel that government intervention causes more problems than it solves.

Still other economists, known as supply-siders, argue that instability is due to shifts in AS.

Keep in mind as we develop and use the AD/AS model that the issue of business cycles and stability is one with a short-run perspective, i.e. the monthly fluctuations in macro variables. Many economists are more interested in the long-run perspective on how much real GDP is growing on average over long periods of time. The factors affecting short-run output fluctuations and long-run output growth could in fact be very different.

and long-run output growth could in fact be very different. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
and long-run output growth could in fact be very different. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Chapter 9: Aggregate Spending

We continue to study the AD/AS model of the macro economy. In this chapter we focus solely on the AD curve to get a better understanding of why the AD might shift, leading to business cycles.

Recall that macro equilibrium is the level of price and output where AD and AS intersect. A desirable macro equilibrium is one where real GDP is at its full employment level.

is one where real GDP is at its full employment level. Note that if AD is

Note that if AD is too low (AD1), real GDP is too low, and unemployment will be too high. If AD is too high (AD2), real GDP is too high, unemployment is too low, and prices are too high.

How do we get stuck at AD1 or AD2? How can we get back to full employment? To answer these questions, we take a closer look at four components of aggregate demand:

Consumption (C)take a closer look at four components of aggregate demand: Investment (I) Government Spending (G) Net

Investment (I)look at four components of aggregate demand: Consumption (C) Government Spending (G) Net Exports (X -

Government Spending (G)of aggregate demand: Consumption (C) Investment (I) Net Exports (X - IM) In part one we

Net Exports (X - IM)Consumption (C) Investment (I) Government Spending (G) In part one we focus on consumption. Consumption (C)

In part one we focus on consumption.

Consumption (C)

Consumption is the largest component of AD. Recall that consumer spending accounts for 2/3 of GDP in the United States.

Keynes argued that the most important determinant of consumption is disposable income, or income leftover after taxes. Consumers do one of two things with their disposable income: They save it or they spend it:

Disposable income = consumption + saving or Yd = C + S

When consumers receive additional disposable income (like a bonus at work) they must decide how much of that addition to save, and how much to spend. The fraction of each dollar of disposable income that is spent is called the marginal propensity to consume (MPC):

spent is called the marginal propensity to consume (MPC) : Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
spent is called the marginal propensity to consume (MPC) : Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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For example, suppose I receive an extra $1000 in disposable income for designing an online course and I spend $750 and save $250 of that extra income. My MPC is

I spend $750 and save $250 of that extra income. My MPC is Of course, anything

Of course, anything I do not consume, I save so that my marginal propensity to save (MPS) is

1 - MPC = 1 - .75 = .25

The MPC is an essential part of our model of consumer behavior.

Disposable income is not the only factor affected consumption decisions. Other factors include:

Expectations. Your consumption and savings decisions today are based not only on current income, but expectations Your consumption and savings decisions today are based not only on current income, but expectations about future income. College student often run up credit card bills today based on income expectations when they leave college. I save money in a retirement account today based on future retirement plans.

Wealth. Your consumption depends not only on current income, but savings from previous periods. You may Your consumption depends not only on current income, but savings from previous periods. You may spend money today that was saved from a summer job. A lot of consumption spending today is due to wealth from the stock market gains of the 1990s.

Credit. The easier it is to get credit, the easier it is for consumers to buy The easier it is to get credit, the easier it is for consumers to buy today and pay with future income. Also, the cost of credit, i.e. interest rates affect the willingness of consumers to borrow today.

Taxes. Higher taxes mean lower disposable income, while a tax cut means more disposable income.rates affect the willingness of consumers to borrow today. Prices. Higher prices make people feel poorer,

Prices. Higher prices make people feel poorer, and they reduce spending. This is the real balance Higher prices make people feel poorer, and they reduce spending. This is the real balance effect we discussed in chapter 8.

If we want to model consumer behavior, it can be complicated to look at all of these factors at once, so lets

put them in two categories (1) spending that is affected by current income and (2) spending not influenced by current income Using these two categories, we get the equation

C = a + b(Yd)

where,

C = current consumption

a = autonomous consumption (consumption not influenced by current income)

b = marginal propensity to consumer Yd = disposable income

The equation above is a model of consumer spending behavior, known as the consumption function. We can use this equation to predict how changes in income will affect consumer spending.

predict how changes in income will affect consumer spending. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
predict how changes in income will affect consumer spending. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Example. Recall that I consumer $750 out of an additional $1000 in income, for an MPC = .75. Now suppose my autonomous consumption is $50. This gives me a consumption function of

C = $50 + .75Yd I can now calculate my consumption spending for various levels of income:

 

Consumption, C

Disposable Income, Yd

A

$125

$100

B

200

200

C

275

300

D

350

400

E

425

500

We can draw a picture of the consumption function using the table above.

a picture of the consumption function using the table above. In addition to the consumption function,

In addition to the consumption function, I have also draw a 45-degree line. At point B, where the 2 lines intersect, represents that level of disposable income where C = Yd = 200. At an income of less than 200, C > Yd, or I am dissaving. At an income greater than 200, C < Yd, so I am saving.

The consumption function will shift up or down with any changes in the economy that impact consumer confidence, wealth, credit, and taxes. For example, suppose credit card companies cut back on issuing credit cards to college students. This means that college students will be consuming less at every income level because they will not be able to finance purchases with their own credit card. As a result, the aggregate consumption function will shift down:

result, the aggregate consumption function will shift down: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
result, the aggregate consumption function will shift down: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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This would also affect aggregate demand as well: a downward shift in the consumption function implies a decrease (shift left) in aggregate demand.

The table below summarizes how factors will affect the consumption function and aggregate demand:

shift factor

consumption function

aggregate demand

increase in consumer confidence

increase (shift up)

increase (shift right)

increase in wealth

increase (shift up)

increase (shift right)

increase in credit

increase (shift up)

increase (shift right)

increase in cost of credit

decrease (shift down)

decrease (shift left)

increase in taxes

decrease (shift down)

decrease (shift left)

Chapter 9: Aggregate Spending, part II

Recall we are looking at the four components of aggregate demand:

consumption (C)we are looking at the four components of aggregate demand: investment (I) government spending (G) net

investment (I)at the four components of aggregate demand: consumption (C) government spending (G) net exports (X-IM) In

government spending (G)of aggregate demand: consumption (C) investment (I) net exports (X-IM) In part one we focused on

net exports (X-IM)consumption (C) investment (I) government spending (G) In part one we focused on consumption, the largest

In part one we focused on consumption, the largest component. Now we continue looking the other components.

Investment (I)

Recall the investment expenditures refer NOT to money but to purchases of new factories, buildings, and equipment and inventories of firms. Where consumer savings take money out of the circular flow of income (a leakage), investment spending puts money into the economy (an injection). In fact, consumers savings are often lent out to firms to use for investment.

savings are often lent out to firms to use for investment. Virgilio Devonaire Marco Umipig/BS ECONOMICS
savings are often lent out to firms to use for investment. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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What factors affect the level of investment?

Expectations. Again, expectations play an important role. Firms must expect future profitability to make the . Again, expectations play an important role. Firms must expect future profitability to make the investment in the first place. Expectations of higher sales will increase investment, ceteris paribus.

Interest rates. Interest rates represent the cost of investment if firms must borrow money to make . Interest rates represent the cost of investment if firms must borrow money to make the investment. Even if firms have the cash to buy equipment, interest rates represent the opportunity cost of investment, because that cash could have been earning that interest rate if it was not used to buy equipment. Higher interest rates discourage investment, ceteris paribus.

Technology. Advances in cost cutting technology or the development of new products will increase investment demand, Advances in cost cutting technology or the development of new products will increase investment demand, ceteris paribus, as firms acquire the better equipment or new products.

Note that in our Keynesian model investment is NOT affected by current income, so it is autonomous.

Government Spending and Net Exports (G, X-IM)

Both government spending and net exports are also assumed to be autonomous. Government expenditures are more political decisions than economic ones (although not entirely) . Net exports are more dependent on other countries' income.

Aggregate Expenditure (AE)

If we add up all of the planned spending of each component, we get aggregate expenditure, or how much consumers, firms, government, and foreigners plan to spend at each income level:

AE = C + I + G + X - IM = a + bY + I + G + X - IM

In our model, we are at an equilibrium when planned spending (AE) is equal to actual output (Y) or when

AE = Y

This equilibrium may occur below, at, or above full employment output.

Example. Suppose our model economy looks like this (in billions of dollars):

C = 100 + .75Y I = 160

G = 200

X-IM = 40

Let's solve for the expenditure equilibrium. Equilibrium occurs when AE = Y, so

Y

= C + I + G = 100 + .75Y + 160 + 200 + 40

Y

= 500 + .75Y

Y - .75Y = 500 .25Y = 500

Y = 500/.25

Ye = 2000

If full employment output, Yf = 2500, our equilibrium would be below full employment output by 500. This is known as a recessionary gap. If equilibrium output exceeds Yf then there is an inflationary gap.

output exceeds Yf then there is an inflationary gap. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
output exceeds Yf then there is an inflationary gap. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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We can plot the equilibrium on the graph below. Note that Ye is where the AE line intersects the 45 degree line.

that Ye is where the AE line intersects the 45 degree line. So even at equilibrium

So even at equilibrium we can have macro failure in that we are above or below full employment. In the coming chapters we look at how we wind up away from our goal of full employment, and how the economy reacts.

our goal of full employment, and how the economy reacts. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
our goal of full employment, and how the economy reacts. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Chapter 10: Self-Adjustment or Instability?

In our model of the economy built in chapter 9, we discovered that macro equilibrium may be at full

employment output, below full employment output (a recessionary gap), or above full employment output (an

inflationary gap). In this chapter we look at the adjustment from one macro equilibrium to another.

First, let's consider an economy at full employment equilibrium as pictured below.

an economy at full employment equilibrium as pictured below. So this economy is at full employment

So this economy is at full employment (which mean the unemployment rate is as low as possible without triggering inflation). Prices are stable at P0. Life is good.

This ideal balance in the economy will be upset if the AD curve shifts, which means one of the components of AD changes. Let's consider a change in investment spending. Investment is actually the most volatile component of GDP, fluctuating significantly from quarter to quarter (see figure 10.3, page 193).

A decline in investment will initially shift the AD curve to the left. Firms are spending less, so real GDP

demanded is lower at each and every price:

less, so real GDP demanded is lower at each and every price: But the changes do

But the changes do not stop with the initial decline in investment. A businesses spending less this will me some workers who make business products will lose their jobs, and thus spend less. As consumers spend less,

businesses cut back more

in investment. This is true for an change in autonomous spending (spending NOT dependent on current income). This is known as the multiplier effect.

The decline in total spending and in AD will be greater than the initial decrease

We can calculate the total spending change the results from a change in autonomous spending by using the multiplier:

a change in autonomous spending by using the multiplier: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
a change in autonomous spending by using the multiplier: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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total change in spending = (multiplier) x (initial change in spending)

multiplier = `1/(1-MPC)

So, if investment falls by $100 billion and the MPC = .75, then total spending will fall by

100 x 1/(1-.75) = 100 x (1/.25) = 100 x 4 = $400 billion

The multiplier effect causes AD to shift even further to the left:

effect causes AD to shift even further to the left: Now AD has shifted left by

Now AD has shifted left by $400 billion, but equilibrium output will fall by LESS than $400 billion (to Qe) because prices fall slightly offsetting the spending decreases (due to the real balance effect).

At the new equilibrium above (at Qe) there is cyclical unemployment because there is a gap between actual real GDP and full employment GDP (Qf).

Note that the multiplier also works in the opposite direction: an increase in autonomous spending will lead to an even greater increase in total spending.

So what if we are not at full employment? As we will see in the coming chapter, the government has the power to shift the AD curve, although such intervention is not without risk.

AD curve, although such intervention is not without risk. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
AD curve, although such intervention is not without risk. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 11: Fiscal Policy

During the 2000 Presidential campaign, both Gore and Bush claimed to have a plan to continue the prosperity the United States has enjoyed since the end of the 1990-91 recession. These economic plans included both tax policy and spending initiatives. Now President Bush is working to push a tax cut through Congress. In the chapter we look at how taxes and government expenditures impact the economy and may potentially move the economy from a recessionary or an inflationary gap to a full-employment equilibrium. We will also examine the potential risks of government intervention.

I. Fiscal Policy

The federal governments power to levy taxes and decide how that revenue is spent, and even borrow money all affect the aggregate demand curve and therefore macroeconomic outcomes: prices, output, and employment. The government can increase or decrease the aggregate demand curve by:

increasing or decreasing its purchases of goods and servicescan increase or decrease the aggregate demand curve by: cutting or raising taxes raising or cutting

cutting or raising taxesincreasing or decreasing its purchases of goods and services raising or cutting transfer payments (social security,

raising or cutting transfer payments (social security, welfare, unemployment benefits)its purchases of goods and services cutting or raising taxes When Congress and the President use

When Congress and the President use purchases, taxes or transfers to affect macroeconomic outcomes, this is known as fiscal policy.

A. Fiscal Stimulus: Increasing Aggregate Demand

Suppose the economy is at an equilibrium that is below full employment output:

is at an equilibrium that is below full employment output: The government can attempt to shift

The government can attempt to shift the AD curve to the right, increasing output, employment, and prices by either (1) cutting taxes or (2) increasing spending.

by either (1) cutting taxes or (2) increasing spending. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
by either (1) cutting taxes or (2) increasing spending. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Note that the government must shift the AD curve to the right FARTHER than the actual real GDP gap. Why? Because as the AD curve shifts right, prices rise as well.

Increasing Government Spending

How much of an increase is necessary to close the GDP gap? Recall from chapter 10 that any increase in autonomous spending has a multiplier effect, where the total shift in AD is greater than the initial increase in autonomous expenditure:

total increase in AD = multiplier x initial increase in spending

where the multiplier = 1/(1-MPC)

So in deciding how much to increase spending, the government needs to take the multiplier effect into account. If the MPC = .8, then the multiplier = 1/(1-.8) = 5. If the government wishes to increase the AD curve by $200 billion, and the MPC = .8, then

the increase in spending = increase in AD/multiplier = $200 billion / 5 = $40 billion.

If the government increases spending by $40 billion, the AD curve will shift $200 billion to the right.

Cutting Taxes

How much of a tax cut is necessary to close the gap? The answer will be different from our answer for spending. A tax cut increases disposable income, which in turn increases consumer spending, which has a multiplier effect throughout the economy. However if the MPC is less than 1 then some of the tax cut is spent, and some of the tax cut is saved.

Consider a $40 billion tax cut and an MPC of .8. The initial increase in consumption will be

$40 billion x .8 = $32 billion.

The total increase in AD will be

$32 billion x 5 = $160 billion.

total increase in AD will be $32 billion x 5 = $160 billion. Virgilio Devonaire Marco
total increase in AD will be $32 billion x 5 = $160 billion. Virgilio Devonaire Marco

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Recall that a $40 billion increase in spending increased AD by $200 billion. Thus a tax cut is less powerful than a spending increase of the same size.

So if the government desires a $200 billion increase in AD, the tax cut must be greater than $40 billion.

tax cut = [increase in AD x (1 - MPC)] / MPC = ($200 billion x .2) / .8 = $50 billion.

Cutting taxes by $50 billion will increase AD by $200 billion.

Transfers are like a negative tax, so an increase in transfer payments would work the same way as a tax cut, by increasing disposable income.

B. Fiscal Restraint: Decreasing Aggregate Demand

Sometimes the objective of fiscal policy is too cool off and economy where equilibrium is above full employment output:

economy where equilibrium is above full employment output: The government can reduce aggregate demand by either

The government can reduce aggregate demand by either (1) decreasing spending or (2) raising taxes.

by either (1) decreasing spending or (2) raising taxes. Here the multiplier effect works in reverse:

Here the multiplier effect works in reverse: the spending decrease or tax increase is smaller that the desired decrease in AD. As before with fiscal stimulus, a spending decrease is more powerful that a tax increase of the same size.

is more powerful that a tax increase of the same size. Virgilio Devonaire Marco Umipig/BS ECONOMICS
is more powerful that a tax increase of the same size. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Suppose the government wishes to reduce AD by $500 billion, and the MPC = .8 (which means the multiplier is 5). They can decrease spending by

$500 billion / 5 = $100 billion.

Or they can increase taxes by

($500 billion x .2) / .8 = $125 billion.

II. Problems with Fiscal Policy

Our simple model above does not account for problems that can occur with fiscal policy because our model does not look at (1) how the spending is financed (through borrowing or tax revenue) or (2) how long fiscal policy takes to work. In the real work there are a couple of problems with fiscal policy:

Crowding Out. When the government increases spending by borrowing money (like with Treasury bonds), that leaves fewer When the government increases spending by borrowing money (like with Treasury bonds), that leaves fewer funds available for firms to borrow for investment and for consumers to borrow to purchase goods and services. In others words, the government "crowds out" private investment. This crowding out may offset the increased spending so that the increase in AD is smaller than expected. We discuss crowding out in greater detail in chapter 12.

Time Lags. It takes time for the government to recognize the need for intervention, to agree . It takes time for the government to recognize the need for intervention, to agree on a policy, to implement the policy, and for the policy to start affecting the behavior of consumers and firms. For example, it may take months for Congress and the President to recognize that the economy is in a recession. Then months will pass as Republicans and Democrats argue over appropriate spending hikes or tax cuts. When the tax cut finally takes effect, it may take many more months before consumers and firms finally start spending again. The whole process could easily take two years. In the meantime during those two years, the economy is suffering. By the time the tax cut starts working, the recession could be over (the 1990-91 recession lasted only 8 months). We discuss the issue of time lags in chapter 19.

8 months). We discuss the issue of time lags in chapter 19. Virgilio Devonaire Marco Umipig/BS
8 months). We discuss the issue of time lags in chapter 19. Virgilio Devonaire Marco Umipig/BS

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Chapter 12: Deficits, Surpluses, and Debt

We now turn our attention to how government spending is financed, and the economic consequences of these financing decisions. First lets start with some definitions:

I. Deficits, Surpluses and Debt: Definitions and A Brief History

A budget deficit occurs when the government spending exceeds government revenue in a given time period, usually one year:

deficit = government spending - revenue, where spending > revenue.

A budget surplus occurs when government spending is less than government revenue in a given time period:

surplus = revenue - spending, where revenue > spending.

In measuring deficits and surpluses, the government uses its fiscal year (October 1 - September 30), not its calendar year.

The national debt is a running total of all deficits minus all surpluses, since George Washington. The United States has borrowed more that is has saved during its 224 years, so the United States owes its citizens and foreign governments about $5.6 trillion as of 1999. The United States borrows money by having the Dept. of the Treasury issue Treasury bonds, which are IOUs from the federal government. These bonds are purchased by U.S. companies and households, and the foreign governments, companies, and households. Treasury bonds are a very safe investment, which makes them very popular.

Note that the deficit and the debt are NOT the same thing. Journalists and politicians confuse them all of the time, but you know better, now don't you?

The graph below plots the deficit/surplus from 1930 to 2000:

The graph below plots the deficit/surplus from 1930 to 2000: From 1970 to 1997, the federal

From 1970 to 1997, the federal government ran a deficit every single year. Starting in 1998, the federal government began running surpluses. In the 1980s the size of deficits exploded, greatly increasing the national debt:

of deficits exploded, greatly increasing the national debt: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
of deficits exploded, greatly increasing the national debt: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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The government's chronic deficit spending has caused much concern/debate about the causes and consequences of deficit spending. However, as the deficit shrank and turned into a surplus in the late 1990s, this gave way to debates about what should be done with the federal budget surplus. What caused the deficits of the 1980s and 1990s? Why are we now running a surplus? What are the economic consequences of these changes?

II. Fiscal Policy, the Budget, and the Business Cycle

In any given fiscal year the budget consists of spending in two categories: The first category is spending and revenue resulting from decisions/commitments made is prior years. Included in this category are things like Social Security & Medicare, interest payments on the national debt, and veterans benefits. This category is about 80% of federal expenditures. The second category is known as discretionary spending, and it is this category that is determined from year-to-year and includes expenditures on education, crime, transportation. The latter category is altered for fiscal policy, but comprises only 20% of federal expenditures.

Spending of the federal government changes over the business cycle due to automatic stabilizers. These are items in the budget that are countercyclical, i.e. designed to stimulate the economy in a contraction or cool off the economy in an expansion:

Unemployment benefits, food stamps, and other welfare benefits will automatically increase during a recession and decrease during an expansion.in a contraction or cool off the economy in an expansion: Income taxes will automatically decrease

Income taxes will automatically decrease during a recession and increase during an expansionduring a recession and decrease during an expansion. Inflation also affects the deficits by affecting the

Inflation also affects the deficits by affecting the size of social security payments, federal pension payments, and interest on the federal debt.

Thus, the size of the federal deficit/surplus is sensitive to the business cycle. We expect larger deficits (or smaller surpluses) during recessions and smaller deficits (or larger surpluses) during expansions. The federal surplus today is due mostly to a long economic expansion rather than any fiscal restraint shown by politicians.

III. What are the economic consequences of deficits, surpluses, and the national debt?

consequences of deficits, surpluses, and the national debt? Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
consequences of deficits, surpluses, and the national debt? Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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The Crowding Out Effect

One concern raised over the deficits in the 1980s and 1990s is the possibility that as the federal government borrows money to finance deficits, there is less money left for the private sector to borrow. This is the opportunity cost of the federal deficits. However, crowding out may not necessarily be a bad thing if the government expenditure is an investment in things like education, job training and infrastructure.

Also, U.S. government debt does have some advantages: Treasury bonds are desirable savings vehicles for households, firms, and foriegn governments because they are very low risk and highly liquid. This means U.S. government debt makes a valuable product available to savers.

What to do with a surplus?

The Congressional Budget Office (CBO) projects huge surpluses over the next 10 years, totaling $5.6 trillion, thanks to a long period of economic growth, which substantially increased tax revenues:

economic growth, which substantially increased tax revenues: Keep in mind that these are projections. The shaded

Keep in mind that these are projections. The shaded area above shows the margin of error if the underlying economic forecasts are wrong. CBO forecasts are notoriously optimistic.

The government cannot just take the surplus and start buying stock on Etrade, or put it under a very big matress. The choices facing the federal government today about the use of the surplus include:

giving it back to the taxpayers (tax cuts)government today about the use of the surplus include: increase income transfers (like with a prescription

increase income transfers (like with a prescription drug benefit for Medicare)surplus include: giving it back to the taxpayers (tax cuts) save it (to pay down our

save it (to pay down our national debt)(like with a prescription drug benefit for Medicare) spend it on goods and services (hire more

spend it on goods and services (hire more teachers, build more highways or prisons)for Medicare) save it (to pay down our national debt) Republicans favor tax cuts, while many

Republicans favor tax cuts, while many Democrats want to use the surplus to increase Social Security/Medicare benefits. Both parties want to pay down the debt. However, it is unlikely we can do all of this, so some choices must be made.

Is the debt a burden to future generations?

A debt of $5.6 trillion may sound scary, but let's put it into perspective. The U.S. has a large national debt, but it also has a large economy, which means that our ability to service our debt is large. A better measure of the

to service our debt is large. A better measure of the Virgilio Devonaire Marco Umipig/BS ECONOMICS
to service our debt is large. A better measure of the Virgilio Devonaire Marco Umipig/BS ECONOMICS

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debt burden is the ration of debt to GDP. Looking at the graph below, the U.S. debt seems very manageable relative to other countries:

U.S. debt seems very manageable relative to other countries: Politicians who argue for paying down the
U.S. debt seems very manageable relative to other countries: Politicians who argue for paying down the

Politicians who argue for paying down the debt are concerned that the debt may hurt the economic well-being of future generations that are stuck with the interest payments.

To understand if this is true, let's look at who owns the debt (figure 12.4, page 241). Almost 80% of the national debt is held by U.S. households, corporations, and federal/state/local government agencies. The remaining 20% is held by foreigners. So servicing the debt (paying interest, issuing bonds) just redistributes income from taxpayers to bondholders--it does not take anything away. However, it is true that bondholders tend to be a wealthier subset of taxpayers. Even the interest paid to foreigners is likely used to purchase U.S. goods and services.

The true burden of the debt is the opportunity costs of the spending financed by the debt. If the debt is used to build F-18 fighters for the Army, then the opportunity costs are the other goods that could be produced land, labor and capital used to make the jets.

be produced land, labor and capital used to make the jets. Virgilio Devonaire Marco Umipig/BS ECONOMICS
be produced land, labor and capital used to make the jets. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Myths vs. Realties for the United States National Debt

Myth #1: The National Debt will cause the United States to go bankrupt

Reality: The U.S. is not like you or me. The U.S. government has the power to tax the largest economy in the world, the power to print money and has an infinite life expectancy. All of these factors mean the federal government can incur large amounts of debt. Myth #2: We have to pay back all of the $5.6 trillion in debt Reality: The U.S. can simply "roll over" its debt year after year. That is, the Treasury Dept. issues new bonds to pay off the old ones. This is not a problem as long as investors are willing to hold U.S. Treasury bonds. U.S. Treasury bonds are very popular due to their liquidity (they are easily converted to cash), their low risk (they have zero default risk because they are backed by "the full faith and credit" of the U.S. government), and certain tax advantages. Myth #3: The interest payments on the national debt are a burden to future generations. Reality: U.S. citizens or even agencies of the U.S. government own most of the debt. Thus we are just paying interest to ourselves. Myth #4: Foreign ownership of the debt causes money to flow out of the U.S. Reality: Foreign interests own only about 15% of the debt, and this proportion has remained virtually unchanged since 1980. They typically reinvest their interest payments in the U.S. Myth #5: The national debt is out of control. Reality: The true measure of the debt of a nation is the ratio of that debt to the size of the economy. The debt-to-GDP ratio for the U.S. is relatively modest compared (1) to other nations and (2) historically.

There are, however two potential problems with our national debt:

1. The interest payments on the debt redistribute income from taxpayers to bondholders. This redistribution is potentially regressive since wealthier households hold Treasury bonds. So all taxpayers pay debt interest but mostly wealthier taxpayers receive that interest. However, higher income households also bear a larger tax burden than low- and middle-income households: In 1999 the top 1% of household in terms of income paid over 30% of all income taxes.

2. Large debts may produce the crowding out effect. Large debt levels by the U.S. government increase the demand for loanable funds, which increases interest rates and reduces the amount of private borrowing for investment spending. The size of this effect is a subject of debate among economists.

size of this effect is a subject of debate among economists. Virgilio Devonaire Marco Umipig/BS ECONOMICS
size of this effect is a subject of debate among economists. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Chapter 13: Money and Banks

Chapters 13, 14, and 15 examine the role of money in the economy, which includes the governments role in determining how much money is in circulation. Modeling the role of money is crucial to building a model of the macroeconomy. In this chapter we look at the functions, measures and creation of money.

I. What is money?

A. Defining the functions of money

To put is simply, money is anything commonly accepted in exchange for goods or services. Throughout the history of the world, many things have served at money: gold, silver, cows, horses, cigarettes, and more. Money has several functions:

Money is a medium of exchange. Money is accepted in exchange for goods and services. This is the main function . Money is accepted in exchange for goods and services. This is the main function of money. In the absence of a medium of exchange we would be stuck bartering for stuff we want. This is inefficient because it requires a double coincidence of wants. I have to want what you are trading, and you have to want what I am trading. In our large and complex economy, that is pretty unlikely.

Money is a store of value. Money can be used to hold your wealth, and used later to purchase something. In Money can be used to hold your wealth, and used later to purchase something. In times of high inflation or political instability, money may not be a good store of value. The U.S. dollar is considered to be an excellent store of value, but the Russian ruble is a lousy one.

Money is a standard of value (or unit of account). Money is the benchmark used to measure value. If I tell you the price of Money is the benchmark used to measure value. If I tell you the price of a product, you immediately know how cheap/expensive it is, and can compare that value to other products.

There are two types of money: commodity money and fiat money. Commodity money is money with its own value as a good. Gold coins are commodity money because the gold is worth something. Fiat money has no value other that given to it as money. The U.S. dollar today is fiat money. A $10 bill is worth something because the federal government says so, and because we accept it in exchange for goods and services. Fiat money is more efficient because commodity money has an opportunity cost: the gold in a gold coin could be used for something else, like jewelry.

B. Measuring money

Money comes in many different forms and these differ in terms of how easily they convert to cash. The U.S. has four measures of its money supply:

M1 = currency in circulation + checkable deposits + traveler's checks = currency in circulation + checkable deposits + traveler's checks

M2 = M1 + savings deposits + small time deposits (CDs < $100,000) + money market = M1 + savings deposits + small time deposits (CDs < $100,000) + money market mutual funds

M3 = M2 + large time deposits + other stuff = M2 + large time deposits + other stuff

L = M3 + other stuff = M3 + other stuff

These measures get larger and larger because they include the measure below it. M1 contains the most liquid assets, i.e. assets easily converted to cash. We add assets less and less liquid assets for the broader measures of money. The most-watched measures of the money supply are M1 and M2.

The most-watched measures of the money supply are M1 and M2. Virgilio Devonaire Marco Umipig/BS ECONOMICS
The most-watched measures of the money supply are M1 and M2. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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However, the behavior of these two measures of money can be quite different. As the graphs below show, M2 has grown much faster than M1.

As the graphs below show, M2 has grown much faster than M1. II. Banks and the

II. Banks and the Creation of Money

The currency you hold in your wallet was literally created by the U.S. Dept. of the Treasury, Bureau of Engraving, in Washington D.C. and the coins at mints in Philadelphia and Denver. However, most money in circulation is created by transferring balances electronically. When a bank makes a loan, it simply credits an account and that account is counted in M2. So banks have the power to create money.

We can demonstrate money creation through the use of a T account that shows a banks assets and liabilities.

A bank's assets are the way a bank uses its funds. A bank's liabilities are the sources of a banks funds.

Suppose I empty my son Timmy's piggy bank (actually his bank looks like a Noah's Ark, but I digress

a savings account for him. Suppose there is $100 in change in the piggy bank (it's a big bank). The banks

balance sheet will change when I open the account:

) and start

sheet will change when I open the account: ) and start Note that assets must equal

Note that assets must equal liabilities. The bank receives the $100 in coins and puts it in their vault, increasing its assets by $100. The bank opens my son's account, which is a liability, since Timmy can withdraw the money at any time. Note how this has changed the money supply. M1 has fallen by $100 because the coins are out of circulation, but M2 has remained unchanged because savings deposits have increased by $100, offsetting the decrease in

M1.

U.S. banks operate on a fractional reserve banking system. This means that banks are required to keep only a fraction of deposits on hand to satisfy withdrawals. The bank then lends out the remaining fraction of deposits. The assets kept by the bank are known as reserves. Banks are required by law to keep a certain % of deposits as reserves. This is known as the required reserve ratio.

Back to our example, suppose the required reserve ratio is 20%. This means the bank must keep $20 of Timmy's deposit, but can lend out the other $80:

$20 of Timmy's deposit, but can lend out the other $80: Virgilio Devonaire Marco Umipig/BS ECONOMICS
$20 of Timmy's deposit, but can lend out the other $80: Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Suppose the bank uses the $80 to loan to Bob, crediting Bob with $80 in his account. With $180 in deposits, the bank must keep 20%, or $36 and is free to lend the excess:

bank must keep 20%, or $36 and is free to lend the excess: Suppose the bank

Suppose the bank lends the excess $64 to Ed, increasing deposits to $180 + $64 = $244. Required reserves are (.2 x $244 = $48.80):

+ $64 = $244. Required reserves are (.2 x $244 = $48.80): The bank can then

The bank can then lend the $51.20, and the process continues. But look at the T-account above, and you see that Timmy's deposit and the banks use of it has increased the money supply, M2 by $244 which is $144 MORE than the initial $100 increase in bank reserves

If we carried this example through, how much money can be created from the initial $100 in reserves? This depends on the required reserve ratio.

the money multiplier = 1 / (required reserve ratio)

and

potential deposit creation = initial excess reserves x money multiplier

In our example, there was an initial deposit of $100, so initial excess reserves are $80. The money multiplier is 1/.2 = 5. Then total deposit creation is 5 x $80 = $400. The $100 deposit creates $400 in new lending capacity (see table 13.4, page 266 for a demonstration).

The money multiplier allows use to calculate only potential money creation. In reality, money creation may be smaller because

the loans are spent, causing deposit balances and bank reserves to fallcreation. In reality, money creation may be smaller because banks may keep some excess reserves in

banks may keep some excess reserves in addition to the required reservesspent, causing deposit balances and bank reserves to fall As we have seen in this example,

As we have seen in this example, banks are not only a safe place to store money, but they act as a financial intermediary, transferring money from savers (by accepting deposits) to borrowers (by making loans).

(by accepting deposits) to borrowers (by making loans). Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
(by accepting deposits) to borrowers (by making loans). Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 14: The Federal Reserve System

The Federal Reserve System (known as the Fed) is the central bank of the United States. The Fed was created by the U.S. government to regulated the banking system and control the money supply. Through their control of the money supply and interest rates, the Fed exerts enormous power over the U.S. economy, probably much more control than the President or Congress.

I. Structure of the Fed

The creation of the Federal Reserve came about after a severe financial panic in 1907. The Fed was created to avoid the recurring financial crises and bank failures that plagued the U.S. banking system up to 1907. Because Americans tend to be very suspicious of centralized power and moneyed interests, the Fed structure is decentralized:

1. The Board of Governors.

At the top of the Fed are 7 governors, appointed by the President to 14-year nonrenewable terms. This long term gives the Fed governors some measure of political independence in their decisions, because they will hold office longer than the President that appoints them.

One governor serves as chairman for 4-years terms. The current chair is Alan Greenspan, who has served as chair since 1987 (and has been reappointed by Bush and Clinton since then). Mr. Greenspan reports to Congress twice a year, and is probably the second most powerful man in the United States (some would put him first).

2. Federal Reserve Banks.

There are 12 regional banks, each covered a region of the United States. They perform a variety of services for

private banks, including check clearing, reserve deposits, providing currency, and providing emergency loans. The Federal Reserve Bank of New York (FRBNY) is the most important of these banks. Click here to see a map of the 12 Federal Reserve districts.

3. The Federal Open Market Committee (FOMC).

The FOMC has 12 members which include all 7 governors, the President of the FRBNY, and 4 of the other regional bank presidents on a rotating basis. The FOMC meets every 6 weeks, assesses the condition of the economy, and votes on monetary policy in the coming weeks.

II. Monetary Tools

To understand the role of money in our macro model, we are interested in how the Fed controls the money supply (M1). There are three tools available to Fed for this:

1. Reserve requirements .Recall that banks are required to keep a certain percentage of deposits as reserves.

The Federal Reserve sets this requirement. This directly impacts the amount of excess reserves available for lending by banks, and thus the money multiplier:

for lending by banks, and thus the money multiplier: So increasing the reserve requirement will decrease
for lending by banks, and thus the money multiplier: So increasing the reserve requirement will decrease

So increasing the reserve requirement will decrease the money supply; decreasing the reserve requirement will increase the money supply.

In reality, the Fed rarely changes the reserve requirement because such a change is very powerful and expensive for banks to implement. Change the reserve requirement to temporarily change the money supply is like using dynamite to kill a fly: It will work, but there are less powerful tools that will do the job with less collateral damage.

tools that will do the job with less collateral damage. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
tools that will do the job with less collateral damage. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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2. The Discount Rate .Banks keep their excess reserves to a minimum because only their loans and securities earn money. If banks are running low on reserves they have several alternative to get the needed cash:

Borrow money from another bank. This short-term interbank lending market is known as the federal funds market . Here money is usually lent overnight. Banks charge each other an federal funds market. Here money is usually lent overnight. Banks charge each other an interest rate known as the federal fund rate.

Sell securities. This may cause the bank to incur a loss on the security.each other an interest rate known as the federal fund rate. Borrow from the Fed. The

Borrow from the Fed. The bank can get a discount loan from the Federal Reserve Bank in its district. The Fed charges an interest discount loan from the Federal Reserve Bank in its district. The Fed charges an interest rate known as the discount rate.

The Fed can encourage bank borrowing with a low discount rate or discourage bank borrowing with a high discount rate:

rate or discourage bank borrowing with a high discount rate: In reality, the discount rate is
rate or discourage bank borrowing with a high discount rate: In reality, the discount rate is

In reality, the discount rate is not particularly effective in controlling the money supply, because very few banks go to the discount window to get a loan from the Fed. The discount rate has more of an announcement effect, where the Fed uses it to signal the direction of monetary policy.

3. Open Market Operations. Open market operations (OMO) are the main policy tool of the Fed. The Fed buys and sells Treasury bonds in financial markets in an effort to control the level of back reserves. The FOMC votes on OMO and the FRBNY implements OMO.

When the Fed SELLS bonds, people and institutions buy them with their own fund, decreasing bank reserves and the money supply. When the Fed BUYS bonds, people and institutions sell them and deposit the proceeds, increasing bank reserves and the money supply.

the proceeds, increasing bank reserves and the money supply. Altering bank reserves will in turn alter
the proceeds, increasing bank reserves and the money supply. Altering bank reserves will in turn alter
the proceeds, increasing bank reserves and the money supply. Altering bank reserves will in turn alter

Altering bank reserves will in turn alter the federal funds rate. A decrease in bank reserves with increase the federal funds rate, while an increase in banks reserves will decrease the federal funds rate. When the FOMC meets, they vote on a target for the federal funds rate, and then buy and sell bonds until the target is reached.

III. The Fed and Monetary Policy

The Fed is much more independent of the President and Congress than other government agencies, like the EPA or the Dept. of Education. First, the Fed governors are appointed, not elected, and have long terms so they do not have to worry about losing their jobs if the make the President angry. Second, the Fed is self- financing--it does not depend on Congress for money. The Fed makes its own money with OMO. It uses the profits to finance its operations and turns the rest over to the Treasury.

The central banks of most industrialized nations, like the Fed, have this independence. Why is independence important? As we will see in later chapters, sometimes the Fed must make unpopular decisions, especially when trying to control inflation. The Fed's independence allows it to focus on long-run economic goals instead of short-run re-election goals.

However some Fed critics argue that the Fed has too much power and is too undemocratic.

that the Fed has too much power and is too undemocratic. Virgilio Devonaire Marco Umipig/BS ECONOMICS
that the Fed has too much power and is too undemocratic. Virgilio Devonaire Marco Umipig/BS ECONOMICS

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Eco 200 820 Principles of Macroeconomics

Myths vs. Realties for the United States Federal Reserve System

The Internet gives a forum to all sorts of crackpot theories, many of which sound convincing, but contain blatant historical inaccuracies. Here are a few about the Fed, along with a response. The research into the myths below was done by Edward Flaherty, who has a web site devoted to debunking conspiracy theories and myths. (http://members.home.net/flaherty15/conspire.htm)

Myth #1: The Federal Reserve Act of 1913 was the result of a secret meeting between Wall Street Bankers and government officials on Jekyll Island, Georgia and gave New York City banks control over the money supply.

Reality: The meeting did take place, but it was not a secret. Congress rejected the plan for a central banking system that came out of this meeting. The control over monetary policy was given to the Federal Reserve Board, a government body, not to banks.

Myth #2: The Federal Reserve Act is unconstitutional. The Constitution does not give Congress the power to create a central bank.

Reality: Federal and Supreme Court rulings have found the Federal Reserve to be constitutional, under the "necessary and proper" clause of the U.S. Constitution (Article I, Section 8, clause 19).

Myth #3: The Federal Reserve is a privately owned bank that profits at taxpayer expense.

Reality: The member banks in each district privately own each of the 12 Federal Reserve banks. However, the government-appointed Board of Governors controls these banks. Also, the Federal Reserve System rebates almost all of its profits to the Treasury each year, actually REDUCING the taxpayer burden.

Myth #4: The Federal Reserve is owned and controlled by foreigners, who dictate monetary policy for their own benefit.

Reality: This is just not true. Each Federal Reserve bank is owned by member banks in that district. Individuals and non-bank institutions, foreign or domestic, are not allowed to own shares in any Federal Reserve bank. Again, the Board sets monetary policy not the Federal Reserve banks.

Myth #5: The Federal Reserve had President Kennedy killed because he tried to usurp the Fed's power by authorizing the Treasury to issue silver-backed currency.

Reality: This is my personal favorite. Kennedy actually wanted to phase out silver certificates, and agreed with the Federal Reserve on most policy matters. He actually favored legislation to give the Fed more power, not less.

favored legislation to give the Fed more power, not less. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
favored legislation to give the Fed more power, not less. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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Chapter 15: Monetary Policy

Monetary policy is the manipulation of the money supply with the objective of affecting macroeconomic outcomes such as GDP growth, inflation, unemployment, and exchange rates. Monetary policy in the United States is conducted by the Federal Reserve, in particular, by the FOMC.

In the chapter we take a closer look at monetary policy by examining how money supply, and thus the Fed, affects aggregate demand. We also compare the effectiveness of monetary and fiscal policy.

I. The Money Market

To understand the role of money in the macroeconomy we first need to look at money demand and money supply. By money supply we are usually referring to M1 or M2.

The Demand for Money

Keynes (yes, him again) believed the demand for money came from 3 sources:

1. Transactions demand. People hold money to buy stuff.

2. Precautionary demand. People hold money for emergencies (cash for a tow truck, savings for unexpected job loss).

3. Speculative demand. People hold money to take advantage of a financial opportunity at a later date.

The decision to hold money involves a tradeoff. Holding M1 is advantageous in buying goods and services, however assets in M1 (cash, checking accounts) earn very little, if any, interest. Holding assets with a competitive interest rate, like bonds is not convenient for buying goods and services. We can think of the interest rate as the opportunity cost or price of holding money. The demand for money (M1) is downward- sloping with respect to interest rates:

(M1) is downward- sloping with respect to interest rates: An increase in national income will shift

An increase in national income will shift the money demand curve to the right, because people buy more stuff. Also, technology like ATM/debit cards will shift the money demand curve to the left because people do not have to hold as much M1 since it is easier to access a savings account.

Money Supply

As seen above, we assume that money supply is set by the Federal Reserve at the level they choose, so money supply is vertical at the quantity chosen by the Fed.

money supply is vertical at the quantity chosen by the Fed. Virgilio Devonaire Marco Umipig/BS ECONOMICS
money supply is vertical at the quantity chosen by the Fed. Virgilio Devonaire Marco Umipig/BS ECONOMICS

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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By shifting the money supply, the Fed can change equilibrium interest rates. Suppose the Fed buys bonds on the open market. This increases the money supply, shifting the MS curve to the right, causing interest rates to fall:

the MS curve to the right, causing interest rates to fall: II. Money and Aggregate Demand:

II. Money and Aggregate Demand: A Keynesian View

A change in interest rates will in turn affect the spending decisions of consumers and firms. With lower interest rates it is cheaper for firms to invest and for consumers to buy durable goods, and this will shift the aggregate demand curve to the right, increasing output:

the aggregate demand curve to the right, increasing output: Similarly, decreasing the money supply would raise

Similarly, decreasing the money supply would raise interest rates, decrease investment and consumption, and decrease aggregate demand:

investment and consumption, and decrease aggregate demand: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
investment and consumption, and decrease aggregate demand: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
investment and consumption, and decrease aggregate demand: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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III. Monetary Policy: Keynesian vs. Monetarist Views

In the Keynesian model above, interest rates & investment are the transmission mechanism of monetary policy, i.e. that is the way monetary policy affects macroeconomic outcomes. However, there are other points of view.

The Monetarists believe that monetary policy affects prices, but not real GDP or unemployment. The impact of

monetary policy can be expressed using the equation of exchange:

MV = PQ

Where M= the quantity of money in circulation, V = the velocity of money, P = the price level, and Q = real GDP. Velocity is the number of times a dollar is used to purchase goods and services in a given year.

If we assume that V is stable (it doesn't change very often), the a change in the money supply, M must change P or Q. So no matter what happens to interest rates, total spending changes. If we assume the Q is near full capacity (the vertical part of the AS curve) then changes in M only affect P (see figure 15.5, page 301).

This difference in the Keynesian and Monetarists views also leads to different remedies for fighting inflation

and unemployment

Fighting Inflation

Keynesians would advocate a decrease in the money supply (contractionary monetary policy), which would increase interest rates, decrease spending, decrease AD, and decrease prices and real output.

Monetarists would argue that if inflation is too high, then interest rates are already high:

nominal interest rate = real interest rate + anticipated inflation rate

So Monetarists believe that decreasing the money supply will cause nominal interest rates to FALL (not rise) because the anticipated inflation rate will fall eventually. Monetarists advocate steady, predictable money growth to keep anticipated inflation and nominal interest rates low.

Note that both Keynesians and Monetarists advocate a decrease in the money supply to fight inflation, but they expect it to work for different reasons.

Fighting Unemployment

Keynesians would advocate an increase in the money supply (expansionary monetary policy), which would decrease interest rates, increase spending, increase AD, increase prices and output, and decrease unemployment.

But monetarists believe that an increase in the money supply will affect mostly prices, not output. This would

raise inflationary expectations and actually INCREASE nominal interest rates. Monetarists do not believe that expansionary monetary policy is effective, unless the economy is WAY below full-employment (on the horizontal part of the AS curve).

In general, Monetarists believe in fixed money supply targets, or a "rule" for how much to change the money supply. Keynesians disagree, and believe in more flexibility or "discretion", with the Fed adjusting money supply to respond to economic conditions. This debate is known as "rules vs. discretion."

Tables 15.2 and 15.3 summarize the differences between Keynesians and Monetarists on the efficacy of fiscal

and monetary policy.

Monetarists on the efficacy of fiscal and monetary policy. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
Monetarists on the efficacy of fiscal and monetary policy. Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP School of Economics

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Chapter 16: Supply-Side Policy--Short-Run Options

Thusfar in our policy discussions we have looked at fiscal and monetary policies, both of which are designed to shift the demand curve. In this chapter, and in chapter 17 we will examine policies designed to shift the aggregate supply curve in the short run to deal with business cycles, and in the long run to encourage economic growth and raise living standards.

I. Why shift AS?

A. Stagflation

In the mid 1970s both inflation and unemployment rose at the same time. This situation is known as stagflation. This cannot occur with an aggregate demand shift. If AD increases, then inflation rises but unemployment falls (because output rises). If AD falls, then inflation falls but unemployment rises. The explanation lies with the aggregate supply curve. If the AS supply curve shifts left (decreases) due to costs increases (like with the rising oil prices in the 1970s), we see both higher prices and lower output (higher unemployment):

both higher prices and lower output (higher unemployment): Also, if we are near the vertical portion

Also, if we are near the vertical portion of the AS curve, increases in AD will impact mostly prices and not output:

increases in AD will impact mostly prices and not output: Stagflation creates a big problem for

Stagflation creates a big problem for policy makers: Do they increase AD to increase output (and employment) but make inflation worse? Or do they fight inflation by decreasing AD, but making unemployment worse?

B. The Phillips Curve

As long as the AS curve is upward sloping, changes in AD involve a tradeoff between two undesirable outcomes: higher inflation or higher unemployment:

outcomes: higher inflation or higher unemployment: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP
outcomes: higher inflation or higher unemployment: Virgilio Devonaire Marco Umipig/BS ECONOMICS 200313674/UP

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M A C R O E C O N O M I C S P a

This tradeoff was first developed by economist A.W. Phillips, as is known as the Phillips curve: