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AP Economics - Short notes from Krugman’s Economics for AP by Keshara Senanayake Modules 1!"!!$!5,6,7 !1%!11!1"!1!1$!1&!1'!1(!1)!1*!"%!"1!""!"!"&!"(!")!"*!%! !1%!11!1"!1!1$!1&!1'!1(!1)!1*!"%!"1!""!"!"&!"(!")!"*!%! and 1 +o )!*!"$!"' ,oer .on your o/n0
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1-$" 7$& .e8ce9t &!'!(!)!*! "$!"'!'-$%!$!$$0 is for reie/ing eerything :eaturing hel9 from 6uslan .module "&0! Shaili .Module % and 10! and Peter .Module "*0 Module 1 pages 2 - 8 Economics is the study of scarcity and choice ;economics inoles individual choice (what each person chooses to do/not to do) >something can 9ose limitations and affect your indiidual choice .your budget
4he economy is a system that coordinated choices about 9roduction and consum9tion distributes goods
?S has an market economy 9roductionnion bet/een 1*1( - 1**1 marked as general failure because lack of ra/ material and lack of a demand for good 9roduced 4he 9roblem of command economies is a lack of incentive rewards or punishments that motivate particular choices 3n market economies 9roducers can charger high 9rices /hen theirs a shortage of something .inc 9rofit0 ;high 9rices 7 9rofits are incenties to 9roduce more of the most-needed goods !roperty rights establish o/nershi9 and grant indiiduals the right to trade goods and serices to each other hel9s create incenties 9ro9erty o/nershi9 encourages the 9roduction of things that hae alue to kee9 or for mutual gain ;o/nershi9 encourages resources to be 9ut to their best 9ossible use Marginal analysis is the study of the cost and benefits of doing a little bit more of an actiity ersus a litle bit less ;you hae to make marginal decisions /hich inoles looking at trade-offs the gain of doing something is marginal benefit the cost of doing something is marginal cost if marginal benefit e8ceeds marginal cost the actiity should continue
6esources are scarce .like me girls! so come at me /hile 3’m aailable0
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;income isn’t the only thing that 9reents 9eo9le from getting /hat they /ant time is also in limited su99ly some 9eo9le trade money for time .like sho99ing at the local store for high 9riced goods 9eo9le of the conenience0 A resource is anything that can be used to 9roduce something else? the economies resources are sometimes called "actors o" production can be classified into .$0 grou9s ;#and refers to all resources that come from nature ;$apital refers to manufactured goods goods used to make other goods goods and serices ;Entrepreneurships risk taking
Economic analysis that inoles saying ho/ the /orld should /ork is kno/n as normative economics ;&ormative economics makes 9rescri9tions about the /ay the economy should /ork t his ask for o9inions .9rescri9tie0 generally @uestions related to this Positie economics is used more by b y those in the economics 9rofession ;Economics ans/er a ariety of @uestion? Some are definite .like a 9rediction0 or it can be a 2hat ifB @uestion economic models 9roide sim9le re9resentations that are useful for ans/ering 2hat ifB @uestions the ans/ers to such @uestions sere as a guide to 9olicy .these are 9redictions not 9rescri9tions meaning they can tell you you /hat /ill ha99en but not if it is good or not0 CCthe aboe is 9ositie economics but normatie economics can 9ose @uestions that engage 9olicy alsoCC Economic analysis is used to sho/ that some 9olicies are clearly better than others regardless of indiidual o9inion
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;income isn’t the only thing that 9reents 9eo9le from getting /hat they /ant time is also in limited su99ly some 9eo9le trade money for time .like sho99ing at the local store for high 9riced goods 9eo9le of the conenience0 A resource is anything that can be used to 9roduce something else? the economies resources are sometimes called "actors o" production can be classified into .$0 grou9s ;#and refers to all resources that come from nature ;$apital refers to manufactured goods goods used to make other goods goods and serices ;Entrepreneurships risk taking
Economic analysis that inoles saying ho/ the /orld should /ork is kno/n as normative economics ;&ormative economics makes 9rescri9tions about the /ay the economy should /ork t his ask for o9inions .9rescri9tie0 generally @uestions related to this Positie economics is used more by b y those in the economics 9rofession ;Economics ans/er a ariety of @uestion? Some are definite .like a 9rediction0 or it can be a 2hat ifB @uestion economic models 9roide sim9le re9resentations that are useful for ans/ering 2hat ifB @uestions the ans/ers to such @uestions sere as a guide to 9olicy .these are 9redictions not 9rescri9tions meaning they can tell you you /hat /ill ha99en but not if it is good or not0 CCthe aboe is 9ositie economics but normatie economics can 9ose @uestions that engage 9olicy alsoCC Economic analysis is used to sho/ that some 9olicies are clearly better than others regardless of indiidual o9inion
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Economist disagree to an e8tent but it is oer e8aggerated by the media? Politics 9lay a big role also! and 9o/erful interest grou9s kno/ /hat o9inions they /ant to hear and they find economist /ho / ho agree and gies them a 9rominence ;een though it is blo/n out of 9ro9ortion economist do disagree differences in alues contributes .moral o99osition for
Module 2 pages 1'-1
Eery since the great de9ression and the economy 9lunged more 9eo9le hae begun to look into ho/ macroeconomics /orks they look to deelo9 9olicies to 9reent such disasters in the future ;4he effort to understand economic slum9s and find /a ys to 9reent them is at the core of macroeconomics 4he %usiness cycle is the short-run alternation bet/een economic do/nturns .recessions 0 and economic u9turns .epansions 0 A depression is a dee9 and 9rolonged do/nturn! /hi le a less 9rolonged economic do/nturn is a recession .9eriods in /hich out9ut and em9loyment are falling0 follo/ed by economic u9turns .epansions 0 ;>?S has had 11 recessions since 2233 4he definition of recession in many countries is a 9eriod of at least t/o consecutie @uarters . months F 1 @uarter0 /here aggregate out9ut falls this definition is too strict so in the >?S the +ational ureau of Economic 6esearch determines if it’s a recessions .by looking at a ariety of economic indicators0
Een though recessions are less seere than de9ressions! it can l ead to oblessness
;falling unem9loyment is looked for/ard to in e89ansions usiness cycle also de9ends on out9ut .the @uantity of goods and serices 9roduced0 the business cycle! the economy’s economy’s leel of out9ut and its unem9loyment go it different directions .lo/er leels of out9ut has fe/er /orkers so unem9loyment is high using same logic gro/th in out9ut needs more /orkers and lo/ers unem9loyment0
during
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*ggregate output is used to measure the rise and fall of an economy’s out9ut it is the economy’s total 9roductions of goods and serices for a gien time 9eriod .usually a year0 it falls during recessions and rises during e89ansions
;+n"lation is a rise in oerall 9rice leel o99osite is de"lation /hich is a fall in the oerall 9rice leel A change in 9rice of goods does not signal inflati on or deflation -- instead it changes the o99ortunity cost of it +n"lation and de"lation are terms used for general changes of goods
Price stability is /hen the aggregate 9rice leel is changing only slo/ly kee9s the economy stable Economic growth .increase in the ma8imum 9ossible out9ut of an economy0 is the reason /hy a maority of Americans can afford coneniences many lacked in 9reious years unlike short term increases in aggregate out9ut after a recession! economic gro/th is an increase in 9roductie ca9acity that 9ermit’s a sustained rise in aggregate out9ut oer time ;this is needed for a nations 9ros9erity sustained rise in out9ut 9er 9erson F higher /ages and higher standard of liing ./e can see later on though /hat is good for economic gro/th is bad for short-run stabili=ation of business cycle and ice ersa0
A model is any sim9lified ersion of reality that is used to better understand real-life situations ;economist can create a sim9lified re9resentation by finding
means
that all other releant factors
Sometimes you can’t create small-scale ersion of the /hole economy or use a com9uter 9rogram ;4hought e89eriments are used as a form of economic modeling .most effectie form usually0 sim9lified! hy9othetical ersions of real-life situations economist models are usually in a form of a gra9h
Module . pages 1-21 !roduction pro%a%ilities curves are models that hel9 economist think about the trade-offs eery economy
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faces hel9s us understand e""iciency ! opportunity cost! and economic growth Iou make trade-o""s /hen you gie u9 something in order to hae something else to think of necessary trade-offs of an economy economist use 9roduction 9ossibilities cure model im9roes understanding of trade-offs by considering a sim9lified economy that 9roduces only t/o goods .enables us to use a gra9h0 3m9ortant to note that the 9oints inside or on the 9roduction 9ossibilities cure .Shaded area0 mean different things if a 9roduction 9oint lies inside or on the cure it is feasible a 9roduction 9oint outside the cure is not feasible? Production cures hel9s to sho/ the trade-offs of decisions .going to/ards either e8treme or staying in the middle0 4hinking in terms of a 9roduction 9ossibilities cure sim9lifies the com9le8 realities model /ith many goods it /ould be much harder to study trade-offs! efficiency! and economic gro/th Production 9ossibilities cure is useful for illustrating the conce9t of e""iciency ;an economy is efficient if there are no missed o99ortunities no /ay to make some 9eo9le better off /ithout making other 9eo9le /orse off 3nefficient use of resources is /hen you don’t effectiely use /hat you hae 2hen an economy is using all its resources efficiently! the only /ay one 9erson can be made better off is by rearranging the use of resources that makes someone else /orse off? 3f an economy is 9roducing at a 9oint on its 9roduction 9ossibilities cure! the economy is efficient in 9roduction +ne""iciency occurs if you hae an o99ortunity to 9roduce more good but don’t ;another e8am9le occurs /hen 9eo9le in the economy are inoluntarily unem9loyed ./ant to /ork but can’t find obs0 economy is not efficient in 9roduction because it could 9roduce more out9ut if those 9eo9le /ere em9loyed ;9roduction 9ossibilities cure sho/s the amount that can 9ossibly be 9roduced if all resources are fully em9loyed changed in em9loyment moe the economy close to or further from the 9roduction 9ossibility cure .PP,0 .the cure is determined by /hat /ould be 9ossible if their /as full em9loyment0 greater unem9loyment is sho/ed by 9oints farther belo/ the PP, economy is not reaching its 9ossibilities if it is not using all of its resources? Jo/er unem9loyment is re9resented by 9oints closer to the PP, as it decreases the economy moes closer to reaching its 9ossibilities
;understand that efficiency in 9roduction is only 9art of /hat’s re@uired for the economy as a /hole to be efficient efficiency re@uired that the economy allocate its resources so that consumers are as /ell off as 9ossible if the economy does this it is efficient in allocation efficiency for an economy as a /hole re@uired both efficiency in 9roduction and efficiency in allocation -; an economy must 9roduce as much of each good as it can! gien the 9roduction of other goods! and it must also 9roduce the mi8 of goods that 9eo9le /ant to consume 4he PP, is useful to reminder that the true cost of any good is not only its 9rice but also eerything else in addition to money to get the good -- also the o99ortunity cost 2hen
/e assume that the opportunity cost of an additional unit of a good doesn’t change regardless of
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the out9ut mi8! the 9roduction 9ossibilities cure is a straight line the slo9e of the straight-line 9roduction 9ossibilities cure is e@ual to the o99ortunity cost the o99ortunity cost for the good measured on the hori=ontal a8is in terms of the good measured on the ertical a8is .de9ending on the scenario the 9erson can face a constant opportunity cost /here a good has a set o99ortunity cost or it can hae increasing opportunity cost /here the goods o99ortunity cost increases0 /hen o99ortunity cost are increasing the PP, is a bo/ed-out cure rather than a straight line 3t is easier to /ork /ith PP, /ith a straight line but generally in reality o99ortunity costs are ty9ically increasing ;/hen only a small amount of a good is 9roduced the o99ortunity cost of 9roducing that good is relatiely lo/ because the economy needs to use only those resources that are /ell suited for its 9roduction? As more of a good is 9roduced! its o99ortunity cost ty9ically rises because /ell-suited in9uts are used u9 and less ada9table in9uts must be used instead .E8am9le /ith corn gro/ a little corn you can gro/ it in small 9laces /here nothing else gro/s nothing like /heatL but increase corn 9roduction you hae to use land resered for /heat no/ for cornL PP, hel9s us talk about economic growth .allo/s a sustained rise in aggregate out9ut0 ;Economic gro/th means an e89ansion of the economy’s 9roduction 9ossibilities the economy can 9roduce more of eerything .economic gro/th can cause an out/ard shift of the cure0 unless PP, shifts out/ards the 9oints beyond the PP, are unattainable .are beyond the economy’s 9ossibilities0 Generally ."0 sources of economic growth? ne is an increase in resources used to 9roduce goods and serices .labor
/hat
the economy actually 9roduces
;3f an economy’s PP, shifts in/ard! the economy has become smaller? 4his could ha99en if the econom y loses resources or technology? 4he 9roduction 9ossibilities cure is a ery sim9lified model of an economy! but it does teach us im9ortant lessons about real-life economies? 3t gies us a clear sense of /hat constitutes economic efficiency! it illustrates the conce9t of o99ortunity cost! and it makes clear /hat economic gro/th is about? Module pages 2.-20
3n a market economy! indiiduals engage in trade they 9roide goods and serices to others and receie goods and serices in return trade is /here 9eo9le diide task among themseles 4here are gains from trade 9eo9le can get more of /hat they /ant through trade than they could if they tried to be self-sufficient? 4his increase in out9ut is due to s9eciali=ation each 9erson s9eciali=es in the task that he or she is good at 9erforming Adam
Smith’s 1((' book he ealth o" &ations used the adantages of s9eciali=ation! and the
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resulting gains from trade as a starting 9oint described ho/ if you s9lit u9 /ork you /ill be more efficient instead of haing one 9erson make an entire thing hae him do one ste9 of the 9rocess to make it re9eatedly ;economy as a /hole can 9roduce more /hen each 9erson s9eciali=es in task and trades /it h others ;the benefits of speciali3ation are the reason a 9erson ty9ically focuses on only one ty9e of good or serice it is to eeryone’s benefit /hen indiiduals s9eciali=e in their career choices .if someone only maors in being a doctor he or she /ill be more skilled than someone /ho decided to become a 9ilot and doctor0 ;as long as indiiduals kno/ that they can find the goods and serices that they /ant in the market! they are /illing to forgo self-sufficiency and are /illing to s9eciali=e .9ilots kno/ he
trade
based
An indiidual has a comparative advantage in 9roducing something if the o99ortunity cost of that 9roduction is lo/er for that indiidual than for other 9eo9le 9eo9le trade /hen the trade is beneficial and is less than his
indiidual has an a%solute advantage in 9roducing a good or serice if he or she can make more of it /ith a gien amount of time and resources? aing an absolute adantage is not the same thing as haing a com9aratie adantage +4EN ,om9aratie +4 absolute adantage is the basis for mutual gain? EOAMPJE .,I> #10 assume eerything is made in one dayL 3n italy an automobile is 9roduced by ) /orkers and a /ashing machine by ? 3n the >?S! automobiles is made by ' /orkers and /ashing machines by "? 4he >?S has an asbolute adantage in the 9roduction of both? 3taly has a com9aratie adantage in automobiles? 2 2ell lets find o99ortunity cost? ) /orkers for automobile < /orkers for /ashing machine F "? Meaning the o99ortunity cost of making an automobile is )< /ashing machines? 2hile in the >?S the o99ortunity cost is '<" F ./hich is greater0? >sing the same logic >?S has an adantage in /ashing machine? kno/
you’re trying to lo/er o99ortunity cost
Economist has a ery 9ositie ie/ of international trade because they ie/ it in terms of com9aratie adantage? As a note is a cure is flatter on a PP, for something it as a com9aratie adantage for the item on the 8 a8is! if the cure is more u9 it has a com9aratie adantage for the y a8is? mutual
gains doesn’t de9end on each country’s being better at 9roducing something een if one country has an absolute adantage in both industries there are still mutual gains from trade
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Module 4 Su99ly and Qemand 3ntroduction and QemandB Su99ly and Qemand A model of a com9etitie market Market is a grou9 of 9roducers and consumers /ho e8change a good or serice 9ayment? $ompetitive market is a market in /hich there are many buyers and sellers of the same good or serice! none of /hom can influence the 9rice at /hich the good or serice is sold .some markets like cola consumers can influence! but for coffee bean 9rices can fluctuate due to natural 9roblems0
;2hen a market is com9etitie! its behaior is /ell described by the supply and demand model many markets are com9etitie ; & key elements to this model 10 the demand curve "0 the supply curve 0 factors that cause demand cure and
4he uantity demanded is the actual amount of a good or serice consumers are /illing and able to buy at some s9ecific 9rice A demand cure is a gra9hical re9resentation of the demand schedule? 3t sho/s the relationshi9 bet/een @uantity and 9rice? 2hen the demand cure slo9es do/n this reflects the idea that higher 9rice reduces the @uantity demanded he law o" demand says that a higher 9rice for a good or serice! all other things being e@ual!
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leads 9eo9le to demand a smaller quantity of that good Prices can rise and more 9eo9le can still demand a good .like coffee 9rice A+Q demand rose from "%%" to "%%'0 this is because the eerything de9ends on all other things being e@ualB in the case of coffee the /orld has change from "%%" to "%%' A change in demand is a shift of the demand cure! /hich changes the @uantity demanded at any gien 9rice theirs a 3G difference bet/een changes in demand and MREME+4S AJ+G 4E QEMA+Q ,>6RE A moement along the demand cure is a change in the @uantity demand of a good that is the result of a change in that good’s 9rice Gra9hically a movement along a demand curve is a change in the @uantity demanded of a good that is the result of a change in that goods 9rice? :or e8am9le if the 9rice of coffee dro9s from T1?&% to T1 9er 9ound consum9tion /ill rise from )?1 billion to 1% billion? >4 if 9rice remains unchanged and there is an increase in demand U it /ill be a right/ard shift of the /hole demand cure 2hen economist talk about change in demand and they say the demand for O increasedB or the demand for I increasedB they are saying the demand cure for O or I S3:4EQ not that the @uantity demand rose or fell because of a change in 9rice 2hen economist talk about an increase in demandB they mean a rightward shift of the demand cure so at any gien 9rice consumers demand a larger @uantity of the good or serice a decrease in demand is a leftward shift of the demand cure at any gien 9rice Economist hae & 9rinci9al factors that shi ft the demand cure for a good or serice 10 ,hanges in price o" related goods or services "0 ,hanges in income 0 ,hanges in taste $0 ,hanges in epectations &0 ,hanges in the num%er o" consumers 4he aboe & are the most im9ortant factors that /hen /e say that demand falls as its 9rice rises! all other things being e@ual! /e are stating then the factors that shift the demand are remaining unchanged 4/o are su%stitutes if a rise in the 9rice of one of the goods leads to an increase in the demand for the other good .tea and coffee0 4/o goods are complements if a rise in the 9rice of one of the goods leads to a decrease in the demand for the other good .cookies and milk0 ice ersa also a99lies 2hen a rise in income increases the demand for the good .normal0 i t is a normal good but the demand for some 9roducts falls /hen income rises? 2hen a rise in income decreases the demand for a good! it is an in"erior good these goods are less desirableB than more e89ensie alternaties so /hen 9eo9le can afford it they sto9 buying inferior goods and s/itch to the consum9tion to the 9referred more e89ensie alternatie? /hen a good is inferior a rise in income shifts the demand cure to the left but a fall in income /ill sift the demand cure to the right .casual dining F normal fast-food F interior0 Peo9le hae certain 9references . tastes 0 that determine /hat they choose to consume and that these tastes change .changes in demand change due to fads
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e89ected
changes in future incomes can lead to changes in demand .you kno/ your income /ill rise /ill borro/ today and increase your demand for certain goods like/ise i f income dro9s you reduce your demand for goods0 an individual demand curve illustrates the relationshi9 bet/een @uantit y demand and 9rice for an indiidual consumer market demand curve sho/s ho/ the combined @uantity demanded by all consumers de9ends on the market 9rice of that good .demand cure usually F market demand cure0 market demand cure is the hori=ontal sum of the indiidual demand cures of all consumers in the market .to understand the conce9t of hori=ontal sum 3f candy is T" 9er 9ound keshara buys 1% 9ounds and Vohn buys &! if candy is T1 9er 9ound keshara buys "% 9ounds and Vohn buys 1& 9ounds? 3f Keshara and Vohn are only t/o consumers! the market cure! /hich sho/s the @uantit y of candy demanded by all consumers at any gien 9rice /ill sho/ that at T" 9eo9le /ill buy 1& 9ounds of candy and at T1 9eo9le /ill buy & 9ounds of candy0
4AJE &?1 +5 * *&, 6 *7E 96+9E W in 9rice of F W demand of A X in 9rice of F X demand of A +5 * *&, 6 *7E $:M!#EME& W in 9rice of F X demand of A X in 9rice of F W demand of A $;*&
3f A is a inferior good W 3ncome F X demand for A X 3ncome F W demand for A $;*&
3f taste changes in faor of A F W demand for A 3f taste changes in against of A F X demand for A $;*&
W in 9rice of A in the future F W in demand of A today
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X in 9rice of A in the future F X in demand of A today 3f A is a normal goodY W 3n income in the future F W in demand of A today X 3n income in the future F X in demand of A today 3f A is an inferior goodY W 3n income in the future FX in demand of A today X 3n income in the future F W in demand of A today
$;*&
W 3n the number of consumers of A F W market demand of A X 3n the number of consumers of A F X market demand of A
Module 4he uantity supplied is the actual amount of a good or serice 9roducers are /illing to sell at some s9ecific 9rice A supply schedule sho/s ho/ much of a good or serice 9roducers /ill su99ly at different 9rices /orks in a similar /ay as demand schedule su99ly cure sho/s the relationshi9 bet/een @uantity su99lied and 9rice normal that for a su99ly cure generally higher 9rices leads to a higher @uantity su99lies? this is often referred to as the law o" supply this says that other things being e@ual! the 9rice and @uantity su99lied of a good are 9ositiely related demand cures slo9e do/n/ards /hile su99ly cures slo9e u9/ard .the higher the 9rice offered the more of any good
to kno/ that changes and su99ly and moements along the su99ly cure are different ;movement along the supply curve is a change in the @uantity of a good that is the result of a change in that good’s 9rice .change in su99ly /ill S3:4 the su99ly cure due to su99ly more 9roduces or adanced t echnologyL
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/hile moement is u9 or do/n0 An
increase in su99lyB is a rightward shift of the su99ly cure at any gien 9rice 9roducers su99ly a large @uantity of goods than before a decrease in su99ly they mean a leftward shift of the su99ly cure at any gien 9rice the 9roducers su99ly a smaller @uantity of goods than before Economist beliee shifts of the su99ly cure for a good or seride are m ainly due to & factors 10 ,hanges in input prices "0 ,hanges in the prices o" related goods or services 0 ,hanges in technology $0 ,hanges in epectations &0 ,hanges in the num%er o" producers An input is
anything that is used to 9roduce a good or serice you need in9uts to make out9uts in9uts hae 9rices to make anilla ice cream you need in9uts like cream! sugar! ectL increase in in9ut 9rices can make final good 9rices more e89ensie so 9roducers are less /illing to su99ly the final good at any gien 9rice and the su99ly cure shifts to the left .a fall in 9rice of in9uts can shift the cure to the right0 /hen
a 9roducer sells seeral 9roducts! the @uantity of any one good it is /illing to su99ly at any gien 9rice depends on the prices o" its other co-produced goods this effect can run in both directions ;an oil refinery /ill su99ly less gas /hen 9rice of heating oil rises shifting the su99ly cure for gas to the left but /ill su99ly more gas at any gien 9rice /hen the 9rice of heating oil falls! shifting the su99ly cure to the right this means gasoline and other co-9roduced oil 9roducts are su%stitutes in production for refiners other goods can be complements in production crude oil 9roducers see that oil /ells 9roduce natural gas as a by-9roduct of oil e8traction the higher 9rice at /hich driller sell natural gas the more oil /ells they /ill drill and the more oil they /ill su99ly at any gien 9rice for oil .so natural gas is a com9lement for crude oil0 technology B
means all the methods 9eo9le can use to turn in9uts into useful goods and serices .the se@uence of actiities needed to turn corn into cereal is technology0 better technology can reduce the cost of 9roduction letting 9roducer s9end less on in9uts to 9roduce the same out9ut increasing su99ly and shifting the su99ly cure to the right ust
like in the demand cure! changes in epectations can also change the su99ly cure ; /hen the su99liers hae some choice about /hen they 9ut their good u9 for sale changes in the e89ected future 9rice of a good can lead the su99lier to su99ly less or more of the good today storage of goods is a business strategy 9roducers choose to sell during 9eak seasons in 9rices choices the 9roducer makes de9ends on a com9arison of the current 9rice ersus the e89ected future 9rice sho/s ho/ changes in e89ectations can alter su99ly an increase in future 9rice of good
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of indiidual demand cures! the market su99ly cure is the hori=ontal sum of the indiidual su99ly cure of all te 9roducers sho/s that an increase in the number of 9roducers leads to an increase in su99l and a right/ard shift of the su99ly cure 5*$:7 ;* ;+5 9!!# $;*&
W Price of an in9ut used to 9roduce A F X su99ly of A X Price of an in9ut used to 9roduce A F W su99ly of A $;*&
3f A and are substitutes in 9roductions W Price of F X su99ly of A X Price of F W su99ly of A 3f A and are com9lements in 9roduction W Price of F W su99ly of A X Price of F X su99ly of A $;*&
3f the technology used to 9roduce A im9roes F W su99ly of A $;*&
W Price of A in the future F X su99ly of A today X Price of A in the future F W su99ly of A today $;*&
S far demand cure! su99ly cure! and the set of factors that shift each cure has been e89lained? together they can be used to 9roduct the actual 9rice at /hich the good is bought and sold! as /ell as the actual @uantity transacted in
com9etitie markets the interaction of su99ly and demand moe to/ard euili%rium
;an economic situation is in e@uilibrium /hen no indiidual /ould be better off doing something better .closed line at the su9ermarket o9en 9eo9le rush to/ards ne/ line until all the lines are long again this is e@uilibrium0 hel9s
us understand the 9rice at /hich good or serice is bought and sold as /ell as the @uantity transacted of the good or serice com9etitie market is in e@uilibrium /hen 9rice has moed to a leel at /hich the @uantity of the good demanded e@uals the @uantity of the good su99lied
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at
that 9rice no indiidual seller can make him
market e@uilibrium the 9rice has moed to a leel that e8actly matches the @uantity demanded by consumers to the @uantity su99lied by sellers? 4he 9rice that matches the @uantity su99lied and @uantity demanded is the euili%rium price the @uantity bought and sold at that 9rice is the euili%rium uantity the e@uilibrium 9rice is also kno/n as the market-clearing price the 9rice that ,lears the marketB by ensuring that eery buyer /illing to 9ay that 9rice finds a seller to sell at that 9rice easiest
/ay to find the e@uilibrium 9rice and @uantity in a market is by 9utting the su99ly cure and demand cure on the same diagram since su99ly cure sho/s the @uantit y su99lied at any gien 9rice and the demand cure sho/s the @uantity demanded at any gien 9rice the 9rice at /hich the t/o cures cross is the e@uilibrium 9rice the 9rice at /hich the @uantity su99lied F @uantity demanded o/
can /e be sure that markets /ill arrie at e@uilibrium 9rice ask three sim9le @uestions
1) hy do all sales and purchases in market take place at the same price@
3n a market /here the buyers and sellers hae both been around sales and 9urchases tend to hae a uniform 9rice so /e can talk about market 9rice? 3n any /ell established on going market all sellers receie and all buyers 9ay a99ro8imately the same 9rice .9eo9le /ould see that if a 9rice is too high they /ould sho9 else/here so seller /ould offer a better deal? Also a seller /ould not sell for less if he kne/ /hat most buyers /ere 9aying0 this is market 9rice 2) hy does the market price "all i" it is a%ove the euili%rium price@
4here is surplus of a good /hen the @uantity su99lied e8ceeds the @uantity demanded? Sur9luses occur /hen the 9rice is aboe its e@uilibrium leel? .also kno/n as e8cess of su99ly0 .9rice of a good /ill fall /heneer there is sur9lus /heneer market is aboe e@uilibrium leelL .) hy does the market price rise i" it is %elow the euili%rium price@
4here is a shortage of a good /hen the @uantity demanded e8ceeds the @uantity su99lied? Shortages occur /hen the 9rice is belo/ its e@uilibrium leel .also kno/n as e8cess demand0 -; in this situation buyers /ill offer more or sellers /ill charge higher 9rices bidding u9 of 9rices ha99ens /heneer there are shortages and there /ill be shortages /heneer the 9rice is belo/ its e@uilibrium leel .so market 9rice /ill al/ays rise if it is belo/ the e@uilibrium leel0 using
the aboe /e can al/ays see that the market 9rice /ill al/ays moe to/ards e@uilibrium 9rice .the 9rice at /hich there is neither sur9lus nor shortage
Module A
PAGE # 1&
Qemand cure and su99ly cure can shift for many reasons! /hen cures shifts the e@uilibrium 9rice and @uantity change Qemand cure shifts an increase in demand is indicated by a right/ard shift of the demand cure this causes a shortage because @uantity demanded e8ceeds the @uantity su99lied? 2hen a 9rice of an item rises this can generate an increase in the @uantity su99lies! an u9/ard moement along the su99ly cure? A ne/ e@uilibrium is established general 9rinci9al 2hen demand for a good or serice increases! the e@uilibrium 9rice and the e@uilibrium @uantity of the good or serice both rise /orks ice ersa /hen demand for a good or serice decreases! the e@uilibrium 9rice and the e@uilibrium @uantity of a good or serice both fall o/ markets res9ond to changes in demand An increase in demand leads to a rise in both the e@uilibrium 9rice and the e@uilibrium @uantity? A decrease in demand leads to a fall in both the e@uilibrium 9rice and e@uilibrium @uantity say
a drought ha99ens and the su99ly cure shifts to the left a shortage can ha99en that causes a rise in 9rice and a fall in @uantity demanded! an u9/ard moement along the demand cure? 4he ne/ e@uilibrium /ould hae a higher 9rice and a lo/er e@uilibrium @uantity? as a general 9rinci9le 2hen su99ly of a good or serice decreases! the e@uilibrium 9rice of the good or serice rises and the e@uili brium @uantity of the good or serice falls /hen
su99ly increases leads to a right/ard shift in the su99ly cure? As a result e@uilibrium 9rice falls and @uantity demanded rises? as a general 9rinci9al 2hen a su99ly of a good or serice increases! the e@uilibrium 9rice of a good or serice falls and the e@uilibrium @uantity of the good or serice 9rices o/ markets res9ond to change in su99ly An increase in su99ly leads to a fall in the e@uilibrium 9rice and a rise in the e@uilibrium @uantity? A decrease in su99ly leads to a rise in the e@uilibrium 9rice and a fall in the e@uilibrium @uantity? Some
eents shift both the demand and su99ly cures at the same time?
2hen
demand increases and su99ly decreases! the e@uilibrium 9rice rises but the change in the e@uilibrium @uantity is ambiguous 2hen
demand decreases and su99ly increases! the e@uilibrium 9rice falls but the change in the e@uilibrium @uantity is ambiguous 2hen
both demand and su99ly increase! the e@uilibrium @uantity increases but the change in e@uilibrium 9rice is ambiguous 2hen
both demand decrease! the e@uilibrium @uantity decreases but the change in e@uilibrium 9rice is ambiguous
Module 1' almost
all countries calculate a set of #’s kno/n as the national income and 9roduct accounts
PAGE # 1'
accuracy of a country’s accounts is a good indicator of its state of economic deelo9ment in >?S these #’s are calculated by the ureau of Economic Analysis! a diision of the >?S ? goernment’s Qe9artment of ,ommerce the national income and 9roduct accounts! often referred to sim9ly as t he national accounts! kee9 track of the s9ending of consumers! sales of 9roducers! business inestment s9ending! goernment 9urchases and other flo/s of money among different sectors of the economy 4he ,ircular-:lo/ Qiagram to understand national accounts look at the circular-flo/ diagram a sim9lified re9resentation of the macro economy sho/s the flo/ of money! goods and serices! and factors of 9roduction through t he economy allo/s us to isuali=e key conce9ts behind national accounts underlying 9rinci9al is that the flo/ of money into each marketS economy is com9le8 but you can learn a lot using a sim9le diagram?
sim9le
model of the macro economy re9resenting the transactions that take 9lace by ."0 kinds of flo/s around a circle flo/s of 9hysical things such as goods! serices! labor or ra/ m aterial in one direction and flo/s of money that 9ay for these things in the o99osite direction? in this case the 9hysical flo/s are in yello/ money is teal sim9le
circular-flo/ those economy /ith only " inhabitants households and firms ;a household consists of either an indii dual
PAGE # 1(
/e think of households as o/ning
model omits many things for sim9licity 4he E89anded ,ircular-:lo/ Qiagram 4his diagram sho/s only the flo/ of money in the economy but is e89anded to include e8tra elements that /ere ignored in the sim9le circular flo/ .for sim9licity0 underlying 9rinci9al that in flo/ of money into each market or sector must e@ual the outflo/ of money coming from that market or sector still a99lies sin this model
in
the 9roduct markets! households engage in consumer s9ending! buying goods and serices from domestic firm and from firms in the rest of the /orld households o/n factors of 9roduction -- land! labor! and ca9ital and they sell these factors of 9roduction to firms! receiing rent! /ages! and interest 9ayments in return firms buy and 9ay households for the use of those factors of 9roduction in factor markets! re9resented to the right of center in the diagram ;most households get their income from /ages earned by selling labor additional income from their indirect o/nershi9 of 9hysical ca9ital used by firms in the form of stocks shares in the o/nershi9 of a com9any and bonds loans to firms in the form of an 3> that 9ays interest ;the income households receie from the factors market i ncludes 9rofit distributed to com9any shareholders and the interest 9ayments on any bonds that they hold ;households receie rent from firms in e8change for the use of land or structures that the households o/n
PAGE # 1)
in
factor markets households receie income i n form of /ages! 9rofit! interest and rent ia factor markets households
s9end most of the income receied from factors of 9roduction on goods
also set aside a 9ortion of their income for 9riate saings these go into financial markets /here indiiduals! banks .and other instit utions0 buy
im9ortant
general characteristic of the circular-flo/ diagram the total sum of flo/s of money out of a gien bo8 is e@ual to the total sum of flo/s of money into that bo8 ;sim9le a matter of account /hat goes in must come out
goernment
returns a 9ortion of the money it collects from ta8es to households in the form of goernment transfers but it uses much of i ts ta8 reenue 7 addition funds it borro/ed in financial markets through goernment borro/ing to buy goods
of the /orld 9artici9ates in the >S economy ;some goods and serices are sold to other countri es .e89orts0 lead to a flo/ of funds from the rest of the /orld into the >?S ;some of the goods and serices 9urchased by the residents of the >?S are 9roduced abroad and are kno/n as im9orts leads to a flo/ of funds out of the >?S ;foreign can 9artici9ate in >?S financial markets foreign lending .lending by foreigners to borro/ers in >?S < 9urchases of stocks in American com9anies generates a flo/ of funds into the >?S from the rest of the /orld .conersely >?S lending to others is a flo/ of money out0 firms
also buy goods and serices in our economy might buy inestment goods .ca9ital goods0 to 9roduce items ;com9anies might accumulate an inentory good and ra/ materials held to facilitate business o9eration ;national accounts count this inestment s9ending s9ending on ne/ 9roductie 9hysical ca9ital as 9art of total s9ending on goods
PAGE # 1*
because it leads to lo/er sales inestment s9ending included s9ending on the construction of any structure 9roduces a future out9ut ;if /e add u9 consumer s9ending on goods
distinction bet/een class of goods and serices the difference bet/een final goods and serices ersus intermediate goods and serices Gross Qomestic Product final goods and serices are goods and serices sold to the final! or end user ;intermediate goods and serices are goods
domestic 9roduct or GQP is the total alue of all final goods and serices 9roduced in an economy during gien 9eriod .a year0 /ays to calculate GQP 10 surey firms and add u9 the total alue of their 9roduction of final goods
reality not all of this final s9ending goes to/ard domestically 9roduced goods
- 3M difference bet/een alue of e89orts and im9orts is kno/n as net e89orts
PAGE # "%
0 sum the total factors income earned by households from firms in the economy ;includes /ages earned by labor! the interest earned by those /ho lend their saings to firms and the goernment! the rent earned by the shareholders! the o/ners of the firm’ 9hysical ca9ital alid measure because money firms earn by selling goods
2hat is included in GQP domestically 9roduced final goods and serices! i ncluding ca9ital goods! ne/ constriction of structures! and changes to inentories +ot included in GQP intermediate goods and serices in9uts used goods financial assets such as stocks and bonds foreign-9roduced goods and serices
Module 11 Most
im9ortant use of GQP is as a measure of the si=e of the economy! 9roiding us a scale against /hich to com9are the economic 9erformance of other years or other countries? .>SA GQP Z T1$!"&* billion /hile Va9an’s GQP /as T&!%$* billion outdated as a side note because ,hina is #" right no/0 be careful /ith GQP numbers! es9ecially /hen making com9arisons oer time because 9art of the increase in the alue of GQP oer time re9resents increases in the 9rice of good and serices rather than an increase in out9ut .3?e? >S GQP /as T(!%)& billion in 1**$ and had a99ro8imately doubled to T1$!"&% billion in "%%* but note >S 9roduction didn’t double? 4o measure actual changes in aggregate out9ut! /e need a modified ersion of GQP that is adusted for 9rice changes kno/n as real GQP 6EAJ GQP A measure of aggregate out9ut
PAGE # "1
een
though GQP number is a useful statistic! one that 9roides a good /ay to com9are the si=e of different economies it is not a good measure of the economy’s gro/th oer time? GQP can gro/ because the economy gro/s! but it can also gro/ because of inflation een if the economy’s out9ut doesn’t change GQP /ill go u9 if the 9rices of the good and serices the economy 9roduces increases .GQP can fall because the economy is 9roducing less or because 9rices hae fallen0 to measure economy’s gro/th accurately /e need a measure of aggregate out9ut the total @uantity of final goods and serices the economy 9roduces the measure that is sued for this 9ur9ose is kno/n as 6EAJ GQP by tracking real GQP oer time /e aoid the 9roblem of changes in 9rices distorti ng the alue of changes in 9roduction oer time :6M 4E K 4 EJP >S >+QE6S4A+Q Jet’s imagine a economy in /hich only t/o goods! a99les and oranges are 9roduced and in /hi ch both goods are sold only to final consumers 4AJE 11?1 ,alculating GQP and real GQP in a sim9l e economy
Iear 1 [uantity of a99les .billions0 Price of an a99le [uantity of oranges .billions0 Price of an orange GQP .billions of dollars0 6eal GQP
"!%%% T%?"& 1!%%% T%?&% T1!%%% T1!%%%
Iear " "!"%% T%?% 1!"%% T%?(% T1!&%% T1!1&%
2e can say based on the data the alue of the sales increased from year 1 to " in the first year the total alue of the sales /as ."!%%% billion O T%?"&0 7 .1!%%% billion O T%?&%0 F T1!%%% billion in the second it /as ."!"%% billion O T%?%0 7 .1!"%% billion O T%?(%0 F T1!&%% billion ./hich is &%H larger0 but it is also clear that from the table that this increase in dollar alue of the GQP oerstates the real gro/th in the economy! although the @uantities of both a99les and oranges increase! the 9rices of the goods also rose so 9art of the &%H increase reflects higher 9rices! not higher 9roduction of out9ut to estimate true increase in aggregate out9ut 9roduced! /e hae to check ho/ much /ould GQP gone u9 if the 9rices had not changed to do this in this case /e hae to find the alue of out9ut for year " e89ressed in year 1 9rices ;in year 1 the 9rice /as a99les /as T%?"& each and 9rice of orange T%?&% each so year " out9ut at year 1 9rices is ."!"%% billion O T%?"&0 7 .1!"%% billion O T%?&%0 F T1!1&% billion and out9ut i n year 1 at year 1 9rices /as T1!%%% bullion so in this e8am9le! GQP measured in year 1 9rices rose 1&H from the T1!%%% billion to T1!1&% billion
6eal GQP is the total alue of final goods and serices 9roduced in t he economy during a gien year!
PAGE # ""
calculated .if 9rices had stayed constant0 using t he 9rices of a selected base year ;a GQP number that has not been adusted for changes in 9rices is calculated using t he 9rices in the year in /hich the out9ut is 9roduced called +ominal GQP .GQP at current 9rices0 +ominal GQP is the total alue of all final goods and serices 9roduced in the economy during a gien year! calculated /ith the 9rices current in the year in /hich the out9ut is 9roduced ;if /e used nominal GQP to measure the true change in out /e /ould hae oerstated the true gro/th in out9ut ase don table 11?1 /e can see different /ays to calculate real GQP by using a different base year .using " yields 1&?$H /hile using 1 yields 1&H0 in this calculation /e see that the real GQP increased by 1&H .1& or 1&?$ -- neither is more correct0 most goernment economist /ho 9ut together the >S national accounts hae ado9ted a method to measure the change in real GQP kno/n as chain-linking ,hain-linking is the method of calculating changes in the real GQP using the aerage bet/een the gro/th rate calculated using an early base year and the gro/th rate calculated using a late base year ;>S statistics on real GQP are al/ays e89ressed in chained dollars ./hich s9lit’s the difference bet/een using early and late base years0
GQP is a country’s aggregate out9ut other things e@ual a country /ith a larger 9o9ulation /ill hae a higher GQP sim9le because it has more 9eo9le ;so if /e /ant to com9are GQP across countries but /ant to elimi nate the effect of difference in 9o9ulation si=e! /e use the measure GQP 9er ca9ita GQP 9er ca9ita is the GQP diided b y the si=e of the 9o9ulationD it is e@uialent to the aerage GQP 9er 9erson real GQP 9er ca9ita is useful .such as in com9arison of labor 9roductiity bet/een t /o countries because it is a rough measure of the aerage real out9ut 9er 9erson it has /ell-kno/n limitations as a measure of a country’s liing standard .economist are accused of belieing that gro/th in real GQP in ca9ita is the only thing that matters -- thinking that increasing the real GQP 9er ca9ita is a goal in itself0 this is false a country’s real GQP 9er ca9ita is not a sufficient measure of human /elfare in that country and /hy gro/th in real GQP is not an a99ro9riate 9olicy goal real GQP does not include the things that contribute to ha99iness .leisure time! natural beauty! house/ork0 real GQP increases /ith e89enditures on some tings that make 9eo9le unha99y .diseases! crime! natural disasters! ect0 real GQP 9er ca9ita is a measure of an economy’s aerage aggregate out9ut 9er 9erson and so of /hat it ,A+ do a country /ith high GQP can afford to be healthy! to be /ell educated! and to hae a good @uality of life .but @uality of life does not F high GQP 9er ca9ita0
Module 12 you’re
em9loyed if and only if you hae a ob not as subtle because a 9erson /ho isn’t /orking doesn’t that that /e consider that 9erson unem9loyed indiiduals in retirement?S census bureau defined unem9loyed 9eo9le as indiiduals /ho are actiely looking for /ork but
PAGE # "
aren’t currently em9loyed A country’s labor force is e@ual to the sum of the em9loyed and the unem9loyed .indiiduals /ho are /orking and those /ho are looking for /ork0 4he labor force 9artici9ation rate is the H of the 9o9ulation 1' or older that is in the labor force Jabor force 9artici9ation rate F labor force<9o9ulation age 1' or older O 1%% 4he unem9loyment rate is the 9ercentage of the total number of 9eo9le in the labor force /ho are unem9loyed >nem9loyment rate F number of unem9loyed /orkers
unem9loyment rate is a good indicator of ho/ easy or difficult it is to find a ob gien the current state of the economy ./hen unem9loyment rate is lo/ nearly eeryone /ho /ants a ob can find one /orks ice ersa0 though unem9loyment is a good indicator of current labor market conditions! it is not a 9erfect measure
unem9loyment neer falls to =ero a /orker /ho is confident of finding a ob! but had not acce9ted a 9ositions! is counted as unem9loyed fre@uently!
9eo9le /ho /ould like to /ork but aren’t /orking still don’t get counted as unem9loyed an indiidual /ho has gien u9 looking for a ob for the time being .lack of aailability of ob0 isn’t counted as unem9loyed because he
>nderem9loyed
are 9eo9le /ho /ork 9art-time because they cannot find full-time obs they aren’t counted for unem9loyment either ureau of Jabor Statistics is the federal agency that calculated official unem9loyment also calculated broader measures of labor underutili=ationB that include the three categories of frustrated /orker /hen measured unem9loyed counts marginally attached /orkers .including discouraged /orkers0 and the underem9loyed are counted it is significantly higher
broadest
measure of unem9loyment and underem9loyment! kno/n as >'! is the sum of these three measures 9lus the unem9loyed it is substantially higher ;>' and the unem9loyment rate moe ery much in 9arallel! so changed in the unem9loyment rate remain a good guide for /hat’s ha99ening in the oerall labor m arket unem9loyment
rate aries greatly among demogra9hic grou9s .other things being e@ual! obs are easier
PAGE # "$
to find /ith more e89erienced /orkers and for /orkers during their 9rimeB /orking years "&-&$L0 ;younger /orkers! and for /orkers near retirement obs are harder to find .all things being e@ual0 .race also counts into dis9arity0
although
unem9loyment is not e8act! literal measure of the H of 9eo9le unable to find obs! it is a good indicator of oerall labor market conditi ons .u9s and do/ns of the unem9loyment rate closely reflect economic changes that im9act 9eo9le’s lies0
/hile
recessions are marked usually by rising unem9loyment im9ortant to recogni=e that economic e89ansions aren’t al/ays 9eriods of falling unem9loyment in the case of the book /e see that the recession of 1**%-1**1 and "%%1 the unem9loyment rate continues to rise for more than a year after the recession /as officially oer? 4he e89lanation is both cases is that although the economy is gro/ing! it /as not gro/ing fast enough to reduce the unem9loyment rate book
uses figure 1"?& .aerage gro/th .8 a8is0 s? change in unem9loyment rate .9ercentage 9oints0 .y a8is0 some years /ere the gro/th /as in the negatie ./hich means the real GQP shrank0 do/n/ard trend on this gra9h sho/s that there is generally a strong negatie relationshi9 bet/een gro/th in the economy and the rate of unem9loyment years of high gro/th in real GQP /ere also years in /hich the unem9loyment rate fell! and years of lo/ or negatie gro/th in real GQP /ere years in /hich the unem9loyment rate rose0 ./hen ertical a8is is negatie meaning unem9loyment fell years of aboeaerage gro/th /ere usually in years in /hich the unem9loyment /as falling .you can guess belo/ aerage gro/th /as the o99osite0
PAGE # "&
there
are 9eriods in /hich GQP is gro/ing! but at a belo/-aerage rateD these are 9eriods in /hich the economy isn’t in a recession but unem9loyment is still rising .sometimes called a gro/thB recessionB
Module 1. 4he ,auses and ,ategories of >nem9loyment fast
economic gro/th tends to reduce the unem9loyment rate a %H unem9loyment is not feasible neer dro99ed belo/ "?*H unem9loyment
een /hen businesses are haing a hard time finding /orkers /e start /ith the obseration that een in the best of times obs are constantly being created
Vob ,reation and Vob Qestruction in
early "%1% unem9loyment /as 1%H in Vuly "%%( it /as $?(H .historically lo/0 yet in that month $?& ob se9arationsB terminations of em9loyment occurred many
reasons for ob loss ; a structural change in the economy industries rise and fall as ne/ technologies emerge and consumers’ taste change structural changes can create ne/ obs also ;9oor management 9erformance or bad luck at indiidual com9anies also leads to ob loss for their
PAGE # "'
em9loyees constant churning of /orkforce is an ineitable feature of the modern economy this churning is one source of frictional unem9loyment one main reason that there is a considerable amount of unem9loyment een /hen obs are abundant
:rictional >nem9loyment /orkers /ho loses ob inoluntary .due to ob destruction0 choose not t o take the first ne/ ob offered .ie a 9rofessional basketball 9layer looses his ob and get a ob coaching the local high school basketball team he should refuse and take the time to look for a ob that takes adantage of his skills0 ;indiidual /orkers are constantly leaing obs for 9ersonal reasons .family moes! dissatisfaction! and better ob 9ros9ects0 /orkers
/ho s9end time looking for unem9loyment are engaged in Vob search if all /orkers<obs /ere alike ob search /ouldn’t be necessaryD if i nformation about obs
unem9loyment is unem9loyment due to the time /orkers s9end in ob search a certain amount of frictional unem9loyment i s ineitable for ."0 reasons ;.10 the constant 9rocess of ob creation and ob destruction ;."0 ne/ /orkers are al/ays entering the ob market ;a limited amount of frictional unem9loyment is harmless .may be een good0 economy is more 9roductie if /orkers take the time to find obs that are /ell matched to their skills and /orkers /ho are unem9loyed for a brief time /hile searching fr the right ob don’t e89erience hardshi9 ;lo/ unem9loyment rate 9eriods of unem9loyment tend to be short suggestion the unem9loyment is frictional in
9eriods of higher unem9loyment /orkers tend to be obless for lon ger 9eriods of time! suggesting a smaller share of unem9loyment is frictional .long term unem9loymentB rates um90 Structural unem9loyment frictional unem9loyment een e8ist /hen the # of 9eo9le seeking obs F the number of obs being offered the e8istence of frictional unem9lo yment doesn’t mean a sur9lus of labor there is a 9ersistent sur9lus of ob-seekers in a 9articular ob market .ie more /orkers /< a skill than there are obs for that skill or there may be more /orkers in a 9articular region than there are obs aailable in that region0 Structural
unem9loyment is unem9loyment that results /hen there are more 9eo9le seeking obs in a labor market than there are obs aail able at the current /age rate su99ly
and demand model tells us that the 9rice of a good! serice! or factor of 9roduction tends to moe to/ard an e@uilibrium leel that matches the @uantity su99lied /ith the @uantity demanded es9ecially true .in general0 of labor markets ;labor demand cure indicates that /hen t he 9rice of labor -- /age rate -- i ncreases! em9loyees demand less labor ;the labor su99ly cure indicates that /hen the 9rice of labor increases! more /orkers are /illing to su99ly labor at the 9reailing /age rate
PAGE # "(
;these t/o forces coincide to lead to an e@uilibrium /age for any gien ty9e of labor in a 9articular location e@uilibrium /age is 2.e0 een
at the e@uilibrium /age rate! 2.e0 there /ill still be some frictional unem9loyment because there /ill al/ays be some /orkers engaged in ob search een /hen the # of obs are F to the # of /orkers seeking obs but there /ouldn’t be any structural unem9loyment in this labor market Structural unem9loyment occurs /hen the /age rate is! for some reason! 9ersistentl y aboe 2.e0 seeral factors can lead to an /age rate in e8cess of 2.e0 most im9ortant are minimum /age! labor unions! efficiency /ages! and the side effects of goernment 9olicy
M3+3M>M 2AGE a minum /age is a goernment mandates floor on the 9rice of labor the national minimum /age in "%%* /as T(?"& for many Americans this is irreleantD the market e@uilibrium /age for these /orkers i s /ell aboe this floor 9rice but for less skilled /orkers the minimum /age may be binding it affects the /ages that 9eo9le are actually 9aid and can lead to structural unem9loyment in countries /ith higher minimum /ages! the range of /orkers for /ho the minimum /age is binding is larger you
can gra9hically see the effects of a binding minimum /age
in
this market there is a legal floor on /ages .2.f00 /hich is aboe the e@uilibrium /age rate 2.e0 this leads to a 9ersistent sur9lus in the labor market the @uantity of labor su99lied! [.s0 is larger than the @uantity demanded [.d0 more 9eo9le /ant to /ork than they can find obs at the minimum /age leading to structural unem9loyment gien
that minimum /ages .binding minimum /ages0 generally lead to structurally unem9loyment makes you /onder /hy goernment im9oses them rationale is to ensure that 9eo9le /ho /ork can earn enough income to afford at least a minimally comfortable lifestyle comes at a cost because it may
PAGE # ")
eliminate em9loyment o99ortunities for some /orkers /ho /ould hae /illingly /orked for lo/er /ages as seen in the figure aboe not only are there more sellers of labor that they are buyers! there are also fe/er 9eo9le /orking at a minimum /age [.Q0 than they /ould hae been /ith no minimum /age [.e0L although
economist broadly agree that high minimum /age has em9loyment reducing effects there is some @uestion about /hether this is a good descri9tion of ho/ minimum /age actually /orks some research hae 9roduced eidence that increases in the minimum /age actually increases em9loyment argue that firms that em9loy lo/-skill ed /orkers restrict their hiring in order t o kee9 /ages lo/ so as a result minimum /age can sometimes be increased /ithout a loss of obs most economist agree that s sufficiently high minimum /age does lead to structural unem9loyment
JA6 >+3+S actions
of labor unions can hae similar effects as those of minimum / age leading to structural unem9loyment ;by bargaining collectiely for all of a firm’s /orkers! unions often /in higher /ages from em9loyees that they could hae indiidually 9rocess is kno/n as collectie bargaining intended to gie /orked more bargaining 9o/er ;labor union e8ercise bargaining 9o/er by threatening firms /ith a labor strike .collectie refusal to /ork0 /hen /orks hae more bargaining 9o/er they demandJ3, PJ3,I 9ublic 9olicy designed to hel9 /orkers /ho lose their obs can lead to structural unem9loyment as an unintended side effect like /elfare the dra/back is that it reduces the incentie to @uickly find a ne/ ob and by kee9ing more 9eo9le searching longer benefits increase structural and frictional unem9loyment +urosclerorisB 9ersistent high unem9loyment that affects # of Euro9ean countries attributed to unem9loyment benefits 4E +A4>6AJ 6A4E : >+EMPJIME+4 frictional unem9loyment is ineitable and many economies suffer from structural unem9loyment so a certain amount of unem9loyment is natural Actual unem9loyment fluctuated around this normal leel the natural rate of unem9loyment is the normal unem9loyment around /hich the actual unem9loyment rate fluctuates it is the rate of unem9loyment that arises from t he effects of frictional 9lus structural
PAGE # "*
unem9loyment ;cyclical unem9loyment is the deiation of the actual rate of unem9loyment from the natural rateD it is the difference bet/een the actual and natural rates of unem9lo yment cyclical unem9loyment is the share of unem9loyment that arises from the business cycle
S +atural unem9loyment F friction 7 structural unem9loyment Actual unem9loyment F natural 7 cyclical unem9loyment the
natural rate of unem9lo yment changes oer time! and it can be affected by economic 9olicies
,A+GES 3+ 4E +A4>6AJ 6A4E : >+EMPJIME+4 9riate sector economistS natural rates rises and fall oer time the
main causes of change in the natural rate of unem9loyment is changes in the characteristics of the labor force! in labor market instructions! and in goernment 9olicies ,A+GES 3+ JA6 :6,E ,A6A,4E63S43,S ;young /orkers tend to hae much higher unem9loyment unem9loyment rates tend to be lo/er for e89erienced than for e89erienced /orkers because e89erience /orks tend to stay in a gien ob longer than do ine89erienced ones! they hae a lo/er frictional unem9loyment ,A+GES 3+ JA6 MA6KE4 3+S4>4343+S ;union is 9art of this .unions negotiate aboe the e@uilibrium leel /hich can be a source of structural unem9loyment0 other instructional changes may also /ork some labor economist beliee that tem9orary goernment agencies hae reduced frictional unem9loyment by hel9ing m atch /orkers to ob internet /ebsites may hae reduced frictional unem9lo yment also ;technology change cou9led /ith labor market institutions can also affect the national rate of unem9loyment leads to an increase in demand for skilled /orkers /ho are familiar /i th eoling technology and a reduction in the demand for unskilled /orkers economic theory states that /ages should increase for skilled /orkers and decrease for unskilled and i f /ages cannot go do/n for unskilled .due to binding minimum /age0 increases structural unem9loyment and therefore a higher natural rate of unem9loyment /ill result ,A+GES 3+ GRE6+ME+4 PJ3,3ES a high minimum /age can cause structural unem9loyment generous unem9loyment benefits can increase both structural and frictional unem9loyment so these goernment 9olicies meant to hel9 can hae the undesirable effect of raising the natural rate of unem9loyment some goernment 9olicies might reduce natural rate .like ob training and em9loyment subsidies ob training 9rograms are su99ose to 9roide unem9loyed /orkers /ith skills that /iden the range of obs they can 9erson and em9loyment subsidies are 9ayments either to /orkers or to em9loyers that 9roide a financial incentie to acce9t or offer obs
PAGE # %
Module 1 high
rate of inflation not the high rate of unem9loyment /as the 9rinci9al concern for 9olicy makers at the time .during the 1*(%’s - 1*)%’s0 ;inflation is something to /orry about and 9olicy makes does not like it /hen it increases inflation can im9ose costs on the economy common
misconce9tion is that inflation makes eeryone 9oorer .it does not0 a lot of countries re9lace their currencies imagine if you re9lace the dollar /ith a ne/ dollarB at the e8change rate of ( to 1? 3f you o/ed T1$%!%%% on your home it /ould become T"%!%%% in the ne/ dollars? 3f you had a /age of 1$ dollars it is no/ " ne/ dollars this /ould bring >S 9rices back to /hen V:K /as 9resident ;so does eeryone become richer + 9rices /ould be lo/er but so /ould /ages and income in general? 3f you cut a /orkers /age and 9rices at the same rate the /orker’s real wage -- the /age rate diided by the 9rice leel -- doesn’t change? ringing the oerall 9rice leel to V:K’s days /ould hae no effect on the oerall 9urchasing 9o/er because doing so /ould reduce incomes e8actly as much as it reduced 9rices conersely
a rise in 9rices in 1*'%s didn’t make America 9oorer because it raised incomes the same amount the real income the income diided by the 9rice leel -- hasn’t been affected by the rise i n oerall 9rices S the leel of 9rice doesn’t matter? 3+:JA43+ 6A4E MA44E6SN Qistinguish bet/een leel of 9rices and the inflation rate? 4he inflation rate is the 9ercent increase in the oerall leel of 9rices 9er year? ; calculated by 3nflation rate F 9rice leel in year " - 9rice leel in year 1 < Price leel in year 1
C 1%% H
;in the figure in the book you see the 9ast $% years 9rice leels hae gone u9 but inflation rate .the rate at /hich consumer 9rices are rising0 has had both u9s and do/ns .generally do/n/ard0
Economist beliee that high rates of inflation im9ose significant economic costs? the most im9ortant are shoe-leather costs! menu costs! and unit-of-account costs hoe-leather costs in
inflation rate discourages 9eo9le form holding money! because the 9urchasing 9o/er of the cash in your /allet and the finds in your bank account steadily erodes as the oerall leel of 9rices rises leads to 9eo9le to search for /ays to reduce the amount of money they hold the
German hy9erinflation of 1*"1-1*" merchants een hired runner to take cash to banks many times a day to e8change the currency @uickly for something that can hold alue .foreign currency0 in an effort to aoid haing the 9urchasing 9o/er of t heir money eroded 9eo9le used u9 aluable recourses .runner /< time and labor0 that could hae been used 9roductiely else/here
PAGE # 1
the
increased cost of transactions b y inflation are kno/n as shoe-leather costs! an allusion to the /ear and tear caused by the e8tra running around /hen 9eo9le are trying to aoid holding money are substantial in economies /ith ery high inflation rates most estimates suggest that the shoe-leather cost of inflation at the rates seen in the >?S /hich in 9eacetime has neer had inflation aboe 1&H .@uite small0
Menu $ostB changing a listed 9rice has a real cost called menu cost in the face of inflation firms are forced to change the 9rices more often than they /ould if the 9rice leel /as more or less stable means higher costs for the economy as a /hole in
times of high inflation menu costs are substantial /hen inflation rate is high merchants may decide to sto9 listing 9rices in terms of the local currency and use either an artificial unit in effect measuring 9rices relatie to another or a more stable currency .like >S dollar0 ;menu costs are also 9resent in lo/-inflation economies .but not as seere0 in lo/ inflation economies businesses might u9date their 9rices more s9oradically .not dailynit-of-account costs of inflation are the costs arising from the /ay inflation makes money a less reliable unit of measurement this
is es9ecially im9ortant in the ta8 system because inflation can distort the measures of income on /hich ta8es are collected 1%H inflation each year? ,om9any buys land for T1%%!%% sells for T11%!%%% ne8t year no real gain but a 9hantom gain of T1%!%%% /hich the >S ta8 la/s /ould state as a ca9ital gain and the com9any /ould hae to 9ay ta8es for that big 9roblem in the 1*(%s
high
inflation im9oses oerall costs on the economy inflation can 9roduce /inners and l osers /ithin the economy ;inflations hel9s some and hurts others in economic transactions! such as loans! often inole contracts that e8tend oer a 9eriod of time and these contracts are normally s9ecified in nominal .dollar0 terms in case of a loan the borro/er receies a certain among of funds at the beginning and the loan contract s9ecifies ho/ much he or she must re9ay at some future date /hat dollar re9ayment is /orth in real terms .in terms of 9urchasing 9o/er0 de9ends greatly on the rate of inflation oer the interening years of the loan
PAGE # "
;interest rate on a loan is the 9ercentage of the loan amount that the borro/er must 9ay the lender .ty9ically on annual basis0 in addition to re9ayment of the loan amount itself ;economist summari=e the effect of inflation on borro/ers and lenders by distinguishing bet/een nominal interest rates and real interest rates? ;the nominal interest rate is the interest rate that is actually 9ain for a loan! unadusted for the effects of inflation .banks
borro/er and lender enter into a loan contract the contract normall y s9ecifies a nominal interest rate but each 9arty has the e89ectation about the future rate of inflati on and therefore an e89ectation about the real interest rate on the loan if the actual inflation rate is higher than e89ected borro/ers gain at the e89ense of the lender borro/s /ill re9ay their loans /ith funds that hae a lo/er real alue than had been e89ected they can 9urchase fe/er goods and serices due to the sur9rising high inflation rate and conersely a lo/er inflation rate /oul d be beneficial to the lender and borro/ers must re9ay their lenders /ith a higher real alue than had been e89ected in
modern America home mortgages are the most im9ortant source of gains and losses for inflation because of gains for some and losses for others result from the inflation being eit her higher or lo/ers cause an uncertainty about the future of inflation rate and this discourages 9eo9le from entering into any form of long term contract this is an additional cost of high inflation because high rates of inflation are usually un9redictable countries /ith high and uncertain inflation! long-term loans are rate .makes it difficult for 9eo9le to make long-term inestments0 note
deflation .oerall dro9 in 9rice leel 9roduces /inners and losers also0
3nflation is Easy! Qisinflation 3s ard 9olicy
makes generally moe forcefully t o bring inflation back do/n because e89eriences sho/s that bringing the inflation rate do/n a 9rocess called disinflation is ery difficult and costly once a higher rate of inflation has become /ell established in the economy during
1*() - 1*)) the decade began /ith high inflation rate but by the end inflation /as about $H a maor economic achieement but it came at a high cost much of the fall of inflation resulted from the ery seere recession of 1*)1 - 1*)" /hich droe unem9lo yment to 1%?)H highest leel since the great de9ression economist beliee that this 9eriod of high unem9loyment /as necessary because they beliee t hat the only /ay to reduce inflation that has become dee9ly embedded in the economy is through 9olicies that tem9orarily de9ress the economy the best /ay to aoid to haing to 9ut the economy through a /ringer is to reduce inflation ho/eer is to aoid haing serious inflation from the first 9lace 9olicy
makers res9ond forcefully to signs that inflation may be accelerating as a form of 9reentie medicine for the economy
PAGE #
Module 14 ("irst two pages) aggregate price level
re9resents the oerall leel of 9rices ariety of goods and serices by the use of a 9rice inde8
/e
summari=e the 9rices of the huge
;to measure aerage 9rice changes for consumer goods and serices! economists track changes in the cost of a ty9ical consumer’s consum9tion bundle the ty9ical basket of goods an serices 9urchased before the 9rices change a
hy9othetical consum9tion bundle! used to measure changes in the oerall 9rice leel is kno/n as a market %asket 2orking /ith market baskets and a base year! /e obtain /hat is kno/n as a price inde ! a measure of the oerall 9rice leel? 3t is al/ays cited along /ith the year for /hich the aggregate 9rice leel is being measured and the base year
Price inde8 in a gien year F ,ost of market basket in a gien year<,ost of market basket in base year O 1%%
;9rice inde8es are also the basis for measuring i nflation 9rice leel mentioned in the inflation ate formula is sim9ly a 9rice inde8 alue and the inflation rate is determined as the annual 9ercentage change in an official 9rice inde8 the
inflation rate from year 1 t% year " is calculated by this .consider year 1 and " are consecutie years0
3nflation rate F Price inde8 in year " - Price 3nde8 in year 1 < Price inde8 in year 1 F 1%% the the
inflation rateB is referring to the annual 9ercent change in t he consumer 9rice inde8 consumer 9rice inde8 .,P30 measures the cost of the market basket of a ty9ical urban American
family the 9roducer 9rice inde8! PP3 measures changes in the 9rice of goods and serices 9urchased by 9roducers GQP deflator for a gien year is 1%% times the ratio of nominal GQP to real GQP
Module 1 book
uses the story of :t?Myers initial rise
PAGE # $
; lets e8amine chain reaction /e need .$0 sim9lifying assum9tions 10 *ssume producers are willing to supply additional output at a "ied price .so T1 billion on inestment goods by firms T1 billion /orth of additional goods
situation /hen there is a change in inestment s9ending home builders s9ent e8tra T1%% billion on home construction ;direct effect of increase inestment s9ending /ill be to increase income and the alue of aggregate out9ut by the same amount T s9ent on house construction translates into T for income
see
the total effect on aggregate out9ut if /e sum the effect from all these rounds of s9ending increases /e need to kno/ marginal 9ro9ensity to consume .MP,0 /hich is the increase in consumer s9ending /hen dis9osable income rises by T1 /hen
consumer s9ending changes /< rise
2< assum9tion of no ta8es and no international trade each T1 increases in s9ending raises both real GQP and dis9osable income T1%% billion increase in inestment s9ending raises real GQP by T1%% billion .in dis9osable income0 T1%% billion more in dis9osable income leads to a second round increase of real GQP by further .continues on0 MP, O T1%% billion ."nd round0 follo/ed by third round i ncrease in consumer s9ending MP, O MP, O T1%% billion and so on
PAGE # &
So total increase in real GQP .infinite rounds0 F .1 7 MP, 7 MP,]" 7 MP,] 7 Y0 O T1%% billion so C1'' %illion sets a chain reaction and net result o" this chain is C1'' %illion increase in investment spending leads to a change in real <,! that is a multiple o" the si3e o" that initial change in spending math comes in to e89lain /hat the multi9le is Sum of infinite series in form 1 7 O]" 7 O]?? 2here 8 is bet/een % and 1 F 1<.1-O0
o total increase in real <,! "rom C1'' %illion rise in +B 1/(1-M!$) = C1'' %illion Een though there can be an endless # of rounds of e89ansions of real GQP total rise is limited to the # gained from using the e@uation aboe because at each stage some of the rise in dis9osable income leaks outB because it is saed leaing less and less to be s9ent in the ne8t round ho/ much an additional dollar of dis9osable income is saed de9ends on MPS distinguish
bet/een the initial change in aggregate s9ending before real GQP rises and the additional change in aggregate s9ending caused by the change i n real GQP as the reaction unfolds .housing boom 9eo9le feel richer and s9end more this /ill lead to an initial rise in consumer s9ending before real GQP rises also lead to "nd and later rounds of higher consumer s9ending as real GQP and dis9osable income rise0 An autonomous change in aggregate s9ending is an initial rise
real GQP then multiplier D /** .assuming no ta8es
Multiplier D /** D 1/(1-M!$) si=e
of multi9lier de9ends on MP, if MP, is high so is multi9lier igher MP, the less dis9osable income leaks outB into saings consumes
debate ho/ much to s9end in total consume s9ending normally accounts for "< of total s9ending on final goods
im9ortant factor affecting a famil y’s consumer s9ending is its current dis9osable i ncome .after ta8es are 9aid
of Jabor statistics .JS0 collect annual data on income
PAGE # '
4he consumption "actor is an e@uation sho/ing ho/ an indiidual household’s consumer s9ending aries /< household’s current dis9osable income sim9lest
ersion of it as a linear function
c F a 7 MP, O yd Jo/ercase letters F ariable measured for indiidual household c F indiidual household consumer s9ending yd F indiidual household current dis9osable income a F constant term indiidual household autonomous consumer s9ending is the amount o" money a household would spend i" it had no disposa%le income ;assume a ; % because able to fund some consum9tion by borro/ing
that MP, is the ratio of a change in consumer s9ending to the change in current dis9osable income? >sing ne/ ariables M!$ D c/yd
Multi9ly both sides by \yd MP, O \yd F \c ;this sho/s that /hen yd goes u9 by T1! c goes u9 by MP, O T1
Gra9h of consum9tion function .c F a 7 MP, O yd0 yd on hori=ontal a8is and c on the ertical ;indiidual household autonomous consumer s9ending a! is the alue of , /hen yd is % .ertical interce9t of consum9tion function c f 0 ;M!$ is slope o" line .remember MP, F \c<\yd0 4he
aggregate consumption "unction is the relationshi9 for the economy as a /hole bet/een aggregate current dis9osable income and aggregate consumer s9ending .macroeconomics0
, F A 7 MP, O IQ , F aggregate consumer s9ending IQ F aggregate current dis9osable income A F aggregate autonomous consumer s9ending .amount of consume s9ending then IQ F %0
PAGE # (
6elationshi9
re9resented by , F analogous to c f
aggregate
consum9tion function sho/s relationshi9 bet/een di s9osable income and consume s9ending for economy as a /hile .all things being e@ual0 but it can shift /hen things other than dis9osable income changes t/o 9rinci9al causes of shifts of the aggregate consum9tion function .10 changes in epected "uture disposa%le income and ."0 changes in aggregate wealth $hanges in epected "uture disposa%le incomeB Su99ose you get a good ob but the ob<9aychecks /ont start for seeral months but it’s likely you /ill start s9ending more on final goods
4he aboe gra9hs sho/ ho/ changes in e89ected future dis9osable income can affect consumer s9ending sho/ ho/ changes in epected "uture disposa%le income a""ect the aggregate consumption "actor ,:1 is initial aggregate consum9tion factor 9anel .a0 sho/s higher e89ect dis9osable income /hich increases A .aggregate autonomous consumer s9ending0 from A1 to A" this shifts aggregate consum9tion factor from ,:1 to ,:" 9anel ."0 sho/s the o99osite /hen future dis9osable income dro9s consumers /ill no/ s9end less at any gien leel of current dis9osable income .I Q0 corres9onding to a fall in A from A1 to A" effect is to shift the aggregate consum9tion factor do/n form ,:1 to ,:" based
on A Theory of the Consumption Factor Milton :reidman sho/ed that e89ected future income had other effects 9eo9le /ith high current income sae a larger fraction of their income than those /< lo/ current income does not a99ly to the oerall saings rate .H the country’s dis9osable income is saed0 difference bet/een current
PAGE # )
high current incomes are doing good but if they e89ect lo/er incomes they might sae more0 2hen
economy gro/s by contrast current
need to look at factors that determine inestment s9ending !lanned investment spending is the inestment s9ending that businesses intend to undertake during a gien 9eriod the leel of inestment s9ending businesses actually carry out is sometimes not the same leel as /as 9lanned 9lanned inestment s9ending de9ends on .0 9rinci9al factors (1)interest rateF (2) the epected "uture level o" real <,!F and (.) the current level o" production capacity
+nterest rates e""ect %usiness ;like house construction they /ill build more homes /hen interest rates are lo/ so more 9eo9le /ould buy homes .more likely to sell0 firms
/ith inestment s9ending 9roects /ill go ahead /ith a 9roect if they e89ect a rate of return that is higher than the cost of the funds they /ould hae to borro/ if interest rises fe/er 9roects /i ll 9ass and as a result inestment s9ending /ill be lo/er ;9ast 9rofits used to finance inestment s9ending are called retained earnings een if a firm 9ays for inestment s9ending out of retained earnings the trade-off it must make is deciding /hether or not to fund a 9roect remains the same because it needs to take into account o99ortunity cost for its funds .so trade-off firms face /hen com9aring a 9roect’s rate of return to the market has not changes using retained or borro/ed funds0 a fall in interest rates makes some inestment 9roects that /ere un9rofitable!
PAGE # *
9rofitable at the ne/ lo/er interest rates ;so 9lanned inestment s9ending s9ending on inestment 9roects that firms oluntarily decide /hether to or not to undertake is negatiely related to interest rate .higher interest rate leads to a lo/er leel of 9lanned inestment0 Epected "uture real <,!F production capacityF and investment spending if firm doesn’t e89ect sales to gro/ into the future and has enough ca9acity to continue to 9roduce t he amount is currently selling it /ill engage in inestment s9ending only to re9lace e8isting e@ui9ment
together effects on inestment s9ending .10 gro/th in e89ected future sales ."0 the si=e of the current 9roduction ca9acity /e can see one situation in /hich firms /ill undertake high leels of inestment s9ending /hen they e89ect sales to gro/ ra9idly so een e8cess 9roduction ca9acity /i ll be used u9 leadings firms to resume inestment s9ending indictor of high e89ected gro/th in future sales is a high e89ected gro/th rate of real GQP this results in a higher leel of inestment s9ending .conersely lo/er rate of e89ected future gro/th rate of real GQP leads to lo/er 9lanned inestment s9ending0 +nventories and 9nplanned investment spending firms maintain inventories stocks of goods held to satisfy future sales firms hold inentory so they can @uickly satisfy buyers a consumer can 9urchase an item off the shelf rather than /ait business often hold inentories of their in9uts to hae a steady su99ly of necessary materials
at any gien 9eriod actual inestment s9ending is F to 9lanned inestment s9ending 9lus un9lanned inestment s9ending +unplanned D unplanned investment spending +planned D planned investment spending + D actual investment spending
PAGE #
%$henB + D +unplanned G + planned
rising
inentories indicate 9ositie un9lanned inentory inestments and a slo/ing economy as sales are less than been forecast falling inentories indicate negatie un9lanned inentory inestment and a gro/ing economy as sales are greater than forecast
Module 1A great
de9ression caused by massive negative demand shock ;negatie demand shock to the economy is a left/ard shift of the aggregate demand cure .a cure /hich sho/s the relationshi9 bet/een the aggregate 9rice leel and the @uantity of aggregate out9ut demanded by households! firms! the goernment! and the rest of the /orld0
this
sho/s /hat might hae been the aggregate demand cure in 1* at the end of the 1*"*-1* recession hori=ontal a8is sho/s the total @uantity of domestic good
Rertical a8is sho/s aggregate 9rice leel .measured b y the GQP deflator for a gien year is F to 1%%8 the ratio of nominal GQP for that year to real GQP for that year e89ressed in terms of a selected base year0 /<
ariables /e can dra/ cure AQ to sho/ ho/ much aggregate out9ut /ould hae been demanded in 1** .one 9oint of the cure F actual data for 1*0 /hen aggregate 9rice leel /as (?* total @uantity of domestic goods
PAGE # $1
aggregate
demand cure is do/n/ard slo9ing sho/in g a negatie relationshi9 bet/een aggregate 9rice leel and the @uantity of aggregate out9ut demanded higher aggregate 9rice leel reduces the @uantit y of aggregate out9ut demanded lo/er aggregate 9rice leel increases the @uantity of aggregate out9ut demanded hy is *ggregate demand curve downward sloping@
6ecall the basic e@uation of national income accounting GQP F , 7 3 7 G 7 O - 3M , F consumer s9ending 3 F inestment s9ending G F goernment 9urchases of goods
is +4 46>E that because the demand cure for any one good is do/n/ard slo9ing the demand cure for aggregate out9ut is also do/n/ard slo9ing demand cure for any indiidual good sho/s ho/ the @uantity demanded de9ends on the 9rice of that good! holding the 9rices of other goods and serices constant? main reason @uantity of a good demanded falls /hen the 9rice of that good rises .or the @uantity of a good demanded falls as /e moe u9 the demand cure0 is that 9eo9le s/itch their consum9tion to other goods that hae become relatiely less e89ensie but /hen /e consider moements u9
an increases in the aggregate price level reduces the purchasing power o" many assets ;if 9erson had T&!%%% in bank and aggregate 9rice leel rose by "&H the T&! %%% /ould buy as much as T$?%%% as before /< loss of 9urchasing 9o/er the o/ner /ould scale back consum9tion 9lans a lot of 9eo9le /ould res9ond the same /ay leading to a fall in s9ending on final goods
fall in aggregate 9rice leel increases the 9o/er of consumers’ assets and leads to more consumer demand the /ealth effect of a change in the aggregate 9rice leel is the change in consumer s9ending caused by the altered 9urchasing 9o/er of consumers’ assets %ecause o" wealth e""ect consumer spending $ "alls w/ aggregate price level rise .leading to do/n/ard slo9ing aggregate demand cure0 +nterest 7ate E""ect money refers to cash and bank de9osits on /hi ch 9eo9le can /rite checks 9eo9le hold money because
PAGE # $"
it reduces cost
reduces the funds aailable for lending to other borro/ers and dries interest rates u9 this rise reduces inestment s9ending because it makes the cost of borro/ing higher also reduces consumer s9ending because households sae more of their dis9osable income so
a rise in aggregate price level depressed investment spending +F and consumer spending $ through e""ect on the purchasing power on money holdings kno/n as the interest rate effect of a change in the aggregate 9rice leel also leads to a do/n/ard slo9ing aggregate demand cure hi"ts o" the aggregate demand curve in
the analysis of su99ly
PAGE # $
Sums u9 the factors that shift u9 aggregate demand
+ote :iscal 9olicy is the use of ta8es! goernment 9urchases of goods and serices to stabili= e the economy Monetary 9olicy is the central bank’s use of changes in the @uantit y of money or the interest rate to stabili=e the economy
Module 18 1*"*-1*
had a shar9 fall is aggregate demand .a reduction in the @uantit y of goods and serices demanded at any gien 9rice leel 0 ; a conse@uence in decline in demand is a fall in 9rices of goods
in real GQP and 9rices are related ;1*"*-1* >S economy /as moing do/n its aggregate supply curve /hich sho/s the relationshi9 bet/een the economy’s aggregate 9rice leel .oerall 9rice leel of final goodsS economy moes do/n its short-run aggregate su99ly cure 1*"*- 1* sho/ed .70 relationshi9 in the short run bet/een the aggregate 9rice leel and the @uantity of aggregate out9ut su99lied .rise in the aggregate 9rice leel rise in the @uantity of aggregate out9ut su99lied0 fall in aggregate 9rice leel fall in the @uantity of aggregate out9ut su99lied 2hy is there a .70 relationshi9
Producers
consider if 9roducing a unit of out9ut is 9rofitable or not
Profit 9er unit of out9ut F Price 9er unit of out9ut - Production cost 9er unit of out9ut
PAGE # $$
So it de9ends on /hether the 9rice the 9roducer receies for a unit of out9ut is ; or ^ than the cost of 9roducing that unit of out9ut? costs 9roducers face are fi8ed 9er unit of out9ut and can’t be changed for some time largest source of infle8ible 9roduction cost is the /ages 9aid to /orkers? Wages refers to all forms of /orker com9ensation .including em9loyer -9aid health care
is characteri=ed by sticky wages ( nominal /ages that are slo/ to change during either high unem9loyment
understand that nominal terms gies rise to an u9/ard -slo9ing short -run aggregate su99ly cure ; 9rices are set differently in different kinds of markets you need to kno/ that 9rices ar eset different in different markets perfectly competitive markets, 9roducers take 9rices as gienD in imperfectly competitive markets, 9roducers hae some ability to choose the 9rices they charge? ;both kinds of markets has short-run 9ositie relationshi9 bet/een 9rices and out9ut .different reasons0 behaior
of 9roducers in per"ectly competitive markets take the 9rice as gien? ;imagine if the aggregate 9rice leel falls 9rice receied by the t y9ical 9roducer of a final good
aggregate 9rice leel rises 9roducer receies a higher 9rice for its final good or serice? .note many 9roduction costs are fi8ed in the short run0 9roduction cost 9er unit of out9ut doesn’t rise by the same 9ro9ortion as the rise in the 9rice of a unit and since a 9erfectly com9etitie 9roducer takes the 9rice as gien 9rofit 9er unit of out9ut rises and out9ut increases? im9erfectly com9etitie 9roducer that is able to set its o/n 9rice if a rise in the demand for this 9roducer’s 9roduct! it /ill be able to sell more at any gien 9rice .because of stronger demand0! it /ill 9robably choose to increase 9rices
in an industry’s 9ricing 9o/erBD demand F strong! firms /< 9ricing 9o/er are able to raise 9rices but if there is a fall in demand firms /ill try to limit the fall in their sales by cutting 9rices? oth res9onses of firms in 9erfectly
PAGE # $&
4he .70 relationshi9 bet/een the aggregate 9rice leel and aggregate out9ut in the short run gies the short -run aggregate su99ly cure its u9/ard slo9e? ; 4he moement do/n the !A " short -run aggregate supply curve) cure corres9onds to the deflation and fall in aggregate out9ut e89erienced oer those years? hi"ts o" the hort -7un *ggregate upply $urve
there can also be shifts of the short -run aggregate su99ly cure .:igure 1)?"0 Panel .a0 a decrease in short #run aggregate supply `a left/ard shift of the short -run aggregate su99ly cure? AS decreases /hen 9roducers reduce the @uantity of aggregate out9ut they are /ill ing to su99ly at any gien aggregate 9rice leel? Panel .b0 sho/s ` an increase in short #run aggregate supply `a right/ard shift of the short -run aggregate su99ly cure? Aggregate su99ly increases /hen 9roducers increase the @uantity of aggregate out9ut at any gien aggregate 9rice leel?
2hy can the short -run aggregate su99ly cure can shi ft 6ememberN 9roducers make out9ut decisions based on 9rofit 9er unit of out9ut? Short
-run aggregate su99ly cure sho/s the relationshi9 bet/een the aggregate 9rice leel and aggregate out9ut some 9roduction costs are fi8ed in the short run so a change in the aggregate 9rice leel leads to a change in 9roducers’ 9rofit 9er unit of out9ut thus a change in aggregate out9ut? ut other factors can affect 9rofit 9er unit and thus aggregate out9ut? 3f something increases 9roduction cost
shift
the left
PAGE # $'
3f something lo/ers 9roduction costs shift to the right Jist of 9ossible things that causes shift
3m9ortant factors that affect 9roducers’ 9rofit 9rofit 9er unit and shifts in the short -run aggregate su99ly cure $hanges in $ommodity !rices
A commodity, a standardi=ed in9ut bought and sold in bulk @uantities? An increase in the 9rice of a commodity raises 9roduction costs across the economy and reduced the @uantity of aggregate out9ut su99lied at any gien aggregate 9rice leel! shifting the short -run aggregate su99ly cure to the left? .a decline in commodity 9rices reduces reduces 9roduction costs! leading to an increase in the @uantity su99lied at any gien aggregate 9rice leel and a right/ard shift of the short -run aggregate su99ly cure?0 -; influence of commodity 9rices is not ca9tured by the short -run aggregate aggregate su99ly ecause commodities are not a final good! their 9rices are not included in the calculation of the aggregate 9rice leel? ;commodities re9resent a significant cost of 9roduction to most su99liers! ust like nominal /ages do? So changes in commodity 9rices hae large im9acts on 9roduction costs? $hanges in &ominal ages
;the dollar /ages of many /orkers are fi8ed because they are set by contracts or informal agreements made in the 9ast? +ominal /ages can change /< time? .ieif their is an rise in nominal /ages .because lets say health care 9remiums /ent u90 thus increases 9roduction costs shifts the short -run aggregate su99ly cure t o the left? ,onersely! a fall in nominal /ages .health care 9remiums lo/ers0 from the 9oint of ie/ of em9loyersD it reduces 9roduction costs and shifts the short -run aggregate su99ly cure to the right?0 note
in the 1*(%s! the surge in the 9rice of oil had the indirect effect of also raising nominal /ages? --; knock -onB effect occurred since many /age contracts included cost #of #living allowances that automatically raised the nominal /age /hen consumer 9rices increased?
PAGE # $(
;surge in the 9rice of oil --; led l ed to an increase in oerall consumer 9rices --; ultimately caused a rise in nominal /ages? Economy e89erienced t/o left/ard shifts of the aggregate su99ly cure first generated by the initial surge in the 9rice of oil the second generated by the induced increase in nominal /ages? $hanges in !roductivity increase in 9roductiity --; /orker can 9roduce more units of out9ut /ith the same @uantity of in9uts? ;a rise in 9roductiity! increases 9roducers’ 9rofits and shifts t he short -run aggregate su99ly su99l y cure to the right? .,onersely! a fall in 9roductiity reduces the number of unit s of out9ut a /orker can 9roduce /it h the same @uantity of in9uts? so the cost 9er unit of out9ut rises! 9rofit falls! and @uantity su99lied falls? 4his shifts the short -run aggregate su99ly cure t o the left?0
he #ong-7un *ggregate upply $urve /e_e
seen a fall in the aggregate 9rice leel leads to a decline in the @uantity of aggregate out9ut su99lied result of nominal /ages that are sticky in the short run? ; +4EN /ages are negotiated in long run but in long run! nominal /ages .like the aggregate 9rice leel0 are fle8ible ;2age ;2age fle8ibility changes the long -run relationshi9 bet/een the aggregate 9rice leel and aggregate su99ly in the long run the aggregate 9rice leel has no effect on the @uantity of aggregate out9ut su99lied? lets say /e cut all prices "of inputs like nominal wage$ in the economy in half at the same time! as /ell as the 9rices of final goods and serices? 3f aggregate 9rice leel has been haled and all in9ut 9rices! including nominal /ages haled! nothing /ould ha99en to aggregate out9ut ;ased this on the fact that each 9roducer /ould receie a lo/er 9rice for its 9roducts --; but costs /ould fall by the same 9ro9ortion? eery unit of out9ut 9rofitable to 9roduce before the change in 9rices /ould still be 9rofitable to 9roduce after the change in 9rices? so haling of all 9rices in the economy has no effect on the economy’s aggregate out9ut? S! changes in the aggregate price level now have no e""ect on the uantity o" aggregate output supplied in the long run, all 9rices are fully fle8ible so note that inflation or deflation has the same effect as someone changing all 9rices by the same 9ro9ortion? changes in the aggregate 9rice leel do not change the @uantity of aggregate out9ut su99lied in the long run%
PAGE # $)
4he long -run aggregate supply curveF illustrated in :igure 1)? by the cure &!A, sho/s the relationshi9 bet/een the aggregate 9rice leel and the @uantity of aggregate su99lied out9ut su99lied that /ould e8ist if all 9rices! including nominal /ages! /ere fully fle8ible? 4he long -run aggregate su99ly cure i s ertical since changes in the aggregate 9rice l eel hae no effect on aggregate out9ut in the long run? not only is the &!A cure ertical but also note its 9osition along the hori=ontal a8is marks an im9ortant im 9ortant benchmark for out9ut? 4he hori=ontal interce9t in :igure 1)?! /here &!A touches the hori=ontal a8is is the t he economy’s potential outputF '() the leel of real GQP the economy /oul d 9roduce if all 9rices .also nominal /ages0 /ere fully fle8ible? in reality actual leel of real GQP is almost al/ays either aboe or belo/ 9otential out9ut? ;note that economy’s economy’s 9otential out9ut hel9s defines the trend around around /hich actual aggregate out9ut out9ut fluctuates from year t o year?
ased on :igure 1)?$ see that economy normally 9roduces more or less than 9otenti al ut9ut
;, estimated annual 9otential out9ut for the 9ur9ose of federal budget analysis sho/ed 1*)*-"%%* by the black line and the actual alues of >?S? real GQP oer the same 9eriod are the blue line
PAGE # $*
;years shaded 9ur9le on hori=ontal a8is corres9ond to 9eriods in /hich the actual aggregate out9ut e8ceeded 9otential out9ut >?S 9otential out9ut has risen steadily oer time is a series of right/ard shifts hat causes shi"ts o" the LRAS curve increases
in the @uantity of resources! including land! labor! ca9ital! and entre9reneurshi9 increases in the @uality of resources! as /ith a better-educated /orkforce technological 9rogress oer
long run! as the si=e of the labor force and the 9roductiity of labor both rise! for e8am9le! the leel of real GQP that the economy is ca9able of 9roducing also rises? can
think of long -run economic gro/th as gro/th in the economy’s 9otential out9ut? generally think long -run aggregate su99ly cure as shifting to the right oer time as an economy e89eriences long -run gro/th?
5rom the hort 7un to the #ong 7un as you can see economy usually 9roduces more or less than 9otential out9ut ;economy is normally on its short -run aggregate su99ly cure but not usually on its long -run aggregate su99ly cure? understand
that the economy is al/ays in one of only t/o states /ith res9ect to the short -run and long
-run aggregate su99ly cures? ;economy can be on both cures simultaneously by being at a 9oint /here the cures cross .as in the fe/ years in :igure 1)?$ in /hich actual aggregate out9ut and 9otential out9ut roughly coincided0? ;it can also be on the short -run aggregate su99ly cure but not the long -run aggregate su99ly cure .as in the years in /hich actual aggregate out9ut and 9otential out9ut did not coincide0? +4EN 3f the economy is on the short -run but not the long -run aggregate su99ly cure! t he short -run aggregate su99ly cure /ill shift oer time until the economy is at a 9oint /here both cures cross ./here actual aggregate out9ut is F to 9otential out9ut?0
PAGE # &%
Aboe figure sho/s ho/ this /ork both 9anels &!A is the long -run aggregate su99ly cure! !A 1 is the initial short -run aggregate su99ly cure! and the aggregate 9rice leel is at ( 1? 3n 9anel .a0 the economy starts at the initial 9roduction 9oint . A10 /hich corres9onds to a @uantity of aggregate out9ut su99lied! .' 1!0 that is higher than 9otential out9ut! .'(%$ Producing an aggregate out9ut leel .such as ' 10 that is higher than 9otential out9ut .'( 0 is 9ossible only because nominal /ages haen’t yet fully adusted u9/ard? until
u9/ard adustment in nominal /ages occurs! 9roducers are earning high 9rofits and 9roducing a high leel of out9ut? a leel of aggregate out9ut higher than 9otential out9ut means a lo/ leel of unem9loyment? since obs are abundant and /orkers are scarce! nominal /ages /ill rise oer time! gradually shifting the short -run aggregate su99ly cure l eft/ard? Eentually! it /ill be in a ne/ 9osition! such as !A "? 3n 9anel .b0! the initial 9roduction 9oint! A1! corres9onds to an aggregate out9ut leel! ' 1! that is lo/er than 9otential out9ut! '(% Producing an aggregate out9ut leel .such as ' 10 that is lo/er than 9otential out9ut .'( 0 is 9ossible only because nominal /ages haen’t yet fully adusted do/n/ard? >ntil this do/n/ard adustment occurs! 9roducers are earning lo/ .or negatie0 9rofits and 9roducing a lo/ leel of out9ut? An aggregate out9ut leel lo/er than 9otential out9ut means high unem9loyment? ecause /orkers are abundant and obs are scarce! nominal /ages /ill fall oer time! shifting the short -run aggregate su99ly cure gradually to the right? Eentually! it /ill be in a ne/ 9osition! such as !A "?
Module 10 1*"*-1*
>S moed do/n short run aggregate su99ly as aggregate 9rice leel fell ;caused by a left/ard shift of the aggregate demand cure maor fall in consumer s9ending 1*(*-1*)% >S moed u9 aggregate demand cure as aggregate 9rice leel rose ;caused by left/ard shift of aggregate su99ly cure .fall in short run aggregate su99ly0 /e
must aggregate su99ly and aggregate demand cure together result is *,-* model basic model used to understand economic fluctuations
PAGE # &1
Short-run macroeconomic e@uilibrium look on ne8t 9age at AQ-AS model in short run the 9oint in /hich AQ and S6AS cures intersect! ES6 is the short-run macroeconomic euili%rium 9oint at /hich the @uantity of aggregate out9ut su99lied is F the @uantit y demanded by domestic household businesses
9rice leel at ES6 ! !E is the short-run euili%rium aggregate price level aggregate out9ut at ES6 ! e is the short-run aggregate output
leel
of
/e
kno/ shortage of any indiidual good causes its market 9rice t o rise and a sur9lus of the good causes its market 9rice to fall ensures market reaches e@uilibrium .a99lies to short-run macroeconomic e@uilibrium0 if aggregate 9rice leel is aboe e@uilibrium leel the @uantity of aggregate out9ut su99lied e8ceeds the @uantity of aggregate out9ut dem anded ./hich leads to a fall in the aggregate 9rice leel and 9ushed it to/ards e@uilibrium0 if aggregate 9rice leel is belo/ its e@uilibrium leel the @uantity of aggregate out9ut su99lied is less than the @uantity of aggregate out9ut demanded /hich leads to a rise in aggregate 9rice leel 9ushing it to/ards e@uilibrium
in
reality there is a long-term u9/ard trend in both aggregate out9ut and the aggregate 9rice leel assume that a fall in either ariable means a fall com9ared to the long-run trend .say if aggregate 9rice leel normally rises $H a year! a year in /hich aggregate 9rice leel rises only H is a 1H decline0 rare for decline many cases in /hich aggregate 9rice leel fell relatie to long-run trend ;short-run e@uilibrium aggregate out9ut and short-run e@uilibrium aggregate 9rice leel can change because of shifts of either the AQ cure or the S6AS cure hi"ts o" the *ggregate demandB hort-run E""ects an eent that shifts aggregate demand cure is kno/n as demand shock .such as changes in e89ectations or /ealth! effect of the si=e of e8isting stock of 9hysical ca9ital! or the use of fiscal
:igure 1*?" sho/s short-run effects of negatie<9ositie demand shock shifts the aggregate demand cure AQ to the left 9anel .a0L .from AQ1 to AQ"0 economy moes do/n S6AS from E1 to E" leading to lo/er short-run e@uilibrium aggregate out9ut and a lo/er run e@uilibrium aggregate 9rice leel
PAGE # &"
a
9ositie demand shock shift aggregate demand cure to the right 9anel .b0L economy moes u9 along the S6AS cure from E1 to E" leads to a higher short-run e@uilibrium aggregate out9ut and a higher short-run aggregate 9rice leel demand shocks cause aggregate output and aggregate price level to move in the same direction
Shifts of S6AS cure an eent that shifts the short-run aggregate su99ly cure .changes in commodity 9rices! nomi nal /ages! or 9roductiity0 is kno/n a su99ly shock ;negatie su99ly shock raises 9roduction costs
e@uilibrium at E1 /< aggregate 9rice leel P1 and aggregate out9ut I1 some kind of negatie su99ly shock causes the short-run aggregate su99ly cure to shift to the left from S6AS1 to S6AS" aggregate out9ut also falls and the aggregate 9rice leel rises an u9/ard moement along the AQ cure at ne/ e@uilibrium E" the short-run e@uilibrium aggregate 9rice leel P" is higher and the short- run aggregate out9ut leel I" is lo/er inflation
7 falling aggregate out9ut in 9anel .a0 F stagflation falling aggregate out9ut leads to rising em9loyment and 9eo9le feel their 9urchasing 9o/er decrease a
9ositie su99ly shock in 9anel .b0 has o99osite effect a right/ard shift of the S6AS cure from S6AS1 to S6AS" results in a rise in aggregate out9ut and a fall in the aggregate 9rice leel! a do/n/ard moement along the AQ cure aggregate 9rice leel fell com9ared /< long-run trend negatie
and 9ositie su99ly shock .unlike dem and shock0 cause aggregate 9rice leel and aggregate out9ut to moe in o99osite directions
PAGE # &
;able to shift AQ cure ia monetary
Jong-6un Macroeconomic E@uilibrium 1*?$ sho/s aggregate demand cure for both short-run and long-run aggregate su99ly cure aggregate demand cure! AQ crosses the short-run aggregate su99ly cure S6AS at EJ6 ;/e assume enough time as ela9se that the economy is also on the long-run aggregate su99ly cure J6AS so EJ6 is at the intersection of all three cures S6AS! J6AS! and AQ ;so short-run e@uilibrium aggregate out9ut F 9otential out9ut ;4he economy is in long-run macroeconomic e@uilibrium /hen the 9oint of short-run macroeconomic e@uilibrium is on the long-run aggregate su99ly one
----
PAGE # &$
to
see im9ortance of long-run macroeconomic e@uilibrium consider /hat ha99ens /< demand shock moes the economy a/ay from long-run macroeconomic e@uilibrium ;figure 1*?& assume that initial aggregate demand cure is AQ1 and initial short-run aggregate su99ly cure is S6AS1 so initial macroeconomic e@uilibrium is at E1 /hich lies on the long-run aggregate su99ly cure J6AS the economy starts from a 9oint of short-run and long-run macroeconomic e@uilibrium! and short-run e@uilibrium aggregate out9ut F 9otential out9ut I1 su99ose is aggregate demand falls and the aggregate demand cure shifts left/ards to AQ" results in a lo/er e@uilibrium aggregate 9rice leel at P" and a lo/er e@uilibrium out9ut leel at I" as economy settles in short run at E" >?S economy 1*"*-1* the short-run effect of such a fall in aggregate demand is a falling aggregate 9rice leel and falling aggregate out9ut
;aggregate out9ut in this ne/ short-run e@uilibrium E" is belo/ 9otential out9ut /hen this ha99ens economy faces a recessionary ga9 comes /< high unem9loyment in face of high unem9loyment! nominal /ages fall .as do any stick 9rices0 leading 9roducers to increase out9ut as a result recessionary ga9 causes short-run aggregate su99ly cure to shift to the right 9rocess continues until S6AS1 reaches ne/ 9osition at S6AS" bringing economy to e@uilibrium E /hen AQ"! S6AS"! and J6AS all intersect ;at E economy is back in long-run macroeconomic e@uilibrium it is back at 9otential I1 but at a lo/er aggregate 9rice leel P sho/ing a long-run fall in aggregate 9rice leel ;economy is self-correcting in the long run
PAGE # &&
imagine
increase in aggregate demand in 1*?' /e assume that initial aggregate demand cure is AQ1 and initial short-run aggregate su99ly cure is S6AS1 so that initial macroeconomic e@uilibrium at E1 lies on the long-run aggregate su99ly cure J6AS initially economy is in long-run macroeconomic e@uilibrium su99ose
aggregate demand rises AQ cure shift right/ard to AQ" thus higher 9rice leel P" and a higher aggregate out9ut leel at I" economy settles in the short run at E" ;aggregate out9ut in this ne/ short-run e@uilibrium is aboe 9otential out9ut and unem9loyment is lo/ in order to 9roduce this higher leel of aggregate out9ut economy is e89eriencing an inflationary ga9 ;in the fact of lo/ unem9loyment! nominal /ages /ill rise and .as /ill other sticky 9rices0 causes the short-run aggregate su99ly cure to shift gradually to the left as 9roducers reduce out9ut in face of rising nominal /age continues until S6AS reaches ne/ 9osition at S6AS" bringing economy into e@uilibrium E /here AQ"! S6AS"! and J6AS all intersect at E economy is back in long-run macroeconomic e@uilibrium
summari=e ho/ economy res9onds to recessionary
< Potential out9ut
H
O 1%%
analysis sho/s that out9ut ga9 tends to/ard =ero
if there is a recessionary ga9! so out9ut ga9 is negatie! nominal /ages eentually fall moing economy back to 9otential out9ut and bringing the out9ut ga9 back to =ero if there is an inflationary ga9! so out9ut ga9 is 9ositie! nominal /ages rise moing economy back to 9otential out9ut and again bringing the out9ut ga9 back to =ero
S in long run economy is self-correcting shocks to aggregate demand affect aggregate out9ut in the
PAGE # &'
S64 6>+ but +4 4E J+G 6>+N
Module 2' /e’e
seen economy is self-correcting in l ong-run /ill eentually trend back to 9otential out9ut but most macroeconomist beliee this takes a long time ;if aggregate out9ut is belo/ 9otential out9ut! the economy can suffer an e8tended 9eriod of de9ressed aggregate out9ut and high unem9loyment before it returns to normal foundation
is based on Vohn Maynard Keynes recommend that goernments not /ait for economy to correct itself and goernment should use fiscal 9olicy to get the economy back to 9otential out9ut in the aftermath of a shift in aggregate demand cure rationale for actie stabili=ation 9olicy /hich is the use of goernment 9olicy to reduce the seerity of recessions and rein in e8cessiely strong e89ansions effectie de9ending on ty9e of shock Policy in the :ace of Qemand Shocks if
the economy is in negatie demand shock .as seen in 1*?& /here AQ1 moed to AQ"0 Monetary and fiscal 9olicy shift the aggregate demand cure if
9olicy makers react @uickly to fall in aggregate demand they can use monetary or fiscal 9olicy to shift the aggregate demand cure back to the right ;if 9olicy /ere able to 9erfectly antici9ate shifts of the aggregate demand cure and counteract t hem it could short-circuit the /hole 9rocess .sho/n in 1*?&0 instead of going through a 9eriod of lo/ aggregate out9ut and falling 9rices goernment could manage the economy so it /ould stay on E1 9olicy
that short-circuit’s the adustment sho/n in 1*& is desirable because .10 the tem9orary fall in aggregate out9ut that /ould ha99en /ithout 9olicy interention is a bad thing since such a decline is associated /< high unem9loyment ."0 9rice stability is a desirable goal 9reenting deflation .fall of aggregate 9rice leel0 F good 9olicy
makers should al/ays act to offset declines in aggregate demand some 9olicy measures to increase aggregate demand .es9ecially those that increase budget deficient0 may hae long-term costs in terms of lo/er long-run gro/th in the real /orld 9olicy makers aren’t 9erfectly informed and effects of their 9olicy aren’t 9erfectly 9redictable created the danger that stabili=ation 9olicy /ill do more harm than good 9olicy makers should also try to offset 9ositie shocks of aggregate demand most economist beliee any short-run gains from an inflationary ga9 must be 9aid back later so 9olicy makers try to offset 9ositie as /ell as negatie demand shock these usually rely on M+E4A6I 9olicy 6es9onding to Qemand Shocks in 9anel .a0 1*? /e sa/ the effect of a negatie su99l y shock short run such a shock leads to lo/er aggregate out9ut but higher aggregate 9rice leel 9olicy makers can res9ond to negatie demand shock by using monetary
the case S>PPJI shock there are no goernment 9olicies to counteract the changes in 9roduction costs that shift the short-run aggregate su99ly cure
PAGE # &(
9olicy
res9onse to a negatie su99ly shock cannot aim to sim9ly 9ush the cure that shifted back to its original 9osition if
you consider using monetary
any
9olicy that shifts the aggregate demand cure hel9s one 9roblem /hile making the other one /orse if goernment acts to increase aggregate demand and limit the rise in unem9loyment it reduces the decline in out9ut but causes more inflation if it acts to reduce aggregate demand it curbs inflation but causes more unem9loyment .1*(%’s /e chose to stabili=e 9rices farther lo/er the high unem9loyment0 :iscal Policy 4he basics changes
in the federal budget changes in a goernment s9ending
circular flo/ of income and s9ending in the economy as a /hole one of the sectors re9resented in that figure /as goernment funds flo/ into the goernment in form of ta8es
are re@uired 9ayments to the goernment in >?S ta8es are collected at the federal and state leel .and local leels by counties! cities! and to/ns0 at
the federal leel the main ta8es are income ta8es on both 9ersonal income?S goernment s9ending takes t/o forms one is 9urchases of goods?S transfer 9ayments are accounted by three big 9rograms 10 Social security guaranteed income to older Americans! disabled Americans! and the suriing s9ouses
social insurance is used to describe goernment 9rograms that are intended to 9rotect families against economic hardshi9 .includes social security
GQP F , 7 3 7 G 7 O - 3M
GQP
F alue of all final goods
sum
of
PAGE # &)
consumer s9ending .,0! inestment s9ending .30! goernment 9urchases of goods
directly controls goernment 9urchases of goods and serices .G0 through changes in ta8es and transfers goernment also influences consumer s9ending .,0 and inestment s9ending .30 dis9osable
income is the total income households hae to s9end F to total income they receie from /ages! diidend! interest! and rent M3+>ES ta8es PJ>S goernment transfers so an increase in ta8es or a decrease in goernment transfers reduces dis9osable income a fall in dis9osable income leads to a fall in consumer s9ending .the conerse is true so either a decrease in ta8es
note
that goernment ta8es 9rofits and changes in the rules determine ho/ much a business o/es can increase
goernment itself is a source of s9ending in the economy and ta8es
/ants to shift the aggregate demand cure because it /ants to close either a recessionary ga9 created /hen aggregate out9ut falls belo/ 9otential out9ut or an inflationary ga9 created /hen aggregate out9ut e8ceeds 9otential out9ut figure
"%?$ belo/ sho/s an economy facing a recessionary ga9 S6AS is the short run aggregate su99ly cure and J6AS is the long-run aggregate su99ly cure and AQ1 is the initial aggregate demand cure at the initial short-run macroeconomic e@uilibrium E1! aggregate out9ut I1 is belo/ 9otential out9ut I9 goernment /ants to increase aggregate demand shifting the aggregate demand cure right/ard to AQ" this /ould increase aggregate out9ut making it F to I9 fiscal 9olicy that increases aggregate demand is called e89ansionary fiscal 9olicy and t a8es three forms .10 an increase in goernment 9urchases of goods
PAGE # &*
A ,autionary +ote Jags in :iscal Policy after
seeing "%?$<"%?& it may seem obious that goernment should actiely use fiscal 9olicy but many economist caution against an e8tremely actie stabili=ation 9olicy arguing that a goernment that tries too hard to stabili=e the economy can make it een less stable in
case of fiscal 9olicy one key reason for caution are im9ortant time lags in its use ;think about /hat has to ha99en before the goernment increases s9ending to fight a recessionary ga9 the goernment has to reali=e that the recessionary ga9 e8ists economic data takes time to collect
of these lags an attem9t to increase s9ending to fight a recessionary ga9 may take long to get
PAGE # '%
going that the economy has already recoered on its o/n in fact a recessionary ga9 may hae turned into an inflationary ga9 by the time fiscal 9olicy has been taken into effect .so fiscal 9olicy can make t hings /orse
Module 21 9sing the Multiplier to Estimate the +n"luence o"
goernment s9ends T&% billion building bridges and roads goernment’s 9urchases /ill directly increase total s9ending on final goods and serices by T&% billion --; indirect effect is that goernment’s 9urchases /ill start a chain reaction throughout the economy? ;4he firms 9roducing the goods and serices 9urchased by the goernment /ill earn reenues --; flo/ to households./ages<9rofit
Assume
that the aggregate 9rice leel is fi8ed! so that any increase in nominal GQP is also a rise in real GQP! and that the interest rate is fi8ed? 3n that case! the multi9lier is 1<.1 - *(C 0 . *(C is the marginal propensity to consume, the fraction of an additional dollar in dis9osable income that is s9ent?0 ;if MP, F %?&! the multi9lier is 1<.1 - %?&0 F 1<%?& F "? if multi9lier of "! a T&% billion increase in goernment 9urchases of goods and serices /ould increase real GQP by T1%% billi on? f that T1%% billion! T&% billion is the initial effect from the increase in +, and the remaining T&% billion is the subse@uent effect of more 9roduction leading to more income /hich leads to more consumer s9ending --; leads to more 9roduction! and so on? if
goernment 9urchases of goods and serices are instead reduced same m ath but use a minus sign .so real GQP falls by T1%% billion?0 4his is the result of less 9roduction leading to less income! /hi ch leads to less consum9tion --; leads to less 9roduction! and so on?
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Multiplier E""ects o" $hanges in
or ,ontractionary fiscal 9olicy doesn’t hae to be goernment 9urchases of goods and serices? ;Goernments can also change transfer 9ayments or ta8es? --; change in goernment transfers or ta8es shifts the aggregate demand cure by less than an e@ual -si=ed change in goernment 9urchases! resulting in a smaller effect on real GQP? instead of s9ending T&% billion on building bridges imagine if goernment sim9ly hands out T&% billion in the form of goernment transfers?.no direct effect on aggregate demand as /< goernment 9urchases0 ;6eal GQP and income gro/ only because households s9end some of that T&% billion .but not all0 they /ill s9end according to MP, .if MP, F %?& households s9end only &% cents of eery additional dollar they receie in transfers?0 4able "1?1 sho/s a hy9othetical com9arison of t/o e89ansionary fiscal 9olicies assuming an *(C F %?& and multi9lier F " each
case! there is a first -round effect on real GQP! either from 9urchases by the goernment or from 9urchases by the consumers /ho receied the checks! follo/ed by a series of additional rounds as rising real GQP raises income .all of /hich is dis9osable under our assum9tion of no ta8es0! /hi ch raises consum9tion? first -round effect of the transfer 9rogram is smallerD because /e hae assumed that the *(C is %?&! only T"& billion of the T&% billion is s9ent! /ith the other T"& billion saed? And as a result! all the further rounds are smaller! too? At end transfer 9ayment increases real GQP by only T&% billion? 3n com9arison! a T&% billion increase in goernment 9urchases 9roduces a T1%% billion increase in real GQP? if
e89ansionary fiscal 9olicy takes t he form of a rise in transfer 9ayments! real GQP may rise by either more or less than the initial goernment outlay .if multi9lier may be either more or less than 10 3n 4able "1?1! a T&% billion rise in transfer 9ayments increases real GQP by T&% billion! so that the multi9lier is e8actly 1? 3f a smaller share of the initial transfer had been s9ent! the multi9lier on that transfer /ould hae been less than 1? 3f a larger share of the initial transfer had been s9ent! the multi9l ier /ould hae been more than 1? A ta8 cut has an effect similar to the effect of a transfer? .increases dis9osable income! series of increases in consumer s9ending0 oerall
effect is smaller than that of an e@ual -si=ed increase in goernment 9urchases of goods and serices the autonomous increase in aggregate s9ending is small er because households sae 9art of the amount of the ta8 cut ;4hey sae a fraction of the ta8 cut e@ual to their *( .or 1 - *(C 0? ta8es
change the si=e of the multi9lier --; in real /orld goernments rarely im9ose lump-sum taes (in /hich the amount of ta8 a household o/es is inde9endent of its income?0 ;ta8es generally de9end 9ositiely on the leel of real GQP ta8es
that de9end 9ositiely on real GQP reduce the si=e of the multi9li er? ;economist argue /ho should get ta8 cuts
PAGE # '"
/ho o/n a lot of stocks because the latter tend to be /ealthier and tend to sae more of any increase in dis9osable income? ;if true dollar s9ent on unem9loyment benefits increases aggregate demand more than a dollar ’s /orth of diidend ta8 cuts? ;ow aes *""ect the Multiplier goernment
ta8es ca9ture some 9art of the increase in real GQP that occurs in each round of t he multi9lier 9rocess .since most de9end 9ositiel y on real GQP?0 so dis9osable income increases by considerably less than T1 once /e include ta8es in the model? increase
in goernment ta8 reenue /hen real GQP rises is a conse@uence of the /ay the ta8 la/s are /ritten --; causes sources of goernment reenue to increase automatically /hen real GQP goes u9? ;i?e?! income ta8 recei9ts increase /hen real GQP rises because the amount each indiidual o/es in ta8es de9ends 9ositiely on his or her income! and households’ ta8able income rises /hen real GQP rises? ;Sales ta8 recei9ts increase /hen real GQP rises since 9eo9le /i th more income s9end more on goods
in ta8 reenue reduces the aderse effect of the init ial fall in aggregate demand? 4he automati c decrease in goernment ta8 reenue generated by a fall in real GQP`caused by a decrease in the amount of ta8es households 9ay`acts like an automatic e89ansionary fiscal 9olicy im9lemented in the face of a recession? ;Similarly! /hen the economy e89ands! the goernment finds itself automaticall y 9ursuing a ,ontractionary fiscal 9olicy`a ta8 increase? Goernment s9ending and ta8ation rules that cause fiscal 9olicy to be automatically e89ansionary /hen the economy contracts and automatically ,ontractionary /hen the economy e89ands! /ithout re@uiring any deliberate action by 9olicy makers! are called automatic sta%ili3ers 4he rules that goern ta8 collection aren’t the only automatic stabili=ers! although they are the most im9ortant ones? ;Some goernment transfers also 9lay a stabili=ing role .i?e? more 9eo9le receie unem9loyment insurance /hen the economy is de9ressed than /hen it is booming? 4he same is true of Medicaid and food stam9s?0 --; So transfer 9ayments tend to rise /hen the econom y is contracting and fall /hen the economy is e89anding? ;Jike changes in ta8 reenue! these automatic changes in transfers tend to reduce the si=e of the multi9lier
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because the total change in dis9osable income that results from a gien rise or fall in real GQP is smaller?
good
thing that goernment transfers reduce the multi9lier? ;E89ansionary and ,ontractionary fiscal 9olicies that are t he result of automatic stabili=ers are /idel y considered hel9ful to macroeconomic stabili=ation! because they blunt the e8tremes of the business cycle? is fiscal 9olicy that is the direct result of deliberate actions by 9olicy makers rather than automatic adustment? .i?e? during a recession! the goernment may 9ass legislation that cuts ta8es and increases goernment s9ending in order to stim ulate the economy? economists tend to su99ort the use of discretionary fiscal 9olicy only in s9ecial circumstances! such as an es9ecially seere recession0 ,iscretionary "iscal policy
Module 22 Matching 9p avings and +nvestment pending ."0 needed sources of economic gro/th are .10 increases in the skills and kno/ledge of the /orkforce . human capital$ ."0 increases in ca9ital`goods used to make other goods . physical capital$% uman
ca9ital ia goernment through 9ublic education? .9riate 9ost-secondary education is also an im9ortant source of human ca9ital?0 9hysical ca9ital! /ith the e8ce9tion of infrastructure such as roads and bridges! is mainly created through 9riate inestment s9ending .s9ending by firms rather than by the goernment0 in
modern economy indiiduals and firms /ho create 9hysical ca9ital often do it /ith other 9eo9le’s money .T they borro/
he avingsH +nvestment pending +dentity asic foundation saings F inestment s9ending is that it is a "actF account %yB savingsHinvestment spending identity (savings and investment spending are always D "or the economy as a whole) imagine
a highly sim9lified economy in /hich there is no goernment and no interaction /ith other countries? So oerall income of this sim9lified economy /ould F total s9ending in the economy? the only /ay 9eo9le could earn income /ould be by selling something to someone else and eery dollar s9ent in the economy /ould create income for somebody? So in this sim9lified economy! otal income D otal spending Peo9le can s9end it on consum9tion or sae it So it must be true that otal income D $onsumer spending G avings
PAGE # '$
6ememberN S9ending consists of either consumer s9ending or inestment s9ending otal spending D $onsumer spending G +nvestment spending Putting these together! /e get $onsumer spending G avings D $onsumer spending GI +nvestment spending Subtract consumer s9ending from both sides! and /e get
avings D +nvestment spending So
basic accounting fact that saings F inestment s9ending for the economy as a /hole? sim9lified economy though . /< no goernment and no economic interaction /ith the rest of the /orld?0 /< realistic com9lications back into the story changes things in ."0 /ays? .10 households are not the only 9arties that can sae in an economy .goernment can sae! too! if it collects more ta8 reenue than it s9ends? the difference is called a %udget ? 3f goernment s9ending e8ceeds ta8 reenue! there is a %udget de"icit `a negatie budget sur9lus? goernment isdissaingB by s9ending more than its ta8 reenues0 %udget
%alance can refer to both cases! .a budget deficit0?
budget
balance can be 9ositie .a budget sur9lus0 or negatie
&ational savings is F 9riate saings 7 budget balance ; 9riate saings F dis9osable income .income after ta8es0 minus consum9tion? ."0 one country is 9art of a /ider /orld economy saings doesn’t need to be s9ent on 9hysical ca9ital located in the same country in /hich the saings are generated? saings of 9eo9le /ho lie in any one country can be used to finance inestment s9ending that takes 9lace in other countries? any
gien country can receie inflows of funds .foreign saings that finance inestment s9ending in the country0 Any
gien country can also generate outflows of funds .domestic saings that finance inestment s9ending in another country?0
$apital in"low into a country is the net effect of international inflo/s and outflo/s of funds on the total saings aailable for inestment s9ending in any gien country ;e@ual to the total inflo/ of foreign funds minus the total outflo/ of domestic funds to other countries0
;ca9ital inflo/ can be negatie .more ca9ital can flo/ out of a country than flo/s into it0 from
a national 9ers9ectie! a dollar generated by national saings and a dollar generated by ca9ital inflo/ are not e@uialent? both
finance the same dollar’s /orth of inestment s9ending! but any dollar borro/ed from a saer must eentually be re9aid /ith interest? dollar
from national saings is re9aid /ith interest to someone domestically .a 9riate 9arty or the goernment?0
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dollar
that comes as ca9ital inflo/ must be re9aid /ith interest to a foreigner? dollar of inestment s9ending financed by a ca9ital inflo/ comes at a higher national cost .the interest that must eentually be 9aid to a foreigner than a dollar of inestment s9ending financed by national saings?0
a99lication
of the saingsUinestment s9ending identity to an economy that is o9en to inflo/s or outflo/s of ca9ital means that inestment s9ending is e@ual to saings! /here saings is e@ual to national saings plus ca9ital inflo/? 4 ;in an economy /< 9ositie ca9ital inflo/! some inestment s9ending is funded by the saings of foreigners? in an economy /< negatie ca9ital inflo/ .a net outflo/0! some 9ortion of national saings is funding inestment s9ending in other countries?
he 5inancial ystem :inancial
markets are /here households inest t heir current saings and their wealth ( accumulated Saings0 by 9urchasing financial assets% "inancial asset is a 9a9er claim that entitles the buyer to future income from the seller? A household can also inest its current saings or /ealth by 9urchasing a physical assetF a claim on a tangible obect! 0 such as a 9ree8isting house or 9ree8isting 9iece of e@ui9ment?0 gies the o/ner the right to dis9ose of the obect as he or she /ishes .for e8am9le! rent it or sell it0? if
you do to a bank to get a loan! the bank /ould be creating a financial asset your loan? is one im9ortant kind of financial asset in the real /orld! one that is o/ned by the lender
A loan
increating
that loan! you and the bank /ould also be creating a lia%ility ; a re@uirement to 9ay money in the future? your
loan is a financial asset from the bank’s 9oint of ie/ is a liability from your 9oint of ie/ a re@uirement that you re9ay the loan! including any interest? 3n
addition to loans! there are .0 other im9ortant kinds of financial assets stocks! bonds! and ank deposits% since
financial asset is a claim to future income that someone has to 9ay! it is also someone else’s liability? 4hese
four ty9es of financial assets e8ist because the economy has deelo9ed a set of 99eciali=ed markets! like the stock market and the bond market! and s9eciali=ed institutions! like banks! that facilitate the flo/ of funds from lenders to borro/ers? ;A /ell - functioning financial system is a critical ingredient in achieing l ong -run gro/th because it encourages greater saings and inestment s9ending? ensures that saings and inestment s9ending are undertaken efficiently?
hree asks o" a 5inancial ystem .0
im9ortant 9roblems facing borro/ers and lenders transaction costs! risk! and the desire for li-uidity%
PAGE # ''
;4he three tasks of a financial system are to reduce these 9roblems in a cost -effectie /ay? enhances the efficiency of financial markets and makes it more likely that lenders and borro/ers /ill make mutually beneficial trades that make society as a /hole richer?
7educing ransaction $osts ransaction costs are the e89enses of actually 9utting together and e8ecuting a deal? arranging a loan re@uires s9ending time and money negotiating the terms of the deal! erifying the borro/er’s ability to 9ay! dra/ing u9 and e8ecuting legal documents ect? /hen
large businesses /ant to borro/ mone y! they either get a loan from a bank or sell bonds in the bond market? loan from a bank aoids large transaction costs because it inoles only a single borro/er and a single lender? 9rinci9al reason there is a bond market is that it allo/s com9anies to borro/ large sums of money /ithout incurring large transaction costs?
7educing 7isk "inancial riskF uncertainty about future outcomes that inole financial losses or gains? ;:inancial risk is a 9roblem if future is uncertainD it holds the 9otential for losses as /ell as gains?
A
/ell -functioning financial system hel9s 9eo9le reduce their e89osure to risk? most 9eo9le are riskaerse Su99ose the o/ner of a business e89ects to make a greater 9rofit if she buys additional ca9ital e@ui9ment but isn’t com9letely sure of this result? could 9ay for the e@ui9ment by using her saings or selling her house? ut if the 9rofit is significantly less than e89ected! she /ill hae lost her saings! or her house .or both0? /ould be e89osing herself to a lot of risk due to uncertainty about ho/ /ell or 9oorly the business 9erforms? being risk -aerse! this business o/ner /ants to share the risk of 9urchasing ne/ ca9ital e@ui9ment /ith someone! een if that re@uires sharing some of the 9rofit if all goes /ell? can do this by selling shares of her com9any to other 9eo9le and using the money she receies from selling shares! rather than money from the sale of her other assets! to finance the e@ui9ment 9urchase? y
selling shares in her com9any! she reduces her 9ersonal losses if the 9rofit is less than e89ected she /on’t hae lost her other assets? if things go /ell! the shareholders earn a share of the 9rofit as a return on their inestment? by selling share of her business! the o/ner has achieed diversification ;she has been able to inest in seeral things in a /ay that lo/ers her total risk? She has maintained her inestment in her bank account! a financial assetD in o/nershi9 of her house! a 9hysical assetD and in o/nershi9 of the unsold 9ortion of her business! also a 9hysical asset? by
using diversi"ication `inesting in seeral assets /ith unrelated! or inde9endent! risk the business o/ner has lo/ered her total risk of loss? 4he
desire of indiiduals to reduce their total risk by engaging in diersification is /hy /e hae stocks and a stock market?
!roviding #iuidity
PAGE # '(
third and final task of the financial system is to 9roide inestors /ith li-uidity, /hich .like risk0 becomes releant because the future is uncertain? An
asset is liuid if it can be @uickly conerted into cash /ithout much loss of alue! illiuid if it cannot? anks
9roide a further /ay for indiiduals to hold li@uid assets and still finance illi@uid inestments? to hel9 lenders and borro/ers make mutually beneficial deals the economy needs /ays to reduce transaction costs! to reduce and manage risk through diersification! and to 9roide li@uidit y?
ypes o" 5inancial *ssets four main ty9es of financial assets loans, bonds! stocks! and ank deposits% financial innoation has allo/ed the creation of a /ide range of loan#acked securities%
#oans #oan is a lending agreement bet/een an indiidual lender and an indiidual borro/er? loan is usually tailored to the needs of the borro/erD loan also must meet the borro/er’s needs and ability to re9ay? ;bad as9ect of loans is that making a loan to an indiidual 9erson or a business ty9ically inoles a lot of transaction costs .cost of negotiating the terms of the loan! inestigating the borro/er’s credit history and ability to re9ay! ect0 4o minimi=e these costs! large borro/ers such as maor cor9orations and goernments often sell
6onds bond
is an 3> issued by the borro/er? seller of the bond 9romises to 9ay a fi8ed sum of interest each year and to re9ay the 9rinci9al .alue stated on the face of the bond0 to the o/ner of the bond on a 9articular date?0 bond is a financial asset from its o/ner’s 9oint of ie/ and a liability from its issuer’s 9oint of ie/? A
bond issuer sells a number of bonds /ith a gien interest rate and maturit y date to /hoeer is /illing to buy them! a 9rocess that aoids costly negotiation of the terms of a loan /ith many indiidual lenders? ond 9urchasers can ac@uire information free of charge on the @ualit y of the bond issuer! such as the bond issuer’s credit history! from ond # rating agencies rather than haing to incur the e89ense of inestigating it themseles? the risk that the bond issuer might fail to make concern for inestors is the 9ossibility of de"ault 9ayments as s9ecified by the bond contract? ;nce a bond’s risk of default has been rated! it can be sold on the bond market as a more or less standardi=ed 9roduct .9roduct /ith clearly defined terms and @uality?0 bonds /ith a higher default risk must 9ay a higher interest rate to attract inestors? ;bonds is that they are easy to resell? 9roides li@uidity to bond 9urchasers? .Joans! in contrast! are much more difficult to resell because! unli ke bonds! they are not standardi=ed they differ in si=e! @uality! terms! and so on? making them less li@uid0
#oan-%acked ecurities #oan-%acked securities are assets created by 9ooling indiidual loans and selling shares in that 9ool .a 9rocess called securiti.ation0
PAGE # ')
2hile
mortgage-backed securities! in /hich thousands of indiidual home mortgages are 9ooled and shares sold to inestors! securiti=ation has also been /idely a99lied to student loans! credit card loans! and auto loans? loan-backed securities trade on financial markets like bonds and are 9referred by inestors because they 9roide m ore diersification and li@uidity than indiidual loans? /ith
so many loans 9ackaged together! it can be difficult to assess the true @ualit y of the asset? 4hat difficulty came to haunt inestors
tocks stock
is a share in the o/nershi9 of a com9any? ;A share of stock is a financial asset from its o/ner’s 9oint of ie/ and a liabili ty from the com9any’s 9oint of ie/? +ot
all com9anies sell shares of their stockD 9riately heldB com9anies are o/ned by an indiidual or a fe/ 9artners! /ho get to kee9 all of the com9any’s 9rofit? /hy
don’t rich 9eo9le kee9 com9lete o/nershi9 for themseles and ust sell bonds for their inestment s9ending bcause fe/ indiiduals are risk -tolerant enough to face the risk inoled in being the sole o/ner of a large com9any? e8istence
of stocks also im9roes the /elfare of inestors /ho buy stocks .that is! shareo/ners! or shareholders0? Shareo/ners are able to enoy the higher returns oer tim e that stocks generally offer in com9arison to bonds? do/nside
o/ning the stock of a gien com9any is riskier than o/ning a bond issued by the same com9any? a bond is a 9romise /hile a stock is a ho9e by la/! a com9any must 9ay /hat it o/es its lenders .bondholders0 before it distributes any 9rofit to its shareholders? And if the com9any should fail .that is! be unable to 9ay its interest obligations and declare bankru9tcy0! its 9hysical and financial assets go to its bondholders`its lenders`/hile its shareholders ty9ically receie nothing?
stock
is a higher return but /< higher risk
5inancial +ntermediaries "inancial intermediary is an institution that transforms funds gathered from many indiiduals into financial assets?
4he
most im9ortant ty9es of financial intermediaries are mutual funds, pension funds, life insurance companies, and anks% A ;about <$th of the financial assets Americans o/n are held through these intermediaries rather than directly?
PAGE # '*
Mutual 5unds o/ning shares of a com9any entails risk in return for a higher 9otential re/ard? ;stock inestorscan lo/er their total risk by engaging in diersification? y o/ning a diversified portfolio of stocks .grou9 of stocks in /hich risks are unrelated to! or offset! one another rather than concentrating inestment in t he shares of a single com9any or a grou9 of related com9anies0 inestors can reduce their risk? financial
adisers! a/are adise their clients to diersify not only their stock 9ortfolio but also their entire /ealth by holding other assets in addition to stock`assets such as bonds! real estate! and cash .7 inserance0 indiiduals /ho don’t hae a large amount of money to inest building a diersified stock 9ortfolio can incur high transaction costs because they are bu ying a fe/ shares of a lot of com9anies? mutual funds hel9 sole the 9roblem of achieing diersification /ithout high transaction costs?
A mutual
"und is a financial intermediary that creates a stock 9ortfolio by buying and holding shares in com9anies and then selling shares of the stock portfolio to indiidual inestors? ;inestors /ith a relatiely small amount of money to inest can indirectly hold a diersified 9ortfolio! achieing a better return for any gien leel of risk than they could other/ise achiee? mutual
funds do charge fees for their serices? .fees are @uite small for mutual funds that sim9ly hold a diersified 9ortfolio of stocks! /ithout trying to 9ick /inners0 ? fees charged by mutual funds that claim to hae s9ecial e89ertise in inesting your money can be high?
!ension 5unds and #i"e +nsurance $ompanies pension "undsF non9rofit institutions that collect the saings of their members and inest those funds in a /ide ariety of assets! 9roiding their members /ith income /hen they retire?
9ension funds are subect to s9ecial rules
Americans
also hae substantial holdings in the 9olicies of li"e insurance companiesF /hich guarantee a 9ayment to the 9olicyholder’s beneficiaries .ty9ically! the family0 /hen the 9olicyholder dies? by leeting 9olicyholders to cushion their beneficiaries from financial hardshi9 arising from their death! li fe insurance com9anies also im9roe /elfare by reducing risk?
6anks 9roblem of li@uidity 9eo9le /ant assets that can be readily conerted into cash? onds and stocks are much more li@uid than 9hysical assets or loans! .but high transaction costs0
for many small
PAGE # (%
ank is an institution that hel9s resole the conflict bet/een lenders’needs for li@uidity and the financing needs of borro/ers /ho don’t /ant to use the stock or bond markets?
A bank /orks by first acce9ting funds from depositors) " /hen you 9ut your money in a bank! you are becoming a lender by lending the bank your money? you receie credit for a %ank deposit .a claim on the bank! /hich is obliged to gie you your cash if and /hen you demand it?0 So a bank de9osit is a financial asset o/ned by the de9ositor and a liability of the bank that holds it? A
bank kee9s only a fraction of its customers’ de9osits in the form of ready cash? ;Most of its de9osits are lent out to businesses
a bank enables those /ho /ish to borro/ for long lengths of time to use the funds of those /ho /ish to lend but simultaneously /ant to maintain the ability to get their cash back on demand? ;%ank is a financial intermediary that 9roides li@uid financial assets in the form of de9osits to lenders and uses their funds to finance the illi@uid inestment s9ending needs of borro/ers?
; bank lends for long 9eriods of time but also subect to the condition that its de9ositors could demand their funds back at any time? bank counts on the fact that on aerage only a small fraction of its de9ositors /ill /ant their cash at the same time? some 9eo9le /ill make /ithdra/als and others /ill make ne/ de9osits roughly cancel each other out? bank needs to kee9 only a limited amount of cash on hand to satisfy its de9ositors? ; if a bank becomes financially inca9able of 9aying its de9ositors! indii dual bank de9osits are currently guaranteed to de9ositors u9 to T"&%!%%% by the :ederal Qe9osit 3nsurance ,or9oration! or :Q3,! a federal agency? reduces the risk to a de9ositor of holding a bank de9osit! in turn reducing the incentie to /ithdra/ funds if concerns about the financial state of the bank should arise
banks
need hold only a fraction of their de9ositors’ cash? y reconciling the needs of saers for li@uid assets /ith the needs of borro/ers for long -term financing! banks 9lay a key economic role?
Module 2. he Meaning o" Money money is used to mean /ealth?B ;economist’s definition of money doesn’t include all forms of /ealth? dollar bills in your /allet are moneyD other forms of /ealth`such as cars! houses! and stock certificates`aren’t money?
hat +s Money@
money is any asset that can easily be used to 9urchase goods and serices?
PAGE # (1
before
/e defined an asset as li-uid if it can easily be conerted into cash? ;Money consists of cash itself ./hich is li@uid by definition0 in circulation .actual cash in the hands of the 9ublic0 is considered money? ;So are checka%le %ank deposits .bank accounts on /hich 9eo9le can /rite checks?0 $urrency
Are currency and checkable bank de9osits the only assets that are considered money 3t de9ends? As /e’ll see later! there are t/o /idely used definiti ons of the money supplyF .the total alue of financial assets in the economy that are considered money?0 ;4he narro/er definition considers only the most li@uid assets to be money .currency in circulation
make a distinction bet/een those assets that can easily be used to 9urchase goods and serices! and those that can’t? ;Money 9lays a crucial role in generating gains from trade because it makes indirect e8change 9ossible? ;/ould be e8tremely difficult for e8changing 9arties barter the goods and serices they sell .instead of using money0 barter
/orks if one 9arty /ants /hat the other 9arty is giing kno/n as the 9roblem of finding a double coincidence of /antsB ;in a barter system! t/o 9arties can trade only /hen each /ants /hat the other has to offer? Money
soles this 9roblem indiiduals can trade /hat they hae to offer for money and trade money for /hat they /ant? /ith
ability to make transactions /ith money rather than relying on bartering this makes it easier to achiee gains from trade! the e8istence of money increases /elfare! een though money does not directly 9roduce anything?
7oles o" Money Money
9lays three main roles in any modern economy it is a medium of e/change, a store of value, and a unit of account%
Medium o" Echange money
can act as a medium o" echange .an asset that indiiduals use to trade for goods and serices rather than for consum9tion0 +oteN Peo9le can’t eat dollar bills they use dollar bills to trade for edible goods and their accom9anying serices?
normal
times! the official money of a gien country is also the medium of e8change in
PAGE # ("
irtually all transactions in that country? .Quring troubled economic times! ho/eer! other goods or assets often 9lay that role instead?0
tore o" ?alue money
must also be a store o" value .a means of holding 9urchasing 9o/er oer tim e?0 ;money is by no means the only store of alue? Any asset that holds its 9urchasing 9o/er oer time is a store of alue? . store -of -alue role is a necessary but not distincti e feature of money?0
9nit o" *ccount money
seres as unit o" account ;the commonly acce9ted measure indiiduals use to set 9rices and make economic calculations?
istorically 9easants 9aid lando/ners in goods
ypes o" Money Money
has been used for thousands of year for most of that 9eriod! 9eo9le used commodity moneyB the medium of e8change /as a good .gold
currency that initially re9laced commodity money /as commodity -%acked moneyF a medium of e8change /ith no intrinsic alue /hose ultimate alue /as guaranteed by a 9romise that it could al/ays be conerted into aluable goods on demand? ;big adantage of commodity -backed money oer sim 9le commodity money! .gold
>?S? dollar bill isn’t commodity money! and it isn’t een commodity -backed?
its
PAGE # (
alue arises entirely from the fact that it is generally acce9ted as a means of 9ayment ;role that is ultimately decreed by the >?S? goernment? Money
/hose alue deries entirely from it s official status as a means of e8change is kno/n as "iat money because it e8ists by goernment fiat, .referring to 9olicy declared by a ruler?0
:iat
money has ."0 maor adantages oer commodity -backed money? ; .10 it doesn’t tie u9 any real resources! e8ce9t for the 9a9er it’s 9rinted on? ; ."0 the money su99ly can be managed based on the needs of the economy! instead of being determined by the amount of gold and siler 9ros9ectors ha99en to discoer? ; has some risk such as counterfeiting ; benefit that counterfeiters get b y e8changing fake bills for real goods and serices comes at the e89ense of the >?S? federal goernment! /hich coers a small but nontriial 9art of its o/n e89enses by issuing ne/ currency to meet gro/ing demand for money? larger
risk is that goernment officials /ho hae the authority to 9rint money /ill be tem9ted to abuse the 9riilege by 9rinting a lot of T to cause inflation?
Measuring the Money upply :ederal
6esere calculates the si=e of ."0 monetary aggregatesF oerall measures of the money su99ly! /hich differ in ho/ strictly money is defined? ;4he t/o aggregates are kno/n as M1 and M"? ;M1! the narro/est definition has only currency in circulation .also kno/n as cash0! traeler’s checks! and checkable bank de9osits? ;M" starts /ith M1 and adds seeral other kinds of assets! often referred to as near -moneys `financial assets that aren’t directly usable as a m edium of e8change but can be readily conerted int o cash or checkable bank de9osits! such as saings accounts? since
currency and checkable de9osits are directly usable as a medium of e8change! M1 is the most li@uid measure of money? ;M" consists of M1 9lus other ty9es of assets t/o ty9es of bank de9osits! kno/n as saings de9osits and time de9osits! both of /hich are considered non checkable! 9lus money market funds! /hich are mutual funds that inest only in li@uid assets and bear a close resemblance to bank de9osits? 4hese near moneys 9ay interest /hile cash .currency in circulation0 does not! and they ty9ically 9ay higher interest rates than any offered on checkable bank de9osits?
PAGE # ($
Module 24 (made %y 7uslan)
2hat banks do - A bank is a financial intermediary that uses li@uid assets in the form of bank de9osits to finance the illi@uid inestments of the borro/ers? - anks create li@uidity .because they don_t need to kee9 all of of the funds they receie sitting around in cash form as not eeryone /ants their m oney back at the same time unless there_s a ank run0 - o/eer! since at least a fe/ bank customers are going to be asking for their money to be /ithdra/n back to them! banks need to kee9 bank reseres /ith cash handy .reseres can be ke9t in either a banks ault! or at the federal resere
e0 - 2e use a -account to summari=e a banks financial 9osition - Qe9osits are liabilities because the 9eo9le can /ithdra/ them at any time - Joans are assets because it_s e89ected the 9eo9le /ho took them out /ill re9ay them - 6eseres are assets because they are 9iles of cash of course they_re assets
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- anks are re@uired by la/ to hae more assets then liabilities by a s9ecific 9ercentage - 3n the e8am9le aboe! the reserve ratio! or the ratio of reseres held to bank de9osits receied is 1%H .1%%!%%%1!%%%!%%%0 - :ederal 6esere regulates banks in the >S- es9ecially by setting a reuired reserve ratio
4he Problem of ank 6uns - A bank run is /hen eeryone tries to /ithdra/ their funds in a short timeframe .she sho/ed us an e8am9le of one in that black-and-/hite cli9 of 0t1s a Wonderful &ife$ - Jike /e sa/ in the cli9! if a significant share of de9ositors demanded their money back at the same time! the bank /ouldn_t be able to raise enough cash to meet those demands - 4hat_s because! like /e sa/ in the 4-account! most of the money banks hold is held in the form of loans? Joans are illi@uid! they can_t easily be conerted to cash on short notice? - anks fi8 this 9roblem by selling their loans to other banks for fast cash? Problem is! they hae to sell the loans at a discount- say &%H? - So in the case of a bank run! the bank /ill be forced to sell off its assets reall y chea9ly! leading to a ank failure? - 2ank failure bank /on_t be able to 9ay off its de9ositors in full? - ank runs are caused by fear of bank failure and so many times it_s like a self-fulfilling 9ro9hecy? - ank runs aren_t only bad for the bank and it_s de9ositors! history has sho/n they_re contagious one bank run leads to another
ank 6egulation - ank runs are bad? 4hat_s /hy our goernment .successfully0 tries to aoid them /ith regulationsN - 4he system! successfully 9rotecting us >S cit i=ens since the 1*%s! has three main features deposit insurance, capital re-uirements, reserve re-uirements ? - ,eposit insurance 4he :Q3, 9roides a de9osit insurance! or a guarantee that de9ositors /ill be 9aid
PAGE # ('
een if the bank come u9 to the funds .u9 to "&%!%%%T 9er account as of no/0 - 4his creates lack of incentie! banks start 9ulling high risk moes they succeed! they 9rofit! they fail! the goernment bails them out? 4o 9reent the banks from going too cray! regulation "-- $apital reuirementB banks are re@uired to hold substantially more assets then the alue of bank de9osits? 4he e8cess they hold oer their bank de9osits is called the ank1s capital% 3n our 4-account e8am9le! the bank has T1%%!%%% more assets then de9osits? 4hat_s *H of their total assets .T1%%!%%%S! it_s set at 1%H? - he ,iscount indowB one final 9rotection! banks are allo/ed to borro/ money from the :ederal 6esere! to aoid haing to fire-sale t here assets /hen they need cash @uick
o/ anks ,reate Money - Without banks! the @uantity of currency in circulation /ould e@ual the money su99ly .the amount of currency the goernment mints and 9rints0 - anks ho/eer do e8ist! and they affect the currency in circulation in t/o / ays ・
・
Removing some currency from circulation (money in vaults, unlike money in wallets, is not considered part of the money supply) More importantly, banks create money by making loans
- Keshara has mad gua9 in a shoebo8 and he_s about to de9osit it into the bank? After the de9osit! Keshara still has that money .lets say T1%%%0! ust no/ it_s sitting in the bank? 4he bank takes that money! and loans out T*%% to Ms?Sch/eit=er? +o/ Ms?Sch/eit=er has T*%% she can s9end? Keshara still has T1!%%%? All of a sudden! there_s no/ T1!*%%N 4he bank ust created moneyN - ut Ms?Sch/eit=er s9ends all that money at :erry_s? :erry_s no/ has T*%% that it_s going to 9ut in the bank? 4he banks going to take that money! and loan out another T)1%? +o/! Keshara still has T1!%%% in the bank! :erry_s has T*%% in the bank! and there_s another T)1% u9 for s9ending by /hoeer took out that loan? 4he bank ust took Keshara_s initial T1!%%% in the money su99ly and turned it into T"!(1% in the money su99lyN Stacks on stacks on stacks on stacks? - 4he aboe scenario re9resents /hat /e call the money multiplier ? A?K?A my middle name?
PAGE # ((
6eseres! ank Qe9osits! and the Money Multi9lier - 3n the Keshara-Sch/eit=er-:erry_s e8am9le /e assume that all the money eentuall y finds it_s /ay back to a bank? 4hat_s not al/ays the case- money leaks out of the banking system? - Jeaks reduce the si=e of the money multi9lier - A leak in this case is /hen borro/ers kee9 their funds as cash! rather than the saings leak / ere used to /hen it comes to GQP leaks - Sim9lifying life and assuming a check-able de9osits only /orld! in /hich all the money is in the bank and none of it in our /allets! also assuming a minimum resere ratio of 1%H! and lastly that eery bank is lending out any ecess reserves .any reseres they ha99en to hae aboe the minimum re@uired0 ・
Increase of $1 in e!cess reserves " $1 # $ # $%1 # $&' #
- rr F resere ratio - 3ncrease of T1%%% in e8cess reseres F T1%%% 7 T1%%%.1- rr$ 7 T1%%%.1-rr$]" 7 T1%%%.1-rr$] 7 ??? - 3n sim9lest form! an increase of T1%%% in e8cess reseres F T1%%%
4he Money Multi9lier in 6eality - 3n reality! the determination of the money su99ly is more com9licated! it_s de9ends not only on rr but also on the fraction of the money su99ly that indiiduals chose to hold in the form of currency? - :ederal 6esere controls the money %ase! the sum of currency in circulation and the reseres held by banks? - 4he :ederal 6esere does not control ho/ t hat sum is allocated bet/een the bank reseres and the currency in circulation? - 2hen Keshara first took that T1!%%% .that he initially ke9t under his bed0! he took that T1%%% out of circulation but also 9ut that same T1%%% into the bank reseres - 4he amount in reseres gro/s! the amount in circulation shrinks! the monetary base stays unchanged? - Monetary base is different from money su99ly in t/o /ays
PAGE # ()
・
・
・
・
ank reserves, which are a big part of the monetary base, aren*t accounted for in the money supply ($1 in a wallet counts as money supply because it*s available to spend, $1 in a bank vault isn*t because well it*s locked up) +heckable bank deposits, a huge part of the money supply, isn*t accounted for in monetary supply Monetary base is pretty much all the physical cash out there printed, whether sitting in a reserve or in a person*s wallet, while money supply is how much money is actually out there up for spending -ormal definition of the money multiplier the ratio of the money su99ly to the
monetary base? ・
Jooking at the >S! if /e used the sim9lified model mentioned before! the multi9lier should be 1%? 3n reality! it_s closer to 1?*? 4hat_s a big difference? +ormally! the e89lanation is that 9eo9le hold significant amount of cash rather then giing the money to the bank /here it can multi9l y? o/eer! due to the "%%) crisis the goernment tried stabili=ing the economy-- in doing so it made it much more attractie to hold on to e8cess reseres so instead of loaning money out banks ust had trillions of dollars all of a sudden sitting there? Quring "%%)! the multi9lier /as as lo/ as %?)?
Module 2A 4he :ederal 6esere Monetary Policy he 5ederal 7eserve ystem --; :ederal 6esere System seres as the central bank of t he >nited States? ;3t has t/o 9arts the oard of Goernors! /hich is 9art of the >?S? goernment! and the 1" regional :ederal 6esere anks! /hich are 9riately o/ned?
PAGE # (*
he 5unctions o" the 5ederal 7eserve ystem --; :ederal 6esere’s functions fall into four basic categories 9roiding financial serices to de9ository institutions! su9erising and regulating banks and other financial institutions! maintaining the stability of the financial system! and conducting monetary 9olicy? !rovide 5inancial ervices
;1" regional :ederal 6esere anks 9roide financial serices to de9ository institutions .banks and >?S? goernment0? ; 4he :ederal 6esere is banker’s bankB .holds reseres! clears checks! 9roides cash! and transfers funds for commercial banks0 ;:ed also is banker and fiscal agent for the federal goernment? 4he >?S? 4reasury has its checking account /ith the :ederal 6esere upervise and 7egulate 6anking +nstitutions
; :ederal 6esere System must ensure the safety and soundness of the nation’s banking and financial system? ;regional :ederal 6esere anks e8amine
--; :ederal 6esere System /as created /as to 9roide the nation /ith a safe and stable monetary and financial system? --; charged /ith maintaining the integrity of the financial system? --; :ederal 6esere banks 9roid li@uidity to financial institutions to ensure their safety and soundness? $onduct Monetary !olicy
; :ederal 6esere’s must conduct of monetary 9olicy --; uses the tools of monetary 9olicy to 9reent or address e8treme macroeconomic fluctuations in the >?S? economy? hat the 5ed ,oes ;4he :ederal 6esere carries these functions by using it_s three main 9olicy tools reserve re-uirements, the discount rate, and open #market operations% he 7eserve 7euirement ;note that :ed sets a minimum re@uired resere ratio! currently e@ual to 1%H for checkable bank de9osits? --; anks that fail to maintain at least the re@uired resere ratio face 9enalties?
--; if a bank has insufficient reseres to meet the :ed’s resere re@uirement it borro/s additional reseres from other banks ia the "ederal "unds market .a financial market that allo/s banks that fall short of the resere re@uirement to borro/ reseres0 from banks that are holding e8cess reseres? ; interest rate in this market is determined by su99ly and demand but the su99ly and demand for bank reseres are both strongly affected by :ederal 6esere actions?
PAGE # )%
;"ederal "unds rateF the interest rate at /hich funds are borro/ed and lent in the federal funds market is im9ortant for monetary 9olicy --; to alter the money su99ly! the :ed can change resere re@uirements? --; if:ed reduces the re@uired resere ratio! banks /ill lend a larger 9ercentage of their de9osits! leading to m ore loans and an increase in the money su99ly ia the money multi9lier? ; if :ed increases the re@uired resere ratio! banks are forced t o reduce their lending! leading to a fall in the money su99ly ia the money multi9lier? he ,iscount 7ate
;anks in need of reseres can also borro/ from the :ed itself ia the discount window% --; discount rate is the interest rate the :ed charges on those loans? --; the discount rate i s set 1 9ercentage 9oint aboe the federal funds rate in order to discourage banks from turning to the :ed /hen they are in need of reseres? ; to alter the money su99ly! the :ed can change the discount rate? --; if :ed reduces the s9read bet/een the discount rate and the federal funds rate! the cost to banks of being short of reseres fallsD banks res9ond by increasing their lending! and the money su99ly increases ia the money multi9lier? ; 3f the :ed increases the s9read bet/een the discount rate and the federal funds rate! bank lending falls` and so /ill the money su99ly ia the money multi9lier? ;most monetary 9olicy is conducted almost e8clusiely using the :ed’s third 9olicy tool o9en -market o9erations? :pen-Market :perations --; :ederal 6esere also has assets and liabilities? --; assets consist of its holdings of debt issued by the >?S? goernment .mainly short -term >?S? goernment bonds /ith a maturity of less than one year --; >?S? 4reasury bills0
--; note that >?S? 4reasury bills held by the :ed are a liability of the goernment but an asset of the :ed? --; :ed’s liabilities consist of currency in circulation and bank reseres? .insert :igure "(?1 /hich sho/s the assets and liabilities of the :ed in the form of a 4-account?0
;open -market operation the :ederal 6esere buys?S? 4reasury bills normally /< commercial anks .banks that mainly make business loans! as o99osed to home loans?0
PAGE # )1
--; :ed neer buys >?S? 4reasury bills directly from the federal goernment? ./hen a central bank buys goernment debt directly from the goernment! it is lending directly to the goernment`in effect! the central bank is issuing 9rinting moneyB to finance the goernment’s budget deficit? --; leads to inflation0
.insert :igure "(?"0
4his sho/s the changes in the financial 9osition of both the :ed and commercial banks that result from o9en -market o9erations? ; /hen :ed buys >?S? 4reasury bills from a commercial bank --; 9ays by crediting the bank’s resere account by an amount e@ual to the alue of the 4reasury bills? ; sho/n in 9anel .a0 the :ed buys T1%% million of >?S? 4reasury bills from commercial banks --; increases the monetary base by T1%% million because it increases bank reseres by T1%% million? --; /hen :ed sells >?S? 4reasury bills to commercial bank it debits the banks’ accounts! reducing their reseres? sho/n in 9anel .b0! /here :ed sells T1%% million of >?S? 4reasury bills? --; bank reseres and the monetary base decrease?
:ed gets the funds to 9urchase >?S? 4reasury bills from banks by creating them --; that credits the banks’ accounts /ith e8tra reseres? --; :ed issues currency to 9ay for 4reasury bills /hen banks /ant the addit ional reseres in the form of currency? --; /e hae fiat money so :ed can create additional monetary base at its o/n discretion? ----; change in bank reseres caused by an o9en -market o9eration doesn’t directl y affect the money su99ly --; it starts the money multi9lier in motion?
PAGE # )"
T1%% million increase in reseres sho/n in 9anel .a0! commercial banks /ould lend out their additional reseres --; increasing the money su99ly by T1%% million? ;some those loans /ould be de9osited back into the banking system! increasing reseres again and 9ermitting a further round of loans! and so on! leading to a rise in the money su99ly ;o9en -market sale has the reerse effect --; bank reseres fall! re@uiring banks to reduce their loans! leading to a fall in the money su99ly? ; :ed controls the money su99ly`checkable de9osits 9lus currency in circulation? --; it controls only the monetary base` bank reseres 9lus currency in circulation?
;by increasing or reducing the monetary base! the :ed can e8ert a 9o/erful influence on both the money su99ly and interest rates?
Module 28
he ,emand "or Money --; note that M1 consists of currency in circulation .cash0 7 checkable bank de9osits 7 traeler’s checks? M" .broader definition0 consists of M1 9lus de9osits t hat can easily be transferred into checkable de9osits?
Peo9le hold money to make it easier to 9urchase goods and serices? he :pportunity $ost o" ;olding Money --;economic decisions inole trade -offs at the margin? ; indiiduals decide ho/ much of a good to consume by determining /hether the benefit they’d gain from consuming a bit more of any gien good is /orth the cost?
;same decision 9rocess is used /hen deciding ho/ much money to hold?
--; 3ndiiduals< firms o hold some of their assets in the form of money because of the conenience --; money can be used to make 9urchases directly! /hile other assets can’t? .an o99ortunity cost associated for that conenience money held in your /allet earns no interest?0 --;9eo9le continue to kee9 cash in their /allets rather than leae the funds in an interest -bearing account because they don’t /ant to hae to go to an A4M to /ithdra/ money eery time they /ant to make a small 9urchase? --; the conenience of kee9ing some cash in your /allet is more aluable than the interest you /ould earn by kee9ing that money in the bank?
--; trade off in holding money in checking account --; because you can earn a higher interest rate b y 9utting your money in assets other than a checking account?
PAGE # )
--; banks offer certificates of de9osit .,Qs0 /hich 9ay a higher interest rate than ordinary bank accounts? but also carry a 9enalty if you /ithdra/ the funds before a certain amount of time --; An indiidual /ho kee9s funds in a checking account is forgoing the higher interest rate those funds /ould hae earned if 9laced in a ,Q in return for the conenience of haing cash readily aailable /hen needed? --.insert table ")?10
4his sho/s the o99ortunity cost of holding money in a s9ecific month! Vune "%%(? ; 4he first ro/ sho/s the interest rate on one -month ,Qs and in Vune _%( one -month ,Qs yielded &?%H? ;4he second ro/ sho/s the interest rate on interest -bearing bank accounts .s9ecifically! those included in M10? ;:unds in these accounts /ere more accessible than those in ,Qs! but the 9rice of that conenience /as a much lo/er interest rate! only "?$()H? ;last ro/ sho/s the interest rate on currency --; cash in your /allet /hich has no interest 4able ")?1 sho/s the o99ortunity cost of holding money at one 9oint in time --; the o99ortunity cost of holding money changes /hen the oerall leel of interest rates changes? ;! /hen the oerall leel of interest rates falls! the o99ortunity cost of holding money falls .insert table ")?"0
4able ")?" sho/s ho/ selected interest rates changed bet/een Vune "%%( - Vune "%%) --; :ederal 6esere /as slashing rates in an effort to fight off recession? ; bet/een Vune "%%( and Vune "%%)! t he federal funds rate . rate the :ed controls most directly0 fell by ? "& 9ercentage
PAGE # )$
9oints? ; 4he interest rate on one -month ,Qs fell almost as much! "?) 9ercentage 9oints? --; All short -term interest rates .rates on financial assets that come due! or mature! /ithin less than a year0 tend to moe together! /ith rare e8ce9tions? ; reason short -term interest rates tend to moe together is that ,Qs and other short -term assets .like one< three-month >?S? 4reasury bills0 are in effect com9eting for the same business? ;Any short -term asset that offers a lo/er -than -aerage interest rate /ill be sold by inestors --; /ho_ll moe their /ealth into a higher -yielding short -term asset? --; selling of the asset then forces its interest rate u9 because inestors must be re/arded /ith a higher rate in order to conince them to buy it? ; ,onersely! inestors /ill moe their /ealth into any short -term financial asset that offers an aboe -aerage interest rate ;4he 9urchase of the asset dries its interest rate do/n /hen sellers find they can lo/er the rate of return on the asset and still find /illing buyers? --; interest rates on short -term financial assets tend to be roughly the same because no asset /ill consistently offer a higher -than - aerage or a lo/er -than -aerage interest rate? --; short -term interest rates fell bet/een Vune "%%( and Vune "%%)! the interest rates on money didn’t fall by the same amount? ; 4he interest rate on currency remained at =ero? 4he interest rate 9aid on demand de9osits did fall! but by much less than short -term interest rates? As a result! the o99ortunity cost of holding money fell? 4he last t/o ro/s of 4able ")?" sho/ the differences bet/een the interest rates on demand de9osits and currency and the interest rate on ,Qs? differences declined shar9ly bet/een Vune "%%(- "%%)? ;sho/s the higher the short -term interest rate the higher the o99ortunity cost of holding money the lo/er the short -term interest rate the lo/er the o99ortunity cost of holding money? 4able ")?" short -term interest rates >long - term interest rates interest rates on financial assets that mature! or come due! a number of years into the future ;difference bet/een short -term< long -term interest rates is sometimes im9ortant as a 9ractical matter? it’s short -term rates usually affect money demand! because the decision to hold money inoles trading off the conenience of holding cash ersus the 9ayoff from holding assets that mature in the short -term assume
that there is only one interest rate for no/
PAGE # )&
he Money ,emand $urve note
oerall leel of interest rates affects the o99ortunity cost of holding money so @uantity of money indiiduals and firms /ant to hold is negatiely related to the interest rate? .insert :igure ")?10
; hori=ontal a8is sho/s the @uantity of money demanded and the ertical a8is sho/s the nominal interest rate! r, /hich you can think of as a re9resentatie short -term interest rate such as the rate on one -month ,Qs? ; /e 9lace nominal interest rate on the erticle a8is .not real interest rate0 because o99ortunity cost of holding money includes both the real return that could be earned on a bank de9osit and the erosion in 9urchasing 9o/er caused by inflation? nominal interest rate includes both the forgone real return and the e89ected loss due to inflation? ence! r in :igure ")?1 and all subse@uent figures is the nominal interest rate?
relationshi9
bet/een the interest rate and the @uantity of money demanded by the 9ublic is illustrated by the money demand curveF *3, in :igure ")?1 ;4he money demand cure slo9es do/n/ard because a higher i nterest rate increases the o99ortunity cost of holding money! leading the 9ublic to reduce the @uantity of money it demands? if
interest rate is ery lo/ the interest forgone by holding money is relatiely small? indiiduals< firms /ill tend to hold relatiely large amounts of money to aoid the cost and to aoid conerting other assets into money /hen making 9urchases? if
the interest rate is relatiely high the o99ortunity cost of holding money is high? Peo9le /ill kee9ing only small amounts in cash and de9osits! conerting assets into money
PAGE # )'
only /hen needed?
/e dra/ the money demand cure /ith the interest rate most 9eo9le the releant @uestion in deciding ho/ much money to hold is /hether to 9ut the funds in the form of other assets that can be turned fairly @uickly and easily into money?
.stocks hae broker’s fees /hen you sell stock
doesn’t
fit0
releant
com9arison is /ith assets that are close toB money`fairly li@uid assets like ,Qs? And as /e’e already seen! the interest rates on all these assets normally moe closely together?
hi"ts o" the Money ,emand $urve the money demand cure can be shifted by a number of factors?
:igure ")?" sho/s shifts of the money demand cure
; an increase in the demand for money corres9onds to a right/ard shift of the *3 cure! raising the @uantity of money demanded at any gien interest 6ate ;a fall in the demand for money corres9onds to a left/ard shift of the *3 cure! reducing the @uantity of money demanded at any gien interest rate? 4he most im9ortant factors causing the money demand cure to shift are changes in the aggregate 9rice l eel! changes in real GQP! changes in banking technology! and changes in banking institutions?
$hanges in the *ggregate !rice #evel
PAGE # )(
higher
9rices increase the demand or mone y .a right/ard shift of the *3 cure0! and lo/er 9rices reduce the demand for money .a left/ard shift of the *3 cure0? the
demand for money is proportional to the 9rice leel? 4hat is! if the aggregate 9rice leel rises by "%H! the @uantity of money demanded at any gien interest rate! such as r 1 in :igure ")?"! also rises by "%H`the moement from * 1 to * "? this
is because if the 9rice of eerything rises by "%H! i t takes "%H more money to buy the same basket of goods and serices .reerse is true0 $hanges in 7eal <,! an
increase in real GQP`the total @uantity of goods and serices 9roduced and sold in the economy` shifts the money demand cure right/ard? A fall in real GQP shifts the money dem and cure left/ard? $hanges in echnology
3n general! adances in information technology hae tended to reduce the demand for money by making it easier for the 9ublic to make 9urchases /ithout holding significant sums of money? $hanges in +nstitutions ,hanges
in institutions can increase or decrease the demand for money
2hen
banking regulations changed! allo/ing banks to 9ay interest on checking account funds! the demand for money rose and shifted the money demand cure to the right?
Money and +nterest 7ates 4he
federal funds rate is the rate at /hich banks lend reseres to each other to meet the re@uired resere
ratio?
at each of its eight -times -a -year meetings! the :ederal 9en Market ,ommittee sets a target alue for the federal funds rate? .u9 t o :ed officials to achiee that target?0 done by the 9en Market Qesk at the :ederal 6esere ank of +e/ Iork! /hich buys and sells short -term >?S? goernment debt! kno/n as 4reasury bills! to achiee that target? As /e’e already seen! other short -term i nterest rates! such as the rates on ,Qs! moe /ith the federal funds rate?
he Euili%rium +nterest 7ate note /e assumed that there is only one interest rate 9aid on nonmonetary financial assets! both in the short run and in the long run?
.insert :igure ")?0
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;sho/s liuidity pre"erence model o" the interest rate ;says that the interest rate is determined by the su99ly and demand for money in the market for money? this
combines the money demand cure! *3, /ith the money supply curveF *, /hich sho/s ho/ the @uantity of money su99lied by the :ederal 6esere aries /ith the interest rate?
:ederal 6esere can increase or decrease the money su99ly does ia open#market operations, buying or selling 4reasury bills! but it can also lend ia the discount window or change reserve re-uirements%
think that :ed! using one or more of these methods! sim9ly chooses the leel of the money su99ly that it beliees /ill achiee its interest rate target? 4hen the money su99ly cure is a ertical line! * in :igure ")?! /ith a hori=ontal interce9t corres9onding to the money su99ly chosen by the :ed! * "w4 line on top$ ? 4he
money market e@uilibrium is at , /here * and *3 cross? At this 9oint the @uantity of money demanded e@uals the money su99ly! * "w4 line on top$ leading to an e@uilibrium interest rate of r ? 4o understand /hy r is the e@uilibrium interest rate! consider /hat ha99ens if the money market is at a 9oint like &, /here the interest rate! r&, is belo/ r% At r& the 9ublic /ants to hold the @uantity of money *& , an amount larger than the actual money su99ly! *"w4 line on top$ ? at 9oint &, the 9ublic /ants to shift some of its /ealth out of interest -bearing assets such as highdenomination ,Qs ./hich aren’t money0 into money?
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4/o im9lications ne is that the @uantity of money demanded is more than the @uantity of money su99lied? other is that the @uantity of interest -bearing nonmoney assets demanded i s less than the @uantity su99lied? So those trying to sell nonmoney assets /ill find that they hae to offer a higher interest rate to attract buyers? As a result! the interest rate /ill be drien u9 from r& until the 9ublic /ants to hold the @uantity of money that is actually aailable! *% 4hat is! the interest rate /ill rise until it is e@ual to r%
if the money market is at a 9oint such as in :igure ")?! /here the interest rate r is aboe r ? 3n that case the @uantity of money demanded! *, is less than the @uantity of money su99lied! *"w4 line on top$
,orres9ondingly!
the @uantity of interest -bearing nonmoney assets demanded is greater than the @uantity su99lied? 4hose trying to sell interest -bearing nonmoney assets /ill find that they can offer a lo/er interest rate and still find /illing buyers? leads
to a fall in the interest rate from r% 3t falls until the 9ublic /ants to hold the @uantity of money that is actually aailable! *"w4 line on top$ ? Again! the interest rate /ill end u9 at r%
wo Models o" the +nterest 7ate /e hae made li@uidity 9reference model of the interest rate? the e@uilibrium interest rate is the rate at /hich the @uantity of money demanded e@uals the @uantity of money su99lied? consistent
/< loanable funds model of the interest rates! /hich is deelo9ed in the ne8t module? 3n the loanable funds model! /e /ill see that the interest rate matches the @uantity of loanable funds su99lied by saers /ith the @uantity of loanable funds demanded for inestment s9ending?
Module 20 Joanable :unds Market - a hy9othetical market that illustrates the market outcome of the demand for funds generated by borro/ers and the su99ly of funds 9roided? - 9rice determined in loanable funds market is the interest rate - 6eal interest rate F +ominal interest rate - inflation rate - inestors and saes care about the real interest rate 4he 6ate of 6eturn on a 9roect is the 9rofit earned on the 9roect e89ressed as a 9ercentage of its cost
A business /ill /ant a loan /hen the rate of return on its 9roect is ; or F the interest rate - E8am9le at an interest rate of 1"H! only businesses /ith 9roects that yield a rate of return ; or F 1"H /ill /ant to loan ,emand $urve "or #oana%le 5unds
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upply $urve "or #oana%le 5unds
-Peo9le /ant to make money off of the 3nterest rate! so the higher the interest rate the higher the @uantity of loanable funds
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CAn increase in the demand for loanable funds leads! other things e@ual! to a rise in the interest rate CAn increase in the su99ly for loanable funds also leads! other things e@ual! to a rise in the interest rate hi"ts o" the ,emand "or #oana%le 5unds - ,hanges in Perceied usiness 99ortunities ,hange i n belief of increase in inestment s9ending can increase or reduce the amount of desired s9ending at any gien interest rate - ,hanges in Goernment orro/ing Goernments that run deficits are maor sources of the demand for loanable funds? $rowding outB occurs /hen a goernment deficit dries u9 t he interest rate and leads to reduced inestment s9ending - Subsidies or 4a8es on 3nestment S9ending Subsidies gie inestors the incentie to inest! ta8es on inestment s9ending does the o99osite hi"ts o" the upply o" #oana%le 5unds - ,hanges in 9riate saings behaior E8 6ising home 9rices makes homeo/ners feel richer! making them /illing to s9end more and sae less? 4his shifts the su99ly of loanable funds to the left? - 4a8es on interest income 4he higher the ta8 on interest income! the smaller the su99ly of loanable funds - ,hanges in ca9ital inflo/ ,a9ital flo/s into a country can change as inestors’ 9erce9tions of that country change 4he true cost of borro/ing is the real interest rate! not the nominal interest rate E8 3f a firm borro/s T1%k at a nominal interest rate of 1%H! then they 9ay back T11k! but the aerage leel of 9rices increases by 1%H! the real interest rate /ould be % 5isher E""ect An increase in e89ected future inflation dries u9 the nominal interest rate! leaing the e89ected real interest rate unchanged
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he +nterest 7ate in the hort 7un
he +nterest 7ate in the #ong 7un
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4his e8ists guysN >se itNNNN htt9<S goernment has accumulated a lot of debt? !ro%lems !osed %y 7ising
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,e"icits and ,e%ts in !ractice Qebt-GQP ratio is an e8cellent indication of a country’s economic health? +mplicit #ia%ilities 4hese are s9ending 9romises by the goernment! /hich translate into debt! een though they t hey are not accounted for in debt statistics? Social Security! Medicare! and Medicaid are the three largest liabilities! and their 9roected s9ending is ery high?
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Module .1B Monetary !olicy and the +nterest 7ate 6efresher Monetary Policy ho/ the central bank .>S has the :ederal 6esere0 uses changes in the @uantity of money or the interest rate to stabili=e the economy? ,urrent :ed ,hairman- en ernanke? .+e8t /i ll @uite 9ossibly be Vanet IellenN0 Monetary !olicy and the +nterest 7ate Summary :ed can mani9ulate money m oney su99ly to set interest rate! ceteris 9arabis? :ed sets target federal funds rate and uses o9en-market o9erations to achiee it?
5igure .11 4he :ed can increase the Money Su99ly .shift it to the right0 to lo/er the 3nterest 6ate? :ed can also decrease the Money Su99ly in order to increase the 3nterest 6ate?
:ederal 9en Market ,ommittee decides on the interest rate! /hich 9reails for the si8 /eeks before their ne8t meeting? 4he :ed sets a target "ederal "unds rate! /hich is enforced by the t he 9en Market Qesk of the :ederal 6esere ank of +e/ Iork? Iork? 4he buying and selling of 4reasury bills! aka o9en market o9erations! are used until the t arget is reached? ther tools of monetary 9olicy! such as lending through the di scount /indo/ and changing the resere re@uirement! are used infre@uently? infre@uently?
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5igure .12 Goal Qecrease the 3nterest 6ate<3ncrease the Money Su99l y? Action 4aken o9en market 9urchase of treasury bills to 9ush the money su99ly cure right? Goal 3ncrease the 3nterest 6ate<6educe the Money Su99ly? Su99ly? Action 4aken o9en market sale of treasury bills to 9ush the money su99ly cure to the left?
:I3 .inessential0 5ed 7everses $ourse >ntil "%%'! the federal funds rate had been steadily rising! because of the fear of inflation? eginning in Se9tember "%%( there /as much financial olati lity! and so the :ed cut the target :ederal :unds 6ate? Starting in late "%%)! the :ederal 9en Market ,ommittee set a target range for the federal funds rate! bet/een %H and %?"&H! and that’s /hy there a99ears a99ears to be t/o federal funds rates
Monetary !olicy and *ggregate ,emand Summary 3nterest 6ate is inersely i nersely related to Aggregate Qemand? Monetary Policy affects the interest rate! /hich can shift the aggregate demand cure? Epansionary Monetary !olicy :ed e89ands money su99ly lo/er interest rate more inestment s9ending higher real GQP increased consumer s9ending etcetera 4he eentual effect is an increase in Aggregate Qemand $ontractionary $ontractionary Monetary !olicyB :ed contracts the money su99ly higher interest rate less inestment s9ending lo/er real GQP lo/er consumer s9ending etcetera
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Monetary !olicy in !ractice Summary Monetary Policy lags! but it’s the main tool of stabili=ation 9olic y? :ederal funds rate is 9ositiely correlated /ith out9ut ga9! inflation! and the 4aylor 6uleD /ith the 4aylor 6ule being the best indicator? 4he goals of monetary 9olicy makers include fighting recessions and ensuring 9rice stability t hrough a relatiely lo/ .ideally "H0 inflation rate? 2heneer GQP is belo/ 9otential out9ut! the :ed engages in e89ansionary monetary 9olicy ut9ut Ga9 the difference bet/een real GQP and 9otential out9ut? Positie /hen real GQP is greater and negatie /hen real GQP is lesser? ut9ut Ga9 is generally 9ositiel y correlated /ith interest rates! /ith the e8ce9tion being in the *%’s /hen the :ed ke9t rates steady des9ite the increasingly 9ositie out9ut ga9? 3nflation this rate /as lo/ in the *%’s /hich e89lains the steady int erest rates .loose monetary 9olicy0 in that 9eriod? 4his is because interest i s also 9ositiely correlated /ith federal funds rate? aylor 7ule "or Monetary !olicy the best 9redictor of monetary 9ol icy? 3t incor9orates both inflation and out9ut ga9? 4he >S :ederal 6esere uses a loosely defined ersion of this rule /hil e setting its monetary 9olicy? 4he rule 5ederal "unds rate D 1 G (14 in"lation rate) G ('4 output gap)
5igure .1 4racking Monetary Policy >sing the ut9ut Ga9! 3nflation! and the 4aylor 6ule a0 2hen out9ut ga9 is 9ositie! the federal funds rate rises? And ice ersa? b0 3f inflation is high! federal funds rate is also highD if inflation is lo/! f?f? rate is lo/? c0 4he 9roected federal funds rate! deried from the 4aylor 6ule! closely mirrors the actually federal funds rate? 4he 4aylor 6ule matches actual monetary 9oli cy better than ust the out9ut ga9 or the inflation rate! and it uses a combination of both?
