Macroeconomics Class Notes.docx

8/14/2019 Macroeconomics Class Notes.docx

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Macroeconomics

Chapter 1: Ten Principles of Economics

How People make Decisions

- People Face Trade-Offso Free Lunch Argumento Scarcitylimited nature of societys resourceso Economicsstudy of how society manages scarce resourceso Time/Money Spend on one thing is lost on another endeavoro Efficiency- society gets maximum benefit from scarce resources (Size of Pie)o Equality- benefits are distributed uniformly among societys members (Size of Slice)o Tax increase: pie becomes smaller (less efficient) since there is less an incentive to

work

- The Cost of something is What you Give up to Get Ito Opportunity Costwhat you give up to get that item, (explicit+implicit)o Going to College vs time lost not working and spending money for tuition.

- Rational People Think at the Margino Marginal Changesmall incremental adjustment to an existing plan of action.o Rational Decision maker takes action if marginal benefit of the action exceeds the

marginal cost

- People Respond to Incentiveso IncentiveInduces a person to act (i.e. punishment or reward)o Seat Belt example cost benefit of driving slower and safer vs faster with belt

How People Interact

- Trade Can Make Everyone Better Offo Specialize in what they do besto Enjoy greater variety of goods and services

- Markets Are Usually a Good Way to Organize Economic Activityo Market Economydecisions are made by millions of firms and households (free

market), Driving Forces Principle and Self Interest

o Even though decision making power is decentralized it works by invisible hand- Governments can Sometimes Improve Market Outcomes

o Government needs to enforce rules and institutions that are key to market economyo Property Rightsindividuals can own and control scarce resourceso Basically stealing is illegal and punishableo Market Failure- market fails to produce an efficient allocation of resourceso Externalityimpact of one persons actions on the well-being of a bystander (i.e

pollution)


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o Market Power- ability of a single person to unduly influence market princes (leads tofailure)

How the Economy as a Whole Works

- A Countrys Standard of Living Depends on Its Ability to Produce Goods and Serviceso Differences in Standards of living are attributed to productivity of countrieso Productivityamount of goods and services produced from a unit of labor inputo Technologically advanced countries are able to have workers produce more goods

per unit time

- Prices Rise When the Government Prints Too Much Moneyo Inflationan increase in the overall level of prices in the economyo About 2.5% per yearo Keep inflation low is goal of economic policymakerso Quantity of money causes inflation

- Society Faces a Short-Run Trade-off Between inflation and Unemploymento Short Term effects on monetary injects

Stimulates spending and demand for goods and services Higher demand causes firms to raise prices and hire more workers More hiring means lower unemployment

o Business Cyclethe irregular and largely unpredictable fluctuations in economicactivity, as measured by the production of goods and services or the number of

people employed

o Changing the amount the government spends, the amount it taxes, and the amountit prints can influence inflation and unemployment in the short run

Conclusion

Individual

- People face trade-offs among alternative goals- Cost of Any action is measured in terms of opportunity cost- Rational people Marginal cost vs marginal benefit- People change behavior due to incentivesInteractions

- Trade and interdependence can be mutually beneficial- Free market coordinates activity among people- Government can improve market (avoiding market failure or promoting equality)Whole Economy

- Productivity related to living standards- Quantity of money source of inflation/Short Tradeoff Between Inflation v Unemployment


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Chapter 2: Thinking Like an Economist

The Economist as Scientist

- Scientific Method: Observation, Theory, and More Observationo Cannot produce experiments must use historical events to experimentally

determine theory similar to evolutionary biologist

- The Role of Assumptionso Simplify calculations (i.e. physicist assume vacuum) we assume only 2 countrieso Examples assumptions

Short Run- prices fixed Long Runeverything is flexible

- Economic Modelso Diagrams and equations may omit minor detailso This helps create a deeper understanding

- Circular-Flow Diagramo Two types of decision makers

Firms Produce Goods and Services Using Inputs like labor land and capital

(buildings and machines)

These inputs are called factors of production (labor land and capital) Households

Markets for goods and services- households are buyers Markets for the factors of production- households are sellers firms

are buyers

o In these markets household provides the input that firmsuse to produce


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- Our Second Model: The Production Possibilities Frontiero Assumption: only 2 goods, these two goods use all of the economys factors of

production

o Production Possibilities Frontier- shows various combinations of outputo Can only produce on or inside of the curve (C is impossible)o Said to be efficient if economy operates on the lineo Point D is inefficient for some reason (i.e. unemployment)o Opportunity cost at A 1 car per 2 computerso Opportunity cost not constant- (to produce a car) less at y intercept more at x

intercept

o

Technological increase in possible output of computers leaves car maximum fixed but

shifted production possibilities frontier

- Microeconomics and Macroeconomicso Microeconomicsstudy of how households and firms make decisions and how they

interact in specific markets


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o Macroeconomics- study of economywide phenomena- Positive versus Normative analysis

o Polly: Minimum-wage laws cause unemployment- scientific descriptive observationo Norm: The Government should raise minimum wage- policy maker, change he

would like

o Positive Statements- descriptiveo Normative Statements- prescriptive (how it ought to be)o Economics is majorly positive when normative includes ethics religion and political

philosophy

- Economists in Washingtono Have to weigh pros and cons of policy

- Why Economists Disagreeo Economists disagree about vailidity of alternative positive theorieso May have different values therefore normative views

- Differences in Scientific Judgmentso Example- deciding whether to tax households income or spendingo Different positive views about the responsiveness of saving to tax incentives

- Perception Versus Realityo 2-4 propositions

Chapter 3:Interdependence and the Gains from Trade

A Parable for the Modern economy

- Interdependence allows for a higher standard of living and more opportunitieso Two people in the world each provide 1 good ( Meat and Potatoes). With trade

both people can enjoy both goods instead of being independent

o What if one person is more proficient at producing both goods? Should they stilltrade?

- Production Possibilitieso One faction is greater at producing both goods

oo Trade is still beneficial


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o Helps each faction focus on producing what it is most efficient at producing incomparison to the other faction

- Comparative Advantage: The Driving Force of Specializationo Absolute Advantagewhoever requires a smaller quantity of inputs to produce a

good

o Opportunity Costsecond piece of the puzzle. What does the more efficient partygive up in order to produce both

o Whoever gives up less of other good has smaller opportunity cost- they have thecomparative advantage

o Unless they are identical one party will have comparative advantage in one goodwhile the other has comparative advantage in the other.

- Comparative Advantage and Tradeo Trade benefits everyone when there are different comparative advantages

- The Price of the Tradeo For both parties to gain from trade, the price at which they trade must lie between

the two opportunity costs.

- Should the United States Trade with Other Countrieso Importsgoods produced abroad and sold domesticallyo ExportsGoods Prodcued Domestically and sold abroad

Chapter 4: The Market Forces of Supply and Demand

Markets and Competition

o Supply and Demand refer to people as they interact with one another in competitivemarkets

- Market- a group of buyers and sellers of a particular good or serviceo Buyers determine demand and sellers determine supplyo Markeys can be more or less organized

- Competitive market- a market in which there are too many buyers and sellers for one toimpact market price

o In this chapter assume markets are perfectly competitive 1- goods offered for sale are exactly the same 2- the buyers and sellers are so numerous that no single buyer or seller can

change price

- Price Taker Buyers and sellers who accept price in perfect marketo At market price buyers can buy all they want and sellers can sell all they want

- Monopolyseller sets the price- Looking at Demand first

o Quantity demandedamount of the good that buyers are willing and able topurchase


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Law of Demandother things equal price of a good rises quantitydemanded of a good falls and vice versa

- Demand Schedulerelationship between price of good and quantity demanded holdingconstant everything else

- Demand Curvedownward sloping curve relating price and quantity demanded- Market demand is horizontal sum of individual demands

- Shift right-increase in demand, Shift Left- decrease in demand- Normal Good- demand falls when income falls- Inferior Gooddemand rises when income falls (i.e bus ride)- Substitutesfall in price of one good reduces demand of another (similar) good- Complementsfall in price of one good raises demand of another (cars and gas)- Taste, expectations (i.e higher incoming salary, expected price drop), # of buyers,- Change in price is move along demand curve- Change in taste, expectationsvariables not on graph shift the entire curve

Supply

- Quantity suppliedamount that sellers are willing and able to sell- Law of supplyrelationship between price and quantity supplied

o When price of good rises quantity supplied rises and vice versa- Supply Scheduletable that shows relationship between price and quantity supplied

(holding everything else constant)

- Supply Curve- relates price to quantity supplied- Market Supply versus Individual Supply

o Sum horizontally- More easily produced supply curve shifts to right- Things that shift curve

o Technologyo Expectations


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o Number of SellersEquilibrium

- Equilibriumintersection of supply and demand- Equilibrium priceprice at equilibrium, or called market clearing price, (everyone is

satisfied) buyers bought all they want sellers sold all they want

- Equilibrium quantityquantity at equilibrium- Price is below equilibrium price

o Shortage of the gooddemanders are unable to buy all they want at the priceo Sellers can respond by raising prices which decreases demand= shift ALONG supply

and demand curve

o This equilibrium action is defined as law of supply and demando Surplus- opposite of shortage

Analyzing Changes in equilibrium

- Determine difference between change in demand or supply or change along thecurve refer to end of chapter 4

Chapter 5: Elasticity and its Application

The Elasticity of Demand


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- Elasticity- how much consumers respond to changes in variables, price, income,substitutes

o Price of Elasticity of Demandhow much the quantity demanded respondsto a change in price

oElastic means quantity demanded changes with factors inelastic doesntbudge

o Inelastic is horizontal or vertical? Rules of thumb for price elasticity ofdemand

Availability of Close Substitutesmore subs is more elastic Necessities versus Luxuriesnecessities more inelastic Definition of the Market -- narrower market (specific) more

elasticeasier to find substitutes

Time Horizon -- over a longer time goods become more elastic

Greater the number the more elastic the good

- Midpoint Methodo Given data take midpoint and calculate elasticity from thereo Price elasticity of demand = (Q2Q1) / [(Q2+ Q1) / 2]////(P2P1) / [(P2+ P1) /

2].

o From Q=quant P=Priceo Considered elastic if elasticity is greater than 1 quantity moves

proportionaley more than price

o Unit elasticity is when elasticicty=1o Flatter the curve more elastic the demand


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oo Total Revenuethe amount paid by buyers and received by sellers of a goodo Total revenue= PXQo When demand is inelastic (a price elasticity less than 1),

price and total revenue move in the same direction.o When demand is elastic (a price elasticity greater than 1),

price and total revenue move in opposite directions.o If demand is unit elastic (a price elasticity exactly equal to

1), total revenue remains constant when the price changes.- Elasticity and Total revenue along Linear Demand Curve

o On linear curves even though demand is constant elasticityis not


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oo 5-1f

- Other Demand Elasticitieso Income elasticity of demand- measures how the quantity

demanded changes as income changeso Income elasticity of demand = Percentage change in quantity

demanded////Percentage change in income.

o Cross Price Elasticity of Demand- measures how quantitydemanded of one good responds to a change in the price of

another good

o Cross Price Elasticity of Demand=

Substitutes have a positive value Compliments have a negative value

Elasticity of Supply

- Price Elasticity of Supply- measures how much the quantitysupplied responds to change in price

o Elastic- quantity supplied responds substantially to changein price

o Inelastic- quantity supplied responds only slightly tochange in price

o Factors are time period and amount of good producediebeachfront is inelastic

Price Elasticity of Supply=

- Variety of Supply Curveso Perfectly inelastic- verticalo Perfectly elastic- horizontal


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Chapter 6: Supply Demand and Government Policies

Controls on Prices

- Price Ceiling- maximum price set by government- Price Floor- minimum price set by government- How Price Ceilings Affect Market Outcomes

o If Price Ceiling is above equilibrium position it is notbinding and therefore nothing occurs

oo Price Ceiling dont help all buyerslonger wait times and

sometimes ice cream cannot even be attainedo Binding ceilings result in a shortage and rationing goodso Discrimination can occur in between seller and buyero Free markets ration goods with prices and are efficient and

impersonal

- How Price Floors Affect Market Outcomeso Equilibrium is above price floornothing occurso Equilibrium Above price floor this causes a surplus and is

binding

oTaxes

o Tax Incidence- how the burden of a tax is distributedamong people who make up the economy


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- Taxes on Sellers Affect Market Outcomeso Supply curve shifts left (upward)o Size in shift is equivalent to the size of the tax therefore at

distance between the shifted supply curve and the originalat the new equilibrium is equal to the size of the tax

oo Both are worse off but buyers get brunt

- How Taxes on Buyers Affect Market Outcomeso Demand curve affected

oo Taxes levied on sellers and buyers are equivalent

- Elasticity and Tax Incidenceo


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oo Naturally with more inelastic goods the firm will be able to

shove most of the tax onto the consumer and with elastic

goods that have inelastic supply and elastic demand


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Chapter 7:Consumer, Producers, and the Efficiency of Markets

Consumer Surplus- Willingness to pay- how much the buyer values the good (max

price)

- Consumer Surplus- amount buyer was willing to pay subtractedfrom what he paid- Using the Demand Curve to Measure Consumer Surplus

o

oo What Does Consumer Surplus Mean

Consumers determine their own benefit Consumer surplus does reflect economic

well beingProducer Surplus

-Cost and The Willingness to Sell- If opportunity cost is less than pay the work is done

o Product Surplus- the amount a seller is paid minus the costof production

Measures benefit seller receives from participatingin a market

- Using the supply Curve to Measure Producer Surpluso Same exact idea as the pervious graph with demand curves


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o The area below the price and above the supply curvemeasure the producer surplus in a market

o- How a Higher Price Raises Producer Surplus

oMarket Efficiency- Benevolent social planner

o All knowing, all powerful, well-intentioned dictatoro If allocation of resources maximizes total surplus we will

say its efficiento If a low cost producer is being skipped over by a high cost

producero Equality- do buyers and sellers have a similar level of

economic well-being


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oo Naturally people who value the good the most and can

make it the cheapest are the one who live in surplus.Thisis a product of the free mark. Economic well being cannot

be increased by the social plannero Free markets produce the quantityof goods that maximizes

the sum of consumer and producer surplus

o- Market Efficiency and Market Failure

o Without externalities free market would operate fine butsome political intervention is required

Chapter 8: Application: The Costs of Taxation

- The Deadweight Loss of Taxationo Cost of taxes to buyers and sellers exceeds revenue raised

by government Deadweight- Who pays the tax is dependent on elasticites and not on who the

tax is levied against


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-- How a Tax Affects Market Participants

oo Deadweight Loss Fall in total surplus that results when a

tax distorts a market outcome

oo Tax distorts incentives and causes markets to allocate

resources inefficiently- Deadweight Losses and the Gains from Trade


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o Ultimate source of deadweight- Taxes cause deadweightlosses because they prevent buyers and sellers fromrealizing some of the gains from trade.

oo People near the tip of the equilibrium are pushed out of the

market by the tax that shifts the price to the newequiblirum spot of money received and money paid bysupply and demander respectively

- Determinants of the Deadweight Losso Price elasticities of supply and demand determine size of

deadweight loss greater elasticity= greater deadweight


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- Deadweight Loss and Tax Revenue as Taxes Varyo Deadweight loss double tax- quandruple losso Triple tax- 9 times deadweight loss

oChapter 9: Application: International Trade

The Determinants of Trade

- Equilibrium without Trade

o-

The World Price and Comparative Advantageo World price- Prevailing world market priceo Action depends on the world price export if higher than

domestic if lower than import.o In essence it is a comparison of comparative advantages


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The Winners and Losers from Trade

- Must assume 1 economy will have no affect on market or worldprice

- This assumption doesnt mean our conclusions dont apply incomplicated cases

- Gains and Losses of an Exporting Country

oo Demand is perfectly elastic country is small and world

buys as much as it wantso Domestic producers are better offo Domestic consumers are worse off

- Gains and Losses of an Import Country

o


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o Supply curve is perfect elastic because country is smalleconomy

o Domestic consumers are better offo Domestic producers are worse off

- Trade raises the economic well being of nation in sense that gainsof winner exceed losses of losers

- Effects of a Tariffo Tariff- a tax on imported goodso Tarrifs reduce the quantity of imports and moves domestic

market closer to its equilibrium without trade

oo Red area is deadweight produced by tariff/tax

- Other Benefits of International Tradeo Increased Variety of goodso Lower costs through economies of scaleo Increased Competitiono Enhanced flow of ideas

Arguments for Restricting Trade

- May hurt domestic producers if world price is lower- The Jobs Argument

o Free trade can destroy a countries domestic jobs- The National-Security Argument

o Becoming dependent on a foreign company for goods ofnational security is a bad idea


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- The Infant-Industry Argumento Need restrictions to help get them started

- Unfair-Competition Argumento Free trade is desirable only if all countries play by same

rules Diff laws and regulations can give unfair advantagein 1 country

- Protection-as-a-Bargaining-Chip Argumento We can threaten to block trade as a bargain

It may not work and hurt own welfare Or back down and look dumb

o Job destruction is what leads to progressChapter 10: Measuring a Nations Income

The Economys Income and Expenditure

- GDP measures total income of everyone and total expenditure onthe economys output of goods and services

o Income must equal expenditure Every transaction has a buyer and a seller

oo GDP- the market value of all final goods and servicesproduced within a country in a given period of time

o GDP weighs values of different goodso GDP includes market value of housing services goods and

other things. Does not include illicit sells


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o GDP only includes final goodsex hallmark card not thepaper

o Unless an intermediate good is saved for a later date likestockpiling paper for another year

o GDP includes tangible goods and intangible (haircuts etc)o GDP does not include used good or goods created in thepast like used carso Usual interval is a year or a quarter but reported as a rate

($/yr)o Difference between total income vs dollar spent on good

Small discrepancy is called statistical discrepancyComponents of GDP

- Y=C+I+G+NXo C=Consumption

spending by households on goods and services(exluding new housing)

o I=Investment Purchase of goods that will be used in the future to

produce more goods and services. Sum of capitalequipment, inventories, and structures

Includes expenditure on new housingo G=Government Purchases

Spending by local state and federal Include salaries and expenditures on public works

o NX=net exports Exports-imports

- Other measures of Incomeo GNP

Total income earned by permanent resideso Net National Product

GNP- losses from depreciation Depreciation is defined as consumption of

fixed capital old machines etco National income

Total income earned by nations residents inproduction of goods and services

Almost identical to NNPo Personal income

Income that households and noncorporatebuisnesses receive

Exlcludes retained earnings- income thatcoproations have earned but not paid to owners

o Disposable personal income Income households and noncorporate buisnesses

have after satisfying all obligation to government


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o Introduction of new goods: when a new good isintroduced, consumers have more variety and cost forsame well being reduces

o Unmeasured quality change: quality good deterioratesfrom one year to the next but the price maintains the same,

the value of a dollar falls- GDP Deflator versus the CPI

o GDP reflects prices of all goods and services PRODUCEDdomestically

o CPI is BOUGHT by consumerso Makes sense with things like oilwhen oil goes up

CPI climbs much more than GDP because it isconsumed more than produced in the country

o 2ndDifferenceo CPI compares a fixed basket of goods in the base yearo GDP compares price of currently produced goods

-- Dollar Figures from Different Times

o

o Price level can be plugged in as CPI in that year- Indexation

o Indexed- a dollar amount is automatically corrected forchanges in price level by law or contract

o For example cost of living announcemento Many laws account for indexation and job wages- Real and Nominal Interest Rateso Dont compare amount of money before and after but the

amount of purchasing power Say collect 100 dollars in interest in a year starting

w/ 1000 DVD costs 10 bucks

0% inflation 10% increase purchase power


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6% inflation 4% increase purchase power 10% inflation 0% increase purchasing

power Dont forget deflation

- Nominal interest rate- measured in change in dollar amounts- Real Interest Rate- interest rate corrected for inflation

o Real Interest Rate= Nominal-Inflation Rate

Chapter 12: Production and Growth

Economic Growth around the World

- Growth rate measures change in real GDP per person per yearProductivity: Its Role and Determinants

- Productivity is an easy explanation for differences in standard- Productivity- the quantity of goods services produced from each

unit of labor input- How Productivity is determined

o Physical Capital per worker Physical Capital- the stock of equipment and

structures used to produce goods and services

Basically Tools Inputs like labor and capital are called factors of

production Capital is a produced factor of production capital

used to be an output but is now an inputo Human Capital per Work

Human Capital- knowledge and skills that workersacquire through education, training, experience

It is similar to physical capitalo Natural Resources Per Work

Natural Resources- inputs into production such asland rivers, mineral deposits

Renewable and non-renewableo Forests are renewableo Oil takes very long to renew so

nonrenewable short termo Technological Knowledge

Technological Knowledge- understanding the bestways to produce goods and services

Some knowledge like assembly linesbecomes public


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Others like Coca Cola recipe is privateEconomic Growth and Public Policy

- Saving and Investmento For a society to invest more in capital it must consume lessand save more incomeo Sacrifice consumption for higher consumption in the

future- Diminishing Returns and the Catch-Up Effect

o Capital is subject to diminishing returnso Diminishing Returns- as stock of capital rises, extra output

produced from unit of capital fallso Productivity increases less and lesso In the long run, the higher saving rate leads to a higher

level of productivity and income but not to higher growth

in these variableso But growth can last for several decades investing in capitalo Catch-up effect- poor countries that invest a little get

bigger returnseasier to catch up when behind

o- Investment from Abroad

o Capital Investment that is owned and operated by a foreignentity is called foreign direct investment

o Investment that is financed with foreign money butoperated by domestic residents is called foreign portfolioinvestment

- Educationo It is at least as important as investment in physical capitalo Investment leads to higher wages and positive

externalities such as a pooling of ideas


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o But poor countries face a brain drain effect where allhighly educated workers leave to enjoy higher standards ofliving in richer counties

- Health and Nutritiono Human capital can describe expenditures that lead to a

healthier populationo Wealth and health affect each othero Investing in one is a virtuous cycle

- Property Rights and Political Stabilityo Property right is ability of people to exercise authority

over the resources they owno Corruption and theft discourages domestic saving and

investment from abroado Political instability can be a cause in wavering property

rights- Free Trade

o Inward oriented policies try to increase productivity whileignoring outside influenceo Poor countries are better off pursuing outward oriented

policies that make the countries part of the economyo Geography matters for free trade.seaports are key and

landlocked countries face an extra roadblock- Research and Development

o To a large extent knowledge is a public goodo Government use to support farming research now focuses

more on aerospace research and scientific continuationo Patent system can encourage research government can

offer incentives- Population Growth

o With growth comes larger labor force but that also meansthe population consumes more

o Large amounts of population dilute Capital stockie schoolage children strain education system

o People also argue it promotes technological progessmorepeople means more scientist and invetors and that meansmore technological advance which benefits everyone

Chapter 13: Saving Investment and the financial System

Financial Institutions in the U.S. Economy

- Financial System- consist of the institutions that help to matchone persons saving with another persons investment

- Savers and Buyers


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o Possibly saving for retirement and borrowers possiblyborrowing for possession of a house

- The financial system is set up to coordinate savers and borrowerso Financial institutions are in two categories

Financial markets Financial Intermediaries- Financial Markets- institutions through which a person who

wants to save can DIRECTLY supply funds to a person who wantsto borrow

o Bond Market Bond a certificate of indebtedness that specifies

the obligations of borrower to hold of bond Identifies a time at which loan will be repaid,

called date of maturity

And interest rate that will be paidperiodically until it matures

Principal is repayment for the amountborrowed

Bonds can be sold Term- length of time until bond matures Perpetuity- bond that pays interest forever Credit Risk- probability that the borrower

will fail to pay interest or principal Default- Failure to pay Junk Bonds- offered by shaky companies that

have high risk of failure and therefore havehigh interest rates

Tax treatment- the way tax laws treat theinterest earned on a bond

Municipal bonds- local and state bondsarent taxed so have lower interest

o The Stock Market Stock- represents ownership in a firm and is

therefore a claim to profits that the firm makes Equity Finance- sale of stock to raise money Debt Finance- Sale of bond to raise money Own stock=partial owner, Own Bond=

creditor Stocks are higher risk and return Stock Index- computed average of a group of

stock priceso Dow Jones


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- Financial Intermediaries- financial institutions through whichsavers indirectly provide funds to borrowers

o Banks Besides the obvious they facilitate purchases of

goods and services allowing people to write checks

against deposits and debit cars Banks create special asset that is a medium of

exchangeo Mutual Funds

Mutual Fund- institution that sells shares to thepublic and uses the proceeds to buy a selection, orportfolio of various types of stocks bonds or both

Allows people with small amounts of moneyto diversify their investments

Potentially puts their money in hands ofbetter professional money managers

Index funds buy all stocks in a given stock index canperform even better than mutual funds 13-1b

Saving and Investment in the National Income Accounts

- Some Important Identitieso Y=C+I+G+NXo National Saving (T=tax)

S=I S=Y-C-G S=(Y-T-C)+(T-G) private saving + public Saving

o Private Saving- amount of income left after taxes andconsumption

o Public Saving- amount of tax revenue left after paying for itspending

o T>G- Budget Surpluso T


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oo We are talking about real interest rate

- Policy 1 Saving Incentiveso Could possibly change tax laws to promote saving

oo If a reform of the tax laws encouraged saving the resultwould be lower interest rates and greater investment

oo Investment Incentives

- Policy 2: Investment Incentiveo Investment tax credit gives a tax advantage to any firm

building a new factory/ new piece of equipment


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- Policy 3: Government Budget Deficits and Surpluseo Budget deficit produces

oo Less public savingo Crowding Out- fall in investment because of government

borrowingo Overall lesson- when government reduces national saving,

interest rate rises and investment falls

Chapter 14: The Basic Tools of Finance

Present Value: Measuring the Time Value of Money

o Finance- the field that studies how people make decisionsregarding the allocation of resources over time andhandling of risk

o Compare sums of money at different points in timeo How to manage risko Build on our analysis of time and risk to examine what

determines the value of an asseto Present Value- the amount today that would be needed at

current interest rates to match a future sumo Future Value- value of present money in the futureo Compounding- earn interest off interesto R=rate, X=amnt received in N years the present value is

X/(1+r)^N Finding present value of future sum is called

discountingManaging risk

- Risk Averse- people dislike bad things more than they likecomparable good things

- The Markets for Insurance


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oo Insurance is essentially a gamble and instead of the risk all

being on one person it spreads risk around say 10000people

o Insurance companies suffer from Adverse selection- self-selecting high risk applicant

pool Moral hazard- After people buy insurance they have

less incentive to be carful about risky behavior

- Diversification of Firm-Specific Risko Diversification- Dont put all investments in one basket

oo Firm Specific Risk- uncertainty associated with specific

companieso Market Risk- uncertainty associated with the entire

economy- Trade-off between Risk and Return

o Weighed out by personAsset Valuation

- What determines the price of a share of stock?o Supply and demando Persons willingness to pay for a share


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oo Percent of their savings in stocks

- Fundamental Analysiso Obviously wanted

Undervalued Fairly valued Overvalued

o Fundamental Analysis- detailed analysis of a company toestimate its value

o Dividends- cash payments that a company makes to itsshareholders

- The Efficient Markets Hypothesiso Efficient Market Hypothesis- all stocks are fairly valued all

the time since the # of people who overvalue them is thesame as the # who undervalue them

o 14.2 READo Basically the efficient market hypothesis says it is

impossible to beat the marketo Very hard to because irrationalities balance out and you

are left with a near perfect market- Market Irrationality

o Speculative Bubble- when price of an asset rises about itsapparent fundamental value

o Some think that irregularities and irrationalities arecaused by waves of optimism and pessimismbasically

human emotiono Informational Efficiency- description of asset prices that

rationally reflect all available information

o

Random Walk- path of a variable whose changes areimpossible to predict


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Chapter 15: Unemployment

Identifying Unemployment

- How is Unemployment Measured?o Employed: worked as employees, for their own business,

or unpaid in family members business

Both full-time and part time counto Unemployed: people who are not employed and have tried

to find employment in last 4 weeksalso accounts for

people laid off waiting for call backso Not In Labor Force: Students, homemaker, retireo Labor Force- sum of employed and unemployedo Unemployment rate- % of labor force unemployedo Labor Force Participation Rate-% of total adult population

in labor forceo Natural Rate of unemployment-normal rate of

unemployment around which unemployment fluctuateso Cyclical Unemployment-efentition of this cycle natural

rate is 5%

o

o


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- Does The Unemployment Rate measure what we want it to?o Discouraged workers- do not show up in unemployment

stats stop looking after a while even though they areworkers without jobs

o Marginally attached workers are persons who currently are neitherworking nor looking for work but indicate that they want and areavailable for a job and have looked for work sometime in the recent past.

o Discouraged workers are marginally attached workers who have given ajob-market-related reason for not currently looking for a job.

o Persons employed part-time for economic reasons are those who want andare available for full-time work but have had to settle for a part-timeschedule.

- How Long are the Unemployed without Work?o Most spells of unemployment are short, and most

unemployment observed at any given time is long-term Its very few that are unemployed for long

- Why are There Always Some People Unemployedo Frictional unemployment- unemployment that is a result

of finding the right workers for the right jobso Structural Unemployment-Quantity of labor supplied

exceeds quantity demanded This results when wages are set above equilibrium

by either Minimum wag

e laws

Unions Efficiency Wages

Job Search

- Job Search- Process of matching workers with appropriate jobs- Why some Frictional Unemployment is Inevitable

o Sectoral Shifts: changes in composition of demand amongindustries or regions

Oil firms cut back workers with dropping prices Automakers increase production with slashed oil

prices- Public Policy and Job Search

o The internet helps expedite job searcho They have govt programs but some say it hurts job search

- Unemployment Insuranceo Unemployment Insurance- government program that

offers partial protection against job loss This also increases the amount of unemployed

because it offers less of an incentive to work again


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Minimum-Wage Laws

-- Dont affect that many people vast majority of workers are above

minimum wage

Unions and Collective Bargaining

- Union- a worker association that bargains with employers overwages, benefits, and working conditions

- Economics of Unionso Collective Bargaining- process by which unions and firms

agree on terms of employmento Strike-union can organize a withdrawal of labor from the

firm

- Are Unions Good or Bad for the Economyo Critics

Unions are a type of cartel Reduce quantity of labor demanded Cause workers to be unemployed and reduce

wages in the rest of the economy Inefficient and inequitable Workers benefit at expense of others

o Advocates Necessary antidote to market power Fights company town Protect workers

- The Theory of efficiency Wageso Efficieny Wages- firms operate more efficiently if wages

are above equilibrium Ma ybe profitable for firms to keep wages high even

in a surplus of laboro Theories as to why this might be true

Higher wages means better worker health


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Worker turnover with less turnover less cost toretrain people

Worker Quality: get talented workers with highwage incetive

Work Effort: High wages make workers more eagerto keep their jobs

PRELIM 1 COMPLETE


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Chapter 16: The Monetary System

The Meaning of Money

- The Functions of Moneyo No money have to barter: exchange good for another good

In a barter system trade requires a doublecoincidence of wants: each person has a good theother wants

o Money is used to mean Wealtho Money- is the set of assets in the economy that peopleregularly use to buy goods and services from each othero Even though stocks would make you wealthy they are not

considered money- you cant buyo Money has three functions in the economy that other

functions of wealth do not Medium of exchange

Is an item that buyers give to sellers whenthey purchase goods and services

Unit of account Yardstick people use to post prices and

record debts Store of value

Item that people can use to transferpurchasing power from the present to thefuture

Wealth refers to total of all stores of valueo Including monetary and nonmonetary

Liquidity How easy with which an asset can be

converted into the economys medium of

exchangeo Houses and Rembrandt paintings are

not easily liquidatedo Stocks and Bonds are

- Kinds of Moneyo Commodity Money

When money takes the form of a commodity withintrinsic value


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Intrinsic valueo Item would have value even if it were

not used as moneyo I.E Goldo When money=gold it is called gold

standard Fiat Money

o Money without intrinsic valueo Fiat is an order or decree so money

established by government- Money in the US Economy

o Money Stock Quantity of money circulating

Currencyo Paper bills and coins in the hands of

the public

Demand depositso Balances in bank accounts that

depositors can access on demandsimply by writing a check or debitcard

The Federal Reserve System

o Federal Reserve Central bank of the United States

o Central Bank An institution designed to oversee the banking

system and regulate the quantity of money in theeconomy

- The Feds Organizationo 7 members of the board of governors


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o Have 2 Jobs Regulate banks and ensure the health of the

banking system

Feds act as a lender of last resort Lender who cant borrow from anyone else Banks can get regular loans from Fed

Control quantity Of Money that is available ineconomy

Quantity is called money supplyo Decisions about the money supply is

called monetary policy- Federal Open Market Committee

o The Feds primary tool is the Open Market Operation Purchase and sale of US government bonds

When FOMC wants to increase money supplyFed creates dollars and buys government

bonds from public in bond markets

Banks and the Money Supply

- Simple Case of 100% Reserve Bankingo Reserves

Deposits that the bank receives but have not loanedout

o With all money in deposits banks do not influence thesupply of money

- Money Creation with Fractional-Reserve Bankingo Fractional-reserve banking

Banking system in which banks hold only a fractionof deposits as reserves

o Reserve ration Fraction of total deposits that it holds as reserves

o Feds set a minimum reserve requirement Excess reserves is reserves above minimum excess

o When Banks hold only a fraction of deposits in reservebanks create money

o Basically make the economy more liquid but it is NOT anywealthier

Loans create a corresponding liability for those whoborrowed money

- The Money Multipliero Money Multiplier

The amount of money the banking systemgenerates with each dollar of reserves


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Money multiplier is the reciprocal of the reserveration

- Bank Capital, Leverage, and the Financial Crisis of 08-09o Bank Capital

Resources that a bank obtains from issuing equityto its owners

o 16-3do Leverage

Use of borrowed money to supplement existingfunds for investment purposes

o Leverage Ratio Ratio of the banks total assets to bank capital

o Insolvent Bank is unable to pay off its debt holders and

depositors in fullo Capital requirement

Banks held to this amount so that banks will be ableto pay off their depositors Capital requirement depends on the risk of of banks

assetsThe Feds Tools of Monetary Control

-How the Fed Influences the Quantity of Reserveso Open Market Operations

Buy or Sell Government Bondso Fed Lending to Banks

Banks borrow to satisfy Regulators Depositor withdrawals New loans Or other reasons

Discount Rate When banks borrow from Feds discount

window Feds use lending not only to control money supply

but to also help financial institutions when they arein trouble

- How the Fed Influences the Reserve Ratioo Feds can change the reserve requirementso Feds can also choose to pay interest on reserves

In doing so it promotes for the bank to hold moremoney in reserves and introduces money into theeconomy

- Problems in controlling the Money Supply


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o Fed does not control the amount of money that householdschoose to hold as deposits in banks

The less money in deposits in the bank the lessmoney can be created through reserves and loans

o Fed does not control the amount that bankers choose tolend

Sometimes fewer loans and greater reserves willlead to less money than other days

Not totally consistent day to day Fed is vigilant so it gets updated stats every week

- Federal Funds Rateo Short term interest rate that banks charge one another for

loans Usually are paid overnight

o Feds can try to control federal funds rate buy injectingmoney into banks strengthening reserves which creates

fewer banks that need loans

Chapter 17: Money Growth and Inflation

The Classical Theory of Inflation

- The Level Prices and the Value of Moneyo Inflation concerns the value of the economys medium of

exchangeo We can view the price level as the price of a basket of

goods and services or as a measure of the value of moneyo When overall price levels rise, the value of money falls

It is the measure of how much money is worth ingoods

- Money Supply, Money Demand, and Monetary Equilibriumo Supply and demand for money determines the value of

money Assume that money supply is a variable that Fed

Controlso Money Demand

Basically how much wealth people want in liquidform

Also depends on interest rates but for a latertime

Main Variable is average level of prices in theeconomy

Higher price level (lower value of money)increases quantity demanded


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o What ensures that the quantity of money the fed suppliesbalances out demand?

Short run Interest rates play a role

Long run Overall level of prices adjusts to the level atwhich the demand for money equals the

supply- basically comes to EQ

- The Effects of a Monetary Injection

o With an increase in money supply the value of moneydecreases

Quantity Theory of Money Quantity of money available in an economy

determines the value of moneyo Growth in quantity of money is

primary cause of inflation

- A Brief Look at the Adjustment Process

o Injection of money increases the demand of goods andservices

Economys ability to supply goods and services hasnot changed


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oo Sometimes the government will pay for its spending byliterally printing its moneyo Inflation tax

Government raises revenue by printing money It is not a legit tax but a tax that affects

everyone who holds money Also defined as the revenue the government

raises by creating money- The Fisher Effect

o Real interest rate tells you about your change inpurchasing power

Real Interest rate= nominal-Inflationo When the fed increases the rate of money growth the long

run result is higher inflation and higher nominal interestrate

This 1:1 balancing is to show that the real interestrate is unaffected by money

Called Fisher Effect

The Costs of Inflation

- A fall in Purchasing Power? The Inflation Fallacyo Inflation itself does not reduce peoples real purchasing

power Everyone is affected and everyone has more money

o Although the effect of the money supply is not obvious toreal variables persistent growth in money supply doeshave an effect


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- Shoeleather Costso Inflation tax transfers resources from households to

governmento Inflation tax gives people an incentive that causes

deadweight losses for society as a whole Waste of scarce resources trying to avoid tax

o Small example is withdrawing smaller amounts of moneyfrom the bank at a time

This is done in order to keep more gatheringinterest in bank

o Shoeleather cost Resources wasted when inflation encourages

people to reduce their money holdings i.e. have to walk to the bank more and wear

down their shoes- Menu Costs

o Cost of adjusting prices on a menu Average firm reduces costs once a year

o Menu Costs Costs of changing prices

Wasted Resources Time spent deciding new prices Making and send new price catalougs

o Basically when it gets so bad you go out of your way tochange nominal values it causes deadweight

- Relative-Price Variability and the Misallocation of resourceso When inflation distorts relative prices consumer decisions

are distorted and the market is less able to allocateresources

o Basically the reverse of menu changing it is when the menuisnt changed how relative prices change dramatically

- Inflation-Induced Tax Distortionso Tax code creates burden on income earned from savings

Nominal Capital Gains tax treatment Nominal Interest Income Tax treatment

o One Solution is to index inflation so that tax laws written toinclude inflation

- Confusion and Inconvenienceo Changing values of money in relation to real purchasing

power just confuses publico Federal Reserves job is to ensure reliability of a unit of

measuremento Inflation can make it more difficult for investorts to sort

successful from unsuccessful firms


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- A Special Cost of Unexpected Inflation: Arbitrary Redistributionsof Wealth

o Surprise inflation effects people that take out loans Inflation can redistribute wealth among debtors

and creditors Can take into account inflation with nominalinterest rate

- Inflation is Bad, But Deflation May Be Worseo Moderate deflation would negate the shoeleather

argument Cost of holding money would go down and

approach 0 Called Friedman Rule

But There are also similar costs to deflation asinflation like menu costs and stuff

Deflation is often a symptom of a deeper economicproblems

Deflation normally hurts poorer side thedebtors and drives up unemployment

Chapter 18: Open-Economy Macroeconomics: Basic Concepts

The International Flows of Goods and Capital

Closed Economy-economy that does not interact with othereconomies

Open Economy- economy that interacts freely with othereconomies around the world

- The Flow of Goods: Exports, Imports and Net Exportso Exports- domestically produced sold abroado Imports- foreign produced sold domesticallyo Net Exports- difference between value of exports and

imports Also called Trade Balance Trade surplus NX>0 Trade defecit NX


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Cost of transport Government Policies

oo Weight of object effects how easy it is to export/import

- The flow of Financial Resources: Net Capital Outflowo Net Capital outflow (net foreign investment)

The purchase of foreign assets by domesticresidents minus the purchase of domestic assets byforeigners

o Mcdonalds in Russia Foreign direct investment

o American Buys stock in Russian Corp Foreign portfolio investment

o Variables that influence net capital outflow Real interest rate comparison Perceived economic and political risk Government policies

- The Equality of Net Exports and Net Capital Outflowo Net capital outflow= net exports

Trade Surplus NX>0 With foreign currency it buys foreign assets NCO>0

- Saving Investment, and Their Relationship to the InternationalFlows

o S=I+NXo S=I + NCO

When a nations savings exceeds domesticinvestment it invests also abroad so NCO>0


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oThe Prices for International Transactions: Real and Nominal Exchange

Rates

- Nominal Exchange Rateso Nominal Exchange rate

Rate at which a person can trade the currency ofone country for the currency of another

o Appreciation When the Dollar Buys more currencyo Depreciation When Dollar Buys less currency

o When the dollar is said to strengthen it can buy moreforeign currency

- Real Exchange Rateso Real Exchange Rate

Rate at which person can trade goods and service


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Real exchange Rate= (Nominal Exchange Rate XDomestic Price) /// Foreign Price

o Real exchange rate is key to how much a country importsand exports

o Use price indexes to calculate real exchange rate Price index of US=P Price Index of Foreign= P* E= nominal exchange rate Real Exchange rate=(e x P)/P*

A First Theory of Exchange-Rate Determination: Purchasing-Power

Parity

Pruchasing Power Parit- a unit of any given currency should be able to buy

the same quantity of goods in all countries

- The Basic Logic of Purchasing-Power Parityo Law of one Price

A good must sell for the same price in all locationso Arbitrage

Taking advantage of price differences for same itemin different markets

Basically over time the money you make witharbitrage will drive supply and demand until itsprice is uniform in all markets so a yen buys the

same item in japan as in the US- Implications of Purchasing-Power Parity

o Example If a pound of coffee costs 500 yen and $5

Then the exchange rate should be100yen/dollar

1/p=e/p*o If purchasing power of dollar is always same at home and

abroad real exchange rate, relative price of domestic andforeign goods cannot change therefore it is constant

o Nominal exchange rate depends on the price level in eachcountry

o ** When Central bank prints large amounts of money, thatmoney loses value both in terms of the goods and service itcan buy and in terms of amount of currency**


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o- Limitations of Purchasing-Power Parity

o Many goods are not easily traded so the reflected value inreal purchasing power might not shine through

Haircuts have difficult arbitrage and the real pricedifference would be hard to eliminate

o Second Reason is that many goods are not perfectsubstitutes when they are produced in different countries

Types of Cars for example

Chapter 19: A Macroeconomic theory of the Open Economy

Supply and Demand for Loanable Funds and For Foreign-currency

Exchange

- The Market for Loanable Fundso When NCO>0 the country is experiencing a net outflow of

capital: the net purchase of capital overseas adds to thedemand for domestically generated loanable funds

o At equilibrium interest rate the amount that people wantto save balances desired quantities of domestic investmentand net capital outflow

o Real interest rate in each country matters and is thedeciding factor in deciding between two countries to buy

bonds from


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o- The Market for Foreign-Currency Exchange

o NCO=NXo Real exchange rate balances supply and demand in market

for foreign currency exchange

o Converting back and forth from dollars to yen to

dollars offsets anything gained from NCO so that iswhy the supply of dollars is vertical

o If real exchange rate is below equilibrium level quantity ofdollars supplied would be less than demanded resulting inshortage that would push value of dollar upward

- Net Capital Outflow: The Link Between the Two Marketso In Market of Loanable funds

Supply comes from national savings Demand comes from domestic investment

and net capital outflow And the real interest rate balances supply

and demando In Market of Foreign-currency exchange

Supply comes from net capital outflow Demand comes from net exports Real exchange rate balances supply and

demand


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o Net Capital outflow links two markets When US interest rate is high owning US assets is

more attractive NCO for US is low

- Simultaneous Equilibrium in Two Markets

oHow Policies and Events Affect an Open Economy

- Government Budget Deficitso What happens when a government operates in a deficit in

an open economy


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oo Higher interest rates prevent foreign investment and

promote foreigners in domestic investmento In an open economy budget deficit

Raises real interest rates Crowds out domestic investment Causes currency to appreciate Push trade balance toward deficit

- Trade Policyo A government policy that directly influences the quantity

of goods and services that a country imports or exports Tariff- tax on imported goods Import Quota-limit on quantity

o Effects of an Import quota


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o Import quota reduces imports and exports but NX stays

the same When dollar appreciates in value in market for

foreign-currency exchange domestic goods becomemore expensive relative to forging goods

This encourages imports and discourages exportso Trade policies do not affect trade balance

NX=NCO=S-I- Political Instability and capital Flight

o Capital Flight Large and sudden reduction in demand for assets

located in a country


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Chapter 20: Aggregate Demand and Aggregate Supply

Recession- period of falling incomes and rising unemployment

Depression- severe form of recession

Three Key Facts about Economic Fluctuations

- Fact 1: Economic Fluctuations are Irregular and Unpredictableo Fluctuations are often called the business cycleo Fairly impossible to predict


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o- Most Macroeconomic quantities Fluctuate Together

o Real GDP variable used to monitor short run changeso For Short-run fluctuations the variable you look at does

not really matter Income Auto sales Retail sales

- Fact 3: AS Output Falls, Unemployment Riseso Changes in economys output of goods and services are

strongly correlated with changes in economys utilization

of labor force


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Explaining Short-Run Economic Fluctuations

- The Assumptions of Classical Economicso Money is a veil

Only real variables matter- The Reality of Short-Run Fluctuations

o Classical theory applies in long run but not in the short runo Example

When new gold was found it took time for prices torise that means more purchasing power and higheramounts of employment and production

o New model focuses on real and nominal variableinteraction

- The Model of Aggregate Demand and Aggregate Supplyo Focus on two variables

Economys output of goods and services Real GDP

Average Level of Prices Measured by CPI or GDP deflator

o Model of aggregate demand and aggregate supply Model that most economists use to explain short-

run fluctuations in economic activity around itslong-run trend

Vertical Axis Overall price level

Horizontal axis Overall quantity of goods and services

producedo Aggregate demand curve

Quantity of goods and services that these industrieswant to buy

Households Firms Government Customers abroad

o Aggregate supply curve Quantity of goods and services firm produce and

sell at each price levelo Price level and quantity output adjust to bring demand and

supply into equilibriumo Microeconomic understandings of 1 market and one item

does not applyo We need a macroeconomic theory that explains

Total quantity of goods and services demanded Total quantity of goods and services supplied


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The Aggregate-Demand Curve

-- Y=C+I+G+Nx

o Each component contributes to aggregate demand forgoods and services Assume G is fixed by government policy

o The Price level and Consumption: The Wealth Effect A decrease in price level raises real value

Makes one wealthier Increase in spending means larger quantity of

goods and services demanded Increase in price level reduces real value of money

Reduces consumer spending and quantity ofgoods and services demanded

o The Price Level and Investment: The Interest-Rate Effect Lower price level reduces interest rate

Encourages greater spending on investmentgoods

Increasing quantity of goods and servicesdemanded

Higher price level raises interest rate Discourages investment spending Decreases quantity demanded

o The Price Level and Net Exports: The Exchange-Rate Effect Fall in price level

Causes interest rates to fall Real value of dollar declines Depreciation stimulates net exports

o Increases quantity of goods andservices demanded

Rise in price levelo Interest rates rise


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o Real value increaseso Appreciation reduces net exports and

quantity of goods and servicesdemanded

Three reasons fall in price level increases quantityof goods and services demanded

Consumers are wealthier Interest rates fall stimulates demand for

investment goods

Currency depreciates Stimulates demand fornet exports

- Why the Aggregate-Demand Curve Might Shifto Shift Arising from Changes in Consumption

Any event that changes how much people want toconsume at a given price level shifts the curve

Saving money for retirement shifts to left Investments shift to right

Cut taxes promotes spending so shifts righto Shift Arising from Changes in Investment

Any event that shifts how much firms want to investat a given price level

New computer technologyo Invest in computers increases so shift

to right Tax policy

o Tax credit shift to right Increase in money supply

o Stimulates investment shift to righto Shift Arising from changes in Government Purchases

Reduce purchases Demand curve shifts left

Increase Shifts Right

o Shifts Arising from Changes in Net Exports Foreign recession

Fewer exports shift to left Confidence lost in foreign economies

Appreciates US dollaro Makes US goods more expensive shift

to left

The Aggregate-Supply Curve

Long Run aggregate-supply is verticalShort run it is upward sloping


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- Why it is vertical in the Long Runo In the Long run economy production is based on real GDP

Depends on Labor Capital Natural resources Technology

Just a factor since GDP is only a function of Outputand not price level in long run so it is vertical

Vertical curve is a graphical representation ofclassical dichotomy and monetary neutrality

- Why the Long Run Aggregate-Supply curve Might Shifto Natural rate of output

Production of goods and services that an economyachieves in the long run when unemployment is atits normal rate

o Shifts Arising from Changes in Labor Immigrants

More labor shift to right Any change in natural rate of unemployment shifts

the long-run aggregate-supply curve Unemployment natural rate could shift due

to government policyo Shifts Arising from Changes in Capital

Increase in capital stock increases productivity Shift to right

o Shifts from changes in Natural resources New mineral discovery

Shift to righto Shifts from Technological Knowledge

Invention of Computer Shifts Right

- Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation

o Most important forces are technology and monetary policy Short-run fluctuations in output and price level

should be viewed as deviations from continuing

long run trends of output growth and inflation- Why the Aggregate-Supply curve slopes upward in the Short Run


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oo When the price level rises aggregate supply shifts to the

righto All theories share same theme

Quantity of output supplied deviates from long runlevel when actual price level deviates from expectedprice level

o 3 Theories

Stick-Wage Theory Nominal wages are slow to adjust tochanging economic conditions

o So therefore short run the wages aresticky

o Price level turns out 105 instead of100 and wages are stuck at $10

Amount hired will increase


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o Nominal wages based on expectedprices and dont respond immediately

when the actual price level isnt the

expected Sticky-Price Theory

Similar to menu costs Expected prices are higher than actual

o Lag behind sales decline andproduction is cut back

The Misperceptions Theory Changes in overall price level can

temporarily mislead supplies about what ishappening in individual markets

o Overall price level falls Production will decrease

o Suppliers of goods and services may notice theprice of their output rising and infer,mistakenly, that their relative prices are rising.They would conclude that it is a good time toproduce.

Quantity of output Supplied= Natural Rate+ a( APL-EPL)

Actual price level-expected- Why the Short-Run Aggregate-Supply Curve Might Shift

o 1 new variable from short run aggregate supply Price level that people expected to prevail

When expected price level riseso Shift to lefto Higher wages, cost increase, firms

produce smaller quantity of goodsand services at any given actual pricelevel

An increase in the expected price levelreduces supply shift left

Two Causes of Economic Fluctuations

- The Effects of a Shift in Aggregate Demando Wave Of pessimism

Cut back in spending Firms delay purchases

o Four steps to analyzing macroeconomic fluctuations Which curve shifts Which direction does it shift Impact of price level in the short run


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Keep track of new short-run equilibrium and longrun equilibrium and their transition

oo Example

Wave of pessimism affects spending plans Aggregate demand curve affected

Second Households and firms want to buy a smallerquantity of goods at any price level

Reduces aggregate demandshift to left Price Level falls down along short run aggregate

supply

Afterwards short run supply shift right tobalance out and be at same point along longrun aggregate supply curve

Shifts the curve are affected in the long run entirelyby price level and not by level of output

Shift in aggregate demand is nominal change- The Effects of a shift in Aggregate Supply

o Stagflation Falling output and rising prices

Occurs when aggregate supply curve shiftsto left

Shift in price level expectation may evenincrease nominal wages

o Higher prices leading to higher wagesleading to higher prices

Wage-price spiral


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Supply curve brings itself back into line

Spiral slows down and with highunemployment companies have leverage

oo Government could make a policy to keep output the sameo This would permanently rise prices

Chapter 21: The Influence of Monetary and Fiscal Policy on AggregateDemand

How Monetary Policy Influences Aggregate Demand

For US Economy most important reason for downward slope of aggregatedemand is interest-rate effect

Theory of Liquidity Preference- Keynes theory that the interest rate adjuststo bring money supply and money demand into balance

- The Theory of Liquidity Preference


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o For this chapter assume short term so inflation ispractically constant

Nominal and real interest rates move togethero Money Supply

Open Market Operations Discount Rate In This Chapter assume money supply is fixed by

Fed Money Supply is independent of Interest Rate

o Money Demand

Increase in interest rate increases cost of holdingmoney so decreases demand

Opposite is also trueo Equilibrium in the Money Market

Interest rate adjusts to balance the supply anddemand for money

Equilibrium interest rate Forces people to be content with money the Fed has

created- The Downward Slope of the Aggregate-Demand Curve

o Higher price level raises money demando Higher money demand leads to higher interest rateo Higher interest rate reduces quantity of goods and services

demanded


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oo Interest rate is price of borrowing

- Changes in the Money Supplyo Whenever the quantity of goods and services demanded

changes for any given price level, the aggregate-demandcurve shifts

oo When Fed increases money supply lowers interest rate andincreases quantity of goods and services demanded at anygiven price shifting AD curve to right

- The Role of Interest-Rate Targets in Fed Policyo Federal funds rate is the target of a lot of Fed policies

Even though they affect the money supplyo Monetary policy can be described either in terms of the

money supply or in terms of the interest rateo Changes in monetary policy aimed at expanding aggregate

demand can be described either as increasing money

supply or lowering interest rate

How Fiscal Policy Influences Aggregate Demand

Fiscal Policy- government choices regarding overall level of governmentpurchases and taxes

- Changes in Government Purchases


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o IF the government places 20 billion to order new fighterjets

Which way will the curve shift Multiplier effect aggregate demand shift larger than

20 billion Crowding out effect

Shift less than 20 billion- The Multiplier Effect

o Repercussions of 20 Billion dollar Purchaseo The 20 billion the government spent is felt by the workers

increased wages and employment They then go out with higher income and demand

more goods and services Each dollar spent by government can raise demand

by more than a dollar Called Multiplier effect

o Investment accelerator

When higher demand for planes is used to buymore equipment or build other plants

Higher demand spurs higher demand forinvestment goods

- A Formula for the Spending Multipliero Marginal Propensity to Consume

The fraction of extra income that a householdconsumes rather than saves

o Multiplier= 1/(1-MPC)o Basically measures how much consumer will spend with

change to income- Other Applications of the Multiplier Effect

o Applies to any component of GDP- The Crowding-Out effect

o $20 billion spending by government causes interest rate torise


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Reduces investment spending and puts downwardpressure on aggregate demand

o Crowding-out effect Reduction in aggregate demand that results when a

fiscal expansion raises the interest rate

o- Changes in Taxes

o Household perception about a permanent or temporarytax change effects size in shift of aggregate demand

Using Policy to Stabilize the Economy

- The Case for Active Stabilization Policyo Government should stabilize the private economies

aggregate demando

Government should avoid being a cause of economicfluctuationso Fight waves of optimism and pessimismo Take away the punch bowl just as the party gets going

- The Case Against Active Stabilization policyo People believe economy should be left to stabilize short

run fluctuationso Admit in theory it can stabilize economy but doubt

whether it is possible in practiceo There is a lot of lag

Monetary policies changes nterest rates Which influences investment spending

But many firms make investment plans far inadvance

o At least six months for changes in monetary policy to haveeffect

o Changes can last for several years- Automatic Stabilizers


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-- Negative relationship between employment and inflation

- Aggregate Demand, Aggregate Supply, and the Phillips Curveo Phillips curve shows the combinations of inflation and

unemployment that arise in shifts of AD

oShifts in the Phillips Curve: The Role of Expectations

- The Long-Run Phillips Curveo People face a long run Phillips curve that is vertical

Money neutrality of the real variableunemployment

o Unemployment tends towards it natural rate ofunemployment


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o- The Meaning of Natural

o Unemployment rate to which the economy gravitatestoward

o Say unions get more power the natural rate ofunemployment goes up

Natural because it is beyond the influence ofmonetary policy

o Other policies can change unemployment Improving function of the labor markets can do just

thato Lower unemployment means more workers producing

more goods and services For any given rate of money growth and inflation

- Reconciling Theory and Evidenceo Expected inflation

Measures how much people expect the overall pricelevel to change

Expected price level effects nominal wages Expected inflation determines position of short run

aggregate supply curve Every monetary change eventually goes from actual

to expected in which the curve shifts back to longrun equilibrium

- The Short-Run Phillips Curveo Unemployment Rate= Nat Rate- a(actual inflation-expected

inflation)


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oo Over time the expected becomes the actual and in doing so

they will take into accounto Overtime you only change inflation and not employment

- The Natural Experiment for the Natural-Rate Hypothesiso Natural state hypothesis

Unemployment eventually returns to its naturalrate, regardless of the rate of inflation

US economy experiment was shown to hold true As consumers got used to the idea of higher

inflation prices and wages adjusted andunemployment fell back to its natural rate

Shifts in the Phillips Curve: The Role of Supply Shocks

Supply Shock- an event that directly alters firms costs and prices, shifting

the economys aggregate-supply curve and thus the Phillips curve

Example is when oil becomes scarce cost of producing gasoline, heating oil,tires and other goods goes up

This means it reduces quantity of goods and services supplied at any givenprice level

StagflationFalling output and rising pricesOccurs with supply shock in this case


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Adverse shift in AS policymakers have to fight either unemployment orinflation

The Curve future of the PC depends on peoples perception

If people expect the supply shock to be temporary expected inflation will notchange and the curve will soon revert to its former position if people believeit is a new era of higher inflation curve will remain in less desirable position

Policymakers accommodate adverse shock supply by increasing aggregatedemand with money injection

Still had to deal with trade-off between inflation and unemployment formany years

OPEC-used market power

The Cost of Reducing Inflation

Policy pursued by Fed to combat OPEC was disinflation

Disinflation

Reduction in Inflation

- The Sacrifice Ratioo When Fed contracts money

Aggregate demand falls Reduces quantity of goods and services that firms

produce Fall in production leads to rise in unemployment

o In order to reduce inflation we must endure a period of highunemployment and lower output


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oo Studies done estimating cost to reduce inflationo Sacrifice Ratio

Number of percentage points annual output lost inprocess of reducing inflation by 1%

Typical ratio is 5o Could either reduce it in 1 year or in 5

More spread out with less effect on percent productionis seen as better

Not as extreme- Rational Expectations and the Possibility of Costless Disinflation

o Rational Expectations People optimally use all information they have

Info about government policies the forecastingand future

o All about expected versus actual inflationo With super accurate expected inflation rates compared to

actual short run repercussions are very short lived

- The Volcker Disinflationo Volcker disinflation came at the cost of producing a recession

Inflation goes down and unemployment increases


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Shift back to same unemployment occurs asexpected inflation rate meets actual

o Two positive outcomes Volcker Disinflation did not impose as high as a

sacrificial ratio as calculated

People didnt believe Volcker so expected inflation didnot fall and the short run curve didnt shift down asquickly as it could have

- The Greenspan Erao Small fluctuations in unemployment and inflation rate

o Started with favorable supply shocko Experienced favorable shift in both direction of inflation and

unemployment

Inflation was almost 0 and unemployment lowered People thought natural rate was lower

9/11, dot.com bubble, corporate accounting scandals- The Phillips Curve during the Financial Crisis

o After the housing bubble Inflation decreased and unemployment increased

Government wanted to enact a policy of ridingthe Phillips curve back upward

o


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Chapter 23: Six Debates over Macroeconomic Policy

Should Monetary and Fiscal Policymakers try to Stabilize the Economy

- Pro Argumento Economies tend to fluctuate When households and firms become pessimistic

They cut back spendingo Reducing aggregate demand

Real GDP and other measures of income fallo No reason for society to suffer through the booms and

busts of business cycle Leaning against the wind

Strategy used to try to balance out severityof economic fluctuations

o Increase spendingo Cut taxeso Boost money supplyo When AD is excessive

Cut taxes Government spending Expand money

- Cono Lab in enacting monetary policy six monthso Sometimes policy overcompensates for a small natural

fluctuations and overshoots its target demand or outputo Do no harm doing to much is bad

Should the Government Fight Recessions with Spending Hikes Rather

than Tax Cuts

- Pro Spending Hikeo By increasing money supply interest rates lower

This favors new spending and adds to aggregatedemand

o Fiscal actions can have multiplier effects: Higher leads tohigher incomes leads to more demand

o Traditional Keynesian anlaysis indicates govnermnetspending is better than tax decreases

o Not all tax decreases goes to spending (especially true iftax cut is viewed as temporary

o 3 kinds of spending Shovel-ready Federal aid


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Increased payments to jobless throughunemployment insurance

- Con: Should use Tax Cutso Have influences on AD and ASo Increase AD by increasing disposable incomeo Can choose to do tax credits on investments Most volatile component of GDP and stimulating

investment is key to ending recessiono Tax cuts create a system where unemployed workers have

greater incentive to search for jobs Work longer hours Therefore increasing supply

o Tax cuts can increase production without increasinginflation

o Problems with increasing spending Consumers understand spending likely means tax

increases to help pay for spending Taxes increases to support spending will account

for deadweight loss with greater taxeso Can the government spend money quickly and wisely

Planning takes years and proper spending mighttake extra time to decide

o Tax cuts have advantage of decentralizing spendingo Possibility of ill conceived bridges to nowhereo Short run benefit of government spending may not

compensate for long-run cost

Should Monetary Policy be made by rule Rather than by Discretion

- Pro Monetary Policy should be made by ruleo Possibility of too much powero Political Business cycle

Central bank manipulates economy to get reelectionof president

o Might lead to more than desirable inflationo Might just want to keep achieving lower employmento Commit central bank to policy rule

3% growth money per year 1% for every percent unemployment rises above its

natural rate- Con Should not be made a rule

o One advantage of policy is flexibilityo A lot of the alleged problems are hypotheticalo Corruptiono Political motives


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o Balanced budget means greater national saving Investment Economic growth College grads enter more prosperous economy

o As long as deficit is moderate it is ok 1.5 trillion is to muchShould the Tax Laws be Reformed to Encourage Saving

- Pro Tax laws should encourage savingso Saving rate is key determinant of long run prosperityo Higher Savings Rates is bettero Tax code nowadays discourages savingo Investments and saving stuff is heavily taxedo Can be like a tax on wealtho Tax can improve to be an incentive to saveo Maybe reconsider entire tax system

Switch from income to consumption which wouldincrease incentive to save- Con Tax laws should not be reformed to encourage saving

o Tax law should also try to distribute burden fairlyo Problem with these proposals is that incentive to save

increases burden on those who can least affordo The tax policy may not be effective anyways

No theory shows that taxes to incentivize savingwill do that

o Substitution effect and income effect Higher rate of return raises the benefit of saving Higher rate of return lowers need for saving Both depend on target level of consumption in the

futureo Ways to increase saving other than tax breaks on richo Can increase net saving by reducing budget deficit

Also increases prosperity for future generationso Tax reforms for more savings increase budget deficit

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