Circular Flow

The Government’s Role

Imperfect Information Externalities Public Goods Lack of Competition Business Cycles

Correct for:

Externalities• Someone outside a transaction benefits

from the transaction ... and doesn’t payToo little produced.

• Someone outside a transaction incurs costs because of it ... but isn’t paid

Too much produced.

Consumption by one person does not diminish the quantity or quality available to others.Public goods can be jointly consumedPublic goods are non-excludable

Everybody has incentive to be a free rider

• When everyone free rides, too little (or none) is produced.

Public GoodsPublic Goods

Macroeconomic Policy

• Monetary Policy

– Policies that influence money and credit (money supply and interest rates).

• Fiscal Policy

– Policies that control government spending and taxation.

GDP “Output”• Gross Domestic Product (GDP)Gross Domestic Product (GDP) is the

market value of final goods and services produced within a country during a year. Market Value: The worth of a thing is

the price it will bring. Only Final Goods and Services Count GDP must be produced within our

borders Net additions to inventory are current

output so they are also included in GDP.

GDP as Valued-Added

GDP as Expenditures: C + I + G + XGDP as Expenditures: C + I + G + X

GDP (GNP) as Income

GDP – GNP – NNP – NI – PI – DI

Real and Nominal GDP• “Real“ GDP adjusts for inflation. • Nominal GDP ($GDP) measures national

output based on current prices of goods and services.

• Real GDP measures of the quantity of final goods and services produced– Real GDP measures current output at

constant prices

• Consumer Price Index (CPI)Consumer Price Index (CPI) – measures the cost over time of a typical bundle of

goods and services purchased by households.

• Producer Price Index (PPI)Producer Price Index (PPI)– measures average prices received by producers

over time for raw materials, intermediate, and final goods.

• GDP Price Deflator (GDP Price Index, GDPPI)GDP Price Deflator (GDP Price Index, GDPPI)– measures average prices over time of all goods

and services included in GDP.

Foreign Exchange

• Foreign ExchangeForeign ExchangeForeign money, including paper money and bank deposits that are denominated in foreign currency

• Foreign Exchange MarketForeign Exchange MarketA global market in which people trade one currency for another

• Exchange RateExchange RateThe price of one country’s currency in terms of another country’s currency

Appreciation and Depreciation

• A currency A currency appreciatesappreciates when it buys more of a when it buys more of a foreign currency.foreign currency.– AppreciationAppreciation of a nation’s currency makes foreign of a nation’s currency makes foreign

goods cheaper.goods cheaper.– AppreciationAppreciation Imports Up and Exports Down. Imports Up and Exports Down.

• A currency A currency depreciatesdepreciates when it buys less of a when it buys less of a foreign currency.foreign currency.– DepreciationDepreciation makes foreign goods more expensive. makes foreign goods more expensive.– DepreciationDepreciation Imports Down and Exports Up. Imports Down and Exports Up.

Categories of current account transactions:Categories of current account transactions:

1.1. Merchandise tradeMerchandise trade-- import and export of goods-- import and export of goods

2.2. Service tradeService trade-- import and export of services-- import and export of services

3.3. IncomeIncome-- both investment income and -- both investment income and employee compensation employee compensation

4.4. Unilateral transfersUnilateral transfers-- gifts to and from foreigners-- gifts to and from foreigners

Current AccountCurrent Account

Current Account vs. Financial Account

• The balance of payments must balance—that is,

Current Account + Financial Account = 0

• If there is a current account deficit, then there must be a financial account surplus that exactly offsets that deficit.

– If we buy more goods and services from foreigners than they buy from us, we have to borrow the difference sell them our IOUs.

U.S. Real GDP(Recessions Shaded)

Unemployment

Rate ofUnemployment

= number unemployednumber in the Labor Force

The unemployment rate is the percentage of the labor force that is not working.

• Discouraged Workers: workers who have looked for work in the past year, but have stopped because they believe no one will offer them a job.• Underemployment: employment of workers in jobs

that do not fully utilize their productive skills.

Flavors of Unemployment

Seasonal Unemployment Frictional Unemployment: searching

for jobs Structural Unemployment

Reflects imperfect match between employee skills and requirements of available jobs.

Cyclical Unemployment Results from business cycle

fluctuations.

• “Natural” Rate of Unemployment A normal rate, considering both frictional and structural factors. – Also called the NAIRUNAIRU (Nonaccelerating Inflation

Rate of Unemployment) -- ~5% for US economy

The “natural” rate can change

• Potential Real GDPThe level of output when nonlabor resources are fully utilized and unemployment is at its natural rate.

• GDP gap = potential real GDP – actual GDP

Flavors of Price Inflation• Demand-pull inflation:

– caused by increases in aggregate demand outpacing increases in aggregate supply.

• Cost-push inflation:

– increased production costs cause firms to raise prices.• Wage-push inflation• Energy costs and inflation

• Hyperinflation:

– extremely high rate of inflation.• Printing money as last resort

Interest Rates

• Nominal Interest Rate (i): the observed interest rate in the market.

• Real Interest Rate (r): nominal rate adjusted for inflation ().

• r = i -

Aggregate Demand (AD): the economy-wide demand for goods and services.

• Aggregate demand curve relates aggregate expenditure for goods and services to the price level

• The aggregate demand curve slopes downward owing to price-level effects:

– Wealth Effect (Real Wealth/Real Balances)

– Interest Rate Effect

– International Trade Effect (Substitution)

The Aggregate Demand Curve

Changes in the price level result in changes in quantity demanded.

Factors that Affect AD Shifts in AD

• Consumption– Income– Wealth– Interest Rates– Expectations– Demographics– Taxes

• Investment– Interest Rates– Technology– Cost of Capital Goods– Capacity Utilization

AD = C + I + G + NXAD = C + I + G + NX

Government Spending Net Exports

– Domestic & Foreign Income

– Domestic & Foreign Prices

– Exchange Rates– Government Policy

Shifting Aggregate Demand Curve

Aggregate Supply: Short – Run & Long – Run

Short-run Aggregate Supply• Aggregate Supply (AS) shows the quantity of

real GDP produced at different price levels.

• Short-run AS slopes upward – a higher price level (holding production costs and

capital constant in the short-run) higher profit margins firms want to produce more.

The Shape of Long-run AS (LRAS)• Resource costs are NOT fixed in the long-run.

– As prices rises, workers demand and get higher wages

Profits don’t rise with price

• AS is set by production possibilities in the long-run

– LRAS is not affected by prices

– LRAS is vertical: higher prices cannot elicit more output in the long-run.

Shifting the Long-Run Aggregate Supply Curve

Growth occurs as the labor force and capital stock grow and as technological innovation improves production efficiency.

Aggregate Demand - Aggregate

Supply Equilibrium

Aggregate Demand and

Supply Equilibrium:

Short-run and long-run

responses to increase in aggregate demand