The National Economic Accounts 30/04/10 9:44 PMThe NEA group of statistics that measures various aspects of the economy’s performance – production and income“more production and income = better economy”

GDP: (Gross domestic production) measures the dollar value of production within the nation’s borders – production not sales

GNP: (Gross national product) – dollar value of production by a country’s citizens

Includes production by American workers abroad Excludes production by foreign workers in America

The BEA provides “flash” estimates of GDP for each quarter about 30 days after the quarter ends.

Good that are produced but not sold show up in inventories at the manufacturers (not in GDP)

The change in business inventories is added to final sales to arrive at GDP

Consumption Expenditures Dollar value of all goods and services sold to households

Government Expenditures Dollar value of goods and services sold to governments

Investment Expenditures

Expenditures by businesses on plant and equipment and change in business inventories

Exports and Imports Exports – goods and services produced here and sold abroad Imports should not be included in our GDP (still counted in

consumption expenditures by households)

Net exports = exports - imports

CALCULATING GDP:

GDP per capita = GDP Population

Can be used to make international comparisons (living standards)

Expenditure ApproachGDP = C + I + G + X

C – consumption expenditures by householdsI – investment by firmsG – government purchasesX – net exports

Income Approach

Add up all the income that was earned in the economy“Whenever something is produced just enough is earned to buy it back.”

Adjusting for Price ChangesNominal GDP – regular GDP (sometimes current-dollar GDP)Real GDP – GDP adjusted for price changes using a base year

The Underground EconomyAll the illegal and legal production of goods and services that does not pass through markets

One estimate of underground household production puts it at 30% of official GDP

Anything households do for themselves and that does not pass through a market goes unmeasured (lawn maintenance, cleaning, babysitting, housepainter who wants cash to avoid taxes, illegal gambling services, prostitution)

Things not counted in GDP: Secondhand sales (used and resold goods) Transactions purely financial (If you buy 100 shares of IBM stocks, someone

got your money and you got their shares) Intermediate sales

o (popsicle sticks used for production of popsicles)o (purchase of flour by a baker)

NI (National Income) – the income earned by all factors of production (land, labor, and capital)

measures the income earned by households and profits earned by firms - after adjusting for depreciation and indirect business taxes

NI - income earned by household and firmsPI (personal income) – income received by households onlyDPI (disposable personal income) – income of households after taxes have been paid ; subtract personal taxes from PI

Inflation & Unemployment 30/04/10 9:44 PMCost of Unemployment – labor is being underutilized

Not using resources fully (producing inside the Production Possibilities Frontier)

Cost of Inflation Massive redistribution of wealth (from lenders to borrowers) Rising prices hurt families on fixed income Implies rising income Benefit - Owners of firms whose prices are rising

Inflation: rise in most prices in the economy-can occur during recessions-problem when the economy is growing faster than normalMeasured:

Each month the Bureau of Labor Statistics (BLS) checks prices on 90,000 items at more than 23,000 retail and service outlets.

o Check prices on the same item in every part of the country

CPI (Consumer Price Index) measures the average change over time in prices paid by urban consumers for a market basket of consumer goods and services (The BLS computes CPI for each month)

It overstates the amount of inflation since it does not count for all quality improvements

CPI = Total Cost this Period x 100 Total Cost Base Period

Inflation Rate: take the % change in CPI= CPI (this period) – CPI (previous period) x 100

CPI (previous period)

GDP DeflatorAnother way to measure inflationIgnores import prices (if import price on beer increased CPI would respond but not GDP Deflator)

GDP Deflator = nominal GDP x 100 Real GDP

Real GDP = nominal GDP x 100 Real GDP

Inflation Rate: take the % change in the GDP deflator

The Costs of Inflation: (consider Circular Flow Diagram) Financial wealth is eroded Inflation discourages savings

o Value of savings accounts, trust funds etc. worth less than before inflation

o “Why save if inflation will simply eat away at the value of savings?” Misallocation of resources – “menu costs”

o (Restaurants need to produce new menus with adjusted prices) Inflation Tax

o Lenders – hurt because dollars loaned are repaid with dollars not worth as much because of inflation.

Biggest lender is households (considering money into bank account a loan to the bank) – they do not anticipate inflation

Banks add an inflation surcharge onto interest rates they charge

o Borrowers – benefit they get to repay with inflated dollars Biggest borrower is the Federal Government

Irving Fisher – “Fisher’s Hypothesis”Nominal IR = Real IR + Expected Inflation

Unemployment BLS reports statistics based on 2 broad surveys taken each month

Means that a resource, labor, is not being used to its fullest potential. (inside the PPF)

Problem during recessions – periods when GDP is decliningLabor force does not include:

retired persons those too young to work anyone who is not seeking employment

Unemployment Rate = Number of Unemployed Labor Force

Five categories of Unemployment:Hidden Unemployed: Those able to work, but not actively seeking employment because they are discouraged (not in labor force)Structural: the economy is structured or set up to their disadvantage. (Welder looking for work in Cleveland, but welding jobs are in Dallas)Seasonal: out of work because of the time of year (farmers, construction workers)Cyclical: Individuals who loser their jobs during a recession Frictional: People in between jobs (someone who quits to find another job)

*4.6% is the average unemployment rate(4-5% unemployment) - economy at full employment

Sometimes called NAIRU (non-accelerating inflation rate of unemployment)

When employment falls below this rate; inflation accelerates

Aggregate Supply & Aggregate Demand 30/04/10 9:44 PM

Average growth rate of US – approx. 3%

Negative growth periods – recessions(refer to business cycle)

AS/AD model highlights factors that determine – output, income, employment, prices in the economy

Classical Economic Theory(1800 – 1930) Say’s law – “supply creates its own demand”

Whenever anything is produced (supplied), it generates enough income to purchase (demand) the item.

Prices would adjust to ensure no excess productiono Unpurchased items collect in inventorieso Swelling inventories would induce producers to lower prices,

the items in the inventory would now sell

Resources and Technology determine Output Amount of Resources and state of technology determines supply Supply determines output

Keynesian Theory

(1936) John Maynard Keynes – model of the way the economy works is AS/AD model

Model indicates that Great Depression was caused by the lack of demand for goods and services.

Aggregate SupplyThe supply of ALL goods and services by ALL suppliers in the economy

Classical view – output depends on amount of resources available and technology (not prices)Classical AS curve would be vertical – price doesn’t affect the output

In recessionary conditions: increase in PL may increase Supply It is easy to increase supply during a recession with unused

resources

Keynesian AS curve is upward sloping - The increase in PL induces suppliers to provide more output

Aggregate DemandThe demand for ALL goods and services by ALL households, businesses, governments, and foreigners

Not all the time demand goes down when prices rise As prices rise, someone benefits (owners of businesses that have

products that are rising in price) income rises in proportion to prices

Consumption Function and Total Spending

MPC: given an extra dollar how much is spent? (critical for Keynesians) Keynes – the Great Depression was caused by lack of spending

Consumer Spending is determined by income Graph: consumption function – upward from left to right

o Indicates that “spending increases as income increases”o MPC: slope or the rate at which consumption function rises

Components of Agg Expenditures (GPD = C+I+G+X) – refer to graph

Break-Even PointThe intersection of the 45 degree ray and the total spending line.

Point to right of break even point Total Spending line (red) is below the 45 degree ray (blue) we know

that spending must be less than income Savings is taking place (spending < income) Distance between the two lines: the amount of saving in the

economy

Inventory Accumulation

Saving – things produced not bought – unpurchased things in inventoriesTo right of break even point: inventories accumulating

Causes producers to cut back production And let some workers go Causing income to fall (going back to the break even point)

To the left of break even point: Spending > income (by using previous savings) Dissaving Inventories fall Producers step up production Hire more workers

Total Change in Income = Initial change in Spending x Multiplier

Fisher’s Hypothesis: Prices rise – inflation induces lenders to raise interest rates consumers and borrowers consume less Inflation causes decline in total spending

Aggregate Demand (second pass)

AD graph slopes downwards – When prices rise, total spending falls even though incomes rise in proportion to the rise in price.

Total spending falls: foreign buyers do not experience the rise in incomes and Fisher’s Hypothesis

Aggregate Supply and Aggregate Demand TogetherKeynesian and Classical Aggregate Supply curves do not always give the same effect.

Shifting Aggregate DEMAND Curve

FACTOR DIRECTIONBusinesses expect higher future sales RightIncrease in consumer confidence RightIncrease in Government spending RightForeigners like our products RightDecrease in MS LeftDecrease in Taxes Right

Shifting Aggregate SUPPLY CurveFACTOR DIRECTIONDecrease in Resource Availability LeftIncrease in Technology/ Productivity Right

Keynesian and Classical will have same effect if the AS curve shiftsDifferent effect when AD curve shifts and AS doesn’t

SummaryClassical Theory

When the economy is at or near full capacity Use vertical AS curve – represents long run Gives predictions (for over the years) when the economy has time

to adjust to price changeKeynes“In the long run we are all dead”

When economy are in recessions, operating well below full capacity Use upward sloping AS curve – represents short run

What causes business cycles? AS/AD shifts cause fluctuations in economic activity Resulting changes in Equilibrium output and prices are the business

cycles we observe in the real world

Fiscal Policy 30/04/10 9:44 PMKeynes said: The Great Depression was caused by a deficiency of spending, or not enough demand

Keynes Remedy was to increase spending Fed government boost level of spending (shift AD to the right)

o Government could not tax because it would just shift AD back to the left

Government had to run a deficit – spend money that wasn’t collected from tax revenue

-No government wanted to try Keynes’ remedy to the Great Depression until 1940s that World War II forced many governments to spend

more money than they had

Surplus: Government spend less than they take through taxes Should run during expansions

Deficit: Government spends more than they take from tax revenues Should run during recessions

Fiscal PolicyChanges in Government spending and Taxes

Fiscal Policy AD curve shifts Government Spending

Taxes Use when

Expansionary Right Increase Decrease Recession

Contractionary Left Decrease Increase Inflation

Recession – economy is producing below potentialInflation – economy producing above potential

Multipliers for Fiscal PolicyExample:

If government spending increases by $20 billion, this will have a multiplier effect if the MPC is 0.8 we expect real GDP to increase by $100 billion

o Multiplier = 1 ÷ MPC (0.8) = 5o Change in Real GDP = $20 billion x 5 = $100 billion

Total Spending line shifts up by $20 billion Real GDP (on horizontal axis) increases by $100 billion

If government lowers taxes by $20 billion, we expect real GDP to increase by just $80 billion

o Multiplier = 5o MPC is 0.8 which means consumers increase spending by (0.8

x 20) $16 billion. Households save $4 billion of tax cuto Change in Real GDP = $16 billion x 5 = $80 billion

So, if the government were to increase spending by $20 billion while simultaneously increasing taxes by $20 billion. The net effect would be $20 billion increase in real GDP

Government spending increase $20 bil would mean $100 increase in real GDP

Tax increase by $20 bil would mean $80 bil decrease in real GDP Therefore $100 bil - $80bil = $20 bil increase in real GDP!

Change in Real GDP = Initial change in spending x Multiplier

Balanced-budget MoveWhen the government changes spending and taxes so that the effects on the budget are neutral – balanced budget move

Example: if government increases spending by $5 million and increases taxes by $5 million. Real GDP will increase $5 million.

Government spending has a stronger impact than tax changes

Phillips Tradeoff (1958)Fiscal policy cannot remedy both unemployment and inflation at the same time.There is an inverse relationship:

Unemployment high, inflation low Unemployment low, inflation high

(mid 1970s) contradicted Phillips Tradeoffstagflation: Both unemployment and inflation were high

When there is a left shift in the AS curve Prices are high – high inflation Output is lower, income is lower – unemployment high

SOLUTION to stagflation: get AS curve to shift to the right

o Technological advance oro Make resources more available

supply-side economics: attempt to shift the AS curve right Special tax policies Less government regulation

Crowding Out (refer to diagram)Can show fiscal policy ineffective.

The increase in IR (interest rates) causing a decline in spending that occurs when the government borrows money to finance a deficit.

Suppose Economy was in a recessiono Implement expansionary fiscal policy

Government would need to borrow money to run a deficit to cure the recession.

o This would raise interest rates.

When they raise interest rates to “crowd-out” some people who would’ve bought the loan but now wouldn’t due to the increase in IR

Biggest lenders: Households (deposit money in a bank – loan to bank)Largest demanders of loanable funds: The Fed Government

When they deficit-spend to stimulate the economy the demand for funds shifts right – higher Equilibrium real IR

Crowding out is reflected (on the graph) by the AD curve shifting back to the left after a fiscal policy has just shifted it to the right.

Rational Expectations(1995) Robert Lucas won Nobel Prize for hypothesis: Households and businesses will use all the information available to them when making economic decisions.

Rational expectations –implies- fiscal policy will be ineffective at changing the quantity of output.

Suppose government tries to stimulate economy through expansionary fiscal policy:

o Government deficit-spends (shifting AD right) People understand this results in higher prices

o When they expect high prices, they supply less labor and products right now (shifting AS left)

Therefore output does not change – only prices rise

Automatic StabilizersGovernment policies already put in place that promote deficit spending during recessions and surplus budgets during expansions – These prevent recessions from becoming depressions- And prevent inflations from becoming hyperinflations

Some examples: Income taxes

Anti poverty programs – Temporary Aid to Needy Families (TANF)

Consider how income taxes are affected as economy in recession. More people are unemployed/make less income – owe less tax. In other words, government tax revenues will automatically fall during recession and this is exactly the type of fiscal policy called for to fight a recession.

Consider TANF when economy in recession. More households will qualify for TANF funds. Government spending on antipoverty programs automatically increase during a recession and boost in government spending is just the sort of fiscal policy to fight the recession.

Automatic Stabilizers prevent the business cycles from becoming TOO extreme in either direction. Economists credit automatic stabilizers, not fiscal policy, for the decreased amplitude of business cycles since World War II

Summary

Fiscal Policy: addresses unemployment or inflation has drawbacks and is not completely effective

o Drawback: Policy to fight recession, promotes inflation With Stagflation, fiscal policy can only fix one problem

Crowding Out and Ration Expectations Make fiscal policy partially ineffective.

Crowding Out refers to the rise in borrowing costs to firms and households after the government borrows to deficit spend.

Rational Expectations assume people and firms expect higher prices in expansionary fiscal policy, and people work less and firms supply less – Offsets the policy because prices rise and output stays the same.

Problem with Fiscal Policy: There are time lags.

Laws and programs that will work to fight recessions or inflations (called automatic stabilizers)

Money and Banking 30/04/10 9:44 PMThe Supply of MoneyReplace the word “money” with the word “income”

The money supply in the US is controlled by the Federal Reserve

Money – anything society accepts in payment for a good or serviceM1 includes:

Currency: coins and paper money Transaction Accounts: checking accounts, and accounts that

function like it

Credit Cards Not part of the money supply Like taking out a loan from a bank

Savings Accounts and CDs (very liquid) Money in savings accounts might be part of MS – very easy to

withdraw money and make a purchase CDs (Certificates of Deposits) are easily cashed – no merchant

accepts for payment

Liquidity – the ability to turn an asset into cash rapidly and without loss.

M2 includes:

Everything in M1 Money deposited in savings accounts Certificates of Deposits Retail money funds

M1: Currency, transaction accounts, travelers’ checksM2: M1 + $ in savings accounts, CDs, retail money fundsM3: Items that are less liquid (eurodollars)

Fiat Money – money that is not backed by any precious commodityThe US, and most nations use fiat money

Coins and paper money have nothing standing behind them except the fact that they are legal tender

Legal tender: (coin and paper money must be accepted in exchange for goods and services by the decree of the government)

From (1873 – 1933) the US was on some form of the gold standard. The MS was backed by gold (or combination of gold and silver) Advantage of gold standard: the Money supply must be kept limited

since the supply of gold is limited

Fiat money supply must be kept relatively limitedNation’s that do not keep the supply limited will see it diminish in value, sometimes to the point of becoming worthless.

Fiat monetary system is more flexible – gold holdings by the gov. need not increase in order to expand the nation’s supply of money.

What is money good for?

Medium of Exchange – used to buy goods and services More efficient than barter (double coincidence of wants)

Unit of Account – used to measure and compare (which corporation is bigger, comparing the dollar figure)

Store of Value – used to accumulate wealth (work hard for 40 yrs and keep 20% of each paycheck. Then live like

a king) Poor store of value during inflationary times Good store of value during deflations

Federal Reserve System (the bank of banks)The central bank of the US

Controls the MS Supervises all depository institutions within a country All banks report to the FED each week

If you need a loan go to the bank

If the bank needs a loan it may borrow from the FED-If you feel uncomfortable carrying lots of cash put it in the bank-If the bank feels uncomfortable with cash in its vault, it deposits in the FED

FACTS ABOUT THE FED 12 branches – to make it convenient for banks to do banking Main headquarters is in Washington DC The President of US appoints 7 members of the Board of Governors

or the Fed Reserve System The President appoints 1 to be the chairman and 1 to be the vice

chairman ALL members of the Board of Governors serve 14 year terms Board of Governors makes the important decisions concerning the

MS. (should M1 and M2 be increased? Held steady? Etc.)

Fractional Reserve BankingBanks keep a fraction of the money deposited

Use it to make loans or other investmentsThe FED requires all depository institutions to keep 10% of funds deposited in transaction accounts as reserves – this helps the FED control the MS

Money Expansion Process

Imagine a counterfeiter prints $1000 in phony bills and spends it at a jewelry store

The jeweler deposits the phony bills into bank

Bank (not detecting the phony bills) credits the jeweler’s account by $1000

Bank must hold $100 (required reserves) Remaining $900 are used to make loans

Suppose it is a loan to someone wanting home improvemento $900 spent on painto Owner of paint shop deposits $900 into account (boosts M1

and M2)o –The money supply is increased when bank make loans with

excess reserveso Bank holds $90 from $900 (required reserve)o The $810 is excess reserves o Bank uses $810 to buy real estateo If the person who has the check of $810 deposits it o –The money supply is going up again

Bank who receives the $810 keeps $81 Remaining $729 is excess reserves that can be used as

loans or investment.The $1000 in counterfeit money will have led to a $10,000 increase in the MS. The money expansion process where banks create transaction account money by using their reserves to make loans or buy investments.

Money deposited into transaction accounts IS part of the MS.

How much the MS will increase:Money multiplier = 1 .

Reserve Requirement Example: if reserve requirement is 10% then

Money multiplier = 1/.10 = 10

Change in the MS because of initial change in bank reserves:Change in MS = Money Multiplier x Change in Bank Reserves

A $1000 deposit will lead to (10 x $1000)= $10,000 increase in MS

Policy Tools of Fed Reserve1. Reserve Requirement

If the Reserve requirement was lowered, banks would have more excess reserves to make more loans and investments. Increasing the money supply.

Raise Reserve Requirement – decrease MS Lower Reserve Requirement – increase MS

2. Discount Rate – the rate of interest the FED charges when it makes loans to depository institutions.

If the FED lowers discount rate, it encourages banks to borrow. These borrowings by banks from the FED increases the bank reserves. Increasing the Money supply (by a multiple of the borrowings from the FED)

Raise Discount Rate – decrease MS Lower Discount Rate – increase MS

3. OMOs (Open Market Operations) – buying or selling of government securities (bonds)

This is done in the secondary market

If the FED buys government securities in the secondary market, the FED pays for the securities with a check that the seller deposits in a bank account. This deposit is and increase in the bank reserves. Increasing the MS (by a multiple of this increase in bank reserves)

In the secondary market: Buy Bonds – increase MS Sell Bonds – decrease MS

Tool Description Increase MS Decrease MSReserve Requirements

Change the % of each deposit the bank must hold

Lower Raise

Discount Rate Change the rate of interest the FED charges on bank borrowings

Lower Raise

OMO Buy or sell government securities in the secondary market

Buy Sell

Monetary Policy 30/04/10 9:44 PMMonetary Policy – changes in the money supply to fight recessions or inflations.

The Board of Governors of the FED designs and executes monetary policy in the US.FOMC (Federal Open Market Committee)

helps the Board of Governors decide which tool to use. Comprised of 12 members

o 7 of the Board with 5 presidents of the 12 FED regional banks sit on the FOMC

Changes in the Money Supply

Classical View

- changes in the MS have no effect on the Equilibrium quantity of output; only prices and wages are affected.Theory: increase in the MS would increase AD, which results in higher Prices (because Classical AS curve is vertical – output not affected, and unemployment)

The Classical economists based conclusions on how $ affects the economy on the equation of exchange:

M x V = P x QM is money supply (can be defined as M1 or M2)V is velocity of money (number of times the typical $ of M1 or M2 is used to make purchases during a year)P is Price level (average price of a good or service in the economy)

Q is quantity of output or real GDP

Classical economists assume V and Q are constantMonetary neutrality – A change in the MS would result in proportional change in prices. The quantity of output, unemployment etc would be unaffected.

If true then if M increases 10%, P must also increase 10%

Classical notion that the only things that can affect the quantity of output are resource availability and technology

Monetarist View

In the US, the velocity of M1 was 3.6 in 1960 and 8.6 in 2004. Clearly the monetary neutrality Classical theory is not constant.

We can no longer conclude that a change in the MS causes a proportional change in prices.

Monetarist View: Change in the MS affects the economy in many ways

o Interest rates affected affect spending levels affect ADo More money more spending

Assumption that V and Q are stable, but not constant, in the short run

Milton Friedman, Nobel Prize-winning economist called the father of monetarism

An increase in the MS shifts AD to the right increase in price level and increase in quantity of output (since AS curve is upward sloping)

Keynesian View

Like Monetarist view – concerned with short run, upward sloping ASDifference is that Keynesians believe that:

a change in the MS affects the economy through one channel – interest rates

FEDIncrease MS lower interest rates increase borrowing and spending increase AD(refer to graph with nominal IR as y-axis and Quantity of $ on x-axis)

Decrease MS higher interest rates

They argue that fiscal policy (taxes and gov. spending) should be used to close recessionary and inflationary gaps.

M x V = P x QClassical View: (refer to graph with AS vertical and AD shift right)

In the long run a change in MS will affect only pricesOnly resources and technology can affect output in the long run (not MS)

V and Q constant An increase in M will have a proportional effect on P Q is unaffected

Monetarist View: (refer to graph with AS upward sloping and AD shift right)In the short run a change in the MS will have a big effect on the economyBest thing FED can do is allow MS to grow at a steady, constant rate

V and Q are stable in the short run An increase in M will affect both P and Q

Keynesian View:Change in MS affects spending through interest rates and the effect will be mildFiscal policy should be used to close recessionary and inflationary gaps.Monetary policy is ineffective

SUMMARY“demand management policy” refers to both monetary and fiscal policy because they both shift the AD curve.

Monetarist – A decrease in the MS lower prices less output. Therefore good way to fight inflation – but can result in recession

CLASSICAL MONETARIST KEYNESIANChange in MS affects

Price Level Price Level andOutput

Price Level andOutput

Through Many variables Many variables Interest ratesEffect is Strong but limited

to prices and wages

Strong Weak

V and Q Constant Stable variable

SITUATIONS WHEN INCREASING THE MONEY SUPPLY

Classical:Increase MS shift AD right (and because of LRAS vertical) Prices up (output unaffected)

Monetarist:Increase MS shift AD right (and because SRAS upward sloping Price & Output increases

Keynesian:Increase MS shift AD right (same SRAS upward sloping like monetarist) Price & Output increases

Economic Growth 30/04/10 9:44 PMReal GDP per capita represents – how much was produced, per person in the nation

When more goods and services are produced, this implies more material wealth.

This shows – economic growth – increments in material wealth.

More output per person implies higher living standards

In the US since World War II, real GDP is typically 3%

International Trade and Exchange 30/04/10 9:44 PM

Famous People 30/04/10 9:44 PMChapter 19

Milton Friedman Called father of monetarism Nobel prize winning economist

There are many channels through which a change in the money supply will affect the economy. “They are too numerous to enumerate”