FIYS 197 FOUNDATIONS OF ECONOMIC THINKING Rob Lemke Department of Economics Lake Forest College Fall 2008

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1 FIYS 197 FOUNDATIONS OF ECONOMIC THINKING Rb Lemke Department f Ecnmics Lake Frest Cllege Fall 2008 VIII. Macrecnmics The Basics (Taylr Chapters 21 25) 1. Intrductin. Macrecnmics fcuses n the ecnmy as a whle, including issues like grwth, unemplyment, inflatin, and the balance f trade. Gals: 1. Ecnmics grwth (imprved standards f living). 2. Lw unemplyment. 3. Lw inflatin. 4. Sustainable balance f trade. Mdels: 1. Aggregate Demand / Aggregate Supply 2. Keynesian Mdel 3. Neclassical Mdel Plicy Tls: 1. Mnetary Plicy 2. Fiscal Plicy We will discuss each f these in turn ver the remainder f the semester. 2. Grss Dmestic Prduct. Macrecnmic plicy is cncerned with a natin s well-being. What d we mean by well-being? Hw shuld it be measured? It can t be measured in any perfect way. Well-being includes a lt f things, including leisure time, family clseness, TV prgrams, jb pprtunities, etc. By necessity, ecnmists fcus n smething that can be measured, and in particular, in the value f gds and services prduced in an ecnmy. This t is nt perfect as nly market gds and services will enter the calculatin. Thus, this mits quality issues and wn-prductin issues. Grss Dmestic Prduct (GDP) is the value f all final gds and services prduced within a cuntry in a given year. GDP in the United States is ver $14 trillin. 1

2 Example: Farmer, Miller, Baker. The Set-Up. Farmer uses land seed. Prvides labr. Sells wheat fr $400. Miller pays $400 fr wheat. Prvides labr. Sells flur fr $1,000. Baker pays $1,000 fr flur. Prvides labr. Sells bread fr $2,000. Stre pays $2,000 fr bread. Prvides labr and shelf space. Sells bread fr $2,800. Peple pay $2,800 fr bread. What is the GDP frm this example? Farmer: $400 f gds and services. Miller: $600 Baker: $1,000 Stre: $800 Ttal: $2,800 S, hw else can GDP be cmputed? Value f final gds prduced: Stre sells bread fr $2,800. Value f final gds bught: Peple pay $2,800 fr bread. It is these last tw ways that the gvernment actually ges abut measuring GDP. In any ecnmy, Y = C + I + G + (X M). We add exprts, because they are prduced in the United States, even thugh they are nt cnsumed here. We subtract imprts because they are cnsumed here, thugh they were nt prduced here. Thus, we can readily see that GDP = Y = the value f gds prduced in a cuntry, nt the value f gds cnsumed. In the U.S. ecnmy, thugh things have changed ver time, C cmprises abut 70% f GDP, I cmprises 15% f GDP, G cmprises 20% f GDP, X cmprises 10% f GDP, M cmprises -15% f GDP. Fr the recrd, X M is the trade balance. When X M is psitive, exprts exceed imprts, and the cuntry is said t have a trade surplus. When X M is negative, imprts exceed exprts, and the cuntry is said t have a trade deficit. What ges int C? Durable gds make up abut 15% f C, Nn-durable gds make up abut 15% f C. Services make up abut 60% f C. Husing & buildings make up abut 10% f C 2

3 Is it bad t have s much f cnsumptin be cmprised f services rather than f manufactured gds? N, fr at least tw reasns. First, if we value services, then we shuld prefer them t manufactured gds. Wuld yu rather have a heart transplant r anther DVD? Secnd, services d nt require the same kinds f natural resurces as manufactured gds d. 3. Internatinal Cmparisns Frequently ecnmists cmpare GDP in tw dimensins acrss time and/r acrss cuntries. When cmparing GDP acrss time, we must take int accunt inflatin, that is price increases ver time. When cmparing GDP acrss cuntry, we need t adjust fr each cuntry s currency by using exchange rates. We will wrry abut this later. When cmparing GDP acrss cuntries, ne must use exchange rates (r sme ther means) t cnvert GDPs measured in yen, reals, pess, eurs, etc. int a cmmn currency, say dllar. Exchange rates are stated in terms f hw many units f ne currency ne unit f anther currency can buy. Fr example, 1 U.S. dllar can purchase 0.67 British punds, r, equivalently, 1 British pund can purchase 1.5 dllars. It is imprtant t understand what number is being reprted. Als, it must be that the exchange rates are reciprcals f ne anther. Hint: the wrds per U.S. dllar means t put the dllar sign in the denminatr. If 1 U.S. dllar is wrth 200 yen, then hw much is 100,000 yen wrth? 1 dllar = 200 yen 1 yen = 1 dllar / ,000 yen ( 1 dllar / 200 yen) = $500. A weaker dllar means that a dllar is less valuable, i.e., it purchases less. In this case, a weaker dllar purchases fewer units f anther currency. Example: If 1 U.S. dllar currently purchases 0.67 British punds, but then the dllar falls r becmes less valuable, 1 U.S. dllar will then purchase fewer than 0.67 punds. What is the implicatin f internatinal trade when exchange rates change? Example: Suppse a value meal csts $5 r 5. Further suppse that 1 dllar can be exchanged fr 0.5 punds. Then an American must pay $5 fr a meal in the U.S. r $10 fr a meal in Lndn. At this exchange rate, Lndn is extremely expensive. Nw suppse the dllar gets strnger. In fact, cnditins change s that 1 dllar can purchase 0.8 punds. Nw an American while still paying $5 fr a meal in the U.S. can pay $8 fr a meal in Lndn. The implicatin is that a strnger dllar makes freign gds (i.e., imprts) cheaper fr Americans t buy. 3

4 The same analysis can be used t determine the cst (r price) f ptential imprts. Lessn: when the value f the dllar falls, U.S. exprts becme a gd deal t freigners, while imprts t the United States becme mre expensive. Thus, a weaker dllar shuld help alleviate a trade deficit. The implicatin is that a weaker dllar makes freign gds mre expensive t Americans, and U.S. gds cheaper fr freigners. 4. Ecnmic Grwth Bradly defined, ecnmic grwth refers t an increase in GDP, which at least psitively crrelated with an imprved standard f living. Cmparisns regarding ecnmic grwth within a cuntry ver time r acrss cuntries must be made at the per persn (r per capita) level, therwise GDP will increase (r decrease) simply because f changes in ppulatin. Ultimately, we want ecnmic grwth t reflect an increase in prductivity due t mre physical capital, mre human capital, r better technlgy. Per capita GDP in the United States in 2007 was ver $40,000. In Mexic it was just ver $7,000. This means that the average persn in the United States can prduce (and can cnsume) ver 5 times the gds and services that the average persn in Mexic can. GDP cmparisns are made using exchange rates. This is nt analgus t price levels. The purchasing pwer parity index can als be used t cnvert GDP numbers t better reflect purchasing pwer. Althugh the gap narrws when adjusting by purchasing pwer parity, large differences still remain. Suppse grwth in the United States average 2% ver the next 50 years, and it averages 5% in Mexic. In 50 years, a GDP per capita cmparisn will yield: U.S per capita GDP = $40,000(1.02) 50 = $108,000 Mexic 2058 per capita GDP = $7,000(1.05) 50 = $81,000 The lessn is that develping cuntries have a lng way t g t catch up. The idea that develping cuntries will eventually catch up is called cnvergence. Peple disagree whether cnvergence is inevitable, likely, r unlikely. There are sme gd examples Suth Krea and Japan, just t name tw. But there are als sme cases that peple thught wuld have cnverged by nw Mexic and Brazil, fr example. The best way t think f ecnmic grwth is with an aggregate prductin functin. Grwth is the prduct f increased human capital (educatin and skills), increased capital per wrker, and technlgy. Capital deepening refers t an ecnmy building up mre capital per wrker r mre human capital per wrker. There has been substantial human capital and physical capital deepening in the United States ver the last 50 years. 1960: Cllege degree = 6%. 2005: Cllege degree = 22%. 1960: $16,000 f capital per wrker. 2005: $36,000 f capital per wrker. Empirically, develping cuntries need t have mre capital deepening t catch up t develped cuntries, but they find it difficult. This is a significant reasn why the wrld ecnmies haven t demnstrated mre cnvergence. 4

5 5. Unemplyment Smene is unemplyed nly if they are an adult, withut a jb, wuld like a jb, and have been searching fr a jb recently. An emplyed persn is anyne wh wrked at least 1 hur fr pay last week r wrked at least 15 hurs fr free last week. In the United States, the adult ppulatin is usually taken t be everyne age 16 r lder. Of this ppulatin, peple nt in the labr frce include students, the disabled, retired persns, and, generally, peple wh d nt want a jb (e.g., stay-at-hme parents). The labr frce cnsists f all emplyed persns plus all unemplyed persns. Labr Frce Participatin Rate = Labr Frce / Adult Ppulatin. The U.S. labr frce participatin rate is abut 66.2% verall. Fr males it is almst 75%, while it is 60% fr females. The labr frce participatin rate is ver 92% fr males between 45 and 54, but is nly 44% fr wmen between the ages f 20 and 24. Unemplyment Rate = Unemplyed / Labr Frce. In the United States in 2006, there were rughly 229 millin adults. Of these, 151 millin were in the labr frce. Of these, 144 millin were emplyed. Frm these statistics we have: 2006 labr frce participatin rate = 151 / 229 = 66% unemplyment rate = 7 / 151 = 4.6%. Ntice that in the United States, when the unemplyment rate increases by 0.1 percentage pints (say frm 4.6% t 4.7%), an additinal 150,000 peple are unemplyed. If the unemplyment rate increases by 1 percentage pint (say frm 4.6% t 5.6%), an additinal 1.5 millin peple are unemplyed. Nte the large numbers fr the U.S. ecnmy. Even when unemplyment is nly 5%, ver 7 millin peple are lking fr wrk. Mst f these will find a new jb within 4 weeks, and almst all will d s within 26 weeks, but sme will be unemplyed fr a lng, lng time. There are three types f unemplyment frictinal, structural, and cyclical. Frictinal unemplyment ccurs naturally as peple switch jbs vluntarily and as firms enter and exit the market place. Frictinal unemplyment, thugh persnally difficult, is actually a gd sign fr an ecnmy. Frictinal unemplyment is an indicatr that resurces (labr) are being assigned t their mst prductive uses (firm match). Structural unemplyment ccurs when wrker skills d nt match the needs f firms. Fr example, an ecnmy may have trained many peple t be civil engineers, but recent technlgy develpments r prgress in internatinal trade may cause the ecnmy t need fewer civil engineers and mre sftware engineers. In this case, many civil engineers will lse their jb. Eventually the ecnmy will prduce mre sftware engineers, but until this time, unemplyment will exist. Structural unemplyment can be very severe, and it can take a lng time fr an ecnmy t crrect. Of curse, a capitalistic ecnmy will prbably crrect it much faster than a cmmand and cntrl ecnmy. Cyclical unemplyment is the unemplyment that ccurs as the ecnmy ges thrugh cntractinary perids. That is, cyclical unemplyment mves cunter-cyclically with ecnmic activity. When the 5

6 ecnmy is expanding, cyclical unemplyment is naturally lw as firms are increasing wages and trying t hire mre wrkers. When the ecnmy is cntracting, cyclical unemplyment is naturally high as firms are slw t hire wrkers (and may be quick t fire them). Whereas frictinal unemplyment is essentially gd, bth structural and cyclical unemplyment are painful fr an ecnmy. Slving structural unemplyment prblems is gd fr the ecnmy. Nt a tn can be dne abut cyclical unemplyment ther than trying t limit cntractinary perids in an ecnmy. The natural rate f unemplyment is the rate f unemplyment that can be said t ccur naturally n average when cyclical unemplyment is minimal. Put differently, we wuld nt expect the actual unemplyment rate t dip belw the natural rate f unemplyment (r at least nt dip belw it very far r fr very lng). The natural rate includes the natural amunt f frictinal unemplyment, plus sme structural unemplyment and very little cyclical unemplyment. If ne lks at Exhibit 23-2 n page 427, yu will ntice that the unemplyment rate in the United States mves arund quite a bit histrically. In the 1980s, it was thught that the natural rate was 5.5%. During the expansinary perid f the 1990s, ecnmists revised their expectatins t say that the natural rate f unemplyment was nw 4.5%. The main reasns fr the adjustment were that the Internet allwed fr quicker and better jb searches (lwering frictinal unemplyment), a yunger ppulatin (the baby bmers were in their prime wrking years), and technlgy develpments were lwering the amunt f structural unemplyment as wrkers culd be retrained quickly and still have valuable skills. The unemplyment rate (r the natural rate f unemplyment) varies acrss regins r cuntries fr several reasns having very little t d with definitins f the labr frce r the unemplyed. Differences arise primarily due t labr plicies that affect frictinal and structural unemplyment (r just circumstance). Peple between the ages 35 and 55 are much mre likely t be emplyed than yunger r lder wrkers, because peple in this age bracket are mre tied t the labr market as thers als depend n their incme. Peple are mre likely t be unemplyed the better unemplyment benefits are, as peple have less f an incentive t return t wrk as they wuld be giving up lucrative benefits. Peple are mre likely t be unemplyed the mre difficult it is t fire peple, as firms are mre reluctant t hire new wrkers. Peple are mre likely t be emplyed the mre educated/prductive they are, as nt wrking is mre cstly when ne is mre prductive (because wages are attached t prductivity). Peple are mre likely t be unemplyed the less mbile they are bth physically and skillwise, as they are less likely t find and btain gd jb matches. 6. Inflatin Inflatin refers t a general increase in prices. Deflatin, which ccurs rarely in the United States, refers t a general decrease in prices. Prices can increase ver time fr varius reasns. Largely they increase because f changes in the mney supply and because f shrt-run phenmenn that cause real shrt-term changes in prices but nt much lng-term change. In the lng-run, thugh, all prices increase When smething is valued in terms f current prices, it is a nminal value. When the value f smething is adjusted fr inflatin, it is a real value. In particular, when calculating real values, ne will always take a particular year s dllar value, s it might be said, fr example, real incmes measured in 2000 dllars. 6

7 Because we are thinking at the macr level, we dn t think f a single price, such as the price f gas, increasing ver time. Rather, we think f the general level f prices, r the price level, increasing ver time. The gvernment defines a typical basket f gds, and then prices that basket each mnth in several lcatins. The price level then reflects the price f that particular basket ver time. The price level, r price index, can be referred t as the cst f living. There are several significant prblems with this idea f a price index r level. It is difficult t accunt fr changes in quality. It is difficult t accunt fr different baskets fr different types f peple in different regins. Fr example, the basket is simply different fr a family with 2 babies than the basket fr a retired cuple in pr health. Peple can change their purchasing ver time t reflect a changing budget line. (It is estimated that at least half f the increase in prices reflected in gvernment published price indexes is avided by changing purchasing habits.) This is called substitutin bias. Althugh the U.S. gvernment publishes many different priced indexes, the main ne is the Cnsumer Price Index (CPI). We will cnstruct a price index frm data n the price f a basket, but keep in mind that the gvernment des this, peple dn t. The pint is fr yu t be able t take what the gvernment publishes, which is the actual CPI, and t use it t calculate inflatin rates and real values. Nminal Price Price Index Inflatin Rate Year f Basket (2004 dllars) 2001 $1, ,200 1,750 = 68.6 N. A $1, ,320 1,750 = 75.4 ( ) / 68.6 = = 9.9% 2003 $1, ,500 1,750 = 85.7 ( ) / 75.4 = = 13.7% 2004 $1, ,750 1,750 = ( ) / 85.7 = = 16.7% 2005 $1, ,800 1,750 = ( ) / = = 2.9% Exercise fr hme: Cmpute the price index has the base year been Shw that the inflatin rates are the same when using this new index. Nw, fr further practice, take the fllwing price index and calculate the inflatin rate, and the real value f average incme fr the year. Year CPI (1982 base) Nminal Average Incme Inflatin Rate Real 1998 Average Incme $32,000 N. A. (163.0 / 148.2) 32,000 = $35, $34, % (163.0 / 152.4) 34,500 = $36, $35, % (163.0 / 156.9) 35,000 = $36, $37, % (163.0 / 160.5) 37,000 = $37, $38, % (163.0 / 163.0) 38,500 = $38,500 7

8 In 1960, a hamburger, fries, and cke cst $0.35, and the CPI was In 2006, the same fd cst $2.50 in the frm f a happy meal and the CPI was Which meal cst mre? We have $0.35 * 100 / 29.6 = $1.18 in 1983 dllars and $2.50 * 100 / = $1.24 in 1983 dllars. Thus, the fd cst mre in 2006 than in 1960, but nt by much. Given that inflatin is the nrm, a graph f nmial and real GDP ver time has sme intutitive characteristics. Nminal GDP is steeper than real GDP. Real GDP is measured in the year s dllars as determined by the nminal and real intersectin. Real GDP exceeds nminal GDP t the left f the intersectin; reverse t the right. [Draw the graph 1960 t 2005: Nminal $500 billin t $14 trillin; real 200 dllars frm $2.2 trillin t $10 trillin; $10 trillin in 2000.] Inflatin Hurts: Peple hlding cash. Peple n fixed incmes. Peple/freigners hlding bnds. Mst wrkers as wages rarely keep up with inflatin. Faith in ne s ecnmy. Inflatin Helps: Debtrs (hmewners). The gvernment when in debt. 7. Trade Balance The trade balance is the dllar value f exprts minus imprts (trade balance = X M). When the trade balance is psitive, s that exprts exceed imprts, a cuntry is said t have a trade surplus. When the trace balance is negative, s that imprts exceed exprts, a cuntry is said t have a trade deficit. Is a trade deficit bad? We will see later. The current accunt is a balance sheet tracking financial flws (r flws f currency, hence current accunt ) in and ut f a cuntry. The exact ppsite ledger is called the capital accunt. The current accunt includes exprts and imprts f gds, services, incme payments, and transfers. U.S Current Accunt (in billins) Exprts Imprts Balance Gds $1,024 $1,860 -$836 Services $413 $342 $71 Incme Payments $622 $629 -$7 Transfers $0 $84 -$84 Current Accunt Balance -$856 Thus, the U.S current accunt had a $856 billin deficit, while cncurrently the U.S capital accunt had a $856 billin surplus. Histrically, the U.S. runs trade surpluses and deficits, thugh we have been in deficit since Presently the current accunt deficit is abut 6% f GDP. 8

9 Hw des the trade balance relate t ther macrecnmic variables? This is answered by lking at the natinal saving and investment identity. Recall that GDP = Y = C + I + G + (X M). Mney leakages frm the U.S. ecnmy fr cnsumptin gds are: S + T + M Nn-cnsumptin injectins int the U.S. ecnmy are: I + G + X. Ultimately, leakages and injectins ffset ne anther, yielding: S + T + M = I + G + X where the right hand side represents mney ut while the left hand side represents mney in. Anther way t lk at this identity is t cnsider the supply f and demand fr financial capital. Supply f Financial Capital: S + (M X). Demand fr Financial Capital: I + (G T) Supply equaling demand yields the natinal saving and investment identity: S + (M X) = I + (G T). Rearranging, we have: which can be described as: M X = (I S) (T G), Trade Deficit = Net Dmestic Investment Gvernment Savings. This equatin is very helpful in understanding hw currency must flw (i.e., hw the trade balance is affected) when certain macr variables change. In particular: Dmestic investment with n change in savings r gvernment savings trade deficit. Dmestic savings with n change in investment r gvernment savings trade deficit. Gvernment savings (gvernment deficit ) with n change in dmestic investment r savings trade deficit. Finally, return t the earlier questin. Are trade deficits bad? It really depends n what is causing them. In mderatin, prbably nt what if we called it a capital surplus? Then peple may supprt a trade deficit. There are tw striking prblems, hwever: 1. A capital surplus can mean we are purchasing capital gds r cnsumptin gds. Purchasing cnsumptin gds, thugh included in the capital accunt, is nt the same as purchasing capital investment. 2. An increasing trade deficit can arise frm lwer savings (dmestic r gvernment), which is nt ideal. 9

10 IX. Macrecnmic Mdels (Taylr Chapters 26 28) 1. Aggregate Demand Aggregate Supply. Say s Law stipulates that supply creates its wn demand. The idea is that when firms make gds and services, they pay wrkers, investrs, etc., and these payments create the mney/incme that allws peple t purchase the gds and services created. Keynes Law stipulates that demand creates its wn supply. Keynes actually never said this s frmally. The idea is that firms will nly prvide gds and services when there are cnsumers wh are demanding said gds and services. Fr this t happen, peple must have jbs and receive decent wages. Aggregate Supply (AS) relates the ttal amunt f gds and services supplied in an ecnmy at different price levels, hlding all else fixed (and in particular, hlding technlgy and the price f factrs f prductin fixed). The AS curve is shallw fr a while, but then it increases sharply just befre the ecnmy reaches ptential GDP, and increases extremely sharply after that. Aggregate Demand (AD) relates the ttal amunt f gds and services demanded in an ecnmy at different price levels, hlding all else fixed. It is generally thught f as AD = C + I + G + X M. In general, AD is thught t be fairly steep as peple need t cnsume regardless f the price level. The AD curve slpes dwnward due t: The wealth effect whereby wealth can purchase fewer gds as the price level increases. The interest rate effect whereby it is mre expensive t finance the purchase f gds and services as the price level increases. The freign price effect whereby freign gds are relatively cheaper as the price level increases. Equilibrium, as in all mdels, is the intersectin f aggregate supply and aggregate demand. Price Level AD = Aggregate Demand AS = Aggregate Supply P* Y* Ptential GDP Real GDP 10

11 Shifts in Aggregate Supply: Aggregate Supply will shift ut with an increase in prductivity. Shifts in Aggregate Demand: Aggregate Demand will shift ut when C, I, G, r X (r M) increase. One way t increase cnsumptin (C) is by lwering taxes. This raises a standard questin. Shuld the gvernment lwer taxes r increase gvernment spending (G) if it wants t increase aggregate demand? There is n clear answer. Sme peple advcate lwering taxes, because it allws peple t spend n what is mst valuable (rather than, say, buying a $400 hammer). Others argue it is better t increase gvernment spending, because it will all be spent, rather than ptentially saved. It can als be spent n particular prjects f use t the United States. Keynes Law is mst apprpriate during the shrt run(usually recessins), when AD intersects AS n the shallw prtin f AS. In this case, we need t spur AD t recver t ptential GDP equilibrium. Keynes wuld als argue, hwever, that fcusing attentin n AD during an expansin (by running a budget surplus) is als a gd (and necessary) actin. Say s Law is mst apprpriate during the lng run (usually expansinary perids), when AD intersects AS n its steep prtin. In this case, the supply side f the ecnmy is ging t determine cntinued grwth. 2. The Keynesian Perspective (Chapter 27) In the lng run, we are all dead. Keynes argued fr plicy makers t fcus n the shrt run, recessins r expansins. Keynes Reasning: The mst fundamental argument in Keynes is that prices and wages d nt adjust quickly. In the shrt run, if nt als in the lng run, wages and prices are sticky dwnwards. That is, wrkers are nt quick t accept a wage decrease, and firms are nt quick t lwer prices. It is unclear why wages and prices are sticky. Ptentially fr behaviral/psychlgical reasns. Ptentially because f imperfect infrmatin it is a difficult crdinatin prblem t slve. The implicatin is that AD can intersect AS substantially belw ptential GDP. [Draw a graph f price level stickiness and recessin (page 510).] Keynes Plicy Prpsal: Keynes primary plicy prpsal was simply t increase AD during recessinary perids, either thrugh G r T. That is, during recessins, the gvernment shuld run a deficit. He wuld prefer t increase G rather than lwer T, arguing that the gvernment needed t make sure the mney was indeed spent. Equally imprtant, Keynes argued that during expansinary perids the gvernment shuld run a surplus. In gd times, that is, G r T. This is the part f Keynes that mst plicy makers have ignred. 11

12 The permanent incme hypthesis stipulates that peple make cnsumptin decisins based n their expected future r lifetime incme. Thus, changes in taxes that are perceived t be permanent have a much greater effect n AD than d perceived temprary changes. In applicatin, a $1,000 ne-time rebate will nt increase AD as much as an annunced $500 permanent reductin in annual taxes, fr example. The Multiplier: Suppse GDP is $200 billin belw ptential GDP. By hw much shuld gvernment spending be increased r taxes be decreased? The gut reactin is t change either by $200 billin, but this is nt crrect. Suppse incme increases by $100. Husehlds will pay sme in taxes. They will als save sme. They will inevitably spend sme f the mney n freign gds as well. Ultimately, f the $100, maybe $60 is spent n dmestic gds and services. But this $60 is then incme fr thers. They ultimately spend $36. This turns int $36 f incme, f which the recipients als spend 60%, r $21.6. And s n. The pint is that mney gets spent ver and ver. Let NL (net leakage rate) be the percent f incme nt spent n dmestic GDP. In this case, NL = 40% = 0.4. The amunt f new incme generated by a $1 injectin is then $1 / NL. This is the multiplier. The bk defines F t be the fractin f incme spent n dmestic gds and services, s that F = 1 NL, r that F + NL = 1. In this case: Multiplier = 1 1 = NL 1 F. If GDP is $200 billin belw ptential GDP, and the multiplier is 2.5, then the gvernment injectin shuld satisfy: Injectin x Multiplier = Ptential GDP Actual GDP. Injectin x 2.5 = $200 billin Injectin = $80 billin. The Phillips Curve: Because Keynesians fcus n the shrt run, and in particular shifting ut AD in the shrt run, the immediate questin becmes: what is the tradeff f ding this? The answer is fund in a tradeff between unemplyment and inflatin. In rder t lwer unemplyment, the gvernment must increase spending, which increases inflatin. If the gvernment wants t lwer inflatin, it will achieve this by letting unemplyment creep up. The shrt-run Phillips curve, therefre, stipulates that there is a negative relatinship between unemplyment and inflatin in the shrt run. The Phillips curve can shift when smething fundamental t the ecnmy, such as il prices, changes. [Draw sme typical Phillips curves clse t rigin in 1960s, further ut in 1990s, way ut in 1970s.] 12

13 3. The Neclassical Perspective (Chapter 28) The neclassical view fcuses n the lng run. Neclassicalists admit there can be shrt run recessins, but that plicy needs t fcus n achieving ptential GDP in the lng run. They believe the prices and wages will adjust as necessary in the lng run, s that AD will intersect AS at full emplyment. The gal, therefre, needs t be t shift ut AS (i.e., ecnmic grwth). Neclassical ecnmists treat AS as being vertical in the lng run. That is, the ecnmy will achieve ptential GDP, at any price level, in the lng run as AD will always intersect at ptential GDP. [Draw vertical AS with AD intersectins at varius price levels. Page 540.] Implicatins f the neclassical framewrk: Fcus n plicies prmting lng-term grwth rather than fighting a shrt-term recessin. Neclassicalists tend t want t fight inflatin rather than unemplyment, as a lw, cnstant inflatin rate is gd fr lng-term grwth as business, cnsumers, wrkers, etc. can make better predictins abut the future and the value f assets/investments. The lng-run Phillips curve is vertical at the natural rate f unemplyment. [Graph this.] X. Mnetary Plicy (Taylr Chapters 29 & 30) 1. Mney and Banking (Chapter 29). Mney: Mney is anything that serves sciety in three functins as a medium f exchange, as a unit f accunt, and as a stre f value. A medium f exchange is anything that is widely accepted as a methd f payment. A unit f accunt is a cmmn way f measuring market values. A stre f value is smething that serves as a way f preserving ecnmic value s that it can be spent r cnsumed in the future. Mney must satisfy each f these three cnditins simultaneusly. That is nt t say that ther things are nt used as payment (barter still exists) r thers are nt stres f value (precius metals). But nthing in the United States serves all three purpses at the same time ther than U.S. currency. We wn t really care hw we define the mney supply. Fr the recrd, there are tw traditinal measures: M1 equals all currency + demand depsits/checking accunts + traveler s checks. M2 = M1 + savings accunts + time depsits + mney market funds. 13

14 Banking Net Wrth: The primary functin f banks in an ecnmy is t facilitate the exchange f wealth (mney) between savers and brrwers. That is, banks are a financial intermediary. Of curse, the primary functin f a bank frm the bank s perspective is t make prfit. Banks earn prfit by paying interest n depsits and charging a higher rate f interest n lans. A bank s balance sheet indicates the three things banks d with depsits. Assets Liabilities Reserves $2 millin Depsits $10 millin Bnds $4 millin Lans $5 millin Ttal $11 millin Ttal $10 millin In this case, the bank s net wrth is $11 millin - $10 millin = $1 millin. The mst imprtant prblem banks face is that even banks with psitive net wrth wuld find it difficult (r impssible) t hnr all depsits at any given time. Histrically, this is the surce f financial crisis in the banking sectr. The prblem is cmpunded if the value f lans falls s that the bank s net value is in fact negative, in which case the bank literally culd nt hnr all depsits, even if it culd call in all lans. When peple lse cnfidence in banks, a run n banks can ccur, which spreads financial panic. A run n a bank is simply a time when mre peple demand their depsits than the bank can prvide, regardless f its net wrth. Of curse, if banks did nt invest in gvernment bnds r lans, banks culd nt earn prfit, and this wuld be bad fr the ecnmy as the ecnmy needs banks t play their rle f financial intermediary. The Mney Multiplier: When banks lend ut mney, they are in effect increasing the mney supply. Think f an ecnmy having a single bank. This bank takes in depsits, keeps 20% and lends ut the remaning 80%. Eventually this mney lands in the hands f peple wh make depsits. The bank repeats the prcess, keeping 20% and lending ut 80%. And s n. Step 1: Depsits = $10 millin. Reserves = $2 millin. Lans = $8 millin. Ttal Assets = $10 millin. Step 2: Depsits = $ = $18 millin. Reserves = $ = $3.8 millin. Lans = $ = $14.2 millin Ttal Assets = $18 millin. Step 3: Depsits = $ = $24.2 millin. Reserves = $ = $5.04 millin. Lans = $ = $19.16 millin Ttal Assets = $24.2 millin. And s n. 14

15 The mney multiplier rule is the fllwing. If banks keep R percent f depsits in reserve, then the mney supply will grw frm m f currency int M = m R dllars f mney. The mney multiplier, f curse, depends n banks chsing t nly keep R% f depsits. Ecnmic cnditins may cause banks t becme mre cautius. Similarly, the mney multiplier applies nly if ecnmic agents depsit unused mney in banks. Sme mney is inevitably held as cash fr varius reasns. Example: If the FED injects $20 billin when the reserve requirement is 8%, the mney supply culd grw by as much as $20b 0.08 = $250 billin. 2. Mnetary Plicy (Chapter 30). The FED: The FED (r Federal Reserve System) is the central bank f the United States. It prints currency, cnducts mnetary plicy, and serves as the bank fr banks. There are 13 reginal Federal Reserve Banks. Our class visited the Federal Reserve Bank f Chicag. In additin t printing mney, clearing checks, etc., the FED regulates banks. It is thrugh these regulatins, in part, that the FED cntrls the mney supply. Mnetary Plicy Tls Recall that mnetary plicy refers t the FED trying t adjust the mney supply t stimulate r cl-ff the ecnmy. An increased mney supply is thught t stimulate the ecnmy, while a decreased mney supply is thught t cl-ff the ecnmy. The FED has at its dispsal essentially 3 tls by which t cntrl the mney supply. 1. The FED can cnduct pen market peratins. That is, the FED can buy r sell gvernment bnds. When it sells bnds, it receives mney in exchange fr bnds. Thus, selling bnds lwers the mney supply as currency is taken ut f circulatin. Alternatively, the FED can purchase bnds. When the FED purchases bnds, it gives banks mney (currency) in exchange fr bnds. This increases the mney supply. 2. The FED sets the minimum reserve requirement that banks must bey. That is, the FED stipulates whether banks must keep 5%, 10%, r 15% f their depsits in reserve. As we have already seen, when the reserve requirement increases, the mney supply decreases (and vice versa). In practice, the FED rarely uses the reserve requirement t cntrl the mney supply. In part because banks dn t need t match the reserve requirement, rather, banks must match r exceed it. Ultimately, if banks are pessimistic and nt lending ut all f their ptential depsits, lwering the reserve requirement will have n effect n the ecnmy. 3. The FED requires banks t have a certain amunt f mney n hand, due t the reserve requirement, n a daily basis. Banks that cme up shrt n this frnt must brrw (n a daily basis) frm the FED itself. The rate the FED charges ther banks is called the discunt rate. The higher the discunt rate, the mre cstly it is t cme up shrt in depsits. Thus, a higher discunt rate reduces the mney supply as banks dn t lend ut marginal mnies that may be needed t meet the reserve requirement. Likewise, the lwer the discunt rate, the less cstly it is t cme up shrt in depsits. Thus, a lwer discunt rate increases the mney supply as banks lend ut mre marginal mnies as banks are mre willing t brrw frm the FED. 15

16 In practice the FED desn t cntrl the mney supply with the discunt rate. Rather, banks almst always brrw frm each ther rather frm the FED. The FED watches this rate, and when the FED annunces an increase r increase in its targeted interest rate, it is this interest rate that the FED is talking abut. In particular, the FED will cnduct pen market peratins until the ver-night interest rate charges by banks t banks hits this interest rate. This interest rate is called the federal funds rate. Mnetary Plicy: In review, the FED stensibly can increase r decrease the mney supply in three ways: EXPANSIONARY MONETARY POLICY Increase Mney Supply Purchase gvernment bnds. Decrease the reserve requirement. Lwer the discunt rate. CONTRACTIONARY MONETARY POLICY Decrease Mney Supply Sell gvernment bnds. Increase the reserve requirement. Raise the discunt rate. The mney supply directly affects interest rates in an ecnmy. Cnsider the market fr lanable funds. Demand fr lanable funds is taken as fixed. Expansinary mnetary plicy shifts the supply f lanable funds t the right, which lwers the interest rate. This shuld make sense. As mre mney is supplied, the price f mney must fall, and the interest rate is the price f mney. Similarly, cntractinary mnetary plicy shifts the supply f lanable funds t the left, which increases interest rates. [Draw a nice graph with dllars n the x-axis and the interest rate n the y-axis. See page 574.] In terms f the AS AD mdel, expansinary mnetary plicy lwers interest rates which will shift AD ut as private investment increases. Cntractinary mnetary plicy, n the ther hand, increases interest rates which will shift AD in as private investment falls. In review: M r I, C P, real Y. M r I, C P, real Y. Real Interest Rates: Hw lw can the interest rates fall? Remember that interest rates are stated in nminal terms. The lender assumes the risk f inflatin, while the brrwer assumes the risk f deflatin. Published interest rates (i.e., nminal rates) cannt fall belw 0%. The reasn is that at negative rates ne wuld never invest funds. One wuld literally be better ff saving mney in yur mattress r a safe. Real interest rates, hwever, which equal the nminal rate minus inflatin, can be negative. If the nminal rate is 3% and inflatin is 5%, then the real interest rate is -2%. Investrs can be enticed t make this investment, even if they knew inflatin was ging t be 5%, because the alternative is t hld mney and receive a -5% rate f return thanks t inflatin. 16

17 Prblems with Mnetary Plicy: 1. The FED can t frce banks t lend ut mney during bad times. S lwering the reserve requirement r lwering the federal funds rate might nt spur AD. 2. Mnetary plicy requires the circulatin f mney, which can take a while (1 t 3 years). Thus, mnetary plicy isn t a very quick remedy. In particular, the velcity f mney determines in part the effectiveness f mnetary plicy. Velcity = nminal GDP mney supply. The velcity f mney, therefre, is the average number f times mney is spent in the year. The velcity f mney has been knwn t increase r decrease fr unclear reasns. The velcity f mney increased steadily t abut 6 in Since then, it has been much mre erratic, ranging frm 4 t Shuld mnetary plicy be used t target unemplyment (ptential GDP) r inflatin? Mst ecnmists believe that mnetary plicy is best suited t target inflatin. A lw, cnstant, and predictable inflatin rate allws an ecnmy t grw steadily ver time as ecnmic agents can predict prices. Keynes might disagree. Still, many cuntries have passed laws requiring the central bank t target inflatin. In the United States, the charge given t the FED includes valuing bth lw levels f inflatin and unemplyment a tricky tradeff given the Phillips curve. XI. Fiscal Plicy (Taylr Chapters 32 & 33) 3. Gvernment Budgets (Chapter 32). Over the last 50 years, the federal gvernment has been respnsible fr spending between 15% and 20% f GDP. The fur largest cmpnents typically are scial security, health care (Medicare & Medicaid), natinal defense, and interest n the debt. Over this same time perid, state and lcal gvernment spending has increased frm 10% f GDP t almst 20% f GDP. Educatin has accunted fr just a small fractin f this, increasing frm 4% t 6%, but keep in mind that the number f students in the system has fallen markedly. Per pupil expenditures have actually dubled ver this time perid. When the gvernment spends less mney than it cllects in taxes, T G > 0, the gvernment is said t run a budget surplus. When the gvernment spends mre mney than its cllects in taxes, G T > 0, the gvernment is said t run a budget deficit. The U.S. federal gvernment last ran a budget surplus in 2001, but this includes the scial security surplus. Taxatin Whether the federal gvernment runs a deficit r a surplus really depends n the amunt f taxes cllected as spending is fairly cnstant at 20% f GDP. The federal gvernment cllects mst f its revenue frm three surces: A prgressive persnal incme tax. (50%) A regressive payrll tax. (40%) A crprate tax. (10%) 17

18 Debt t GDP Rati Remember that federal deficits are nt necessarily bad, especially if gvernment spending is warding ff a recessin. Recently the U.S. gvernment has run deficits n the rder t 2% t 5% f GDP. The prblem with cntinually running a deficit, hwever, is that the debt (the ttal amunt wed) cntinues t grw. Presently interest n the debt is an enrmus expenditure fr the federal gvernment (almst $500 billin per year). This prevents the gvernment frm spending n mre necessary prgrams. Shuld the gvernment wrry abut having a $9 trillin debt? Need t lk at debt as a percent f GDP. By this measure, debt t GDP is under 40%. It was ver 100% at the end f Wrld War II. The claim that husehlds must balance their budget, and therefre gvernments shuld as well, is just wrng. Fr ne, husehlds dn t. Husehlds brrw against future incme t purchase hmes and t affrd a higher standard f living tday. Gvernments shuld d this as well. Of curse, when gvernments d this, they are taking frm the next generatin t give t the current generatin, whereas husehlds knw that their future selves are still n the hk. Secnd, gvernments can tax and they (hpefully) live frever. Bth f these make a debt mre manageable and mre sensible. Fiscal Plicy Expansinary fiscal plicy is shrt-term plicy that increases gvernment spending r decreases taxes. Either plicy shifts AD ut, which increases utput. This is the main idea behind Keynes. In cntrast, cntractinary fiscal plicy is shrt-term plicy that decreases gvernment spending r increases taxes. Pliticians are frequently hesitant t put the brakes n ecnmic expansin, but they prbably shuld. In part it wuld help reduce the debt. There are sme prblems with fiscal plicy. Fiscal plicy is hard t time. The legislative prcess takes time. It als takes time fr the mney t be spent r given t ptential cnsumers. Many anti-gvernment flks wuld argue that the federal gvernment acts s slwly that a fiscal stimulus almst always cmes abut after the ecnmy has turned the crner n the recessin. When the gvernment brrws t finance the fiscal stimulus, interest rates increase, and this decreases private investment. Thus, the fiscal stimulus is, in part, ffset by lwer private investment which wuld have been gd fr the ecnmy. Cnsumer, wrkers, and firms prbably dn t respnd t temprary fiscal plicy as they wuld permanent fiscal plicy. 18

19 Because f these prblems, many ecnmists advcate fr relying n autmatic stabilizers t ward ff recessin r t cl ff the ecnmy during an expansin. An autmatic stabilizer is a plicy that autmatically injects mney int the ecnmy during bad times and remves mney frm the ecnmy during gd times. The U.S. ecnmy has several autmatic stabilizers. The prgressive tax structure taxes autmatically increase (decrease) when incmes increase (decrease). Unemplyment benefits, welfare assistance, etc. benefits increase (decrease) when unemplyment increases (decreases). 4. Gvernment Brrwing and Natinal Savings (Chapter 33). Recall the natinal savings and investment identity; S + (M X) = I + (G T). That is, private savings plus freign savings (the trade deficit) equals private investment plus gvernment brrwing (gvernment investment). Thus, when gvernment brrwing increases, either private investment must fall, private savings must increase, r the trade deficit must increase. In particular, if private savings and the trade deficit remain fixed, then gvernment brrwing is financed by reducing private investment. This wuld seem particularly bad as private investment is gd. The idea that gvernment brrwing replaces private investment is called crwding ut. That is, gvernment brrwing crwds ut private investment. The mechanism by which this happens is that the gvernment cmpetes fr funds when it brrws, which shifts ut the demand fr lanable funds, which results in a higher interest rate. Mney that nce wuld have financed a 5% private prject when gvernment interest rates were 4% might nt be funded if increased gvernment brrwing increases the gvernment s rate t 4.8% (because gvernment lans are safer). [Draw a graph f the lanable funds market. Pg. 649.] Crwding ut is less f a prblem when the gvernment spends its mney n physical capital investments r investments int human capital. Many peple disagree abut hw well (r prly) the gvernment spends its mney and invests in capital prjects and human capital. 19