AP Maro Eonomis Review Prodution Possibility Curve Capital goods Capital goods P r i e B2 B Pe B C upply 2 A Market Equilibrium W Consumer goods F emand E Consumer goods A hange in emand versus a hange in the Quantity emanded Change in emand Change in Quantity emanded Moves the urve Inome Future Expetations # of Buyers Quantity Qe A hange in upply versus a hange in the Quantity upplied Change in upply Change in Quantity upplied Moves the urve Moves Along the AME urve Costs of Prodution Caused only by Prie hange. # of ellers Future Expetations Moves Along the AME urve Caused only by Prie hange. Consumer Information Taxes and ubsidies Taste and Preferene Pries of goods using same resoures ubstitues and Complements Time period of prodution 1
Eonomi growth The Rule of 70 is a devie that an find the number of years it will for some amount to double. # of yrs to double the real GP = 70 annual rate of growth Take the growth rate in 2004 of 4.0 70/4.0 = 17.5 years for Real GP to double Imagine that the rate of growth was 10%? Only 7 years to double! GRO OMETIC PROUCT efining Market Value of the total goods and servies produed within the boundaries of the U whether by Amerians or foreigners in one year. GRO OMETIC PROUCT Expenditures Approah Consumption by Households Investment by Businesses Government Purhases Expenditures by Foreigners G = = P Inome Approah Wages Rents Interest Profits tatistial Adjustments NOMINAL GP vs. REAL GP Nominal GP reflets the urrent prie level of goods and servies and ignores the effet of inflation on the growth of GP. this measure is alled Current ollar GP. Real GP measures the value of goods and servies adjusted for hange in the prie level. It will reflet the real hange in output. This measure is alled the Constant ollar GP. indiates what the GP would be if the purhasing power of the dollar has not hanged from what it was in a base year. The government urrently uses 2000 as its base year for Real GP measurement. GP Prie Index Prie Index in a given = year Real GP = Prie of market basket in speifi year Prie of same market basket in base year An Alternative Method Prie Index (in hundredths) = Nominal GP Prie Index (in hundredths) Nominal GP Real GP x 100 isposable Inome By subtrating from Personal Inome, the dollars lost to taxes, we have the isposable Inome. This is the bottom line of national inome aounting. isposable Inome = C 2
GP understates the well-being by not ounting non market transations by not measuring Improved Produt Quality by not onsidering Leisure Time GP Overstates the well-being by ignoring the Composition and istribution of Output GP and the Environment Per Capita GP measures the GP in terms of goods and servies per person Unemployment Rate = Unemployed Labor Fore Fritional temporary, transitional, short-term ( between jobs or searh unemployment) trutural tehnologial or long term. basi hanges in the struture of the labor fore whih make ertain skills obsolete. Cylial eonomi downturns in the business yle. The Full employment rate of unemployment or the Natural Rate of Unemployment (NRU) is present when the eonomy is produing its potential output. The Natural Rate of Unemployment exists when the ylial unemployment is zero. GP Gap and Okun s Law The basi loss of unemployment is forgone output. Potential GP is the apaity of the eonomy assuming the Natural Rate of Unemployment. The growth of the Potential GP assumes the normal growth rate of the real GP. GP GAP is the amount by whih atual GP falls short of potential GP For every 1% the unemployment rate exeeds the natural rate Approximately a 2% GP Gap ours. Inflation A rising of the general level of pries CPI = Prie of the market basket in the partiular year x 100 Prie of the same market basket in 2000 Produer Prie Index (PPI) Pries at the wholesale or prodution level whih are early indiators of inflation. 70 divided by rate of inflation (expressed as whole numbers) will yield the number of years for the prie level to double. Theories of Inflation:emand Pull Exess of total demand pries are bid upward by the exess demand eonomy is seeking a point beyond its PPC when full employment-full prodution is evident P r i e l e v e l Range 1 Range 2 Inreases in total spending Range 3 Quantity 3
Theories of Inflation:Cost Push pries rising when output and employment are both delining aggregate demand not exessive Per unit prodution osts are rising due to raw materials, energy, labor, et. High per unit osts ause deline in profit; hene, the prie level is pushed up by these osts. Abrupt inreases in the osts of raw materials or energy inputs drive up per-unit prodution osts and hene pries. Unantiipated Inflation Those who benefit Flexible Inome penders ebtors Those who lose Fixed Inome avers Creditors COLA-helps to stay up with rising pries Real and Nominal Inome Nominal inome is the number of dollars earned as rent, wages, interest or profit Real inome measures the amount of goods and servies nominal inome an buy. If nominal inome rises faster than prie level, real inome will rise. If the prie level inreases faster than nominal inome, then real inome will fall. Your real inome falls only when nominal inome fails to keep up with inflation. PL 1 o Long Run Equilibrium lr Real domesti output In the extended A- model, equilibrium ours at the intersetion of A and the lr and the sr. is the amount of Real GP at full employment. sr EMAN-PULL INFLATION and elf-corretion PL 3 [7%] PL 2 [5%] PL 1 [2%] o lr 2 sr sr a Y2 b Real domesti output hort Run Inrease in A shows point b Long Run Nominal Wages rise and 2 sr moves left. RGP returns to previous level on As lr But PL rises even more to PL 3! PL 3 [5%] PL 2 [3%] PL 1 [2%] o COT-PUH INFLATION with government ation Y 2 b lr 2 sr sr Q f a Real domesti output If government stimulates A to dotted line, an inflationary spiral will our PL 3 at. We have Full Employment but at a higher prie level. 4
PL 3 [5%] PL 1 [2%] COT-PUH INFLATION with NO government ation lr 2 sr sr a If government lets the reession take its ourse, nominal wages will fall in the long run and return to point a PL 1 at. Reession PL 1 [5%] PL 2 [3%] PL 3 [2%] lr a b 1 sr 2 sr This deline in the prie level will eventually shift the 1 sr to 2 sr. Prie level delines to PL 3 at. hown at point. o Real domesti output o Y2 Real domesti output Annual rate of inflation The Phillips Curve Conept 7 5 4 3 2 1 0 As inflation delines... 1 2 3 4 5 7 Unemployment inreases PC Unemployment rate (perent) The Phillips Curve ummary The short run Phillips Curve is downward sloping. Aggregate emand hanges move along the same short run Phillips urve. Aggregate upply hanges reate new short run Phillips urves. In the long run, there is not a stable relationship between unemployment and inflation. The long-run Phillips urve is the vertial line at the natural rate of unemployment. Expansionary Fisal Poliy Goal: To Redue Unemployment and Effets of Reession Inrease Government pending erease Tax Rates Or Combination of the Two Contrationary Fisal Poliy Goal: To Redue emand Pull Inflation erease Government pending Inrease Tax Rates Or Combination of the Two EXPANIONARY FICAL POLICY the multiplier at work... $20 billion derease in tax rates; $15 billion in new onsumption spending Prie level MP =.25 P 2 P 1 $490$550 $0 billion inrease in Aggregate emand Real GP (billions) 5
CONTRACTIONARY FICAL POLICY the multiplier at work... $20 billion inrease in tax rates; $15 billion lost in onsumption spending Prie level MP =.25 P 2 P 1 A A 3 4 $490$550 $0 billion derease in Aggregate emand Real GP (billions) Built-in tability ome hanges in relative levels of government expenditures and taxes our automatially. This is not like disretionary hanges in spending and tax rates sine these net tax revenues vary diretly with RGP. tends to inrease the government defiit (or redue the surplus) during reession or to inrease the surplus ( or redue the defiit) during inflation without requiring speifi ation by poliy makers. Real Interest Rate, (perent) Crowding Out Effet Inreased demand for loanable funds i% by government raises the i% interest rate. LF 0 LF 1 2 Quantity of Loanable Funds Fisal poliy weakened by NET EXPORT EFFECT Expansionary fisal poliy Problem: Reession More government spending and/or lower taxes Higher domesti interest rates (rowding-out effet) Inreased foreign demand for dollars (foreigners want to earn higher interest) ollar appreiates Net Exports deline (A dereases, partially offsetting expansionary poliy) Contrationary fisal poliy Problem: Inflation Lower government spending and/or higher taxes Lower domesti interest rates (government role in loanable funds market is less) ereased foreign demand for dollars (foreigners find higher rates elsewhere) ollar depreiates Net Exports inrease (A inreases, partially offsetting ontrationary poliy) upply-ide Eonomis upply-ide Eonomis aims to manipulate aggregate supply by enating poliies designed to stimulate inentives to work, to save and invest (inluding measures to enourage entrepreneurship). These poliies may inlude tax uts whih will inrease disposable inomes, thus inreasing household saving and inrease the profitability of investments by businesses. Tax ut stimulates more onsumption, saving and investment to inrease A. The new investment moves the urve to the right. Work inentives push more workers into employment and they spend and save inreasing A further. Low taxes at to push risk takers to move toward new prodution methods and new produts. Laffer Curve shows the relationship between tax rates and tax revenues Up to a point, higher tax rates will result in larger tax revenues. But still higher tax rates will adversely affet inentives to work and produe, reduing the size of the tax base and reduing tax revenues. Lower tax rates will lessen tax evasion and avoidane, and redue government transfer payments.
M E M A O N U E R Y E Large time deposits Money market aounts avings deposits mall time deposits Chekable deposits Travelers heks Curreny M3 M2 MI i% i% 1 The Money Market upply of money is a m vertial line sine monetary authorities (FE) and finanial institutions have provided m the eonomy with a ertain stok of money. $$ demanded Creation of Money in the Banking ystem Money supply is inreased when: 1. Banks issue loans to ustomers and reeive a demand deposit. 2. Banks buy seurities from the publi and redit a demand deposit for the ost. Money supply is dereased when: 1. Customers repay loans take money from their demand deposit. 2. Banks sell seurities to the publi and a demand deposit is redued to pay for the bond. One bank an loan only its exess reserves and is limited by those reserves in reating money. The banking system reates a multiplied amount. The Money Multiplier 1 Money = Multiplier Required reserve ratio Maximum emand- eposit reation = Exess reserves x Money Multiplier Curreny drain and no reditable ustomers will derease the amount multiplied. EY MONEY Goal: Cheap, available redit; inrease the money supply M i% I n C A PL RGP Ations Results FE will buy government bonds from banks and the publi Inrease the bank exess reserves, and banks an make more loans. FE will lower the legal reserve ratio An inrease in the money supply will lower the interest rate, ausing Investment to inrease and equilibrium GP to rise. FE will lower the disount rate harged to member banks The amount of the hange will be dependent on the size of the Inome Multiplier (1/MP) Easy money is reinfored by the Net Export Effet Prie level Real rate of interest, i 10 8 m 0 0 Quantity of money demanded and supplied PL 3 PL 2 PL 1 Easy Monetary Poliy And Equilibrium GP m1 m2 m3 Real domesti output, GP A 3 (I=$25) (I=$20) (I=$15) 10 8 Investment emand Amount of investment, i If the Money upply Inreases to timulate the Eonomy Interest Rate ereases Investment Inreases A & GP Inreases with slight inflation Inreasing money supply ontinues the growth but, wath. 7
Tight Money Goal: Restrit redit; derease the money supply M i% I n C A PL RGP Ations Results FE will sell government bonds to banks and the publi erease the bank exess reserves, and banks will issue fewer loans FE will raise the legal reserve ratio An derease in the money supply will raise the interest rate, ausing Investment to inrease and equilibrium GP to fall. FE will raise the disount rate harged to member banks The amount of the hange will be dependent on the size of the Inome Multiplier (1/MP) Tight money is reinfored by the Net Export Effet Prie level Real rate of interest, i 10 8 m 0 0 Quantity of money demanded and supplied PL 1 PL 2 PL 3 Tight Monetary Poliy And Equilibrium GP m3 m2 m1 Real domesti output, GP (I=$25) (I=$20) A 3 (I=$15) 10 8 Investment emand Amount of investment, i If the Money upply ereases to ool the Eonomy Interest Rate Inreases Investment ereases A & GP ereases with lower PL ereasing money supply ontinues the ooling as falls. Nominal Rate = Real Interest rate expeted rate of inflation Real Interest Rate = Nominal rate expeted rate of inflation Money Market Graph Nominal Interest Rate i % i% e m Q e Q of $$ demanded The supply of money is vertial no matter what the interest rate is on the vertial axis. The FE ontrols the supply of money. m The demand for money is omposed of the transation demand and asset demand. r r e Loanable Funds Market Real Interest Rate emand is: Q e LF Q of LF LF Business for investment Consumer for spending Government for efiit spending upply is mostly from private savings Changes in the real interest rate aused by movements of demand (from borrowers) and supply (from savers). GROWTH IN THE A- MOEL C LR1 LR2 A Capital Goods B Q 1 Q 2 Real GP Consumer Goods 8
Classial View: is vertial and determines the output at A is stable and determines the prie level as long as money supply is stable. If A is unstable, pries and wages adjust. P 1 P 2 Real omesti Output A shift to shows that the prie level delines. Keynesian View: Produt pries and wages are downward inflexible is horizontal up to P 1 Qf then beomes vertial If A is unstable, Q hanges in A have no 2 effet on PL but affet Real omesti Output RGP. Movement from to redues the Real GP but the PL remains onstant. NEW CLICAL VIEW OF ELF-CORRECTION elf-corretion P 3 P 2 P 1 LR 2 1 Q 1 Real omesti Output a b A inreases moves eonomy from a to b. Prie level rises (P 2 ) and then self-orretion to by shifting left to 2 as Nominal Wages rise. Monetary rule : supported by Monetarists and other Neo-Classial Eonomists like Rational Expetationists. direts the Fed to expand the money supply eah year at the same annual rate as the typial growth of the eonomy s produtive apaity. isretionary Fisal and Monetary Poliy (espeially monetary): supported by Mainstream Eonomists. ummary of Alternative Views New Classial Eonomis Issue Mainstream Monetarism Rational Maroeonomis expetations Keynesian Based View of the Potentially table in long run table in long run private unstable at natural rate of at natural rate of eonomy unemployment unemployment Cause of Investment does Inappropriate Unantiipated A observed not equal saving monetary poliy and shoks in stability of ausing hanges in the short run private A; shoks eonomy Appropriate Ative fisal and Monetary rule Monetary rule maro poliy monetary How hanges By hanging By diretly No effet on output in money interest rates, hanging A beause prie-level supply affet hanging whih hanges hanges are the eonomy investment and GP antiipated real GP View of Unstable table No onsensus veloity of money How fisal Changes A and No effet unless No effet on output poliy affets GP via the money supply beause prie-level the eonomy multiplier hanges hanges are antiipated View of Cost Possible (wagepush, shok) run in absene of run in absene of Impossible in long Impossible in long push inflation exessive money exessive money supply growth supply growth efiits, urpluses and ebt A budget defiit is the amount by whih the government expenditure exeeds the government revenue in a partiular year. A budget surplus is the amount by whih the government revenue exeeds the government expenditure in a partiular year. The National or Publi ebt is the aumulated defiits and surpluses of the government over time. 9
Types of Budgets Annually Balaned proylial Cylially Balaned to hard to predit yles Funtional Finane-work for goals Comparative Advantage is the ability to produe an item at a lower opportunity ost. Resoures are sare, so that one an only produe more of one produt by taking the resoures away from another. It means that total world output will be greatest when eah good is produed by the nation whih has the lowest domesti opportunity ost. As a result of trade, ountries that trade produts based on their own speialization will have more of BOTH produts (produed and traded for). Terms of Trade the exhange ratio between goods traded. This ratio explains how the gains from international speialization and trade are divided among the trading nations; it depends on the world supply and demand for the two produts. Flexible exhange rates $ Prie of Foreign Curreny $ f The intersetion will be the exhange rate. Quantity of Foreign Curreny A nation s Balane of Payments reords all the transations that take plae between its residents and the residents of a foreign nation. Current Aount Mdse. Trade ervies Trade Net Investment Inome Net Transfers = Capital Aount Real Investment Finanial Investments Offiial Reserves Aount to balane a defiit to balane a surplus ollar prie of foreign urreny $P/ f The Market For Curreny FC epreiates; $ Appreiates FC Appreiates; $ epreiates FC prie of dollars FCP/ $ ollar epreiates; FC Appreiates ollar Appreiates; FC epreiates Q Quantity of $ eterminants of exhange rates: Changes in tastes Changes in relative inomes Changes in relative pries Changes in relative interest rates peulation in urrenies Q Quantity of foreign urreny 10