Macroeconomics Chapter 1: Ten Principles of Economics How People make Decisions People Face Trade-Offs o Free Lunch Argument

o Scarcity limited nature of societys resources o Economics study of how society manages scarce resources o Time/Money Spend on one thing is lost on another endeavor o Efficiency- society gets maximum benefit from scarce resources (Size of Pie) o Equality- benefits are distributed uniformly among societys members (Size of Slice) o Tax increase: pie becomes smaller (less efficient) since there is less an incentive to work The Cost of something is What you Give up to Get It o Opportunity Cost what you give up to get that item, (explicit+implicit) o Going to College vs time lost not working and spending money for tuition. Rational People Think at the Margin o Marginal Change small incremental adjustment to an existing plan of action. o Rational Decision maker takes action if marginal benefit of the action exceeds the marginal cost People Respond to Incentives o Incentive Induces a person to act (i.e. punishment or reward) o Seat Belt example cost benefit of driving slower and safer vs faster with belt How People Interact Trade Can Make Everyone Better Off o Specialize in what they do best o Enjoy greater variety of goods and services Markets Are Usually a Good Way to Organize Economic Activity o Market Economy decisions are made by millions of firms and households (free market), Driving Forces Principle and Self Interest o Even though decision making power is decentralized it works by invisible hand Governments can Sometimes Improve Market Outcomes o Government needs to enforce rules and institutions that are key to market economy o Property Rights individuals can own and control scarce resources o Basically stealing is illegal and punishable o Market Failure- market fails to produce an efficient allocation of resources o Externality impact of one persons actions on the well-being of a bystander (i.e pollution)

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

How the Economy as a Whole Works A Countrys Standard of Living Depends on Its Ability to Produce Goods and Services o Differences in Standards of living are attributed to productivity of countries o Productivity amount of goods and services produced from a unit of labor input o Technologically advanced countries are able to have workers produce more goods per unit time Prices Rise When the Government Prints Too Much Money o Inflation an increase in the overall level of prices in the economy o About 2.5% per year o Keep inflation low is goal of economic policymakers o Quantity of money causes inflation Society Faces a Short-Run Trade-off Between inflation and Unemployment o Short Term effects on monetary injects Stimulates spending and demand for goods and services Higher demand causes firms to raise prices and hire more workers More hiring means lower unemployment o Business Cycle the irregular and largely unpredictable fluctuations in economic activity, as measured by the production of goods and services or the number of people employed o Changing the amount the government spends, the amount it taxes, and the amount it prints can influence inflation and unemployment in the short run

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

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

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

Chapter 2: Thinking Like an Economist The Economist as Scientist Scientific Method: Observation, Theory, and More Observation o Cannot produce experiments must use historical events to experimentally determine theory similar to evolutionary biologist The Role of Assumptions o Simplify calculations (i.e. physicist assume vacuum) we assume only 2 countries o Examples assumptions Short Run- prices fixed Long Run everything is flexible Economic Models o Diagrams and equations may omit minor details o This helps create a deeper understanding Circular-Flow Diagram o Two types of decision makers Firms Produce Goods and Services Using Inputs like labor land and capital (buildings and machines) These inputs are called factors of production (labor land and capital) Households Markets for goods and services- households are buyers Markets for the factors of production- households are sellers firms are buyers o In these markets household provides the input that firms use to produce

Our Second Model: The Production Possibilities Frontier o Assumption: only 2 goods, these two goods use all of the economys factors of production o Production Possibilities Frontier- shows various combinations of output o Can only produce on or inside of the curve (C is impossible) o Said to be efficient if economy operates on the line o Point D is inefficient for some reason (i.e. unemployment) o Opportunity cost at A 1 car per 2 computers o Opportunity cost not constant- (to produce a car) less at y intercept more at x intercept o

Technological increase in possible output of computers leaves car maximum fixed but shifted production possibilities frontier

Microeconomics and Macroeconomics o Microeconomics study of how households and firms make decisions and how they interact in specific markets

o Macroeconomics- study of economywide phenomena Positive versus Normative analysis o Polly: Minimum-wage laws cause unemployment- scientific descriptive observation o Norm: The Government should raise minimum wage- policy maker, change he would like o Positive Statements- descriptive o Normative Statements- prescriptive (how it ought to be) o Economics is majorly positive when normative includes ethics religion and political philosophy Economists in Washington o Have to weigh pros and cons of policy Why Economists Disagree o Economists disagree about vailidity of alternative positive theories o May have different values therefore normative views Differences in Scientific Judgments o Example- deciding whether to tax households income or spending o Different positive views about the responsiveness of saving to tax incentives Perception Versus Reality o 2-4 propositions

Chapter 3: Interdependence and the Gains from Trade A Parable for the Modern economy Interdependence allows for a higher standard of living and more opportunities o Two people in the world each provide 1 good ( Meat and Potatoes). With trade both people can enjoy both goods instead of being independent o What if one person is more proficient at producing both goods? Should they still trade? Production Possibilities o One faction is greater at producing both goods

o o

Trade is still beneficial

Helps each faction focus on producing what it is most efficient at producing in comparison to the other faction Comparative Advantage: The Driving Force of Specialization o Absolute Advantage whoever requires a smaller quantity of inputs to produce a good o Opportunity Cost second piece of the puzzle. What does the more efficient party give up in order to produce both o Whoever gives up less of other good has smaller opportunity cost- they have the comparative advantage o Unless they are identical one party will have comparative advantage in one good while the other has comparative advantage in the other. Comparative Advantage and Trade o Trade benefits everyone when there are different comparative advantages The Price of the Trade o For both parties to gain from trade, the price at which they trade must lie between the two opportunity costs. Should the United States Trade with Other Countries o Imports goods produced abroad and sold domestically o Exports Goods Prodcued Domestically and sold abroad

Chapter 4 : The Market Forces of Supply and Demand Markets and Competition Supply and Demand refer to people as they interact with one another in competitive markets Market- a group of buyers and sellers of a particular good or service o Buyers determine demand and sellers determine supply o Markeys can be more or less organized Competitive market- a market in which there are too many buyers and sellers for one to impact market price o In this chapter assume markets are perfectly competitive 1- goods offered for sale are exactly the same 2- the buyers and sellers are so numerous that no single buyer or seller can change price Price Taker Buyers and sellers who accept price in perfect market o At market price buyers can buy all they want and sellers can sell all they want Monopoly seller sets the price Looking at Demand first o Quantity demanded amount of the good that buyers are willing and able to purchase o

Law of Demand other things equal price of a good rises quantity demanded of a good falls and vice versa Demand Schedule relationship between price of good and quantity demanded holding constant everything else Demand Curve downward sloping curve relating price and quantity demanded Market demand is horizontal sum of individual demands

Supply -

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

Quantity supplied amount that sellers are willing and able to sell Law of supply relationship between price and quantity supplied o When price of good rises quantity supplied rises and vice versa Supply Schedule table that shows relationship between price and quantity supplied (holding everything else constant) Supply Curve- relates price to quantity supplied Market Supply versus Individual Supply o Sum horizontally More easily produced supply curve shifts to right Things that shift curve o Technology o Expectations

o Equilibrium -

Number of Sellers

Equilibrium intersection of supply and demand Equilibrium price price at equilibrium, or called market clearing price, (everyone is satisfied) buyers bought all they want sellers sold all they want Equilibrium quantity quantity at equilibrium Price is below equilibrium price o Shortage of the good demanders are unable to buy all they want at the price o Sellers can respond by raising prices which decreases demand= shift ALONG supply and demand curve o This equilibrium action is defined as law of supply and demand o Surplus- opposite of shortage

Analyzing Changes in equilibrium Determine difference between change in demand or supply or change along the curve refer to end of chapter 4

Chapter 5: Elasticity and its Application The Elasticity of Demand

Elasticity- how much consumers respond to changes in variables, price, income, substitutes o Price of Elasticity of Demand how much the quantity demanded responds to a change in price o Elastic means quantity demanded changes with factors inelastic doesnt budge o Inelastic is horizontal or vertical? Rules of thumb for price elasticity of demand Availability of Close Substitutes more subs is more elastic Necessities versus Luxuries necessities more inelastic Definition of the Market -- narrower market (specific) more elasticeasier to find substitutes Time Horizon -- over a longer time goods become more elastic

Greater the number the more elastic the good Midpoint Method o Given data take midpoint and calculate elasticity from there o Price elasticity of demand = (Q2 Q1) / [(Q2 + Q1) / 2]////(P2 P1) / [(P2 + P1) / 2]. o From Q=quant P=Price o Considered elastic if elasticity is greater than 1 quantity moves proportionaley more than price o Unit elasticity is when elasticicty=1 o Flatter the curve more elastic the demand

o o Total Revenue the amount paid by buyers and received by sellers of a good o Total revenue= PXQ o When demand is inelastic (a price elasticity less than 1), price and total revenue move in the same direction. o When demand is elastic (a price elasticity greater than 1), price and total revenue move in opposite directions. o If demand is unit elastic (a price elasticity exactly equal to 1), total revenue remains constant when the price changes. Elasticity and Total revenue along Linear Demand Curve o On linear curves even though demand is constant elasticity is not

o o 5-1f Other Demand Elasticities o Income elasticity of demand- measures how the quantity demanded changes as income changes o Income elasticity of demand = Percentage change in quantity demanded////Percentage change in income. o Cross Price Elasticity of Demand- measures how quantity demanded of one good responds to a change in the price of another good o Cross Price Elasticity of Demand= Substitutes have a positive value Compliments have a negative value

Elasticity of Supply Price Elasticity of Supply- measures how much the quantity supplied responds to change in price o Elastic- quantity supplied responds substantially to change in price o Inelastic- quantity supplied responds only slightly to change in price o Factors are time period and amount of good producedie beachfront is inelastic Price Elasticity of Supply=

Variety of Supply Curves o Perfectly inelastic- vertical o Perfectly elastic- horizontal

Chapter 6: Supply Demand and Government Policies Controls on Prices Price Ceiling- maximum price set by government Price Floor- minimum price set by government How Price Ceilings Affect Market Outcomes o If Price Ceiling is above equilibrium position it is not binding and therefore nothing occurs

o o Price Ceiling dont help all buyerslonger wait times and sometimes ice cream cannot even be attained o Binding ceilings result in a shortage and rationing goods o Discrimination can occur in between seller and buyer o Free markets ration goods with prices and are efficient and impersonal How Price Floors Affect Market Outcomes o Equilibrium is above price floornothing occurs o Equilibrium Above price floor this causes a surplus and is binding

Taxes

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

Taxes on Sellers Affect Market Outcomes o Supply curve shifts left (upward) o Size in shift is equivalent to the size of the tax therefore at distance between the shifted supply curve and the original at the new equilibrium is equal to the size of the tax

o o Both are worse off but buyers get brunt How Taxes on Buyers Affect Market Outcomes o Demand curve affected

o o Taxes levied on sellers and buyers are equivalent Elasticity and Tax Incidence o

o o Naturally with more inelastic goods the firm will be able to shove most of the tax onto the consumer and with elastic goods that have inelastic supply and elastic demand

Chapter 7: Consumer, Producers, and the Efficiency of Markets Consumer Surplus Willingness to pay- how much the buyer values the good (max price) Consumer Surplus- amount buyer was willing to pay subtracted from what he paid Using the Demand Curve to Measure Consumer Surplus

o o What Does Consumer Surplus Mean Consumers determine their own benefit Consumer surplus does reflect economic well being Producer Surplus -Cost and The Willingness to Sell - If opportunity cost is less than pay the work is done o Product Surplus- the amount a seller is paid minus the cost of production Measures benefit seller receives from participating in a market - Using the supply Curve to Measure Producer Surplus o Same exact idea as the pervious graph with demand curves

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

o How a Higher Price Raises Producer Surplus

o Market Efficiency - Benevolent social planner o All knowing, all powerful, well-intentioned dictator o If allocation of resources maximizes total surplus we will say its efficient o If a low cost producer is being skipped over by a high cost producer o Equality- do buyers and sellers have a similar level of economic well-being

o o Naturally people who value the good the most and can make it the cheapest are the one who live in surplus. This is a product of the free mark. Economic well being cannot be increased by the social planner o Free markets produce the quantityof goods that maximizes the sum of consumer and producer surplus

o Market Efficiency and Market Failure o Without externalities free market would operate fine but some political intervention is required

Chapter 8: Application: The Costs of Taxation The Deadweight Loss of Taxation o Cost of taxes to buyers and sellers exceeds revenue raised by government Deadweight Who pays the tax is dependent on elasticites and not on who the tax is levied against

How a Tax Affects Market Participants

o o Deadweight Loss Fall in total surplus that results when a tax distorts a market outcome

o o Tax distorts incentives and causes markets to allocate resources inefficiently Deadweight Losses and the Gains from Trade

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

o o People near the tip of the equilibrium are pushed out of the market by the tax that shifts the price to the new equiblirum spot of money received and money paid by supply and demander respectively Determinants of the Deadweight Loss o Price elasticities of supply and demand determine size of deadweight loss greater elasticity= greater deadweight

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

o Chapter 9: Application: International Trade The Determinants of Trade Equilibrium without Trade

o The World Price and Comparative Advantage o World price- Prevailing world market price o Action depends on the world price export if higher than domestic if lower than import. o In essence it is a comparison of comparative advantages

The Winners and Losers from Trade Must assume 1 economy will have no affect on market or world price This assumption doesnt mean our conclusions dont apply in complicated cases Gains and Losses of an Exporting Country

o o Demand is perfectly elastic country is small and world buys as much as it wants o Domestic producers are better off o Domestic consumers are worse off Gains and Losses of an Import Country

o Supply curve is perfect elastic because country is small economy o Domestic consumers are better off o Domestic producers are worse off Trade raises the economic well being of nation in sense that gains of winner exceed losses of losers Effects of a Tariff o Tariff- a tax on imported goods o Tarrifs reduce the quantity of imports and moves domestic market closer to its equilibrium without trade

o o Red area is deadweight produced by tariff/tax Other Benefits of International Trade o Increased Variety of goods o Lower costs through economies of scale o Increased Competition o Enhanced flow of ideas

Arguments for Restricting Trade May hurt domestic producers if world price is lower The Jobs Argument o Free trade can destroy a countries domestic jobs The National-Security Argument o Becoming dependent on a foreign company for goods of national security is a bad idea

The Infant-Industry Argument o Need restrictions to help get them started Unfair-Competition Argument o Free trade is desirable only if all countries play by same rules Diff laws and regulations can give unfair advantage in 1 country Protection-as-a-Bargaining-Chip Argument o We can threaten to block trade as a bargain It may not work and hurt own welfare Or back down and look dumb o Job destruction is what leads to progress

Chapter 10: Measuring a Nations Income The Economys Income and Expenditure GDP measures total income of everyone and total expenditure on the economys output of goods and services o Income must equal expenditure Every transaction has a buyer and a seller

o o GDP- the market value of all final goods and services produced within a country in a given period of time o GDP weighs values of different goods o GDP includes market value of housing services goods and other things. Does not include illicit sells

o GDP only includes final goodsex hallmark card not the paper o Unless an intermediate good is saved for a later date like stockpiling paper for another year o GDP includes tangible goods and intangible (haircuts etc) o GDP does not include used good or goods created in the past like used cars o Usual interval is a year or a quarter but reported as a rate ($/yr) o Difference between total income vs dollar spent on good Small discrepancy is called statistical discrepancy Components of GDP Y=C+I+G+NX o C=Consumption spending by households on goods and services (exluding new housing) o I=Investment Purchase of goods that will be used in the future to produce more goods and services. Sum of capital equipment, inventories, and structures Includes expenditure on new housing o G=Government Purchases Spending by local state and federal Include salaries and expenditures on public works o NX=net exports Exports-imports Other measures of Income o GNP Total income earned by permanent resides o Net National Product GNP- losses from depreciation Depreciation is defined as consumption of fixed capital old machines etc o National income Total income earned by nations residents in production of goods and services Almost identical to NNP o Personal income Income that households and noncorporate buisnesses receive Exlcludes retained earnings- income that coproations have earned but not paid to owners o Disposable personal income Income households and noncorporate buisnesses have after satisfying all obligation to government

Real versus Nominal GDP o Basically real accounts for inflation o Positive GDP includes producing larger amount of goods and services and goods and services being sold at higher prices o Nominal GDP- production of goods and services valued at current prices o Real GDP- goods and services valued at constant prices Need a Base Year GDP Deflator o GDP deflator=Nominal/Real *100% For base year GDP deflator=100% o Inflation rate in year(n)= ((GDP Def(n)-GDP Def(n-1))) / (GDP def(n-1)

Chapter 11: Measuring the Cost of Living The Consumer Price Index Find a way turning dollar figures into measures of purchasing power The purpose of the consumer price index CPI monitors cost of living over time Consumer Price Index- measure of overall cost of goods and services bought by a typical consumer Steps to computing CPI o Fix the Baskets: Determine which prices are most important to typical consumers weigh goods based on amount bought o Find the Prices: Find price of each good and services in basket at each point in time o Compute the Baskets Cost: Use the price data to calculate cost of basket at different times o Choose a base year and compute the index CPI= Price in current year/ Price in base year X100 o Compute the inflation rate Inflation(n)=((CPI(n)-CPI(n-1)))/((CPI(n-1) Producer price-index- measures the cost of basket of goods and services bought by firms o Since firms pass costs on to their consumers PPI is good indicator of change in CPI Problems in measuring the Cost of Living o Substitution Bias: when prices change year to year they do not all change proportionately

o Introduction of new goods: when a new good is introduced, consumers have more variety and cost for same well being reduces o Unmeasured quality change: quality good deteriorates from one year to the next but the price maintains the same, the value of a dollar falls GDP Deflator versus the CPI o GDP reflects prices of all goods and services PRODUCED domestically o CPI is BOUGHT by consumers o Makes sense with things like oilwhen oil goes up CPI climbs much more than GDP because it is consumed more than produced in the country o 2nd Difference o CPI compares a fixed basket of goods in the base year o GDP compares price of currently produced goods

Dollar Figures from Different Times o o Price level can be plugged in as CPI in that year Indexation o Indexed- a dollar amount is automatically corrected for changes in price level by law or contract o For example cost of living announcement o Many laws account for indexation and job wages Real and Nominal Interest Rates o Dont compare amount of money before and after but the amount of purchasing power Say collect 100 dollars in interest in a year starting w/ 1000 DVD costs 10 bucks 0% inflation 10% increase purchase power

6% inflation 4% increase purchase power 10% inflation 0% increase purchasing power Dont forget deflation Nominal interest rate- measured in change in dollar amounts Real Interest Rate- interest rate corrected for inflation o Real Interest Rate= Nominal-Inflation Rate

Chapter 12 : Production and Growth Economic Growth around the World Growth rate measures change in real GDP per person per year

Productivity: Its Role and Determinants Productivity is an easy explanation for differences in standard Productivity- the quantity of goods services produced from each unit of labor input How Productivity is determined o Physical Capital per worker Physical Capital- the stock of equipment and structures used to produce goods and services Basically Tools Inputs like labor and capital are called factors of production Capital is a produced factor of production capital used to be an output but is now an input o Human Capital per Work Human Capital- knowledge and skills that workers acquire through education, training, experience It is similar to physical capital o Natural Resources Per Work Natural Resources- inputs into production such as land rivers, mineral deposits Renewable and non-renewable o Forests are renewable o Oil takes very long to renew so nonrenewable short term o Technological Knowledge Technological Knowledge- understanding the best ways to produce goods and services Some knowledge like assembly lines becomes public

Others like Coca Cola recipe is private

Economic Growth and Public Policy Saving and Investment o For a society to invest more in capital it must consume less and save more income o Sacrifice consumption for higher consumption in the future Diminishing Returns and the Catch-Up Effect o Capital is subject to diminishing returns o Diminishing Returns- as stock of capital rises, extra output produced from unit of capital falls o Productivity increases less and less o In the long run, the higher saving rate leads to a higher level of productivity and income but not to higher growth in these variables o But growth can last for several decades investing in capital o Catch-up effect- poor countries that invest a little get bigger returnseasier to catch up when behind

o Investment from Abroad o Capital Investment that is owned and operated by a foreign entity is called foreign direct investment o Investment that is financed with foreign money but operated by domestic residents is called foreign portfolio investment Education o It is at least as important as investment in physical capital o Investment leads to higher wages and positive externalities such as a pooling of ideas

o But poor countries face a brain drain effect where all highly educated workers leave to enjoy higher standards of living in richer counties Health and Nutrition o Human capital can describe expenditures that lead to a healthier population o Wealth and health affect each other o Investing in one is a virtuous cycle Property Rights and Political Stability o Property right is ability of people to exercise authority over the resources they own o Corruption and theft discourages domestic saving and investment from abroad o Political instability can be a cause in wavering property rights Free Trade o Inward oriented policies try to increase productivity while ignoring outside influence o Poor countries are better off pursuing outward oriented policies that make the countries part of the economy o Geography matters for free trade.seaports are key and landlocked countries face an extra roadblock Research and Development o To a large extent knowledge is a public good o Government use to support farming research now focuses more on aerospace research and scientific continuation o Patent system can encourage research government can offer incentives Population Growth o With growth comes larger labor force but that also means the population consumes more o Large amounts of population dilute Capital stockie school age children strain education system o People also argue it promotes technological progessmore people means more scientist and invetors and that means more technological advance which benefits everyone

Chapter 13: Saving Investment and the financial System Financial Institutions in the U.S. Economy Financial System- consist of the institutions that help to match one persons saving with another persons investment Savers and Buyers

o Possibly saving for retirement and borrowers possibly borrowing for possession of a house The financial system is set up to coordinate savers and borrowers o Financial institutions are in two categories Financial markets Financial Intermediaries Financial Markets- institutions through which a person who wants to save can DIRECTLY supply funds to a person who wants to borrow o Bond Market Bond a certificate of indebtedness that specifies the obligations of borrower to hold of bond Identifies a time at which loan will be repaid, called date of maturity And interest rate that will be paid periodically until it matures Principal is repayment for the amount borrowed Bonds can be sold Term- length of time until bond matures Perpetuity- bond that pays interest forever Credit Risk- probability that the borrower will fail to pay interest or principal Default- Failure to pay Junk Bonds- offered by shaky companies that have high risk of failure and therefore have high interest rates Tax treatment- the way tax laws treat the interest earned on a bond Municipal bonds- local and state bonds arent taxed so have lower interest o The Stock Market Stock- represents ownership in a firm and is therefore a claim to profits that the firm makes Equity Finance- sale of stock to raise money Debt Finance- Sale of bond to raise money Own stock=partial owner, Own Bond= creditor Stocks are higher risk and return Stock Index- computed average of a group of stock prices o Dow Jones

Financial Intermediaries- financial institutions through which savers indirectly provide funds to borrowers o Banks Besides the obvious they facilitate purchases of goods and services allowing people to write checks against deposits and debit cars Banks create special asset that is a medium of exchange o Mutual Funds Mutual Fund- institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio of various types of stocks bonds or both Allows people with small amounts of money to diversify their investments Potentially puts their money in hands of better professional money managers Index funds buy all stocks in a given stock index can perform even better than mutual funds 13-1b

Saving and Investment in the National Income Accounts Some Important Identities o Y=C+I+G+NX o National Saving (T=tax) S=I S=Y-C-G S=(Y-T-C)+(T-G) private saving + public Saving o Private Saving- amount of income left after taxes and consumption o Public Saving- amount of tax revenue left after paying for it spending o T>G- Budget Surplus o T<G- Budget Deficit The Meaning of Saving and Investment o Investment is thought of as purchasing new capital (I.e. equipment or buildings)

The Market for Loanable Funds Market for Loanable Funds- all savers and borrowers go to this market assume it is a single market Supply and Demand for Loanable Funds o Saving is the source of supply of loanable funds o Investment is the source of demand of loanable funds

o o We are talking about real interest rate Policy 1 Saving Incentives o Could possibly change tax laws to promote saving

o o If a reform of the tax laws encouraged saving the result would be lower interest rates and greater investment

o o Investment Incentives Policy 2: Investment Incentive o Investment tax credit gives a tax advantage to any firm building a new factory/ new piece of equipment

Policy 3: Government Budget Deficits and Surpluse o Budget deficit produces

o o Less public saving o Crowding Out- fall in investment because of government borrowing o Overall lesson- when government reduces national saving, interest rate rises and investment falls Chapter 14: The Basic Tools of Finance Present Value: Measuring the Time Value of Money o Finance- the field that studies how people make decisions regarding the allocation of resources over time and handling of risk o Compare sums of money at different points in time o How to manage risk o Build on our analysis of time and risk to examine what determines the value of an asset o Present Value- the amount today that would be needed at current interest rates to match a future sum o Future Value- value of present money in the future o Compounding- earn interest off interest o R=rate, X=amnt received in N years the present value is X/(1+r)^N Finding present value of future sum is called discounting Managing risk Risk Averse- people dislike bad things more than they like comparable good things The Markets for Insurance

o o Insurance is essentially a gamble and instead of the risk all being on one person it spreads risk around say 10000 people o Insurance companies suffer from Adverse selection- self-selecting high risk applicant pool Moral hazard- After people buy insurance they have less incentive to be carful about risky behavior Diversification of Firm-Specific Risk o Diversification- Dont put all investments in one basket

o o Firm Specific Risk- uncertainty associated with specific companies o Market Risk- uncertainty associated with the entire economy Trade-off between Risk and Return o Weighed out by person

Asset Valuation What determines the price of a share of stock? o Supply and demand o Persons willingness to pay for a share

o o Percent of their savings in stocks Fundamental Analysis o Obviously wanted Undervalued Fairly valued Overvalued o Fundamental Analysis- detailed analysis of a company to estimate its value o Dividends- cash payments that a company makes to its shareholders The Efficient Markets Hypothesis o Efficient Market Hypothesis- all stocks are fairly valued all the time since the # of people who overvalue them is the same as the # who undervalue them o 14.2 READ o Basically the efficient market hypothesis says it is impossible to beat the market o Very hard to because irrationalities balance out and you are left with a near perfect market Market Irrationality o Speculative Bubble- when price of an asset rises about its apparent fundamental value o Some think that irregularities and irrationalities are caused by waves of optimism and pessimismbasically human emotion o Informational Efficiency- description of asset prices that rationally reflect all available information o Random Walk- path of a variable whose changes are impossible to predict

Chapter 15: Unemployment Identifying Unemployment How is Unemployment Measured? o Employed: worked as employees, for their own business, or unpaid in family members business Both full-time and part time count o Unemployed: people who are not employed and have tried to find employment in last 4 weeksalso accounts for people laid off waiting for call backs o Not In Labor Force: Students, homemaker, retire o Labor Force- sum of employed and unemployed o Unemployment rate- % of labor force unemployed o Labor Force Participation Rate- % of total adult population in labor force o Natural Rate of unemployment- normal rate of unemployment around which unemployment fluctuates o Cyclical Unemployment- efentition of this cycle natural rate is 5%

Does The Unemployment Rate measure what we want it to? o Discouraged workers- do not show up in unemployment stats stop looking after a while even though they are workers without jobs o Marginally attached workers are persons who currently are neither working nor looking for work but indicate that they want and are available for a job and have looked for work sometime in the recent past. o Discouraged workers are marginally attached workers who have given a job-market-related reason for not currently looking for a job. o Persons employed part-time for economic reasons are those who want and are available for full-time work but have had to settle for a part-time schedule. How Long are the Unemployed without Work? o Most spells of unemployment are short, and most unemployment observed at any given time is long-term Its very few that are unemployed for long Why are There Always Some People Unemployed o Frictional unemployment- unemployment that is a result of finding the right workers for the right jobs o Structural Unemployment- Quantity of labor supplied exceeds quantity demanded This results when wages are set above equilibrium by either Minimum wag e laws Unions Efficiency Wages

Job Search Job Search- Process of matching workers with appropriate jobs Why some Frictional Unemployment is Inevitable o Sectoral Shifts: changes in composition of demand among industries or regions Oil firms cut back workers with dropping prices Automakers increase production with slashed oil prices Public Policy and Job Search o The internet helps expedite job search o They have govt programs but some say it hurts job search Unemployment Insurance o Unemployment Insurance- government program that offers partial protection against job loss This also increases the amount of unemployed because it offers less of an incentive to work again

Minimum-Wage Laws

Dont affect that many people vast majority of workers are above minimum wage

Unions and Collective Bargaining Union- a worker association that bargains with employers over wages, benefits, and working conditions Economics of Unions o Collective Bargaining- process by which unions and firms agree on terms of employment o Strike- union can organize a withdrawal of labor from the firm Are Unions Good or Bad for the Economy o Critics Unions are a type of cartel Reduce quantity of labor demanded Cause workers to be unemployed and reduce wages in the rest of the economy Inefficient and inequitable Workers benefit at expense of others o Advocates Necessary antidote to market power Fights company town Protect workers The Theory of efficiency Wages o Efficieny Wages- firms operate more efficiently if wages are above equilibrium Ma ybe profitable for firms to keep wages high even in a surplus of labor o Theories as to why this might be true Higher wages means better worker health

Worker turnover with less turnover less cost to retrain people Worker Quality: get talented workers with high wage incetive Work Effort: High wages make workers more eager to keep their jobs

PRELIM 1 COMPLETE

Chapter 16: The Monetary System The Meaning of Money The Functions of Money o No money have to barter: exchange good for another good In a barter system trade requires a double coincidence of wants: each person has a good the other wants o Money is used to mean Wealth o Money- is the set of assets in the economy that people regularly use to buy goods and services from each other o Even though stocks would make you wealthy they are not considered money- you cant buy o Money has three functions in the economy that other functions of wealth do not Medium of exchange Is an item that buyers give to sellers when they purchase goods and services Unit of account Yardstick people use to post prices and record debts Store of value Item that people can use to transfer purchasing power from the present to the future Wealth refers to total of all stores of value o Including monetary and nonmonetary Liquidity How easy with which an asset can be converted into the economys medium of exchange o Houses and Rembrandt paintings are not easily liquidated o Stocks and Bonds are Kinds of Money o Commodity Money When money takes the form of a commodity with intrinsic value

Intrinsic value o Item would have value even if it were not used as money o I.E Gold o When money=gold it is called gold standard Fiat Money o Money without intrinsic value o Fiat is an order or decree so money established by government Money in the US Economy o Money Stock Quantity of money circulating Currency o Paper bills and coins in the hands of the public Demand deposits o Balances in bank accounts that depositors can access on demand simply by writing a check or debit card

The Federal Reserve System o Federal Reserve Central bank of the United States o Central Bank An institution designed to oversee the banking system and regulate the quantity of money in the economy The Feds Organization o 7 members of the board of governors

o Have 2 Jobs Regulate banks and ensure the health of the banking system Feds act as a lender of last resort Lender who cant borrow from anyone else Banks can get regular loans from Fed Control quantity Of Money that is available in economy Quantity is called money supply o Decisions about the money supply is called monetary policy Federal Open Market Committee o The Feds primary tool is the Open Market Operation Purchase and sale of US government bonds When FOMC wants to increase money supply Fed creates dollars and buys government bonds from public in bond markets

Banks and the Money Supply Simple Case of 100% Reserve Banking o Reserves Deposits that the bank receives but have not loaned out o With all money in deposits banks do not influence the supply of money Money Creation with Fractional-Reserve Banking o Fractional-reserve banking Banking system in which banks hold only a fraction of deposits as reserves o Reserve ration Fraction of total deposits that it holds as reserves o Feds set a minimum reserve requirement Excess reserves is reserves above minimum excess o When Banks hold only a fraction of deposits in reserve banks create money o Basically make the economy more liquid but it is NOT any wealthier Loans create a corresponding liability for those who borrowed money The Money Multiplier o Money Multiplier The amount of money the banking system generates with each dollar of reserves

Money multiplier is the reciprocal of the reserve ration - Bank Capital, Leverage, and the Financial Crisis of 08-09 o Bank Capital Resources that a bank obtains from issuing equity to its owners o 16-3d o Leverage Use of borrowed money to supplement existing funds for investment purposes o Leverage Ratio Ratio of the banks total assets to bank capital o Insolvent Bank is unable to pay off its debt holders and depositors in full o Capital requirement Banks held to this amount so that banks will be able to pay off their depositors Capital requirement depends on the risk of of banks assets The Feds Tools of Monetary Control -How the Fed Influences the Quantity of Reserves o Open Market Operations Buy or Sell Government Bonds o Fed Lending to Banks Banks borrow to satisfy Regulators Depositor withdrawals New loans Or other reasons Discount Rate When banks borrow from Feds discount window Feds use lending not only to control money supply but to also help financial institutions when they are in trouble - How the Fed Influences the Reserve Ratio o Feds can change the reserve requirements o Feds can also choose to pay interest on reserves In doing so it promotes for the bank to hold more money in reserves and introduces money into the economy - Problems in controlling the Money Supply

o Fed does not control the amount of money that households choose to hold as deposits in banks The less money in deposits in the bank the less money can be created through reserves and loans o Fed does not control the amount that bankers choose to lend Sometimes fewer loans and greater reserves will lead to less money than other days Not totally consistent day to day Fed is vigilant so it gets updated stats every week Federal Funds Rate o Short term interest rate that banks charge one another for loans Usually are paid overnight o Feds can try to control federal funds rate buy injecting money into banks strengthening reserves which creates fewer banks that need loans

Chapter 17: Money Growth and Inflation The Classical Theory of Inflation The Level Prices and the Value of Money o Inflation concerns the value of the economys medium of exchange o We can view the price level as the price of a basket of goods and services or as a measure of the value of money o When overall price levels rise, the value of money falls It is the measure of how much money is worth in goods Money Supply, Money Demand, and Monetary Equilibrium o Supply and demand for money determines the value of money Assume that money supply is a variable that Fed Controls o Money Demand Basically how much wealth people want in liquid form Also depends on interest rates but for a later time Main Variable is average level of prices in the economy Higher price level (lower value of money) increases quantity demanded

o What ensures that the quantity of money the fed supplies balances out demand? Short run Interest rates play a role Long run Overall level of prices adjusts to the level at which the demand for money equals the supply- basically comes to EQ

The Effects of a Monetary Injection o With an increase in money supply the value of money decreases Quantity Theory of Money Quantity of money available in an economy determines the value of money o Growth in quantity of money is primary cause of inflation

A Brief Look at the Adjustment Process o Injection of money increases the demand of goods and services Economys ability to supply goods and services has not changed

This increase in demand causes prices of goods to increase This increase in price level increases quantity of money demanded The Classical Dichotomy and Monetary Neutrality o Economic Variables Nominal Variables Variables measured in monetary units Real Variables Variables measured in physical units o These separation of variables is called the Classical Dichotomy Nominal variables are influenced by developments in monetary system Real variables arent really explained by it o Monetary Neutrality Proposition that changes in the money supply do not affect real variables o Monetary changes affect real variables in the short run Velocity and Quantity Equation o Velocity of money Rate at which money changes hands Usually per year V=(PxY)/M o P=GDP Deflator o Y=GDP o M=Quantity of Money o Quantity Equation MxV=PxY

The Inflation Tax

o o Sometimes the government will pay for its spending by literally printing its money o Inflation tax Government raises revenue by printing money It is not a legit tax but a tax that affects everyone who holds money Also defined as the revenue the government raises by creating money The Fisher Effect o Real interest rate tells you about your change in purchasing power Real Interest rate= nominal-Inflation o When the fed increases the rate of money growth the long run result is higher inflation and higher nominal interest rate This 1:1 balancing is to show that the real interest rate is unaffected by money Called Fisher Effect

The Costs of Inflation A fall in Purchasing Power? The Inflation Fallacy o Inflation itself does not reduce peoples real purchasing power Everyone is affected and everyone has more money o Although the effect of the money supply is not obvious to real variables persistent growth in money supply does have an effect

Shoeleather Costs o Inflation tax transfers resources from households to government o Inflation tax gives people an incentive that causes deadweight losses for society as a whole Waste of scarce resources trying to avoid tax o Small example is withdrawing smaller amounts of money from the bank at a time This is done in order to keep more gathering interest in bank o Shoeleather cost Resources wasted when inflation encourages people to reduce their money holdings i.e. have to walk to the bank more and wear down their shoes Menu Costs o Cost of adjusting prices on a menu Average firm reduces costs once a year o Menu Costs Costs of changing prices Wasted Resources Time spent deciding new prices Making and send new price catalougs o Basically when it gets so bad you go out of your way to change nominal values it causes deadweight Relative-Price Variability and the Misallocation of resources o When inflation distorts relative prices consumer decisions are distorted and the market is less able to allocate resources o Basically the reverse of menu changing it is when the menu isnt changed how relative prices change dramatically Inflation-Induced Tax Distortions o Tax code creates burden on income earned from savings Nominal Capital Gains tax treatment Nominal Interest Income Tax treatment o One Solution is to index inflation so that tax laws written to include inflation Confusion and Inconvenience o Changing values of money in relation to real purchasing power just confuses public o Federal Reserves job is to ensure reliability of a unit of measurement o Inflation can make it more difficult for investorts to sort successful from unsuccessful firms

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth o Surprise inflation effects people that take out loans Inflation can redistribute wealth among debtors and creditors Can take into account inflation with nominal interest rate Inflation is Bad, But Deflation May Be Worse o Moderate deflation would negate the shoeleather argument Cost of holding money would go down and approach 0 Called Friedman Rule But There are also similar costs to deflation as inflation like menu costs and stuff Deflation is often a symptom of a deeper economic problems Deflation normally hurts poorer side the debtors and drives up unemployment

Chapter 18: Open-Economy Macroeconomics: Basic Concepts The International Flows of Goods and Capital Closed Economy-economy that does not interact with other economies Open Economy- economy that interacts freely with other economies around the world The Flow of Goods: Exports, Imports and Net Exports o Exports- domestically produced sold abroad o Imports- foreign produced sold domestically o Net Exports- difference between value of exports and imports Also called Trade Balance Trade surplus NX>0 Trade defecit NX<0 Balanced Trade NX=0 o Factors that effect economies trade balance Tastes of consumers Prices of goods Exchange rates of currecy Incomes of consumers

Cost of transport Government Policies

o o Weight of object effects how easy it is to export/import The flow of Financial Resources: Net Capital Outflow o Net Capital outflow (net foreign investment) The purchase of foreign assets by domestic residents minus the purchase of domestic assets by foreigners o Mcdonalds in Russia Foreign direct investment o American Buys stock in Russian Corp Foreign portfolio investment o Variables that influence net capital outflow Real interest rate comparison Perceived economic and political risk Government policies The Equality of Net Exports and Net Capital Outflow o Net capital outflow= net exports Trade Surplus NX>0 With foreign currency it buys foreign assets NCO>0 Saving Investment, and Their Relationship to the International Flows o S=I+NX o S=I + NCO When a nations savings exceeds domestic investment it invests also abroad so NCO>0

o The Prices for International Transactions: Real and Nominal Exchange Rates Nominal Exchange Rates o Nominal Exchange rate Rate at which a person can trade the currency of one country for the currency of another o Appreciation When the Dollar Buys more currency o Depreciation When Dollar Buys less currency o When the dollar is said to strengthen it can buy more foreign currency Real Exchange Rates o Real Exchange Rate Rate at which person can trade goods and service

Real exchange Rate= (Nominal Exchange Rate X Domestic Price) /// Foreign Price o Real exchange rate is key to how much a country imports and exports o Use price indexes to calculate real exchange rate Price index of US=P Price Index of Foreign= P* E= nominal exchange rate Real Exchange rate=(e x P)/P* A First Theory of Exchange-Rate Determination: Purchasing-Power Parity Pruchasing Power Parit- a unit of any given currency should be able to buy the same quantity of goods in all countries The Basic Logic of Purchasing-Power Parity o Law of one Price A good must sell for the same price in all locations o Arbitrage Taking advantage of price differences for same item in different markets Basically over time the money you make with arbitrage will drive supply and demand until its price is uniform in all markets so a yen buys the same item in japan as in the US Implications of Purchasing-Power Parity o Example If a pound of coffee costs 500 yen and $5 Then the exchange rate should be 100yen/dollar 1/p=e/p* o If purchasing power of dollar is always same at home and abroad real exchange rate, relative price of domestic and foreign goods cannot change therefore it is constant o Nominal exchange rate depends on the price level in each country o ** When Central bank prints large amounts of money, that money loses value both in terms of the goods and service it can buy and in terms of amount of currency**

o Limitations of Purchasing-Power Parity o Many goods are not easily traded so the reflected value in real purchasing power might not shine through Haircuts have difficult arbitrage and the real price difference would be hard to eliminate o Second Reason is that many goods are not perfect substitutes when they are produced in different countries Types of Cars for example

Chapter 19: A Macroeconomic theory of the Open Economy Supply and Demand for Loanable Funds and For Foreign-currency Exchange The Market for Loanable Funds o When NCO>0 the country is experiencing a net outflow of capital: the net purchase of capital overseas adds to the demand for domestically generated loanable funds o At equilibrium interest rate the amount that people want to save balances desired quantities of domestic investment and net capital outflow o Real interest rate in each country matters and is the deciding factor in deciding between two countries to buy bonds from

o The Market for Foreign-Currency Exchange o NCO=NX o Real exchange rate balances supply and demand in market for foreign currency exchange

Converting back and forth from dollars to yen to dollars offsets anything gained from NCO so that is why the supply of dollars is vertical o If real exchange rate is below equilibrium level quantity of dollars supplied would be less than demanded resulting in shortage that would push value of dollar upward Net Capital Outflow: The Link Between the Two Markets o In Market of Loanable funds Supply comes from national savings Demand comes from domestic investment and net capital outflow And the real interest rate balances supply and demand o In Market of Foreign-currency exchange Supply comes from net capital outflow Demand comes from net exports Real exchange rate balances supply and demand

o Net Capital outflow links two markets When US interest rate is high owning US assets is more attractive NCO for US is low

Simultaneous Equilibrium in Two Markets

o How Policies and Events Affect an Open Economy Government Budget Deficits o What happens when a government operates in a deficit in an open economy

o o Higher interest rates prevent foreign investment and promote foreigners in domestic investment o In an open economy budget deficit Raises real interest rates Crowds out domestic investment Causes currency to appreciate Push trade balance toward deficit Trade Policy o A government policy that directly influences the quantity of goods and services that a country imports or exports Tariff- tax on imported goods Import Quota-limit on quantity o Effects of an Import quota

o Import quota reduces imports and exports but NX stays the same When dollar appreciates in value in market for foreign-currency exchange domestic goods become more expensive relative to forging goods This encourages imports and discourages exports o Trade policies do not affect trade balance NX=NCO=S-I Political Instability and capital Flight o Capital Flight Large and sudden reduction in demand for assets located in a country

Chapter 20: Aggregate Demand and Aggregate Supply Recession- period of falling incomes and rising unemployment Depression- severe form of recession Three Key Facts about Economic Fluctuations Fact 1: Economic Fluctuations are Irregular and Unpredictable o Fluctuations are often called the business cycle o Fairly impossible to predict

o Most Macroeconomic quantities Fluctuate Together o Real GDP variable used to monitor short run changes o For Short-run fluctuations the variable you look at does not really matter Income Auto sales Retail sales Fact 3: AS Output Falls, Unemployment Rises o Changes in economys output of goods and services are strongly correlated with changes in economys utilization of labor force

Explaining Short-Run Economic Fluctuations The Assumptions of Classical Economics o Money is a veil Only real variables matter The Reality of Short-Run Fluctuations o Classical theory applies in long run but not in the short run o Example When new gold was found it took time for prices to rise that means more purchasing power and higher amounts of employment and production o New model focuses on real and nominal variable interaction The Model of Aggregate Demand and Aggregate Supply o Focus on two variables Economys output of goods and services Real GDP Average Level of Prices Measured by CPI or GDP deflator o Model of aggregate demand and aggregate supply Model that most economists use to explain shortrun fluctuations in economic activity around its long-run trend Vertical Axis Overall price level Horizontal axis Overall quantity of goods and services produced o Aggregate demand curve Quantity of goods and services that these industries want to buy Households Firms Government Customers abroad o Aggregate supply curve Quantity of goods and services firm produce and sell at each price level o Price level and quantity output adjust to bring demand and supply into equilibrium o Microeconomic understandings of 1 market and one item does not apply o We need a macroeconomic theory that explains Total quantity of goods and services demanded Total quantity of goods and services supplied

The Aggregate-Demand Curve

Y=C+I+G+Nx o Each component contributes to aggregate demand for goods and services Assume G is fixed by government policy o The Price level and Consumption: The Wealth Effect A decrease in price level raises real value Makes one wealthier Increase in spending means larger quantity of goods and services demanded Increase in price level reduces real value of money Reduces consumer spending and quantity of goods and services demanded o The Price Level and Investment: The Interest-Rate Effect Lower price level reduces interest rate Encourages greater spending on investment goods Increasing quantity of goods and services demanded Higher price level raises interest rate Discourages investment spending Decreases quantity demanded o The Price Level and Net Exports: The Exchange-Rate Effect Fall in price level Causes interest rates to fall Real value of dollar declines Depreciation stimulates net exports o Increases quantity of goods and services demanded Rise in price level o Interest rates rise

o Real value increases o Appreciation reduces net exports and quantity of goods and services demanded Three reasons fall in price level increases quantity of goods and services demanded Consumers are wealthier Interest rates fall stimulates demand for investment goods Currency depreciates Stimulates demand for net exports Why the Aggregate-Demand Curve Might Shift o Shift Arising from Changes in Consumption Any event that changes how much people want to consume at a given price level shifts the curve Saving money for retirement shifts to left Investments shift to right Cut taxes promotes spending so shifts right o Shift Arising from Changes in Investment Any event that shifts how much firms want to invest at a given price level New computer technology o Invest in computers increases so shift to right Tax policy o Tax credit shift to right Increase in money supply o Stimulates investment shift to right o Shift Arising from changes in Government Purchases Reduce purchases Demand curve shifts left Increase Shifts Right o Shifts Arising from Changes in Net Exports Foreign recession Fewer exports shift to left Confidence lost in foreign economies Appreciates US dollar o Makes US goods more expensive shift to left

The Aggregate-Supply Curve Long Run aggregate-supply is vertical Short run it is upward sloping

Why it is vertical in the Long Run o In the Long run economy production is based on real GDP Depends on Labor Capital Natural resources Technology Just a factor since GDP is only a function of Output and not price level in long run so it is vertical Vertical curve is a graphical representation of classical dichotomy and monetary neutrality Why the Long Run Aggregate-Supply curve Might Shift o Natural rate of output Production of goods and services that an economy achieves in the long run when unemployment is at its normal rate o Shifts Arising from Changes in Labor Immigrants More labor shift to right Any change in natural rate of unemployment shifts the long-run aggregate-supply curve Unemployment natural rate could shift due to government policy o Shifts Arising from Changes in Capital Increase in capital stock increases productivity Shift to right o Shifts from changes in Natural resources New mineral discovery Shift to right o Shifts from Technological Knowledge Invention of Computer Shifts Right Using Aggregate Demand and Aggregate Supply to Depict LongRun Growth and Inflation o Most important forces are technology and monetary policy Short-run fluctuations in output and price level should be viewed as deviations from continuing long run trends of output growth and inflation Why the Aggregate-Supply curve slopes upward in the Short Run

o o When the price level rises aggregate supply shifts to the right o All theories share same theme Quantity of output supplied deviates from long run level when actual price level deviates from expected price level

o 3 Theories Stick-Wage Theory Nominal wages are slow to adjust to changing economic conditions o So therefore short run the wages are sticky o Price level turns out 105 instead of 100 and wages are stuck at $10 Amount hired will increase

o Nominal wages based on expected prices and dont respond immediately when the actual price level isnt the expected Sticky-Price Theory Similar to menu costs Expected prices are higher than actual o Lag behind sales decline and production is cut back The Misperceptions Theory Changes in overall price level can temporarily mislead supplies about what is happening in individual markets o Overall price level falls Production will decrease o Suppliers of goods and services may notice the
price of their output rising and infer, mistakenly, that their relative prices are rising. They would conclude that it is a good time to produce.

Quantity of output Supplied= Natural Rate+ a( APLEPL) Actual price level-expected Why the Short-Run Aggregate-Supply Curve Might Shift o 1 new variable from short run aggregate supply Price level that people expected to prevail When expected price level rises o Shift to left o Higher wages, cost increase, firms produce smaller quantity of goods and services at any given actual price level An increase in the expected price level reduces supply shift left

Two Causes of Economic Fluctuations The Effects of a Shift in Aggregate Demand o Wave Of pessimism Cut back in spending Firms delay purchases o Four steps to analyzing macroeconomic fluctuations Which curve shifts Which direction does it shift Impact of price level in the short run

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

o o Example Wave of pessimism affects spending plans Aggregate demand curve affected Second Households and firms want to buy a smaller quantity of goods at any price level Reduces aggregate demandshift to left Price Level falls down along short run aggregate supply Afterwards short run supply shift right to balance out and be at same point along long run aggregate supply curve Shifts the curve are affected in the long run entirely by price level and not by level of output Shift in aggregate demand is nominal change The Effects of a shift in Aggregate Supply o Stagflation Falling output and rising prices Occurs when aggregate supply curve shifts to left Shift in price level expectation may even increase nominal wages o Higher prices leading to higher wages leading to higher prices Wage-price spiral

Supply curve brings itself back into line Spiral slows down and with high unemployment companies have leverage

o o Government could make a policy to keep output the same o This would permanently rise prices Chapter 21: The Influence of Monetary and Fiscal Policy on Aggregate Demand How Monetary Policy Influences Aggregate Demand For US Economy most important reason for downward slope of aggregate demand is interest-rate effect Theory of Liquidity Preference- Keynes theory that the interest rate adjusts to bring money supply and money demand into balance The Theory of Liquidity Preference

o For this chapter assume short term so inflation is practically constant Nominal and real interest rates move together o Money Supply Open Market Operations Discount Rate In This Chapter assume money supply is fixed by Fed Money Supply is independent of Interest Rate

o Money Demand Increase in interest rate increases cost of holding money so decreases demand Opposite is also true o Equilibrium in the Money Market Interest rate adjusts to balance the supply and demand for money Equilibrium interest rate Forces people to be content with money the Fed has created The Downward Slope of the Aggregate-Demand Curve o Higher price level raises money demand o Higher money demand leads to higher interest rate o Higher interest rate reduces quantity of goods and services demanded

o o Interest rate is price of borrowing Changes in the Money Supply o Whenever the quantity of goods and services demanded changes for any given price level, the aggregate-demand curve shifts

o o When Fed increases money supply lowers interest rate and increases quantity of goods and services demanded at any given price shifting AD curve to right The Role of Interest-Rate Targets in Fed Policy o Federal funds rate is the target of a lot of Fed policies Even though they affect the money supply o Monetary policy can be described either in terms of the money supply or in terms of the interest rate o Changes in monetary policy aimed at expanding aggregate demand can be described either as increasing money supply or lowering interest rate

How Fiscal Policy Influences Aggregate Demand Fiscal Policy- government choices regarding overall level of government purchases and taxes Changes in Government Purchases

o IF the government places 20 billion to order new fighter jets Which way will the curve shift Multiplier effect aggregate demand shift larger than 20 billion Crowding out effect Shift less than 20 billion The Multiplier Effect o Repercussions of 20 Billion dollar Purchase o The 20 billion the government spent is felt by the workers increased wages and employment They then go out with higher income and demand more goods and services Each dollar spent by government can raise demand by more than a dollar Called Multiplier effect

o Investment accelerator When higher demand for planes is used to buy more equipment or build other plants Higher demand spurs higher demand for investment goods A Formula for the Spending Multiplier o Marginal Propensity to Consume The fraction of extra income that a household consumes rather than saves o Multiplier= 1/(1-MPC) o Basically measures how much consumer will spend with change to income Other Applications of the Multiplier Effect o Applies to any component of GDP The Crowding-Out effect o $20 billion spending by government causes interest rate to rise

Reduces investment spending and puts downward pressure on aggregate demand o Crowding-out effect Reduction in aggregate demand that results when a fiscal expansion raises the interest rate

o Changes in Taxes o Household perception about a permanent or temporary tax change effects size in shift of aggregate demand

Using Policy to Stabilize the Economy The Case for Active Stabilization Policy o Government should stabilize the private economies aggregate demand o Government should avoid being a cause of economic fluctuations o Fight waves of optimism and pessimism o Take away the punch bowl just as the party gets going The Case Against Active Stabilization policy o People believe economy should be left to stabilize short run fluctuations o Admit in theory it can stabilize economy but doubt whether it is possible in practice o There is a lot of lag Monetary policies changes nterest rates Which influences investment spending But many firms make investment plans far in advance o At least six months for changes in monetary policy to have effect o Changes can last for several years Automatic Stabilizers

o Changes in fiscal policy that stimulate aggregate demand when the economy goes into a recession without policymakers having to take any deliberate action o Taxes have built in stabiliziers so that during a recession there are basically tax cuts which stimulates aggregate demand o Government spending acts as an automatic stabilizer During a recession more government spending goes to welfare programs Which stimulates aggregate demand o A Strict balanced budget would eliminate automatic stabilizers Chapter 22: The Short-Run Trade-off between Inflation and Unemployment Misery Index Purports to measure the health of the economy It adds together inflation rate and unemployment rate Unemployment rate o Long Run Determinants Labor market features Min wage laws Unions Efficiency wages Effectiveness of job search Inflation Rate o Primarily dependent on growth in money supply Long Run they are unrelated

Short run relationship between unemployment rate and inflation rate Short run policmakers can increase aggregate demand and move economy up along short run aggregate supply where they can expand output and lower unemployment at the cost of rising pirce levels - Lowering inflation produces the opposite effect The Phillips Curve This curve shows the short-run trade-off between inflation and unemployment

Negative relationship between employment and inflation Aggregate Demand, Aggregate Supply, and the Phillips Curve o Phillips curve shows the combinations of inflation and unemployment that arise in shifts of AD

o Shifts in the Phillips Curve: The Role of Expectations The Long-Run Phillips Curve o People face a long run Phillips curve that is vertical Money neutrality of the real variable unemployment o Unemployment tends towards it natural rate of unemployment

o The Meaning of Natural o Unemployment rate to which the economy gravitates toward o Say unions get more power the natural rate of unemployment goes up Natural because it is beyond the influence of monetary policy o Other policies can change unemployment Improving function of the labor markets can do just that o Lower unemployment means more workers producing more goods and services For any given rate of money growth and inflation Reconciling Theory and Evidence o Expected inflation Measures how much people expect the overall price level to change Expected price level effects nominal wages Expected inflation determines position of short run aggregate supply curve Every monetary change eventually goes from actual to expected in which the curve shifts back to long run equilibrium The Short-Run Phillips Curve o Unemployment Rate= Nat Rate- a(actual inflation-expected inflation)

o o Over time the expected becomes the actual and in doing so they will take into account o Overtime you only change inflation and not employment The Natural Experiment for the Natural-Rate Hypothesis o Natural state hypothesis Unemployment eventually returns to its natural rate, regardless of the rate of inflation US economy experiment was shown to hold true As consumers got used to the idea of higher inflation prices and wages adjusted and unemployment fell back to its natural rate

Shifts in the Phillips Curve: The Role of Supply Shocks Supply Shock- an event that directly alters firms costs and prices, shifting the economys aggregate-supply curve and thus the Phillips curve Example is when oil becomes scarce cost of producing gasoline, heating oil, tires and other goods goes up This means it reduces quantity of goods and services supplied at any given price level Stagflation Falling output and rising prices Occurs with supply shock in this case

Adverse shift in AS policymakers have to fight either unemployment or inflation The Curve future of the PC depends on peoples perception If people expect the supply shock to be temporary expected inflation will not change and the curve will soon revert to its former position if people believe it is a new era of higher inflation curve will remain in less desirable position Policymakers accommodate adverse shock supply by increasing aggregate demand with money injection Still had to deal with trade-off between inflation and unemployment for many years OPEC-used market power The Cost of Reducing Inflation Policy pursued by Fed to combat OPEC was disinflation Disinflation Reduction in Inflation The Sacrifice Ratio o When Fed contracts money Aggregate demand falls Reduces quantity of goods and services that firms produce Fall in production leads to rise in unemployment o In order to reduce inflation we must endure a period of high unemployment and lower output

o o Studies done estimating cost to reduce inflation o Sacrifice Ratio Number of percentage points annual output lost in process of reducing inflation by 1% Typical ratio is 5 o Could either reduce it in 1 year or in 5 More spread out with less effect on percent production is seen as better Not as extreme Rational Expectations and the Possibility of Costless Disinflation o Rational Expectations People optimally use all information they have Info about government policies the forecasting and future o All about expected versus actual inflation o With super accurate expected inflation rates compared to actual short run repercussions are very short lived The Volcker Disinflation o Volcker disinflation came at the cost of producing a recession

Inflation goes down and unemployment increases

Shift back to same unemployment occurs as expected inflation rate meets actual o Two positive outcomes Volcker Disinflation did not impose as high as a sacrificial ratio as calculated People didnt believe Volcker so expected inflation did not fall and the short run curve didnt shift down as quickly as it could have The Greenspan Era o Small fluctuations in unemployment and inflation rate

o Started with favorable supply shock o Experienced favorable shift in both direction of inflation and unemployment Inflation was almost 0 and unemployment lowered People thought natural rate was lower 9/11, dot.com bubble, corporate accounting scandals The Phillips Curve during the Financial Crisis o After the housing bubble Inflation decreased and unemployment increased Government wanted to enact a policy of riding the Phillips curve back upward

Chapter 23: Six Debates over Macroeconomic Policy Should Monetary and Fiscal Policymakers try to Stabilize the Economy Pro Argument o Economies tend to fluctuate When households and firms become pessimistic They cut back spending o Reducing aggregate demand Real GDP and other measures of income fall o No reason for society to suffer through the booms and busts of business cycle Leaning against the wind Strategy used to try to balance out severity of economic fluctuations o Increase spending o Cut taxes o Boost money supply o When AD is excessive Cut taxes Government spending Expand money Con o Lab in enacting monetary policy six months o Sometimes policy overcompensates for a small natural fluctuations and overshoots its target demand or output o Do no harm doing to much is bad

Should the Government Fight Recessions with Spending Hikes Rather than Tax Cuts Pro Spending Hike o By increasing money supply interest rates lower This favors new spending and adds to aggregate demand o Fiscal actions can have multiplier effects: Higher leads to higher incomes leads to more demand o Traditional Keynesian anlaysis indicates govnermnet spending is better than tax decreases o Not all tax decreases goes to spending (especially true if tax cut is viewed as temporary o 3 kinds of spending Shovel-ready Federal aid

Increased payments to jobless through unemployment insurance Con: Should use Tax Cuts o Have influences on AD and AS o Increase AD by increasing disposable income o Can choose to do tax credits on investments Most volatile component of GDP and stimulating investment is key to ending recession o Tax cuts create a system where unemployed workers have greater incentive to search for jobs Work longer hours Therefore increasing supply o Tax cuts can increase production without increasing inflation o Problems with increasing spending Consumers understand spending likely means tax increases to help pay for spending Taxes increases to support spending will account for deadweight loss with greater taxes o Can the government spend money quickly and wisely Planning takes years and proper spending might take extra time to decide o Tax cuts have advantage of decentralizing spending o Possibility of ill conceived bridges to nowhere o Short run benefit of government spending may not compensate for long-run cost

Should Monetary Policy be made by rule Rather than by Discretion Pro Monetary Policy should be made by rule o Possibility of too much power o Political Business cycle Central bank manipulates economy to get reelection of president o Might lead to more than desirable inflation o Might just want to keep achieving lower employment o Commit central bank to policy rule 3% growth money per year 1% for every percent unemployment rises above its natural rate Con Should not be made a rule o One advantage of policy is flexibility o A lot of the alleged problems are hypothetical o Corruption o Political motives

Should the Central Bank Aim for Zero Inflation - Pro 0% inflation rate o Costs of inflation Shoeleather Menu Increased variability Tax liabilities Confusion and Inconvenience o Some argue costs are too small at 3% inflation o Costs of achieving 0 inflation Period of high unemployment Low output o It has temporary costs and permanent benefits o Credible commitment to zero inflation Could lead to permanent 0 inflation o 0 is a natural focal point and fed can achieve price stability and fully eliminate costs of inflation - Con: should not aim for 0 o Benefit from 0 to moderate inflation is small o Cost of reaching it is large o Social costs are larger than this 20% figure o Recession experienced hurts those who can least afford to pay o Public dislikes inflation but it is a fallacy o Permanent value can be lost during recession that leads to 0% inflation Workers lose skills and living standard are lower Investment even more volatile during recession o Some think inflation greases the wheels of the labor market o Inflation makes it easier for real wages to adjust to changes in labor market Should Government Balance its Budget Pro Should not balance budget o During war it is good to be able to run balance deficit o Allow it during temporary downturn in economic activity o 1% of lifetime earnings o Debt can rise indefinitely Cons Should Balance Budget o Hurt future generations o Just putting off judgment day

o Balanced budget means greater national saving Investment Economic growth College grads enter more prosperous economy o As long as deficit is moderate it is ok 1.5 trillion is to much Should the Tax Laws be Reformed to Encourage Saving Pro Tax laws should encourage savings o Saving rate is key determinant of long run prosperity o Higher Savings Rates is better o Tax code nowadays discourages saving o Investments and saving stuff is heavily taxed o Can be like a tax on wealth o Tax can improve to be an incentive to save o Maybe reconsider entire tax system Switch from income to consumption which would increase incentive to save Con Tax laws should not be reformed to encourage saving o Tax law should also try to distribute burden fairly o Problem with these proposals is that incentive to save increases burden on those who can least afford o The tax policy may not be effective anyways No theory shows that taxes to incentivize saving will do that o Substitution effect and income effect Higher rate of return raises the benefit of saving Higher rate of return lowers need for saving Both depend on target level of consumption in the future o Ways to increase saving other than tax breaks on rich o Can increase net saving by reducing budget deficit Also increases prosperity for future generations o Tax reforms for more savings increase budget deficit