PAGE # 1

AP Economics - Short notes from Krugmans Economics for AP by Keshara Senanayake Modules 1!"!#!$!5,6,7!1%!11!1"!1#!1$!1&!1'!1(!1)!1*!"%!"1!""!"#!"&!"(!")!"*!#%! and #1 +o )!*!"$!"' ,o-er .on your o/n0 #"!##!#$!#&!$1!$"!$& .S,12E345E60

1-$" 7$& .e8ce9t &!'!(!)!*! "$!"'!#'-$%!$#!$$0 is for re-ie/ing e-erything

:eaturing hel9 from 6uslan .module "&0! Shaili .Module #% and #10! and Peter .Module "*0 Module 1 pages 2 - 8 Economics is the study of scarcity and choice ;economics in-ol-es individual choice (what each person chooses to do/not to do) >something can 9ose limitations and affect your indi-idual choice .your budget<room si=e0 4he economy is a system that coordinated choices about 9roduction and consum9tion distributes goods<ser-ices to indi-iduals ;the >?S has an market economy 9roduction<consum9tion is based on /hat many firms and 9eo9le /ant? +o central authority tells 9eo9le /hat to 9roduct<shi9 the indi-idual 9roducer tries to make the most 9rofit 9ossible ;A command economy! is an industry /hich is 9ublicly o/ned and has a central authority making 9roduction<consum9tion decisions? E8am9le So-iet >nion bet/een 1*1( - 1**1 marked as general failure because lack of ra/ material and lack of a demand for good 9roduced 4he 9roblem of command economies is a lack of incentive rewards or punishments that motivate particular choices 3n market economies 9roducers can charger high 9rices /hen theirs a shortage of something .inc 9rofit0 ;high 9rices 7 9rofits are incenti-es to 9roduce more of the most-needed goods !roperty rights establish o/nershi9 and grant indi-iduals the right to trade goods and ser-ices to each other hel9s create incenti-es 9ro9erty o/nershi9 encourages the 9roduction of things that ha-e -alue to kee9 or for mutual gain ;o/nershi9 encourages resources to be 9ut to their best 9ossible use Marginal analysis is the study of the cost and benefits of doing a little bit more of an acti-ity -ersus a litle bit less ;you ha-e to make marginal decisions /hich in-ol-es looking at trade-offs the gain of doing something is marginal benefit the cost of doing something is marginal cost if marginal benefit e8ceeds marginal cost the acti-ity should continue 6esources are scarce .like me girls! so come at me /hile 3m a-ailable0

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;income isnt the only thing that 9re-ents 9eo9le from getting /hat they /ant time is also in limited su99ly some 9eo9le trade money for time .like sho99ing at the local store for high 9riced goods 9eo9le of the con-enience0 A resource is anything that can be used to 9roduce something else? the economies resources are sometimes called "actors o" production can be classified into .$0 grou9s ;#and refers to all resources that come from nature ;$apital refers to manufactured goods used to make other goods and ser-ices ;Entrepreneurships risk taking<inno-ation<organi=ation of resources for 9roduction ;la%or is the effort of the /orkers A resource is scarce /hen there is not enough of it a-ailable to satisfy the -arious /ays a society /ants to use it ;like indi-iduals make choices! scarcity of resources means society as a /hole must make choices ;society can make choices as a collection of indi-idual choices /hile others are community-/ide choices 4he -alue of /hat you must gi-e u9 /hen you make a 9articular choice is an o99ortunity cost Economics can be broken do/n into Microeconomics and Macroeconomics ;Microeconomics focused on choices made by indi-iduals! households! or firms .smaller 9arts of that make u9 the economy0 ;Macroeconomics focuses on the bigger 9icture the general u9s and do/ns of the economy /hen studying macroeconomics you learn ho/ economist e89lain these fluctuations and ho/ go-ernments use economic 9olicy to minimi=e the damage they cause Macroeconomics focuses on economic aggregates /hich are economic measures like unem9loyment<inflation rate<gross domestic 9roduct that summari=e data across many different markets Economic analysis is used to ans/er @uestions about the /ay the /orld /orks! @uestions /ith definite right</rong ans/ers are positive economics ;!ositive economics is the branch of economics analysis that describes the /ay the economy actually /orks generally @uestions related to this are fact .this is descri9ti-e0 Economic analysis that in-ol-es saying ho/ the /orld should /ork is kno/n as normative economics ;&ormative economics makes 9rescri9tions about the /ay the economy should /ork generally @uestions related to this ask for o9inions .9rescri9ti-e0 Positi-e economics is used more by those in the economics 9rofession ;Economics ans/er a -ariety of @uestion? Some are definite .like a 9rediction0 or it can be a A2hat ifB @uestion economic models 9ro-ide sim9le re9resentations that are useful for ans/ering A2hat ifB @uestions the ans/ers to such @uestions ser-e as a guide to 9olicy .these are 9redictions not 9rescri9tions meaning they can tell you /hat /ill ha99en but not if it is good or not0 CCthe abo-e is 9ositi-e economics but normati-e economics can 9ose @uestions that engage 9olicy alsoCC Economic analysis is used to sho/ that some 9olicies are clearly better than others regardless of indi-idual o9inion

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Economist disagree to an e8tent but it is o-er e8aggerated by the media? Politics 9lay a big role also! and 9o/erful interest grou9s kno/ /hat o9inions they /ant to hear and they find economist /ho agree and gi-es them a 9rominence ;e-en though it is blo/n out of 9ro9ortion economist do disagree differences in -alues contributes .moral o99osition for<against0 another is differences in the /ay they conduct economic analysisD economist base their conclusions on models formed by making sim9lifying assum9tions about reality .they can disagree on their sim9lifications and therefore on their conclusions0 dis9uted are resol-ed by accumulation of e-idence that sho/s /hich assum9tion does a better Eob of fitting the facts Cside note -alue-added ta8 is a national sales ta8C Module 2 pages 1'-1( E-ery since the great de9ression and the economy 9lunged more 9eo9le ha-e begun to look into ho/ macroeconomics /orks they look to de-elo9 9olicies to 9re-ent such disasters in the future ;4he effort to understand economic slum9s and find /ays to 9re-ent them is at the core of macroeconomics 4he %usiness cycle is the short-run alternation bet/een economic do/nturns .recessions0 and economic u9turns .e)pansions0 A depression is a dee9 and 9rolonged do/nturn! /hile a less 9rolonged economic do/nturn is a recession .9eriods in /hich out9ut and em9loyment are falling0 follo/ed by economic u9turns .e)pansions0 ;>?S has had 11 recessions since 2233 4he definition of recession in many countries is a 9eriod of at least t/o consecuti-e @uarters .# months F 1 @uarter0 /here aggregate out9ut falls this definition is too strict so in the >?S the +ational Gureau of Economic 6esearch determines if its a recessions .by looking at a -ariety of economic indicators0 E-en though recessions are less se-ere than de9ressions! it can lead to Eoblessness<reduced 9roduction<reduced li-ing standard Employment is the number of 9eo9le currently em9loyed in the economy and unemployment is the number of 9eo9le acti-ely looking for /ork but arent currently em9loyed la%or "orce F unem9loyment 7 em9loyment ;4he unem9loyment rate is the H of the labor force that is unem9loyed good indicator of market strength .high unem9loyment signals 9oor Eob marketD lo/ unem9loyment rate signals a good Eob market0 ;falling unem9loyment is looked for/ard to in e89ansions Gusiness cycle also de9ends on out9ut .the @uantity of goods and ser-ices 9roduced0 during the business cycle! the economys le-el of out9ut and its unem9loyment go it different directions .lo/er le-els of out9ut has fe/er /orkers so unem9loyment is high using same logic gro/th in out9ut needs more /orkers and lo/ers unem9loyment0

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*ggregate output is used to measure the rise and fall of an economys out9ut it is the economys total 9roductions of goods and ser-ices for a gi-en time 9eriod .usually a year0 it falls during recessions and rises during e89ansions ;+n"lation is a rise in o-erall 9rice le-el o99osite is de"lation /hich is a fall in the o-erall 9rice le-el A change in 9rice of goods does not signal inflation or deflation -- instead it changes the o99ortunity cost of it +n"lation and de"lation are terms used for general changes of goods<ser-ices throughout the economy ;Goth can lea-e negati-e affects +n"lation discouraged 9eo9le from holding cash since rising 9rice le-el indicated cash is loosing -alue so a dollar /ill buy less than before ;,e"lation causes the o99osite 9roblem! since o-erall 9rice falls! the dollar /ill buy more and 9eo9le /ith cash tend to hold it rather than in-est it Price stability is /hen the aggregate 9rice le-el is changing only slo/ly kee9s the economy stable Economic growth .increase in the ma8imum 9ossible out9ut of an economy0 is the reason /hy a maEority of Americans can afford con-eniences many lacked in 9re-ious years unlike short term increases in aggregate out9ut after a recession! economic gro/th is an increase in 9roducti-e ca9acity that 9ermits a sustained rise in aggregate out9ut o-er time ;this is needed for a nations 9ros9erity sustained rise in out9ut 9er 9erson F higher /ages and higher standard of li-ing ./e can see later on though /hat is good for economic gro/th is bad for short-run stabili=ation of business cycle and -ice -ersa0 A model is any sim9lified -ersion of reality that is used to better understand real-life situations ;economist can create a sim9lified re9resentation by finding<creating a real but sim9lified economy .like trying to find the economic role of money some economist ha-e studied the system of e8change in 223 /here in 9risons 9risoners used cigarettes as a uni-ersal form of 9ayment0 ;another 9ossibility is to use a com9uter to stimulate the /orkings of an economy .ta8 models /hich are used by the go-ernment are large mathematical 9rograms used to asses ho/ 9ro9osed changed /ould affect different grou9s of 9eo9le0 Models are im9ortant for their sim9licity and allo/s economist to focus on one change at a time .allo/s us to hold e-erything constant and study ho/ one change affects o-erall economic outcomes0 ;An important assumption is the other things e-ual assumption means that all other rele-ant factors remain unchanged? .also kno/n as 9aribus assum9tion0 Sometimes you cant create small-scale -ersion of the /hole economy or use a com9uter 9rogram ;4hought e89eriments are used as a form of economic modeling .most effecti-e form usually0 sim9lified! hy9othetical -ersions of real-life situations economist models are usually in a form of a gra9h Module . pages 1/-21 !roduction pro%a%ilities curves are models that hel9 economist think about the trade-offs e-ery economy

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faces hel9s us understand e""iciency! opportunity cost! and economic growth Iou make trade-o""s /hen you gi-e u9 something in order to ha-e something else to think of necessary trade-offs of an economy economist use 9roduction 9ossibilities cur-e model im9ro-es understanding of trade-offs by considering a sim9lified economy that 9roduces only t/o goods .enables us to use a gra9h0 3m9ortant to note that the 9oints inside or on the 9roduction 9ossibilities cur-e .Shaded area0 mean different things if a 9roduction 9oint lies inside or on the cur-e it is feasible a 9roduction 9oint outside the cur-e is not feasible? Production cur-es hel9s to sho/ the trade-offs of decisions .going to/ards either e8treme or staying in the middle0 4hinking in terms of a 9roduction 9ossibilities cur-e sim9lifies the com9le8 realities model /ith many goods it /ould be much harder to study trade-offs! efficiency! and economic gro/th Production 9ossibilities cur-e is useful for illustrating the conce9t of e""iciency ;an economy is efficient if there are no missed o99ortunities no /ay to make some 9eo9le better off /ithout making other 9eo9le /orse off 3nefficient use of resources is /hen you dont effecti-ely use /hat you ha-e 2hen an economy is using all its resources efficiently! the only /ay one 9erson can be made better off is by rearranging the use of resources that makes someone else /orse off? 3f an economy is 9roducing at a 9oint on its 9roduction 9ossibilities cur-e! the economy is efficient in 9roduction +ne""iciency occurs if you ha-e an o99ortunity to 9roduce more good but dont ;another e8am9le occurs /hen 9eo9le in the economy are in-oluntarily unem9loyed ./ant to /ork but cant find Eobs0 economy is not efficient in 9roduction because it could 9roduce more out9ut if those 9eo9le /ere em9loyed ;9roduction 9ossibilities cur-e sho/s the amount that can 9ossibly be 9roduced if all resources are fully em9loyed changed in em9loyment mo-e the economy close to or further from the 9roduction 9ossibility cur-e .PP,0 .the cur-e is determined by /hat /ould be 9ossible if their /as full em9loyment0 greater unem9loyment is sho/ed by 9oints farther belo/ the PP, economy is not reaching its 9ossibilities if it is not using all of its resources? Jo/er unem9loyment is re9resented by 9oints closer to the PP, as it decreases the economy mo-es closer to reaching its 9ossibilities ;understand that efficiency in 9roduction is only 9art of /hats re@uired for the economy as a /hole to be efficient efficiency re@uired that the economy allocate its resources so that consumers are as /ell off as 9ossible if the economy does this it is efficient in allocation efficiency for an economy as a /hole re@uired both efficiency in 9roduction and efficiency in allocation -; an economy must 9roduce as much of each good as it can! gi-en the 9roduction of other goods! and it must also 9roduce the mi8 of goods that 9eo9le /ant to consume 4he PP, is useful to reminder that the true cost of any good is not only its 9rice but also e-erything else in addition to money to get the good -- also the o99ortunity cost 2hen /e assume that the opportunity cost of an additional unit of a good doesnt change regardless of

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the out9ut mi8! the 9roduction 9ossibilities cur-e is a straight line the slo9e of the straight-line 9roduction 9ossibilities cur-e is e@ual to the o99ortunity cost the o99ortunity cost for the good measured on the hori=ontal a8is in terms of the good measured on the -ertical a8is .de9ending on the scenario the 9erson can face a constant opportunity cost /here a good has a set o99ortunity cost or it can ha-e increasing opportunity cost /here the goods o99ortunity cost increases0 /hen o99ortunity cost are increasing the PP, is a bo/ed-out cur-e rather than a straight line 3t is easier to /ork /ith PP, /ith a straight line but generally in reality o99ortunity costs are ty9ically increasing ;/hen only a small amount of a good is 9roduced the o99ortunity cost of 9roducing that good is relati-ely lo/ because the economy needs to use only those resources that are /ell suited for its 9roduction? As more of a good is 9roduced! its o99ortunity cost ty9ically rises because /ell-suited in9uts are used u9 and less ada9table in9uts must be used instead .E8am9le /ith corn gro/ a little corn you can gro/ it in small 9laces /here nothing else gro/s Knothing like /heatL but increase corn 9roduction you ha-e to use land reser-ed for /heat no/ for cornL PP, hel9s us talk about economic growth .allo/s a sustained rise in aggregate out9ut0 ;Economic gro/th means an e89ansion of the economys 9roduction 9ossibilities the economy can 9roduce more of e-erything .economic gro/th can cause an out/ard shift of the cur-e0 unless PP, shifts out/ards the 9oints beyond the PP, are unattainable .are beyond the economys 9ossibilities0 Generally ."0 sources of economic growth? Mne is an increase in resources used to 9roduce goods and ser-ices .labor<land<ca9ital<entre9reneurshi90 Another source of economic gro/th is 9rogress in technology! the technical means for 9roducing goods and ser-ices technology s9ecific to the 9roduction of only one good has no affect if all resources are de-oted to the other good so it /ould not be a sim9le out/ard e89ansion of e-ery 9oint along the PP, Economic gro/th is an increase in /hat the economy can 9roduce /hat the economy actually 9roduces de9end on the choices 9eo9le make ;3f an economys PP, shifts in/ard! the economy has become smaller? 4his could ha99en if the economy loses resources or technology? 4he 9roduction 9ossibilities cur-e is a -ery sim9lified model of an economy! but it does teach us im9ortant lessons about real-life economies? 3t gi-es us a clear sense of /hat constitutes economic efficiency! it illustrates the conce9t of o99ortunity cost! and it makes clear /hat economic gro/th is about? Module ( pages 2.-20 3n a market economy! indi-iduals engage in trade they 9ro-ide goods and ser-ices to others and recei-e goods and ser-ices in return trade is /here 9eo9le di-ide task among themsel-es 4here are gains from trade 9eo9le can get more of /hat they /ant through trade than they could if they tried to be self-sufficient? 4his increase in out9ut is due to s9eciali=ation each 9erson s9eciali=es in the task that he or she is good at 9erforming Adam Smiths 1((' book 1he 2ealth o" &ations used the ad-antages of s9eciali=ation! and the

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resulting gains from trade as a starting 9oint described ho/ if you s9lit u9 /ork you /ill be more efficient instead of ha-ing one 9erson make an entire thing ha-e him do one ste9 of the 9rocess to make it re9eatedly ;economy as a /hole can 9roduce more /hen each 9erson s9eciali=es in task and trades /ith others ;the benefits of speciali3ation are the reason a 9erson ty9ically focuses on only one ty9e of good or ser-ice it is to e-eryones benefit /hen indi-iduals s9eciali=e in their career choices .if someone only maEors in being a doctor he or she /ill be more skilled than someone /ho decided to become a 9ilot and doctor0 ;as long as indi-iduals kno/ that they can find the goods and ser-ices that they /ant in the market! they are /illing to forgo self-sufficiency and are /illing to s9eciali=e .9ilots kno/ he<she can find a doctor so 9ilots dont need to become doctors0 4he PP, .9roduction 9ossibilities0 cur-e model are useful for illustrating gains from trade trade based on com9arati-e ad-antage An indi-idual has a comparative advantage in 9roducing something if the o99ortunity cost of that 9roduction is lo/er for that indi-idual than for other 9eo9le 9eo9le trade /hen the trade is beneficial and is less than his<her o/n o99ortunity cost E-eryone has a com9arati-e ad-antage in something and e-eryone has a com9arati-e disad-antage in something An indi-idual has an a%solute advantage in 9roducing a good or ser-ice if he or she can make more of it /ith a gi-en amount of time and resources? 1a-ing an absolute ad-antage is not the same thing as ha-ing a com9arati-e ad-antage +M4EN ,om9arati-e +M4 absolute ad-antage is the basis for mutual gain? EOAMPJE .,I> #10 Kassume e-erything is made in one dayL 3n italy an automobile is 9roduced by ) /orkers and a /ashing machine by #? 3n the >?S! automobiles is made by ' /orkers and /ashing machines by "? 4he >?S has an asbolute ad-antage in the 9roduction of both? 3taly has a com9arati-e ad-antage in automobiles? 1M2P 2ell lets find o99ortunity cost? ) /orkers for automobile < # /orkers for /ashing machine F "? Meaning the o99ortunity cost of making an automobile is )<# /ashing machines? 2hile in the >?S the o99ortunity cost is '<" F # ./hich is greater0? >sing the same logic >?S has an ad-antage in /ashing machine? kno/ youre trying to lo/er o99ortunity cost Economist has a -ery 9ositi-e -ie/ of international trade because they -ie/ it in terms of com9arati-e ad-antage? As a note is a cur-e is flatter on a PP, for something it as a com9arati-e ad-antage for the item on the 8 a8is! if the cur-e is more u9 it has a com9arati-e ad-antage for the y a8is? mutual gains doesnt de9end on each countrys being better at 9roducing something e-en if one country has an absolute ad-antage in both industries there are still mutual gains from trade

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Module 4
ASu99ly and Qemand 3ntroduction and QemandB Su99ly and Qemand A model of a com9etiti-e market Market is a grou9 of 9roducers and consumers /ho e8change a good or ser-ice 9ayment? $ompetitive market is a market in /hich there are many buyers and sellers of the same good or ser-ice! none of /hom can influence the 9rice at /hich the good or ser-ice is sold .some markets like cola consumers can influence! but for coffee bean 9rices can fluctuate due to natural 9roblems0 ;2hen a market is com9etiti-e! its beha-ior is /ell described by the supply and demand model many markets are com9etiti-e ; & key elements to this model 10 the demand curve "0 the supply curve #0 factors that cause demand cur-e and<or cause su99ly cur-e to shift $0 4he market e@uilibrium includes e-uili%rium price and e-uili%rium -uantity &0 4he /ay the market e@uilibrium changes /hen the su99ly cur-e or demand cur-e shifts Qemand cur-e 3n general for any good or ser-ice that 9eo9le /ant to buy A/antB as in they are /illing and able to buy it! de9ends on the 9rice? 4he higher the 9rice! the less of the good or ser-ice 9eo9le /ant to 9urchaseD alternati-ely! the lo/er the 9rice! the more they /ant to 9urchase the decision to 9urchase de9ends on the 9rice A demand schedule .usually a table0 /hich sho/s ho/ much of a good or ser-ice consumers /ill be /illing and able to buy at different 9rices 4he -uantity demanded is the actual amount of a good or ser-ice consumers are /illing and able to buy at some s9ecific 9rice A demand cur-e is a gra9hical re9resentation of the demand schedule? 3t sho/s the relationshi9 bet/een @uantity and 9rice? 2hen the demand cur-e slo9es do/n this reflects the idea that higher 9rice reduces the @uantity demanded 1he law o" demand says that a higher 9rice for a good or ser-ice! all other things being e@ual!

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leads 9eo9le to demand a smaller quantity of that good Prices can rise and more 9eo9le can still demand a good .like coffee 9rice A+Q demand rose from "%%" to "%%'0 this is because the e-erything de9ends on Aall other things being e@ualB in the case of coffee the /orld has change from "%%" to "%%' A change in demand is a shift of the demand cur-e! /hich changes the @uantity demanded at any gi-en 9rice theirs a G3G difference bet/een changes in demand and MMREME+4S AJM+G 41E QEMA+Q ,>6RE A mo-ement along the demand cur-e is a change in the @uantity demand of a good that is the result of a change in that goods 9rice Gra9hically a movement along a demand curve is a change in the @uantity demanded of a good that is the result of a change in that goodSs 9rice? :or e8am9le if the 9rice of coffee dro9s from T1?&% to T1 9er 9ound consum9tion /ill rise from )?1 billion to 1% billion? G>4 if 9rice remains unchanged and there is an increase in demand U it /ill be a right/ard shift of the /hole demand cur-e 2hen economist talk about change in demand and they say Athe demand for O increasedB or Athe demand for I increasedB they are saying the demand cur-e for O or I S13:4EQ not that the @uantity demand rose or fell because of a change in 9rice 2hen economist talk about an Aincrease in demandB they mean a rightward shift of the demand cur-e so at any gi-en 9rice consumers demand a larger @uantity of the good or ser-ice a decrease in demand is a leftward shift of the demand cur-e at any gi-en 9rice Economist ha-e & 9rinci9al factors that shift the demand cur-e for a good or ser-ice 10 ,hanges in price o" related goods or services "0 ,hanges in income #0 ,hanges in taste $0 ,hanges in e)pectations &0 ,hanges in the num%er o" consumers 4he abo-e & are the most im9ortant factors that /hen /e say that demand falls as its 9rice rises! all other things being e@ual! /e are stating then the factors that shift the demand are remaining unchanged 4/o are su%stitutes if a rise in the 9rice of one of the goods leads to an increase in the demand for the other good .tea and coffee0 4/o goods are complements if a rise in the 9rice of one of the goods leads to a decrease in the demand for the other good .cookies and milk0 -ice -ersa also a99lies 2hen a rise in income increases the demand for the good .normal0 it is a normal good but the demand for some 9roducts falls /hen income rises? 2hen a rise in income decreases the demand for a good! it is an in"erior good these goods are Aless desirableB than more e89ensi-e alternati-es so /hen 9eo9le can afford it they sto9 buying inferior goods and s/itch to the consum9tion to the 9referred more e89ensi-e alternati-e? /hen a good is inferior a rise in income shifts the demand cur-e to the left but a fall in income /ill sift the demand cur-e to the right .casual dining F normal fast-food F interior0 Peo9le ha-e certain 9references .tastes0 that determine /hat they choose to consume and that these tastes change .changes in demand change due to fads<beliefs<cultural shifts0 economist ha-e little to do to influence consumers taste .marketers<ad-ertisers can0 a change in taste has a 9redictable im9act on demand /hen tastes change in fa-or of a good more 9eo9le /ant to buy it at any gi-en 9rice! so the demand cur-e shifts to the right? /hen tastes change against a good! fe/er 9eo9le /ant to buy it at any gi-en 9rice! so the demand cur-e shifts to the left current demand for a good can be affected by its "uture price? sho99ers /ait for seasonal sales .during 9ost-holiday markdo/ns0 in this case e89ectations of a future dro9 in 9rice lead to a decrease in demand today .like-/ise a future rise is likely to cause an increase in demand today0

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e89ected changes in future incomes can lead to changes in demand .you kno/ your income /ill rise /ill borro/ today and increase your demand for certain goods like/ise if income dro9s you reduce your demand for goods0 an individual demand curve illustrates the relationshi9 bet/een @uantity demand and 9rice for an indi-idual consumer market demand curve sho/s ho/ the combined @uantity demanded by all consumers de9ends on the market 9rice of that good .demand cur-e usually F market demand cur-e0 market demand cur-e is the hori=ontal sum of the indi-idual demand cur-es of all consumers in the market .to understand the conce9t of hori=ontal sum 3f candy is T" 9er 9ound keshara buys 1% 9ounds and Vohn buys &! if candy is T1 9er 9ound keshara buys "% 9ounds and Vohn buys 1& 9ounds? 3f Keshara and Vohn are only t/o consumers! the market cur-e! /hich sho/s the @uantity of candy demanded by all consumers at any gi-en 9rice /ill sho/ that at T" 9eo9le /ill buy 1& 9ounds of candy and at T1 9eo9le /ill buy #& 9ounds of candy0

4AGJE &?1 +5 * *&, 6 *7E 89861+191E8 W in 9rice of G F W demand of A X in 9rice of G F X demand of A +5 * *&, 6 *7E $:M!#EME&18 W in 9rice of G F X demand of A X in 9rice of G F W demand of A $;*&<E8 +& +&$:ME 3f A is a normal good W income F W demand for A X 3ncome F X demand for A 3f A is a inferior good W 3ncome F X demand for A X 3ncome F W demand for A $;*&<E8 +& 1*81E 3f taste changes in fa-or of A F W demand for A 3f taste changes in against of A F X demand for A $;*&<E8 +& E=!E$1*1+:&8 W in 9rice of A in the future F W in demand of A today

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X in 9rice of A in the future F X in demand of A today 3f A is a normal goodY W 3n income in the future F W in demand of A today X 3n income in the future F X in demand of A today 3f A is an inferior goodY W 3n income in the future FX in demand of A today X 3n income in the future F W in demand of A today $;*&<E8 +& 1;E &9M6E7 :5 $:&89ME78 W 3n the number of consumers of A F W market demand of A X 3n the number of consumers of A F X market demand of A

Module /
4he -uantity supplied is the actual amount of a good or ser-ice 9roducers are /illing to sell at some s9ecific 9rice A supply schedule sho/s ho/ much of a good or ser-ice 9roducers /ill su99ly at different 9rices /orks in a similar /ay as demand schedule su99ly cur-e sho/s the relationshi9 bet/een @uantity su99lied and 9rice normal that for a su99ly cur-e generally higher 9rices leads to a higher @uantity su99lies? this is often referred to as the law o" supply this says that other things being e@ual! the 9rice and @uantity su99lied of a good are 9ositi-ely related demand cur-es slo9e do/n/ards /hile su99ly cur-es slo9e u9/ard .the higher the 9rice offered the more of any good<ser-ice 9roducers are /illing to sell0 A change in supply is a shift of the su99ly cur-e! /hich changes the @uantity of su99lied at any gi-en 9rice im9ortant to kno/ that changes and su99ly and mo-ements along the su99ly cur-e are different ;movement along the supply curve is a change in the @uantity of a good that is the result of a change in that goods 9rice .change in su99ly /ill S13:4 the su99ly cur-e due to su99ly Kmore 9roduces or ad-anced technologyL

PAGE # 1"

/hile mo-ement is u9 or do/n0 An Aincrease in su99lyB is a rightward shift of the su99ly cur-e at any gi-en 9rice 9roducers su99ly a large @uantity of goods than before a decrease in su99ly they mean a leftward shift of the su99ly cur-e at any gi-en 9rice the 9roducers su99ly a smaller @uantity of goods than before Economist belie-e shifts of the su99ly cur-e for a good or ser-ide are mainly due to & factors 10 ,hanges in input prices "0 ,hanges in the prices o" related goods or services #0 ,hanges in technology $0 ,hanges in e)pectations &0 ,hanges in the num%er o" producers An input is anything that is used to 9roduce a good or ser-ice you need in9uts to make out9uts in9uts ha-e 9rices Kto make -anilla ice cream you need in9uts like cream! sugar! ectL increase in in9ut 9rices can make final good 9rices more e89ensi-e so 9roducers are less /illing to su99ly the final good at any gi-en 9rice and the su99ly cur-e shifts to the left .a fall in 9rice of in9uts can shift the cur-e to the right0 /hen a 9roducer sells se-eral 9roducts! the @uantity of any one good it is /illing to su99ly at any gi-en 9rice depends on the prices o" its other co-produced goods this effect can run in both directions ;an oil refinery /ill su99ly less gas /hen 9rice of heating oil rises shifting the su99ly cur-e for gas to the left but /ill su99ly more gas at any gi-en 9rice /hen the 9rice of heating oil falls! shifting the su99ly cur-e to the right this means gasoline and other co-9roduced oil 9roducts are su%stitutes in production for refiners other goods can be complements in production crude oil 9roducers see that oil /ells 9roduce natural gas as a by-9roduct of oil e8traction the higher 9rice at /hich driller sell natural gas the more oil /ells they /ill drill and the more oil they /ill su99ly at any gi-en 9rice for oil .so natural gas is a com9lement for crude oil0 AtechnologyB means all the methods 9eo9le can use to turn in9uts into useful goods and ser-ices .the se@uence of acti-ities needed to turn corn into cereal is technology0 better technology can reduce the cost of 9roduction letting 9roducer s9end less on in9uts to 9roduce the same out9ut increasing su99ly and shifting the su99ly cur-e to the right Eust like in the demand cur-e! changes in e)pectations can also change the su99ly cur-e ; /hen the su99liers ha-e some choice about /hen they 9ut their good u9 for sale changes in the e89ected future 9rice of a good can lead the su99lier to su99ly less or more of the good today storage of goods is a business strategy 9roducers choose to sell during 9eak seasons in 9rices choices the 9roducer makes de9ends on a com9arison of the current 9rice -ersus the e89ected future 9rice sho/s ho/ changes in e89ectations can alter su99ly an increase in future 9rice of good<ser-ice reduces su99ly today .a left/ard shift of the su99ly cur-e0 a fall in the future increases su99ly today .a right/ard shift of the su99ly cur-e0 ,hanges in the number of 9roducers affect the su99ly cur-e .Eust like changes in the # of consumers affects the demand cur-e0 An individual supply curve illustrates the relationshi9 bet/een @uantity su99lied and 9rice for an indi-idual 9roducer 4he market supply curve sho/s ho/ the combined total @uantity su99lied by all indi-idual 9roducers in the market de9ends on the market 9rice of that good Eust as market demand cur-e is the hori=ontal sum

PAGE # 1#

of indi-idual demand cur-es! the market su99ly cur-e is the hori=ontal sum of the indi-idual su99ly cur-e of all te 9roducers sho/s that an increase in the number of 9roducers leads to an increase in su99l and a right/ard shift of the su99ly cur-e 5*$1:78 1;*1 8;+51 89!!#> $;*&<E8 +& +&!91 !7+$E8 W Price of an in9ut used to 9roduce A F X su99ly of A X Price of an in9ut used to 9roduce A F W su99ly of A $;*&<E8 +& 1;E !7+$E8 :5 7E#*1E, <::,8 :7 8E7?+$E8 3f A and G are substitutes in 9roductions W Price of G F X su99ly of A X Price of G F W su99ly of A 3f A and G are com9lements in 9roduction W Price of G F W su99ly of A X Price of G F X su99ly of A $;*&<E8 +& 1E$;&:#:<> 3f the technology used to 9roduce A im9ro-es F W su99ly of A $;*&<E8 +& E=!E$1*1+:&8 W Price of A in the future F X su99ly of A today X Price of A in the future F W su99ly of A today $;*&<E8 +& 1;E &9M6E7 :5 !7:,9$E78 W +umber of 9roducers of A F W market su99ly of A X +umber of 9roducers of A F X market su99ly of A SM far demand cur-e! su99ly cur-e! and the set of factors that shift each cur-e has been e89lained? together they can be used to 9roduct the actual 9rice at /hich the good is bought and sold! as /ell as the actual @uantity transacted in com9etiti-e markets the interaction of su99ly and demand mo-e to/ard e-uili%rium ;an economic situation is in e@uilibrium /hen no indi-idual /ould be better off doing something better .closed line at the su9ermarket o9en 9eo9le rush to/ards ne/ line until all the lines are long again this is e@uilibrium0 hel9s us understand the 9rice at /hich good or ser-ice is bought and sold as /ell as the @uantity transacted of the good or ser-ice com9etiti-e market is in e@uilibrium /hen 9rice has mo-ed to a le-el at /hich the @uantity of the good demanded e@uals the @uantity of the good su99lied

PAGE # 1$

at that 9rice no indi-idual seller can make him<herself better off by offering to sell more or less of the good and no indi-idual buyer can make himself better by offering to buy more or less of a good at market e@uilibrium the 9rice has mo-ed to a le-el that e8actly matches the @uantity demanded by consumers to the @uantity su99lied by sellers? 4he 9rice that matches the @uantity su99lied and @uantity demanded is the e-uili%rium price the @uantity bought and sold at that 9rice is the e-uili%rium -uantity the e@uilibrium 9rice is also kno/n as the market-clearing price the 9rice that A,lears the marketB by ensuring that e-ery buyer /illing to 9ay that 9rice finds a seller to sell at that 9rice easiest /ay to find the e@uilibrium 9rice and @uantity in a market is by 9utting the su99ly cur-e and demand cur-e on the same diagram since su99ly cur-e sho/s the @uantity su99lied at any gi-en 9rice and the demand cur-e sho/s the @uantity demanded at any gi-en 9rice the 9rice at /hich the t/o cur-es cross is the e@uilibrium 9rice the 9rice at /hich the @uantity su99lied F @uantity demanded 1o/ can /e be sure that markets /ill arri-e at e@uilibrium 9riceP ask three sim9le @uestions 1) 2hy do all sales and purchases in market take place at the same price@ 3n a market /here the buyers and sellers ha-e both been around sales and 9urchases tend to ha-e a uniform 9rice so /e can talk about market 9rice? 3n any /ell established on going market all sellers recei-e and all buyers 9ay a99ro8imately the same 9rice .9eo9le /ould see that if a 9rice is too high they /ould sho9 else/here so seller /ould offer a better deal? Also a seller /ould not sell for less if he kne/ /hat most buyers /ere 9aying0 this is market 9rice 2) 2hy does the market price "all i" it is a%ove the e-uili%rium price@ 4here is surplus of a good /hen the @uantity su99lied e8ceeds the @uantity demanded? Sur9luses occur /hen the 9rice is abo-e its e@uilibrium le-el? .also kno/n as e8cess of su99ly0 .9rice of a good /ill fall /hene-er there is sur9lus K/hene-er market is abo-e e@uilibrium le-elL .) 2hy does the market price rise i" it is %elow the e-uili%rium price@ 4here is a shortage of a good /hen the @uantity demanded e8ceeds the @uantity su99lied? Shortages occur /hen the 9rice is belo/ its e@uilibrium le-el .also kno/n as e8cess demand0 -; in this situation buyers /ill offer more or sellers /ill charge higher 9rices bidding u9 of 9rices ha99ens /hene-er there are shortages and there /ill be shortages /hene-er the 9rice is belo/ its e@uilibrium le-el .so market 9rice /ill al/ays rise if it is belo/ the e@uilibrium le-el0 using the abo-e /e can al/ays see that the market 9rice /ill al/ays mo-e to/ards e@uilibrium 9rice .the 9rice at /hich there is neither sur9lus nor shortage

Module A

PAGE # 1&

Qemand cur-e and su99ly cur-e can shift for many reasons! /hen cur-es shifts the e@uilibrium 9rice and @uantity change Qemand cur-e shifts an increase in demand is indicated by a right/ard shift of the demand cur-e this causes a shortage because @uantity demanded e8ceeds the @uantity su99lied? 2hen a 9rice of an item rises this can generate an increase in the @uantity su99lies! an u9/ard mo-ement along the su99ly cur-e? A ne/ e@uilibrium is established general 9rinci9al 2hen demand for a good or ser-ice increases! the e@uilibrium 9rice and the e@uilibrium @uantity of the good or ser-ice both rise /orks -ice -ersa /hen demand for a good or ser-ice decreases! the e@uilibrium 9rice and the e@uilibrium @uantity of a good or ser-ice both fall 1o/ markets res9ond to changes in demand An increase in demand leads to a rise in both the e@uilibrium 9rice and the e@uilibrium @uantity? A decrease in demand leads to a fall in both the e@uilibrium 9rice and e@uilibrium @uantity say a drought ha99ens and the su99ly cur-e shifts to the left a shortage can ha99en that causes a rise in 9rice and a fall in @uantity demanded! an u9/ard mo-ement along the demand cur-e? 4he ne/ e@uilibrium /ould ha-e a higher 9rice and a lo/er e@uilibrium @uantity? 1as a general 9rinci9le 2hen su99ly of a good or ser-ice decreases! the e@uilibrium 9rice of the good or ser-ice rises and the e@uilibrium @uantity of the good or ser-ice falls /hen su99ly increases leads to a right/ard shift in the su99ly cur-e? As a result e@uilibrium 9rice falls and @uantity demanded rises? 1as a general 9rinci9al 2hen a su99ly of a good or ser-ice increases! the e@uilibrium 9rice of a good or ser-ice falls and the e@uilibrium @uantity of the good or ser-ice 9rices 1o/ markets res9ond to change in su99ly An increase in su99ly leads to a fall in the e@uilibrium 9rice and a rise in the e@uilibrium @uantity? A decrease in su99ly leads to a rise in the e@uilibrium 9rice and a fall in the e@uilibrium @uantity? Some e-ents shift both the demand and su99ly cur-es at the same time? 2hen demand increases and su99ly decreases! the e@uilibrium 9rice rises but the change in the e@uilibrium @uantity is ambiguous 2hen demand decreases and su99ly increases! the e@uilibrium 9rice falls but the change in the e@uilibrium @uantity is ambiguous 2hen both demand and su99ly increase! the e@uilibrium @uantity increases but the change in e@uilibrium 9rice is ambiguous 2hen both demand decrease! the e@uilibrium @uantity decreases but the change in e@uilibrium 9rice is ambiguous

Module 1'
almost all countries calculate a set of #s kno/n as the national income and 9roduct accounts

PAGE # 1'

accuracy of a countrys accounts is a good indicator of its state of economic de-elo9ment in >?S these #s are calculated by the Gureau of Economic Analysis! a di-ision of the >?S? go-ernments Qe9artment of ,ommerce the national income and 9roduct accounts! often referred to sim9ly as the national accounts! kee9 track of the s9ending of consumers! sales of 9roducers! business in-estment s9ending! go-ernment 9urchases and other flo/s of money among different sectors of the economy 4he ,ircular-:lo/ Qiagram to understand national accounts look at the circular-flo/ diagram a sim9lified re9resentation of the macro economy sho/s the flo/ of money! goods and ser-ices! and factors of 9roduction through the economy allo/s us to -isuali=e key conce9ts behind national accounts underlying 9rinci9al is that the flo/ of money into each market<sector is F to the flo/ of money coming out of that market or sector 4he Sim9le ,ircular :lo/ Qiagram >S economy is com9le8 but you can learn a lot using a sim9le diagram?

sim9le model of the macro economy re9resenting the transactions that take 9lace by ."0 kinds of flo/s around a circle flo/s of 9hysical things such as goods! ser-ices! labor or ra/ material in one direction and flo/s of money that 9ay for these things in the o99osite direction? in this case the 9hysical flo/s are in yello/ money is teal sim9le circular-flo/ those economy /ith only " inhabitants households and firms ;a household consists of either an indi-idual<grou9 of indi-iduals /ho share their income ;a firm is an organi=ation that 9roduces goods and ser-ices for sale and that em9loys members of households t/o kinds of markets in this sim9le economy on one side .left here0 markets for goods and ser-ices .kno/n as 9roduct markets0 in /hich households buy goods<ser-ices they /ant from firms? 9roduces a flo/ of goods<ser-ices to the households and return flo/ of money to firms Mther side are factor markets in /hich firms buy the resources they need to 9roduct goods and ser-ices best kno/n factor market is the Jabor Market in /hich /orkers are 9aid for their time besides labor

PAGE # 1(

/e think of households as o/ning<selling the other factors of 9roduction to firms this model omits many things for sim9licity 4he E89anded ,ircular-:lo/ Qiagram 4his diagram sho/s only the flo/ of money in the economy but is e89anded to include e8tra elements that /ere ignored in the sim9le circular flo/ .for sim9licity0 underlying 9rinci9al that in flo/ of money into each market or sector must e@ual the outflo/ of money coming from that market or sector still a99lies sin this model

in the 9roduct markets! households engage in consumer s9ending! buying goods and ser-ices from domestic firm and from firms in the rest of the /orld households o/n factors of 9roduction -- land! labor! and ca9ital and they sell these factors of 9roduction to firms! recei-ing rent! /ages! and interest 9ayments in return firms buy and 9ay households for the use of those factors of 9roduction in factor markets! re9resented to the right of center in the diagram ;most households get their income from /ages earned by selling labor additional income from their indirect o/nershi9 of 9hysical ca9ital used by firms in the form of stocks shares in the o/nershi9 of a com9any and bonds loans to firms in the form of an 3M> that 9ays interest ;the income households recei-e from the factors market includes 9rofit distributed to com9any shareholders and the interest 9ayments on any bonds that they hold ;households recei-e rent from firms in e8change for the use of land or structures that the households o/n

PAGE # 1)

in factor markets households recei-e income in form of /ages! 9rofit! interest and rent -ia factor markets households s9end most of the income recei-ed from factors of 9roduction on goods<ser-ices goods and ser-ices do not absorb all of household income reasons .10 households dont get to kee9 all the income they recei-e -ia the factor markets? 4hey must 9ay 9art of their income to the go-ernment n the form of ta8es such as income ta8 and sales takes also some households recei-e go-ernment transfers 9ayments that the go-ernment makes to indi-iduals /ithout e89ecting a good<ser-ice in return .such as unem9loyment insurance0 total income households ha-e left after 9aying ta8es and recei-ing go-ernment transfers is dis9osable income households also set aside a 9ortion of their income for 9ri-ate sa-ings these go into financial markets /here indi-iduals! banks .and other institutions0 buy<sell stocks<bonds as /ell as make loans as sho/n in 1%?" the financial markets also recei-e funds from the rest of the /orld and 9ro-ide funds to the go-ernment<firms<to rest of the /orld im9ortant general characteristic of the circular-flo/ diagram the total sum of flo/s of money out of a gi-en bo8 is e@ual to the total sum of flo/s of money into that bo8 ;sim9le a matter of account /hat goes in must come out go-ernment returns a 9ortion of the money it collects from ta8es to households in the form of go-ernment transfers but it uses much of its ta8 re-enue 7 addition funds it borro/ed in financial markets through go-ernment borro/ing to buy goods<ser-ices ;go-ernment 9urchases of goods and ser-ices! the total 9urchase made by federal! state! and local go-ernments! includes e-erything from military to schools rest of the /orld 9artici9ates in the >S economy ;some goods and ser-ices are sold to other countries .e89orts0 lead to a flo/ of funds from the rest of the /orld into the >?S ;some of the goods and ser-ices 9urchased by the residents of the >?S are 9roduced abroad and are kno/n as im9orts leads to a flo/ of funds out of the >?S ;foreign can 9artici9ate in >?S financial markets foreign lending .lending by foreigners to borro/ers in >?S < 9urchases of stocks in American com9anies generates a flo/ of funds into the >?S from the rest of the /orld .con-ersely >?S lending to others is a flo/ of money out0 firms also buy goods and ser-ices in our economy might buy in-estment goods .ca9ital goods0 to 9roduce items ;com9anies might accumulate an in-entory good and ra/ materials held to facilitate business o9eration ;national accounts count this in-estment s9ending s9ending on ne/ 9roducti-e 9hysical ca9ital as 9art of total s9ending on goods<ser-ices ;changes in in-entories of finished goods are counted as in-estment s9ending because like machinery they change the ability of a firm to make future sales so s9ending on additions to in-entories is a form of in-estment by a firms and con-ersely a dra/ing-do/n of in-entories is a fall in in-estment s9ending

PAGE # 1*

because it leads to lo/er sales in-estment s9ending included s9ending on the construction of any structure 9roduces a future out9ut ;if /e add u9 consumer s9ending on goods<ser-ices! in-estment s9ending! go-ernment 9urchases of goods<ser-ices! and the -alue of e89orts! then subtract the -alue of im9ortant gi-es us a measure of the o-erall market -alue of the goods and ser-ices the economy 9roduces ,AJJEQ GQPN .gross domestic 9roduct0 im9ortant distinction bet/een class of goods and ser-ices the difference bet/een final goods and ser-ices -ersus intermediate goods and ser-ices Gross Qomestic Product final goods and ser-ices are goods and ser-ices sold to the final! or end user ;intermediate goods and ser-ices are goods<ser-ices that are in9uts into the 9roduction of final goods<ser-ices the 9urchaser is another firm +M4 the final user Gross domestic 9roduct or GQP is the total -alue of all final goods and ser-ices 9roduced in an economy during gi-en 9eriod .a year0 # /ays to calculate GQP 10 sur-ey firms and add u9 the total -alue of their 9roduction of final goods<ser-ices ;this e8cludes intermediate goods because then it /ould be counted se-eral times .thus inflating GQP0 ;to a-oid double-counting /e only count the 9roducers -alue added in the calculation of QP the difference bet/een the -alue of its sales and the -alue of the in9uts it 9urchases from other businesses "0 add u9 aggregate s9ending on domestically 9roduced final goods the sum of consumer s9ending 0,! in-estment s9ending .30! go-ernment 9urchases of goods and ser-ices .G0! and e89orts minus im9orts .O3M0 ;GQP can be measured by flo/ of fund into firms this measurement must also a-oid double-counting ;to sol-e double-counting /e count only the -alue of the sales to final buyers .Such as consumers! firms that 9urchase in-estment goods! the go-ernment! or foreign buyers0 .basically /e omit sale of in9uts from one business to another /hen estimating GQP using s9ending data0 ;national accounts QM include in-estment s9ending by firms as 9art of final s9ending .steel isnt counted for final s9ending for a car but the com9anys 9urchase of ne/ machinery for its factories is considered 9art of final s9ending0 Kin9uts are used u9 not ca9ital goods /ill last for a considerable time arent closely tied to current 9roduction! the national accounts consider such 9urchase a form of final sale0 4he ty9es of s9ending that make of GQP is consumer s9ending .,0! in-estment s9ending .30! go-ernment 9urchases of goods<ser-ices .G0 and e89orts .O0 in reality not all of this final s9ending goes to/ard domestically 9roduced goods<ser-ices must take into account s9ending on im9orts /hich is detonated by 3M income s9ent on im9orts is not s9end on domestic goods<ser-ices and it is income that has AleakedB across national borders so to calculate domestic 9roduction using s9ending data /e must subtract s9ending on im9orts GQP F , 7 3 7 G 7 O - 3M O - 3M difference bet/een -alue of e89orts and im9orts is kno/n as net e89orts

PAGE # "%

#0 sum the total factors income earned by households from firms in the economy ;includes /ages earned by labor! the interest earned by those /ho lend their sa-ings to firms and the go-ernment! the rent earned by the shareholders! the o/ners of the firm 9hysical ca9ital -alid measure because money firms earn by selling goods<ser-ices must go some/hereD /hate-er isnt 9aid as /ages! interest! or rent is 9rofit 9art of 9rofit is 9aid out to shareholders in di-idends

2hat is included in GQP domestically 9roduced final goods and ser-ices! including ca9ital goods! ne/ constriction of structures! and changes to in-entories +ot included in GQP intermediate goods and ser-ices in9uts used goods financial assets such as stocks and bonds foreign-9roduced goods and ser-ices

Module 11
Most im9ortant use of GQP is as a measure of the si=e of the economy! 9ro-iding us a scale against /hich to com9are the economic 9erformance of other years or other countries? .>SA GQP Z T1$!"&* billion /hile Va9ans GQP /as T&!%$* billion outdated as a side note because ,hina is #" right no/0 be careful /ith GQP numbers! es9ecially /hen making com9arisons o-er time because 9art of the increase in the -alue of GQP o-er time re9resents increases in the 9rice of good and ser-ices rather than an increase in out9ut .3?e? >S GQP /as T(!%)& billion in 1**$ and had a99ro8imately doubled to T1$!"&% billion in "%%* but note >S 9roduction didnt double? 4o measure actual changes in aggregate out9ut! /e need a modified -ersion of GQP that is adEusted for 9rice changes kno/n as real GQP 6EAJ GQP A measure of aggregate out9ut

PAGE # "1

e-en though GQP number is a useful statistic! one that 9ro-ides a good /ay to com9are the si=e of different economies it is not a good measure of the economys gro/th o-er time? GQP can gro/ because the economy gro/s! but it can also gro/ because of inflation e-en if the economys out9ut doesnt change GQP /ill go u9 if the 9rices of the good and ser-ices the economy 9roduces increases .GQP can fall because the economy is 9roducing less or because 9rices ha-e fallen0 to measure economys gro/th accurately /e need a measure of aggregate out9ut the total @uantity of final goods and ser-ices the economy 9roduces the measure that is sued for this 9ur9ose is kno/n as 6EAJ GQP by tracking real GQP o-er time /e a-oid the 9roblem of changes in 9rices distorting the -alue of changes in 9roduction o-er time :6MM 41E GMMK 4M 1EJP >S >+QE6S4A+Q Jets imagine a economy in /hich only t/o goods! a99les and oranges are 9roduced and in /hich both goods are sold only to final consumers 4AGJE 11?1 ,alculating GQP and real GQP in a sim9le economy

Iear 1 [uantity of a99les .billions0 Price of an a99le [uantity of oranges .billions0 Price of an orange GQP .billions of dollars0 6eal GQP "!%%% T%?"& 1!%%% T%?&% T1!%%% T1!%%% "!"%% T%?#% 1!"%% T%?(% T1!&%% T1!1&%

Iear "

2e can say based on the data the -alue of the sales increased from year 1 to " in the first year the total -alue of the sales /as ."!%%% billion O T%?"&0 7 .1!%%% billion O T%?&%0 F T1!%%% billion in the second it /as ."!"%% billion O T%?#%0 7 .1!"%% billion O T%?(%0 F T1!&%% billion ./hich is &%H larger0 but it is also clear that from the table that this increase in dollar -alue of the GQP o-erstates the real gro/th in the economy! although the @uantities of both a99les and oranges increase! the 9rices of the goods also rose so 9art of the &%H increase reflects higher 9rices! not higher 9roduction of out9ut to estimate true increase in aggregate out9ut 9roduced! /e ha-e to check ho/ much /ould GQP gone u9 if the 9rices had not changed to do this in this case /e ha-e to find the -alue of out9ut for year " e89ressed in year 1 9rices ;in year 1 the 9rice /as a99les /as T%?"& each and 9rice of orange T%?&% each so year " out9ut at year 1 9rices is ."!"%% billion O T%?"&0 7 .1!"%% billion O T%?&%0 F T1!1&% billion and out9ut in year 1 at year 1 9rices /as T1!%%% bullion so in this e8am9le! GQP measured in year 1 9rices rose 1&H from the T1!%%% billion to T1!1&% billion 6eal GQP is the total -alue of final goods and ser-ices 9roduced in the economy during a gi-en year!

PAGE # ""

calculated .if 9rices had stayed constant0 using the 9rices of a selected base year ;a GQP number that has not been adEusted for changes in 9rices is calculated using the 9rices in the year in /hich the out9ut is 9roduced called +ominal GQP .GQP at current 9rices0 +ominal GQP is the total -alue of all final goods and ser-ices 9roduced in the economy during a gi-en year! calculated /ith the 9rices current in the year in /hich the out9ut is 9roduced ;if /e used nominal GQP to measure the true change in out /e /ould ha-e o-erstated the true gro/th in out9ut Gase don table 11?1 /e can see different /ays to calculate real GQP by using a different base year .using " yields 1&?$H /hile using 1 yields 1&H0 in this calculation /e see that the real GQP increased by 1&H .1& or 1&?$ -- neither is more correct0 most go-ernment economist /ho 9ut together the >S national accounts ha-e ado9ted a method to measure the change in real GQP kno/n as chain-linking ,hain-linking is the method of calculating changes in the real GQP using the a-erage bet/een the gro/th rate calculated using an early base year and the gro/th rate calculated using a late base year ;>S statistics on real GQP are al/ays e89ressed in chained dollars ./hich s9lits the difference bet/een using early and late base years0

GQP is a countrys aggregate out9ut other things e@ual a country /ith a larger 9o9ulation /ill ha-e a higher GQP sim9le because it has more 9eo9le ;so if /e /ant to com9are GQP across countries but /ant to eliminate the effect of difference in 9o9ulation si=e! /e use the measure GQP 9er ca9ita GQP 9er ca9ita is the GQP di-ided by the si=e of the 9o9ulationD it is e@ui-alent to the a-erage GQP 9er 9erson real GQP 9er ca9ita is useful .such as in com9arison of labor 9roducti-ity bet/een t/o countries because it is a rough measure of the a-erage real out9ut 9er 9erson it has /ell-kno/n limitations as a measure of a countrys li-ing standard .economist are accused of belie-ing that gro/th in real GQP in ca9ita is the only thing that matters -- thinking that increasing the real GQP 9er ca9ita is a goal in itself0 this is false a countrys real GQP 9er ca9ita is not a sufficient measure of human /elfare in that country and /hy gro/th in real GQP is not an a99ro9riate 9olicy goal real GQP does not include the things that contribute to ha99iness .leisure time! natural beauty! house/ork0 real GQP increases /ith e89enditures on some tings that make 9eo9le unha99y .diseases! crime! natural disasters! ect0 real GQP 9er ca9ita is a measure of an economys a-erage aggregate out9ut 9er 9erson and so of /hat it ,A+ do a country /ith high GQP can afford to be healthy! to be /ell educated! and to ha-e a good @uality of life .but @uality of life does not F high GQP 9er ca9ita0

Module 12
youre em9loyed if and only if you ha-e a Eob not as subtle because a 9erson /ho isnt /orking doesnt that that /e consider that 9erson unem9loyed indi-iduals in retirement<disabled >?S census bureau defined unem9loyed 9eo9le as indi-iduals /ho are acti-ely looking for /ork but

PAGE # "#

arent currently em9loyed A countrys labor force is e@ual to the sum of the em9loyed and the unem9loyed .indi-iduals /ho are /orking and those /ho are looking for /ork0 4he labor force 9artici9ation rate is the H of the 9o9ulation 1' or older that is in the labor force Jabor force 9artici9ation rate F labor force<9o9ulation age 1' or older O 1%% 4he unem9loyment rate is the 9ercentage of the total number of 9eo9le in the labor force /ho are unem9loyed >nem9loyment rate F number of unem9loyed /orkers<labor force O 1%% the unem9loyment rate is a good indicator of ho/ easy or difficult it is to find a Eob gi-en the current state of the economy ./hen unem9loyment rate is lo/ nearly e-eryone /ho /ants a Eob can find one /orks -ice -ersa0 though unem9loyment is a good indicator of current labor market conditions! it is not a 9erfect measure unem9loyment ne-er falls to =ero a /orker /ho is confident of finding a Eob! but had not acce9ted a 9ositions! is counted as unem9loyed fre@uently! 9eo9le /ho /ould like to /ork but arent /orking still dont get counted as unem9loyed an indi-idual /ho has gi-en u9 looking for a Eob for the time being .lack of a-ailability of Eob0 isnt counted as unem9loyed because he<she hasnt been searching for a Eob for the 9re-ious four /eeks indi-iduals /ho /ant to /ork but arent currently searching because they see little 9ros9ect of finding a Eob are kno/n as discouraged /orkers because it does not count discouraged /orkers measured unem9loyment rate may understate the actual H of 9eo9le /ho /ant to /ork but are unable to find Eobs Qiscouraged /orkers are 9art of a larger grou9 kno/n as marginally attached /orkers ; Marginally attached /orkers /ould like to be em9loyed and ha-e looked for a Eob in the recent 9ast but are not currently looking for /ork not included /hen unem9loyment is calculated >nderem9loyed are 9eo9le /ho /ork 9art-time because they cannot find full-time Eobs they arent counted for unem9loyment either Gureau of Jabor Statistics is the federal agency that calculated official unem9loyment also calculated broader Ameasures of labor underutili=ationB that include the three categories of frustrated /orker /hen measured unem9loyed counts marginally attached /orkers .including discouraged /orkers0 and the underem9loyed are counted it is significantly higher broadest measure of unem9loyment and underem9loyment! kno/n as >'! is the sum of these three measures 9lus the unem9loyed it is substantially higher ;>' and the unem9loyment rate mo-e -ery much in 9arallel! so changed in the unem9loyment rate remain a good guide for /hats ha99ening in the o-erall labor market unem9loyment rate -aries greatly among demogra9hic grou9s .other things being e@ual! Eobs are easier

PAGE # "$

to find /ith more e89erienced /orkers and for /orkers during their A9rimeB /orking years K"&-&$L0 ;younger /orkers! and for /orkers near retirement Eobs are harder to find .all things being e@ual0 .race also counts into dis9arity0 although unem9loyment is not e8act! literal measure of the H of 9eo9le unable to find Eobs! it is a good indicator of o-erall labor market conditions .u9s and do/ns of the unem9loyment rate closely reflect economic changes that im9act 9eo9les li-es0

/hile recessions are marked usually by rising unem9loyment im9ortant to recogni=e that economic e89ansions arent al/ays 9eriods of falling unem9loyment in the case of the book /e see that the recession of 1**%-1**1 and "%%1 the unem9loyment rate continues to rise for more than a year after the recession /as officially o-er? 4he e89lanation is both cases is that although the economy is gro/ing! it /as not gro/ing fast enough to reduce the unem9loyment rate book uses figure 1"?& .a-erage gro/th .8 a8is0 -s? change in unem9loyment rate .9ercentage 9oints0 .y a8is0 some years /ere the gro/th /as in the negati-e ./hich means the real GQP shrank0 do/n/ard trend on this gra9h sho/s that there is generally a strong negati-e relationshi9 bet/een gro/th in the economy and the rate of unem9loyment years of high gro/th in real GQP /ere also years in /hich the unem9loyment rate fell! and years of lo/ or negati-e gro/th in real GQP /ere years in /hich the unem9loyment rate rose0 ./hen -ertical a8is is negati-e meaning unem9loyment fell years of abo-ea-erage gro/th /ere usually in years in /hich the unem9loyment /as falling .you can guess belo/ a-erage gro/th /as the o99osite0

PAGE # "&

there are 9eriods in /hich GQP is gro/ing! but at a belo/-a-erage rateD these are 9eriods in /hich the economy isnt in a recession but unem9loyment is still rising .sometimes called a Agro/thB recessionB

Module 1.
4he ,auses and ,ategories of >nem9loyment fast economic gro/th tends to reduce the unem9loyment rate a %H unem9loyment is not feasible ne-er dro99ed belo/ "?*H unem9loyment e-en /hen businesses are ha-ing a hard time finding /orkers /e start /ith the obser-ation that e-en in the best of times Eobs are constantly being created<destroyed Vob ,reation and Vob Qestruction in early "%1% unem9loyment /as 1%H in Vuly "%%( it /as $?(H .historically lo/0 yet in that month $?& AEob se9arationsB terminations of em9loyment occurred many reasons for Eob loss ; a structural change in the economy industries rise and fall as ne/ technologies emerge and consumers taste change structural changes can create ne/ Eobs also ;9oor management 9erformance or bad luck at indi-idual com9anies also leads to Eob loss for their

PAGE # "'

em9loyees constant churning of /orkforce is an ine-itable feature of the modern economy this churning is one source of frictional unem9loyment one main reason that there is a considerable amount of unem9loyment e-en /hen Eobs are abundant :rictional >nem9loyment /orkers /ho loses Eob in-oluntary .due to Eob destruction0 choose not to take the first ne/ Eob offered .ie a 9rofessional basketball 9layer looses his Eob and get a Eob coaching the local high school basketball team he should refuse and take the time to look for a Eob that takes ad-antage of his skills0 ;indi-idual /orkers are constantly lea-ing Eobs for 9ersonal reasons .family mo-es! dissatisfaction! and better Eob 9ros9ects0 /orkers /ho s9end time looking for unem9loyment are engaged in Vob search if all /orkers<Eobs /ere alike Eob search /ouldnt be necessaryD if information about Eobs</orkers /ere 9erfect Eob search /ould be @uick in 9ractice its normal for a /orker /ho loses a Eob! or younger /orker seeking a Eob to s9end a fe/ /eeks searching :rictional unem9loyment is unem9loyment due to the time /orkers s9end in Eob search a certain amount of frictional unem9loyment is ine-itable for ."0 reasons ;.10 the constant 9rocess of Eob creation and Eob destruction ;."0 ne/ /orkers are al/ays entering the Eob market ;a limited amount of frictional unem9loyment is harmless .may be e-en good0 economy is more 9roducti-e if /orkers take the time to find Eobs that are /ell matched to their skills and /orkers /ho are unem9loyed for a brief time /hile searching fr the right Eob dont e89erience hardshi9 ;lo/ unem9loyment rate 9eriods of unem9loyment tend to be short suggestion the unem9loyment is frictional in 9eriods of higher unem9loyment /orkers tend to be Eobless for longer 9eriods of time! suggesting a smaller share of unem9loyment is frictional .Along term unem9loymentB rates Eum90 Structural unem9loyment frictional unem9loyment e-en e8ist /hen the # of 9eo9le seeking Eobs F the number of Eobs being offered the e8istence of frictional unem9loyment doesnt mean a sur9lus of labor there is a 9ersistent sur9lus of Eob-seekers in a 9articular Eob market .ie more /orkers /< a skill than there are Eobs for that skill or there may be more /orkers in a 9articular region than there are Eobs a-ailable in that region0 Structural unem9loyment is unem9loyment that results /hen there are more 9eo9le seeking Eobs in a labor market than there are Eobs a-ailable at the current /age rate su99ly and demand model tells us that the 9rice of a good! ser-ice! or factor of 9roduction tends to mo-e to/ard an e@uilibrium le-el that matches the @uantity su99lied /ith the @uantity demanded es9ecially true .in general0 of labor markets ;labor demand cur-e indicates that /hen the 9rice of labor -- /age rate -- increases! em9loyees demand less labor ;the labor su99ly cur-e indicates that /hen the 9rice of labor increases! more /orkers are /illing to su99ly labor at the 9re-ailing /age rate

PAGE # "(

;these t/o forces coincide to lead to an e@uilibrium /age for any gi-en ty9e of labor in a 9articular location e@uilibrium /age is 2.e0 e-en at the e@uilibrium /age rate! 2.e0 there /ill still be some frictional unem9loyment because there /ill al/ays be some /orkers engaged in Eob search e-en /hen the # of Eobs are F to the # of /orkers seeking Eobs but there /ouldnt be any structural unem9loyment in this labor market Structural unem9loyment occurs /hen the /age rate is! for some reason! 9ersistently abo-e 2.e0 se-eral factors can lead to an /age rate in e8cess of 2.e0 most im9ortant are minimum /age! labor unions! efficiency /ages! and the side effects of go-ernment 9olicy M3+3M>M 2AGE a minum /age is a go-ernment mandates floor on the 9rice of labor the national minimum /age in "%%* /as T(?"& for many Americans this is irrele-antD the market e@uilibrium /age for these /orkers is /ell abo-e this floor 9rice but for less skilled /orkers the minimum /age may be binding it affects the /ages that 9eo9le are actually 9aid and can lead to structural unem9loyment in countries /ith higher minimum /ages! the range of /orkers for /ho the minimum /age is binding is larger you can gra9hically see the effects of a binding minimum /age

in this market there is a legal floor on /ages .2.f00 /hich is abo-e the e@uilibrium /age rate 2.e0 this leads to a 9ersistent sur9lus in the labor market the @uantity of labor su99lied! [.s0 is larger than the @uantity demanded [.d0 more 9eo9le /ant to /ork than they can find Eobs at the minimum /age leading to structural unem9loyment gi-en that minimum /ages .binding minimum /ages0 generally lead to structurally unem9loyment makes you /onder /hy go-ernment im9oses them rationale is to ensure that 9eo9le /ho /ork can earn enough income to afford at least a minimally comfortable lifestyle comes at a cost because it may

PAGE # ")

eliminate em9loyment o99ortunities for some /orkers /ho /ould ha-e /illingly /orked for lo/er /ages as seen in the figure abo-e not only are there more sellers of labor that they are buyers! there are also fe/er 9eo9le /orking at a minimum /age [.Q0 than they /ould ha-e been /ith no minimum /age K[.e0L although economist broadly agree that high minimum /age has em9loyment reducing effects there is some @uestion about /hether this is a good descri9tion of ho/ minimum /age actually /orks some research ha-e 9roduced e-idence that increases in the minimum /age actually increases em9loyment argue that firms that em9loy lo/-skilled /orkers restrict their hiring in order to kee9 /ages lo/ so as a result minimum /age can sometimes be increased /ithout a loss of Eobs most economist agree that s sufficiently high minimum /age does lead to structural unem9loyment JAGM6 >+3M+S actions of labor unions can ha-e similar effects as those of minimum /age leading to structural unem9loyment ;by bargaining collecti-ely for all of a firms /orkers! unions often /in higher /ages from em9loyees that they could ha-e indi-idually 9rocess is kno/n as collecti-e bargaining intended to gi-e /orked more bargaining 9o/er ;labor union e8ercise bargaining 9o/er by threatening firms /ith a labor strike .collecti-e refusal to /ork0 /hen /orks ha-e more bargaining 9o/er they demand<recei-e higher /ages unions also bargain o-er benefits ./hich is like additional /ages0 economist /ho study the effects of unions on /ages find that unioni=ed /orkers earn higher than non-union the result of these increased /ages is the same result as minimum /age labor unions 9ush the /age that /orkers recei-e abo-e the e@uilibrium 9rime conse@uently there are more 9eo9le /illing to /ork at the /age being than there are Eobs a-ailable ;like binding minimum /age this leads to structural unem9loyment E::3,3E+,I 2AGES actions by firms may also contribute to structural unem9loyment firms may choose to 9ay efficiency /ages /ages that em9loyees set abo-e the e@uilibrium /age rate as an incenti-e for better em9loyee 9ractices .they might /ork harder0 use of efficiency /ages by firms leads to structural unem9loyment .results in a 9ool of /orkers /ho /ant Eobs but cant find them0 S3QE E::E,4S M: P>GJ3, PMJ3,I 9ublic 9olicy designed to hel9 /orkers /ho lose their Eobs can lead to structural unem9loyment as an unintended side effect like /elfare the dra/back is that it reduces the incenti-e to @uickly find a ne/ Eob and by kee9ing more 9eo9le searching longer benefits increase structural and frictional unem9loyment A+urosclerorisB 9ersistent high unem9loyment that affects # of Euro9ean countries attributed to unem9loyment benefits 41E +A4>6AJ 6A4E M: >+EMPJMIME+4 frictional unem9loyment is ine-itable and many economies suffer from structural unem9loyment so a certain amount of unem9loyment is natural Actual unem9loyment fluctuated around this normal le-el the natural rate of unem9loyment is the normal unem9loyment around /hich the actual unem9loyment rate fluctuates it is the rate of unem9loyment that arises from the effects of frictional 9lus structural

PAGE # "*

unem9loyment ;cyclical unem9loyment is the de-iation of the actual rate of unem9loyment from the natural rateD it is the difference bet/een the actual and natural rates of unem9loyment cyclical unem9loyment is the share of unem9loyment that arises from the business cycle SM +atural unem9loyment F friction 7 structural unem9loyment Actual unem9loyment F natural 7 cyclical unem9loyment the natural rate of unem9loyment changes o-er time! and it can be affected by economic 9olicies ,1A+GES 3+ 41E +A4>6AJ 6A4E M: >+EMPJMIME+4 9ri-ate sector economist<go-ernment agencies need estimates of the natural rate of unem9loyment to make forecast < conduct 9olicy analyses sho/s that >S natural rates rises and fall o-er time the main causes of change in the natural rate of unem9loyment is changes in the characteristics of the labor force! in labor market instructions! and in go-ernment 9olicies ,1A+GES 3+ JAGM6 :M6,E ,1A6A,4E63S43,S ;young /orkers tend to ha-e much higher unem9loyment unem9loyment rates tend to be lo/er for e89erienced than for e89erienced /orkers because e89erience /orks tend to stay in a gi-en Eob longer than do ine89erienced ones! they ha-e a lo/er frictional unem9loyment ,1A+GES 3+ JAGM6 MA6KE4 3+S4>4343M+S ;union is 9art of this .unions negotiate abo-e the e@uilibrium le-el /hich can be a source of structural unem9loyment0 other instructional changes may also /ork some labor economist belie-e that tem9orary go-ernment agencies ha-e reduced frictional unem9loyment by hel9ing match /orkers to Eob internet /ebsites may ha-e reduced frictional unem9loyment also ;technology change cou9led /ith labor market institutions can also affect the national rate of unem9loyment leads to an increase in demand for skilled /orkers /ho are familiar /ith e-ol-ing technology and a reduction in the demand for unskilled /orkers economic theory states that /ages should increase for skilled /orkers and decrease for unskilled and if /ages cannot go do/n for unskilled .due to binding minimum /age0 increases structural unem9loyment and therefore a higher natural rate of unem9loyment /ill result ,1A+GES 3+ GMRE6+ME+4 PMJ3,3ES a high minimum /age can cause structural unem9loyment generous unem9loyment benefits can increase both structural and frictional unem9loyment so these go-ernment 9olicies meant to hel9 can ha-e the undesirable effect of raising the natural rate of unem9loyment some go-ernment 9olicies might reduce natural rate .like Eob training and em9loyment subsidies Eob training 9rograms are su99ose to 9ro-ide unem9loyed /orkers /ith skills that /iden the range of Eobs they can 9erson and em9loyment subsidies are 9ayments either to /orkers or to em9loyers that 9ro-ide a financial incenti-e to acce9t or offer Eobs

PAGE # #%

Module 1(
high rate of inflation not the high rate of unem9loyment /as the 9rinci9al concern for 9olicy makers at the time .during the 1*(%s - 1*)%s0 ;inflation is something to /orry about and 9olicy makes does not like it /hen it increases inflation can im9ose costs on the economy common misconce9tion is that inflation makes e-eryone 9oorer .it does not0 a lot of countries re9lace their currencies imagine if you re9lace the dollar /ith a Ane/ dollarB at the e8change rate of ( to 1? 3f you o/ed T1$%!%%% on your home it /ould become T"%!%%% in the ne/ dollars? 3f you had a /age of 1$ dollars it is no/ " ne/ dollars this /ould bring >S 9rices back to /hen V:K /as 9resident ;so does e-eryone become richerP +M 9rices /ould be lo/er but so /ould /ages and income in general? 3f you cut a /orkers /age and 9rices at the same rate the /orkers real wage -- the /age rate di-ided by the 9rice le-el -- doesnt change? Gringing the o-erall 9rice le-el to V:Ks days /ould ha-e no effect on the o-erall 9urchasing 9o/er because doing so /ould reduce incomes e8actly as much as it reduced 9rices con-ersely a rise in 9rices in 1*'%s didnt make America 9oorer because it raised incomes the same amount the real income the income di-ided by the 9rice le-el -- hasnt been affected by the rise in o-erall 9rices SM the le-el of 9rice doesnt matter? 3+:JA43M+ 6A4E MA44E6SN Qistinguish bet/een le-el of 9rices and the inflation rate? 4he inflation rate is the 9ercent increase in the o-erall le-el of 9rices 9er year? ; calculated by 3nflation rate F 9rice le-el in year " - 9rice le-el in year 1 < Price le-el in year 1 C 1%% H

;in the figure in the book you see the 9ast $% years 9rice le-els ha-e gone u9 but inflation rate .the rate at /hich consumer 9rices are rising0 has had both u9s and do/ns .generally do/n/ard0 Economist belie-e that high rates of inflation im9ose significant economic costs? the most im9ortant are shoe-leather costs! menu costs! and unit-of-account costs 8hoe-leather costs in inflation rate discourages 9eo9le form holding money! because the 9urchasing 9o/er of the cash in your /allet and the finds in your bank account steadily erodes as the o-erall le-el of 9rices rises leads to 9eo9le to search for /ays to reduce the amount of money they hold the German hy9erinflation of 1*"1-1*"# merchants e-en hired runner to take cash to banks many times a day to e8change the currency @uickly for something that can hold -alue .foreign currency0 in an effort to a-oid ha-ing the 9urchasing 9o/er of their money eroded 9eo9le used u9 -aluable recourses .runner /< time and labor0 that could ha-e been used 9roducti-ely else/here

PAGE # #1

the increased cost of transactions by inflation are kno/n as shoe-leather costs! an allusion to the /ear and tear caused by the e8tra running around /hen 9eo9le are trying to a-oid holding money are substantial in economies /ith -ery high inflation rates most estimates suggest that the shoe-leather cost of inflation at the rates seen in the >?S /hich in 9eacetime has ne-er had inflation abo-e 1&H .@uite small0 Menu $ostB changing a listed 9rice has a real cost called menu cost in the face of inflation firms are forced to change the 9rices more often than they /ould if the 9rice le-el /as more or less stable means higher costs for the economy as a /hole in times of high inflation menu costs are substantial /hen inflation rate is high merchants may decide to sto9 listing 9rices in terms of the local currency and use either an artificial unit in effect measuring 9rices relati-e to another or a more stable currency .like >S dollar0 ;menu costs are also 9resent in lo/-inflation economies .but not as se-ere0 in lo/ inflation economies businesses might u9date their 9rices more s9oradically .not daily<fre@uently as in highinflation<hy9erinflation0 /< technological ad-ances menu costs are less and less im9ortant since 9rices cane be changed electronically and fe/er merchants attach 9rice stickers to merchandise 9nit-:"-*ccount $osts ;/e state contracts in monetary terms .renter o/ners a certain dollars 9er month< a com9any issues a bond 9romise to 9ay the bondholder the dollar -alue of the bond /hen it comes due0 ;this role of the dollar as a basis for contracts and calculation is called the unit-of account role of money im9ortant as9ect of modern economy yet its a role that can be degraded by inflation /hich causes the 9urchasing 9o/er of a dollar to change o-er time a dollar ne8t year is /orth less than a dollar from this year ;the effect many economist argue is to reduce the @uality of the economic decisions the economy as a /hole makes less efficient use of its resources because of the uncertainty caused by changes in the united of account the dollar ;>nit-of-account costs of inflation are the costs arising from the /ay inflation makes money a less reliable unit of measurement this is es9ecially im9ortant in the ta8 system because inflation can distort the measures of income on /hich ta8es are collected 1%H inflation each year? ,om9any buys land for T1%%!%% sells for T11%!%%% ne8t year no real gain but a 9hantom gain of T1%!%%% /hich the >S ta8 la/s /ould state as a ca9ital gain and the com9any /ould ha-e to 9ay ta8es for that big 9roblem in the 1*(%s high inflation im9oses o-erall costs on the economy inflation can 9roduce /inners and losers /ithin the economy ;inflations hel9s some and hurts others in economic transactions! such as loans! often in-ol-e contracts that e8tend o-er a 9eriod of time and these contracts are normally s9ecified in nominal .dollar0 terms in case of a loan the borro/er recei-es a certain among of funds at the beginning and the loan contract s9ecifies ho/ much he or she must re9ay at some future date /hat dollar re9ayment is /orth in real terms .in terms of 9urchasing 9o/er0 de9ends greatly on the rate of inflation o-er the inter-ening years of the loan

PAGE # #"

;interest rate on a loan is the 9ercentage of the loan amount that the borro/er must 9ay the lender .ty9ically on annual basis0 in addition to re9ayment of the loan amount itself ;economist summari=e the effect of inflation on borro/ers and lenders by distinguishing bet/een nominal interest rates and real interest rates? ;the nominal interest rate is the interest rate that is actually 9ain for a loan! unadEusted for the effects of inflation .banks<student loans0 ;the real interest rate is the nominal interest rate adEusted for inflation adEustment is achie-ed sim9ly by subtracting the inflation rate from the nominal interest rate /hen borro/er and lender enter into a loan contract the contract normally s9ecifies a nominal interest rate but each 9arty has the e89ectation about the future rate of inflation and therefore an e89ectation about the real interest rate on the loan if the actual inflation rate is higher than e89ected borro/ers gain at the e89ense of the lender borro/s /ill re9ay their loans /ith funds that ha-e a lo/er real -alue than had been e89ected they can 9urchase fe/er goods and ser-ices due to the sur9rising high inflation rate and con-ersely a lo/er inflation rate /ould be beneficial to the lender and borro/ers must re9ay their lenders /ith a higher real -alue than had been e89ected in modern America home mortgages are the most im9ortant source of gains and losses for inflation because of gains for some and losses for others result from the inflation being either higher or lo/ers cause an uncertainty about the future of inflation rate and this discourages 9eo9le from entering into any form of long term contract this is an additional cost of high inflation because high rates of inflation are usually un9redictable countries /ith high and uncertain inflation! long-term loans are rate .makes it difficult for 9eo9le to make long-term in-estments0 note deflation .o-erall dro9 in 9rice le-el 9roduces /inners and losers also0 3nflation is Easy! Qisinflation 3s 1ard 9olicy makes generally mo-e forcefully to bring inflation back do/n because e89eriences sho/s that bringing the inflation rate do/n a 9rocess called disinflation is -ery difficult and costly once a higher rate of inflation has become /ell established in the economy during 1*() - 1*)) the decade began /ith high inflation rate but by the end inflation /as about $H a maEor economic achie-ement but it came at a high cost much of the fall of inflation resulted from the -ery se-ere recession of 1*)1 - 1*)" /hich dro-e unem9loyment to 1%?)H highest le-el since the great de9ression economist belie-e that this 9eriod of high unem9loyment /as necessary because they belie-e that the only /ay to reduce inflation that has become dee9ly embedded in the economy is through 9olicies that tem9orarily de9ress the economy the best /ay to a-oid to ha-ing to 9ut the economy through a /ringer is to reduce inflation ho/e-er is to a-oid ha-ing serious inflation from the first 9lace 9olicy makers res9ond forcefully to signs that inflation may be accelerating as a form of 9re-enti-e medicine for the economy

PAGE # ##

Module 14 ("irst two pages)

aggregate price level re9resents the o-erall le-el of 9rices /e summari=e the 9rices of the huge -ariety of goods and ser-ices by the use of a 9rice inde8 ;to measure a-erage 9rice changes for consumer goods and ser-ices! economists track changes in the cost of a ty9ical consumers consum9tion bundle the ty9ical basket of goods an ser-ices 9urchased before the 9rices change a hy9othetical consum9tion bundle! used to measure changes in the o-erall 9rice le-el is kno/n as a market %asket 2orking /ith market baskets and a base year! /e obtain /hat is kno/n as a price inde)! a measure of the o-erall 9rice le-el? 3t is al/ays cited along /ith the year for /hich the aggregate 9rice le-el is being measured and the base year Price inde8 in a gi-en year F ,ost of market basket in a gi-en year<,ost of market basket in base year O 1%% ;9rice inde8es are also the basis for measuring inflation 9rice le-el mentioned in the inflation ate formula is sim9ly a 9rice inde8 -alue and the inflation rate is determined as the annual 9ercentage change in an official 9rice inde8 the inflation rate from year 1 t% year " is calculated by this .consider year 1 and " are consecuti-e years0 3nflation rate F Price inde8 in year " - Price 3nde8 in year 1 < Price inde8 in year 1 F 1%% the Ainflation rateB is referring to the annual 9ercent change in the consumer 9rice inde8 the consumer 9rice inde8 .,P30 measures the cost of the market basket of a ty9ical urban American family the 9roducer 9rice inde8! PP3 measures changes in the 9rice of goods and ser-ices 9urchased by 9roducers GQP deflator for a gi-en year is 1%% times the ratio of nominal GQP to real GQP

Module 1/
book uses the story of :t?Myers initial rise<fall in s9ending leads to changes in income lead to further changes in s9ending and so on

PAGE # #$

; lets e8amine chain reaction /e need .$0 sim9lifying assum9tions 10 *ssume producers are willing to supply additional output at a "i)ed price .so T1 billion on in-estment goods by firms T1 billion /orth of additional goods<ser-ices /ithout dri-ing u9 o-erall 9rice0 SM changes in o-erall s9ending translates into changes in aggregate out9ut .measured by real GQP0 .idea is ok in short run not long run0 "0 2e take interest rates as given #0 *ssume there is no government spending and no ta)es $0 assume that e)ports and imports are 3ero hy9othetical situation /hen there is a change in in-estment s9ending home builders s9ent e8tra T1%% billion on home construction ;direct effect of increase in-estment s9ending /ill be to increase income and the -alue of aggregate out9ut by the same amount T s9ent on house construction translates into T for income<su99lies if 9rocess sto99ed there the increase in in-estment s9ending /ould raise o-erall income by e8actly T1%% billion .doesnt sto9 here0 increase in aggregate out9ut leads to increase in dis9osable income that flo/s to households in the form of 9rofits</ages increase in households dis9osable income leads to a rise in consumer s9ending induces firm to increase out9ut again another rise in dis9osable income another rise in consuming s9ending .multi9le rounds of increase aggregate out9ut0 see the total effect on aggregate out9ut if /e sum the effect from all these rounds of s9ending increases /e need to kno/ marginal 9ro9ensity to consume .MP,0 /hich is the increase in consumer s9ending /hen dis9osable income rises by T1 /hen consumer s9ending changes /< rise<fall of dis9osable income MP, is the change in consumer s9ending di-ided by change in dis9osable income MP, F \ ,onsumer S9ending < \ Qis9osable income .\ F change in0 .so if consumer s9ending goes by u9 T' billion and dis9osable income by T1% billion MP, is %?'0 consumers s9end 9art not all of an additional dollar of dis9osable income MP, is bet/een % and 1 additional income that consumers dont s9end is sa-edD the marginal 9ro9ensity to sa-e MPS fraction of an addition dollar of dis9osable income that is sa-ed .MPS is the increase in household sa-ings /hen dis9osable income rises by T10 MPS F 1 - MP, 2< assum9tion of no ta8es and no international trade each T1 increases in s9ending raises both real GQP and dis9osable income T1%% billion increase in in-estment s9ending raises real GQP by T1%% billion .in dis9osable income0 T1%% billion more in dis9osable income leads to a second round increase of real GQP by further .continues on0 MP, O T1%% billion ."nd round0 follo/ed by third round increase in consumer s9ending MP, O MP, O T1%% billion and so on

PAGE # #&

So total increase in real GQP .infinite rounds0 F .1 7 MP, 7 MP,]" 7 MP,]# 7 Y0 O T1%% billion so C1'' %illion sets a chain reaction and net result o" this chain is C1'' %illion increase in investment spending leads to a change in real <,! that is a multiple o" the si3e o" that initial change in spending math comes in to e89lain /hat the multi9le is Sum of infinite series in form 1 7 O]" 7 O]#?? 2here 8 is bet/een % and 1 F 1<.1-O0

8o total increase in real <,! "rom C1'' %illion rise in +B 1/(1-M!$) = C1'' %illion
E-en though there can be an endless # of rounds of e89ansions of real GQP total rise is limited to the # gained from using the e@uation abo-e because at each stage some of the rise in dis9osable income Aleaks outB because it is sa-ed lea-ing less and less to be s9ent in the ne8t round ho/ much an additional dollar of dis9osable income is sa-ed de9ends on MPS distinguish bet/een the initial change in aggregate s9ending before real GQP rises and the additional change in aggregate s9ending caused by the change in real GQP as the reaction unfolds .housing boom 9eo9le feel richer and s9end more this /ill lead to an initial rise in consumer s9ending before real GQP rises also lead to "nd and later rounds of higher consumer s9ending as real GQP and dis9osable income rise0 An autonomous change in aggregate s9ending is an initial rise<fall in aggregate s9ending that is the cause of a series of income<s9ending changes 4he multiplier is the ratio of the total change in real GQP caused by an autonomous change in aggregate s9ending to the si=e of that autonomous change? Jet \AAS stand for autonomous change in aggregate s9ending and \I stand for total change in

real GQP then multiplier D E>/E**8

.assuming no ta8es<trade0 total change in real GQP caused by an autonomous change in aggregate s9ending is E> D 1/(1-M!$) = E**8

Multiplier D E>/E**8 D 1/(1-M!$)

si=e of multi9lier de9ends on MP, if MP, is high so is multi9lier 1igher MP, the less dis9osable income Aleaks outB into sa-ings consumes debate ho/ much to s9end in total consume s9ending normally accounts for "<# of total s9ending on final goods<ser-ices most im9ortant factor affecting a familys consumer s9ending is its current dis9osable income .after ta8es are 9aid<go-ernment transfers recei-ed0 .9eo9le /< higher dis9osable income ob-iously s9end more<ha-e higher consumer s9ending than those /< lo/er dis9osable income0 bureau of Jabor statistics .GJS0 collect annual data on income<s9ending /hat GJS calls after-ta8 income F current dis9osable income .they include transfers from go-ernment also0

PAGE # #'

4he consumption "actor is an e@uation sho/ing ho/ an indi-idual households consumer s9ending -aries /< households current dis9osable income sim9lest -ersion of it as a linear function

c F a 7 MP, O yd
Jo/ercase letters F -ariable measured for indi-idual household c F indi-idual household consumer s9ending yd F indi-idual household current dis9osable income a F constant term indi-idual household autonomous consumer s9ending is the amount o" money a household would spend i" it had no disposa%le income ;assume a ; % because able to fund some consum9tion by borro/ing<using sa-ings note y is for income remember that MP, is the ratio of a change in consumer s9ending to the change in current dis9osable income? >sing ne/ -ariables M!$ D Ec/Eyd Multi9ly both sides by \yd MP, O \yd F \c ;this sho/s that /hen yd goes u9 by T1! c goes u9 by MP, O T1

Gra9h of consum9tion function .c F a 7 MP, O yd0 yd on hori=ontal a8is and c on the -ertical ;indi-idual household autonomous consumer s9ending a! is the -alue of , /hen yd is % .-ertical interce9t of consum9tion function cf0 ;M!$ is slope o" line .remember MP, F \c<\yd0 4he aggregate consumption "unction is the relationshi9 for the economy as a /hole bet/een aggregate current dis9osable income and aggregate consumer s9ending .macroeconomics0 , F A 7 MP, O IQ , F aggregate consumer s9ending IQ F aggregate current dis9osable income A F aggregate autonomous consumer s9ending .amount of consume s9ending then IQ F %0

PAGE # #(

6elationshi9 re9resented by ,F analogous to cf

aggregate consum9tion function sho/s relationshi9 bet/een dis9osable income and consume s9ending for economy as a /hile .all things being e@ual0 but it can shift /hen things other than dis9osable income changes t/o 9rinci9al causes of shifts of the aggregate consum9tion function .10 changes in e)pected "uture disposa%le income and ."0 changes in aggregate wealth $hanges in e)pected "uture disposa%le incomeB Su99ose you get a good Eob but the Eob<9aychecks /ont start for se-eral months but its likely you /ill start s9ending more on final goods<ser-ices right a/ay .Kno/ing higher income is coming0 su99ose you ha-e a good Eob but com9any is firing! kno/ing you might lose your Eob and ha-e to take a lo/er 9ay some/here else e-en though your dis9osable income hasnt gone do/n yet you might as /ell cut back on s9ending e-en /hile still em9loyed .to sa-e for later0 4he abo-e gra9hs sho/ ho/ changes in e89ected future dis9osable income can affect consumer s9ending sho/ ho/ changes in e)pected "uture disposa%le income a""ect the aggregate consumption "actor ,:1 is initial aggregate consum9tion factor 9anel .a0 sho/s higher e89ect dis9osable income /hich increases A .aggregate autonomous consumer s9ending0 from A1 to A" this shifts aggregate consum9tion factor from ,:1 to ,:" 9anel ."0 sho/s the o99osite /hen future dis9osable income dro9s consumers /ill no/ s9end less at any gi-en le-el of current dis9osable income .IQ0 corres9onding to a fall in A from A1 to A" effect is to shift the aggregate consum9tion factor do/n form ,:1 to ,:" based on A Theory of the Consumption Factor Milton :reidman sho/ed that e89ected future income had other effects 9eo9le /ith high current income sa-e a larger fraction of their income than those /< lo/ current income does not a99ly to the o-erall sa-ings rate .H the countrys dis9osable income is sa-ed0 difference bet/een current<e89ected income that creates a 9ositi-e relationshi9 bet/een current<e89ected bet/een current and e89ected sa-ings rate .many -ariables in-ol-ed many 9eo9le /< lo/ income are ha-ing a bad year but /ill find Eobs e-entually? Some e89ect future incomes that are higher so their sa-ings are lo/<negati-e? Some 9eo9le /<

PAGE # #)

high current incomes are doing good but if they e89ect lo/er incomes they might sa-e more0 2hen economy gro/s by contrast current<e89ected future income rise together higher current income tends to lead to higher sa-ings today but higher e89ected future income lead to lo/er sa-ings today so theres a /eak relationshi9 bet/een current income and the sa-ings rate $hanges in *ggregate 2ealth 2ealth has an effect on consumer s9ending effect of /ealth on s9ending is em9hasi=ed by an a model of ho/ consumers make choices about s9ending -erse sa-ing called li"e-cycle hypothesis according to this consumers 9lan their s9ending o-er their lifetime .not Eust to current dis9osable income0 9eo9le try to smooth consum9tion o-er their lifetime .sa-e some of their current dis9osable income during their years of 9eak earnings K$%s - &%sL and during retirement li-e off the /ealth they ha-e accumulated /hile /orking it im9lies the role of /ealth in consumer s9ending .middle age cou9le /ho ha-e accumulated a lot of /ealth K9aid of debtsL /ill s9end more on goods and ser-ices than a cou9le /ith same current dis9osable income but still need to sa-e for their retirement0 since /ealth affects household consumer s9ending changes in wealth across the economy can shi"t the aggregate consumption "unction a rise in aggregate /ealth increases the -ertical interce9t A .aggregate autonomous consumer s9ending0 this shifts the aggregate consum9tion function u9 in the same /ay as does an e89ected increase in future dis9osable income .decline in aggregate /ealth reduces A and shifts the aggregate consum9tion function do/n0 +nvestment spending e-en though consumer s9ending ; than in-estment s9ending boom<bust in in-estment s9ending dri-e business cycle .most recessions originate as a fall in in-estment s9ending0 s/ings in in-estment s9ending are much more dramatic than those in consumer s9ending due to multi9lier 9rocess decline in consumer s9ending is usually a result of a 9rocess that begins /< a slum9 in in-estment s9ending /e need to look at factors that determine in-estment s9ending !lanned investment spending is the in-estment s9ending that businesses intend to undertake during a gi-en 9eriod the le-el of in-estment s9ending businesses actually carry out is sometimes not the same le-el as /as 9lanned 9lanned in-estment s9ending de9ends on .#0 9rinci9al factors (1)interest rateF (2) the e)pected "uture level o" real <,!F and (.) the current level o" production capacity +nterest rates e""ect %usiness ;like house construction they /ill build more homes /hen interest rates are lo/ so more 9eo9le /ould buy homes .more likely to sell0 firms /ith in-estment s9ending 9roEects /ill go ahead /ith a 9roEect if they e89ect a rate of return that is higher than the cost of the funds they /ould ha-e to borro/ if interest rises fe/er 9roEects /ill 9ass and as a result in-estment s9ending /ill be lo/er ;9ast 9rofits used to finance in-estment s9ending are called retained earnings e-en if a firm 9ays for in-estment s9ending out of retained earnings the trade-off it must make is deciding /hether or not to fund a 9roEect remains the same because it needs to take into account o99ortunity cost for its funds .so trade-off firms face /hen com9aring a 9roEects rate of return to the market has not changes using retained or borro/ed funds0 a fall in interest rates makes some in-estment 9roEects that /ere un9rofitable!

PAGE # #*

9rofitable at the ne/ lo/er interest rates ;so 9lanned in-estment s9ending s9ending on in-estment 9roEects that firms -oluntarily decide /hether to or not to undertake is negati-ely related to interest rate .higher interest rate leads to a lo/er le-el of 9lanned in-estment0 E)pected "uture real <,!F production capacityF and investment spending if firm doesnt e89ect sales to gro/ into the future and has enough ca9acity to continue to 9roduce the amount is currently selling it /ill engage in in-estment s9ending only to re9lace e8isting e@ui9ment<structures that /ear out<are obsolete by ne/ technology if firm e89ects sales to gro/ in future it /ill find its e8isting 9roduction ca9acity insufficient and /ill undertake in-estment s9ending to meet those needs ;firms /ill undertake more in-estment s9ending /hen they e89ect sales to gro/ is firm has considerably more ca9acity than necessary to meet current 9roduction needs .e-en if it e89ects sales to gro/ it doesnt ha-e to undertake in-estment s9ending until the gro/th rate catches u9 /< the e8cess ca9acity sho/s that current le-el of 9roducti-e ca9acity has a negati-e effect on in-estment s9ending .the higher the current ca9acity the lo/er the in-estment s9ending0 9utting together effects on in-estment s9ending .10 gro/th in e89ected future sales ."0 the si=e of the current 9roduction ca9acity /e can see one situation in /hich firms /ill undertake high le-els of in-estment s9ending /hen they e89ect sales to gro/ ra9idly so e-en e8cess 9roduction ca9acity /ill be used u9 leadings firms to resume in-estment s9ending indictor of high e89ected gro/th in future sales is a high e89ected gro/th rate of real GQP this results in a higher le-el of in-estment s9ending .con-ersely lo/er rate of e89ected future gro/th rate of real GQP leads to lo/er 9lanned in-estment s9ending0 +nventories and 9nplanned investment spending firms maintain inventories stocks of goods held to satisfy future sales firms hold in-entory so they can @uickly satisfy buyers a consumer can 9urchase an item off the shelf rather than /ait business often hold in-entories of their in9uts to ha-e a steady su99ly of necessary materials<s9are 9arts a firm that increases its in-entories is engaging in a form of in-estment s9ending .firm makes )%%k cars! sells (%%k! 1%%k becomes in-entory to be sold in the future0 +nventory investment is the -alue of the change in total in-entories in the economy during a gi-en 9eriod unlike other forms of in-estment s9ending! in-entory in-estment can be negati-e be careful /< in-entories .like manager at su9ermarket kee9 store fully stocked so sho99ers can find /hat theyre looking for but not too hea-ily stocked so shelf s9ace is limited and 9roducts s9oil0 a99lies to firms but sales fluctuate and firms cannot accurately 9roduct sales .so they hold smaller<larger in-entories than intended0 2hen firms in-entories are higher than intended due to unforeseen decrease in sales the result is un9lanned in-entory in-estment an une89ected increase in sales de9letes in-entories and causes the un9lanned in-entory in-estment to be negati-e so at any gi-en 9eriod actual in-estment s9ending is F to 9lanned in-estment s9ending 9lus un9lanned in-estment s9ending +unplanned D unplanned investment spending +planned D planned investment spending + D actual investment spending

PAGE # $%

1henB + D +unplanned G +planned rising in-entories indicate 9ositi-e un9lanned in-entory in-estments and a slo/ing economy as sales are less than been forecast falling in-entories indicate negati-e un9lanned in-entory in-estment and a gro/ing economy as sales are greater than forecast

Module 1A
great de9ression caused by massive negative demand shock ;negati-e demand shock to the economy is a left/ard shift of the aggregate demand cur-e .a cur-e /hich sho/s the relationshi9 bet/een the aggregate 9rice le-el and the @uantity of aggregate out9ut demanded by households! firms! the go-ernment! and the rest of the /orld0

this sho/s /hat might ha-e been the aggregate demand cur-e in 1*## at the end of the 1*"*-1*## recession hori=ontal a8is sho/s the total @uantity of domestic good<ser-ices demanded .measured in "%%& dollars0 /e use real GQP to measure aggregate out9ut .terms use interchangeably0 Rertical a8is sho/s aggregate 9rice le-el .measured by the GQP deflator for a gi-en year is F to 1%%8 the ratio of nominal GQP for that year to real GQP for that year e89ressed in terms of a selected base year0 /< -ariables /e can dra/ cur-e AQ to sho/ ho/ much aggregate out9ut /ould ha-e been demanded in 1**# .one 9oint of the cur-e F actual data for 1*##0 /hen aggregate 9rice le-el /as (?* total @uantity of domestic goods<ser-ices 9roduced /as T(1' billion in "%%& dollars

PAGE # $1

aggregate demand cur-e is do/n/ard slo9ing sho/ing a negati-e relationshi9 bet/een aggregate 9rice le-el and the @uantity of aggregate out9ut demanded higher aggregate 9rice le-el reduces the @uantity of aggregate out9ut demanded lo/er aggregate 9rice le-el increases the @uantity of aggregate out9ut demanded 2hy is *ggregate demand curve downward sloping@ 6ecall the basic e@uation of national income accounting GQP F , 7 3 7 G 7 O - 3M , F consumer s9ending 3 F in-estment s9ending G F go-ernment 9urchases of goods<ser-ices O F e89orts 3 F im9orts if /e measure these -ariables in constant dollars .9rices of a base year0 then the e@uation re9resents the @uantity of domestically 9roduced final goods<ser-ices demanded during a gi-en 9eriod ;G is decided by go-ernment but the other -ariables are 9ri-ate sector to kno/ rise the line slo9es do/n /e need to get /hy rise in aggregate price level reduces $F+F and =-+M it is +M4 46>E that because the demand cur-e for any one good is do/n/ard slo9ing the demand cur-e for aggregate out9ut is also do/n/ard slo9ing demand cur-e for any indi-idual good sho/s ho/ the @uantity demanded de9ends on the 9rice of that good! holding the 9rices of other goods and ser-ices constant? main reason @uantity of a good demanded falls /hen the 9rice of that good rises .or the @uantity of a good demanded falls as /e mo-e u9 the demand cur-e0 is that 9eo9le s/itch their consum9tion to other goods that ha-e become relati-ely less e89ensi-e but /hen /e consider mo-ements u9<do/n a demand cur-e /ere considering a simultaneous change in the 9rices of all final goods and ser-ices AJSM changes in the com9osition of goods<ser-ices in consumer s9ending arent rele-ant to the aggregate demand cur-e if consumers decide to buy fe/er clothes but more cars this doesnt change the total @uantity of final goods<ser-ices they demand 4/o main reasons /hy rise in aggregate 9rice le-el lead to a fall in the @uantity of all domestically 9roduced final goods<ser-ices demanded .10 2ealth e""ect ."0 +nterest rate e""ect o" a change in the aggregate price level 1he 2ealth E""ect an increases in the aggregate price level reduces the purchasing power o" many assets ;if 9erson had T&!%%% in bank and aggregate 9rice le-el rose by "&H the T&!%%% /ould buy as much as T$?%%% as before /< loss of 9urchasing 9o/er the o/ner /ould scale back consum9tion 9lans a lot of 9eo9le /ould res9ond the same /ay leading to a fall in s9ending on final goods<ser-ices because a rise in the aggregate 9rice le-el reduces the 9urchasing 9o/er of e-eryones bank account a fall in aggregate 9rice le-el increases the 9o/er of consumers assets and leads to more consumer demand the /ealth effect of a change in the aggregate 9rice le-el is the change in consumer s9ending caused by the altered 9urchasing 9o/er of consumers assets %ecause o" wealth e""ect consumer spending $ "alls w/ aggregate price level rise .leading to do/n/ard slo9ing aggregate demand cur-e0 +nterest 7ate E""ect money refers to cash and bank de9osits on /hich 9eo9le can /rite checks 9eo9le hold money because

PAGE # $"

it reduces cost<incon-enience of making transactions an increase in aggregate 9rice le-el reduces the 9urchasing 9o/er of a gi-en amount of money holdings so in res9onse to increase in aggregate 9rice le-el 9ublic tires to increase money holdings by either by borro/ing more or by selling assets like bonds this reduces the funds a-ailable for lending to other borro/ers and dri-es interest rates u9 this rise reduces in-estment s9ending because it makes the cost of borro/ing higher also reduces consumer s9ending because households sa-e more of their dis9osable income so a rise in aggregate price level depressed investment spending +F and consumer spending $ through e""ect on the purchasing power on money holdings kno/n as the interest rate effect of a change in the aggregate 9rice le-el also leads to a do/n/ard slo9ing aggregate demand cur-e 8hi"ts o" the aggregate demand curve in the analysis of su99ly<demand in the market for an indi-idual good the distinction bet/een mo-ements along the demand cur-e and shifts of the demand cur-e is stressed same distinction a99lies to the aggregate demand cur-e figure 1(?1 from a cou9le 9ages ago sho/s a mo-ement along the aggregate demand cur-e a change in the aggregate @uantity of goods<ser-ices demanded as the aggregate 9rice le-el changes ;can be shifts of the aggregate demand cur-e also changes in the @uantity of goods<ser-ices demanded at any gi-en 9rice .as sho/n in 1(?" ne8t 9age0 an increase in aggregate demand means a S13:4 of the aggregate demand cur-e to the right .sho/n in 1(?"a0 from AQ1 to AQ" right/ard shift occurs /hen the @uantity of aggregate out9ut demanded increases at any gi-en aggregate 9rice le-el a decrease in aggregate demand means AQ cur-e shifts to the left .seen in 1(?"b0 this im9lies that the @uantity of aggregate out9ut demanded falls at any gi-en aggregate 9rice le-el? A number of factors can shift aggregate demand cur-e most im9ortant are changes in e)pectationsF changes in wealthF and the si3e o" the e)isting stock o" capital both fiscal<monetary 9olicy can shift the aggregate demand cur-e all & factors set multi9lier 9rocess in motion by causing an initial rise<fall in real GQP they change dis9osable income leading to additional changes in aggregate s9ending ./hich lead to further changes in real GQP0

PAGE # $#

Sums u9 the factors that shift u9 aggregate demand

+ote :iscal 9olicy is the use of ta8es! go-ernment 9urchases of goods and ser-ices to stabili=e the economy Monetary 9olicy is the central banks use of changes in the @uantity of money or the interest rate to stabili=e the economy

Module 18
1*"*-1*## had a shar9 fall is aggregate demand .a reduction in the @uantity of goods and ser-ices demanded at any gi-en 9rice le-el 0 ; a conse@uence in decline in demand is a fall in 9rices of goods<ser-ices ;another conse@uence /as a decline in the out9ut of most goods<ser-ices ;#rd conse@uence .tied to fall in real GQP0 /as rise in unem9loyment rate 9lunge in real GQP and 9rices are related ;1*"*-1*## >S economy /as mo-ing do/n its aggregate supply curve /hich sho/s the relationshi9 bet/een the economys aggregate 9rice le-el .o-erall 9rice le-el of final goods<ser-ices in the economy0 and the total @uantity of final goods and ser-ices .or aggregate out9ut0 9roducers are /illing to su99ly ;1*"* - 1*## >S economy mo-es do/n its short-run aggregate su99ly cur-e 1*"*- 1*## sho/ed .70 relationshi9 in the short run bet/een the aggregate 9rice le-el and the @uantity of aggregate out9ut su99lied .rise in the aggregate 9rice le-el rise in the @uantity of aggregate out9ut su99lied0 fall in aggregate 9rice le-el fall in the @uantity of aggregate out9ut su99lied 2hy is there a .70 relationshi9P Producers consider if 9roducing a unit of out9ut is 9rofitable or not Profit 9er unit of out9ut F Price 9er unit of out9ut - Production cost 9er unit of out9ut

PAGE # $$

So it de9ends on /hether the 9rice the 9roducer recei-es for a unit of out9ut is ; or ^ than the cost of 9roducing that unit of out9ut? costs 9roducers face are fi8ed 9er unit of out9ut and cant be changed for some time largest source of infle8ible 9roduction cost is the /ages 9aid to /orkers? Wages refers to all forms of /orker com9ensation .including em9loyer -9aid health care<retirement benefits /< earnings0 2ages F infle8ible 9roduction cost because the T amount of any gi-en /age 9aid . nominal wage) is determined by contracts that /ere signed a/hile ago .e-en if there are no formal contracts there are informal agreements0 management and /orkers .com9anies also fear /orker resentment /on_t raise during good economic times Kfear them asking for moreL nor cut during bad times0 economy is characteri=ed by sticky wages (nominal /ages that are slo/ to change during either high unem9loyment<labor shortages0 +ominal /ages cannot be sticky fore-er .formal contracts and informal agreements /ill be renegotiated to take into account changed economic circumstances0 ;time it takes for nominal /ages to become fle8ible is the difference bet/een short run from the long run? to understand that nominal terms gi-es rise to an u9/ard -slo9ing short -run aggregate su99ly cur-e ; 9rices are set differently in different kinds of markets you need to kno/ that 9rices ar eset different in different markets perfectly competitive markets, 9roducers take 9rices as gi-enD in imperfectly competitive markets, 9roducers ha-e some ability to choose the 9rices they charge? ;both kinds of markets has short-run 9ositi-e relationshi9 bet/een 9rices and out9ut .different reasons0 beha-ior of 9roducers in per"ectly competitive markets take the 9rice as gi-en? ;imagine if the aggregate 9rice le-el falls 9rice recei-ed by the ty9ical 9roducer of a final good<ser-ice falls? since many 9roduction costs are fi8ed in the short run 9roduction cost 9er unit of out9ut doesnt fall by the same 9ro9ortion as the fall in the 9rice of out9ut? 9rofit 9er unit of out9ut declines! leading 9erfectly com9etiti-e 9roducers to reduce the @uantity su99lied in the short run? if aggregate 9rice le-el rises 9roducer recei-es a higher 9rice for its final good or ser-ice? .note many 9roduction costs are fi8ed in the short run0 9roduction cost 9er unit of out9ut doesnt rise by the same 9ro9ortion as the rise in the 9rice of a unit and since a 9erfectly com9etiti-e 9roducer takes the 9rice as gi-en 9rofit 9er unit of out9ut rises and out9ut increases? im9erfectly com9etiti-e 9roducer that is able to set its o/n 9rice if a rise in the demand for this 9roducers 9roduct! it /ill be able to sell more at any gi-en 9rice .because of stronger demand0! it /ill 9robably choose to increase 9rices<out9ut to increase 9rofit 9er unit of out9ut? -ariations in an industrys A9ricing 9o/erBD demand F strong! firms /< 9ricing 9o/er are able to raise 9rices but if there is a fall in demand firms /ill try to limit the fall in their sales by cutting 9rices? Goth res9onses of firms in 9erfectly<im9erfectly com9etiti-e industries lead to an u9/ard -slo9ing relationshi9 bet/een aggregate out9ut< the aggregate 9rice le-el? ;.70 relationshi9 bet/een the aggregate 9rice le-el and the @uantity of aggregate out9ut 9roducers are /illing to su99ly during the time 9eriod /hen many 9roduction costs be taken as fi8ed is illustrated by the short -run aggregate supply curve

PAGE # $&

4he .70 relationshi9 bet/een the aggregate 9rice le-el and aggregate out9ut in the short run gi-es the short -run aggregate su99ly cur-e its u9/ard slo9e? ; 4he mo-ement do/n the !A " short -run aggregate supply curve ) cur-e corres9onds to the deflation and fall in aggregate out9ut e89erienced o-er those years? 8hi"ts o" the 8hort -7un *ggregate 8upply $urve

there can also be shifts of the short -run aggregate su99ly cur-e .:igure 1)?"0 Panel .a0 a decrease in short #run aggregate supply`a left/ard shift of the short -run aggregate su99ly cur-e? AS decreases /hen 9roducers reduce the @uantity of aggregate out9ut they are /illing to su99ly at any gi-en aggregate 9rice le-el? Panel .b0 sho/s ` an increase in short #run aggregate supply`a right/ard shift of the short -run aggregate su99ly cur-e? Aggregate su99ly increases /hen 9roducers increase the @uantity of aggregate out9ut at any gi-en aggregate 9rice le-el? 2hy can the short -run aggregate su99ly cur-e can shiftP 6ememberN 9roducers make out9ut decisions based on 9rofit 9er unit of out9ut? Short -run aggregate su99ly cur-e sho/s the relationshi9 bet/een the aggregate 9rice le-el and aggregate out9ut some 9roduction costs are fi8ed in the short run so a change in the aggregate 9rice le-el leads to a change in 9roducers 9rofit 9er unit of out9ut thus a change in aggregate out9ut? Gut other factors can affect 9rofit 9er unit and thus aggregate out9ut? 3f something increases 9roduction cost shift the left

PAGE # $'

3f something lo/ers 9roduction costs shift to the right Jist of 9ossible things that causes shift

3m9ortant factors that affect 9roducers 9rofit 9er unit and shifts in the short -run aggregate su99ly cur-e $hanges in $ommodity !rices A commodity, a standardi=ed in9ut bought and sold in bulk @uantities? An increase in the 9rice of a commodity raises 9roduction costs across the economy and reduced the @uantity of aggregate out9ut su99lied at any gi-en aggregate 9rice le-el! shifting the short -run aggregate su99ly cur-e to the left? .a decline in commodity 9rices reduces 9roduction costs! leading to an increase in the @uantity su99lied at any gi-en aggregate 9rice le-el and a right/ard shift of the short -run aggregate su99ly cur-e?0 -; influence of commodity 9rices is not ca9tured by the short -run aggregate su99ly Gecause commodities are not a final good! their 9rices are not included in the calculation of the aggregate 9rice le-el? ;commodities re9resent a significant cost of 9roduction to most su99liers! Eust like nominal /ages do? So changes in commodity 9rices ha-e large im9acts on 9roduction costs? $hanges in &ominal 2ages ;the dollar /ages of many /orkers are fi8ed because they are set by contracts or informal agreements made in the 9ast? +ominal /ages can change /< time? .ie if their is an rise in nominal /ages .because lets say health care 9remiums /ent u90 thus increases 9roduction costs shifts the short -run aggregate su99ly cur-e to the left? ,on-ersely! a fall in nominal /ages .health care 9remiums lo/ers0 from the 9oint of -ie/ of em9loyersD it reduces 9roduction costs and shifts the short -run aggregate su99ly cur-e to the right?0 note in the 1*(%s! the surge in the 9rice of oil had the indirect effect of also raising nominal /ages? --; Aknock -onB effect occurred since many /age contracts included cost #of #living allowances that automatically raised the nominal /age /hen consumer 9rices increased?

PAGE # $(

;surge in the 9rice of oil --; led to an increase in o-erall consumer 9rices --; ultimately caused a rise in nominal /ages? Economy e89erienced t/o left/ard shifts of the aggregate su99ly cur-e first generated by the initial surge in the 9rice of oil the second generated by the induced increase in nominal /ages? $hanges in !roductivity increase in 9roducti-ity --; /orker can 9roduce more units of out9ut /ith the same @uantity of in9uts? ;a rise in 9roducti-ity! increases 9roducers 9rofits and shifts the short -run aggregate su99ly cur-e to the right? .,on-ersely! a fall in 9roducti-ity reduces the number of units of out9ut a /orker can 9roduce /ith the same @uantity of in9uts? so the cost 9er unit of out9ut rises! 9rofit falls! and @uantity su99lied falls? 4his shifts the short -run aggregate su99ly cur-e to the left?0

1he #ong-7un *ggregate 8upply $urve /e_-e seen a fall in the aggregate 9rice le-el leads to a decline in the @uantity of aggregate out9ut su99lied result of nominal /ages that are sticky in the short run? ; +M4EN /ages are negotiated in long run but in long run! nominal /ages .like the aggregate 9rice le-el0 are fle8ible ;2age fle8ibility changes the long -run relationshi9 bet/een the aggregate 9rice le-el and aggregate su99ly in the long run the aggregate 9rice le-el has no effect on the @uantity of aggregate out9ut su99lied? lets say /e cut all prices "of inputs like nominal wage$ in the economy in half at the same time! as /ell as the 9rices of final goods and ser-ices? 3f aggregate 9rice le-el has been hal-ed and all in9ut 9rices! including nominal /ages hal-ed! nothing /ould ha99en to aggregate out9ut ;Gased this on the fact that each 9roducer /ould recei-e a lo/er 9rice for its 9roducts --; but costs /ould fall by the same 9ro9ortion? e-ery unit of out9ut 9rofitable to 9roduce before the change in 9rices /ould still be 9rofitable to 9roduce after the change in 9rices? so hal-ing of all 9rices in the economy has no effect on the economys aggregate out9ut? SM! changes in the aggregate price level now have no e""ect on the -uantity o" aggregate output supplied in the long run, all 9rices are fully fle8ible so note that inflation or deflation has the same effect as someone changing all 9rices by the same 9ro9ortion? changes in the aggregate 9rice le-el do not change the @uantity of aggregate out9ut su99lied in the long run%

PAGE # $)

4he long -run aggregate supply curveF illustrated in :igure 1)?# by the cur-e &!A , sho/s the relationshi9 bet/een the aggregate 9rice le-el and the @uantity of aggregate su99lied out9ut su99lied that /ould e8ist if all 9rices! including nominal /ages! /ere fully fle8ible? 4he long -run aggregate su99ly cur-e is -ertical since changes in the aggregate 9rice le-el ha-e no effect on aggregate out9ut in the long run? not only is the &!A cur-e -ertical but also note its 9osition along the hori=ontal a8is marks an im9ortant benchmark for out9ut? 4he hori=ontal interce9t in :igure 1)?#! /here &!A touches the hori=ontal a8is is the economys potential outputF '() the le-el of real GQP the economy /ould 9roduce if all 9rices .also nominal /ages0 /ere fully fle8ible? in reality actual le-el of real GQP is almost al/ays either abo-e or belo/ 9otential out9ut? ;note that economys 9otential out9ut hel9s defines the trend around /hich actual aggregate out9ut fluctuates from year to year? Gased on :igure 1)?$ see that economy normally 9roduces more or less than 9otential Mut9ut

;,GM estimated annual 9otential out9ut for the 9ur9ose of federal budget analysis sho/ed 1*)*-"%%* by the black line and the actual -alues of >?S? real GQP o-er the same 9eriod are the blue line

PAGE # $*

;years shaded 9ur9le on hori=ontal a8is corres9ond to 9eriods in /hich the actual aggregate out9ut e8ceeded 9otential out9ut >?S 9otential out9ut has risen steadily o-er time is a series of right/ard shifts 2hat causes shi"ts o" the LRAS curve increases in the @uantity of resources! including land! labor! ca9ital! and entre9reneurshi9 increases in the @uality of resources! as /ith a better-educated /orkforce technological 9rogress o-er long run! as the si=e of the labor force and the 9roducti-ity of labor both rise! for e8am9le! the le-el of real GQP that the economy is ca9able of 9roducing also rises? can think of long -run economic gro/th as gro/th in the economys 9otential out9ut? generally think long -run aggregate su99ly cur-e as shifting to the right o-er time as an economy e89eriences long -run gro/th? 5rom the 8hort 7un to the #ong 7un as you can see economy usually 9roduces more or less than 9otential out9ut ;economy is normally on its short -run aggregate su99ly cur-e but not usually on its long -run aggregate su99ly cur-e? understand that the economy is al/ays in one of only t/o states /ith res9ect to the short -run and long -run aggregate su99ly cur-es? ;economy can be on both cur-es simultaneously by being at a 9oint /here the cur-es cross .as in the fe/ years in :igure 1)?$ in /hich actual aggregate out9ut and 9otential out9ut roughly coincided0? ;it can also be on the short -run aggregate su99ly cur-e but not the long -run aggregate su99ly cur-e .as in the years in /hich actual aggregate out9ut and 9otential out9ut did not coincide0? +M4EN 3f the economy is on the short -run but not the long -run aggregate su99ly cur-e! the short -run aggregate su99ly cur-e /ill shift o-er time until the economy is at a 9oint /here both cur-es cross ./here actual aggregate out9ut is F to 9otential out9ut?0

PAGE # &%

Abo-e figure sho/s ho/ this /ork both 9anels &!A is the long -run aggregate su99ly cur-e! !A 1 is the initial short -run aggregate su99ly cur-e! and the aggregate 9rice le-el is at (1? 3n 9anel .a0 the economy starts at the initial 9roduction 9oint .A10 /hich corres9onds to a @uantity of aggregate out9ut su99lied! .'1!0 that is higher than 9otential out9ut! .'(%$ Producing an aggregate out9ut le-el .such as '10 that is higher than 9otential out9ut .'(0 is 9ossible only because nominal /ages ha-ent yet fully adEusted u9/ard? until u9/ard adEustment in nominal /ages occurs! 9roducers are earning high 9rofits and 9roducing a high le-el of out9ut? a le-el of aggregate out9ut higher than 9otential out9ut means a lo/ le-el of unem9loyment? since Eobs are abundant and /orkers are scarce! nominal /ages /ill rise o-er time! gradually shifting the short -run aggregate su99ly cur-e left/ard? E-entually! it /ill be in a ne/ 9osition! such as !A "? 3n 9anel .b0! the initial 9roduction 9oint! A1! corres9onds to an aggregate out9ut le-el! '1! that is lo/er than 9otential out9ut! '(% Producing an aggregate out9ut le-el .such as '10 that is lo/er than 9otential out9ut .'(0 is 9ossible only because nominal /ages ha-ent yet fully adEusted do/n/ard? >ntil this do/n/ard adEustment occurs! 9roducers are earning lo/ .or negati-e0 9rofits and 9roducing a lo/ le-el of out9ut? An aggregate out9ut le-el lo/er than 9otential out9ut means high unem9loyment? Gecause /orkers are abundant and Eobs are scarce! nominal /ages /ill fall o-er time! shifting the short -run aggregate su99ly cur-e gradually to the right? E-entually! it /ill be in a ne/ 9osition! such as !A "?

Module 10
1*"*-1*## >S mo-ed do/n short run aggregate su99ly as aggregate 9rice le-el fell ;caused by a left/ard shift of the aggregate demand cur-e maEor fall in consumer s9ending 1*(*-1*)% >S mo-ed u9 aggregate demand cur-e as aggregate 9rice le-el rose ;caused by left/ard shift of aggregate su99ly cur-e .fall in short run aggregate su99ly0 /e must aggregate su99ly and aggregate demand cur-e together result is *,-*8 model basic model used to understand economic fluctuations

PAGE # &1

Short-run macroeconomic e@uilibrium look on ne8t 9age at AQ-AS model in short run the 9oint in /hich AQ and S6AS cur-es intersect! ES6 is the short-run macroeconomic e-uili%rium 9oint at /hich the @uantity of aggregate out9ut su99lied is F the @uantity demanded by domestic household businesses<go-ernment</orld aggregate 9rice le-el at ES6! !E is the short-run e-uili%rium aggregate price level le-el of aggregate out9ut at ES6! >e is the short-run aggregate output /e kno/ shortage of any indi-idual good causes its market 9rice to rise and a sur9lus of the good causes its market 9rice to fall ensures market reaches e@uilibrium .a99lies to short-run macroeconomic e@uilibrium0 if aggregate 9rice le-el is abo-e e@uilibrium le-el the @uantity of aggregate out9ut su99lied e8ceeds the @uantity of aggregate out9ut demanded ./hich leads to a fall in the aggregate 9rice le-el and 9ushed it to/ards e@uilibrium0 if aggregate 9rice le-el is belo/ its e@uilibrium le-el the @uantity of aggregate out9ut su99lied is less than the @uantity of aggregate out9ut demanded /hich leads to a rise in aggregate 9rice le-el 9ushing it to/ards e@uilibrium

in reality there is a long-term u9/ard trend in both aggregate out9ut and the aggregate 9rice le-el assume that a fall in either -ariable means a fall com9ared to the long-run trend .say if aggregate 9rice le-el normally rises $H a year! a year in /hich aggregate 9rice le-el rises only #H is a 1H decline0 rare for decline many cases in /hich aggregate 9rice le-el fell relati-e to long-run trend ;short-run e@uilibrium aggregate out9ut and short-run e@uilibrium aggregate 9rice le-el can change because of shifts of either the AQ cur-e or the S6AS cur-e 8hi"ts o" the *ggregate demandB 8hort-run E""ects an e-ent that shifts aggregate demand cur-e is kno/n as demand shock .such as changes in e89ectations or /ealth! effect of the si=e of e8isting stock of 9hysical ca9ital! or the use of fiscal<monetary 9olicy0 .great de9ression caused by negati-e demand shock! ended by 9ositi-e demand chock a huge increase in go-ernment 9urchases during 22330 :igure 1*?" sho/s short-run effects of negati-e<9ositi-e demand shock shifts the aggregate demand cur-e AQ to the left K9anel .a0L .from AQ1 to AQ"0 economy mo-es do/n S6AS from E1 to E" leading to lo/er short-run e@uilibrium aggregate out9ut and a lo/er run e@uilibrium aggregate 9rice le-el

PAGE # &"

a 9ositi-e demand shock shift aggregate demand cur-e to the right K9anel .b0L economy mo-es u9 along the S6AS cur-e from E1 to E" leads to a higher short-run e@uilibrium aggregate out9ut and a higher short-run aggregate 9rice le-el demand shocks cause aggregate output and aggregate price level to move in the same direction

Shifts of S6AS cur-e an e-ent that shifts the short-run aggregate su99ly cur-e .changes in commodity 9rices! nominal /ages! or 9roducti-ity0 is kno/n a su99ly shock ;negati-e su99ly shock raises 9roduction costs<reduces the @uantity 9roducers are /illing to su99ly at any gi-en aggregate 9rice le-el .leading to a left/ard shift of the short-run aggregate su99ly cur-e0 a 9ositi-e su99ly shock reduces 9roduction costs and increases the @uantity su99lied at any gi-en aggregate 9rice le-el .leading to a right/ard shift of the short-run aggregate su99ly cur-e0 in figure 1*?# 9anel .a0 you can see effects of negati-e su99ly shock initial e@uilibrium at E1 /< aggregate 9rice le-el P1 and aggregate out9ut I1 some kind of negati-e su99ly shock causes the short-run aggregate su99ly cur-e to shift to the left from S6AS1 to S6AS" aggregate out9ut also falls and the aggregate 9rice le-el rises an u9/ard mo-ement along the AQ cur-e at ne/ e@uilibrium E" the short-run e@uilibrium aggregate 9rice le-el P" is higher and the short- run aggregate out9ut le-el I" is lo/er inflation 7 falling aggregate out9ut in 9anel .a0 F stagflation falling aggregate out9ut leads to rising em9loyment and 9eo9le feel their 9urchasing 9o/er decrease a 9ositi-e su99ly shock in 9anel .b0 has o99osite effect a right/ard shift of the S6AS cur-e from S6AS1 to S6AS" results in a rise in aggregate out9ut and a fall in the aggregate 9rice le-el! a do/n/ard mo-ement along the AQ cur-e aggregate 9rice le-el fell com9ared /< long-run trend negati-e and 9ositi-e su99ly shock .unlike demand shock0 cause aggregate 9rice le-el and aggregate out9ut to mo-e in o99osite directions

PAGE # &#

;able to shift AQ cur-e -ia monetary<fiscal 9olicy much harder for go-ernment to shift AS cur-e

Jong-6un Macroeconomic E@uilibrium 1*?$ sho/s aggregate demand cur-e for both short-run and long-run aggregate su99ly cur-e aggregate demand cur-e! AQ crosses the short-run aggregate su99ly cur-e S6AS at EJ6 ;/e assume enough time as ela9se that the economy is also on the long-run aggregate su99ly cur-e J6AS so EJ6 is at the intersection of all three cur-es S6AS! J6AS! and AQ ;so short-run e@uilibrium aggregate out9ut F 9otential out9ut ;4he economy is in long-run macroeconomic e@uilibrium /hen the 9oint of short-run macroeconomic e@uilibrium is on the long-run aggregate su99ly one

----

PAGE # &$

to see im9ortance of long-run macroeconomic e@uilibrium consider /hat ha99ens /< demand shock mo-es the economy a/ay from long-run macroeconomic e@uilibrium ;figure 1*?& assume that initial aggregate demand cur-e is AQ1 and initial short-run aggregate su99ly cur-e is S6AS1 so initial macroeconomic e@uilibrium is at E1 /hich lies on the long-run aggregate su99ly cur-e J6AS the economy starts from a 9oint of short-run and long-run macroeconomic e@uilibrium! and short-run e@uilibrium aggregate out9ut F 9otential out9ut I1 su99ose is aggregate demand falls and the aggregate demand cur-e shifts left/ards to AQ" results in a lo/er e@uilibrium aggregate 9rice le-el at P" and a lo/er e@uilibrium out9ut le-el at I" as economy settles in short run at E" >?S economy 1*"*-1*## the short-run effect of such a fall in aggregate demand is a falling aggregate 9rice le-el and falling aggregate out9ut ;aggregate out9ut in this ne/ short-run e@uilibrium E" is belo/ 9otential out9ut /hen this ha99ens economy faces a recessionary ga9 comes /< high unem9loyment in face of high unem9loyment! nominal /ages fall .as do any stick 9rices0 leading 9roducers to increase out9ut as a result recessionary ga9 causes short-run aggregate su99ly cur-e to shift to the right 9rocess continues until S6AS1 reaches ne/ 9osition at S6AS" bringing economy to e@uilibrium E# /hen AQ"! S6AS"! and J6AS all intersect ;at E# economy is back in long-run macroeconomic e@uilibrium it is back at 9otential I1 but at a lo/er aggregate 9rice le-el P# sho/ing a long-run fall in aggregate 9rice le-el ;economy is self-correcting in the long run

PAGE # &&

imagine increase in aggregate demand in 1*?' /e assume that initial aggregate demand cur-e is AQ1 and initial short-run aggregate su99ly cur-e is S6AS1 so that initial macroeconomic e@uilibrium at E1 lies on the long-run aggregate su99ly cur-e J6AS initially economy is in long-run macroeconomic e@uilibrium su99ose aggregate demand rises AQ cur-e shift right/ard to AQ" thus higher 9rice le-el P" and a higher aggregate out9ut le-el at I" economy settles in the short run at E" ;aggregate out9ut in this ne/ short-run e@uilibrium is abo-e 9otential out9ut and unem9loyment is lo/ in order to 9roduce this higher le-el of aggregate out9ut economy is e89eriencing an inflationary ga9 ;in the fact of lo/ unem9loyment! nominal /ages /ill rise and .as /ill other sticky 9rices0 causes the short-run aggregate su99ly cur-e to shift gradually to the left as 9roducers reduce out9ut in face of rising nominal /age continues until S6AS reaches ne/ 9osition at S6AS" bringing economy into e@uilibrium E# /here AQ"! S6AS"! and J6AS all intersect at E# economy is back in long-run macroeconomic e@uilibrium<back at 9otential out9ut but at higher 9rice le-el P# reflecting a long-run rise in aggregate 9rice le-el .economy is again self-correcting0 to summari=e ho/ economy res9onds to recessionary<inflationary ga9 /e focus on the out9ut ga9 H difference bet/een actual aggregate out9ut and 9otential out9ut Mut9ut ga9 F Actual aggregate out9ut - Potential Mut9ut our analysis sho/s that out9ut ga9 tends to/ard =ero if there is a recessionary ga9! so out9ut ga9 is negati-e! nominal /ages e-entually fall mo-ing economy back to 9otential out9ut and bringing the out9ut ga9 back to =ero if there is an inflationary ga9! so out9ut ga9 is 9ositi-e! nominal /ages rise mo-ing economy back to 9otential out9ut and again bringing the out9ut ga9 back to =ero SM in long run economy is self-correcting shocks to aggregate demand affect aggregate out9ut in the < Potential out9ut O 1%%

PAGE # &'

S1M64 6>+ but +M4 41E JM+G 6>+N

Module 2'
/e-e seen economy is self-correcting in long-run /ill e-entually trend back to 9otential out9ut but most macroeconomist belie-e this takes a long time ;if aggregate out9ut is belo/ 9otential out9ut! the economy can suffer an e8tended 9eriod of de9ressed aggregate out9ut and high unem9loyment before it returns to normal foundation is based on Vohn Maynard Keynes recommend that go-ernments not /ait for economy to correct itself and go-ernment should use fiscal 9olicy to get the economy back to 9otential out9ut in the aftermath of a shift in aggregate demand cur-e rationale for acti-e stabili=ation 9olicy /hich is the use of go-ernment 9olicy to reduce the se-erity of recessions and rein in e8cessi-ely strong e89ansions effecti-e de9ending on ty9e of shock Policy in the :ace of Qemand Shocks if the economy is in negati-e demand shock .as seen in 1*?& /here AQ1 mo-ed to AQ"0 Monetary and fiscal 9olicy shift the aggregate demand cur-e if 9olicy makers react @uickly to fall in aggregate demand they can use monetary or fiscal 9olicy to shift the aggregate demand cur-e back to the right ;if 9olicy /ere able to 9erfectly antici9ate shifts of the aggregate demand cur-e and counteract them it could short-circuit the /hole 9rocess .sho/n in 1*?&0 instead of going through a 9eriod of lo/ aggregate out9ut and falling 9rices go-ernment could manage the economy so it /ould stay on E1 9olicy that short-circuits the adEustment sho/n in 1*& is desirable because .10 the tem9orary fall in aggregate out9ut that /ould ha99en /ithout 9olicy inter-ention is a bad thing since such a decline is associated /< high unem9loyment ."0 9rice stability is a desirable goal 9re-enting deflation .fall of aggregate 9rice le-el0 F good 9olicy makers should al/ays act to offset declines in aggregate demand some 9olicy measures to increase aggregate demand .es9ecially those that increase budget deficient0 may ha-e long-term costs in terms of lo/er long-run gro/th in the real /orld 9olicy makers arent 9erfectly informed and effects of their 9olicy arent 9erfectly 9redictable created the danger that stabili=ation 9olicy /ill do more harm than good 9olicy makers should also try to offset 9ositi-e shocks of aggregate demand most economist belie-e any short-run gains from an inflationary ga9 must be 9aid back later so 9olicy makers try to offset 9ositi-e as /ell as negati-e demand shock these usually rely on MM+E4A6I 9olicy 6es9onding to Qemand Shocks in 9anel .a0 1*?# /e sa/ the effect of a negati-e su99ly shock short run such a shock leads to lo/er aggregate out9ut but higher aggregate 9rice le-el 9olicy makers can res9ond to negati-e demand shock by using monetary<fiscal 9olicy to return aggregate demand to its original le-el in the case S>PPJI shock there are no go-ernment 9olicies to counteract the changes in 9roduction costs that shift the short-run aggregate su99ly cur-e

PAGE # &(

9olicy res9onse to a negati-e su99ly shock cannot aim to sim9ly 9ush the cur-e that shifted back to its original 9osition if you consider using monetary<fiscal 9olicy to shift aggregate demand cur-e in res9onse to su99ly shock the right res9onse isnt e8act t/o bad things .a fall in aggregate out9ut! leading to a rise in unem9loyment! and a rise in the aggregate 9rice le-el0 ha99en at the same time any 9olicy that shifts the aggregate demand cur-e hel9s one 9roblem /hile making the other one /orse if go-ernment acts to increase aggregate demand and limit the rise in unem9loyment it reduces the decline in out9ut but causes more inflation if it acts to reduce aggregate demand it curbs inflation but causes more unem9loyment .1*(%s /e chose to stabili=e 9rices farther lo/er the high unem9loyment0 :iscal Policy 4he basics changes in the federal budget changes in a go-ernment s9ending<ta8ation ha-e large effects on the American economy /e begin by sho/ing ho/ ta8es<go- s9ending affect economys flo/ of income 4a8es! Go-ernment Purchases of Goods and Ser-ices! 4ransfers! and Gorro/ing in circular flo/ of income and s9ending in the economy as a /hole one of the sectors re9resented in that figure /as go-ernment funds flo/ into the go-ernment in form of ta8es<borro/ing funds flo/ out in the form of go-ernment 9urchases of goods<ser-ices and go-ernment transfers to households ta8es are re@uired 9ayments to the go-ernment in >?S ta8es are collected at the federal and state le-el .and local le-els by counties! cities! and to/ns0 at the federal le-el the main ta8es are income ta8es on both 9ersonal income<cor9orate 9rofits as /ell as social insurgence >?S go-ernment s9ending takes t/o forms one is 9urchases of goods<ser-ices the other form is go-ernment transfers /hich are 9ayments made by the go-ernment to households for /hich no good<ser-ice is 9ro-ided in return most >?S transfer 9ayments are accounted by three big 9rograms 10 Social security guaranteed income to older Americans! disabled Americans! and the sur-i-ing s9ouses<de9ending children of deceased beneficiaries "0 Medicare co-ers healthcare for Americans o-er '& #0 Medicaid co-ers healthcare for Americans /< lo/ incomes note social insurance is used to describe go-ernment 9rograms that are intended to 9rotect families against economic hardshi9 .includes social security<medicare<medicard<unem9loyment insurance<food stam9s0 largely 9aid for /< s9ecial dedicated ta8es on /ages .social insurance ta80 ta8ation<go-ernment s9ending ha-e a strong effect on total aggregate s9ending in the economy 4he Go-ernment Gudget and 4otal S9ending 6ecall GQP F , 7 3 7 G 7 O - 3M

GQP F -alue of all final goods<ser-ices 9roduced in the economy aggregate s9ending is the total s9ending on final goods<ser-ices 9roduced in an economy sum of

PAGE # &)

consumer s9ending .,0! in-estment s9ending .30! go-ernment 9urchases of goods<ser-ices .G0! and the -alue of e89orts .O0 minus the -alue of im9orts .3M0 3ncludes all sources of aggregate demand go-ernment directly controls go-ernment 9urchases of goods and ser-ices .G0 through changes in ta8es and transfers go-ernment also influences consumer s9ending .,0 and in-estment s9ending .30 dis9osable income is the total income households ha-e to s9end F to total income they recei-e from /ages! di-idend! interest! and rent M3+>ES ta8es PJ>S go-ernment transfers so an increase in ta8es or a decrease in go-ernment transfers reduces dis9osable income a fall in dis9osable income leads to a fall in consumer s9ending .the con-erse is true so either a decrease in ta8es<increase in go-ernment transfers increases dis9osable income /hich leads to a rise in consumer s9ending0 note that go-ernment ta8es 9rofits and changes in the rules determine ho/ much a business o/es can increase<reduce the incenti-e to s9end on in-estment goods since go-ernment itself is a source of s9ending in the economy and ta8es<transfer can effect consumer<firm s9ending the go-ernment can use ta8es or go-ernment s9ending to shift aggregate demand cur-e ."%%) stimulus 9ackage /as a use of fiscal 9olicy to shift aggregate demand cur-e to the right0 E89ansionary and ,ontractionary :iscal Policy go-ernment /ants to shift the aggregate demand cur-e because it /ants to close either a recessionary ga9 created /hen aggregate out9ut falls belo/ 9otential out9ut or an inflationary ga9 created /hen aggregate out9ut e8ceeds 9otential out9ut figure "%?$ belo/ sho/s an economy facing a recessionary ga9 S6AS is the short run aggregate su99ly cur-e and J6AS is the long-run aggregate su99ly cur-e and AQ1 is the initial aggregate demand cur-e at the initial short-run macroeconomic e@uilibrium E1! aggregate out9ut I1 is belo/ 9otential out9ut I9 go-ernment /ants to increase aggregate demand shifting the aggregate demand cur-e right/ard to AQ" this /ould increase aggregate out9ut making it F to I9 fiscal 9olicy that increases aggregate demand is called e89ansionary fiscal 9olicy and ta8es three forms .10 an increase in go-ernment 9urchases of goods<ser-ices ."0 a cut in ta8es .#0 an increase in go-ernment transfers :igure "%?& sho/s the o99osite an economy facing an inflationary ga9 at initial e@uilibrium E1! aggregate out9ut I1 is abo-e the 9otential out9ut I9 9olicy makers try to head off inflation by eliminating inflationary ga9s fiscal 9olicy must reduce aggregate demand and shift the aggregate demand cur-e left/ard to AQ" this reduces aggregate out9ut and makes it F to I9 fiscal 9olicy that reduces the aggregate demand is called ,ontractionary fiscal 9olicy is im9lemented by .10 a reduction in go-ernment 9urchase of goods and ser-ices ."0 an increase in ta8es .#0 a reduction in go-ernment transfers

PAGE # &*

A ,autionary +ote Jags in :iscal Policy after seeing "%?$<"%?& it may seem ob-ious that go-ernment should acti-ely use fiscal 9olicy but many economist caution against an e8tremely acti-e stabili=ation 9olicy arguing that a go-ernment that tries too hard to stabili=e the economy can make it e-en less stable in case of fiscal 9olicy one key reason for caution are im9ortant time lags in its use ;think about /hat has to ha99en before the go-ernment increases s9ending to fight a recessionary ga9 the go-ernment has to reali=e that the recessionary ga9 e8ists economic data takes time to collect<analy=e and recessions are usually recogni=ed only months after they ha-e begun the go-ernment must also de-elo9 a s9ending 9lan .can take months0 it also takes time to s9end money because of these lags an attem9t to increase s9ending to fight a recessionary ga9 may take long to get

PAGE # '%

going that the economy has already reco-ered on its o/n in fact a recessionary ga9 may ha-e turned into an inflationary ga9 by the time fiscal 9olicy has been taken into effect .so fiscal 9olicy can make things /orse

Module 21
9sing the Multiplier to Estimate the +n"luence o" <overnment !olicy An e89ansionary fiscal 9olicy 9ushes the aggregate demand cur-e to the right? A ,ontractionary fiscal 9olicy! like 9ushes the aggregate demand cur-e to the left? ;9olicy makers also need estimates of how much the aggregate demand cur-e is shifted by a gi-en 9olicy? ;use the conce9t of the multi9lier to find out Multiplier E""ects o" an +ncrease in <overnment !urchases o" <oods and 8ervices say go-ernment s9ends T&% billion building bridges and roads go-ernments 9urchases /ill directly increase total s9ending on final goods and ser-ices by T&% billion --; indirect effect is that go-ernments 9urchases /ill start a chain reaction throughout the economy? ;4he firms 9roducing the goods and ser-ices 9urchased by the go-ernment /ill earn re-enues --; flo/ to households./ages<9rofit<interest<rent0 --; 4his increase in dis9osable income /ill lead to a rise in consumer s9ending /hich in turn! /ill induce firms to increase out9ut! leading to a further rise in dis9osable income --; another round of consumer s9ending increases! and so on? multiplier) the ratio of the change in real GQP caused by an autonomous change in aggregate s9ending to the si=e of that autonomous change? An increase in go-ernment 9urchases of goods and ser-ices is an e8am9le of an autonomous increase in aggregate s9ending? Any change in go-ernment 9urchases of goods and ser-ices /ill lead to an e-en greater change in real GQP chain reaction /ill cause the initial change in go-ernment 9urchases to multi9ly through the economy! resulting in an e-en larger final change in real GQP? 4he initial change in s9ending! multi9lied by the multi9lier gi-es us the final change in real GQP? ;think if there are no ta8es or international trade any change in GQP accrues entirely to households? Assume that the aggregate 9rice le-el is fi8ed! so that any increase in nominal GQP is also a rise in real GQP! and that the interest rate is fi8ed? 3n that case! the multi9lier is 1<.1 - *(C0 .*(C is the marginal propensity to consume, the fraction of an additional dollar in dis9osable income that is s9ent?0 ;if MP, F %?&! the multi9lier is 1<.1 - %?&0 F 1<%?& F "? if multi9lier of "! a T&% billion increase in go-ernment 9urchases of goods and ser-ices /ould increase real GQP by T1%% billion? Mf that T1%% billion! T&% billion is the initial effect from the increase in +, and the remaining T&% billion is the subse@uent effect of more 9roduction leading to more income /hich leads to more consumer s9ending --; leads to more 9roduction! and so on? if go-ernment 9urchases of goods and ser-ices are instead reduced same math but use a minus sign .so real GQP falls by T1%% billion?0 4his is the result of less 9roduction leading to less income! /hich leads to less consum9tion --; leads to less 9roduction! and so on?

PAGE # '1

Multiplier E""ects o" $hanges in <overnment 1rans"ers and 1a)es E89ansionary or ,ontractionary fiscal 9olicy doesnt ha-e to be go-ernment 9urchases of goods and ser-ices? ;Go-ernments can also change transfer 9ayments or ta8es? --; change in go-ernment transfers or ta8es shifts the aggregate demand cur-e by less than an e@ual -si=ed change in go-ernment 9urchases! resulting in a smaller effect on real GQP? instead of s9ending T&% billion on building bridges imagine if go-ernment sim9ly hands out T&% billion in the form of go-ernment transfers?.no direct effect on aggregate demand as /< go-ernment 9urchases0 ;6eal GQP and income gro/ only because households s9end some of that T&% billion .but not all0 they /ill s9end according to MP, .if MP, F %?& households s9end only &% cents of e-ery additional dollar they recei-e in transfers?0 4able "1?1 sho/s a hy9othetical com9arison of t/o e89ansionary fiscal 9olicies assuming an *(C F %?& and multi9lier F " each case! there is a first -round effect on real GQP! either from 9urchases by the go-ernment or from 9urchases by the consumers /ho recei-ed the checks! follo/ed by a series of additional rounds as rising real GQP raises income .all of /hich is dis9osable under our assum9tion of no ta8es0! /hich raises consum9tion? first -round effect of the transfer 9rogram is smallerD because /e ha-e assumed that the *(C is %?&! only T"& billion of the T&% billion is s9ent! /ith the other T"& billion sa-ed? And as a result! all the further rounds are smaller! too? At end transfer 9ayment increases real GQP by only T&% billion? 3n com9arison! a T&% billion increase in go-ernment 9urchases 9roduces a T1%% billion increase in real GQP? if e89ansionary fiscal 9olicy takes the form of a rise in transfer 9ayments! real GQP may rise by either more or less than the initial go-ernment outlay .if multi9lier may be either more or less than 10 3n 4able "1?1! a T&% billion rise in transfer 9ayments increases real GQP by T&% billion! so that the multi9lier is e8actly 1? 3f a smaller share of the initial transfer had been s9ent! the multi9lier on that transfer /ould ha-e been less than 1? 3f a larger share of the initial transfer had been s9ent! the multi9lier /ould ha-e been more than 1? A ta8 cut has an effect similar to the effect of a transfer? .increases dis9osable income! series of increases in consumer s9ending0 o-erall effect is smaller than that of an e@ual -si=ed increase in go-ernment 9urchases of goods and ser-ices the autonomous increase in aggregate s9ending is smaller because households sa-e 9art of the amount of the ta8 cut ;4hey sa-e a fraction of the ta8 cut e@ual to their *( .or 1 - *(C0? ta8es change the si=e of the multi9lier --; in real /orld go-ernments rarely im9ose lump-sum ta)es (in /hich the amount of ta8 a household o/es is inde9endent of its income?0 ;ta8es generally de9end 9ositi-ely on the le-el of real GQP ta8es that de9end 9ositi-ely on real GQP reduce the si=e of the multi9lier? ;economist argue /ho should get ta8 cuts<transfers the a-erage unem9loyed /orker /ill s9end a higher share of any increase in his or her dis9osable income than /ould the a-erage reci9ient of di-idend income? 4hat is! 9eo9le /ho are unem9loyed tend to ha-e a higher *(C than 9eo9le

PAGE # '"

/ho o/n a lot of stocks because the latter tend to be /ealthier and tend to sa-e more of any increase in dis9osable income? ;if true dollar s9ent on unem9loyment benefits increases aggregate demand more than a dollars /orth of di-idend ta8 cuts? ;ow 1a)es *""ect the Multiplier go-ernment ta8es ca9ture some 9art of the increase in real GQP that occurs in each round of the multi9lier 9rocess .since most de9end 9ositi-ely on real GQP?0 so dis9osable income increases by considerably less than T1 once /e include ta8es in the model? increase in go-ernment ta8 re-enue /hen real GQP rises is a conse@uence of the /ay the ta8 la/s are /ritten --; causes sources of go-ernment re-enue to increase automatically /hen real GQP goes u9? ;i?e?! income ta8 recei9ts increase /hen real GQP rises because the amount each indi-idual o/es in ta8es de9ends 9ositi-ely on his or her income! and households ta8able income rises /hen real GQP rises? ;Sales ta8 recei9ts increase /hen real GQP rises since 9eo9le /ith more income s9end more on goods<ser-ices? --; cor9orate 9rofit ta8 recei9ts increase /hen real GQP rises because 9rofits increase /hen the economy e89ands? effect of these automatic increases in ta8 re-enue is to reduce the si=e of the multi9lier? .note multi9lier is the result of a chain reaction in /hich higher real GQP leads to higher dis9osable income! /hich leads to higher consumer s9ending! /hich leads to further increases in real GQP0? ;since go-ernment si9hons off some of any increase in real GQP means at each stage of this 9rocess! the increase in consumer s9ending is smaller than it /ould be if ta8es /erent 9art of the 9icture? result is to reduce the multi9lier? good thing that in real life ta8es reduce the multi9lier? ;/hat causes ta8 re-enue to increase /hen the economy e89ands causes it to decrease /hen the economy contracts? ;Since ta8 recei9ts decrease /hen real GQP falls! the effects of these negati-e demand shocks .these cause recessions0 are smaller than they /ould be if there /ere no ta8es? decrease in ta8 re-enue reduces the ad-erse effect of the initial fall in aggregate demand? 4he automatic decrease in go-ernment ta8 re-enue generated by a fall in real GQP`caused by a decrease in the amount of ta8es households 9ay`acts like an automatic e89ansionary fiscal 9olicy im9lemented in the face of a recession? ;Similarly! /hen the economy e89ands! the go-ernment finds itself automatically 9ursuing a ,ontractionary fiscal 9olicy`a ta8 increase? Go-ernment s9ending and ta8ation rules that cause fiscal 9olicy to be automatically e89ansionary /hen the economy contracts and automatically ,ontractionary /hen the economy e89ands! /ithout re@uiring any deliberate action by 9olicy makers! are called automatic sta%ili3ers 4he rules that go-ern ta8 collection arent the only automatic stabili=ers! although they are the most im9ortant ones? ;Some go-ernment transfers also 9lay a stabili=ing role .i?e? more 9eo9le recei-e unem9loyment insurance /hen the economy is de9ressed than /hen it is booming? 4he same is true of Medicaid and food stam9s?0 --; So transfer 9ayments tend to rise /hen the economy is contracting and fall /hen the economy is e89anding? ;Jike changes in ta8 re-enue! these automatic changes in transfers tend to reduce the si=e of the multi9lier

PAGE # '#

because the total change in dis9osable income that results from a gi-en rise or fall in real GQP is smaller? good thing that go-ernment transfers reduce the multi9lier? ;E89ansionary and ,ontractionary fiscal 9olicies that are the result of automatic stabili=ers are /idely considered hel9ful to macroeconomic stabili=ation! because they blunt the e8tremes of the business cycle? ,iscretionary "iscal policy is fiscal 9olicy that is the direct result of deliberate actions by 9olicy makers rather than automatic adEustment? .i?e? during a recession! the go-ernment may 9ass legislation that cuts ta8es and increases go-ernment s9ending in order to stimulate the economy? economists tend to su99ort the use of discretionary fiscal 9olicy only in s9ecial circumstances! such as an es9ecially se-ere recession0

Module 22 Matching 9p 8avings and +nvestment 8pending

."0 needed sources of economic gro/th are .10 increases in the skills and kno/ledge of the /orkforce .human capital$ ."0 increases in ca9ital`goods used to make other goods .physical capital$% 1uman ca9ital -ia go-ernment through 9ublic education? .9ri-ate 9ost-secondary education is also an im9ortant source of human ca9ital?0 9hysical ca9ital! /ith the e8ce9tion of infrastructure such as roads and bridges! is mainly created through 9ri-ate in-estment s9ending .s9ending by firms rather than by the go-ernment0 in modern economy indi-iduals and firms /ho create 9hysical ca9ital often do it /ith other 9eo9les money .T they borro/<raise by selling stock? 3f they borro/ to create 9hysical ca9ital! they are charged an interest rate /hich is the 9rice! calculated as a H of the amount borro/ed! charged by lenders to borro/ers for the use of their sa-ings for one year?0

1he 8avingsH +nvestment 8pending +dentity

Gasic foundation sa-ings F in-estment s9ending is that it is a "actF account %yB savingsHinvestment spending identity (savings and investment spending are always D "or the economy as a whole) imagine a highly sim9lified economy in /hich there is no go-ernment and no interaction /ith other countries? So o-erall income of this sim9lified economy /ould F total s9ending in the economy? the only /ay 9eo9le could earn income /ould be by selling something to someone else and e-ery dollar s9ent in the economy /ould create income for somebody? So in this sim9lified economy! 1otal income D 1otal spending Peo9le can s9end it on consum9tion or sa-e it So it must be true that 1otal income D $onsumer spending G 8avings

PAGE # '$

6ememberN S9ending consists of either consumer s9ending or in-estment s9ending 1otal spending D $onsumer spending G +nvestment spending Putting these together! /e get $onsumer spending G 8avings D $onsumer spending GI+nvestment spending Subtract consumer s9ending from both sides! and /e get

8avings D +nvestment spending

So basic accounting fact that sa-ings F in-estment s9ending for the economy as a /hole? sim9lified economy though . /< no go-ernment and no economic interaction /ith the rest of the /orld?0 /< realistic com9lications back into the story changes things in ."0 /ays? .10 households are not the only 9arties that can sa-e in an economy .go-ernment can sa-e! too! if it collects more ta8 re-enue than it s9ends? the difference is called a %udget ? 3f go-ernment s9ending e8ceeds ta8 re-enue! there is a %udget de"icit`a negati-e budget sur9lus? Kgo-ernment isAdissa-ingB by s9ending more than its ta8 re-enues0 %udget %alance can refer to both cases! budget balance can be 9ositi-e .a budget sur9lus0 or negati-e .a budget deficit0? &ational savings is F 9ri-ate sa-ings 7 budget balance ; 9ri-ate sa-ings F dis9osable income .income after ta8es0 minus consum9tion? ."0 one country is 9art of a /ider /orld economy sa-ings doesnt need to be s9ent on 9hysical ca9ital located in the same country in /hich the sa-ings are generated? sa-ings of 9eo9le /ho li-e in any one country can be used to finance in-estment s9ending that takes 9lace in other countries? any gi-en country can recei-e inflows of funds .foreign sa-ings that finance in-estment s9ending in the country0 Any gi-en country can also generate outflows of funds .domestic sa-ings that finance in-estment s9ending in another country?0 $apital in"low into a country is the net effect of international inflo/s and outflo/s of funds on the total sa-ings a-ailable for in-estment s9ending in any gi-en country ;e@ual to the total inflo/ of foreign funds minus the total outflo/ of domestic funds to other countries0 ;ca9ital inflo/ can be negati-e .more ca9ital can flo/ out of a country than flo/s into it0 from a national 9ers9ecti-e! a dollar generated by national sa-ings and a dollar generated by ca9ital inflo/ are not e@ui-alent? both finance the same dollars /orth of in-estment s9ending! but any dollar borro/ed from a sa-er must e-entually be re9aid /ith interest? dollar from national sa-ings is re9aid /ith interest to someone domestically .a 9ri-ate 9arty or the go-ernment?0

PAGE # '&

dollar that comes as ca9ital inflo/ must be re9aid /ith interest to a foreigner? dollar of in-estment s9ending financed by a ca9ital inflo/ comes at a higher national cost .the interest that must e-entually be 9aid to a foreigner than a dollar of in-estment s9ending financed by national sa-ings?0 a99lication of the sa-ingsUin-estment s9ending identity to an economy that is o9en to inflo/s or outflo/s of ca9ital means that in-estment s9ending is e@ual to sa-ings! /here sa-ings is e@ual to national sa-ings plus ca9ital inflo/? 4 ;in an economy /< 9ositi-e ca9ital inflo/! some in-estment s9ending is funded by the sa-ings of foreigners? in an economy /< negati-e ca9ital inflo/ .a net outflo/0! some 9ortion of national sa-ings is funding in-estment s9ending in other countries?

1he 5inancial 8ystem

:inancial markets are /here households in-est their current sa-ings and their wealth ( accumulated Sa-ings0 by 9urchasing financial assets% "inancial asset is a 9a9er claim that entitles the buyer to future income from the seller? A household can also in-est its current sa-ings or /ealth by 9urchasing a physical assetF a claim on a tangible obEect! 0 such as a 9ree8isting house or 9ree8isting 9iece of e@ui9ment?0 gi-es the o/ner the right to dis9ose of the obEect as he or she /ishes .for e8am9le! rent it or sell it0? if you do to a bank to get a loan! the bank /ould be creating a financial asset your loan? A loan is one im9ortant kind of financial asset in the real /orld! one that is o/ned by the lender increating that loan! you and the bank /ould also be creating a lia%ility ; a re@uirement to 9ay money in the future? your loan is a financial asset from the banks 9oint of -ie/ is a liability from your 9oint of -ie/ a re@uirement that you re9ay the loan! including any interest? 3n addition to loans! there are .#0 other im9ortant kinds of financial assets stocks! bonds! and ,ank deposits% since financial asset is a claim to future income that someone has to 9ay! it is also someone elses liability? 4hese four ty9es of financial assets e8ist because the economy has de-elo9ed a set of 99eciali=ed markets! like the stock market and the bond market! and s9eciali=ed institutions! like banks! that facilitate the flo/ of funds from lenders to borro/ers? ;A /ell - functioning financial system is a critical ingredient in achie-ing long -run gro/th because it encourages greater sa-ings and in-estment s9ending? ensures that sa-ings and in-estment s9ending are undertaken efficiently?

1hree 1asks o" a 5inancial 8ystem

.#0 im9ortant 9roblems facing borro/ers and lenders transaction costs! risk! and the desire for li-uidity%

PAGE # ''

;4he three tasks of a financial system are to reduce these 9roblems in a cost -effecti-e /ay? enhances the efficiency of financial markets and makes it more likely that lenders and borro/ers /ill make mutually beneficial trades that make society as a /hole richer?

7educing 1ransaction $osts

1ransaction costs are the e89enses of actually 9utting together and e8ecuting a deal? arranging a loan re@uires s9ending time and money negotiating the terms of the deal! -erifying the borro/ers ability to 9ay! dra/ing u9 and e8ecuting legal documents ect? /hen large businesses /ant to borro/ money! they either get a loan from a bank or sell bonds in the bond market? loan from a bank a-oids large transaction costs because it in-ol-es only a single borro/er and a single lender? 9rinci9al reason there is a bond market is that it allo/s com9anies to borro/ large sums of money /ithout incurring large transaction costs?

7educing 7isk
"inancial riskF uncertainty about future outcomes that in-ol-e financial losses or gains? ;:inancial risk is a 9roblem if future is uncertainD it holds the 9otential for losses as /ell as gains? A /ell -functioning financial system hel9s 9eo9le reduce their e89osure to risk? most 9eo9le are riska-erse Su99ose the o/ner of a business e89ects to make a greater 9rofit if she buys additional ca9ital e@ui9ment but isnt com9letely sure of this result? could 9ay for the e@ui9ment by using her sa-ings or selling her house? Gut if the 9rofit is significantly less than e89ected! she /ill ha-e lost her sa-ings! or her house .or both0? /ould be e89osing herself to a lot of risk due to uncertainty about ho/ /ell or 9oorly the business 9erforms? being risk -a-erse! this business o/ner /ants to share the risk of 9urchasing ne/ ca9ital e@ui9ment /ith someone! e-en if that re@uires sharing some of the 9rofit if all goes /ell? can do this by selling shares of her com9any to other 9eo9le and using the money she recei-es from selling shares! rather than money from the sale of her other assets! to finance the e@ui9ment 9urchase? Gy selling shares in her com9any! she reduces her 9ersonal losses if the 9rofit is less than e89ected she /ont ha-e lost her other assets? if things go /ell! the shareholders earn a share of the 9rofit as a return on their in-estment? by selling share of her business! the o/ner has achie-ed diversification ;she has been able to in-est in se-eral things in a /ay that lo/ers her total risk? She has maintained her in-estment in her bank account! a financial assetD in o/nershi9 of her house! a 9hysical assetD and in o/nershi9 of the unsold 9ortion of her business! also a 9hysical asset? by using diversi"ication`in-esting in se-eral assets /ith unrelated! or inde9endent! risk the business o/ner has lo/ered her total risk of loss? 4he desire of indi-iduals to reduce their total risk by engaging in di-ersification is /hy /e ha-e stocks and a stock market?

!roviding #i-uidity

PAGE # '(

third and final task of the financial system is to 9ro-ide in-estors /ith li-uidity, /hich .like risk0 becomes rele-ant because the future is uncertain? An asset is li-uid if it can be @uickly con-erted into cash /ithout much loss of -alue! illi-uid if it cannot? Ganks 9ro-ide a further /ay for indi-iduals to hold li@uid assets and still finance illi@uid in-estments? to hel9 lenders and borro/ers make mutually beneficial deals the economy needs /ays to reduce transaction costs! to reduce and manage risk through di-ersification! and to 9ro-ide li@uidity?

1ypes o" 5inancial *ssets

four main ty9es of financial assets loans, bonds! stocks! and ,ank deposits% financial inno-ation has allo/ed the creation of a /ide range of loan#,acked securities%

#oans
#oan is a lending agreement bet/een an indi-idual lender and an indi-idual borro/er? loan is usually tailored to the needs of the borro/erD loan also must meet the borro/ers needs and ability to re9ay? ;bad as9ect of loans is that making a loan to an indi-idual 9erson or a business ty9ically in-ol-es a lot of transaction costs .cost of negotiating the terms of the loan! in-estigating the borro/ers credit history and ability to re9ay! ect0 4o minimi=e these costs! large borro/ers such as maEor cor9orations and go-ernments often sell<issue bonds?

6onds
bond is an 3M> issued by the borro/er? seller of the bond 9romises to 9ay a fi8ed sum of interest each year and to re9ay the 9rinci9al .-alue stated on the face of the bond0 to the o/ner of the bond on a 9articular date?0 bond is a financial asset from its o/ners 9oint of -ie/ and a liability from its issuers 9oint of -ie/? A bond issuer sells a number of bonds /ith a gi-en interest rate and maturity date to /hoe-er is /illing to buy them! a 9rocess that a-oids costly negotiation of the terms of a loan /ith many indi-idual lenders? Gond 9urchasers can ac@uire information free of charge on the @uality of the bond issuer! such as the bond issuers credit history! from ,ond # rating agencies rather than ha-ing to incur the e89ense of in-estigating it themsel-es? concern for in-estors is the 9ossibility of de"ault the risk that the bond issuer might fail to make 9ayments as s9ecified by the bond contract? ;Mnce a bonds risk of default has been rated! it can be sold on the bond market as a more or less standardi=ed 9roduct .9roduct /ith clearly defined terms and @uality?0 bonds /ith a higher default risk must 9ay a higher interest rate to attract in-estors? ;bonds is that they are easy to resell? 9ro-ides li@uidity to bond 9urchasers? .Joans! in contrast! are much more difficult to resell because! unlike bonds! they are not standardi=ed they differ in si=e! @uality! terms! and so on? making them less li@uid0

#oan-%acked 8ecurities
#oan-%acked securities are assets created by 9ooling indi-idual loans and selling shares in that 9ool .a 9rocess called securiti.ation0

PAGE # ')

2hile mortgage-backed securities! in /hich thousands of indi-idual home mortgages are 9ooled and shares sold to in-estors! securiti=ation has also been /idely a99lied to student loans! credit card loans! and auto loans? loan-backed securities trade on financial markets like bonds and are 9referred by in-estors because they 9ro-ide more di-ersification and li@uidity than indi-idual loans? /ith so many loans 9ackaged together! it can be difficult to assess the true @uality of the asset? 4hat difficulty came to haunt in-estors

8tocks
stock is a share in the o/nershi9 of a com9any? ;A share of stock is a financial asset from its o/ners 9oint of -ie/ and a liability from the com9anys 9oint of -ie/? +ot all com9anies sell shares of their stockD A9ri-ately heldB com9anies are o/ned by an indi-idual or a fe/ 9artners! /ho get to kee9 all of the com9anys 9rofit? /hy dont rich 9eo9le kee9 com9lete o/nershi9 for themsel-es and Eust sell bonds for their in-estment s9ending bcause fe/ indi-iduals are risk -tolerant enough to face the risk in-ol-ed in being the sole o/ner of a large com9any? e8istence of stocks also im9ro-es the /elfare of in-estors /ho buy stocks .that is! shareo/ners! or shareholders0? Shareo/ners are able to enEoy the higher returns o-er time that stocks generally offer in com9arison to bonds? do/nside o/ning the stock of a gi-en com9any is riskier than o/ning a bond issued by the same com9any? a bond is a 9romise /hile a stock is a ho9e by la/! a com9any must 9ay /hat it o/es its lenders .bondholders0 before it distributes any 9rofit to its shareholders? And if the com9any should fail .that is! be unable to 9ay its interest obligations and declare bankru9tcy0! its 9hysical and financial assets go to its bondholders`its lenders`/hile its shareholders ty9ically recei-e nothing? stock is a higher return but /< higher risk

5inancial +ntermediaries
"inancial intermediary is an institution that transforms funds gathered from many indi-iduals into financial assets? 4he most im9ortant ty9es of financial intermediaries are mutual funds, pension funds, life insurance companies, and ,anks% A ;about #<$th of the financial assets Americans o/n are held through these intermediaries rather than directly?

PAGE # '*

Mutual 5unds
o/ning shares of a com9any entails risk in return for a higher 9otential re/ard? ;stock in-estorscan lo/er their total risk by engaging in di-ersification? Gy o/ning a diversified portfolio of stocks .grou9 of stocks in /hich risks are unrelated to! or offset! one another rather than concentrating in-estment in the shares of a single com9any or a grou9 of related com9anies0 in-estors can reduce their risk? financial ad-isers! a/are ad-ise their clients to di-ersify not only their stock 9ortfolio but also their entire /ealth by holding other assets in addition to stock`assets such as bonds! real estate! and cash .7 inserance0 indi-iduals /ho dont ha-e a large amount of money to in-est building a di-ersified stock 9ortfolio can incur high transaction costs because they are buying a fe/ shares of a lot of com9anies? mutual funds hel9 sol-e the 9roblem of achie-ing di-ersification /ithout high transaction costs? A mutual "und is a financial intermediary that creates a stock 9ortfolio by buying and holding shares in com9anies and then selling shares of the stock portfolio to indi-idual in-estors? ;in-estors /ith a relati-ely small amount of money to in-est can indirectly hold a di-ersified 9ortfolio! achie-ing a better return for any gi-en le-el of risk than they could other/ise achie-e? mutual funds do charge fees for their ser-ices? .fees are @uite small for mutual funds that sim9ly hold a di-ersified 9ortfolio of stocks! /ithout trying to 9ick /inners0 ? fees charged by mutual funds that claim to ha-e s9ecial e89ertise in in-esting your money can be high?

!ension 5unds and #i"e +nsurance $ompanies

pension "undsF non9rofit institutions that collect the sa-ings of their members and in-est those funds in a /ide -ariety of assets! 9ro-iding their members /ith income /hen they retire? 9ension funds are subEect to s9ecial rules<treatment for ta8 9ur9oses but they function much like mutual funds? ;4hey in-est in a di-erse array of financial assets! allo/ing their members to achie-e more cost -effecti-e di-ersification and conduct more market research than they /ould be able to indi-idually? Americans also ha-e substantial holdings in the 9olicies of li"e insurance companiesF /hich guarantee a 9ayment to the 9olicyholders beneficiaries .ty9ically! the family0 /hen the 9olicyholder dies? by leeting 9olicyholders to cushion their beneficiaries from financial hardshi9 arising from their death! life insurance com9anies also im9ro-e /elfare by reducing risk?

6anks
9roblem of li@uidity 9eo9le /ant assets that can be readily con-erted into cash? Gonds and stocks are much more li@uid than 9hysical assets or loans! .but high transaction costs0 for many small<moderate-si=e com9anies! the cost of issuing bonds and stocks is too large! gi-en the modest amount of money they seek to raise? A

PAGE # (%

,ank is an institution that hel9s resol-e the conflict bet/een lendersneeds for li@uidity and the financing needs of borro/ers /ho dont /ant to use the stock or bond markets? A bank /orks by first acce9ting funds from depositors) "/hen you 9ut your money in a bank! you are becoming a lender by lending the bank your money? you recei-e credit for a %ank deposit .a claim on the bank! /hich is obliged to gi-e you your cash if and /hen you demand it?0 So a bank de9osit is a financial asset o/ned by the de9ositor and a liability of the bank that holds it? A bank kee9s only a fraction of its customers de9osits in the form of ready cash? ;Most of its de9osits are lent out to businesses<borro/ers 4hese loans come /ith a long -term commitment by the bank to the borro/er as long as the borro/er makes his or her 9ayments on time! the loan cannot be recalled by the bank and con-erted into cash? So a bank enables those /ho /ish to borro/ for long lengths of time to use the funds of those /ho /ish to lend but simultaneously /ant to maintain the ability to get their cash back on demand? ;%ank is a financial intermediary that 9ro-ides li@uid financial assets in the form of de9osits to lenders and uses their funds to finance the illi@uid in-estment s9ending needs of borro/ers? ; bank lends for long 9eriods of time but also subEect to the condition that its de9ositors could demand their funds back at any time? bank counts on the fact that on a-erage only a small fraction of its de9ositors /ill /ant their cash at the same time? some 9eo9le /ill make /ithdra/als and others /ill make ne/ de9osits roughly cancel each other out? bank needs to kee9 only a limited amount of cash on hand to satisfy its de9ositors? ; if a bank becomes financially inca9able of 9aying its de9ositors! indi-idual bank de9osits are currently guaranteed to de9ositors u9 to T"&%!%%% by the :ederal Qe9osit 3nsurance ,or9oration! or :Q3,! a federal agency? reduces the risk to a de9ositor of holding a bank de9osit! in turn reducing the incenti-e to /ithdra/ funds if concerns about the financial state of the bank should arise banks need hold only a fraction of their de9ositors cash? Gy reconciling the needs of sa-ers for li@uid assets /ith the needs of borro/ers for long -term financing! banks 9lay a key economic role?

Module 2. 1he Meaning o" Money

money is used to mean A/ealth?B ;economists definition of money doesnt include all forms of /ealth? dollar bills in your /allet are moneyD other forms of /ealth`such as cars! houses! and stock certificates`arent money?

2hat +s Money@
money is any asset that can easily be used to 9urchase goods and ser-ices?

PAGE # (1

before /e defined an asset as li-uid if it can easily be con-erted into cash? ;Money consists of cash itself ./hich is li@uid by definition0 $urrency in circulation .actual cash in the hands of the 9ublic0 is considered money? ;So are checka%le %ank deposits .bank accounts on /hich 9eo9le can /rite checks?0 Are currency and checkable bank de9osits the only assets that are considered moneyP 3t de9ends? As /ell see later! there are t/o /idely used definitions of the money supplyF .the total -alue of financial assets in the economy that are considered money?0 ;4he narro/er definition considers only the most li@uid assets to be money .currency in circulation<tra-elers checks<checkable bank de9osits?0 ;4he broader definition includes these three categories 7 other assets that are AalmostB checkable! such as sa-ings account de9osits that can be transferred into a checking account online /ith a fe/ mouse clicks? both make a distinction bet/een those assets that can easily be used to 9urchase goods and ser-ices! and those that cant? ;Money 9lays a crucial role in generating gains from trade because it makes indirect e8change 9ossible? ;/ould be e8tremely difficult for e8changing 9arties barter the goods and ser-ices they sell .instead of using money0 barter /orks if one 9arty /ants /hat the other 9arty is gi-ing kno/n as the 9roblem of finding a Adouble coincidence of /antsB ;in a barter system! t/o 9arties can trade only /hen each /ants /hat the other has to offer? Money sol-es this 9roblem indi-iduals can trade /hat they ha-e to offer for money and trade money for /hat they /ant? /ith ability to make transactions /ith money rather than relying on bartering this makes it easier to achie-e gains from trade! the e8istence of money increases /elfare! e-en though money does not directly 9roduce anything?

7oles o" Money

Money 9lays three main roles in any modern economy it is a medium of e/change, a store of value, and a unit of account%

Medium o" E)change

money can act as a medium o" e)change .an asset that indi-iduals use to trade for goods and ser-ices rather than for consum9tion0 +oteN Peo9le cant eat dollar bills they use dollar bills to trade for edible goods and their accom9anying ser-ices? normal times! the official money of a gi-en country is also the medium of e8change in

PAGE # ("

-irtually all transactions in that country? .Quring troubled economic times! ho/e-er! other goods or assets often 9lay that role instead?0

8tore o" ?alue

money must also be a store o" value .a means of holding 9urchasing 9o/er o-er time?0 ;money is by no means the only store of -alue? Any asset that holds its 9urchasing 9o/er o-er time is a store of -alue? . store -of --alue role is a necessary but not distincti-e feature of money?0

9nit o" *ccount

money ser-es as unit o" account ;the commonly acce9ted measure indi-iduals use to set 9rices and make economic calculations? 1istorically 9easants 9aid lando/ners in goods<labor rather than money 4oday! rents .like other 9rices0 are almost al/ays s9ecified in money terms? ;4hat makes things much clearer? .if Sam gi-es you # cookies for a ser-ice! and Sonia gi-es you # lolli9o9s for the same ser-ice 2hos offering the better dealP hard to say0 ;but if Sam gi-es T1% and Sonia gi-es T&! the com9arison is easy? ;/ithout a commonly acce9ted measure! the terms of a transaction are harder to determine! making it more difficult to make transactions and achie-e gains from trade?

1ypes o" Money

Money has been used for thousands of year for most of that 9eriod! 9eo9le used commodity moneyB the medium of e8change /as a good .gold<sil-er0 that had intrinsic -alue in other uses? ;these alternati-e uses ga-e commodity money -alue inde9endent of its role as a medium of e8change? 9a9er currency that initially re9laced commodity money /as commodity -%acked moneyF a medium of e8change /ith no intrinsic -alue /hose ultimate -alue /as guaranteed by a 9romise that it could al/ays be con-erted into -aluable goods on demand? ;big ad-antage of commodity -backed money o-er sim9le commodity money! .gold<sil-er0! /as that it tied u9 fe/er -aluable resources? ;although bank still had to kee9 some gold and sil-er on hand! it had to kee9 only enough to satisfy demands for redem9tion of its notes? .rely on the fact that on a normal day only a fraction of its 9a9er notes /ould be redeemed? So the bank needed to kee9 only a 9ortion of the total -alue of its notes in circulation in the form of gold and sil-er in its -aults?0 3t could lend out the remaining gold and sil-er to those /ho /ished to use it? allo/ed society to use the remaining gold and sil-er for other 9ur9oses! all /ith no loss in the ability to achie-e gains from trade? ;As Smith understood! /hen banks re9laced gold and sil-er money /ith 9a9er notes! they reduced the amount of real resources used by society to 9ro-ide the functions of money? A >?S? dollar bill isnt commodity money! and it isnt e-en commodity -backed? its

PAGE # (#

-alue arises entirely from the fact that it is generally acce9ted as a means of 9ayment ;role that is ultimately decreed by the >?S? go-ernment? Money /hose -alue deri-es entirely from its official status as a means of e8change is kno/n as "iat money because it e8ists by go-ernment fiat, .referring to 9olicy declared by a ruler?0 :iat money has ."0 maEor ad-antages o-er commodity -backed money? ; .10 it doesnt tie u9 any real resources! e8ce9t for the 9a9er its 9rinted on? ; ."0 the money su99ly can be managed based on the needs of the economy! instead of being determined by the amount of gold and sil-er 9ros9ectors ha99en to disco-er? ; has some risk such as counterfeiting ; benefit that counterfeiters get by e8changing fake bills for real goods and ser-ices comes at the e89ense of the >?S? federal go-ernment! /hich co-ers a small but nontri-ial 9art of its o/n e89enses by issuing ne/ currency to meet gro/ing demand for money? larger risk is that go-ernment officials /ho ha-e the authority to 9rint money /ill be tem9ted to abuse the 9ri-ilege by 9rinting a lot of T to cause inflation?

Measuring the Money 8upply

:ederal 6eser-e calculates the si=e of ."0 monetary aggregatesF o-erall measures of the money su99ly! /hich differ in ho/ strictly money is defined? ;4he t/o aggregates are kno/n as M1 and M"? ;M1! the narro/est definition has only currency in circulation .also kno/n as cash0! tra-elers checks! and checkable bank de9osits? ;M" starts /ith M1 and adds se-eral other kinds of assets! often referred to as near -moneys`financial assets that arent directly usable as a medium of e8change but can be readily con-erted into cash or checkable bank de9osits! such as sa-ings accounts? since currency and checkable de9osits are directly usable as a medium of e8change! M1 is the most li@uid measure of money? ;M" consists of M1 9lus other ty9es of assets t/o ty9es of bank de9osits! kno/n as sa-ings de9osits and time de9osits! both of /hich are considered non checkable! 9lus money market funds! /hich are mutual funds that in-est only in li@uid assets and bear a close resemblance to bank de9osits? 4hese near moneys 9ay interest /hile cash .currency in circulation0 does not! and they ty9ically 9ay higher interest rates than any offered on checkable bank de9osits?

PAGE # ($

Module 24 (made %y 7uslan)

2hat banks do - A bank is a financial intermediary that uses li@uid assets in the form of bank de9osits to finance the illi@uid in-estments of the borro/ers? - Ganks create li@uidity .because they don_t need to kee9 all of of the funds they recei-e sitting around in cash form as not e-eryone /ants their money back at the same time unless there_s a ,ank run0 - 1o/e-er! since at least a fe/ bank customers are going to be asking for their money to be /ithdra/n back to them! banks need to kee9 bank reser-es /ith cash handy .reser-es can be ke9t in either a banks -ault! or at the federal reser-e

-e0 - 2e use a 1-account to summari=e a banks financial 9osition - Qe9osits are liabilities because the 9eo9le can /ithdra/ them at any time - Joans are assets because it_s e89ected the 9eo9le /ho took them out /ill re9ay them - 6eser-es are assets because they are 9iles of cash of course they_re assets

PAGE # (&

- Ganks are re@uired by la/ to ha-e more assets then liabilities by a s9ecific 9ercentage - 3n the e8am9le abo-e! the reserve ratio! or the ratio of reser-es held to bank de9osits recei-ed is 1%H .1%%!%%% 1!%%%!%%%0 - :ederal 6eser-e regulates banks in the >S- es9ecially by setting a re-uired reserve ratio

4he Problem of Gank 6uns - A bank run is /hen e-eryone tries to /ithdra/ their funds in a short timeframe .she sho/ed us an e8am9le of one in that black-and-/hite cli9 of 0t1s a Wonderful &ife$ - Jike /e sa/ in the cli9! if a significant share of de9ositors demanded their money back at the same time! the bank /ouldn_t be able to raise enough cash to meet those demands - 4hat_s because! like /e sa/ in the 4-account! most of the money banks hold is held in the form of loans? Joans are illi@uid! they can_t easily be con-erted to cash on short notice? - Ganks fi8 this 9roblem by selling their loans to other banks for fast cash? Problem is! they ha-e to sell the loans at a discount- say &%H? - So in the case of a bank run! the bank /ill be forced to sell off its assets really chea9ly! leading to a ,ank failure? - 2ank failure bank /on_t be able to 9ay off its de9ositors in full? - Gank runs are caused by fear of bank failure and so many times it_s like a self-fulfilling 9ro9hecy? - Gank runs aren_t only bad for the bank and it_s de9ositors! history has sho/n they_re contagious one bank run leads to another

Gank 6egulation - Gank runs are bad? 4hat_s /hy our go-ernment .successfully0 tries to a-oid them /ith regulationsN - 4he system! successfully 9rotecting us >S citi=ens since the 1*#%s! has three main features deposit insurance, capital re-uirements, reserve re-uirements? - ,eposit insurance 4he :Q3, 9ro-ides a de9osit insurance! or a guarantee that de9ositors /ill be 9aid

PAGE # ('

e-en if the bank come u9 to the funds .u9 to "&%!%%%T 9er account as of no/0 - 4his creates lack of incenti-e! banks start 9ulling high risk mo-es they succeed! they 9rofit! they fail! the go-ernment bails them out? 4o 9re-ent the banks from going too cray! regulation "-- $apital re-uirementB banks are re@uired to hold substantially more assets then the -alue of bank de9osits? 4he e8cess they hold o-er their bank de9osits is called the ,ank1s capital% 3n our 4-account e8am9le! the bank has T1%%!%%% more assets then de9osits? 4hat_s *H of their total assets .T1%%!%%%<T1!1%%!%%%0? 3n real 9ractice! banks ha-e a ca9ital re@uirement of roughly (H of their assets? - 7eserve re-uirementsB the already mentioned re@uired reser-e ratioN 3n the >S! it_s set at 1%H? - 1he ,iscount 2indowB one final 9rotection! banks are allo/ed to borro/ money from the :ederal 6eser-e! to a-oid ha-ing to fire-sale there assets /hen they need cash @uick

1o/ Ganks ,reate Money - Without banks! the @uantity of currency in circulation /ould e@ual the money su99ly .the amount of currency the go-ernment mints and 9rints0 - Ganks ho/e-er do e8ist! and they affect the currency in circulation in t/o /ays Removing some currency from circulation (money in vaults, unlike money in wallets, is not considered part of the money supply) More importantly, banks create money by making loans - Keshara has mad gua9 in a shoebo8 and he_s about to de9osit it into the bank? After the de9osit! Keshara still has that money .lets say T1%%%0! Eust no/ it_s sitting in the bank? 4he bank takes that money! and loans out T*%% to Ms?Sch/eit=er? +o/ Ms?Sch/eit=er has T*%% she can s9end? Keshara still has T1!%%%? All of a sudden! there_s no/ T1!*%%N 4he bank Eust created moneyN - Gut Ms?Sch/eit=er s9ends all that money at :erry_s? :erry_s no/ has T*%% that it_s going to 9ut in the bank? 4he banks going to take that money! and loan out another T)1%? +o/! Keshara still has T1!%%% in the bank! :erry_s has T*%% in the bank! and there_s another T)1% u9 for s9ending by /hoe-er took out that loan? 4he bank Eust took Keshara_s initial T1!%%% in the money su99ly and turned it into T"!(1% in the money su99lyN Stacks on stacks on stacks on stacks? - 4he abo-e scenario re9resents /hat /e call the money multiplier? A?K?A my middle name?

PAGE # ((

6eser-es! Gank Qe9osits! and the Money Multi9lier - 3n the Keshara-Sch/eit=er-:erry_s e8am9le /e assume that all the money e-entually finds it_s /ay back to a bank? 4hat_s not al/ays the case- money leaks out of the banking system? - Jeaks reduce the si=e of the money multi9lier - A leak in this case is /hen borro/ers kee9 their funds as cash! rather than the asa-ingsa leak /ere used to /hen it comes to GQP leaks - Sim9lifying life and assuming a acheck-able de9osits onlya /orld! in /hich all the money is in the bank and none of it in our /allets! also assuming a minimum reser-e ratio of 1%H! and lastly that e-ery bank is lending out any e)cess reserves .any reser-es they ha99en to ha-e abo-e the minimum re@uired0 Increase of $1 - rr F reser-e ratio - 3ncrease of T1%%% in e8cess reser-es F T1%%% 7 T1%%%.1-rr$ 7 T1%%%.1-rr$]" 7 T1%%%.1-rr$]# 7 ??? - 3n sim9lest form! an increase of T1%%% in e8cess reser-es F T1%%%<rr in e!cess reserves " $1 # $$ # $%1 # $&'$ # (((

4he Money Multi9lier in 6eality - 3n reality! the determination of the money su99ly is more com9licated! it_s de9ends not only on rr but also on the fraction of the money su99ly that indi-iduals chose to hold in the form of currency? - :ederal 6eser-e controls the money %ase! the sum of currency in circulation and the reser-es held by banks? - 4he :ederal 6eser-e does not control ho/ that sum is allocated bet/een the bank reser-es and the currency in circulation? - 2hen Keshara first took that T1!%%% .that he initially ke9t under his bed0! he took that T1%%% out of circulation but also 9ut that same T1%%% into the bank reser-es - 4he amount in reser-es gro/s! the amount in circulation shrinks! the monetary base stays unchanged? - Monetary base is different from money su99ly in t/o /ays

PAGE # ()

)ank reserves, which are a big part of the monetary base, aren*t accounted for in the money supply ($1 in a wallet counts as money supply because it*s available to spend, $1 in a bank vault isn*t because well it*s locked up) +heckable bank deposits, a huge part of the money supply, isn*t accounted for in monetary supply Monetary base is pretty much all the physical cash out there printed, whether sitting in a reserve or in a person*s wallet, while money supply is how much ,money, is actually out there up for spending( -ormal definition of the money multiplier the ratio of the money su99ly to the

monetary base? Jooking at the >S! if /e used the sim9lified model mentioned before! the multi9lier should be 1%? 3n reality! it_s closer to 1?*? 4hat_s a big difference? +ormally! the e89lanation is that 9eo9le hold significant amount of cash rather then gi-ing the money to the bank /here it can multi9ly? 1o/e-er! due to the "%%) crisis the go-ernment tried stabili=ing the economy-- in doing so it made it much more attracti-e to hold on to e8cess reser-es so instead of loaning money out banks Eust had trillions of dollars all of a sudden sitting there? Quring "%%)! the multi9lier /as as lo/ as %?)?

Module 2A
4he :ederal 6eser-e Monetary Policy 1he 5ederal 7eserve 8ystem --; :ederal 6eser-e System ser-es as the central bank of the >nited States? ;3t has t/o 9arts the Goard of Go-ernors! /hich is 9art of the >?S? go-ernment! and the 1" regional :ederal 6eser-e Ganks! /hich are 9ri-ately o/ned?

PAGE # (*

1he 5unctions o" the 5ederal 7eserve 8ystem --; :ederal 6eser-es functions fall into four basic categories 9ro-iding financial ser-ices to de9ository institutions! su9er-ising and regulating banks and other financial institutions! maintaining the stability of the financial system! and conducting monetary 9olicy? !rovide 5inancial 8ervices ;1" regional :ederal 6eser-e Ganks 9ro-ide financial ser-ices to de9ository institutions .banks and >?S? go-ernment0? ; 4he :ederal 6eser-e is Abankers bankB .holds reser-es! clears checks! 9ro-ides cash! and transfers funds for commercial banks0 ;:ed also is banker and fiscal agent for the federal go-ernment? 4he >?S? 4reasury has its checking account /ith the :ederal 6eser-e 8upervise and 7egulate 6anking +nstitutions ; :ederal 6eser-e System must ensure the safety and soundness of the nations banking and financial system? ;regional :ederal 6eser-e Ganks e8amine<regulate commercial banks in their district? ;4he Goard of Go-ernors also engages in regulation<su9er-ision of financial institutions? Maintain the 8ta%ility o" the 5inancial 8ystem --; :ederal 6eser-e System /as created /as to 9ro-ide the nation /ith a safe and stable monetary and financial system? --; charged /ith maintaining the integrity of the financial system? --; :ederal 6eser-e banks 9ro-id li@uidity to financial institutions to ensure their safety and soundness? $onduct Monetary !olicy ; :ederal 6eser-es must conduct of monetary 9olicy --; uses the tools of monetary 9olicy to 9re-ent or address e8treme macroeconomic fluctuations in the >?S? economy? 2hat the 5ed ,oes ;4he :ederal 6eser-e carries these functions by using it_s three main 9olicy tools reserve re-uirements, the discount rate, and open #market operations% 1he 7eserve 7e-uirement ;note that :ed sets a minimum re@uired reser-e ratio! currently e@ual to 1%H for checkable bank de9osits? --; Ganks that fail to maintain at least the re@uired reser-e ratio face 9enalties? --; if a bank has insufficient reser-es to meet the :eds reser-e re@uirement it borro/s additional reser-es from other banks -ia the "ederal "unds market .a financial market that allo/s banks that fall short of the reser-e re@uirement to borro/ reser-es0 from banks that are holding e8cess reser-es? ; interest rate in this market is determined by su99ly and demand but the su99ly and demand for bank reser-es are both strongly affected by :ederal 6eser-e actions?

PAGE # )%

;"ederal "unds rateF the interest rate at /hich funds are borro/ed and lent in the federal funds market is im9ortant for monetary 9olicy --; to alter the money su99ly! the :ed can change reser-e re@uirements? --; if:ed reduces the re@uired reser-e ratio! banks /ill lend a larger 9ercentage of their de9osits! leading to more loans and an increase in the money su99ly -ia the money multi9lier? ; if :ed increases the re@uired reser-e ratio! banks are forced to reduce their lending! leading to a fall in the money su99ly -ia the money multi9lier? 1he ,iscount 7ate ;Ganks in need of reser-es can also borro/ from the :ed itself -ia the discount window% --; discount rate is the interest rate the :ed charges on those loans? --; the discount rate is set 1 9ercentage 9oint abo-e the federal funds rate in order to discourage banks from turning to the :ed /hen they are in need of reser-es? ; to alter the money su99ly! the :ed can change the discount rate? --; if :ed reduces the s9read bet/een the discount rate and the federal funds rate! the cost to banks of being short of reser-es fallsD banks res9ond by increasing their lending! and the money su99ly increases -ia the money multi9lier? ; 3f the :ed increases the s9read bet/een the discount rate and the federal funds rate! bank lending falls` and so /ill the money su99ly -ia the money multi9lier? ;most monetary 9olicy is conducted almost e8clusi-ely using the :eds third 9olicy tool o9en -market o9erations? :pen-Market :perations --; :ederal 6eser-e also has assets and liabilities? --; assets consist of its holdings of debt issued by the >?S? go-ernment .mainly short -term >?S? go-ernment bonds /ith a maturity of less than one year --; >?S? 4reasury bills0 --; note that >?S? 4reasury bills held by the :ed are a liability of the go-ernment but an asset of the :ed? --; :eds liabilities consist of currency in circulation and bank reser-es? .insert :igure "(?1 /hich sho/s the assets and liabilities of the :ed in the form of a 4-account?0

;open -market operation the :ederal 6eser-e buys<sells >?S? 4reasury bills normally /< commercial ,anks .banks that mainly make business loans! as o99osed to home loans?0

PAGE # )1

--; :ed ne-er buys >?S? 4reasury bills directly from the federal go-ernment? ./hen a central bank buys go-ernment debt directly from the go-ernment! it is lending directly to the go-ernment`in effect! the central bank is issuing A9rinting moneyB to finance the go-ernments budget deficit? --; leads to inflation0 .insert :igure "(?"0

4his sho/s the changes in the financial 9osition of both the :ed and commercial banks that result from o9en -market o9erations? ; /hen :ed buys >?S? 4reasury bills from a commercial bank --; 9ays by crediting the banks reser-e account by an amount e@ual to the -alue of the 4reasury bills? ; sho/n in 9anel .a0 the :ed buys T1%% million of >?S? 4reasury bills from commercial banks --; increases the monetary base by T1%% million because it increases bank reser-es by T1%% million? --; /hen :ed sells >?S? 4reasury bills to commercial bank it debits the banks accounts! reducing their reser-es? sho/n in 9anel .b0! /here :ed sells T1%% million of >?S? 4reasury bills? --; bank reser-es and the monetary base decrease? :ed gets the funds to 9urchase >?S? 4reasury bills from banks by creating them --; that credits the banks accounts /ith e8tra reser-es? --; :ed issues currency to 9ay for 4reasury bills /hen banks /ant the additional reser-es in the form of currency? --; /e ha-e fiat money so :ed can create additional monetary base at its o/n discretion? ----; change in bank reser-es caused by an o9en -market o9eration doesnt directly affect the money su99ly --; it starts the money multi9lier in motion?

PAGE # )"

T1%% million increase in reser-es sho/n in 9anel .a0! commercial banks /ould lend out their additional reser-es --; increasing the money su99ly by T1%% million? ;some those loans /ould be de9osited back into the banking system! increasing reser-es again and 9ermitting a further round of loans! and so on! leading to a rise in the money su99ly ;o9en -market sale has the re-erse effect --; bank reser-es fall! re@uiring banks to reduce their loans! leading to a fall in the money su99ly? ; :ed controls the money su99ly`checkable de9osits 9lus currency in circulation? --; it controls only the monetary base` bank reser-es 9lus currency in circulation? ;by increasing or reducing the monetary base! the :ed can e8ert a 9o/erful influence on both the money su99ly and interest rates?

Module 28

1he ,emand "or Money --; note that M1 consists of currency in circulation .cash0 7 checkable bank de9osits 7 tra-elers checks? M" .broader definition0 consists of M1 9lus de9osits that can easily be transferred into checkable de9osits? Peo9le hold money to make it easier to 9urchase goods and ser-ices? 1he :pportunity $ost o" ;olding Money --;economic decisions in-ol-e trade -offs at the margin? ; indi-iduals decide ho/ much of a good to consume by determining /hether the benefit theyd gain from consuming a bit more of any gi-en good is /orth the cost? ;same decision 9rocess is used /hen deciding ho/ much money to hold? --; 3ndi-iduals< firms o hold some of their assets in the form of money because of the con-enience --; money can be used to make 9urchases directly! /hile other assets cant? .an o99ortunity cost associated for that con-enience money held in your /allet earns no interest?0 --;9eo9le continue to kee9 cash in their /allets rather than lea-e the funds in an interest -bearing account because they dont /ant to ha-e to go to an A4M to /ithdra/ money e-ery time they /ant to make a small 9urchase? --; the con-enience of kee9ing some cash in your /allet is more -aluable than the interest you /ould earn by kee9ing that money in the bank? --; trade off in holding money in checking account --; because you can earn a higher interest rate by 9utting your money in assets other than a checking account?

PAGE # )#

--; banks offer certificates of de9osit .,Qs0 /hich 9ay a higher interest rate than ordinary bank accounts? but also carry a 9enalty if you /ithdra/ the funds before a certain amount of time --; An indi-idual /ho kee9s funds in a checking account is forgoing the higher interest rate those funds /ould ha-e earned if 9laced in a ,Q in return for the con-enience of ha-ing cash readily a-ailable /hen needed? --.insert table ")?10

4his sho/s the o99ortunity cost of holding money in a s9ecific month! Vune "%%(? ; 4he first ro/ sho/s the interest rate on one -month ,Qs and in Vune _%( one -month ,Qs yielded &?#%H? ;4he second ro/ sho/s the interest rate on interest -bearing bank accounts .s9ecifically! those included in M10? ;:unds in these accounts /ere more accessible than those in ,Qs! but the 9rice of that con-enience /as a much lo/er interest rate! only "?$()H? ;last ro/ sho/s the interest rate on currency --; cash in your /allet /hich has no interest 4able ")?1 sho/s the o99ortunity cost of holding money at one 9oint in time --; the o99ortunity cost of holding money changes /hen the o-erall le-el of interest rates changes? ;! /hen the o-erall le-el of interest rates falls! the o99ortunity cost of holding money falls .insert table ")?"0

4able ")?" sho/s ho/ selected interest rates changed bet/een Vune "%%( - Vune "%%) --; :ederal 6eser-e /as slashing rates in an effort to fight off recession? ; bet/een Vune "%%( and Vune "%%)! the federal funds rate . rate the :ed controls most directly0 fell by #?"& 9ercentage

PAGE # )$

9oints? ; 4he interest rate on one -month ,Qs fell almost as much! "?) 9ercentage 9oints? --; All short -term interest rates .rates on financial assets that come due! or mature! /ithin less than a year0 tend to mo-e together! /ith rare e8ce9tions? ; reason short -term interest rates tend to mo-e together is that ,Qs and other short -term assets .like one< three-month >?S? 4reasury bills0 are in effect com9eting for the same business? ;Any short -term asset that offers a lo/er -than -a-erage interest rate /ill be sold by in-estors --; /ho_ll mo-e their /ealth into a higher -yielding short -term asset? --; selling of the asset then forces its interest rate u9 because in-estors must be re/arded /ith a higher rate in order to con-ince them to buy it? ; ,on-ersely! in-estors /ill mo-e their /ealth into any short -term financial asset that offers an abo-e -a-erage interest rate ;4he 9urchase of the asset dri-es its interest rate do/n /hen sellers find they can lo/er the rate of return on the asset and still find /illing buyers? --; interest rates on short -term financial assets tend to be roughly the same because no asset /ill consistently offer a higher -than - a-erage or a lo/er -than -a-erage interest rate? --; short -term interest rates fell bet/een Vune "%%( and Vune "%%)! the interest rates on money didnt fall by the same amount? ; 4he interest rate on currency remained at =ero? 4he interest rate 9aid on demand de9osits did fall! but by much less than short -term interest rates? As a result! the o99ortunity cost of holding money fell? 4he last t/o ro/s of 4able ")?" sho/ the differences bet/een the interest rates on demand de9osits and currency and the interest rate on ,Qs? differences declined shar9ly bet/een Vune "%%(- "%%)? ;sho/s the higher the short -term interest rate the higher the o99ortunity cost of holding money the lo/er the short -term interest rate the lo/er the o99ortunity cost of holding money? 4able ")?" short -term interest rates >long - term interest rates interest rates on financial assets that mature! or come due! a number of years into the future ;difference bet/een short -term< long -term interest rates is sometimes im9ortant as a 9ractical matter? its short -term rates usually affect money demand! because the decision to hold money in-ol-es trading off the con-enience of holding cash -ersus the 9ayoff from holding assets that mature in the short -term assume that there is only one interest rate for no/

PAGE # )&

1he Money ,emand $urve note o-erall le-el of interest rates affects the o99ortunity cost of holding money so @uantity of money indi-iduals and firms /ant to hold is negati-ely related to the interest rate? .insert :igure ")?10

; hori=ontal a8is sho/s the @uantity of money demanded and the -ertical a8is sho/s the nominal interest rate! r, /hich you can think of as a re9resentati-e short -term interest rate such as the rate on one -month ,Qs? ; /e 9lace nominal interest rate on the -erticle a8is .not real interest rate0 because o99ortunity cost of holding money includes both the real return that could be earned on a bank de9osit and the erosion in 9urchasing 9o/er caused by inflation? nominal interest rate includes both the forgone real return and the e89ected loss due to inflation? 1ence! r in :igure ")?1 and all subse@uent figures is the nominal interest rate? relationshi9 bet/een the interest rate and the @uantity of money demanded by the 9ublic is illustrated by the money demand curveF *3, in :igure ")?1 ;4he money demand cur-e slo9es do/n/ard because a higher interest rate increases the o99ortunity cost of holding money! leading the 9ublic to reduce the @uantity of money it demands? if interest rate is -ery lo/ the interest forgone by holding money is relati-ely small? indi-iduals< firms /ill tend to hold relati-ely large amounts of money to a-oid the cost and to a-oid con-erting other assets into money /hen making 9urchases? if the interest rate is relati-ely high the o99ortunity cost of holding money is high? Peo9le /ill kee9ing only small amounts in cash and de9osits! con-erting assets into money

PAGE # )'

only /hen needed? /e dra/ the money demand cur-e /ith the interest rate most 9eo9le the rele-ant @uestion in deciding ho/ much money to hold is /hether to 9ut the funds in the form of other assets that can be turned fairly @uickly and easily into money? .stocks ha-e brokers fees /hen you sell stock doesnt fit0 rele-ant com9arison is /ith assets that are Aclose toB money`fairly li@uid assets like ,Qs? And as /e-e already seen! the interest rates on all these assets normally mo-e closely together?

8hi"ts o" the Money ,emand $urve the money demand cur-e can be shifted by a number of factors? :igure ")?" sho/s shifts of the money demand cur-e

; an increase in the demand for money corres9onds to a right/ard shift of the *3 cur-e! raising the @uantity of money demanded at any gi-en interest 6ate ;a fall in the demand for money corres9onds to a left/ard shift of the *3 cur-e! reducing the @uantity of money demanded at any gi-en interest rate? 4he most im9ortant factors causing the money demand cur-e to shift are changes in the aggregate 9rice le-el! changes in real GQP! changes in banking technology! and changes in banking institutions? $hanges in the *ggregate !rice #evel

PAGE # )(

higher 9rices increase the demand or money .a right/ard shift of the *3 cur-e0! and lo/er 9rices reduce the demand for money .a left/ard shift of the *3 cur-e0? the demand for money is proportional to the 9rice le-el? 4hat is! if the aggregate 9rice le-el rises by "%H! the @uantity of money demanded at any gi-en interest rate! such as r1 in :igure ")?"! also rises by "%H`the mo-ement from *1 to *"? this is because if the 9rice of e-erything rises by "%H! it takes "%H more money to buy the same basket of goods and ser-ices .re-erse is true0 $hanges in 7eal <,! an increase in real GQP`the total @uantity of goods and ser-ices 9roduced and sold in the economy` shifts the money demand cur-e right/ard? A fall in real GQP shifts the money demand cur-e left/ard? $hanges in 1echnology 3n general! ad-ances in information technology ha-e tended to reduce the demand for money by making it easier for the 9ublic to make 9urchases /ithout holding significant sums of money? $hanges in +nstitutions ,hanges in institutions can increase or decrease the demand for money 2hen banking regulations changed! allo/ing banks to 9ay interest on checking account funds! the demand for money rose and shifted the money demand cur-e to the right? Money and +nterest 7ates 4he federal funds rate is the rate at /hich banks lend reser-es to each other to meet the re@uired reser-e ratio? at each of its eight -times -a -year meetings! the :ederal M9en Market ,ommittee sets a target -alue for the federal funds rate? .u9 to :ed officials to achie-e that target?0 done by the M9en Market Qesk at the :ederal 6eser-e Gank of +e/ Iork! /hich buys and sells short -term >?S? go-ernment debt! kno/n as 4reasury bills! to achie-e that target? As /e-e already seen! other short -term interest rates! such as the rates on ,Qs! mo-e /ith the federal funds rate?

1he E-uili%rium +nterest 7ate note /e assumed that there is only one interest rate 9aid on nonmonetary financial assets! both in the short run and in the long run? .insert :igure ")?#0

PAGE # ))

;sho/s li-uidity pre"erence model o" the interest rate ;says that the interest rate is determined by the su99ly and demand for money in the market for money? this combines the money demand cur-e! *3, /ith the money supply curveF * , /hich sho/s ho/ the @uantity of money su99lied by the :ederal 6eser-e -aries /ith the interest rate? :ederal 6eser-e can increase or decrease the money su99ly does -ia open#market operations, buying or selling 4reasury bills! but it can also lend -ia the discount window or change reserve re-uirements% think that :ed! using one or more of these methods! sim9ly chooses the le-el of the money su99ly that it belie-es /ill achie-e its interest rate target? 4hen the money su99ly cur-e is a -ertical line! * in :igure ")?#! /ith a hori=ontal interce9t corres9onding to the money su99ly chosen by the :ed! * "w4 line on top$ ? 4he money market e@uilibrium is at 5, /here * and *3 cross? At this 9oint the @uantity of money demanded e@uals the money su99ly! * "w4 line on top$ leading to an e@uilibrium interest rate of r5? 4o understand /hy r5 is the e@uilibrium interest rate! consider /hat ha99ens if the money market is at a 9oint like &, /here the interest rate! r&, is belo/ r5% At r& the 9ublic /ants to hold the @uantity of money *& , an amount larger than the actual money su99ly! *"w4 line on top$ ? at 9oint &, the 9ublic /ants to shift some of its /ealth out of interest -bearing assets such as highdenomination ,Qs ./hich arent money0 into money?

PAGE # )*

4/o im9lications Mne is that the @uantity of money demanded is more than the @uantity of money su99lied? other is that the @uantity of interest -bearing nonmoney assets demanded is less than the @uantity su99lied? So those trying to sell nonmoney assets /ill find that they ha-e to offer a higher interest rate to attract buyers? As a result! the interest rate /ill be dri-en u9 from r& until the 9ublic /ants to hold the @uantity of money that is actually a-ailable! *% 4hat is! the interest rate /ill rise until it is e@ual to r5% if the money market is at a 9oint such as 6 in :igure ")?#! /here the interest rate r6 is abo-e r5? 3n that case the @uantity of money demanded! *6, is less than the @uantity of money su99lied! *"w4 line on top$ ,orres9ondingly! the @uantity of interest -bearing nonmoney assets demanded is greater than the @uantity su99lied? 4hose trying to sell interest -bearing nonmoney assets /ill find that they can offer a lo/er interest rate and still find /illing buyers? leads to a fall in the interest rate from r6% 3t falls until the 9ublic /ants to hold the @uantity of money that is actually a-ailable! *"w4 line on top$ ? Again! the interest rate /ill end u9 at r5% 1wo Models o" the +nterest 7ate /e ha-e made li@uidity 9reference model of the interest rate? the e@uilibrium interest rate is the rate at /hich the @uantity of money demanded e@uals the @uantity of money su99lied? consistent /< loanable funds model of the interest rates! /hich is de-elo9ed in the ne8t module? 3n the loanable funds model! /e /ill see that the interest rate matches the @uantity of loanable funds su99lied by sa-ers /ith the @uantity of loanable funds demanded for in-estment s9ending?

Module 20
Joanable :unds Market - a hy9othetical market that illustrates the market outcome of the demand for funds generated by borro/ers and the su99ly of funds 9ro-ided? - 9rice determined in loanable funds market is the interest rate - 6eal interest rate F +ominal interest rate - inflation rate - in-estors and sa-es care about the real interest rate 4he 6ate of 6eturn on a 9roEect is the 9rofit earned on the 9roEect e89ressed as a 9ercentage of its cost

A business /ill /ant a loan /hen the rate of return on its 9roEect is ; or F the interest rate - E8am9le at an interest rate of 1"H! only businesses /ith 9roEects that yield a rate of return ; or F 1"H /ill /ant to loan ,emand $urve "or #oana%le 5unds

PAGE # *%

8upply $urve "or #oana%le 5unds

-Peo9le /ant to make money off of the 3nterest rate! so the higher the interest rate the higher the @uantity of loanable funds

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CAn increase in the demand for loanable funds leads! other things e@ual! to a rise in the interest rate CAn increase in the su99ly for loanable funds also leads! other things e@ual! to a rise in the interest rate 8hi"ts o" the ,emand "or #oana%le 5unds - ,hanges in Percei-ed Gusiness M99ortunities ,hange in belief of increase in in-estment s9ending can increase or reduce the amount of desired s9ending at any gi-en interest rate - ,hanges in Go-ernment Gorro/ing Go-ernments that run deficits are maEor sources of the demand for loanable funds? $rowding outB occurs /hen a go-ernment deficit dri-es u9 the interest rate and leads to reduced in-estment s9ending - Subsidies or 4a8es on 3n-estment S9ending Subsidies gi-e in-estors the incenti-e to in-est! ta8es on in-estment s9ending does the o99osite 8hi"ts o" the 8upply o" #oana%le 5unds - ,hanges in 9ri-ate sa-ings beha-ior E8 6ising home 9rices makes homeo/ners feel richer! making them /illing to s9end more and sa-e less? 4his shifts the su99ly of loanable funds to the left? - 4a8es on interest income 4he higher the ta8 on interest income! the smaller the su99ly of loanable funds - ,hanges in ca9ital inflo/ ,a9ital flo/s into a country can change as in-estors 9erce9tions of that country change 4he true cost of borro/ing is the real interest rate! not the nominal interest rate E8 3f a firm borro/s T1%k at a nominal interest rate of 1%H! then they 9ay back T11k! but the a-erage le-el of 9rices increases by 1%H! the real interest rate /ould be % 5isher E""ect An increase in e89ected future inflation dri-es u9 the nominal interest rate! lea-ing the e89ected real interest rate unchanged

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1he +nterest 7ate in the 8hort 7un

1he +nterest 7ate in the #ong 7un

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4his e8ists guysN >se itNNNN htt9 <<bcs?/orth9ublishers?com<krugmanba9bmacro<default?as9#'#(%(1bb'#($11bb Module .'- not needed for testN Vust re-ie/ Module "* 3nstead? #ong-run +mplications o" 5iscal !olicyB ,e"icits and the !u%lic ,e%t Main Points 6udget 6alance is a Measure o" 5iscal !olicy Gudget can either be in a sur9lus or deficit? :iscal Policy is needed to balance the budget? ,hanges in fiscal 9olicy dont al/ays translate 9erfectly into changes in the macroeconomy? ,hanges in the budget are often resultant of -olatility in the economy? 6usiness $ycle and the $yclically *dJusted 6udget 6alance Gusiness ,ycle im9acts Gudget Galance 6ecession Qeficit E89ansion Sur9lus ,yclically adEusted budget balance 8hould the 6udget %e 6alanced@ +o? E8cessi-e use of fiscal 9olicy to obsessi-ely balance the budget /ould undermine the 9ur9ose of automatic stabili=ers? ,e"icitsF 8urplusesF and ,e%t Go-ernment runs on the fiscal calendar! and the >S go-ernment has accumulated a lot of debt? !ro%lems !osed %y 7ising <overnment ,e%t Accumulating Go-ernment Qebt causes accumulating interest 9ayments! /hich can increase to a substantial amount? Go-ernments borro/ more to 9ay off debt! e8acerbating the deficit? 4he country may ha-e to default on all of its loans! /hich can ruin a country?

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,e"icits and ,e%ts in !ractice Qebt-GQP ratio is an e8cellent indication of a countrys economic health? +mplicit #ia%ilities 4hese are s9ending 9romises by the go-ernment! /hich translate into debt! e-en though they are not accounted for in debt statistics? Social Security! Medicare! and Medicaid are the three largest liabilities! and their 9roEected s9ending is -ery high?

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Module .1B Monetary !olicy and the +nterest 7ate 6efresher Monetary Policy ho/ the central bank .>S has the :ederal 6eser-e0 uses changes in the @uantity of money or the interest rate to stabili=e the economy? ,urrent :ed ,hairman- Gen Gernanke? .+e8t /ill @uite 9ossibly be Vanet IellenN0 Monetary !olicy and the +nterest 7ate Summary :ed can mani9ulate money su99ly to set interest rate! ceteris 9arabis? :ed sets target federal funds rate and uses o9en-market o9erations to achie-e it?

5igure .1 1 4he :ed can increase the Money Su99ly .shift it to the right0 to lo/er the 3nterest 6ate? :ed can also decrease the Money Su99ly in order to increase the 3nterest 6ate? :ederal M9en Market ,ommittee decides on the interest rate! /hich 9re-ails for the si8 /eeks before their ne8t meeting? 4he :ed sets a target "ederal "unds rate! /hich is enforced by the M9en Market Qesk of the :ederal 6eser-e Gank of +e/ Iork? 4he buying and selling of 4reasury bills! aka o9en market o9erations! are used until the target is reached? Mther tools of monetary 9olicy! such as lending through the discount /indo/ and changing the reser-e re@uirement! are used infre@uently?

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5igure .1 2 Goal Qecrease the 3nterest 6ate<3ncrease the Money Su99ly? Action 4aken o9en market 9urchase of treasury bills to 9ush the money su99ly cur-e right? Goal 3ncrease the 3nterest 6ate<6educe the Money Su99ly? Action 4aken o9en market sale of treasury bills to 9ush the money su99ly cur-e to the left? :I3 .inessential0 5ed 7everses $ourse >ntil "%%'! the federal funds rate had been steadily rising! because of the fear of inflation? Geginning in Se9tember "%%( there /as much financial -olatility! and so the :ed cut the target :ederal :unds 6ate? Starting in late "%%)! the :ederal M9en Market ,ommittee set a target range for the federal funds rate! bet/een %H and %?"&H! and thats /hy there a99ears to be t/o federal funds rates

Monetary !olicy and *ggregate ,emand Summary 3nterest 6ate is in-ersely related to Aggregate Qemand? Monetary Policy affects the interest rate! /hich can shift the aggregate demand cur-e? E)pansionary Monetary !olicy :ed e89ands money su99ly lo/er interest rate more in-estment s9ending higher real GQP increased consumer s9ending etcetera 4he e-entual effect is an increase in Aggregate Qemand $ontractionary Monetary !olicyB :ed contracts the money su99ly higher interest rate less in-estment s9ending lo/er real GQP lo/er consumer s9ending etcetera

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Monetary !olicy in !ractice Summary Monetary Policy lags! but its the main tool of stabili=ation 9olicy? :ederal funds rate is 9ositi-ely correlated /ith out9ut ga9! inflation! and the 4aylor 6uleD /ith the 4aylor 6ule being the best indicator? 4he goals of monetary 9olicy makers include fighting recessions and ensuring 9rice stability through a relati-ely lo/ .ideally "H0 inflation rate? 2hene-er GQP is belo/ 9otential out9ut! the :ed engages in e89ansionary monetary 9olicy Mut9ut Ga9 the difference bet/een real GQP and 9otential out9ut? Positi-e /hen real GQP is greater and negati-e /hen real GQP is lesser? Mut9ut Ga9 is generally 9ositi-ely correlated /ith interest rates! /ith the e8ce9tion being in the *%s /hen the :ed ke9t rates steady des9ite the increasingly 9ositi-e out9ut ga9? 3nflation this rate /as lo/ in the *%s /hich e89lains the steady interest rates .loose monetary 9olicy0 in that 9eriod? 4his is because interest is also 9ositi-ely correlated /ith federal funds rate? 1aylor 7ule "or Monetary !olicy the best 9redictor of monetary 9olicy? 3t incor9orates both inflation and out9ut ga9? 4he >S :ederal 6eser-e uses a loosely defined -ersion of this rule /hile setting its monetary 9olicy? 4he rule 5ederal "unds rate D 1 G (1 4 ) in"lation rate) G (' 4 ) output gap)

5igure .1 ( 4racking Monetary Policy >sing the Mut9ut Ga9! 3nflation! and the 4aylor 6ule a0 2hen out9ut ga9 is 9ositi-e! the federal funds rate rises? And -ice -ersa? b0 3f inflation is high! federal funds rate is also highD if inflation is lo/! f?f? rate is lo/? c0 4he 9roEected federal funds rate! deri-ed from the 4aylor 6ule! closely mirrors the actually federal funds rate? 4he 4aylor 6ule matches actual monetary 9olicy better than Eust the out9ut ga9 or the inflation rate! and it uses a combination of both?

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+n"lation 1argetingB occurs /hen the central bank sets a certain target! and designs its 9olicy accordingly? Setting an inflation target is more for/ard thinking than the 4aylor 6ule! /hich deri-es its numbers from 9ast data? 4his mechanism has t/o maEor ad-antages? 4he first is trans9arencyD the 9ublic kno/s about the central banks obEecti-es! and so there is less economic uncertainty? Second is accountability 9eo9le can Eudge /hether or not inflation targets /ere met? Mne dra/back is that inflation targeting is -ery restricti-e! and it doesnt take other -ariables into account .such as the stability of the financial system0?