FINAL

Addendum 2

A Formula for the Govt. Expenditure Multiplier -->Simple algebra allows us to derive a formula for the size of the multiplier effect. An important number in the formula is the Marginal Propensity to Consume (MPC). It is defined to be the fraction or percentage of an extra dollar of disposable income (DI) that a household consumes. If MPC is 0.75, the household will consume 75 cents out of every 'additional' dollar of DI that she makes. (Recall that marginal means additional.) That means she will save the remaining 25 cents out of every extra dollar of DI. In other words, her Marginal Propensity to Save is 0.25. -->In short, ---->MPC = ∆C/∆(Y-T) (how much of every additional $ in DI gets spent) = 75 cents/100 cents = 0.75 ------>MPC- marginal propensity to consume ------>MPS- marginal propensity to save ------>(Y-T) Disposable Income (DI) The expression for the expenditure multiplier is an infinite geometric series. The formula for adding up such a series is given by -->Multiplier = k (by notation) = 1/(1-MPC) = 1/MPS -->Here, MPC = 0.8; hence the expenditure multiplier is 1/0.2 = 5 ---->This means that a $100 million increase in G on stimulus packages will generate $100*5 = $500 increase in spending and income. As you can see intuitively, higher the MPC (i.e., lower the MPS) more will be spent in every successive stage more income will be generated in every successive stage larger will be the k.

Equilibrium in the AD-AS Model

A good starting point is where SR equilibrium coincides with LR equilibrium. In the graph, long-run equilibrium (where the LRAS intersects AD) coincides with SR equilibrium (where the SRAS intersects AD). In other words, the AD in the short run is enough to produce the LR full employment level of output. During COVID, the output level/equilibrium fell below LRAS line; AD curve shifted left; people were unemployed -->Demand determines where output is going to be if you're horizontal; supply no longer matters

Are we in a recession? How bad is it?

A recession hasn't been declared yet because we need all the details/data This will probably eventually be called a recession; we had negative growth last quarter and next quarter will be bad too Will probably be steepest recession in recent history Unemployment will go up/be high, but things will be worse than the data suggests because people will be stuck at home/can't look for jobs and they won't be counted in the labor force

Aggregate Supply (AS)

AS: This curve depicts the total output (real GDP) that the economy will produce at varying price levels. The shape (slope) of the AS curve depends on the time horizon - LR or SR? LRAS- long run aggregate supply curve Question: How can you explain the shape of the LRAS curve? -->In the LR, production is primarily determined by i) country's size of the labor force (which is tied to population), ii) other natural resources - land, minerals etc., iii) nation's capital stock (which can be increased through investment) and iv) technology for turning input into output. Prices do not play much of a role. Hence, LRAS is independent of the price level and depicted by a vertical line. The output level at which it is vertical is called the long run natural rate of output or the full employment level of output assuming that the country is utilizing its resources fully. (The concept of LRAS is similar to being at a point on the PPF boundary that you studied in chapter 2. This is the best we can do, i.e., the maximum a country can produce given its resources and technology.) Question: When do we shift the LRAS? What are the determinants or shift factors for the LRAS? -->Well, these shift factors are the same 4 factors alluded to above. -->If population grows, the size of the labor force is expected to grow → LRAS will shift out -->If physical capital stock grows → LRAS shifts out -->If human capital (the education or skill level of the workforce) grows, workers become more productive → LRAS shifts out -->As natural resources decrease due to natural calamities or due to destruction by war etc., LRAS shifts in -->Most important shift factor today is technological advancement. As technology gets better, workers become more and more productive and LRAS shifts out. Question: Can the government alter the location of LRAS? What is supply-side policy? Can you name a few? -->Supply side policy, as the name suggests, is any policy that alters the location of the LRAS curve. Supply side policies are specifically designed to shift LRAS out and are often referred to as long run growth-oriented policies. -->Examples: ---->The $1 trillion infrastructure bill that was passed by the US Congress in November 2021 is centered on fixing roads and bridges and expanding broadband internet access, among others. This infusion of government spending is likely to fuel the growth of physical capital and technology and thus shift LRAS out. ---->Immigration policy altering size of the labor force - If labor force increases in the LR, it will shift LRAS out ---->Subsidized student loans for college → more college graduates → productivity of the workforce increases LRAS shifts out ---->Government offering investment tax credit to businesses for undertaking research and development projects spurs technological innovation LRAS shifts out

Duration of unemployment

BLS breaks up the number unemployed by the duration of unemployment, among others. Most worrisome is the size of long-term unemployed. The longer one is unemployed, the harder it gets to find a job! Long term unemployed is defined as those unemployed for 27 weeks and longer. In August 2021, a year and a half into the Covid outbreak, the long-term unemployed in the US labor market stood at 3.1 million. [Compare it with the long term unemployed in January 2020 (right before the pandemic) at 1.16 million!] However, there is good news. The number of long-term unemployed has since dropped significantly and stands at 1.14 million today (which is below the pre pandemic level). Problem with Data Collection by BLS: -->Part-timers are considered fully employed. ---->Question: Does this feature overstate or understate the actual unemployment problem? ------>Clearly understates the actual unemployment problem. People work part time by choice but also due to lack of full-time opportunities. To that extent, they are partly unemployed. -->Discouraged workers are not counted as unemployed. ---->Question: Does this feature overstate or understate the actual unemployment problem? ------>Once again, this feature understates the actual unemployment problem. Discouraged workers are in fact the "hard core unemployed" and their number usually goes up rapidly during recession. -->So by and large, official unemployment statistics are an imperfect measure of joblessness. ---->Question: What is the approximate current unemployment rate once adjustments are made for part-timers and discouraged workers among others? ------>BLS releases an alternative measure of labor force underutilization rate to account for some of the above-mentioned limitations. ------>In August 2022, the alternative measure of unemployment was at 7.0% compared to the official unemployment rate of 3.7% !

Question: How does a single bank create money?

By granting loans. To see this clearly, let us assume we are talking about the M1 definition of money. M1 = currency + demand deposits (let us skip traveler's checks for now) Using the example above, initially currency decreases by $1000 and demand deposits increase by $1000. Hence there is no change in M1, although there is a change in composition of M1. In the next stage, CU can loan out a maximum of $900, the amount of its excess RE. If Emily wants a loan from CU for $900, CU will create a checking account in Emily's name and credit her account with $900. So, at that point, M1 increases by $900. Emily can use this $900 to make a payment anytime. Question: What is the maximum amount a single bank can loan out? -->Dollar for dollar with excess RE. Hence, a single bank can create money $ for $ with its excess RE.

Types of Money - commodity money versus fiat money

Commodity money money with intrinsic value. In other words, items that are used as commodity money would have value even if they were not used as money. -->Examples? Historically speaking, gold, silver, cigarettes in POW camps - they all served the 3 basic functions of money. These commodities have other uses even if they are no longer used as money. Fiat money → money without intrinsic value. You can think of it as a piece of paper that is valuable only because it is certified by Government decree or 'fiat' to be money and the government will accept it in transactions. If it were not for government backing, there would be no difference between fiat money and paper money from a game of monopoly. -->So modern day money is fiat money, right?

Monetary policy can be divided into 2 broad categories

Countercyclical monetary policy; tied to business cycle Expansionary (easy) Monetary Policy involves increases in money supply. Hence, it includes policy tools such as: -->Buying govt. securities in open market; lowering reserve ratio; lowering discount rate or paying lower interest on reserves at the Fed -->Such a policy is typically pursued during the recessionary phase of the business cycle to get the consumers and the businesses to spend again and thus reduce unemployment. -->Pursued to counter recession Contractionary (tight) Monetary Policy involves decreases in money supply. Hence, it includes policy tools such as -->Selling govt. securities in open market; raising reserve ratio; raising discount rate or paying higher interest on reserves at the Fed -->Such a policy is typically pursued during the inflationary phase of the business cycle when the economy is experiencing robust growth and inflation is rising to contain spending. -->Pursued to counter inflation

We will first develop the model of aggregate demand and aggregate supply (AD-AS model) to explain short run economic fluctuations (i.e. booms and recessions) over the business cycle. Next, we will use the AD-AS model to study the impact of demand side policy to alleviate the SR fluctuations of the economy over the business cycle.. We will divide our discussion into five broad sections as follows:

Derivation of AD slope and shift of AD -->The AD curve looks just like the market demand curve you studied in chapter 4 with the exception that now we are looking at the aggregate economy instead of one market at a time. Hence, we are measuring total output of the economy (i.e., real GDP) along the horizontal axis and the aggregate price level (i.e., some measure of a price index) along the vertical axis. ---->When price changes, move along the curve -->You can think of the AD curve as the aggregate spending (or aggregate expenditure) curve. -->Question: what are the various components of aggregate spending? i.e.Who is spending money in the economy? ---->Recall GDP equation from the expenditure side: Y = C + I + G + (X-M) ---->Households (engaged in C), businesses (engaged in I), the govt. sector (engaged in G) and the foreign sector engaged in (X-M) are the four broad groups spending money in the economy. Derivation of LRAS and SRAS slope and shift Determination of equilibrium in the AD-AS model Demand Side Policy Causes of SR fluctuations and the Stabilizing Impact of demand side policy - application to COVID -19 Aggregate Demand (AD)

Changing discount rate

Discount rate refers to the interest rate the Fed charges on short term loans granted to commercial banks and other depository institutions to shore up their reserves. Decrease in discount rate: giving banks an incentive to borrow more from the Fed. How does the borrowing take place? Suppose Commerce Bank wants to borrow $10,000 from the Fed. The Fed simply increases the reserves of Commerce Bank at the Fed by the amount of the loan or $10,000. At this point, the same logic applies as before in the case of open market operations. Commerce Bank will be in a position to make additional loans and hence increase money supply. Alternatively, increase in discount rate: banks will borrow less from the Fed as it is costlier to borrow now which will reduce their reserves at the Fed and hence money supply.

ADDENDUM

Economic stagnation/inflation together → stagflation Adverse Supply Shock (Price Shock) -->Q1. Russian invasion of Ukraine has driven up energy prices. Can you trace out its effects on overall price level and aggregate output (i.e., real GDP) in the US economy in the SR using the AD-AS model? Also, without any policy intervention, how will the US economy have transitioned to the LR? -->Q2. Also, what type of stabilization policy can the Federal Reserve use if they care about i) keeping output or employment very close to natural rate always; ii) maintaining p stability? Starting point E0 Oil P increases -->Cost of production increases overall -->SRAS shifts up from SRAS0 to SRAS1 Such a shock is also called P-shock since P increases from P0 to P1 in SR. In SR, the economy moves from E0 to E1. In LR, the economy moves from E1 back to E0. Why? At E1, Y1 < (Y_0 ) ̅(natural) → economic slowdown. -->Faced with reduced demand, producers lower prices. In the LR, as prices adjust, demand picks up and moves back to E0 along AD0. Meanwhile, the economy undergoes prolonged recession. This is a classic case of stagflation (stagnation + inflation) Q2. Stabilization Policy -->If the Fed wants to avoid economic slowdown, pursue expansionary monetary policy. Increase in M will shift AD out from AD0 to AD1 but the downside of it is that P will be at a permanently higher level of P1 when equilibrium is at E2. The goal of P-stability will be violated. -->If the Fed wants to maintain P stability, "do nothing" will be the right option. P will eventually move back to P0 if the market adjusts on its own but at the expense of recession. -->Hence, policy dilemma for the Fed in this case. This makes the Fed's job harder.

As a starter, let us make sure we know how economists define short run versus long run.

Economists characterize LR (long run) by price flexibility; i.e. prices are free to adjust to clear markets. Likewise, they characterize SR (short run) by price (and wage) stickiness; i.e. prices and wages are slow to respond to changing market conditions, especially they are sticky downward. In other words, SR and LR differ in terms of price responsiveness. Question: How does the graph of the real GDP in the U.S. look like in the long run as well as in the short run? -->The chart of real GDP (i.e. GDP at constant prices) above tells us that there has been an upward trend in real GDP in the long run over the past several decades. However, there have also been fluctuations in the short run; periodic ups and downs in the level of economic activity as measured by real GDP. There have been 12 downturns since the end of WWII as depicted by the shaded vertical bars. The most recent downturn started in the first quarter of 2020 when real GDP fell by 5% (directly tied to COVID-19). This was followed by a much sharper drop of 31.4% in the second quarter of 2020. However, the good news is that the real GDP went back up in the third quarter of 2020 by 33.4% and the upward trend continued in 2021. However, there was a reversal in this trend in the first half of 2022 when real GDP declined for 2 quarters in a row. With the Fed aggressively raising the target for the benchmark interest rate to tame inflation that is currently running 40 year high, the economists and market analysts are now raising the likelihood of a recession occurring in near future.

The Federal Reserve and Monetary Policy

Federal Reserve Banks: quasi-governmental banks -->Not guided by profit motive -->Instead, policies formulated by Board of Governors to promote maximum economic growth accompanied by full employment, stable prices, and moderate long term interest rates (dates back to International Banking Act of 1978, sometimes known as the Humphrey-Hawkins Act) ---->In the balance sheet of the Federal Reserve banks, assets include govt. bonds or securities, loans to commercial banks -->[Digression: government bonds - this is how our govt. borrows in the marketplace - by issuing those bonds or securities. Investors are interested in holding some govt. bonds in their portfolio because it is almost risk-free. One can buy 5,10 or 15 or 30-year Treasury bonds but that does not mean you have to hold onto them until the maturity date. Bonds are bought and sold in the secondary market all the time. Buyers and sellers include general public, commercial banks, and yes, federal reserve banks among others. Of course, foreign governments or banks or individuals can also buy or sell US govt. bonds.] ---->Liabilities of the Federal Reserve Bank include required reserves of commercial banks, deposits of US Dept. of Treasury etc. Question: What is monetary policy? -->It consists of altering the nation's money supply. But as you will learn soon, this is equivalent to changing the short-term interest rate in the marketplace. Hence, monetary policy can also be looked upon as interest rate policy. -->Tools of Monetary Policy: ---->Open market operations ---->Changes in reserve ratio ---->Changes in discount rate ---->Paying interest on reserve balances of member banks at the Fed -->Open Market Operations: The most widely used tool of monetary policy ---->It is carried out by the Federal Open Market Committee (FOMC). FOMC is the policy making body. ---->FOMC is composed of 7 Board members and 5 of the 12 Regional Federal Reserve Bank presidents. The BOGs serve a 14-year term, and their membership is staggered so that one board membership expires every other even year. The Chairperson of the Board today is Jerome Powell. He replaced Janet Yellen (serving as the Secretary of the Treasury under the Biden administration) and took charge in February 2018. It is a 4-year term but can be renewed. President Biden has nominated Powell for a second term. ---->FOMC meets every 6 - 8 weeks in Washington DC for a 2-day closed door meeting. At the meeting, it assesses the nation's economic health using a large volume of data on various economic series and decides in the end whether to increase money supply, decrease money supply or keep it the same. This is equivalent to lowering short term interest rate, raising short term interest rate or keeping it the same. By the way, although only 5 of the 12 Regional Bank Presidents get to vote on any given FOMC meeting, all 12 presidents get to attend the meetings. The Bank Presidents take turns in voting; however, the New York Fed President always gets to vote. ---->Question: What is open market operation? ------>Open market operations refer to buying and selling of govt. bonds or securities by the Federal Reserve Banks in the open market from or to commercial banks or the general public. ---->Question: How does open market operations alter a nation's money supply? ------>Suppose the Fed decides to buy $10,000 worth of govt. bonds from Commerce Bank. How does the Fed pay for these bonds? It is a unique system. Since Commerce Bank will have an account at the Fed, the Fed will increase Commerce Bank's reserves at the Fed by $10,000 with touch of a button on the keyboard. Commerce Bank, in turn, will immediately be in a position to make additional loans up to $10,000. And this is how banks create money as you learned already, by making loans. So, money supply increases by $10,000 by individual banks and by a multiple amount by the banking system as a whole when money multiplier kicks in. ------>If you reverse the logic, you will see that open market selling of bonds worth $10,000 to Commerce Bank decreases money supply since this time the Fed is getting paid for selling bonds to the Commerce Bank. This is taken care of by reducing the reserves of Commerce bank at the Fed by $10,000 and the logic continues. ---->Question: What would be the implications of open market purchase or sale of securities from or to the general public? ------>Implications are qualitatively the same though quantitatively different. ------>If I sell a $10,000 govt. bond to the Fed, I get paid $10,000 and I deposit it in Commerce Bank where I have an account. But now the reserve ratio kicks in and the Commerce Bank can loan out only its excess reserves ($10,000 - 0.1*$10,000) if the reserve ratio is 10%

Demand side policy

First, a few definitions: -->The demand side policy refers to shifting AD through policy tools and includes both monetary and fiscal policy that alters the location of AD. -->While monetary policy (conducted by the Fed) involves changes in money supply or equivalently the interest rate (i.e., the federal funds rate), fiscal policy (conducted by the Federal Government) refers to changes in G and/or taxes. Demand side policy can be expansionary or contractionary. Expansionary demand side policy shifts AD out while contractionary demand side policy shifts AD in. -->Expansionary monetary policy includes increase in money supply or equivalently decrease in the short-term interest rate. -->Contractionary monetary policy includes decrease in money supply or equivalently increase in the short-term interest rate. -->Expansionary fiscal policy includes increase in G or decrease in taxes. -->Contractionary fiscal policy includes decrease in G or increase in taxes. Examples of Demand Side Policy -->Expansionary fiscal ---->President Biden's $1.9 trillion dollar coronavirus aid package (called American Rescue Plan Act of 2021) that included $1400 stimulus checks and extension of $300 weekly jobless aid supplement until September 2021. ---->The $1 trillion infrastructure bill that was approved by the US Congress in November 2021. (Note: the infrastructure spending can influence both LRAS and AD.) ---->President Trump's $2 trillion economic stimulus bill called CARES (Coronavirus Aid, Relief and Economic Security) Act of 2020. ---->These policies listed above are examples of expansionary fiscal policy as they increase government spending (G) which in turn also increases C and I and hence shift AD out. ---->Other examples of expansionary fiscal ------>Suppose the government chooses to lower our personal income taxes. Then C will increase (assuming most of the tax cut will be spent) and hence AD will shift out. ------>Suppose the government chooses to give tax credit to new businesses in the environmental industry. Then I will increase and hence AD will shift out. Examples of expansionary monetary -->Suppose the Fed increases money supply through open market operations this is equivalent to lowering the short-term interest rate in the marketplace I and C (on big-ticket items) will increase and hence AD will shift out. -->In fact, the Fed cut its target for the federal funds rate by a total of 1.5 percentage points at the start of the pandemic (March 2020), bringing it down to a range of 0% to 0.25%. The federal funds rate is a benchmark for other short-term rates, and affects longer-term rates, so this move was aimed at lowering the cost of borrowing on mortgages, auto loans, home equity loans, and other loans and boost C and I spending in turn. The Fed also lowered the discount rate by 2 percentage points from 2.25% to 0.25%. -->Note: In a similar way, we can also talk about contractionary fiscal and monetary policy. Just reverse the logic and you will see AD will shift inward when G decreases, taxes increase or money supply decreases. Example of contractionary monetary -->In March 2022, exactly 2 years after the start of the pandemic, the Fed reversed its course and raised the target for federal funds rate by 0.25% (target range: 0.25% - 0.5%) to combat 40-year high inflation. With inflation persisting, the Fed has raised the interest rate multiple times and by 0.75 percentage points each time. Today the target range for the federal funds rate stands at 3.0%-3.25% and it is expected to go up to 4% by the end of 2022. The Fed wants to push AD back inward to the left!

Monetary Policy and AD

First, let us consider monetary policy to counter economic fallout from Covid-19. What did the Fed do to counter the economic fallout from the pandemic? It stepped in with a broad array of actions to contain the economic damage. First and foremost, the Fed lowered the target for the Federal Funds rate by 1.5 percentage points at the start of the pandemic (by carrying out open market purchase of bonds). Such a deep cut in the target rate in a very short period is unprecedented in history. Since the Federal Funds rate is a benchmark for other short-term rates, and influences longer-term rates, this move by the Fed was aimed at lowering the cost of borrowing on mortgages, auto loans, home equity loans, business loans and many more. As expected, C and I increased and pushed AD out to the right from AD2 closer to AD1 in the graph above (Remember that C alone constitutes more than 2/3 of US aggregate spending). The Fed also stepped up direct lending to member banks by lowering the discount rate from 2.25% to 0.25% so that the banks could keep functioning by borrowing from the Fed. These are classic examples of demand side expansionary monetary policy.

Is there a comparison to the Great Depression?

GDP and unemployment you can compare; thinks this will look a lot like the Depression in terms of depth It will be the worst thing since the Depression, but this is a recession by design/not by accident -->Usually we want people to go back to work as soon as possible but now we don't while the pandemic's going on

Aggregate supply curve

Gap between Y1/Y potential is the output gap; government's job is to close gap between potential/actual Y -->To shift AD out again, you have to reach herd immunity; paying people to vaccinate because they respond to incentives ---->This is Pigouvian solution; talked about externalities, which lead to market failure ------>Negative: taxes; command/control → not wearing a mask/getting vaccinated (command/control would be mask mandates) ------>Positive: getting vaccinated (subsidize to encourage people to do more of this thing)

Introduction to Money

Imagine an economy without money to start with. How would transactions be carried out in such an economy? → Through some sort of a barter system. Question: What is a barter system? -->A direct exchange of goods and services for goods and services. Question: What is the primary limitation of a barter system? -->That it requires "double coincidence of wants"; i.e., to find someone who not only has what I want but also wants what I have. So, getting the right mix

Types of Natural Unemployment

In this section, we talk about why a market economy cannot totally escape unemployment. In other words, why are there always some people unemployed? Few reasons: -->Frictional unemployment: Another name for it is search unemployment. Here unemployment arises because it takes time for workers to search for the jobs that best suit their tastes and skills. Likewise, it takes time for the employers to find the best or most suitable person for a job. This is referred to as frictional unemployment since the economy cannot operate smoothly, i.e., without friction in matching skills and jobs. -->Structural unemployment: Another name for it is wait unemployment. Here unemployment arises because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. There aren't enough jobs to go around. Workers are simply 'waiting' for jobs to become available. Question: Can you draw a graph of the labor market to depict wait unemployment? -->When wages are stuck above the market equilibrium rate, there will be surplus in the labor market. At the going wage of W in the figure above, more people will be interested in working than the number of jobs available (quantity supplied of labor will exceed quantity demanded). This is the basic essence of wait unemployment. -->Question: Why are wages stuck above the market clearing level? Why cannot wages come down to clear the market? ---->Three possible reasons (for structural or wait unemployment) ------>Minimum wage laws ------>Existence of unions ------>Efficiency wages -->Minimum Wage Law ---->Legislation dates back to the Fair Labor Standard Act of 1938. Today the Federally mandated minimum wage is at $7.25 an hour. States can set their own minimum wage as long as it exceeds the Federal minimum. In MO, ---->it is $11.15 per hour. Recall that minimum wage is not yet indexed to CPI. The Biden administration is pushing a policy proposal to raise the Federal minimum wage to $15 an hour in phases by 2025. Some states including California, New York, Massachusetts, and Florida, have already approved an eventual $15 minimum wage phased in over time. Is that something you support or oppose? Raising the minimum wage has been a perennial source of debate. To some economists, raising the federal minimum wage is among the clearest ways to lift people out of poverty. To others, a $15 minimum wage would cost the U.S. jobs and devastate small businesses at a time when they can least afford it! ---->Question: Which demographic group will be affected the most if minimum wage is raised? ------>Clearly the teenagers or ones with less skills and less education. In the absence of minimum wage legislation, their market clearing wage most likely will be less than $7.25 an hour. In that sense, the constraint of minimum wage is binding for them. Studies show that for every 10% increase in minimum wage, teenage unemployment increases between 1%-3%. Existence of Unions -->Workers in many sectors of the economy are unionized. The collective bargaining power of the unionized workers sometimes makes it possible to set wages above the market clearing level. (After all, the unions can threaten to strike if their demands are not met, and management may give in.) Firms respond to higher wages by hiring fewer workers than otherwise, resulting in wait unemployment. Efficiency Wage Theory -->Basic idea: Firms may not always prefer the wages to be lower because workers' productivity might be positively related to the wage rate. Higher wages also make workers more productive. -->Question: How can you explain the association between higher wage and higher productivity? ---->The origin of this theory lies in developing countries where the going market clearing wage may not be enough to provide 2 meals a day. In such dire circumstances, paying workers slightly more may mean better nutrition and hence a healthier and a more productive workforce. ---->Labor economists have started applying similar concepts to the work force of developed economies as well. ---->There are several reasons why a firm may pay efficiency wages. ------>Worker Turnover- a firm can reduce turnover by paying a wage greater than its workers could receive elsewhere; this is especially helpful for firms that face high hiring and training costs. ------>Worker Quality- offering higher wages attracts a better pool of applicants; this is especially helpful for firms that are not able to perfectly gauge the quality of job applicants. ------>Worker Effort- again, if a firm pays a worker more than he or she can receive elsewhere, the worker will be more likely to try to protect his or her job by working harder; this is especially helpful for firms that have difficulty monitoring their workers.

Federal Funds Market

It is the market where commercial banks often lend temporary excess reserves held at the Fed to other banks on an overnight basis and earn additional interest. The interest paid on these overnight loans is called the federal funds rate. So clearly the federal funds rate is a very short-term rate. Remember that banks are required to set aside a fixed fraction of their demand deposit liabilities at the Fed. However, the amount of the demand deposit liabilities varies from day to day depending on the volume of transactions on any given day. So, if a particular bank with heavy transactions is short of required reserves at the end of the day and another bank has more than what is needed in its account at the Fed at the end of the day, clearly it is a win-win for both. To affect our expectations of future inflation, economists will tell you that inflationary expectations typically play a significant role in influencing actual price increases. The Fed wants to convince the financial market that it is committed to the fundamental macro goal of price stability (with an inflation target of 2%). It is hoping that higher borrowing costs will restrain consumer and business spending and cool off the heated economy. The Fed is hoping for a soft landing in which the economy slows enough to bring down inflation while avoiding a recession. However, this is a tough balancing act! Many economists are already forecasting a recession in 2023. Follow the trajectory of the federal funds rate below. Question: What does the Federal Reserve have to do with the federal funds rate? -->The FOMC sets a target goal for the federal funds rate. Then the Fed uses open market operations to make the federal funds rate hit the target. In other words, the Fed changes money supply accordingly to make sure the federal funds rate hits the target. This is a slightly more advanced concept but should become clearer as we delve deeper into policy in the next 2 chapters and talk about the link between money supply and interest rate. -->In short, to reduce the federal funds rate, FOMC conducts open market purchase of bonds which increases money supply. To increase the federal funds rate, FOMC conducts open market selling of bonds which decreases money supply. Question: Why should the general public pay attention to the Fed's decision with respect to the federal funds rate? -->Because the federal funds rate sets the trend for other short-term interest rates in the marketplace. For example, the prime rate is typically a 3% mark up over the federal funds rate. Prime rate, in turn, is used as an index in calculating ARM (adjustable rate of mortgage), student loans, home equity lines of credit etc. In short, raising rates typically restrains spending, while cutting rates encourages such borrowing. -->Now you can understand why the FOMC slashed the federal funds rate to near zero percent when the pandemic hit the US economy in March 2020. Simply to jump start the economy by encouraging the consumers and the businesses to spend more. Check out the graph below. You will see that the FOMC approved its first interest rate hike since the outbreak of COVID-19 in March 2022. Subsequently, there have been two more rate increases in 2022 with the largest increase of 0.75% taking place consecutively in June and July 2022. Within a span of six months, the target range for the federal funds rate has jumped from 0.0%-0.25% to 2.25% - 2.5%. More rate increases are expected in 2022 since the inflation figures in August 2022 based on CPI core (all items less food and energy) indicated that inflation pressures remain strong and stubborn! -->Why has the Fed reversed its course so fast? Because the Fed is very concerned not only about the spike in inflation (which is at a 40 year high), but that it is beginning -->3%-3.25% is target of federal funds rate today

The Crowding-Out Effect

It is the opposite of the multiplier effect. While an increase in G stimulates aggregate spending by a bigger amount and shifts AD out to the right multiple times, it also causes the interest rate to rise, reducing investment spending and shifting AD curve to the left. This reduction in aggregate demand that results when a fiscal expansion raises the interest rate is called the crowding-out effect. To see why interest rates rise, recall that more spending requires more money to carry out transactions thereby shifting the money demand curve out. See the 2-part graph below. At a higher interest rate, there will be a downward pressure on investment spending which is interest sensitive pushing AD to the left. To summarize, when the government increases its purchases by $X, the aggregate demand for goods and services could rise by more or less than $X, depending on whether the multiplier effect or the crowding-out effect is larger.

Do you think the state/federal government should be in charge of categorizing which things need to reopen first?

It would be best if we had federal guidance, but it will probably be at the state level/by groups of states because each one has different risks/population levels

SRAS

Key feature of SR lies in price stickiness. Casual observations of the world support the idea. For example, magazine prices or restaurant menu prices do not change frequently (as it involves administrative and printing costs to change prices). In general, many prices are sticky in the short run and therefore do not adjust immediately to changing market forces. Implications of sticky prices are far reaching. As you will see, output (or real GDP) fluctuates around the long run natural rate or equivalently unemployment fluctuates around the natural rate of unemployment because of sticky prices. Hence, SR Models provide an explanation for the business cycle. Question: Can you draw the SRAS? -->Given that prices are generally sticky in the short run, the aggregate price level is considered fixed. Hence, the SRAS becomes a horizontal line at that fixed price level. -->Summarizing, over long periods of time, prices are fully flexible and hence the LRAS is vertical at the maximum output level. By contrast, over short periods of time, prices are generally sticky and hence the SRAS is flat or horizontal at the fixed price level.

Changing Reserve Ratio: affects ability of banks to create money by altering excess reserves

Lowering reserve ratio: More excess reserves available at each step to loan out. Hence money supply will increase and by a bigger amount for the banking system as a whole. Raising reserve ratio: Less reserves available at each step to loan out. Hence money supply will decrease and by a bigger amount for the banking system as a whole.

Are you worried about inflation in this context?

M1/2/3 have had recent rapid growth because of all the liquidity injected into the economy and we've seen supply disruptions → seems to be recipe for inflation In a situation where interest rates are basically 0, distinctions between monetary/non-monetary assets isn't great so it's hard to interpret money growth as being a precursor to inflation Financial markets don't look worried about inflation Inflation won't be one of the bigger problems if it happens because we'll be more concerned about death rates/unemployment

Functions of Money: Money is what money does. What are the key functions of money?

Medium of exchange → universally accepted as a means of payment. Hence, the need for double coincidence of wants is eliminated immediately. When I am writing a check for $240 to pay for a dress, I am using money as a medium of exchange. Unit of account → it is a common denominator and hence used as a measure of value. For example, when I say the price of my dress is $240, I am using money as a unit of account. Store of value → here we are using money to transfer purchasing power from the present to the future. For example, if I put in $10 a month in a piggy bank so that I can buy a dress in 2 years, I am using money as a store of value. -->Note that money is an imperfect store of value. Why? Because with inflation, money loses its purchasing power → a dollar in your wallet or purse buys less and less. ---->If that is the case, why do we still keep some money in our wallet? Why do we not keep all our wealth in stocks and bonds or other financial assets or houses and earn a rate of return? Because money is the most liquid asset of all. ---->Question: What is liquidity? ------>The relative ease with which an asset can be converted into an economy's medium of exchange. ------>Clearly, money is the most liquid asset because it can be readily/directly used in transactions. Housing, on the other hand, is the most illiquid asset of all. It requires a lot of time and effort to sell a house and hence cannot be used immediately to carry out transactions.

How is introductory macroeconomics going to change as a result of the recession by design?

Micro- about externalities, the pandemic is a good example of externalities; the government needs to be regulating our behavior through command/control Macro- about business cycle; this has been a contractionary/leftward shift in both aggregate demand/supply curves because we can't go out and spend right now → leads to lower equilibrium income -->The natural level of production/unemployment is lower because this is a recession by design

Now you can think of natural unemployment as a combination of frictional and structural unemployment. At any point in time, even in a well-functioning economy, there will always be people frictionally unemployed or structurally unemployed.

Natural unemployment = frictional unemployment + structural unemployment Question: How do various government programs affect the natural unemployment rate? -->Examples of government programs include: ---->Government employment agencies disseminating information about job vacancies ------>The faster information spreads about job openings and worker availability, the more rapidly the economy can match workers and firms. ------>These programs reduce frictional unemployment and hence natural unemployment. ---->Public training programs can ease the transition of workers from declining to growing industries and help disadvantaged groups escape poverty. ------>These programs can reduce frictional/structural unemployment and hence natural unemployment. ---->Unemployment Insurance Programs (or jobless benefits) ------>Definition of unemployment insurance: a government program that partially protects workers' incomes when they become unemployed. ------>In the US, it is typically 50% of former pay for 26 weeks. The coverage was extended by several additional weeks in many states by passing special legislation in Congress during the economic downturn of 2007-2009. Likewise, under the provisions of the CARES act during the pandemic, an additional supplemental payment was provided weekly to those eligible for unemployment benefits. Furthermore, there was an extension of benefits for several additional weeks. Pandemic related extra unemployment benefits expired in early September 2021. ------>Economists are divided on the issue of unemployment insurance benefits. There are those who will tell you that while unemployment insurance reduces the economic hardship of unemployment, it has the undesirable effect of extending job search resulting in higher frictional and hence natural unemployment. In short, such benefits do not give people incentives to look for a job right away. But on the other hand, there are economists who will tell you the fact that the unemployment rate came down from 14.8% in April 2020 to 3.5% in July 2022 was partly due to the generous unemployment benefits which put money in the pockets of those who are likely to spend it the most and kept the economy afloat.

What do you think about the proposed cut in payroll taxes?

Not really reasonable in this situation because we don't want people going back to work; this recession is not like others we've seen We're trying to provide relief; this seems poorly targeted because it will go to people who are working, not to people who actually need help Doesn't really provide social insurance

The multiple COVID relief packages that the U.S. government doled out since the start of the pandemic were straight out of Keynes' playbook.

Note: We are NOT talking about supply shocks here due to limited time on our hands. However, it is worth mentioning that COVID-19 Pandemic also reflects an adverse supply shock. You must have heard about breakdown in "global supply chains" due to the pandemic in recent months. I am copying and pasting a section from the St Louis Fed research division below so that you get a more complete picture. "In response to the COVID-19 outbreak, public health authorities around the world implemented mitigation measures such as social distancing, which shut down entire sectors of the economy, especially those that involve interpersonal contact, such as restaurants and salons. While authorities have forced many such establishments to close, leaving many workers jobless, and issued stay-at home orders (so-called lockdowns), consumers also decreased their use of these services.1 Further, newly jobless workers reduced their consumption of all goods and services. For this reason, most economists would agree that the pandemic combines aspects of both supply and demand shocks. A supply shock is anything that reduces the economy's capacity to produce goods and services, at given prices. Lockdown measures preventing workers from doing their jobs can be seen as a supply shock. A demand shock, on the other hand, reduces consumers' ability or willingness to purchase goods and services, at given prices. People avoiding restaurants for fear of contagion is an example of a demand shock. Additionally, as service sector workers lose their jobs and income, they stop purchasing all kinds of goods, such as cars and appliances, which can also be thought of as a sectoral demand shock. Conventional monetary and fiscal policy can offset some types of aggregate demand shocks, but other policies may be more appropriate to counter supply shocks. Understanding whether supply or demand causes a particular shock is therefore very important for policy design. The government doesn't want to stimulate activity in certain service sectors because of concerns about further spreading COVID-19. The government could, however, stimulate sectors that are not part of the lockdown but are subject to aggregate shocks. This means that it is important to understand whether supply or demand shocks or both affect each sector."

Government Expenditure Multiplier

One more thing. As G increases, it will have a domino effect on the economy. In other words, there will be several rounds of shifts in AD originating from a one-time increase in G. Why? Think of the direct stimulus check of $1400 that many working adults received from the federal government in May 2021 or the check for $1200 that many received back in April or May of 2020 during the early days of the pandemic. Recipients of the checks used part of it to pay for take-out meals at our local restaurants. This kept the doors of our local restaurants open and helped them pay their workers. In the second round, the restaurant workers possibly used part of their paycheck to pay for groceries. In the third round, the grocery store owners possibly used part of their sales revenue to buy new computers to meet the sudden surge in online demand for groceries. And the process continued for a while since one person's spending in the economy is always another person's income. In general, any increase in spending by the government creates a spending chain reaction as it works its way through the economy. The total increase in income is the sum-total of increase in the first round, second round, third round and so on. Therefore, it will be much bigger than the initial increase in government spending. This is referred to as the government expenditure multiplier effect. As G increases, output, or income at the aggregate increases by a bigger amount, i.e., a multiple amount due to several rounds of additional spending that follows. In the U.S., the multiplier is often found to be in the range of 1.5. This implies that a $1,000 increase in G will increase output or GDP by $1,500 or 1.5 times as much. The notion of fiscal multiplier dates to John Maynard Keynes. Keynes was a British economist. His ideas were the outgrowth of the depression of the 1930s. He laid out his ideas in his masterpiece - the General Theory of Employment, Interest and Money (published in 1936). Keynes was a big proponent of increased government spending to jump-start the economy primarily due to the concept of government expenditure multiplier. When the economy slows down and enters recession, a small increase in G can go a long way, according to the Keynesians.

Shift of AD curve

Question: Does a change in the aggregate price level cause a shift in AD? -->No. As you learned in chapter 4 with respect to market demand, when the aggregate p level measured along the vertical axis changes, it is depicted by a movement along the aggregate demand curve. Question: When does the AD curve shift? What are the determinants (or shift factors) for AD? -->In broader terms, when any of the components of AD changes (i.e., C, I, (X-M) or G changes) due to an event happening outside, AD will shift in or out. Let us consider a few examples. We will talk about G separately later under section IV and V since this is a policy variable. Determinants of C spending - can you name a few? -->Consumer confidence in the U.S. rose to its highest level in April 2021 since the early days of the pandemic.(why the surge? Consumers became more optimistic about the U.S. economy as vaccination counts rose, two rounds of government stimulus were distributed, businesses reopened, and the economic recovery showed signs of accelerating.) All else equal, in terms of our AD/AS model, this will imply a rise in C spending and AD will shift outward to the right. -->Or suppose the household propensity to save increases, all else equal. If we are saving more, we must be spending less. Therefore, C will decrease and hence AD will shift in. This is precisely what happened in the early days of the pandemic when we were scared to go out to restaurants or travel. U.S. personal savings rate saw a sharp spike from 8.3% in February 2020 to 33.7% in April 2020! ---->Shifts curve to left because of dip in C spending Determinants of I - can you name a few? -->All else equal, suppose business pessimism is on the rise given the current state of the economy. Thus, I spending coming from the businesses will decrease and hence AD will shift in. -->Or suppose businesses nationwide decide to upgrade their computer system. This time I will increase, and AD will shift out. -->During 2020-2021, there was a tremendous surge in demand for homes for a variety of reasons (such as all-time low mortgage rates and Americans working remotely due to the pandemic needing more space). This fueled I spending (remember that spending on housing is part of I) and shifted AD out. Determinants of net exports [exports (X)- imports (M)] - can you name a few? -->All else equal, if the EU (European Union) nations slow down and enter a recessionary phase, what happens to the US AD curve? -->If EU nations enter recession, they will buy less from the US US exports (X) to EU nations will fall. Thus, (X-M) will fall and AD will shift in. -->What if USD (US dollar) gets stronger against Euro or other major currencies? US goods will become more expensive in the world market and likewise, foreign goods will be relatively cheap for the US residents. Thus, US X will decrease, and M will increase (X-M) will decrease and hence AD in the US will shift in. Question: Can you guess what is happening to AD curve because of COVID-19 crisis? -->Initially, there was a wide shift in the AD curve to the left (i.e., inward shift). This was due to a steep decrease in C, I and NX. In the past, when C decreased, often the increase in I would partly offset the decreasing C or vice versa. But there was no offsetting factor during the early days of the pandemic. All components of AD fell at once. The steep fall in C and I and NX reinforced the shift of AD and pushed it way to the left. -->However, as vaccines started reaching the arms of people starting in 2021 and stimulus checks hit our pockets in 2020 and 2021 along with extension of unemployment insurance benefits, C and I components of AD started increasing again and in turn, shifting AD back out. However, in the first quarter of 2022, the net exports (X-M) fell due to pandemic related supply-chain constraints and a very strong dollar (against most currencies outside U.S.) pushing AD inward to the left in the process.

SR Economic Fluctuations (due to Demand Shocks) and The Role of Demand Side Policy

Question: How do we explain SR economic fluctuations in this framework? -->Using demand shocks or supply shocks. -->Demand shocks shift AD curve in or out due to exogenous changes in events while supply shocks shift SRAS curve up or down due to exogenous changes in events. -->(We will focus on demand shocks only in our discussion.) Shocks temporarily push the economy away from full employment. In turn, they cause fluctuations in output and employment over the business cycle in the short run. When output grows rapidly and exceeds the long run natural rate of output (at which LRAS is vertical), we have an economic boom. When output shrinks and falls below the long run natural rate of output, we have economic slowdown or recession. The Federal government or the Federal Reserve may use its fiscal and monetary policy tools to counter these shocks by shifting AD in the opposite direction to reduce the severity of short-run economic fluctuations and stabilize the economy. Let us use this AD-AS framework to analyze the economic fallout from COVID - 19. Q1: COVID - 19 wreaked havoc on both consumer and business confidence in the US in 2020. At the same time, global trade temporarily came to a halt. Can you trace out its effects on overall price level and aggregate output (i.e., real GDP) in the SR using the AD-AS model? -->The economy begins at A where SR equilibrium coincides with the LR equilibrium. -->Next, a decrease in consumer and business confidence as well as reduction in US net exports due to COVID - 19 lowers C and I and NX. This, in turn, pushes AD inward to the left (a very wide shift) from AD1 to AD2 on the graph. COVID -19 presents a classic case of an adverse demand shock. In the SR, the economy moves from A to B along the SRAS. Price is fixed as expected in the SR. Output at B is lower than the LR natural rate of output (where the LRAS is vertical). This, in turn, implies that the economy gradually slows down and enters a recessionary phase. This is what the US economy experienced in 2020. This recession was primarily caused by an adverse demand shock resulting from a massive decline in aggregate spending (C, I and NX). Q2: Refer to the graph above. Without any policy intervention, how will the US economy have transitioned to the LR? -->Prices are not stuck forever. Eventually prices will adjust to the changing nature of aggregate spending and markets "left alone" will gravitate towards new equilibrium at C. This is because faced with reduced demand; producers will start lowering prices to entice people to spend more. Hence, the transition from SR to LR happens along the shifted AD curve AD2 from point B to point C. At C, output is back to LR natural rate while price level falls. However, this process may take a while. Meanwhile, millions of people will be losing jobs and hundreds of businesses will be closing doors. Q3: Refer to the graph above. Do you see a role for demand side policy here? How can the Federal government or the Federal Reserve intervene to stabilize the economy? -->One of the macro policy goals is the goal of full employment. This means policy makers strive to keep unemployment at the natural rate of unemployment. When the economy slows down and enters recession as in the graph above, unemployment rises above the natural rate. In February 2020, the US unemployment rate was at 3.5% (slightly below the natural rate of 5%). By April, the unemployment rate soared to 14.8% as the U.S. economy got slammed by the pandemic. This is where the Federal Reserve or the Federal government can step in to alleviate the economic hardship and bring the economy back from the brink on the path to recovery. This is what stabilization policy is all about. Countercyclical policy- stabilization policy; federal government counters the phase of the business cycle we're in (use expansionary policy to push us out of recession)

Supply of Money

Question: What constitutes a nation's money supply? -->Economists disagree somewhat on what we should include here in calculating a nation's money supply. Hence, various definitions have emerged over the years such as M1 & M2 definitions of money. -->M1 = currency + checkable deposits + traveler's checks + savings deposits ---->Currency includes coins and paper money. ---->Checkable deposits = demand deposit/checking account ---->M1 is most liquid definition -->Coin is considered token money, i.e., intrinsic value is less than the face value of the coin. In other words, the value of the metal going into making a quarter should be worth less than 25 cents. What if it is not? Then some of us will surely melt them down and make a few bucks out of it! ---->In reality, taxpayers in the US are losing money on pennies and nickels. ---->In 2021 it cost the US Mint 2.1 cents to make a penny and 8.52 cents to make a nickel. The U.S. Mint made money on dimes and quarters though with their respective unit costs at 4.39 cents and 9.63 cents. ---->Paper money consists of Federal Reserve notes - dollar bills issued by the Federal Reserve banks. ------>[Next time before using a dollar bill, look at it closely. There are 12 Federal Reserve banks in the US, and you can tell which of the 12 banks your dollar bill came from. -->Checkable deposits are basically our checking accounts. In economics, we often refer to them as demand deposits because these are balances in bank accounts that depositors can access on demand. In other words, these are accounts against which an unlimited number of checks can be written. Traveler's checks constitute a very small fraction of M1 and are becoming less and less relevant with the improvement in banking technology. You can use your bank cards at all major airports these days to withdraw local currency. In 2020, the Fed changed the definition of M1 to include savings accounts (which used to be counted under M2 definition) given the increased liquidity of such accounts. For example, non-checkable savings deposits are basically our savings accounts. While typically we cannot write checks against them, we can easily transfer money from our savings to our checking accounts with a touch of a button and then write checks. M2 = M1 + small denomination (<$100,000) time deposits + Money Market Mutual Funds + Money Market Deposit Accounts -->In short, M2 = M1 + near money (less liquid but still easy and inexpensive to access) -->The best example of time deposits is CDs (Certificate of Deposits). These CDs have time dimensions - some mature in 6 months, some in 1 year, some in 2 years and so on. Question: Which definition of money is broader? - clearly M2. Question: Which definition of money is the most liquid of all? - clearly M1 Question: Are demand deposits part of M1? Are demand deposits part of M2? -->Yes, and Yes right? Question: Are 'credit cards' considered part of the money supply? What about 'debit cards'? -->Credit cards are not. Why? Think of the way a payment is made using a credit card. It is a way of deferring payment for now. The bank issuing the card to you makes the payment on your behalf immediately. So, this is a way of obtaining a short-term loan if you will. However, if you pay your balance in full at the end of the month, you are not charged any interest. -->What about debit cards? Can you see that it is part of M1? You typically use your debit card against money in your checking account. So, it is akin to writing a check but more convenient. Question: What backs the nation's money supply? Is it backed by gold? -->No, today's money is fiat money and not backed by gold or any other precious metal. So, what gives money its value today? Its acceptability. -->Believe it or not, I accept money in transactions today because I know you will accept it from me tomorrow. It is money's acceptability that gives money its value. However, we all accept them in transactions because for one thing, modern day money is fiat money and hence has the government's backing. But more importantly, we expect money to hold its value. At the end of the day, it is the job of the Fed to keep the value of money relatively stable by appropriately regulating the nation's money supply.

Slope of AD

Question: Why does aggregate demand slope downward? In other words, why does aggregate spending decreases as the price level rises in the U.S. and vice versa? -->Three reasons - ---->Wealth Effect: As price level (P) rises purchasing power of money falls reduces real wealth of consumer and thus ability to purchase goods and services hence as P rises, C decreases and therefore aggregate spending decreases due to the wealth effect ---->Interest Rate Effect: As price level (P) rises people need more money to carry out transactions As households demand more money, they borrow more thus cost of borrowing, i.e. interest rate rises investment spending decreases as well as consumer spending on durable items (since investment and spending on big ticket items need to be financed and interest rate is the cost of borrowing) Hence as P increases interest rate rises, C and I decrease and therefore aggregate spending decreases due to the interest rate effect ---->Impact on Net Exports (X-M): As our price level at home rises, given foreign price level U.S. products become relatively more expensive (and equivalently foreign products become relatively cheap) Hence as P rises, our export to the rest of the world (denoted by X) decreases and likewise our import from the rest of the world (denoted by M) increases (X-M) decreases and therefore overall US aggregate spending decreases due to the foreign trade effect -->Reverse the logic as price level decreases and you will see aggregate spending will go up this time due to the three effects mentioned above.

Goal of full employment

Recall that this is our third macro goal. However, this goal is consistent with the presence of some unemployment. In other words, full employment does not imply 0% unemployment. Hence, we will discuss unemployment here. Unemployment can be divided into two categories. -->Natural rate of unemployment → the amount of unemployment that the economy naturally experiences as a normal part of the functioning of the economy; the normal rate of unemployment around which the actual monthly unemployment rate fluctuates. It is a long-term phenomenon and can be looked upon as the long run average rate of unemployment. -->Cyclical unemployment year-to-year or month to month fluctuations in actual unemployment rate around its natural rate; defined as the deviation of actual unemployment rate from its natural rate - it is considered a short-term phenomenon. (cyclical = actual - natural) ---->Can be zero; goal is to bring actual in line with natural rate There is another way of looking at the natural rate of unemployment. It is also called the 'target rate of unemployment.' Why? -->Given that a free-market economy cannot escape natural unemployment, the goal of full employment is to bring the actual unemployment rate in line with the natural rate of unemployment. In that sense, the natural unemployment rate provides a numerical target for policymakers. -->Question: What is the natural unemployment rate in the US? ---->In the range of 5%-6% (see graph above) but closer to 5% today. -->Cyclical Unemployment is defined as the difference between the actual unemployment rate and the natural rate. ---->Question: Can natural unemployment be reduced to zero? ------>No ---->Question: Can cyclical unemployment be reduced to zero? ------>Yes - in fact, that is the policy goal.

What is recovery going to look like?

Recessions tend to leave scars on the economy; most of the time they're long and painful Could potentially have a quick recovery because most people were temporarily laid off; they still have jobs waiting for them -->The risk is if the pandemic lasts longer than expected; small businesses might not be reopened and temporary layoffs might become permanent job losses → recovery could be longer

Of the four policy tools

Reserve ratios are not used frequently because even a small change can cause massive disruptions in the banking system. Effectiveness of the discount rate depends on how keen the commercial banks are to borrow from the Fed to begin with. (You can drive the horse near the water, but you cannot force the horse to drink!) Paying interest on reserves held at the Fed by member banks is a fairly new practice and hence has not been time tested. Open market operation is considered the most important policy tool.

Paying interest on reserve balances of banks at the Fed

Starting October 2008, the Fed has started paying interest on reserves that banks hold at the Fed. This has given the Fed yet another tool to control money supply. Increase in interest on reserves at the Fed: This will give banks an incentive to hold more reserves at the Fed and lend less leading to a decrease in money supply Decrease in interest on reserves at the Fed: This will give banks an incentive to hold less reserves at the Fed and lend more instead leading to an increase in money supply

Question: What is the business cycle?

Such short run fluctuations in real GDP are commonly referred to as the business cycle. Economy is in recession when the real GDP shrinks as identified by the shaded vertical bars in the figure above. Likewise economic booms occur when the real GDP grows steadily over multiple quarters. One working definition of recession: when real GDP falls for 2 quarters in a row. -->Using this definition, the US economy entered recession in early 2020 and again in 2022. The magnitude of decline in real GDP that we witnessed in 2020 was unprecedented in recent history and comparable to the Great Depression of the 1930s. However, the official arbiter of recession is NBER's (National Bureau of Economics Research) business cycle dating committee which maintains a chronology of US business cycles. The chronology identifies the dates of peaks and troughs that frame economic recessions and expansions. A recession is the period between a peak of economic activity and its subsequent trough, or lowest point. -->Economists generally talk about four different shapes of recession as indicated by the letters of the alphabet - namely U shape, V shape, W shape and L shape. ---->U shape is the most common shape where the economy (as measured by real GDP) shrinks slowly and then gets back up slowly. The V shape denotes a sharp drop in real GDP quickly followed by an equally sharp rise in real GDP. The W shape indicates a sharp quick drop followed by a sharp quick rise but then immediately followed by a resurgence of economic slowdown. This is also known as a double-dip recession - two back to back recessions creating the shape of letter W. Finally, the L shape indicates that once the economy slows down, it stays there for a long time; i.e. an extended recession. -->Question: What was the shape of the pandemic-driven recession in 2020? What ended up happening was a K shaped recovery. A segment of the population recovered relatively quickly and fully (for example, those with high-tech jobs) as reflected in the upper half of letter K. By contrast, another segment of the population (say in hospitality and leisure industries) continued to fall behind as denoted by the lower half of letter K. There is a great disparity in how individuals have been impacted by the pandemic exacerbating the growing income inequality.

What is the role of the FED right now and what should it be if we're thinking of coming out of the pandemic?

The FED sets interest rates/chooses federal funds rate target to influence monetary policy; also acts as lender of last resort, which is coming into play now -->They're shooting lots of liquidity into the system to make sure people/firms/financial institutions who want to borrow can, but the FED's not really set up to lend to anything other than financial firms and it's not them needing help -->They're working with the Treasury to provide liquidity for non-financial firms ---->Could be risky because then the FED becomes an arm of the Treasury and that's not good long term ---->Credit analysis (who should/shouldn't we lend to and how much) is always something the FED's done; it doesn't have the ability to do that for non-financial firms and it's usually done by the private sector → should the FED/Treasury together try to do credit analysis We need to be sure there's plenty of oversight so there's no malfeasance; money will go to powerful/well-connected firms instead of people who need it

The U.S Financial Structure

The Federal Reserve System (the Fed in short) is the kingpin of the US money & banking system. It was created through the Federal Reserve Act of 1913. It consists of 12 Federal Reserve banks serving various geographical regions. Each regional bank has a number and letter associated with it as I stated earlier. Go online to see where these 12 banks are located. There are 7 members in the Board of Governors of the Federal Reserve system. Commercial banks come under the jurisdiction of the Fed. Functions of Fed: -->Keeps reserves, i.e., holds deposits of member banks at the Fed -->Plays an important role in clearing checks -->Helps the Federal government in its day-to-day activities by working closely with the U.S. Treasury -->Carries out periodic supervision of member banks to make sure they are financially sound -->Makes loans to member banks on a case-by-case basis -->Controls nation's money supply - clearly the most important function of the Fed 2a. Money Creation by a Single Bank -->Question: What are the two most basic functions of commercial banks? ---->Accept your deposits and make loans (using your deposits) ---->Balance sheet of a bank gives a snapshot of its banking activities. ---->On any balance sheet, there are assets (amount owned/owed to banks) on one side and liabilities (amount bank owes to others) on the other side. ------>Assets amount owned by the banks, e.g., vault cash (cash held in banks), bank loans ------>Liabilities amount owed to others, e.g., checking accounts (or demand deposits) -->Question: If $1,000 is deposited in a bank today, is there any direct change in money supply immediately? ---->Not immediately. All else equal, if I deposit $1000 in ten bills of $100 in my checking account at the Credit Union today, there will be $1000 less in currency in circulation as a result of this transaction alone and likewise $1000 more in demand deposits in the banking system as a whole. ---->Question: What will Credit Union (CU) do with the additional $1000? ------>CU's demand deposit liabilities are now up by $1000. It is in CU's interest to loan out as much as it can out of it. (After all, the bank's profit comes from the difference in interest they charge on loans and the interest they pay out on deposits which is 0% for checking account). ---->Question: What is the maximum amount CU can loan out as a result of this transaction alone? ------>Well, it is certainly not the entire amount of $1000. Because commercial banks (also called member banks) are required by law to keep a certain fraction of their total demand deposit liabilities in their account with the regional Federal Reserve Bank. The fraction is specified by the Fed. ------>First a few new terms: --------->Reserves (RE) deposits not loaned out yet - $1000 in this example --------->Reserve Ratio (RR) the fraction set by the Fed let us assume for now it is 10% --------->Required RE $1000*0.1 = $100 - this is what CU is required by law to set aside in its account at the Fed --------->Excess RE - the remaining amount $1000 - $100 = $900 ------>In general: --------->Required Reserves = Reserve Ratio * total deposit liabilities --------->Excess Reserves = Total Reserves - Required Reserves ------>So, CU can loan out dollar for dollar with its excess RE which is $900 in this example. ------>Such a banking system is called a fractional reserve banking system. That is banks can loan out at most a fraction of its demand deposit liabilities. ------>Question: What is the implication of a reserve ratio of 100%? --------->Banks will be unable to make loans and go out of business. The amount of excess reserves will be $0 here. ------>Question: What is the implication of a reserve ratio of 0%? --------->Banks may not have enough left to meet depositors' demand for cash on any given day because everything might be loaned out. --------->In fact, even with a reserve ratio of 10% or whatever, banks will not have enough set aside if all depositors want their money back at the same time. This is when bank runs happen - depositors "run" to the banks to get their money out and the panic spreads quickly. ---->Question: Can bank runs be avoided in a fractional reserve banking system? What is FDIC? ------>FDIC stands for Federal Deposit Insurance Corporation. It was created by the Congress in 1933 in the aftermath of a series of bank failures during the Great Depression. Member banks purchase insurance on deposits and in return, obtain Federal government guarantee on deposits up to $100,000 per depositor per account. So, the depositors need not fear losing the money in their account.

What is the US doing around social insurance?

The easiest thing to do would be to quickly hand money to everyone untargeted, but not everyone needs the money; if you're working from home you're still working and you don't need a government check -->The more you try to target specific groups, the slower everything is Ex-post targeting -->Idea is to send money to everyone; for some it would be a loan and for others a grant; you figure out which one you get when we look at your income from this year -->Temporary version of universal basic income; pretty expensive plan on the surface, but most would be repaid because it would go to people who were technically still receiving income

Do you think we will see a higher high education dropout rate?

There's a little money in the CARES Act for higher education; we're going to see an acceleration in learning how to use online resources

What do you think the economy will look like after we emerge from the pandemic?

Things that were already struggling will probably struggle more/go out, especially without a vaccine available if you have to be in close quarters with strangers Other things won't be as closely packed when they reopen because distance will have to be maintained between customers/people don't want to be around others Online shopping will probably hang around because that's what people have had to do We've discovered that some jobs are better virtually; some people may never want to work in an office again/split their time

How do you rate Congress's policy responses?

Two broad goals they did: -->Stimulus/social insurance/disaster relief- not really stimulus because they're not trying to get people to go back to work; tax rebates and stuff; they just wanted to help unemployed people through difficult times -->Business continuity- they want to be sure the economy's ready to open when the pandemic's over; infusion of liquidity/lending money to firms (TARP) helped make money for taxpayers; kept the financial sector going. PPP was aimed at small businesses ---->Bankruptcy is something that's helped a lot of people/protected equity holders; it's financial reorganization of a viable firm → thinks Congress should be more open to this option so taxpayers don't have to bail out everything

Measurement of Unemployment

Unemployment statistics are published by the Bureau of Labor Statistics (BLS). It is defined as the percentage of the labor force that is unemployed. Question: Can you write the mathematical expression for the unemployment rate? -->u = (U / L) * 100 -->Where ---->u = the unemployment rate in percentage ---->U = total number of people unemployed ---->L = total number of people in the labor force -->Question: Who is in the labor force and who is not? ---->The BLS provides a lengthy discussion on their web page. In general, a survey of 60,000 households (randomly selected) is conducted every month drawn from over 700 geographical areas. Minors, those in mental or correctional institutions and those on active military duty are not included in the survey. (i.e., survey is given out to civilian, non-institutionalized, working-age population.) ---->Population = labor force + those not in labor force ---->Labor Force = employed (E)+ unemployed (U) but actively seeking work (or L = E + U) ------>Question: Who is considered "employed" by BLS? --------->Typically, a person who has put in at least 1 hour or more working for pay during the survey week (which usually happens during the middle of the month). So clearly BLS does not make distinction between full-time and part time employed. ------>Question: Who is considered "unemployed" by BLS? --------->Any person who reported as not having a job during the survey week, but willing and available to work and has spent time actively looking for work in the prior 4 weeks (prior to the survey week that is). --------->So, to be considered as unemployed by the BLS, not having a job is not enough. One must be actively seeking employment in the past 4 weeks prior to the survey. --------->From now on, U stands for unemployed but looking. --------->Unemployed is also part of the labor force. ------>Question: Who is considered in the "Not in the Labor Force" category by BLS? --------->Clearly minors, those on active military duty in prisons etc. are not even part of the survey population. Also, not included are home makers, retired people, full time students who do not want to have any job and hence not looking for one. --------->However, there are always people in the labor market who would want to work but they are so frustrated by the job market that they have given up looking. They are called discouraged workers. Because they have given up looking, they are NOT counted as 'unemployed' by the BLS. --------->FYI: The number of discouraged workers went up from 335,000 in January 2020 (pre pandemic) to 624,000 in January 2021 - an increase of 86%! However, in recent months it has started coming down and currently it stands at 366,000 which is slightly above the pre pandemic level. Question: Another useful indicator of the labor market is the labor-Force participation rate. Can you write down the mathematical expression for it? -->Labor Force Participation Rate (LFP in short) ---->LFP = (L /Adult Population) * 100 ---->That is, LFP tells us the fraction of the adult population that is in the labor force. -->FYI: The LFP fell from 63.4% in January 2020 to 60.2% in April 2020 as people dropped out of the labor market in substantial numbers due to loss of jobs during the early days of the pandemic. Today it is slightly higher at 62.4% as the economy reopens and people get back to the labor force. However, it is still 1% below the pre pandemic level!

Kidney market

Unfairness of market v. unfairness of non-market (demand outweighs supply by huge margin) -->Is it fair to let people die without kidney transplants when there are tons of people walking around with two? -->Classic solution is to allow the selling/buying of kidneys; prices will correct the imbalance, so you should make a kidney market to do so ---->Repugnant market (Roth) → people in dire need are willing to pay and are ok with living donors being compensated; those not directly affected think this idea sucks and don't want it (is it moral to sell body parts? Where does it end?) ------>No legal market spurs trafficking and black markets Economics meets ethics; subjective

UBI

Universal basic income -->Everyone deserves a minimum basic standard of living regardless of circumstances (right to economic security) -->Defining characteristics ---->Periodic payment (recurrent payment) ---->Cash payment (recipients can do whatever they want with the money) ---->Universal (everyone gets it; no target population) ---->Individual (paid on individual basis, not by household like welfare programs) ---->Unconditional (no work requirement) -->Growing income/wealth inequality in the US has given this greater interest; how does UBI reduce this? → depends on how you fund it ---->Progressive tax proposed to fund it (rich people pay more taxes, use this to fund everything; wealth tax) → will have income redistribution effect from rich to poor → helps income inequality ---->Makes it possible to quit shitty dead end jobs/go back to school/do creative activities people actually have a passion for → increases possibility of long term income → more productive society/addresses income inequality -->Addresses threats posed by automation/AI displacing workers ---->People think it eliminates more jobs than it creates ---->UBI can be safety net for displaced people that've had their jobs stolen by robots ------>Composition of jobs will change too; software developing/engineering more valued Downsides -->Incentivize not working/amassing wealth → could cause decrease in entrepreneurship -->Could cause increased automation in certain areas (shitty jobs people leave/don't want to be in) → where will the younger workforce go? -->Promotion of laziness? ---->Real experiments show that this isn't a disincentive → they turn their lives around/take better care of their families -->Expensive ---->But you could save on welfare programs Could this have been a federal response to the pandemic? -->Not good as pandemic response; thinks it is worth discussion on its own though

Money Creation by the Banking System as a Whole

We will make a few simplifying assumptions here at the outset: -->There are no previous 'excess reserves' in the system to begin with, i.e., all banks are fully 'loaned up' -->All deposits refer to checkable deposits only. In other words, to keep things simple, we are focusing on M1 definition of money -->No currency withdrawal is taking place for now. -->Any individual bank lends its entire excess reserves to a single borrower who subsequently writes a check for the entire amount of the loan to someone else who, in turn, deposits it in another bank in the banking system and the process continues. Suppose reserve (requirement) ratio is 10%. In round 1, I start the process as before by depositing $1000 (in ten $100 bills) in Credit Union (CU) to begin with. -->Question: What is the maximum amount CU can loan out in round 2? ---->In this example, $900 as explained above. -->Suppose CU loans out this amount to Jill by creating a checkable account in her name. ---->Question: What does Jill do with this loan? (Recall assumption iv) -->Suppose Jill writes a check to John who deposits it in his account in Commerce bank. ---->Implication: As the check clears, CU loses $900 to Commerce Bank in the process. ---->Question: In round 3, what is the maximum amount Commerce Bank can loan out? ------>$900 - $90 = $810 -->Suppose Commerce Bank loans out this amount to Tim by creating a checkable account in his name. ---->Question: What does Tim do with this loan? (Recall assumption iv once again) -->Suppose Tim writes a check of this amount ($810) to Paula who deposits it in her account in Arvest Bank. ---->Implication: As the check clears, this time Commerce bank loses $810 to Arvest Bank in the process. ---->And the process repeats itself until all excess reserves are eliminated. -->Question: What is the total (or maximum) money (i.e., new deposit) creation in the banking system, starting with the initial demand deposit of $1000? ---->$1000 + $900 + $810 + ----------- ---->The above can be shown to be a sum of a Geometric Progression (GP) series. The formula for summation of a GP series is given below: maximum deposit creation = original deposit * money multiplier ------>Money multiplier = 1 / (reserve ratio) ------>In this example, money multiplier = 1/0.1 = 10 ---->Original deposit = $1000 ---->Maximum deposit = $1000*10 = $10,000 - i.e., when the process is complete, 10 times as many deposits will be created Let us focus on the intuition behind this formula. -->First, smaller the reserve ratio requirement, more the individual banks can loan out at every step in the process, hence higher the money multiplier (i.e., inverse relationship with reserve ratio) -->Second, one bank's loss of loans is another bank's gain of deposits in the banking system. (Just as your spending is someone else's income in the economy as a whole). Hence it is not a loss to the banking system as a whole. What is lost by CU is acquired by Commerce Bank, what is lost by Commerce bank is acquired by Arvest Bank and so on. -->Hence while each individual bank can lend only an amount equal to its excess reserves, the banking system as a whole can lend multiple amounts of its excess reserves (where lending is equivalent to creating money). Question: What happens if we relax assumption iii) and allow for currency withdrawal? -->Suppose Jill withdraws $100 in currency from her loan amount of $900 from CU in the example above and writes a check for $800 only to John. How does that alter the amount of money creation? -->Maximum deposit creation $1000 + $800 + ($800-0.1*$800) + ------ -->As you can see, a lesser and lesser amount of loan will be generated at every successive stage compared to the previous scenario. Hence the total will be less as well. -->Currency withdrawal is referred to as "leakage" from deposit creation. To the extent, public withdraws currency, banks do not have access to that amount for deposit creation until the currency is deposited back into the system.

Are you worried about the government that will come out of the pandemic mired in debt?

We're undertaking a lot of debt to keep things running; we will probably have the biggest budget deficits this year as a share of GDP since WWII, but this isn't the time to worry about debt In the midst of a crisis, running up debt is the right thing to do; once we're out we can think about paying down the debt -->We're probably going to have to raise taxes on everyone to pay the debt; maybe value added tax because they raise revenue efficiently Interest rates are very low right now and they're expected to be low for a long time; if this remains, getting rid of the debt will be more difficult

What's your prediction on the short/long-term impacts for education?

We've learned a lot about online educational opportunities -->Now we can listen to talks from all over the world without having to be there in person; it's especially difficult for younger grades and parents have to shoulder a lot of responsibility -->Not ideal; harder to maintain student interest on a screen; there's been a loss in residential/student interpersonal experience

Fiscal Policy and AD

When President Trump was in office, the Senate passed a $2 trillion spending bill on March 27, 2020, the biggest stimulus package by far. It is called the CARES Act - Coronavirus Aid, Relief and Economic Security Act. It included relief for households in the form of direct checks and added unemployment benefits of $600 per week. It also included small business administration loans/grants and reliefs for big corporations, state and local governments and public health, among others. The idea was to jump-start the economy by giving a boost to private sector spending. In other words, as G increases, it boosts C and I. Now think in terms of the graph again. The policy goal here is to shift the AD out to the right from AD2 in the graph above and eventually back to the original level AD1 and the original equilibrium A. This way the Federal government can lessen the length or severity of recession or both. This is a classic example of demand side expansionary fiscal policy. As the pandemic raged on, the U.S. Congress passed an additional round of COVID relief legislation in December 2020 for $900 billion. In March 2021, President Biden signed an additional $1.9 trillion relief package under the American Rescue Plan. In November 2021, the US Congress passed the $1 trillion infrastructure bill. Today the US economy is operating beyond full employment level and excessive and robust growth has given rise to high inflation. The Federal stimulus spending has already dried up and the Fed has started raising the target for the federal funds rate aggressively. The question is whether the Fed can engineer what is called a "soft landing" in which the economy slows just enough to bring down inflation while avoiding a recession!