Macroeconomics chapters 1, 2, 23, 24, 25, 26, Chapter 35, Chapter 33, Macroeconomics chapt 28, Chapt 27 Macroeconomics

Example 1 of 2 of Real GDP Vs Nominal GDP

(1) In each year, nominal GDP is measured using the (then) current prices. Real GDP is measured using constant prices from the base year (2011 in this example).

Three Facts About Economic Fluctuations (1)

(1) Economic fluctuations are irregular and unpredictable. Fluctuations in the economy are often called the business cycle. The term business cycle is somewhat misleading because it suggests that economic fluctuations follow a regular, predictable pattern. In fact, economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy. The longest period in U.S. history without a recession was the economic expansion from 1991 to 2001. hen real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing. When real GDP falls during recessions, businesses have trouble. During such periods of economic contraction, most firms experience declining sales and dwindling profits.

Two Big AD Shifts: (1)

(1) The Great Depression From 1929-1933, money supply fell 28% due to problems in banking system. stock prices fell 90%, reducing C and I. Y fell 27%. P fell 22%. u-rate rose from 3% to 25%. In an average three-year period, real GDP grows about 10%—a bit more than 3% per year. The business cycle, however, causes fluctuations around this average. Two episodes jump out as being particularly significant: the large drop in real GDP in the early 1930s and the large increase in real GDP in the early 1940s. Both of these events are attributable to shifts in aggregate demand. Over the course of U.S. economic history, two fluctuations stand out as especially large. During the early 1930s, the economy went through the Great Depression, when the production of g's & s's plummeted. During the early 1940s, the US entered WW2 and the economy experienced rapidly rising production. Both of these events are usually explained by large shifts in aggregate demand. The economic calamity of the early 1930s is called the Great Depression, & it is by far the largest economic downturn in U.S. history. Real GDP fell by 26% from 1929 to 1933, & unemployment rose from 3% to 25%. At the same time, the price level fell by 22% over these four years. Many other countries experienced similar declines in output and prices during this period. Many economists place primary blame on the decline in the money supply: From 1929 to 1933, the money supply fell by 28%.As you may recall from our discussion of the monetary system, this decline in the money supply was due to problems in the banking system. As households withdrew their money from financially shaky banks and bankers became more cautious and started holding greater reserves, the process of money creation under fractional-reserve banking went into reverse. The Fed, meanwhile, failed to offset this fall in the money multiplier with expansionary open-market operations. As a result, the money supply declined. Many economists blame the Fed's failure to act for the Great Depression's severity. Other economists have suggested alternative reasons for the collapse in aggregate demand. Stock prices fell about 90% during this period, depressing household wealth and consumer spending. In addition, the banking problems may have prevented some firms from obtaining the financing they wanted for new projects and business expansions, reducing investment spending. It is possible that all these forces may have acted together to contract aggregate demand during the Great Depression.

Example 2 of 2 of Real GDP Vs Nominal GDP

(2) The change in nominal GDP reflects both prices & quantities. The change in real GDP is the amount that GDP would change if prices were constant (i.e., if zero inflation). Hence, real GDP is corrected for inflation.

Three Facts About Economic Fluctuations (2)

(2) Most macroeconomic quantities fluctuate together. Real GDP is the variable most commonly used to monitor short-run changes in the economy because it is the most comprehensive measure of economic activity. Real GDP measures the value of all final g's & s's produced within a given period of time. It also measures the total income (adjusted for inflation) of everyone in the economy. It turns out, however, that for monitoring short-run fluctuations, it doesn't really matter which measure of economic activity one looks at. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together. Investment spending varies greatly over the business cycle. Even though investment averages about one-sixth of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions. In other words, when the economy contracts, much of the contraction is due to reduced spending on new factories, housing, & inventories. When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data.

Two Big AD Shifts: (2)

(2) The World War II BoomFrom 1939-1944, govt outlays rose from $9.1 billion to $91.3 billion. Y rose 90%. P rose 20%. unemployment fell from 17% to 1%. The cause of this event was WW2. As the US entered the war overseas, the federal govt had to devote more resources to the military. Govt purchases of g's & s's increased almost fivefold from 1939 to 1944. This huge expansion in aggregate demand almost doubled the economy's production of g's & s's and led to a 20% increase in the price level (although widespread govt price controls limited the rise in prices). Unemployment fell from 17% in 1939 to about 1% in 1944—the lowest level in U.S. history.

Three Facts About Economic Fluctuations (3)

(3) As output falls, unemployment rises. In other words, when real GDP declines, the rate of unemployment rises. This fact is hardly surprising: When firms choose to produce a smaller quantity of g's & s's, they lay off workers, expanding the pool of unemployed. Because there are always some workers between jobs, the unemployment rate is never zero. Instead, it fluctuates around its natural rate of about 5%.

1. The Sticky-Wage Theory

1. The Sticky-Wage Theory-Imperfection: Nominal wages are sticky in the short run, they adjust sluggishly. Due to labor contracts, social norms. Firms and workers set the nominal wage in advance based on PE, the price level they expect to prevail. If P > PE, revenue is higher, but labor cost is not. Production is more profitable, so firms increase output & employment. Hence, higher P causes higher Y, so the SRAS curve slopes upward. According to this theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are "sticky" in the short run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as three years. In addition, this prolonged adjustment may be attributable to slowly changing social norms & notions of fairness that influence wage setting. In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices & don't respond immediately when the actual price level turns out to be different from what was expected. This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected & to produce more when the price level turns out higher than expected. When production is less profitable, so the firm hires fewer workers & reduces the quantity of output supplied. Over time, the labor contract will expire, & the firm can renegotiate with its workers for a lower wage (which they may accept because prices are lower), but in the meantime, employment & production will remain below their long-run levels. Also works in reverse.

The Effects of a Shift in Aggregate Demand

1. We determine whether the event affects aggregate demand or aggregate supply. 2. We determine the direction that the curve shifts. 3. We use the diagram of aggregate demand and aggregate supply to compare the initial and new equilibria. 4. We have to keep track of a new short-run equilibrium, a new long-run equilibrium, and the transition between them. Summarized-1.Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps both). 2. Decide the direction in which the curve shifts. 3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. 4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its new long-run equilibrium. To sum up, this story about shifts in aggregate demand has three important lessons: In the short run, shifts in aggregate demand cause fluctuations in the economy's output of g's & s's. In the long run, shifts in aggregate demand affect the overall price level but don't affect output. Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

The Effects of a Shift in Aggregate Supply

1. We determine whether the event affects aggregate demand or aggregate supply. 2. We determine the direction that the curve shifts. 3. We use the diagram of aggregate demand and aggregate supply to compare the initial and new equilibria. 4. We have to keep track of a new short-run equilibrium, a new long-run equilibrium, and the transition between them. Summarized-1.Decide whether the event shifts the aggregate-demand curve or the aggregate-supply curve (or perhaps both). 2. Decide the direction in which the curve shifts. 3. Use the diagram of aggregate demand and aggregate supply to determine the impact on output and the price level in the short run. 4. Use the diagram of aggregate demand and aggregate supply to analyze how the economy moves from its new short-run equilibrium to its new long-run equilibrium. To sum up, this story about shifts in aggregate supply has two important lessons: Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices). Policymakers who can influence aggregate demand can mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation.

Propositions about Which Most Economists Agree (and % who agree)

A ceiling on rents reduces the quantity and quality of housing available. (93%) ▪ Tariffs and import quotas usually reduce general economic welfare. (93%) ▪ The United States should not restrict employers from outsourcing work to foreign countries. (90%) ▪ The United States should eliminate agriculture subsidies. (85%) The gap between Social Security funds and expenditures will become unsustainably large within the next fifty years if current policies remain unchanged. (85%) ▪ A large federal budget deficit has an adverse effect on the economy. (83%) ▪ A minimum wage increases unemployment among young and unskilled workers. (79%) ▪ Effluent taxes and marketable pollution permits represent a better approach to pollution control than imposition of pollution ceilings. (78%)

Correcting Variables for Inflation: Indexation

A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract. For example, the increase in the CPI automatically determines: the COLA in many multi-year labor contracts. adjustments in Social Security payments and federal income tax brackets. automatically raises the wage when the CPI rises. indexed-the automatic correction by law or contract of a dollar amount for the effects of inflation. Social Security benefits, for instance, are adjusted every year to compensate the elderly for increases in prices. The brackets of the federal income tax—the income levels at which the tax rates change—are also indexed for inflation.

The Slope of the Demand Curve

A fall in the interest rate reduces the cost of borrowing, which increases the quantity of loanable funds demanded.

The Circular-Flow Diagram

A simple depiction of the macroeconomy illustrates GDP as spending, revenue, factor payments, & income Preliminaries: Factors of production-inputs like labor, land, capital, & natural resources. Factor payments-payments to the factors of production (e.g., wages, rent). Households: Own the factors of production, sell/rent them to firms for income. Buy & consume goods & services Firms: Buy/hire factors of production, use them to produce goods & services. Sell goods & services What This Diagram Omits The government collects taxes, buys g&s The financial system matches savers' supply of funds with borrowers' demand for loans The foreign sector trades g&s, financial assets, & currencies with the country's residents Compute the GDP by adding up the total expenditure by households or by adding up the total income (wages, rent, & profit) paid by firms. All the expenditures end up being somebody's income so GDP is the same regardless of how we compute it.

The Market for Loanable Funds

A supply-demand model of the financial system Helps us understand: how the financial system coordinates saving & investment. how govt policies & other factors affect saving, investment, the interest rate. Assume: only one financial market. All savers deposit their saving in this market. All borrowers take out loans from this market. There's one interest rate, which is both the return to saving & the cost of borrowing. The supply of loanable funds comes from saving: Households with extra income can loan it out & earn interest. Public saving, if positive, adds to national saving & the supply of loanable funds. If negative, it reduces national saving & the supply of loanable funds. The demand for loanable funds comes from investment: Firms borrow the funds they need to pay for new equipment, factories, etc. Households borrow the funds they need to purchase new houses.

PPF Example 1 of 3

A. On the graph, find the point that represents (100 computers, 3000 tons of wheat), label it F. Would it be possible for the economy to produce this combination of the two goods? Why or why not? B. Next, find the point that represents (300 computers, 3500 tons of wheat), label it G. Would it be possible for the economy to produce this combination of the two goods?

How Expected Inflation Shifts the PC

According to Friedman and Phelps, it is dangerous to view the Phillips curve as a menu of options available to policymakers. To see why, imagine an economy that starts with low inflation, with an equally low rate of expected inflation, and with unemployment at its natural rate. Now suppose that policymakers try to take advantage of the trade-off between inflation and unemployment by using monetary or fiscal policy to expand aggregate demand. In the short run, when expected inflation is given. Unemployment falls below its natural rate, and the actual inflation rate rises above expected inflation. Policymakers might think they have achieved permanently lower unemployment at the cost of higher inflation—a bargain that, if possible, might be worth making. The higher the expected rate of inflation, the higher the curve representing the short-run trade-off between inflation and unemployment. Expected inflation and actual inflation are equal at a low rate and unemployment is at its natural rate. If the Fed pursues an expansionary monetary policy. Expected inflation is still low, but actual inflation is high. Unemployment is below its natural rate. In the long run, expected inflation rises. Expected inflation and actual inflation are both high, and unemployment is back to its natural rate. This situation, however, will not persist. Over time, people get used to this higher inflation rate, and they raise their expectations of inflation. When expected inflation rises, firms and workers start taking higher inflation into account when setting wages and prices. Thus, Friedman and Phelps concluded that policymakers face only a temporary trade-off between inflation & unemployment. In the long run, expanding aggregate demand more rapidly will yield higher inflation without any reduction in unemployment. In summary-Initially, expected & actual inflation = 3%,unemployment =natural rate (6%). Fed makes inflation 2% higher than expected, u-rate falls to 4%. In the long run, expected inflation increases to 5%, PC shifts upward, unemployment returns to its natural rate.

Active learning 2

Adverse selection or moral hazard? Identify whether each of the following is an example of adverse selection or moral hazard. A. Joe begins smoking in bed after buying fire insurance. (Moral hazard) B. Both of Susan's parents lost their teeth to gum disease, so Susan buys dental insurance. (Adverse selection) C. When Gertrude parks her Corvette convertible, she doesn't bother putting the top up, because her insurance covers theft of any items left in the car. (Moral hazard)

Two Problems in Insurance Markets

Adverse selection: A high-risk person benefits more from insurance, so is more likely to purchase it. Moral hazard: People with insurance have less incentive to avoid risky behavior. Insurance companies can't fully guard against these problems, so they must charge higher prices. As a result, low-risk people sometimes forego insurance & lose the benefits of risk-pooling.

The Greenspan Era

After the OPEC inflation of the 1970s and the Volcker disinflation of the 1980s, the U.S. economy experienced relatively mild fluctuations in inflation & unemployment. This figure shows annual data from 1984 to 2005 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). During most of this period, Alan Greenspan was chairman of the Federal Reserve. Fluctuations in inflation and unemployment were relatively small. Shows inflation & unemployment from 1984 to 2005. This period is called the Greenspan era, after Alan Greenspan who in 1987 followed Paul Volcker as chairman of the Federal Reserve. This period began with a favorable supply shock. In 1986, OPEC members started arguing over production levels, and their long-standing agreement to restrict supply broke down. Oil prices fell by about half. As the figure shows, this favorable supply shock led to falling inflation and falling unemployment from 1984 to 1986. Throughout the Greenspan era, the Fed was careful to avoid repeating the policy mistakes of the 1960s, when excessive aggregate demand pushed unemployment below the natural rate and raised inflation. When unemployment fell & inflation rose in 1989 & 1990, the Fed raised interest rates & contracted aggregate demand, leading to a small recession in 1991 & 1992. Unemployment then rose above most estimates of the natural rate, & inflation fell once again. The rest of the 1990s witnessed technological boom & a period of economic prosperity. Inflation gradually drifted downward, approaching zero by the end of the decade. Unemployment also drifted downward, leading many observers to believe that the natural rate of unemployment had fallen. Part of the credit for this good economic performance goes to Greenspan & his colleagues at the Fed, for low inflation can be achieved only with prudent monetary policy. But good luck in the form of favorable supply shocks is also part of the story. In 2001, however, the economy ran into problems. The end of the dot-com stock market bubble, the 9/11 terrorist attacks, and corporate accounting scandals all depressed aggregate demand. Unemployment rose as the economy experienced its first recession in a decade. But a combo of expansionary monetary and fiscal policies helped end the downturn, and by early 2005, unemployment was close to most estimates of the natural rate. In summary-1986: Oil prices fell 50%. 1989-90: Unemployment fell, inflation rose. Fed raised interest rates, caused a mild recession. 1990s: Unemployment and inflation fell. 2001: Negative demand shocks created the first recession in a decade. Policymakers responded with expansionary monetary and fiscal policy. Inflation and unemployment were low during most of Alan Greenspan's years as Fed Chairman.

PRINCIPLE 1 People Face Tradeoffs

All decisions involve tradeoffs. Examples: ▪ Going to a party the night before your midterm leaves less time for studying. ▪ Having more money to buy stuff requires working longer hours, which leaves less time for leisure. ▪ Protecting the environment requires resources that could otherwise be used to produce consumer goods. Society faces an important tradeoff: efficiency vs. equality Efficiency: when society gets the most from its scarce resources. Equality: when prosperity is distributed uniformly among society's members. Tradeoff: To achieve greater equality, could redistribute income from wealthy to poor. But this reduces incentive to work & produce, shrinks the size of the economic "pie."

Our Second Model: The Production Possibilities Frontier

Also called the Production Possibilities Curve. (PPC) The Production Possibilities Frontier (PPF): a graph that shows the combinations of two goods the economy can possibly produce given the available resources and the available technology. ▪ Example: ▪ Two goods: computers and wheat ▪ One resource: labor (measured in hours) ▪ Economy has 50,000 labor hours per month available for production.

The Slope of the AD Curve: Summary

An increase in P reduces the quantity of g&s demanded because: The wealth effect (C falls). The interest-rate effect (I falls). The exchange-rate effect (NX falls).

The Slope of the Supply Curve

An increase in the interest rate makes saving more attractive, which increases the quantity of loanable funds supplied.

Index Funds vs. Managed Funds

An index fund is a mutual fund that buys all the stocks in a given stock index. An actively managed mutual fund aims to buy only the best stocks. Actively managed funds have higher expenses than index funds. EMH implies that returns on actively managed funds should not consistently exceed the returns on index funds. The performance of these funds can be compared with that of actively managed mutual funds, where a professional portfolio manager picks stocks based on extensive research and alleged expertise. In essence, index funds buy all stocks and thus offer investors the return on the average stock, whereas actively managed funds seek to buy only the best stocks and thereby outperform the market averages. In practice, however, active managers usually fail to beat index funds.

Policy 2: Investment Incentives

An investment tax credit increases the demand for L.F. which raises the eq'm interest rate & increases the eq'm quantity of L.F. 1st, would the tax credit affect supply or demand? Because it would reward firms that borrow & invest in new capital, it would alter investment at any given interest rate &, thereby, change the demand for loanable funds. By contrast, because the tax credit wouldn't affect the amount that households save at any given interest rate, it wouldn't affect the supply of loanable funds. 2nd, which way would the demand curve shift? Because firms would have an incentive to increase investment at any interest rate, the quantity of loanable funds demanded would be higher at any given interest rate. Thus, the demand curve for loanable funds would move to the right, as shown by the shift from D1 to D2 in the figure. 3rd, consider how the equilibrium would change. In Figure 3, the increased demand for loanable funds raises the interest rate from 5% to 6%, & the higher interest rate in turn increases the quantity of loanable funds supplied from $1,200 billion to $1,400 billion, as households respond by increasing the amount they save. This change in household behavior is represented here as a movement along the supply curve. Thus, if a reform of the tax laws encouraged greater investment, the result would be higher interest rates & greater saving.

The Economist as Policy Advisor

As scientists, economists make positive statements, which attempt to describe the world as it is. ▪ As policy advisors, economists make normative statements, which attempt to prescribe how the world should be. ▪ Positive statements can be confirmed or refuted, normative statements cannot. ▪ Govt employs many economists for policy advice. E.g., the U.S. President has a Council of Economic Advisors, which the author of this textbook chaired from 2003 to 2005. REMEMBER:A key difference between positive & normative statements is how we judge their validity.

Summary 4

As scientists, economists try to explain the world using models with appropriate assumptions. • Two simple models are the Circular-Flow Diagram and the Production Possibilities Frontier. • Microeconomics studies the behavior of consumers and firms, and their interactions in markets. Macroeconomics studies the economy as a whole. • As policy advisers, economists offer advice on how to improve the world. (4)

Why the PPF Might Be Bow-Shaped 1 of 3

As the economy shifts resources from beer to mountain bikes: ▪PPF becomes steeper ▪opp. cost of mountain bikes increases So, PPF is bow-shaped when different workers have different skills, different opportunity costs of producing one good in terms of the other. ▪ The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opportunity costs (E.g., different types of land suited for different uses).

The Volcker Disinflation

As we've seen, when Paul Volcker faced the prospect of reducing inflation from its peak of about 10%, the economics profession offered two conflicting predictions. One group of economists offered estimates of the sacrifice ratio & concluded that reducing inflation would have great cost in terms of lost output & high unemployment. Another group offered the theory of rational expectations & concluded that reducing inflation could be much less costly &, perhaps, could even have no cost at all. Volcker did succeed at reducing inflation. Inflation came down from almost 10% in 1980 & 1981 to about 4% in 1983 & 1984. Credit for this reduction in inflation goes completely to monetary policy. Fiscal policy at this time was acting in the opposite direction: The increases in the budget deficit during the Reagan admin were expanding aggregate demand, which tends to raise inflation. The fall in inflation from 1981 to 1984 is attributable to the tough anti-inflation policies of Fed Chairman Paul Volcker. This figure shows annual data from 1979 to 1987 on the unemployment rate & on the inflation rate (as measured by the GDP deflator). The reduction in inflation during this period came at the cost of very high unemployment in 1982 & 1983. Note that the points labeled A, B, & C in this figure correspond roughly to the points in "Disinflationary Monetary Policy". The figure shows that the Volcker disinflation did come at the cost of high unemployment. In 1982 & 1983, the unemployment rate was about 10%—about 4% points above its level when Paul Volcker was appointed Fed chairman. At the same time, the production of g's & s's as measured by real GDP was well below its trend level. The Volcker disinflation produced a recession that was, at the time, the deepest the US had experienced since the Great Depression of the 1930s. To make the transition from high inflation (point A in both figures) to low inflation (point C), the economy had to experience a painful period of high unemployment (point B). 2 reasons not to reject the conclusions of the rational-expectations theorists so quickly. 1st, even though the Volcker disinflation did impose a cost of temporarily high unemployment, the cost was not as large as many economists had predicted. Most estimates of the sacrifice ratio based on the Volcker disinflation are smaller than estimates that'd been obtained from previous data. Perhaps Volcker's tough stand on inflation did have some direct effect on expectations, as the rational-expectations theorists claimed. 2nd, & more important, even though Volcker announced that he would aim monetary policy to lower inflation, much of the public didn't believe him. Because few people thought Volcker would reduce inflation as quickly as he did, expected inflation didn't fall immediately; as a result, the short-run Phillips curve didn't shift down as quickly as it might have. Some evidence for this hypothesis comes from the forecasts made by commercial forecasting firms: Their forecasts of inflation fell more slowly in the 1980s than did actual inflation. Thus, the Volcker disinflation doesn't necessarily refute the rational-expectations view that credible disinflation can be costless. It does show, however, that policymakers can't count on people to immediately believe them when they announce a policy of disinflation. In summary-Fed Chairman Paul Volcker. Appointed in late 1979 under high inflation & unemployment. Changed Fed policy to disinflation1981-1984: Fiscal policy was expansionary, so Fed policy had to be very contractionary to reduce inflation. Success: Inflation fell from 10% to 4%,but at the cost of high unemployment...Disinflation turned out to be very costly. u-rate near 10% in 1982-83

Assumptions & Models

Assumptions simplify the complex world, make it easier to understand. ▪ Example: To study international trade, assume two countries and two goods. Unrealistic, but simple to learn and gives useful insights about the real world. ▪ Model: a highly simplified representation of a more complicated reality. Economists use models to study economic issues.

Why the PPF Might Be Bow-Shaped 3 of 3

At B, most workers are producing bikes. The few left in beer are the best brewers.Producing more bikes would require shifting some of the best brewers away from beer production, causing a big drop in beer output.

Why the PPF Might Be Bow-Shaped 2 of 3

At point A, most workers are producing beer, even those who are better suited to building bikes. So, do not have to give up much beer to get more bikes.

Why the LRAS Curve Might Shift

Because classical macroeconomic theory predicts the quantity of g's & s's produced by an economy in the long run, it also explains the position of the long-run aggregate-supply curve. The long-run level of production is sometimes called potential output or full-employment output. Any event that changes any of the determinants of YN will shift LRAS. Because output in the classical model depends on labor, capital, natural resources, and technological knowledge, we can categorize shifts in the long-run aggregate-supply curve as arising from these four sources. Example: Immigration increases L, causing YN to rise. Changes in L or natural rate of unemployment-Immigration. Baby-boomers retire. Govt policies reduce natural u-rate. Changes in K or H-Investment in factories, equipment. More people get college degrees. Factories destroyed by a hurricane. Changes in natural resources. Discovery of new mineral deposits. Reduction in supply of imported oil. Changing weather patterns that affect agricultural production. Changes in technology. Productivity improvements from technological progress.

The Utility Function and Risk Aversion

Because of diminishing marginal utility, a $1000 loss reduces utility more than a $1000 gain increases it. In other words, diminishing marginal utility is the reason most people are risk averse.

The Phillips Curve During the Financial Crisis Part 1

Ben Bernanke may have hoped to continue the policies of the Greenspan era and to enjoy the relative calm of those years, but his wishes wouldn't be fulfilled. During his first few years on the job, the new Fed chairman faced some daunting challenges. As we've seen in previous chapters, the main challenge arose from problems in the housing market and financial system. From 1995 to 2006, the U.S. housing market boomed and average U.S. house prices more than doubled. But this housing boom proved unsustainable, & from 2006 to 2009 house prices fell by about one-third. This large fall led to declines in household wealth and difficulties for many financial institutions that had bet (through the purchase of mortgage-backed securities) that house prices would continue to rise. The resulting financial crisis resulted in a large decline in aggregate demand and a steep increase in unemployment. In summary-The early 2000s housing market boom turned to bust in 2006. Household wealth fell, millions of mortgage defaults and foreclosures, heavy losses at financial institutions. Result: Sharp drop in aggregate demand, steep rise in unemployment.

Budget Deficits and Surpluses

Budget surplus= an excess of tax revenue over govt spending= T - G= public saving. Budget deficit= a shortfall of tax revenue from govt spending= G - T= -(public saving).

ACTIVE LEARNING 2 Substitution bias

CPI basket: {10 lbs beef, 20 lbs chicken} In 2010 & 2011, households bought CPI basket. In 2012, households bought {5 lbs beef, 25 lbs chicken}. Household basket in 2012: {5 lbs beef, 25 lbs chicken} A. Compute cost of the 2012 household basket. ($9x5)+($6x25)=$195 B. Compute % increase in cost of household basket over 2011-12, compare to CPI inflation rate. Rate of increase: ($195-$150)/150=30% CPI inflation rate from previous problem=40%

Active learning 1 Calculate the CPI

CPI basket: {10 lbs beef, 20 lbs chicken} The CPI basket cost $120 in 2010, the base year. A. Compute the CPI in 2011. Compute the CPI in 2011: Cost of CPI basket in 2011=($5x10)+($5x20)=$150 CPI in 2011=100x($150/$120)=125 B. What was the CPI inflation rate from 2011-2012? Cost of CPI basket in 2012 CPI in 2012 =($9*10)+($6*20)=$210 CPI in 2012=100*($210/$120)=175 CPI inflation rate =(175-125)/125=40%

Economic Fluctuations

Caused by events that shift the AD and/or AS curves. Four steps to analyzing economic fluctuations: 1. Determine whether the event shifts AD or AS. 2. Determine whether curve shifts left or right. 3. Use AD-AS diagram to see how the shift changes Y and P in the short run. 4. Use AD-AS diagram to see how economy moves from new SR eq'm to new LR eq'm. the basic tools we need to analyze fluctuations in economic activity. In particular, we can use what we've learned about aggregate demand & aggregate supply to examine the two basic causes of short-run fluctuations: shifts in aggregate demand & shifts in aggregate supply. To keep things simple, we assume the economy begins in long-run equilibrium. Output and the price level are determined in the long run by the intersection of the aggregate-demand curve and the long-run aggregate-supply curve. At this point, output is at its natural level. Because the economy is always in a short-run equilibrium, the short-run aggregate-supply curve passes through this point as well, indicating that the expected price level has adjusted to this long-run equilibrium. That is, when an economy is in its long-run equilibrium, the expected price level must equal the actual price level so that the intersection of aggregate demand with short-run aggregate supply is the same as the intersection of aggregate demand with long-run aggregate supply.

Compounding

Compounding: the accumulation of a sum of money where the interest earned on the sum earns additional interest. Because of compounding, small differences in interest rates lead to big differences over time.▪ Example: Buy $1000 worth of Microsoft stock, hold for 30 years. If rate of return = 0.08, FV = $10,063. If rate of return = 0.10, FV = $17,450

Example of how CPI is calculated

Compute CPI in each year using 2010 as the base year: 2010: 100 x ($60/$60) = 100 15%= 115 - 100/100 x 100% 2011: 100 x ($69/$60) = 115 13%= 130 - 115/115 x 100% 2012: 100 x ($78/$60) = 130

Example of Nominal GDP

Compute nominal GDP in each year: Increase: 2011: $10 x 400 + $2 x 1000 = $6,000 37.5% 2012: $11 x 500 + $2.50 x 1100 = $8,250 30.9% 2013: $12 x 600 + $3 x 1200 = $10,800

Example of Real GDP

Compute real GDP in each year, using 2011 as the base year: Increase: 2011: $10 x 400 + $2 x 1000 = $6,000 20.0% 2012: $10 x 500 + $2 x 1100 = $7,200 16.7% 2013: $10 x 600 + $2 x 1200 = $8,400

Active learning 1

Compute the labor force, u-rate, adult population, and labor force participation rate using this data: Labor force = employed + unemployed = = U-rate = 100 x (unemployed)/(labor force) = = Population = labor force + not in labor force = = LF partic. rate = 100 x (labor force)/(population) = =

Disinflationary Monetary Policy

Contractionary monetary policy moves economy from A to B.Over time, expected inflation falls, PC shifts downward.In the long run, point C: the natural rate of unemployment, lower inflation.

EXAMPLE 1: A Simple Deposit

Deposit $100 in the bank at 5% interest. What's the future value (FV) of this amount? In N years, FV = $100(1 + 0.05) to the power of N. In 3 years, FV = $100(1 + 0.05) to the power of 3 = $115.76. In 2 years, FV = $100(1 + 0.05) to the power of 2 = $110.25. In 1 year, FV = $100(1 + 0.05) = $105.00. In this example, $100 is the present value (PV). In general, FV = PV(1 + r) to the power of N where r denotes the interest rate (in decimal form). Solve for PV to get: PV = FV/(1 + r) to the power of N

The process of finding a present value of a future sum of money is called?

Discounting. This (PV = FV/(1 + r) to the power N) shows precisely how much future sums should be discounted.

The Cost of Reducing Inflation

Disinflation: a reduction in the inflation rate. To reduce inflation, Fed must slow the rate of money growth, which reduces agg demand. Short run: Output falls and unemployment rises. Long run: Output & unemployment return to their natural rates. Disinflation requires enduring a period of high unemployment and low output. Sacrifice ratio: percentage points of annual output lost per 1 percentage point reduction in inflation. Typical estimate of the sacrifice ratio: 5. To reduce inflation rate 1%, must sacrifice 5% of a year's output. Can spread cost over time, e.g. To reduce inflation by 6%, can either. sacrifice 30% of GDP for one year. sacrifice 10% of GDP for three years. History-In October 1979, as OPEC was imposing adverse supply shocks on the world's economies for the second time in a decade, Fed Chairman Paul Volcker decided that the time for action had come. Volcker had been appointed chairman by President Carter only two months earlier, and he had taken the job knowing that inflation had reached unacceptable levels. As guardian of the nation's monetary system, he felt he had little choice but to pursue a policy of disinflation. Volcker had no doubt that the Fed could reduce inflation through its ability to control the quantity of money.

Reducing Risk Through Diversification

Diversification reduces risk by replacing a single risk with a large number of smaller, unrelated risks. A diversified portfolio contains assets whose returns are not strongly related: Some assets will realize high returns, others low returns. The high & low returns average out, so the portfolio is likely to earn an intermediate return more consistently than any of the assets it contains. Diversification can reduce firm-specific risk, which affects only a single company. Diversification can't reduce market risk, which affects all companies in the stock market. The market for insurance is one example of diversification. This figure shows how the risk of a portfolio, measured here by a statistic called the standard deviation, depends on the number of stocks in the portfolio. The investor is assumed to put an equal percentage of her portfolio in each of the stocks. Increasing the number of stocks reduces but does not eliminate the risk in a stock portfolio. A portfolio with a single stock, standard deviation is 49%. Going from 1 to 10 stocks eliminates about half of the risk. Going from 10 to 20 stocks reduces risks by another 10%. As the number of stocks continues to increase, risk continues to fall, although the reductions in risk beyond 20 to 30 stocks are small.

Active leaning 2 Working with the model

Draw the AD-SRAS-LRAS diagram for the U.S. economy starting in a long-run equilibrium. A boom occurs in Canada. Use your diagram to determine the SR and LR effects on U.S. GDP, the price level, and unemployment. Event: Boom in Canada1. Affects NX, AD curve. 2. Shifts AD right. 3. SR eq'm at point B. P and Y higher, unemployment lower. 4. Over time, PE rises, SRAS shifts left, until LR eq'm at C. Y and unemployment back at initial levels.

Evidence for The Phillips Curve?

During the 1960s, U.S. policymakers opted for reducing unemployment at the expense of higher inflation.

Problems with the CPI

Each of these problems causes the CPI to overstate cost of living increases. The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year. This is important because Social Security payments and many contracts have COLAs tied to the CPI. Some economists have suggested modifying these programs to correct for the measurement problems by, for instance, reducing the magnitude of the automatic benefit increases. The issue is important because many govt programs use the CPI to adjust for changes in the overall level of prices.

Why Economists Disagree

Economists often give conflicting policy advice. ▪ They sometimes disagree about the validity of alternative positive theories about the world. ▪ They may have different values and, therefore, different normative views about what policy should try to accomplish. ▪ Yet, there are many propositions about which most economists agree.

The Economist as Scientist

Economists play two roles: 1. Scientists: try to explain the world. 2. Policy advisors: try to improve it ▪ In the first, economists employ the scientific method, the dispassionate development and testing of theories about how the world works.

The Model of Aggregate Demand and Aggregate Supply

Economists use the model of aggregate demand and aggregate supply to analyze economic fluctuations. On the vertical axis is the overall level of prices. On the horizontal axis is the economy's total output of g's & s's. Output and the price level adjust to the point at which the aggregate-supply and aggregate-demand curves intersect. P (The Price Level) The model determines eq'm price level & eq'm output (real GDP). Y (Real GDP) the quantity of output. Our model of short-run economic fluctuations focuses on the behavior of two variables. The first variable is the economy's output of g's & s's, as measured by real GDP. The second is the average level of prices, as measured by the CPI or the GDP deflator. Notice that output is a real variable, whereas the price level is a nominal variable. By focusing on the relationship between these two variables, we are departing from the classical assumption that real and nominal variables can be studied separately.

The Efficient Markets Hypothesis

Efficient Markets Hypothesis (EMH): the theory that each asset price reflects all publicly available information about the value of the asset. Realize that each company listed on a major stock exchange is followed closely by many money managers, such as the individuals who run mutual funds. Every day, these managers monitor news stories and conduct fundamental analysis to try to determine a stock's value. Their job is to buy a stock when its price falls below its fundamental value and to sell it when its price rises above its fundamental value. The second piece to the efficient markets hypothesis is that the equilibrium of supply and demand sets the market price. This means that, at the market price, the number of shares being offered for sale exactly equals the number of shares that people want to buy. In other words, at the market price, the number of people who think the stock is overvalued exactly balances the number of people who think it's undervalued. As judged by the typical person in the market, all stocks are fairly valued all the time. The efficient markets hypothesis says that it is impossible to beat the market. The accumulation of many studies of financial markets confirms that beating the market is, at best, extremely difficult.

The Phillips Curve Equation

Equation (which is, in essence, another expression of the aggregate-supply equation we've seen previously) relates the unemployment rate to the natural rate of unemployment, actual inflation, and expected inflation. In the short run, expected inflation is given, so higher actual inflation is associated with lower unemployment. (The variable "a" is a parameter that measures how much unemployment responds to unexpected inflation.) In the long run, people come to expect whatever inflation the Fed produces, so actual inflation equals expected inflation, & unemployment is at its natural rate. equation implies there can be no stable short-run Phillips curve. Each short-run Phillips curve reflects a particular expected rate of inflation. (To be precise, if you graph the Equation, you'll find that the downward-sloping short-run Phillips curve intersects the vertical long-run Phillips curve at the expected rate of inflation.) When expected inflation changes, the short-run Phillips curve shifts. In summary-unemployment rate= natural rate of unemployment-a(Actual inflation-expected inflation) Short run Fed can reduce u-rate below the natural u-rate by making inflation greater than expected. Long run Expectations catch up to reality, u-rate goes back to natural u-rate whether inflation is high or low.

Explaining the natural rate: an overview

Even when the economy is doing well, there is always some unemployment, including: Frictional unemployment-occurs when workers spend time searching for the jobs that best suit their skills and tastes. short-term for most workers. Structural unemployment-occurs when there are fewer jobs than workers. usually longer-term.

The Effects of a Shift in SRAS

Event: Oil prices rise-1. Increases costs, shifts SRAS(assume LRAS constant) 2. SRAS shifts left. 3. SR eq'm at point B. P higher, Y lower, unemployment higher From A to B, stagflation, a period of falling output and rising prices. When some event (usually political in origin) reduces the supply of crude oil flowing from this region, the price of oil rises around the world. Firms in the US that produce gasoline, tires, & many other products experience rising costs, and they find it less profitable to supply their output of g's & s's at any given price level. The result is a leftward shift in the aggregate-supply curve, which in turn leads to stagflation. From 1973-1975, oil approximately doubled in price. Oil-importing countries around the world experienced simultaneous inflation and recession. The U.S. inflation rate as measured by the CPI exceeded 10% for the first time in decades. Unemployment rose from 4.9% in 1973 to 8.5% in 1975. In the late 1970s, the OPEC countries again restricted the supply of oil to raise the price. From 1978-1981, the price of oil more than doubled. Once again, the result was stagflation. Inflation, which had subsided somewhat after the first OPEC event, again rose above 10% per year. But because the Fed was not willing to accommodate such a large rise in inflation, a recession soon followed. Unemployment rose from about 6% in 1978 and 1979 to about 10% a few years later. In recent years, developments in the world oil market have not been as important a source of fluctuations for the U.S. economy. One reason is that conservation efforts, changes in technology, and the availability of alternative energy sources have reduced the economy's dependence on oil. The amount of oil used to produce a unit of real GDP has declined by more than 50% since the OPEC shocks of the 1970s. As a result, the impact of any change in oil prices on the U.S. economy is smaller today than it was in the past.

The Effects of a Shift in AD

Event: Stock market crash-1. Affects C, AD curve. 2. C falls, so AD shifts left. 3. SR eq'm at B. P and Y lower, unemployment higher. 4. Over time, PE falls, SRAS shifts right, until LR eq'm at C. Y and unemployment back at initial levels. Because of this event, many people lose confidence in the future and alter their plans. Households cut back on their spending and delay major purchases, and firms put off buying new equipment.

Why the SRAS Curve Might Shift

Everything that shifts LRAS shifts SRAS, too. Also, PE shifts SRAS: If PE rises, workers & firms set higher wages. At each P, production is less profitable, Y falls, SRAS shifts left.

Factors of Production

Factors of production: the resources the economy uses to produce goods & services, including ▪ labor ▪ land ▪ capital (buildings and machines used in production)

Textbook Terminology &/Or Roles (DON'T PRINT) Note this is just to elaborate further on the terminology & or their roles.

Financial system-the group of institutions in the economy that help to match one person's saving with another person's investment. Savers-people who spend less than they earn. (In regards to how it works with the financial system-supply their money to the financial system with the expectation that they'll get it back with interest at a later date.) Borrowers-people who spend more than they earn. (In regards to how it works with the financial system-demand money from the financial system with the knowledge that they'll be required to pay it back with interest at a later date.) Financial Markets-financial institutions through which savers can directly provide funds to borrowers. Bond-a certificate of indebtedness. Simply, a bond buyer is a lender, & a bond is an IOU. The bond identifies the time at which the loan will be repaid, called the date of maturity, & the rate of interest that the borrower will pay periodically until the loan matures. Buyer of a bond gives his money to Intel in exchange for this promise of interest & eventual repayment of the amount borrowed (called the principal). Can hold til maturity or sell it at an earlier time. Term-the length of time until the bond matures. Some bonds have short terms such as a few months, others have terms as long as 30 years. (The British govt has even issued a bond that never matures, called a perpetuity. This bond pays interest forever, but the principal is never repaid.) Interest rate on a bond depends, in part, on its term. Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds. credit risk—the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default. Borrowers can (& sometimes do) default on their loans by declaring bankruptcy. When bond buyers perceive that the probability of default is high, they demand a higher interest rate as compensation for this risk. Because the U.S. govt is considered to have low credit risk, U.S. govt bonds tend to pay low interest rates. By contrast, financially shaky corporations raise money by issuing junk bonds, which pay very high interest rates. Buyers of bonds can judge credit risk by checking with various private agencies that evaluate the credit risk of different bonds. For example, Standard & Poor's rates bonds from AAA (the safest) to D (those already in default). tax treatment—the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income; that is, the bond owner has to pay a portion of the interest he earns in income taxes. By contrast, when state & local govts issue bonds, called municipal bonds, the bond owners aren't required to pay federal income tax on the interest income. Because of this tax advantage, bonds issued by state & local govts typically pay a lower interest rate than bonds issued by corporations or the federal govt. whether it offers inflation protection. Most bonds are written in nominal terms—that is, they promise to pay interest & principal in a specific number of dollars (or perhaps another currency). If prices rise & dollars have less purchasing power, the bondholder is worse off. Some bonds, however, index the payments of interest & principal to a measure of inflation so that when prices rise, the payments rise proportionately. Beginning in 1997, the U.S. govt started issuing such bonds, called Treasury Inflation-Protected Securities (TIPS). Because TIPS offer inflation protection, they pay a lower interest rate than similar bonds without this feature. (The Bond Market is one of the two most important financial markets in our economy.) Stock-a claim to partial ownership in a firm. The most famous stock index is the Dow Jones Industrial Average, which has been computed regularly since 1896. It's now based on the prices of the stocks of 30 major U.S. companies, such as Disney, Microsoft, Coca-Cola, Boeing, Apple, & Walmart. Another well-known stock index is the Standard & Poor's 500 Index, which is based on the prices of the stocks of 500 major companies. Because stock prices reflect expected profitability, these stock indexes are watched closely as possible indicators of future economic conditions. In stock exchanges, the corporation itself receives no money when its stock changes hands. The most important stock exchanges in the U.S. economy are the New York Stock Exchange & the Nasdaq (National Association of Securities Dealers Automated Quotations). Most of the world's countries have their own stock exchanges on which the shares of local companies trade, the most important being those in Tokyo, Shanghai, Hong Kong, & London. The prices at which shares trade on stock exchanges are determined by the supply of & demand for the stock in these companies. Because stock represents ownership in a corporation, the demand for a stock (& thus its price) reflects people's perception of the corporation's future profitability.(The Stock Market is one of the two most important financial markets in our economy.) Financial intermediaries-financial institutions through which savers can indirectly provide funds to borrowers. Banks-Pay depositors interest on their deposits & charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks' costs & returns some profit to the owners of the banks. They facilitate purchases of g's & s's by allowing people to write checks against their deposits & to access those deposits with debit cards. In other words, banks help create a special asset that people can use as a medium of exchange. (One of the two most important financial intermediaries.) Mutual Funds-an institution that sells shares to the public & uses the proceeds to buy a portfolio of stocks & bonds. The primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings. A 2nd advantage claimed by mutual fund companies is that mutual funds give ordinary people access to the skills of professional money managers. The managers of most mutual funds pay close attention to the developments & prospects of the companies in which they buy stock. These managers buy the stock of companies they view as having a profitable future & sell the stock of companies with less promising prospects. This professional management, it's argued, should increase the return that mutual fund depositors earn on their savings. Financial economists, are often skeptical of this argument. Because thousands of money managers are paying close attention to each company's prospects, a company's stock usually trades at a price that reflects the company's true value. As a result, it's hard to "beat the market" by buying good stocks & selling bad ones. In fact, mutual funds called index funds, which buy all the stocks in a given stock index, perform somewhat better on average than mutual funds that take advantage of active trading by professional money managers. The explanation for the superior performance of index funds is that they keep costs low by buying & selling very rarely & by not having to pay the salaries of professional money managers. (One of the two most important financial intermediaries.) National Saving-the total income in the economy that remains after paying for consumption & govt purchases. Because a closed economy doesn't engage in international trade, there are no imports & exports, making net exports (NX) exactly zero. We can simplify the identity as: Y=C+I+G. To see what this identity can tell us about financial markets, we subtract (C) & (G) from both sides of this equation to obtain: Y-C-G=I The left part this (Y-C-G) is total income in the economy remaining after paying for consumption & govt purchases. This is called National saving & is denoted as (S). Substitute S for Y-C-G, write last equation as S=I. This states saving equals investment. In understanding the meaning of national saving, it's helpful to let T denote the amount the govt collects from households in taxes minus the amount it pays back to households in the form of transfer payments ) Social Security & Welfare). We can write national saving in either of 2 ways: S=Y-C-G or S=(Y-T-C) + (T-G). They're the same because the 2 T's in the 2nd equation cancel each other out. The 2nd equation separates national saving into two pieces: private saving (Y-T-C) & public saving (T-G). For the economy as a whole, saving must equal investment. Yet this fact raises some important questions: What mechanisms lie behind this identity? What coordinates those people who are deciding how much to save & those people who are deciding how much to invest? The answer is the financial system. Private Saving-the income that households have left after paying for taxes & consumption. In particular, because households receive income of Y, pay taxes of T, & spend C on consumption, private saving is Y-T-C. Public Saving-the tax revenue that the govt has left after paying for its spending. The govt receives T in tax revenue & spends G on g's & s's. Budget deficit-a shortfall of tax revenue from govt spending. If G exceeds T, the govt spends more than it receives in tax revenue. In this case, public saving (T-G) is negative, & the govt is said to run a budget deficit. Budget Surplus-an excess of tax revenue over govt spending. If T exceeds G , the govt receives more money than it spends. In this case, public saving (T-G) is positive, & the govt is said to run a budget surplus. Market for loanable funds-the market in which those who want to save supply funds & those who want to borrow to invest demand funds. All savers go to this market to deposit their saving, & all borrowers go to this market to take out their loans. In the market for loanable funds, there's one interest rate, which is both the return to saving & the cost of borrowing. The supply of loanable funds comes from people who have some extra income they want to save & lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which then uses the funds to make loans. In both cases, saving is the source of the supply of loanable funds. The demand for loanable funds comes from households & firms who wish to borrow to make investments. This demand includes families taking out mortgages to buy new homes. It also includes firms borrowing to buy new equipment or build factories. In both cases, investment is the source of the demand for loanable funds. The interest rate is the price of a loan. It represents the amount that borrowers pay for loans & the amount that lenders receive on their saving. Because a high interest rate makes borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate rises. Similarly, because a high interest rate makes saving more attractive, the quantity of loanable funds supplied rises as the interest rate rises. In other words, the demand curve for loanable funds slopes downward, & the supply curve for loanable funds slopes upward. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage of loanable funds would encourage lenders to raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loanable funds supplied) & discourage borrowing for investment (thereby decreasing the quantity of loanable funds demanded). Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders compete for the scarce borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which the supply & demand for loanable funds exactly balance. The interest rate in the economy adjusts to balance the supply and demand for loanable funds. The supply of loanable funds comes from national saving, including both private saving & public saving. The demand for loanable funds comes from firms and households that want to borrow for purposes of investment. Adjustment of the interest rate to the equilibrium level occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage of loanable funds would encourage lenders to raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loanable funds supplied) & discourage borrowing for investment (thereby decreasing the quantity of loanable funds demanded). Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders compete for the scarce borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which the supply & demand for loanable funds exactly balance. Recall economists distinguish between the real interest rate & the nominal interest rate. The nominal interest rate is the monetary return to saving & the monetary cost of borrowing. It's the interest rate as usually reported. The real interest rate is the nominal interest rate corrected for inflation; it equals the nominal interest rate minus the inflation rate. Because inflation erodes the value of money over time, the real interest rate more accurately reflects the real return to saving & the real cost of borrowing. Therefore, the supply & demand for loanable funds depend on the real (rather than nominal) interest rate, & the equilibrium in Figure 1 should be interpreted as determining the real interest rate in the economy. When the interest rate adjusts to balance supply & demand in the market for loanable funds, it coordinates the behavior of people who want to save (the suppliers of loanable funds) & the behavior of people who want to invest (the demanders of loanable funds).

The Meaning of "Natural"

Friedman & Phelps used this adjective to describe the unemployment rate toward which the economy gravitates in the long run. Yet the natural rate of unemployment isn't necessarily the socially desirable rate of unemployment. Nor is the natural rate of unemployment constant over time. For example, suppose that a newly formed union uses its market power to raise the real wages of some workers above the equilibrium level. The result is an excess supply of workers and, therefore, a higher natural rate of unemployment. This unemployment is natural not because it is good but because it is beyond the influence of monetary policy. More rapid money growth would reduce neither the market power of the union nor the level of unemployment; it would lead only to more inflation. Although monetary policy can't influence the natural rate of unemployment, other types of policy can. To reduce the natural rate of unemployment, policymakers should look to policies that improve the functioning of the labor market. Various labor-market policies, such as minimum-wage laws, collective-bargaining laws, unemployment insurance, & job-training programs, affect the natural rate of unemployment. A policy change that reduced the natural rate of unemployment would shift the long-run Phillips curve to the left. In addition, because lower unemployment means more workers are producing g's & s's, the quantity of g's & s's supplied would be larger at any given price level and the long-run aggregate-supply curve would shift to the right. The economy could then enjoy lower unemployment & higher output for any given rate of money growth and inflation.

Reconciling Theory and Evidence

Friedman & Phelps's conclusion that there is no long-run trade-off between inflation and unemployment might not seem persuasive. Their argument was based on an appeal to theory, specifically classical theory's prediction of monetary neutrality. By contrast, the negative correlation between inflation & unemployment documented by Phillips, Samuelson, & Solow was based on actual evidence from the real world. Aware of these questions, & they offered a way to reconcile classical macroeconomic theory with the finding of a downward-sloping Phillips curve in data from the UK & the US. They claimed that a negative relationship between inflation & unemployment exists in the short run but that it can't be used by policymakers as a menu of outcomes in the long run. Policymakers can pursue expansionary monetary policy to achieve lower unemployment for a while, but eventually, unemployment will return to its natural rate. In the long run, more expansionary monetary policy leads only to higher inflation. Recall, the long-run aggregate-supply curve is vertical, indicating that the price level doesn't influence quantity supplied in the long run. But the short-run aggregate-supply curve slopes upward, indicating that an increase in the price level raises the quantity of g's & s's that firms supply. According to the sticky-wage theory of aggregate supply, for instance, nominal wages are set in advance based on the price level that workers & firms expect to prevail. When prices turn out to be higher than expected, firms have an incentive to increase production & employment; when prices are lower than expected, firms reduce production & employment. Yet because the expected price level & nominal wages will eventually adjust, the positive relationship between the actual price level & quantity supplied exists only in the short run. Applied this same logic to the Phillips curve. Just as the aggregate-supply curve slopes upward only in the short run, the trade-off between inflation & unemployment holds only in the short run. And just as the long-run aggregate-supply curve is vertical, the long-run Phillips curve is also vertical. Once again, expectations are the key to understanding how the short run & the long run are related. Introduced a new variable into the analysis of the inflation-unemployment trade-off: expected inflation. Expected inflation measures how much people expect the overall price level to change. Because the expected price level affects nominal wages, expected inflation is one factor that determines the position of the short-run aggregate-supply curve. In the short run, the Fed can take expected inflation (&, thus, the short-run aggregate-supply curve) as already determined. When the money supply changes, the aggregate-demand curve shifts & the economy moves along a given short-run aggregate-supply curve. In the short run, therefore, monetary changes lead to unexpected fluctuations in output, prices, unemployment, & inflation. In this way, Friedman & Phelps explained the downward-sloping Phillips curve that Phillips, Samuelson, & Solow had documented. The Fed's ability to create unexpected inflation by increasing the money supply exists only in the short run. In the long run, people come to expect whatever inflation rate the Fed chooses to produce & nominal wages will adjust to keep pace with inflation. As a result, the long-run aggregate-supply curve is vertical. Changes in aggregate demand, such as those due to changes in the money supply, affect neither the economy's output of g's & s's nor the number of workers that firms need to hire to produce those g's & s's. Friedman & Phelps concluded that unemployment returns to its natural rate in the long run. In summary-Evidence (from '60s): PC slopes downward. Theory (Friedman and Phelps):PC is vertical in the long run. To bridge the gap between theory and evidence, Friedman & Phelps introduced a new variable: expected inflation - a measure of how much people expect the price level to change.

The Breakdown of the Phillips Curve

Friedman and Phelps had made a bold prediction in 1968: If policymakers try to take advantage of the Phillips curve by choosing higher inflation to reduce unemployment, they will succeed at reducing unemployment only temporarily. This view—that unemployment eventually returns to its natural rate, regardless of the rate of inflation—is called the natural-rate hypothesis. A few years after Friedman and Phelps proposed this hypothesis, monetary and fiscal policymakers inadvertently created a natural experiment to test it. Their laboratory was the U.S. economy. 1961-1968-These data trace out an almost perfect Phillips curve. As inflation rose over these eight years, unemployment fell. The economic data from this era seemed to confirm that policymakers faced a trade-off between inflation and unemployment. To some economists at the time, it seemed ridiculous to claim that the historically reliable Phillips curve would start shifting once policymakers tried to take advantage of it. In fact, that is exactly what happened. Beginning in the late 1960s, the govt followed policies that expanded the aggregate demand for g's & s's. In part, this expansion was due to fiscal policy: Govt spending rose as the Vietnam War heated up. In part, it was due to monetary policy: Because the Fed was trying to hold down interest rates in the face of expansionary fiscal policy, the money supply (as measured by M2) rose about 13% per year during the period from 1970 to 1972, compared with 7% per year in the early 1960s. As a result, inflation stayed high (about 5%-6% per year in the late 1960s and early 1970s, compared with about 1%-2% per year in the early 1960s). But as Friedman & Phelps had predicted, unemployment didn't stay low. This figure shows annual data from 1961 to 1973 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). The Phillips curve of the 1960s breaks down in the early 1970s, just as Friedman and Phelps had predicted. In particular, as inflation remained high in the early 1970s, people's expectations of inflation caught up with reality, and the unemployment rate reverted to the 5% to 6% range that had prevailed in the early 1960s. Notice that the history illustrated in "The breakdown of the Phillips Curve" resembles the theory of a shifting short-run Phillips curve shown in "How Expected Inflation Shifts the PC". By 1973, policymakers had learned that Friedman and Phelps were right: There is no trade-off between inflation and unemployment in the long run. In summary-Early 1970s: unemployment increased, despite higher inflation. Friedman & Phelps' explanation: expectations were catching up with reality.

CASE STUDY: The 2008-2009 Recession

From 12/2007 to 6/2009, real GDP fell 4.7%. Unemployment rose from 4.4% in 5/2007 to 10.0% in 10/2009. The housing market played a central role in this recession... Rising house prices during 2002-2006 due to: low interest rates. easier credit for "sub-prime" borrowers. government policies to increase homeownership. securitization of mortgages: Investment banks purchased mortgages from lenders, created securities backed by these mortgages, sold the securities to banks, insurance companies, & other investors. Mortgage-backed securities perceived as safe, since house prices "never fall." Consequences of 2006-2009 housing market crash: House prices nationwide fell by 30%. Millions of homeowners "underwater"—owed more than house was worth. Millions of mortgage defaults and foreclosures. Banks selling foreclosed houses increased surplus and downward price pressures. Housing crash badly damaged construction industry: 2010 unemployment rate was 20.6% in construction vs. 9.6% overall. Mortgage-backed securities became "toxic," heavy losses for institutions that purchased them, widespread failures of banks and other financial institutions. Sharply rising unemployment and falling GDP. The policy response: Federal Reserve reduced Fed Funds rate target to near zero. Federal Reserve purchased mortgage-backed securities & other private loans. U.S. Treasury injected capital into the banking system to increase banks' liquidity and solvency in hopes of staving off a "credit crunch." Fiscal policymakers increased govt spending and reduced taxes by $800 billion. Real GDP and employment both fell sharply. The figures cited in this chapter's introduction are worth repeating: Real GDP declined by 4.0% between the fourth quarter of 2007 and the second quarter of 2009, and the rate of unemployment rose from 4.4 in May 2007 to 10.0% in October 2009. The Fed cut its target for the federal funds rate from 5.25% in September 2007 to about zero in December 2008. Second, in an even more unusual move in October 2008, Congress appropriated $700 billion for the Treasury to use to rescue the financial system. Finally, when Barack Obama became president in January 2009. He signed a $787 billion stimulus bill on February 17, 2009. The recovery from this recession began in June 2009, but it was meager by historical standards. Over the next seven years, real GDP growth averaged only 2.2% per year, well below the average rate of growth over the past half century of about 3%. The unemployment rate did not fall below 5.0% until 2016.

Education

Govt can increase productivity by promoting education-investment in human capital (H). Public schools, subsidized loans for college. Education has significant effects: In the U.S., each year of schooling raises a worker's wage by 10%. But investing in H also involves a tradeoff between the present & future: Spending a year in school requires sacrificing a year's wages now to have higher wages later. One problem facing some poor countries is the brain drain—the emigration of many of the most highly educated workers to rich countries, where these workers can enjoy a higher standard of living. If human capital does have positive externalities, then this brain drain makes those people left behind even poorer.

Public safety & job search

Govt employment agencies provide information about job vacancies to speed up the matching of workers with jobs. Public training programs-aim to equip workers displaced from declining industries with the skills needed in growing industries. Advocates of these programs believe that they make the economy operate more efficiently by keeping the labor force more fully employed and that they reduce the inequities inherent in a constantly changing market economy. Critics of these programs question whether the government should get involved with the process of job search. They argue that it's better to let the private market match workers & jobs & that the govt is no better—& most likely worse—at disseminating the right information to the right workers & deciding what kinds of worker training would be most valuable. They claim that these decisions are best made privately by workers & employers. In fact, most job search in our economy takes place without govt intervention.

Income & Expenditure

Gross Domestic Product (GDP)-the market value of all final goods & services produced within a country in a given period of time. It measures total income of everyone in the economy. Also measures total expenditure on the economy's output of g&s. (G&S Goods & Services) Thought to be the single best measure of a society's economic well-being. For the economy as a whole, income equals expenditure because every dollar a buyer spends is a dollar of income for the seller.

Other measures of income

Gross national product (GNP) is the total income earned by a nation's permanent residents (called nationals). It differs from GDP in that it includes income that our citizens earn abroad & excludes income that foreigners earn here. Net national product (NNP) is the total income of a nation's residents (GNP) minus losses from depreciation. Depreciation is the wear & tear on the economy's stock of equipment & structures, such as trucks rusting & old computer models becoming obsolete. In the national income accounts prepared by the Department of Commerce, depreciation is called the "consumption of fixed capital." National income is the total income earned by a nation's residents in the production of g & s. It is almost identical to net national product. These two measures differ because of the statistical discrepancy that arises from problems in data collection. Personal income is the income that households & noncorporate businesses receive. Unlike national income, it excludes retained earnings, the income that corporations earn but don't pay out to their owners. It also subtracts indirect business taxes (such as sales taxes), corporate income taxes, & contributions for social insurance (mostly Social Security taxes). In addition, personal income includes the interest income that households receive from their holdings of govt debt & the income that households receive from government transfer programs, such as welfare & Social Security. Disposable personal income is the income that households & noncorporate businesses have left after satisfying all their obligations to the govt. It equals personal income minus personal taxes & certain nontax payments (such as traffic tickets). When GDP grows rapidly, these other measures of income tend to grow rapidly. When GDP falls, these other measures tend to fall as well. As a result, for monitoring fluctuations in the overall economy, it doesn't matter much which measure of income we use.

Then Why Do We Care About GDP?

Having a large GDP enables a country to afford better schools, a cleaner environment, health care, etc. Many indicators of the quality of life are positively correlated with GDP. For example...

Health and Nutrition

Health care expenditure is a type of investment in human capital—healthier workers are more productive. In countries with significant malnourishment, raising workers' caloric intake raises productivity: Human capital usually refers to education, but it can also be used to describe another type of investment in people: expenditures that lead to a healthier population. Other things being equal, healthier workers=more productive. The right investments in the health of the population=1 way for a nation to increase productivity & raise living standards. Over 1962-95, caloric consumption rose 44% in S. Korea, & economic growth was spectacular. Similarly, during the spectacular economic growth in South Korea from 1962-1995, caloric consumption rose by 44% & average male height rose by 2inch. Nobel winner Robert Fogel: 30% of Great Britain's growth per capita from 1790-1980 was due to improved nutrition. Fogel estimated that in Great Britain in 1780, about 1 in 5 people were so malnourished that they were incapable of manual labor. Among those who could work, insufficient caloric intake substantially reduced the work effort they could put forth. Improved nutrition=increased workers' productivity. Improved health=significant factor in long-run economic growth. According to Fogel. Short stature can be an indicator of malnutrition, especially during gestation & the early years of life. Fogel found that as nations develop economically, people eat more & the population gets taller. From 1775-1975, the average caloric intake in Great Britain rose by 26% & the height of the average man rose by 3.6inch. Studies found height is an indicator of productivity. Looking at data on a large number of workers at a point in time, researchers find taller workers tend to earn more. Because wages reflect a worker's productivity, this finding suggests that taller workers tend to be more productive. The effect of height on wages is especially pronounced in poorer countries, where malnutrition is a bigger risk. The causal link between health & wealth goes both ways. Poor countries are poor in part because their populations aren't healthy, & their populations aren't healthy in part because they are poor & can't afford adequate healthcare & nutrition. Policies that lead to more rapid economic growth would naturally improve health outcomes, which in turn would further promote economic growth.

Conclusion

How People Make Decisions 1. People face trade-offs. 2. The cost of something is what you give up to get it. 3. Rational people think at the margin. 4. People respond to incentives. How People Interact 5. Trade can make everyone better off. 6. Markets are usually a good way to organize economic activity. 7. Governments can sometimes improve market outcomes. How the Economy as a Whole Works 8. A country's standard of living depends on its ability to produce goods and services. 9. Prices rise when the government prints too much money. 10. Society faces a short-run trade-off between inflation and unemployment.

Managing Risk With Insurance

How insurance works: A person facing a risk pays a fee to the insurance company, which in return accepts part or all of the risk. Insurance allows risks to be pooled, & can make risk averse people better off: E.g., it is easier for 10,000 people to each bear 1/10,000 of the risk of a house burning down than for one person to bear the entire risk alone. From the standpoint of the economy as a whole, the role of insurance isn't to eliminate the risks inherent in life but to spread them around more efficiently.

PRINCIPLE 8 A Country's Standard of Living Depends on Its Ability to Produce Goods & Services

Huge variation in living standards across countries and over time: ▪ Average income in rich countries is more than ten times average income in poor countries. ▪ The U.S. standard of living today is about eight times larger than 100 years ago. The most important determinant of living standards: productivity, the amount of goods & services produced per unit of labor. ▪ Productivity depends on the equipment, skills, & technology available to workers. ▪ Other factors (e.g., labor unions, competition from abroad) have far less impact on living standards. the growth rate of a nation's productivity determines the growth rate of its average income.

Human Capital Per Worker

Human capital (H): the knowledge and skills workers acquire through education, training, and experience ▪ H/L = the average worker's human capital ▪ Productivity is higher when the average worker has more human capital (education, skills, etc.). ▪ i.e., an increase in H/L causes an increase in Y/L. Human capital is similar to physical capital in many ways. Like physical capital, human capital raises a nation's ability to produce g's & s's. Also like physical capital, human capital is a produced factor of production. Producing human capital requires inputs in the form of teachers, libraries, & student time. Indeed, students can be viewed as "workers" who have the important job of producing the human capital that will be used in future production.

Why the Slope of SRAS Matters

If AS is vertical, fluctuations in AD do not cause fluctuations in output or employment. If AS slopes up, then shifts in AD do affect output and employment.

Accommodating an Adverse Shift in SRAS

If policymakers do nothing, 4. Low employment causes wages to fall, SRAS shifts right, until LR eq'm at A. Or, policymakers could use fiscal or monetary policy to increase AD and accommodate the AS shift: Y back to YN, but P permanently higher.

3. The Misperceptions Theory

Imperfection: Firms may confuse changes in P with changes in the relative price of the products they sell. If P rises above PE, a firm sees its price rise before realizing all prices are rising. The firm may believe its relative price is rising, & may increase output & employment. So, an increase in P can cause an increase in Y, making the SRAS curve upward-sloping. According to this theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, & this response leads to an upward-sloping aggregate-supply curve. When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices have fallen; that is, they may believe that their prices have fallen compared to other prices in the economy. In both cases, a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of g's & s's supplied. Similar misperceptions arise when the price level is above what was expected. Suppliers of g's & s's may notice the price of their output rising and infer, mistakenly, that their relative prices are rising. They would conclude that it is a good time to produce. Until their misperceptions are corrected, they respond to the higher price level by increasing the quantity of g's & s's supplied. This behavior results in a short-run aggregate-supply curve that slopes upward.

2. The Sticky-Price Theory

Imperfection: Many prices are sticky in the short run. Due to menu costs, the costs of adjusting prices. Examples: cost of printing new menus, the time required to change price tags. Firms set sticky prices in advance based on PE. Suppose the Fed increases the money supply unexpectedly. In the long run, P will rise. In the short run, firms without menu costs can raise their prices immediately. Firms with menu costs wait to raise prices. Meanwhile, their prices are relatively low, which increases demand for their products, so they increase output and employment. Hence, higher P is associated with higher Y, so the SRAS curve slopes upward. The sticky-price theory emphasizes that the prices of some g's & s's also adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing & distributing catalogs & the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run. In other words, because not all prices adjust immediately to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of g's & s's they produce. Similar reasoning applies when the money supply & price level turn out to be above what firms expected when they originally set their prices. While some firms raise their prices quickly in response to the new economic environment, other firms lag behind, keeping their prices at the lower-than-desired levels. These low prices attract customers, inducing these firms to increase employment & production. Thus, during the time these lagging firms are operating with outdated prices, there's a positive association between the overall price level and the quantity of output. This positive association is represented by the upward slope of the short-run aggregate-supply curve.

PRINCIPLE 7 Governments Can Sometimes Improve Market Outcomes

Important role for gov: enforce property rights-the ability of an individual to own & exercise control over scarce resources. (with police, courts) Why we need the gov to intervene-in the economy & change the allocation of resources that people would choose on their own: to promote efficiency or to promote equality. Most policies aim either to enlarge the economic pie or to change how the pie is divided. ▪ People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen. Market failure: when the market fails to allocate society's resources efficiently. Causes of market failure: Externalities, when the production or consumption of a good affects bystanders (e.g. pollution). (Can be an unpriced cost or benefit) Market power, a single buyer or seller has substantial influence on market price (e.g. monopoly) (everyone in town needs water but there's only one well, the owner of the well doesn't face the rigorous competition with which the invisible hand normally keeps self-interest in check; she may take advantage of this opportunity by restricting the output of water so she can charge a higher price.) Public policy may promote efficiency. Gov may alter market outcome to promote equity. ▪ If the market's distribution of economic well-being is not desirable, tax or welfare policies can change how the economic "pie" is divided.

Contrasting the CPI and GDP Deflator

Imported consumer goods: included in CPI, excluded from GDP deflator. Capital goods: excluded from CPI, included in GDP deflator (if produced domestically). The basket: CPI uses fixed basket, GDP deflator uses basket of currently produced goods & services. This matters if different prices are changing by different amounts. The 1st difference is that the GDP deflator reflects the prices of all g&s's produced domestically, whereas the CPI reflects the prices of all g&s's bought by consumers. For example, suppose that the price of an airplane produced by Boeing and sold to the Air Force rises. Even though the plane is part of GDP, it is not part of the basket of g&s's bought by a typical consumer. Thus, the price increase shows up in the GDP deflator but not in the CPI. As another example, suppose that Volvo raises the price of its cars. Because Volvos are made in Sweden, the car isn't part of U.S. GDP. But U.S. consumers buy Volvos, so the car is part of the typical consumer's basket of goods. Hence, a price increase in an imported consumption good, such as a Volvo, shows up in the CPI but not in the GDP deflator. This 1st difference between the CPI & the GDP deflator is particularly important when the price of oil changes. The US produces some oil, but much of the oil we use is imported. As a result, oil & oil products such as gasoline & heating oil make up a much larger share of consumer spending than of GDP. When the price of oil rises, the CPI rises by much more than does the GDP deflator. The 2nd & subtler difference between the GDP deflator & the CPI concerns how various prices are weighted to yield a single number for the overall level of prices. The CPI compares the price of a fixed basket of g&s's with the price of the basket in the base year. Only occasionally does the BLS change the basket of goods. By contrast, the GDP deflator compares the price of currently produced g&s's with the price of those g&s's in the base year. Thus, the group of g&s's used to compute the GDP deflator changes automatically over time. This difference isn't important when all prices are changing proportionately. But if the prices of different g&s's are changing by varying amounts, the way we weight the various prices affects the calculation of the overall inflation rate.

Problems with the CPI: Unmeasured Quality Change

Improvements in the quality of goods in the basket increase the value of each dollar. The BLS tries to account for quality changes but probably misses some, as quality is hard to measure. Thus, the CPI overstates increases in the cost of living.If the quality of a good deteriorates from year to year while its price remains the same, you are getting a lesser good for the same amount of money, so the value of a dollar falls. Similarly, if the quality rises from one year to the next, the value of a dollar rises. The Bureau adjusts the price of the good to account for the quality change. In doing so, it is trying to compute the price of a basket of goods of constant quality.

The Vertical Long-Run Phillips Curve

In 1968, economist Milton Friedman published a paper in the American Economic Review based on an address he had recently given as president of the American Economic Association. The paper, titled "The Role of Monetary Policy," contained sections on "What Monetary Policy Can Do" & "What Monetary Policy Cannot Do." Friedman argued that one thing monetary policy can't do, other than for a short time, is lower unemployment by raising inflation. At about the same time, another economist, Edmund Phelps, reached the same conclusion. Like Friedman, Phelps published a paper denying the existence of a long-run trade-off between inflation & unemployment. Both Friedman & Phelps based their conclusions on classical principles of macroeconomics. Classical theory points to growth in the money supply as the primary determinant of inflation. But classical theory also states that monetary growth doesn't affect real variables such as output & employment; it merely alters all prices & nominal incomes proportionately. In particular, monetary growth doesn't influence those factors that determine the economy's unemployment rate, such as the market power of unions, the role of efficiency wages, & the process of job search. As a result, Friedman & Phelps concluded that, in the long run, the rate of inflation & the rate of unemployment wouldn't be related. According to Friedman, monetary policymakers face a long-run Phillips curve that is vertical. If the Fed increases the money supply slowly, the inflation rate is low. If the Fed increases the money supply quickly, the inflation rate is high. In either case, the unemployment rate tends toward its normal level, called the natural rate of unemployment. The vertical long-run Phillips curve illustrates the conclusion that unemployment doesn't depend on money growth & inflation in the long run. The vertical long-run Phillips curve is, in essence, one expression of the classical idea of monetary neutrality. Previously, monetary neutrality with a vertical long-run aggregate-supply curve. Thus, the vertical long-run aggregate-supply curve & the vertical long-run Phillips curve both imply that monetary policy influences nominal variables (the price level and the inflation rate) but not real variables (output & unemployment). In the long run, regardless of the monetary policy pursued by the Fed, output is at its natural level & unemployment is at its natural rate. In-summary-1968: Milton Friedman & Edmund Phelps argued that the tradeoff was temporary. Natural-rate hypothesis: the claim that unemployment eventually returns to its normal or "natural" rate, regardless of the inflation rate. Based on the classical dichotomy & the vertical LRAS curve. In the long run, faster money growth only causes faster inflation. According to Friedman and Phelps, there is no trade-off between inflation & unemployment in the long run. Growth in the money supply determines the inflation rate. Regardless of the inflation rate, the unemployment rate gravitates toward its natural rate. As a result, the long-run Phillips curve is vertical.

2018 Case study

In 2018, the Department of Labor released a study showing what kinds of workers reported earnings at or below the minimum wage in 2017, when the minimum wage was $7.25 per hour. (A reported wage below the minimum wage is possible because some workers are exempt from the statute, because enforcement is imperfect, and because some workers round down when reporting their wages on surveys.) Here's a summary of the findings: In 2017, 80 million workers were paid at hourly rates (as opposed to being salaried or self-employed), representing about half of the labor force. Among hourly paid workers, about 2.3% reported wages at or below the prevailing federal minimum. Thus, the federal minimum wage directly affects about 1% of all workers. Minimum-wage workers tend to be young. Among employed teenagers (ages 16 to 19) paid by the hour, about 8% earned the minimum wage or less, compared with 1% of hourly paid workers age 25 & older. Minimum-wage workers tend to be less educated. Among hourly paid workers age 16 & older, about 4% of those without a high school diploma earned the minimum wage or less, compared with about 2% of those who completed a high school diploma (but did not attend college) and about 1% of those with a college degree. Minimum-wage workers are more likely to be working part-time. Among part-time workers (those who usually work less than 35 hrs per week), 6% were paid the minimum wage or less, compared with 1% of full-time workers. The industry with the highest proportion of workers with reported hourly wages at or below the minimum wage was leisure and hospitality (11%). About three-fifths of all workers paid at or below the minimum wage were employed in this industry, primarily in restaurants & other food services. For many of these workers, tips supplement their hourly wages. The percentage of hourly paid workers earning the prevailing federal minimum wage or less has changed substantially over time. It has declined from 13.4% in 1979, when data collection first began on a regular basis, to 2.3% in 2017. One reason for this change is that the federal minimum wage has not kept up with inflation. If it had, the minimum wage in 2017 would've been about $10 rather than $7.25 per hour. At a higher level, the minimum wage becomes a binding price floor for more workers.

What the 3 Theories Have in Common:

In all 3 theories, Y deviates from YN when P deviates from PE. Y=YN+a(P-PE) Equation breakdown:Y (Output)=YN(N is Natural rate of output (long run)+ a(a>0 measures how much Y responds to unexpected changes in P) (P (actual price level)-P(Expected price level)E)

ACTIVE LEARNING 1 GDP and its components

In each of the following cases, determine how much GDP and each of its components is affected (if at all). A. Debbie spends $300 to buy her husband dinner at the finest restaurant in Boston. Answer (Consumption & GDP rise by $300)B. Sarah spends $1200 on a new laptop to use in her publishing business. The laptop was built in China. Answer (Investments rise by $1200 net export falls by $1200 & GDP remains unchanged) C. Jane spends $800 on a computer to use in her editing business. She got last year's model on sale for a great price from a local manufacturer. Answer Current GDP & investment don't change, because the computer was build last year. D. General Motors builds $500 million worth of cars, but consumers only buy $470 million worth of them. Answer Consumption rises by $470 million, inventory investment rises by $30 million, & GDP rises by $500 million.

Active Learning 2

In each of the following, what happens to the u-rate? Does the u-rate give an accurate impression of what's happening in the labor market? A.Sue lost her job and begins looking for a new one. B.Jon, a steelworker who has been out of work since his mill closed last year, becomes discouraged and gives up looking for work. Discouraged workers-Would like to work but have given up looking for jobs. classified as "not in the labor force" rather than "unemployed". C.Sam, the sole earner in his family of 5, just lost his $80,000 job as a research scientist. Immediately, he takes a part-time job at McDonald's until he can find another job in his field.

ACTIVE LEARNING 3 CPI vs. GDP deflator

In each scenario, determine the effects on the CPI & the GDP deflator. A. Starbucks raises the price of Frappuccinos. The CPI & GDP deflator both rise. B. Caterpillar raises the price of the industrial tractors it manufactures at its Illinois factory. The GDP deflator rises, the CPI does not. C. Armani raises the price of the Italian jeans it sells in the U.S. The CPI rises, the GDP deflator does not.

Three Theories of SRAS

In each, some type of market imperfection. Result: Output deviates from its natural rate when the actual price level deviates from the price level people expected. 3 theories for the upward slope of the short-run aggregate-supply curve. In each theory, a specific market imperfection causes the supply side of the economy to behave differently in the short run than it does in the long run. The following theories differ in their details, but they share a common theme: The quantity of output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected to prevail. When the price level rises above the level that people expected, output rises above its natural level, & when the price level falls below the expected level, output falls below its natural level.

GDP and Average Schooling in 12 countries

In rich countries, such as the US & Germany, people acquire about 13 years of schooling. In poor countries, such as Bangladesh & Nigeria, people have less than half as much schooling.

GDP and Life Expectancy in 12 countries

In rich countries, such as the US & Germany, people have life expectancy of about 80. In poor countries, such as Bangladesh & Nigeria, people typically die about 10 years earlier.

The 1970s Oil Price Shocks Part 1

In the US during the 1970s, expected inflation did rise substantially. This rise in expected inflation was partly attributable to the Fed's decision to accommodate the supply shock with higher money growth. (Recall that policymakers are said to accommodate an adverse supply shock when they respond to it by increasing aggregate demand in an effort to keep output from falling.) Because of this policy decision, the recession that resulted from the supply shock was smaller than it otherwise might have been, but the U.S. economy faced an unfavorable trade-off between inflation & unemployment for many years. The problem was compounded in 1979 when OPEC once again started to exert its market power, more than doubling the price of oil. This figure shows annual data from 1972 to 1981 on the unemployment rate & on the inflation rate (as measured by the GDP deflator). In the periods 1973-1975 & 1978-1981, increases in world oil prices led to higher inflation & higher unemployment. In 1980, after two OPEC supply shocks, the U.S. economy had an inflation rate of more than 9% & an unemployment rate of about 7%. This combo of inflation & unemployment wasn't at all near the trade-off that seemed possible in the 1960s. (In the 1960s, the Phillips curve suggested that an unemployment rate of 7% would be associated with an inflation rate of only 1%. Inflation of more than 9% was unthinkable.) With the misery index in 1980 near a historic high, the public was widely dissatisfied with the performance of the economy. Largely because of this dissatisfaction, President Jimmy Carter lost his bid for reelection in November 1980 & was replaced by Ronald Reagan. Something had to be done, & soon it would be. In summary-The Fed chose to accommodate the first shock in 1973 with faster money growth.Result: Higher expected inflation, which further shifted PC. 1979: Oil prices surged again, worsening the Fed's tradeoff.

Introduction

In the long run, inflation and unemployment are largely unrelated problems. In the short run, just the opposite is true. One of the Ten Principles of Economics in Chapter 1 is that society faces a short-run trade-off between inflation and unemployment. If monetary and fiscal policymakers expand aggregate demand and move the economy up along the short-run aggregate-supply curve, they can expand output and reduce unemployment for a while, but only at the cost of a more rapidly rising price level. If policymakers contract aggregate demand and move the economy down the short-run aggregate-supply curve, they can reduce inflation, but only at the cost of temporarily lower output and higher unemployment. Summary-In the long run, inflation & unemployment are unrelated: The inflation rate depends mainly on growth in the money supply. Unemployment (the "natural rate") depends on the minimum wage, the market power of unions, efficiency wages, and the process of job search. One of the Ten Principles: In the short run, society faces a trade-off between inflation and unemployment.

CONCLUSION

In the long run, living standards are determined by productivity. Policies that affect the determinants of productivity will therefore affect the next generation's living standards. One of these determinants is saving and investment. In the next chapter, we will learn how saving and investment are determined, and how policies can affect them.

The Long-Run Equilibrium

In the long-run equilibrium, PE = P, Y = YN , & unemployment is at its natural rate. The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve. When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.

PRINCIPLE 10 Society Faces a Short-run Tradeoff Between Inflation and Unemployment

In the short-run (1-2 years), many economic policies push inflation & unemployment in opposite directions. ▪ Other factors can make this tradeoff more or less favorable, but the tradeoff is always present. Most economists describe the short-run effects of money growth as follows: Increasing the amount of money in the economy stimulates the overall level of spending and thus the demand for goods and services. Higher demand may over time cause firms to raise their prices, but in the meantime, it also encourages them to hire more workers and produce a larger quantity of goods and services. More hiring means lower unemployment. What can be done? Policymakers changing the amount that the government spends, the amount it taxes, and the amount of money it prints, policymakers can influence the overall demand for goods and services. Changes in demand in turn influence the combination of inflation and unemployment that the economy experiences in the short run.

PPF and Opportunity Cost

In which country is the opportunity cost of cloth lower? England, because its PPF is not as steep as France's.

PRINCIPLE 4 People Respond to Incentives

Incentive: something that induces a person to act, i.e. the prospect of a reward or punishment. ▪ Rational people respond to incentives. Examples: ▪ When gas prices rise, consumers buy more hybrid cars and fewer gas guzzling SUVs. ▪ When cigarette taxes increase, teen smoking falls.

Real vs Nominal GDP

Inflation can distort economic variables like GDP, so we have two versions of GDP: Nominal GDP-values output using current prices. Not corrected for inflation. OR the production of g & s valued at current prices. Real GDP-values output using the prices of a base year. Is corrected for inflation. OR the production of g & s valued at constant prices. If total spending rises from one year to the next, at least one of two things must be true: 1. the economy is producing a larger output of g & s, or 2. g & s are being sold at higher prices. In particular, they want a measure of the total quantity of g & s the economy is producing independent of changes in the prices of those g & s. What would be the value of the g & s produced this year if valued using the prices that prevailed in some specific year in the past? By evaluating current production using prices that are fixed at past levels, real GDP shows how the economy's overall production of g & s changes over time. Nominal GDP uses current prices to value the economy's production of g & s. Real GDP uses constant base-year prices to value the economy's production of g & s. Because price changes don't affect real GDP, changes in real GDP reflect only changes in the quantities produced. Thus, real GDP measures the economy's production of g & s & is the better gauge to how the overall economy is performing. When economists talk about the economy's GDP, they usually mean real GDP rather than nominal GDP.

Correcting Variables for Inflation: Comparing Dollar Figures from Different Times

Inflation makes it harder to compare dollar amounts from different times. Example: the minimum wage $1.25 in Dec 1963 $7.25 in Dec 2013 Did min wage have more purchasing power in Dec 1963 or Dec 2013? To compare, use CPI to convert 1963 figure into "2013 dollars"... Amount in today's dollars=Amount in year T dollars x price level today/Price level in year T In our example, "year T " is 12/1963, "today" is 12/2013 Min wage was $1.25 in year T CPI = 30.9 in year T, CPI = 234.6 today The minimum wage in 1963 was $9.49 in 2013 dollars. $9.49=$1.25 x 234.6/30.9 Researchers, business analysts, and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures. They can then see how a variable has changed over time after correcting for inflation. Example: the minimum wage...

PRINCIPLE 9 Prices Rise When the Government Prints Too Much Money

Inflation: increases in the general level of prices. ▪ In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall. ▪ The faster the govt creates money, the greater the inflation rate. Historic example In January 1921, a daily newspaper in Germany cost marks. Less than years later, in November 1922, the same newspaper cost marks. All other prices in the economy rose by similar amounts. In Germany in the early 1920s, when prices were on average tripling every month, the quantity of money was also tripling every month. In the US the high inflation of the 1970s was associated with rapid growth in the quantity of money, and the return of low inflation in the 1980s was associated with slower growth in the quantity of money.

Free Trade

Inward-oriented policies(e.g., tariffs, limits on investment from abroad) aim to raise living standards by avoiding interaction with other countries. Outward-oriented policies(e.g., the elimination of restrictions on trade or foreign investment) promote integration with the world economy. Recall: Trade can make everyone better off. Trade has similar effects as discovering new technologies—it improves productivity & living standards. Countries with inward-oriented policies have generally failed to create growth. e.g., Argentina during the 20th century. Countries with outward-oriented policies have often succeeded. e.g., South Korea, Singapore, Taiwan after 1960. Elaborated version: Outward policies-International trade in g's & s's can improve the economic well-being of a country's citizens. In some ways, trade is a type of technology. Elimination of trade restrictions, can lead to experiencing the same kind of economic growth that'd occur after a major technological advance. Examples-South Korea, Singapore, & Taiwan, enjoyed high rates of economic growth. Inward policies-Domestic firms often advance the infant-industry argument, claims they need protection from foreign competition to thrive & grow. Leading policymakers in less developed countries to impose tariffs & other trade restrictions. Adverse impact of inward orientation becomes clear when one considers the small size of many less developed economies. Argentina's GDP for instance is roughly equal to Ohio's. Argentina's legislature prohibits state residents from trading with people living in other states. Unable to take advantage of the gains from trade. Needing to produce all the g's it consumes. Has to produce all its own capital goods, rather than importing state-of-the-art equipment from other states. ​​Living standards fell immediately, & the problem would likely only get worse over time. All because Argentina pursued inward-oriented policies throughout much of the 20th century. Summary- Amount that a nation trades with others isn't only determined by govt policy but also by geography. Countries with natural seaports find trade easier than those without this resource. Not a coincidence that many of the world's major cities, such as NY, San Francisco, & Hong Kong, are located next to oceans. VS landlocked countries find international trade more difficult, they tend to have lower levels of income than countries with easy access to the world's waterways.

Rational Expectations, Costless Disinflation?

Its application to the trade-off between inflation and unemployment. As Friedman and Phelps had first emphasized, expected inflation is an important variable that explains why there is a trade-off between inflation and unemployment in the short run but not in the long run. How quickly the short-run trade-off disappears depends on how quickly people adjust their expectations of inflation. Proponents of rational expectations expanded upon the Friedman-Phelps analysis to argue that when economic policies change, people adjust their expectations of inflation accordingly. The studies of inflation and unemployment that had tried to estimate the sacrifice ratio had failed to take account of the direct effect of the policy regime on expectations. As a result, estimates of the sacrifice ratio were, according to the rational-expectations theorists, unreliable guides for policy. According to Sargent, the sacrifice ratio could be much smaller than suggested by previous estimates. Indeed, in the most extreme case, it could be zero: If the govt made a credible commitment to a policy of low inflation, people would be rational enough to lower their expectations of inflation immediately. The short-run Phillips curve would shift downward, and the economy would reach low inflation quickly without the cost of temporarily high unemployment and low output.In summary-Rational expectations: a theory according to which people optimally use all the information they have, including info about govt policies, when forecasting the future. Early proponents: Robert Lucas, Thomas Sargent, Robert Barro. Implied that disinflation could be much less costly... Suppose the Fed convinces everyone it is committed to reducing inflation. Then, expected inflation falls, the short-run PC shifts downward. Result: Disinflations can cause less unemployment than the traditional sacrifice ratio predicts.

CONCLUSION

Like many other markets, financial markets are governed by the forces of supply & demand. One of the Ten Principles from Chapter 1: Markets are usually a good way to organize economic activity. Financial markets help allocate the economy's scarce resources to their most efficient uses. Financial markets also link the present to the future: They enable savers to convert current income into future purchasing power, & borrowers to acquire capital to produce g's & s's in the future.

ACTIVE LEARNING 1 Review productivity concepts

List the determinants of productivity. K/L, physical capital per worker H/L, human capital per worker N/L, natural resources per worker A, technological knowledge List three policies that attempt to raise living standards by increasing one of the determinants of productivity. Encourage saving and investment, to raise K/L Encourage investment from abroad, to raise K/L Provide public education, to raise H/L Patent laws or grants, to increase A Control population growth, to increase K/L

PRINCIPLE 2 The Cost of Something Is What You Give Up to Get It

Making decisions requires comparing the costs and benefits of alternative choices. The opportunity cost of any item is whatever must be given up to obtain it. ▪ It is the relevant cost for decision making. Examples: The opportunity cost of... ...going to college for a year is not just the tuition, books, and fees, but also the foregone wages. ...seeing a movie is not just the price of the ticket, but the value of the time you spend in the theater.

Market Irrationality

Many believe that stock price movements are partly psychological: J.M. Keynes: stock prices driven by "animal spirits," "waves of pessimism & optimism" Alan Greenspan: 1990s stock market boom due to "irrational exuberance" Bubbles occur when speculators buy overvalued assets expecting prices to rise further. The importance of departures from rational pricing isn't known. There is a long tradition suggesting that fluctuations in stock prices are partly psychological. Stock prices did subsequently fall, but whether the exuberance of the 1990s was irrational given the information available at the time remains debatable. Whenever the price of an asset rises above what appears to be its fundamental value, the market is said to be experiencing a speculative bubble. The possibility of speculative bubbles in the stock market arises in part because the value of the stock to a stockholder depends not only on the stream of dividend payments but also on the final sale price. Thus, a person might be willing to pay more than a stock is worth today if she expects another person to pay even more for it tomorrow. When evaluating a stock, you have to estimate not only the value of the business but also what other people will think the business is worth in the future.

Why the AD Curve Might Shift

Many other factors, however, affect the quantity of g's & s's demanded at a given price level. When one of these other factors changes, the quantity of g's & s's demanded at every price level changes and the aggregate-demand curve shifts. Any event that changes C, I, G, or NX—except a change in P—will shift the AD curve. Example: A stock market boom makes households feel wealthier, C rises, the AD curve shifts right. Changes in C-Stock market boom/crash. Preferences re: consumption/saving tradeoff. Tax hikes/cuts. Changes in I- Firms buy new computers, equipment, factories. Expectations, optimism/pessimism. Interest rates, monetary policy. Investment Tax Credit or other tax incentives. Changes in G-Federal spending, e.g., defense. State & local spending, e.g., roads, schools. Changes in NX-Booms/recessions in countries that buy our exports. Appreciation/depreciation resulting from international speculation in foreign exchange market

Gross Domestic Product (GDP) Elaborated

Market Value (Goods are valued at their market prices, so: All goods measured in the same units (e.g., dollars in the U.S.) Things that don't have a market value are excluded, e.g., housework you do for yourself.) Final (Final goods: intended for the end user. Intermediate goods: used as components or ingredients in the production of other goods. GDP only includes final goods—they already embody the value of the intermediate goods used in their production.) Thus, additions to inventory add to GDP, & when the goods in inventory are later used or sold, the reductions in inventory subtract from GDP. Goods/Services (GDP includes tangible goods (like DVDs, mountain bikes, beer) & intangible services (dry cleaning, concerts, cell phone service) Produced (GDP includes currently produced goods, not goods produced in the past.) Within a country (GDP measures the value of production that occurs within a country's borders, whether done by its own citizens or by foreigners located there.) In a given period of time (Usually a year or a quarter (3 months) When the govt reports the GDP for a quarter, it usually presents GDP "at an annual rate." Meaning the figure reported for quarterly GDP is the amount of income & expenditure during the quarter multiplied by four. When the govt reports quarterly GDP, it presents the data after they have been modified by a statistical procedure called seasonal adjustment.

PRINCIPLE 6 Markets Are Usually A Good Way to Organize Economic Activity

Market: a group of buyers & sellers (need not be in a single location) ▪ "Organize economic activity" means determining ▪ what goods to produce ▪ how to produce them ▪ how much of each to produce ▪ who gets them market economy allocates resources through the decentralized decisions of many households & firms as they interact in markets. Firms decide whom to hire & what to make. Households decide which firms to work for & what to buy with their incomes. Famous insight by Adam Smith in The Wealth of Nations (1776): Each of these households & firms acts as if "led by an invisible hand" to promote general economic well-being. Smith's great insight was that prices adjust to guide buyers and sellers to reach outcomes that, in many cases, maximize the well-being of society as a whole. Important corollary: When a gov prevents prices from adjusting naturally to supply and demand, it impedes the invisible hand's ability to coordinate the decisions of the households and firms that make up an economy. He's saying that participants in the economy are motivated by self-interest and that the "invisible hand" of the marketplace guides this self-interest into promoting general economic well-being. Many of his views remain at the center of modern economics. The invisible hand works through the price system: ▪ The interaction of buyers and sellers determines prices. ▪ Each price reflects the good's value to buyers & the cost of producing the good. ▪ Prices guide self-interested households and firms to make decisions that, in many cases, maximize society's economic well-being. His insights led to the Industrial Revolution and the creation of an assembly line. Adam Smith-should do what they specialize in.

Microeconomics and Macroeconomics

Microeconomics is the study of how households and firms make decisions and how they interact in markets. ▪ Macroeconomics is the study of economy-wide phenomena, including inflation, unemployment, and economic growth. ▪ These two branches of economics are closely intertwined, yet distinct—they address different questions. Take for example A microeconomist might study the effects of rent control on housing in New York City, the impact of foreign competition on the U.S. auto industry, or the effects of education on workers' earnings. A macroeconomist might study the effects of borrowing by the federal government, the changes over time in the economy's unemployment rate, or alternative policies to promote growth in national living standards.

Review: Definitions of Macroeconomics & Microeconomics

Microeconomics: The study of how individual households & firms make decisions, interact with one another in markets. Macroeconomics: The study of the economy as a whole.

Risk Aversion

Most people are risk averse—they dislike uncertainty. Example: You are offered the following gamble. Toss a fair coin. If heads, you win $1000. If tails, you lose $1000. Should you take this gamble? If you are risk averse, the pain of losing $1000 would exceed the pleasure of winning $1000. Since both outcomes are equally likely, you shouldn't take this gamble.

The Duration of unemployment

Most spells of unemployment are short: Typically 1/3 of the unemployed have been unemployed under 5 weeks, 2/3 have been unemployed under 14 weeks. Only 20% have been unemployed over 6 months. Yet, most observed unemployment is long term. The small group of long-term unemployed persons has fairly little turnover, so it accounts for most of the unemployment observed over time. Knowing these facts helps policymakers design better policies to help the unemployed.

Net Exports (NX)

NX = exports - imports Exports-foreign spending on the economy's g&s. Imports-the portions of C, I, & G that are spent on g&s produced abroad. Adding up all the components of GDP gives: Y = C + I + G + NX If you export more your NX will be positive. If you import more then your NX will be negative. Net Exports-spending on domestically produced goods by foreigners (exports) minus spending on foreign goods by domestic residents (imports). Net in net exports refers to the fact that imports are subtracted from exports.

Active learning 1

Natural rate of unemployment = 5% Expected inflation = 2% In PC equation, a= 0.5. A. Plot the long-run Phillips curve. B. Find the u-rate for each of these values of actual inflation: 0%, 6%. Sketch the short-run PC. C. Suppose expected inflation rises to 4%. Repeat part B. D. Instead, suppose the natural rate falls to 4%. Draw the new long-run Phillips curve, then repeat part B. An increase in expected inflation shifts PC to the right. A fall in the natural rate shifts both curves to the left.

Natural Resources Per Worker

Natural resources (N): the inputs into production that nature provides, e.g., land, mineral deposits ▪ Other things equal, more N allows a country to produce more Y. In per-worker terms, an increase in N/L causes an increase in Y/L. ▪ Some countries are rich because they have abundant natural resources (e.g., Saudi Arabia has lots of oil). ▪ But countries need not have much N to be rich (e.g., Japan imports the N it needs). Natural resources-the inputs into the production of g's & s's that are provided by nature, such as land, rivers, & mineral deposits. 2 forms: renewable & nonrenewable. A forest is an example of a renewable resource. When one tree is cut down, a seedling can be planted in its place to be harvested in the future. Oil is an example of a nonrenewable resource. Because oil is produced by nature over many millions of years, there's only a limited supply. The historical success of the U.S was driven in part by the large supply of land well suited for agriculture. Today, some countries in the Middle East, such as Kuwait & Saudi Arabia, are rich simply because they happen to be on top of some of the largest pools of oil in the world. Japan, for instance, is one of the richest countries in the world, despite having few natural resources. International trade makes Japan's success possible. Japan imports many of the natural resources it needs, such as oil, & exports its manufactured goods to economies rich in natural resources.

Budget Deficits, Crowding Out, and Long-Run Growth

Our analysis: Increase in budget deficit causes fall in investment. The govt borrows to finance its deficit, leaving less funds available for investment. This is called crowding out. Recall from the preceding chapter: Investment is important for long-run economic growth. Hence, budget deficits reduce the economy's growth rate & future standard of living.

Example of the Catch-Up Effect

Over 1960-1990, the U.S. and S. Korea devoted a similar share of GDP to investment, so you might expect they would have similar growth performance. But growth was >6% in Korea and only 2% in the U.S. Explanation: the catch-up effect. In 1960, K/L was far smaller in Korea than in the U.S., hence Korea grew faster.

Introduction

Over the long run, real GDP grows about 3% per year on average. In the short run, GDP fluctuates around its trend. Recessions: periods of falling real incomes and rising unemployment. Depressions: severe recessions (very rare). Short-run economic fluctuations are often called business cycles. Explaining these fluctuations is difficult, and the theory of economic fluctuations is controversial. Most economists use the model of aggregate demand and aggregate supply to study fluctuations. This model differs from the classical economic theories economists use to explain the long run.

Using AD & AS to Depict Long-Run Growth and Inflation

Over the long run, tech. progress shifts LRAS to the right & growth in the money supply shifts AD to the right. Result: ongoing inflation and growth in output. Although many forces influence the economy in the long run & can in theory cause such shifts, the two most important forces in practice are technology & monetary policy. Technological progress enhances an economy's ability to produce g's & s's, & the resulting increases in output are reflected in continual shifts of the long-run aggregate-supply curve to the right. At the same time, because the Fed increases the money supply over time, the aggregate-demand curve also shifts to the right. As the figure illustrates, the result is continuing growth in output (as shown by increasing Y) & continuing inflation (as shown by increasing P). This is just another way of representing the classical analysis of growth & inflation we conducted in earlier chapters. As we develop the short-run model, we keep the analysis simple by omitting the continuing growth and inflation shown. But always remember that long-run trends are the background on which short-run fluctuations are superimposed. The short-run fluctuations in output & the price level that we'll be studying should be viewed as deviations from the long-run trends of output growth & inflation.

Problems with the CPI: Substitution Bias

Over time, some prices rise faster than others. They don't all change proportionately: Some prices rise more than others .Consumers substitute toward goods that become relatively cheaper, mitigating the effects of price increases. The CPI misses this substitution because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living. If a price index is computed assuming a fixed basket of goods, it ignores the possibility of consumer substitution &, therefore, overstates the increase in the cost of living from one year to the next.

The Phillips Curve

Phillips curve: shows the short-run trade-off between inflation and unemployment. 1958: A.W. Phillips showed that nominal wage growth was negatively correlated with unemployment in the U.K. 1960: Paul Samuelson & Robert Solow found a negative correlation between U.S. inflation & unemployment, named it "the Phillips Curve." "Probably the single most important macroeconomic relationship is the Phillips curve." These are the words of economist George Akerlof from the lecture he gave when he received the Nobel Prize in 2001. Summary-Although the Phillips curve seems to offer policymakers a menu of inflation-unemployment outcomes, it raises a crucial question: Does this set of possible choices remain the same over time? In other words, is the downward-sloping Phillips curve a stable relationship on which policymakers can rely? Economists took up this issue in the late 1960s, shortly after Samuelson & Solow had introduced the Phillips curve into the macroeconomic policy debate. 1958, economist A. W. Phillips published an article in the British journal Economica that would make him famous. The article was titled "The Relationship between Unemployment and the Rate of Change of Money Wages in the UK, 1861-1957." In it, Phillips showed a negative correlation between the rate of unemployment and the rate of inflation. Phillips showed that yrs with low unemployment tend to have high inflation, & yrs with high unemployment tend to have low inflation. (Phillips examined inflation in nominal wages rather than inflation in prices. For our purposes, the distinction isn't important because these two measures of inflation usually move together.) Phillips concluded that two important macroeconomic variables—inflation & unemployment—were linked in a way that economists hadn't previously appreciated. 2 yrs after Phillips published his article, economists Paul Samuelson & Robert Solow published an article in the American Economic Review called "Analytics of Anti-Inflation Policy" in which they showed a similar negative correlation between inflation & unemployment in data for the US. They reasoned that this correlation arose because low unemployment was associated with high aggregate demand, which in turn put upward pressure on wages & prices throughout the economy. In particular, they suggested that the Phillips curve offers policymakers a menu of possible economic outcomes. By altering monetary & fiscal policy to influence aggregate demand, policymakers could choose any point on this curve. Policymakers might prefer both low inflation & low unemployment, but the historical data as summarized by the Phillips curve indicate that this combo is impossible. According to Samuelson & Solow, policymakers face a trade-off between inflation & unemployment, and the Phillips curve illustrates that trade-off.

The PPF: What We Know So Far

Points on the PPF (like A - E) ▪ possible ▪ efficient: all resources are fully utilized Points under the PPF (like F) ▪ possible ▪ not efficient: some resources underutilized (e.g., workers unemployed, factories idle) Points above the PPF (like G) ▪ not possible

Active Learning 1

Present value You are thinking of buying a six-acre lot for $70,000. The lot will be worth $100,000 in 5 years. A. Should you buy the lot if r= 0.05? PV=$100,000/(1.05) to the power of 5=$78,350. PV of lot > price of lot. Yes Buy It. B. Should you buy it if r= 0.10? PV=$100,000/(1.1) to the power of 5=$62,090. PV of lot < price of lot. No don't buy it.

EXAMPLE 2: Investment Decision

Present value formula: PV = FV/(1 + r) to the power N. Suppose r= 0.06. Should General Motors spend $100 million to build a factory that will yield $200 million in ten years? Solution: Find present value of $200 million in 10 years:PV = ($200 million)/(1.06) to the power of 10 = $112 millionSince PV > cost of factory, GM should build it. Instead, suppose r= 0.09. Should General Motors spend $100 million to build a factory that will yield $200 million in ten years? solution: Find present value of $200 million in 10 years:PV = ($200 million)/(1.09) to the power of 10 = $84 million Since PV < cost of factory, GM should not build it. Present value helps explain why investment falls when the interest rate rises.

Active learn 4 Comparing tuition increases Part 2

Private non-profit 4-year (2010 $) for 1990 it was $16,622. For 2013 it was $30,094. % change was 81.1% Public 4-year (2010 $) for 1990 was $3,396. For 2013 it was $8,893. % change was 161.9%. Public 2-year (2010 $) for 1990 was $1,612. For 2013 it was $3,264. % change was 102.4%

Different Kinds of Saving

Private saving = The portion of households' income that's not used for consumption or paying taxes= Y - T - C. Public saving= Tax revenue less govt spending= T - G. National saving = private saving + public saving= (Y - T - C) + (T - G)= Y - C - G= the portion of national income that's not used for consumption or govt purchases.

The Meaning of Saving and Investment

Private saving is the income remaining after households pay their taxes & pay for consumption. Examples of what households do with saving: Buy corporate bonds or equities. Purchase a certificate of deposit at the bank. Buy shares of a mutual fund. Let accumulate in saving or checking accounts. Investment is the purchase of new capital. Examples of investment: General Motors spends $250 million to build a new factory in Flint, Michigan. You buy $5000 worth of computer equipment for your business. Your parents spend $300,000 to have a new house built. Remember: In economics, investment is NOT the purchase of stocks & bonds!

Labor Force Statistics

Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept. of Labor. Based on regular survey of 60,000 households. Based on "adult population" (16 yrs or older). BLS divides population into 3 groups: Employed: paid employees, self-employed, and unpaid workers in a family business. Unemployed: people not working who have looked for work during previous 4 weeks. Not in the labor force: everyone else. The labor force is the total # of workers, including the employed and unemployed. Unemployment rate (U-Rate): % of the labor force that's unemployed- U-rate=100 x # of unemployed/labor force. Labor force participation rate: % of the adult population that's in the labor force- labor force participation rate=100 x labor force/adult population. This is done every month. Called the Current Population Survey. There's a separate survey for jobs. The jobs number that gets the most attention, however, comes from a separate survey of business 160,000 establishments, which have over 40 million workers on their payrolls. The results from the establishment survey are announced at the same time as the results from the household survey. Both surveys yield information about total employment, but the results are not always the same. One reason is that the establishment survey has a larger sample, which makes it more reliable. Another reason is that the surveys are not measuring exactly the same thing. For example, a person who has two part-time jobs at different companies would be counted as one employed person in the household survey but as two jobs in the establishment survey. As another example, a person running his own small business would be counted as employed in the household survey but would not show up at all in the establishment survey, because the establishment survey counts only employees on business payrolls. The establishment survey is closely watched for its data on jobs, but it says nothing about unemployment. To measure the number of unemployed, we need to know how many people without jobs are trying to find them. The household survey is the only source of that information.

Productivity and Why Productivity Is So Important

Productivity -▪ Recall one of the Ten Principles from Chap. 1:A country's standard of living depends on its ability to produce g&s. ▪ This ability depends on productivity, the average quantity of g&s produced per unit of labor input.▪ Y = real GDP = quantity of output produced L = quantity of labor so productivity = Y/L (output per worker) Why productivity so important When a nation's workers are very productive, real GDP is large and incomes are high. ▪ When productivity grows rapidly, so do living standards. ▪ What, then, determines productivity and its growth rate? its productivity in turn depends on physical capital per worker, human capital per worker, natural resources per worker, and technological knowledge.

The principles of the economy as a whole are:

Productivity is the ultimate source of living standards. • Money growth is the ultimate source of inflation. • Society faces a short-run tradeoff between inflation and unemployment.

PRINCIPLE 5 Trade Can Make Everyone Better Off

Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods. ▪ Countries also benefit from trade and specialization: ▪ Get a better price abroad for goods they produce ▪ Buy other goods more cheaply from abroad than could be produced at home

PRINCIPLE 3 Rational People Think at the Margin

Rational people ▪ systematically and purposefully do the best they can to achieve their objectives. ▪ make decisions by evaluating costs and benefits of marginal changes, incremental adjustments to an existing plan. Examples: ▪ When a student considers whether to go to college for an additional year, he compares the fees & foregone wages to the extra income he could earn with the extra year of education. ▪ When a manager considers whether to increase output, she compares the cost of the needed labor and materials to the extra revenue.

GDP & Economic Well-Being

Real GDP per capita is the main indicator of the average person's standard of living. But GDP isn't a perfect measure of well-being. Robert Kennedy issued a very eloquent yet harsh criticism of GDP: Robert Kennedy's Criticism of GDP-"... doesn't allow for the health of our children, the quality of their education, or the joy of their play. It doesn't include the beauty of our poetry or the strength of our marriages, the intelligence of our public debate or the integrity of our public officials. It measures neither our courage, nor our wisdom, nor our devotion to our country. It measures everything, in short, except that which makes life worthwhile, & it can tell us everything about America except why we're proud that we're Americans." - Senator Robert Kennedy, 1968) In the end, we can conclude that GDP is a good measure of economic well-being for most—but not all—purposes. It's important to keep in mind what GDP includes & what it leaves out. One way to gauge the usefulness of GDP as a measure of economic well-being is to examine international data. International data leave no doubt that a nation's GDP per person is closely associated with its population's standard of living.

Saving and Investment

Recall the national income accounting identity: Y = C + I + G + NX. For the rest of this chapter, focus on the closed economy case: Y = C + I + G. Solve for I: I=Y-C-G= (Y-T-C) +(T-G) This is the National saving. Saving = investment in a closed economy. Accounting refers to the way in which various numbers are defined & added up. Examples: A personal accountant might help an individual add up his income & expenses. A national income accountant does the same thing for the economy as a whole.

The Components of GDP

Recall: GDP is total spending. Four components: Consumption (C)-spending by households on goods & services, with the exception of purchases of new housing. Investment (I)-spending on business capital, residential capital, & inventories. These will be used to produce other g&s in the future. Government Purchases (G) Net Exports (NX) These components add up to GDP (denoted Y) Y = C + I + G + NX

Property Rights and Political Stability

Recall: Markets are usually a good way to organize economic activity. The price system allocates resources to their most efficient uses. This requires respect for property rights, the ability of people to exercise authority over the resources they own. In many poor countries, the justice system doesn't work very well: Contracts aren't always enforced ▪ Fraud, corruption often go unpunished ▪ In some, firms must bribe govt officials for permits Political instability (e.g., frequent coups) creates uncertainty over whether property rights will be protected in the future. When people fear their capital may be stolen by criminals or confiscated by a corrupt govt, there is less investment, including from abroad, and the economy functions less efficiently. Result: lower living standards. Economic stability, efficiency, and healthy growth require law enforcement, effective courts, a stable constitution, & honest govt officials. Elaborated version: Division of production among many firms allows the economy's factors of production to be used as effectively as possible. Achieved because, the economy has to coordinate transactions among these firms, & between firms & consumers. Market economies achieve this coordination through market prices. Market prices= instrument with which the invisible hand of the marketplace brings supply & demand into balance in each of the many thousands of markets that make up the economy. Property rights refer to the ability of people to exercise authority over the resources they own. A mining company won't make the effort to mine iron ore if it expects the ore to be stolen. Companies mine the ore only if it's confident that it'll benefit from the ore's subsequent sale. This reason, courts serve an important role in a market economy: Enforce property rights. Many countries, the system of justice doesn't work well. Contracts=hard to enforce, fraud often goes unpunished. More extreme cases, the govt not only fails to enforce property rights but actually infringes upon them. To do business in some countries, firms are expected to bribe govt officials. Such corruption impedes the coordinating power of markets. Also discourages domestic saving & investment from abroad. When revolutions & coups are common, there's doubt about whether property rights will be respected in the future. If a revolutionary govt might confiscate the capital of some businesses, as was often true after communist revolutions, domestic residents have less incentive to save, invest, & start new businesses. Economic prosperity depends partly on favorable political institutions. Country with an efficient court system, honest govt officials, & a stable constitution will enjoy a higher standard of living than a country with a poor court system, corrupt officials, & frequent revolutions & coups.

The PPF and Opportunity Cost

Recall: The opportunity cost of an item is what must be given up to obtain that item. Moving along a PPF involves shifting resources (e.g., labor) from the production of one good to the other. Society faces a tradeoff: Getting more of one good requires sacrificing some of the other. The slope of the PPF tells you the opportunity cost of one good in terms of the other.

Physical Capital Per Worker

Recall: The stock of equipment and structures used to produce g&s is called [physical] capital, denoted K. ▪ K/L = capital per worker. ▪ Productivity is higher when the average worker has more capital (machines, equipment, etc.). ▪ i.e., an increase in K/L causes an increase in Y/L. An important feature of capital is that it is a produced factor of production. That is, capital is an input into the production process that in the past was an output from the production process. Thus, capital is a factor of production used to produce all kinds of g's & s's, including more capital.

Reminders (DON'T PRINT)

Saving & investment are key ingredients to long-run economic growth: When a country saves a large portion of its GDP, more resources are available for investment in capital, & higher capital raises a country's productivity & living standard. The national income accounts include, in particular, GDP & the many related statistics. Rules of national income accounting include several important identities. Recall that an identity is an equation that must be true because of the way the variables in the equation are defined. Identities are useful to keep in mind because they clarify how different variables are related to one another. Recall that gross domestic product (GDP) is both total income in an economy & the total expenditure on the economy's output of g's & s's. GDP (denoted as Y) is divided into four components of expenditure: consumption (C), investment (I), govt purchases (G), & net exports (NX): Y=C+I+G+NX. A closed economy is one that doesn't interact with other economies. In particular, a closed economy doesn't engage in international trade in g's & s's, & it doesn't engage in international borrowing & lending. Actual economies are open economies—that is, they interact with other economies around the world. Nonetheless, assuming a closed economy is a useful simplification with which we can learn some lessons that apply to all economies. Policy 3 If govt spending exactly equals tax revenue, the govt is said to have a balanced budget. Thus, the most basic lesson about budget deficits follows directly from their effects on the supply and demand for loanable funds: When the govt reduces national saving by running a budget deficit, the interest rate rises & investment falls. Because investment is important for long-run economic growth, govt budget deficits reduce the economy's growth rate. Why, you might ask, does a budget deficit affect the supply of loanable funds, rather than the demand for them? After all, the government finances a budget deficit by selling bonds, thereby borrowing from the private sector. Comes from policy 3. Why does increased borrowing by the govt shift the supply curve, whereas increased borrowing by private investors shifts the demand curve? To answer this question, we need to examine more precisely the meaning of "loanable funds." The model as presented here takes this term to mean the flow of resources available to fund private investment; thus, a govt budget deficit reduces the supply of loanable funds. If, instead, we had defined the term "loanable funds" to mean the flow of resources available from private saving, then the govt budget deficit would increase demand rather than reduce supply. Changing the interpretation of the term would cause a semantic change in how we described the model, but the upshot of the analysis would be the same: In either case, a budget deficit increases the interest rate, thereby crowding out private borrowers who are relying on financial markets to fund private investment projects.

Macroeconomics examples of the difference between saving & investment

Saving: Suppose that Larry earns more than he spends & deposits his unspent income in a bank or uses it to buy some stock or a bond from a corporation. Because Larry's income exceeds his consumption, he adds to the nation's saving. Larry might think of himself as "investing" his money, but a macroeconomist would call Larry's act saving rather than investment. Investment: Refers to the purchase of new capital, such as equipment or buildings. When Moe borrows from the bank to build himself a new house, he adds to the nation's investment. (Remember, the purchase of a new house is the one form of household spending that is investment rather than consumption.) Similarly, when the Curly Corporation sells some stock & uses the proceeds to build a new factory, it also adds to the nation's investment. Other info: Although the accounting identity S=I shows that saving & investment are equal for the economy as a whole, it doesn't mean that saving & investment are equal for every individual household or firm. Larry's saving can be greater than his investment, & he can deposit the excess in a bank. Moe's saving can be less than his investment, & he can borrow the shortfall from a bank. Banks & other financial institutions make these individual differences between saving & investment possible by allowing one person's saving to finance another person's investment.

What Economics Is All About

Scarcity: the limited nature of society's resources. Economics: the study of how society manages its scarce resources, e.g. ▪ how people decide what to buy, how much to work, save, and spend ▪ how firms decide how much to produce, how many workers to hire ▪ how society decides how to divide its resources between national defense, consumer goods, protecting the environment, and other needs. Another definition comes from Alfred Marshall who said " It is the study of mankind in the ordinary business of life." It is about how people make decisions, interact with one another, and how their interactions influence the course of society overall. In most societies, resources are allocated not by an all-powerful dictator but through the combined choices of millions of households and firms.

Summary-Why the LRAS Curve Might Shift

Shifts Arising from Changes in Labor: Increase in immigration. The position of the long-run aggregate-supply curve also depends on the natural rate of unemployment, so any change in the natural rate of unemployment shifts the long-run aggregate-supply curve. Shifts Arising from Changes in Capital: Notice that the same logic applies regardless of whether we are discussing physical capital such as machines and factories or human capital such as college degrees. An increase in either type of capital will raise the economy's ability to produce g's & s's and, thus, shift the long-run aggregate-supply curve to the right. Shifts Arising from Changes in Natural Resources:The discovery of a new mineral deposit shifts the long-run aggregate-supply curve to the right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve to the left. A change in the availability of these resources can also shift the aggregate-supply curve. For example, developments in the world oil market have historically been an important source of shifts in aggregate supply for the US and other oil-importing nations. Shifts Arising from Changes in Technological Knowledge: Although not literally technological, many other events act like changes in technology. For instance, opening up international trade has effects similar to inventing new production processes because it allows a country to specialize in higher-productivity industries; therefore, it also shifts the long-run aggregate-supply curve to the right. Conversely, if the govt passes new regulations preventing firms from using some production methods, perhaps to address worker safety or environmental concerns, the result is a leftward shift in the long-run aggregate-supply curve. In short-Because the long-run aggregate-supply curve reflects the classical model of the economy we developed in previous chapters, it provides a new way to describe our earlier analysis. Any policy or event that raised real GDP in previous chapters can now be described as increasing the quantity of g's & s's supplied and shifting the long-run aggregate-supply curve to the right. Any policy or event that lowered real GDP in previous chapters can now be described as decreasing the quantity of g's & s's supplied and shifting the long-run aggregate-supply curve to the left.

Summary

Short-run fluctuations in GDP & other macroeconomic quantities are irregular & unpredictable. Recessions are periods of falling real GDP & rising unemployment. Economists analyze fluctuations using the model of aggregate demand & aggregate supply. The aggregate demand curve slopes downward because a change in the price level has a wealth effect on consumption, an interest-rate effect on investment, & an exchange-rate effect on net exports. Anything that changes C, I, G, or NX—except a change in the price level—will shift the aggregate demand curve. The long-run aggregate supply curve is vertical because changes in the price level do not affect output in the long run. In the long run, output is determined by labor, capital, natural resources, and technology; changes in any of these will shift the long-run aggregate supply curve. In the short run, output deviates from its natural rate when the price level is different than expected, leading to an upward-sloping short-run aggregate supply curve. The 3 theories proposed to explain this upward slope are the sticky wage theory, the sticky price theory, & the misperceptions theory. The short-run aggregate-supply curve shifts in response to changes in the expected price level and to anything that shifts the long-run aggregate supply curve. Economic fluctuations are caused by shifts in aggregate demand and aggregate supply. When aggregate demand falls, output and the price level fall in the short run. Over time, a change in expectations causes wages, prices, and perceptions to adjust, and the short-run aggregate supply curve shifts rightward. In the long run, the economy returns to the natural rates of output and unemployment, but with a lower price level. A fall in aggregate supply results in stagflation—falling output and rising prices. Wages, prices, and perceptions adjust over time, and the economy recovers.

Active Learning 4

Show of hands surveyYou have a brokerage account with Merrill Lynch. Your broker calls you with a hot tip about a stock: new information suggests that the company will be highly profitable. Should you buy stock in the company? A. Yes B. No C. Not until you read the prospectus. D. What's a prospectus? C is the correct answer.

The Phillips Curve During the Financial Crisis Part 2

Shows what these events meant for inflation & unemployment. From 2007 to 2010, as the decline in aggregate demand raised unemployment from below 5% to about 10%, it also reduced the rate of inflation from 3% in 2006 to below 1% in 2009, the lowest inflation experienced in more than a half-century. In essence, the economy rode down the short-run Phillips curve. This figure shows annual data from 2006 to 2018 on the unemployment rate and on the inflation rate (as measured by the GDP deflator). A financial crisis caused aggregate demand to plummet, leading to much higher unemployment and pushing inflation down to a very low level. After 2010, the economy slowly recovered. Unemployment gradually declined, while the rate of inflation remained between 1% & 2%. One notable feature of this period is that the very low inflation of 2009 and 2010 doesn't appear to have substantially reduced expected inflation and shifted the short-run Phillips curve downward. Instead, expected inflation appears to have remained steady at about 2%, keeping the short-run Phillips curve relatively stable. A common explanation for this phenomenon is that the Federal Reserve had, over the previous 20 yrs, established a lot of credibility in its commitment to keep inflation at about 2%. This credibility kept expected inflation well-anchored. As a result, the position of the short-run Phillips curve reacted less to the dramatic short-run events. By 2018, the unemployment rate fell below 4%, and inflation reached 2.3%, its highest level since 2007. With unemployment below most estimates of the natural rate and inflation slightly above the Fed's target of 2%, the Fed pursued a more contractionary monetary policy, raising the federal funds rate from the roughly zero rates that prevailed from December 2008 to December 2015 to 2.4% in early 2019. How much more monetary tightening would be needed, if any, to keep unemployment near its natural rate and inflation near its target was a hotly debated topic.

The Phillips Curve: A policy Menu?

Since fiscal and mon policy affect agg demand, the PC appeared to offer policymakers a menu of choices: low unemployment with high inflation. low inflation with high unemployment. anything in between. 1960s: U.S. data supported the Phillips curve. Many believed the PC was stable and reliable.

Incomes and Growth Around the World

Since growth rates vary, the country rankings can change over time: ▪ Poor countries are not necessarily doomed to poverty forever, e.g. Singapore incomes were low in 1960 and are quite high now. ▪ Rich countries can't take their status for granted: They may be overtaken by poorer but faster-growing countries. Questions:▪ Why are some countries richer than others?▪ Why do some countries grow quickly while others seem stuck in a poverty trap? ▪ What policies may help raise growth rates and long-run living standards?

Are Natural Resources a Limit to Growth?

Some argue that population growth is depleting the Earth's non-renewable resources, and thus will limit growth in living standards. But technological progress often yields ways to avoid these limits: Hybrid cars use less gas. Better insulation in homes reduces the energy required to heat or cool them. As a resource becomes scarcer, its market price rises, which increases the incentive to conserve it and develop alternatives.

Reminders

Some commentators have added together the inflation rate and the unemployment rate to produce a misery index, which they use to gauge the health of the economy.

Implications of EMH

Stock market is informationally efficient: Each stock price reflects all available information about the value of the company. When good news about a company's prospects becomes public, the company's value and stock price both rise. When a company's prospects deteriorate, its value and price both fall. But at any moment in time, the market price is the best guess of the company's value based on available information. Stock prices follow a random walk: A stock price only changes in response to new information ("news") about the company's value. News can't be predicted, so stock price movements should be impossible to predict. It is impossible to systematically beat the market. By the time the news reaches you, mutual fund managers will have already acted on it. If, based on publicly available information, a person could predict that a stock price would rise by 10% tomorrow, the stock market must be failing to incorporate that information today. According to the theory, the only thing that can move a company's stock price is news that changes the market's perception of the company's value. There is much evidence that stock prices follow, even if not exactly a random walk, something very close to it. For example, you might be tempted to buy stocks that have recently risen and avoid stocks that have recently fallen (or perhaps just the opposite). But statistical studies have shown that following such trends (or bucking them) fails to outperform the market. The correlation between how well a stock does one year and how well it does the following year is about zero.

Explaining structural unemployment

Structural unemployment occurs when not enough jobs to go around. Occurs when wages kept above eq'm. There are three reasons for this.. minimum-wage laws, unions, and efficiency wages. Often thought to explain longer spells of unemployment. As we will see, this kind of unemployment results when wages are set above the level that brings supply & demand into equilibrium.

Summing up 3 Theories of SRAS

Summing Up-There are three alternative explanations for the upward slope of the short-run aggregate-supply curve: sticky wages, sticky prices, & misperceptions about relative prices. All three theories suggest that output deviates in the short run from its natural level when the actual price level deviates from the price level that people had expected to prevail. We can express this mathematically as follows: quantity of output supplied=natural level of output +a(actual price level-expected price level) where (a) is a number that determines how much output responds to unexpected changes in the price level.

The 1970s Oil Price Shocks Part 2

Supply shocks & rising expected inflation worsened the PC tradeoff.

Active Learning 1 Part A

Suppose GDP equals $10 trillion, consumption equals $6.5 trillion, the govt spends $2 trillion & has a budget deficit of $300 billion. Find public saving, taxes, private saving, national saving, & investment. Given: Y = 10.0, C = 6.5, G = 2.0, G - T = 0.3 Public saving = T-G=-0.3 Taxes: T=G-0.3=1.7 Private saving = Y-T-C= 10-1.7-6.5=1.8 National saving = Y-C-G=10-6.5-2=1.5 Investment = national saving =1.5

Deriving the Phillips Curve

Suppose P = 100 this year. The following graphs show two possible outcomes for next year: A. Agg demand low, small increase in P (i.e., low inflation), low output, high unemployment. B. Agg demand high, big increase in P (i.e., high inflation), high output, low unemployment. A. Low agg demand, low inflation, high u-rate. B.High agg demand, high inflation, low u-rate.

The Interest-Rate Effect (P and I )

Suppose P rises. Buying g&s requires more dollars. To get these dollars, people sell bonds or other assets. This drives up interest rates. Result: I falls. (Recall, I depends negatively on interest rates.) The price level is one determinant of the quantity of money demanded. When the price level is lower, households don't need to hold as much money to buy the g's & s's they want. Therefore, when the price level falls, households try to reduce their holdings of money by lending some of it out. As households try to convert some of their money into interest-bearing assets, they drive down interest rates. Interest rates, in turn, affect spending on g's & s's. A lower interest rate makes borrowing less expensive, it encourages firms to borrow more to invest. (A lower interest rate might also stimulate consumer spending.) This logic gives us the second reason the aggregate-demand curve slopes downward. A lower price level reduces the interest rate, encourages greater spending on investment goods, & thereby increases the quantity of g's & s's demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, & decreases the quantity of g's & s's demanded.

The Wealth Effect (P and C )

Suppose P rises. The dollars people hold buy fewer g&s, so real wealth is lower. People feel poorer. Result: C falls. The nominal value of this money is fixed: One dollar is always worth one dollar. Yet the real value of a dollar is not fixed. When the price level falls, the dollars you hold rise in value, increasing your real wealth and your ability to buy g&s. This logic gives us the first reason the aggregate-demand curve slopes downward. A decrease in the price level raises the real value of money and makes consumers wealthier, thereby encouraging them to spend more. The increase in consumer spending means a larger quantity of g&s demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, thereby reducing consumer spending and the quantity of g&s demanded.

The Exchange-Rate Effect (P and NX )

Suppose P rises. U.S. interest rates rise (the interest-rate effect). Foreign investors desire more U.S. bonds. Higher demand for $ in foreign exchange market. U.S. exchange rate appreciates. U.S. exports more expensive to people abroad, imports cheaper to U.S. residents. Result: NX falls. As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response to the lower interest rate, some U.S. investors will seek higher returns by investing abroad. The change in relative prices affects spending, both at home and abroad. This logic yields the third reason the aggregate-demand curve slopes downward. When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of g's & s's demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of g's & s's demanded.

Policy 1: Saving Incentives

Tax incentives for saving increase the supply of L.F. ...which reduces the eq'm interest rate & increases the eq'm quantity of L.F. 1st, which curve would this policy affect? Because the tax change would alter the incentive for households to save at any given interest rate, it would affect the quantity of loanable funds supplied at each interest rate. Thus, the supply of loanable funds would shift. The demand for loanable funds would remain the same because the tax change wouldn't directly affect the amount that borrowers want to borrow at any given interest rate. 2nd, which way would the supply curve shift? Because saving would be taxed less heavily than under current law, households would increase their saving by consuming a smaller fraction of their income. Households would use this additional saving to increase their deposits in banks or to buy more bonds. The supply of loanable funds would increase, and the supply curve would shift to the right from S1 to S2, as shown in Figure 2. Finally, we can compare the old & new equilibria. In the figure, the increased supply of loanable funds reduces the interest rate from 5% to 4%. The lower interest rate raises the quantity of loanable funds demanded from $1,200 billion to $1,600 billion. That is, the shift in the supply curve moves the market equilibrium along the demand curve. With a lower cost of borrowing, households & firms are motivated to borrow more to finance greater investment. Thus, if a reform of the tax laws encouraged greater saving, the result would be lower interest rates & greater investment.

Tech. Knowledge vs. Human Capital

Technological knowledge refers to society's understanding of how to produce g&s. ▪ Human capital results from the effort people expend to acquire this knowledge. ▪ Both are important for productivity. Technological knowledge refers to society's understanding about how the world works. Human capital refers to the resources expended transmitting this understanding to the labor force. Example: Technological knowledge is the quality of society's textbooks, whereas human capital is the amount of time that the population has spent reading them. Workers' productivity depends on both.

Technological Knowledge

Technological knowledge: society's understanding of the best ways to produce g&s ▪ Technological progress does not only mean a faster computer, a higher-definition TV, or a smaller cell phone. ▪ It means any advance in knowledge that boosts productivity (allows society to get more output from its resources). ▪ e.g., Henry Ford and the assembly line. Technological knowledge takes many forms. Some technology is common knowledge—after one person uses it, everyone becomes aware of it. For example, once Henry Ford successfully introduced assembly-line production, other carmakers quickly followed suit. Other tech is proprietary—it's known only by the company that discovers it. Only the Coca-Cola Company, for instance, knows the secret recipe for making its famous soft drink. Still other tech is proprietary for a short time. When a pharmaceutical company discovers a new drug, the patent system gives that company a temporary right to be its exclusive manufacturer. When the patent expires, however, other companies are allowed to make the drug.

Research and Development

Technological progress is the main reason why living standards rise over the long run. One reason is that knowledge is a public good: Ideas can be shared freely, increasing the productivity of many. Policies to promote tech. progress: Patent laws Tax incentives or direct support for private sector R&D Grants for basic research at universities Elaborated Version: Primary reason that living standards are higher today vs a century ago is that technological knowledge has advanced. Examples- telephones, transistors, computers, & internal combustion engines are among the thousands of innovations that have improved the ability to produce g's & s's. Most technological advances come from private research by firms & individual inventors, but there's also a public interest in promoting these efforts. To a large extent, knowledge is a public good: That is, once 1 person discovers an idea, the idea enters society's pool of knowledge & other people can freely use it. U.S. govt has long played a role in the creation & dissemination of technological knowledge. A century ago, sponsored research about farming methods advising farmers how best to use their land. More recently, through the Air Force & NASA, has supported aerospace research; as a result, the U.S is a leading maker of rockets & planes. They continue to encourage advances in knowledge with research grants from the National Science Foundation & the National Institutes of Health & with tax breaks for firms engaging in R&D. When a person or firm creates an innovative product, the inventor can apply for a patent. If deemed truly original, the govt awards the patent, giving the inventor the exclusive right to make the product for a specified number of years. The patent gives the inventor a property right over her invention, turning her new idea from a public good into a private good. By allowing inventors to profit from their inventions—even if only temporarily—the patent system increases the incentive for individuals & firms to engage in research. "Future innovations worldwide will not be transformational enough to promote sustained per-capita economic growth rates in the U.S & western Europe over the next century as high as those over the past 150 years." Economists-59% (Uncertain), 34% (Disagree), 7% (Agree).

The Aggregate-Demand (AD) Curve

The AD curve shows the quantity of all g&s demanded in the economy at any given price level. the aggregate-demand curve slopes downward. Other things being equal, a decrease in the economy's overall level of prices (from, say, P1 to P2 ) raises the quantity of g's & s's demanded (from Y1 to Y2 ). Conversely, an increase in the price level reduces the quantity of g's & s's demanded. As the price level falls, real wealth rises, interest rates fall, and the exchange rate depreciates. These effects stimulate spending on consumption, investment, and net exports. Increased spending on any or all of these components of output means a larger quantity of g's & s's demanded.

The Aggregate-Supply (AS ) Curves

The AS curve shows the total quantity of g&s firms produce and sell at any given price level. AS is: Upward-sloping in short run. Vertical in long run. According to this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance. Unlike the aggregate-demand curve, which always slopes downward, the aggregate-supply curve shows a relationship that depends crucially on the time horizon examined. In the long run, the aggregate-supply curve is vertical, whereas in the short run, the aggregate-supply curve slopes upward. To understand short-run economic fluctuations, and how the short-run behavior of the economy deviates from its long-run behavior, we need to examine both the long-run aggregate-supply curve and the short-run aggregate-supply curve.

Labor force statistics for different groups

The BLS publishes these statistics for demographic groups within the population. These data reveal widely different labor market experiences for different groups.

Our First Model: The Circular-Flow Diagram

The Circular-Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households & firms ▪ Two types of "actors": ▪ households ▪ firms ▪ Two markets: ▪ the market for goods & services (households are buyers, & firms are sellers) ▪ the market for "factors of production"(households are sellers, & firms are buyers.)

Summary 2

The Consumer Price Index is a measure of the cost of living. The CPI tracks the cost of the typical consumer's "basket" of goods & services. The CPI is used to make Cost of Living Adjustments and to correct economic variables for the effects of inflation. The real interest rate is corrected for inflation and is computed by subtracting the inflation rate from the nominal interest rate. (2)

The GDP Deflator

The GDP Deflator-a measure of the overall level of prices. OR a measure of the price level calculated as the ratio of nominal GDP to real GDP times 100. One way to measure the economy's inflation rate is to compute the percentage increase in the GDP deflator from one year to the next. GDP deflator=nominal GDP/Real GDP x 100 The GDP Deflator example: Compute the GDP deflator in each year: 2011: 100 x (6000/6000) = 100.0 2012: 100 x (8250/7200) = 114.6 2013: 100 x (10,800/8400) = 128.6 Inflation rate-the percentage change in some measure of the price level from one period to the next. Inflation-situation in which the economy's overall price level is rising. The GDP deflator is one measure used by economists to monitor the average level of prices in the economy & thus the rate of inflation. the GDP deflator gets its name because it can be used to take inflation out of nominal GDP—that is, to "deflate" nominal GDP for the rise that's due to increases in prices. Recessions are associated not only with lower incomes but also with other forms of economic distress: rising unemployment, falling profits, increased bankruptcies, & so on. (There's no ironclad rule for when the official business cycle dating committee will declare that a recession has occurred, but an old rule of thumb is two consecutive quarters of falling real GDP.) Formula for growth rate of the GDP Deflator 100*[(x final/x intial)1/N-1] N is number of years.

John Maynard Keynes, 1883-1946

The General Theory of Employment, Interest, & Money, 1936. Argued recessions and depressions can result from inadequate demand; policymakers should shift AD. Famous critique of classical theory: The long run is a misleading guide to current affairs. In the long run, we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us when the storm is long past, the ocean will be flat.

The Shape of the PPF

The PPF could be a straight line or bow-shaped.▪ Depends on what happens to opportunity cost as economy shifts resources from one industry to the other. ▪ If opp. cost remains constant, PPF is a straight line. (In the previous example, opp. cost of a computer was always 10 tons of wheat.) ▪ If opp. cost of a good rises as more of the good is produced, PPF is bow-shaped....

The PPF: A Summary

The PPF shows all combinations of two goods that an economy can possibly produce, given its resources and technology. ▪ The PPF illustrates the concepts of tradeoff and opportunity cost, efficiency and inefficiency, unemployment, and economic growth. ▪ A bow-shaped PPF illustrates the concept of increasing opportunity cost.

Summary

The Phillips curve describes the short-run tradeoff between inflation and unemployment. In the long run, there is no tradeoff: inflation is determined by money growth, while unemployment equals its natural rate. Supply shocks and changes in expected inflation shift the short-run Phillips curve, making the tradeoff more or less favorable. The Fed can reduce inflation by contracting the money supply, which moves the economy along its short-run Phillips curve and raises unemployment. In the long run, though, expectations adjust and unemployment returns to its natural rate. Some economists argue that a credible commitment to reducing inflation can lower the costs of disinflation by inducing a rapid adjustment of expectations.

The Rule of 70

The Rule of 70: If a variable grows at a rate of xpercent per year, that variable will double in about 70/xyears. Example: If interest rate is 5%, a deposit will double in about 14 years. If interest rate is 7%, a deposit will double in about 10 years. Doesn't just apply to a growing economy but to savings as well.

Short Run Aggregate Supply (SRAS)

The SRAS curve is upward sloping: Over the period of 1-2 years, an increase in P causes an increase in the quantity of g & s supplied and a decrease in the level of prices tends to reduce the quantity of g's & s's supplied. As a result, the short-run aggregate-supply curve slopes upward. In the short run, the price level does affect the economy's output. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary.

Summary Chapt 26

The U.S. financial system is made up of many types of financial institutions, like the stock & bond markets, banks, & mutual funds. National saving equals private saving plus public saving. In a closed economy, national saving equals investment. The financial system makes this happen. The supply of loanable funds comes from saving. The demand for funds comes from investment. The interest rate adjusts to balance supply & demand in the loanable funds market. A govt budget deficit is negative public saving, so it reduces national saving, the supply of funds available to finance investment. When a budget deficit crowds out investment, it reduces the growth of productivity & GDP. (Chapt 26)

More info

The average income in a rich country, such as the U.S, Japan, or Germany, is about 10 times the average income in a poor country, such as India, Nigeria, or Nicaragua. In the U.S over the past century, average income as measured by real gross domestic product (GDP) per person has grown by about 2% per year. Average income has roughly doubled every 35 years. From 1990 to 2017, GDP per person in China grew at a rate of 9% per year, resulting in a ten-fold increase in average income. This growth has moved China from being one of the poorest countries in the world to being a middle-income country in roughly one generation. If this rapid growth continues for another generation, China will become one of richest countries in the world. Over the same span of time, income per person in Zimbabwe fell by a total of 27%, leaving the typical person in that nation mired in poverty. As the Nobel-Prize-winning economist Robert Lucas put it, "The consequences for human welfare in questions like these are simply staggering: Once one starts to think about them, it is hard to think about anything else." The level of real GDP is a good gauge of economic prosperity, and the growth of real GDP is a good gauge of economic progress. Explaining why living standards vary so much around the world is, in one sense, very easy. The answer can be summarized in a single word—productivity.

Final thoughts

The consumer price index (CPI) shows the cost of a basket of goods and services relative to the cost of the same basket in the base year. The index is used to measure the overall level of prices in the economy. The percentage change in the CPI measures the inflation rate. The CPI is an imperfect measure of the cost of living for three reasons. First, it does not take into account consumers' ability to substitute toward goods that become relatively cheaper over time. Second, it doesn't take into account increases in the purchasing power of the dollar that result from the introduction of new goods. Third, it is distorted by unmeasured changes in the quality of goods and services. Because of these measurement problems, the CPI overstates true inflation.Like the CPI, the GDP deflator measures the overall level of prices in the economy. The two price indexes usually move together, but there are important differences. The GDP deflator differs from the CPI because it reflects the prices of goods and services produced domestically rather than of goods and services bought by consumers. As a result, imported goods affect the CPI but not the GDP deflator. In addition, while the CPI uses a fixed basket of goods, the group of goods and services reflected in the GDP deflator automatically changes over time as the composition of GDP changes. Dollar figures from different times do not represent a valid comparison of purchasing power. To compare a dollar figure from the past with a dollar figure today, the older figure should be inflated using a price index. Various laws & private contracts use price indexes to correct for the effects of inflation. Tax laws, however, are only partially indexed for inflation. Correcting for inflation is especially important when looking at data on interest rates. The nominal interest rate—the interest rate usually reported—is the rate at which the number of dollars in a savings account increases over time. By contrast, the real interest rate is the rate at which the purchasing power of a savings account increases over time. The real interest rate equals the nominal interest rate minus the rate of inflation.

How an Adverse Supply Shock Shifts the PC

The economy experiences stagflation—the combo of falling output (stagnation) & rising prices (inflation). Panel (a) shows the model of aggregate demand & aggregate supply. When the aggregate-supply curve shifts to the left, the equilibrium moves from point A to point B. Output falls from Y1 to Y2, & the price level rises from P1 to P2 . Panel (b) shows the short-run trade-off between inflation & unemployment. The adverse shift in aggregate supply moves the economy from a point with lower unemployment & lower inflation (point A) to a point with higher unemployment & higher inflation (point B). The short-run Phillips curve shifts to the right from PC1 to PC2. Policymakers now face a worse set of options for inflation & unemployment. This shift in aggregate supply is associated with a similar shift in the short-run Phillips curve, shown in panel (b). Because firms need fewer workers to produce the smaller output, employment falls & unemployment rises. Because the price level is higher, the inflation rate—the percentage change in the price level from the previous year—is also higher. Thus, the shift in aggregate supply leads to higher unemployment & higher inflation. The short-run trade-off between inflation & unemployment shifts to the right from PC1 to PC2. Confronted with an adverse shift in aggregate supply, policymakers face a difficult choice between fighting inflation & fighting unemployment. If they contract aggregate demand to fight inflation, they'll raise unemployment further. If they expand aggregate demand to fight unemployment, they will raise inflation further. In other words, policymakers face a less favorable trade-off between inflation & unemployment than they did before the shift in aggregate supply: They have to live with a higher rate of inflation for a given rate of unemployment, a higher rate of unemployment for a given rate of inflation, or some combo of higher unemployment & higher inflation. Faced with such an adverse shift in the Phillips curve, policymakers will ask whether the shift is temporary or permanent. The answer depends on how people adjust their expectations of inflation. If people view the rise in inflation due to the supply shock as a temporary aberration, expected inflation will not change & the Phillips curve will soon revert to its former position. But if people believe the shock will lead to a new era of higher inflation, then expected inflation will rise & the Phillips curve will remain at its new, less desirable position. In summary-SRAS shifts left, prices rise, output & employment fall. Inflation & u-rate both increase as the PC shifts upward.

Introduction

The financial system coordinates saving & investment. Participants in the financial system make decisions regarding the allocation of resources over time & the handling of risk. Finance is the field that studies such decision making.

Financial Institutions

The financial system: the group of institutions that helps match the saving of one person with the investment of another. Financial markets: institutions through which savers can directly provide funds to borrowers. Examples: The bond market. A bond is a certificate of indebtedness. Bond buyer is a lender, & a bond is an IOU. Bond identifies the time at which the loan will be repaid, called the date of maturity, & the rate of interest that the borrower will pay periodically until the loan matures. Buyer of a bond gives his money to Intel in exchange for this promise of interest & eventual repayment of the amount borrowed (called the principal). Can hold til maturity or sell it at an earlier time. Characteristics of Bonds-term-the length of time until the bond matures. (The British govt has even issued a bond that never matures, called a perpetuity. This bond pays interest forever, but the principal is never repaid.) credit risk-the probability that the borrower will fail to pay some of the interest or principal. Such a failure to pay is called a default. U.S. govt bonds tend to pay low interest rates. By contrast, financially shaky corporations raise money by issuing junk bonds, which pay very high interest rates. tax treatment-the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income; that is, the bond owner has to pay a portion of the interest he earns in income taxes. By contrast, when state & local govts issue bonds, called municipal bonds, the bond owners aren't required to pay federal income tax on the interest income. Whether it offers inflation protection. Most bonds are written in nominal terms—that is, they promise to pay interest and principal in a specific number of dollars (or perhaps another currency). The sale of bonds is called debt finance. The stock market. A stock is a claim to partial ownership in a firm. The sale of stock to raise money is called equity finance. A stock index is computed as an average of a group of stock prices. Compared to bonds, stocks carry greater risk but offer potentially higher returns. In stock exchanges the corporation itself receives no money when its stock changes hands. Prices at which shares trade on stock exchanges are determined by the supply of & demand for the stock in these companies. Financial intermediaries: institutions through which savers can indirectly provide funds to borrowers. Examples: Banks-Pay depositors interest on their deposits & charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks' costs & returns some profit to the owners of the banks. They facilitate purchases of g's & s's by allowing people to write checks against their deposits & to access those deposits with debit cards. Simply, banks help create a special asset that people can use as a medium of exchange. Its role in providing a medium of exchange distinguishes it from many other financial institutions. Stocks, bonds, & banks offer a possible store of value for the wealth people have accumulated in past saving. Banks provide easy, cheap, & immediate access to wealth that writing a check or swiping a debit card allows. Mutual funds - institutions that sell shares to the public and use the proceeds to buy portfolios of stocks & bonds. Shareholder of the mutual fund accepts all the risk & return associated with the portfolio. Primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings. People who hold a diverse portfolio of stocks & bonds face less risk because they have only a small stake in each company. Compared to stocks or bonds whose value is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. Make this diversification easy. With only a few hundred dollars, a person can buy shares in a mutual fund &, indirectly, become the part owner or creditor of hundreds of major companies. For this service, the company operating the mutual fund charges shareholders a fee, usually between 0.1% & 1.5% of assets each year. All serve the same goal: directing the resources of savers into the hands of borrowers.

Diminishing Returns and the Catch-Up Effect

The govt can implement policies that raise saving and investment. Then K will rise, causing productivity and living standards to rise. ▪ But this faster growth is temporary, due to diminishing returns to capital: As K rises, the extra output from an additional unit of K falls.... Diminishing returns-the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. In other words, when workers already have a large quantity of capital to use in producing g's & s's, giving them an additional unit of capital increases their productivity only slightly. Sometimes called the diminishing marginal product of capital. catch-up effect-the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. As the higher saving rate allows more capital to be accumulated, the benefits from additional capital become smaller over time, & so growth slows down. In the long run, the higher saving rate leads to a higher level of productivity & income but not to higher growth in these variables. According to studies of international data on economic growth, increasing the saving rate can lead to substantially higher growth for a period of several decades. The property of diminishing returns to capital has another important implication: Other things being equal, it's easier for a country to grow fast if it starts out relatively poor. Rich countries are harder to grow partly because they have large amounts of capital with which to work. When the amount of capital per worker is already so high, additional capital investment has a relatively small effect on productivity. Studies of international data on economic growth confirm this catch-up effect: Controlling for other variables, such as the percentage of GDP devoted to investment, poor countries tend to grow at faster rates than rich countries.

The U.S. Government Debt

The govt finances deficits by borrowing (selling govt bonds). Persistent deficits lead to a rising govt debt. The ratio of govt debt to GDP is a useful measure of the govt's indebtedness relative to its ability to raise tax revenue. Historically, the debt-GDP ratio usually rises during wartime & falls during peacetime—until the early 1980s. The debt-to-GDP ratio is one gauge of the govt's finances. Because GDP is a rough measure of the govt's tax base, a declining debt-to-GDP ratio indicates that the govt indebtedness is shrinking relative to its ability to raise tax revenue. This suggests that the govt is, in some sense, living within its means. By contrast, a rising debt-to-GDP ratio means that the govt indebtedness is increasing relative to its ability to raise tax revenue. It's often interpreted as meaning that fiscal policy—govt spending and taxes—can't be sustained forever at current levels. Throughout history, the primary cause of fluctuations in govt debt has been war. When wars occur, govt spending on national defense rises substantially to pay for soldiers and military equipment. Taxes sometimes rise as well but typically by much less than the increase in spending. The result is a budget deficit & increasing govt debt. When the war is over, govt spending declines & the debt-to-GDP ratio starts declining as well. There are 2 reasons to believe that debt financing of war is an appropriate policy. First, it allows the govt to keep tax rates smooth over time. Without debt financing, wars would require sharp increases in tax rates, which would cause a substantial decline in economic efficiency. 2nd, debt financing of wars shifts part of the cost of wars to future generations, who will have to pay off the govt debt. Putting some of the tax burden on future generations is arguably fair given that they get some of the benefit when a previous generation fights a war to defend the nation from foreign aggressors.

SRAS and LRAS

The imperfections in these theories are temporary. Over time, sticky wages and prices become flexible & misperceptions are corrected. In the LR, PE=P, as curve is vertical. In the long run, PE = P and Y = YN.

Other information

The inflation rate you are likely to hear on the nightly news, however, is calculated from the CPI, which better reflects the g&s's bought by consumers. The CPI is calculated as follows: Price of basket of G&S's in a current year/ Price of basket in base year x 100 The BLS collects & processes data on the prices of thousands of g&s's every month &, by following the five foregoing steps, determines how quickly the cost of living for the typical consumer is rising. When the BLS makes its monthly announcement of the CPI, you can usually hear the number on the evening news or see it in your newsfeed. It reports the index for some narrow categories of g&s's, such as food, clothing, & energy. It also calculates the CPI for all g&s's excluding food & energy. core CPI-a measure of the overall cost of consumer g&s's excluding food & energy. Because food & energy prices show substantial short-run volatility. producer price index (PPI)-a measure of the cost of a basket of g&s's bought by firms. Because firms eventually pass on their costs to consumers in the form of higher consumer prices, changes in the PPI are often thought to be useful for predicting changes in the CPI. Formula for turning dollar figures from year T into today's dollars. Amount in todays dollars= amount in year T dollars x price level today/ price level in year T. The cost of living varies not only over time but also across locations. What seems like a larger paycheck might not turn out to be so once you take into account regional differences in the prices of g&s's. The Bureau of Economic Analysis has used the data collected for the CPI to compare prices around the US. The resulting statistic is called regional price parities. Just as the CPI measures variation in the cost of living from year to year, regional price parities measure variation in the cost of living from state to state. Turns out that the prices of goods, such as food & clothing, explain only a small part of these regional differences. Most goods are tradable: They can be easily transported from one state to another. Because of regional trade, large price disparities are unlikely to persist for long. Services explain a larger part of these regional differences. A haircut, can cost more in one state than in another. If barbers were willing to move to places where the price of a haircut is high, or if customers were willing to fly across the country in search of cheap haircuts, then the prices of haircuts across regions might well converge. But because transporting haircuts is so costly, large price disparities can persist. Housing services are particularly important for understanding regional differences in the cost of living. Such services represent a large share of a typical consumer's budget. Moreover, once built, a house or apartment building can't easily be moved, & the land on which it sits is completely immobile. As a result, differences in housing costs can be persistently large. For example, rents in NY are almost twice those in Mississippi. Formula for turning dollar figures from year T into today's dollars. Amount in todays dollars= amount in year T dollars x price level today/ price level in year T.

Equilibrium

The interest rate adjusts to equate supply & demand. The eq'm quantity of L.F. equals eq'm investment & eq'm saving.

Problems with the CPI: Intro of new goods

The intro of new goods increases variety, allows consumers to find products that more closely meet their needs. The increased variety in turn reduces the cost of maintaining the same level of economic well-being. Think you have a choice between greater variety vs a store with a limited. Most people would pick the store with greater variety. In effect, dollars become more valuable. The CPI misses this effect because it uses a fixed basket of goods. Thus, the CPI overstates increases in the cost of living. As new goods are introduced, consumers have more choices, & each dollar is worth more. Because the CPI is based on a fixed basket of g&s's, it doesn't reflect the increase in the value of the dollar that results from the intro of new goods.

Minimum wage laws

The min. wage may exceed the eq'm wage for the least skilled or experienced workers, causing structural unemployment. But this group is a small part of the labor force, so the min. wage can't explain most unemployment. When a minimum-wage law forces the wage to remain above the level that balances supply and demand, it raises the quantity of labor supplied and reduces the quantity of labor demanded compared to the equilibrium level. There is a surplus of labor. Because there are more workers willing to work than there are jobs, some workers are unemployed. While minimum-wage laws are one reason unemployment exists in the U.S. economy, they do not affect everyone. The vast majority of workers have wages well above the legal minimum, so the law does not prevent most wages from adjusting to balance supply and demand. Minimum-wage laws matter most for the least skilled and least experienced members of the labor force, such as teenagers. Their equilibrium wages tend to be low and, therefore, are more likely to fall below the legal minimum. It is only among these workers that minimum-wage laws explain the existence of unemployment. Structural unemployment that arises from an above-equilibrium wage is, in an important sense, different from the frictional unemployment that arises from the process of job search. The need for job search is not due to the failure of wages to balance labor supply and labor demand. When job search is the explanation for unemployment, workers are searching for the jobs that best suit their tastes and skills. By contrast, when the wage is above the equilibrium level, the quantity of labor supplied exceeds the quantity of labor demanded, and workers are unemployed because they are waiting for jobs to open up.

Aggregate Demand, Aggregate Supply, and the Phillips Curve

The model of aggregate demand and aggregate supply provides an easy explanation for the menu of possible outcomes described by the Phillips curve. The Phillips curve shows the combinations of inflation and unemployment that arise in the short run as shifts in the aggregate-demand curve move the economy along the short-run aggregate-supply curve. An increase in the aggregate demand for g's & s's leads, in the short run, to a larger output of g's & s's & a higher price level. Larger output means greater employment and, thus, a lower rate of unemployment. In addition, a higher price level translates into a higher rate of inflation. Thus, shifts in aggregate demand push inflation and unemployment in opposite directions in the short run—a relationship illustrated by the Phillips curve. Higher aggregate demand moves the economy to an equilibrium with higher output and a higher price level. The two possible outcomes for the economy can be compared either in terms of output and the price level (using the model of aggregate demand and aggregate supply) or in terms of unemployment and inflation (using the Phillips curve). Because monetary and fiscal policy can shift the aggregate-demand curve, they can move an economy along the Phillips curve. Increases in the money supply, increases in govt spending, or cuts in taxes expand aggregate demand and move the economy to a point on the Phillips curve with higher inflation and lower unemployment. Decreases in the money supply, cuts in govt spending, or increases in taxes contract aggregate demand and move the economy to a point on the Phillips curve with lower inflation and higher unemployment. In this sense, the Phillips curve offers policymakers a menu of term-27combos of inflation and unemployment.

The Long-Run Aggregate-Supply Curve (LRAS)

The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate. YN is also called potential output or full-employment output.

Explaining the natural rate of unemployment: a summary

The natural rate of unemployment consists of frictional unemployment-It takes time to search for the right jobs. Occurs even if there are enough jobs to go around. structural unemployment- When wage is above eq'm, not enough jobs. Due to min. wages, labor unions, efficiency wages.

Correcting Variables for Inflation:Real vs. Nominal Interest Rates

The nominal interest rate: the interest rate not corrected for inflation. the rate of growth in the dollar value of a deposit or debt. The real interest rate: corrected for inflation the rate of growth in the purchasing power of a deposit or debt. Real interest rate = (nominal interest rate) - (inflation rate) Example: Deposit $1,000 for one year. Nominal interest rate is 9%. During that year, inflation is 3.5%. Real interest rate = Nominal interest rate - Inflation= 9.0% - 3.5% = 5.5% The purchasing power of the $1000 deposit has grown 5.5%. nominal interest rate-the interest rate as usually reported without a correction for the effects of inflation. real interest rate-the interest rate corrected for the effects of inflation. It's computed by subtracting the rate of inflation from this nominal interest rate. During deflation, the real interest rate exceeds the nominal interest rate. Because inflation is variable, real & nominal interest rates don't always move together.

Classical Economics—A Recap

The previous chapters are based on the ideas of classical economics, especially: The Classical Dichotomy, the separation of variables into two groups: Real - quantities, relative prices. Nominal - measured in terms of money. The neutrality of money: Changes in the money supply affect nominal but not real variables. Most economists believe classical theory describes the world in the long run, but not the short run. In the short run, changes in nominal variables (like the money supply or P ) can affect real variables (like Y or the u-rate). To study the short run, we use a new model. This new model can be built using many of the tools we developed in previous chapters, but it must abandon the classical dichotomy and the neutrality of money. We can no longer separate our analysis of real variables such as output and employment from our analysis of nominal variables such as money and the price level. Our new model focuses on how real and nominal variables interact.

The Production Function

The production function is a graph or equation showing the relation between output and inputs:Y = A F(L, K, H, N)F( ) is a function that shows how inputs are combined to produce output "A" is the level of technology ▪ "A" multiplies the function F( ), so improvements in technology (increases in "A") allow more output (Y) to be produced from any given combination of inputs. The production function has the property constant returns to scale: Changing all inputs by the same percentage causes output to change by that percentage. For example, ▪ Doubling all inputs (multiplying each by 2) causes output to double:Y = A F(L, K, H, N)2Y = A F(2L, 2K, 2H, 2N) ▪ Increasing all inputs 10% (multiplying each by 1.1) causes output to increase by 10% :1.1Y = A F(1.1L, 1.1K, 1.1H, 1.1N) If we multiply each input by 1/L, then output is multiplied by 1/L: Y/L = A F(1, K/L, H/L, N/L) ▪ This equation shows that productivity (output per worker) depends on:▪ the level of technology (A) ▪ physical capital per worker ▪ human capital per worker ▪ natural resources per worker Economists often use a production function to describe the relationship between the quantity of inputs used in production & the quantity of output from production. Y-quantity of output. L-quantity of labor. K-the quantity of physical capital, H-quantity of human capital. N-quantity of natural resources. Y=AF (L,K,H,N) F-function showing how inputs are combined to produce output. A-available production technology. As tech improves, A rises, so the economy produces more output from any given comb of inputs. Many production functions have a property called constant returns to scale. If a production function has constant returns to scale, then doubling all inputs causes the amount of output to double as well. Mathematically, we write that a production function has constant returns to scale if, for any positive number x, xY=AF(xL,xK,xH,xN)A doubling of all inputs would be represented in this equation by x=2 . The right side shows the inputs doubling, and the left side shows output doubling. Production functions with constant returns to scale have an interesting and useful implication. To see this implication, set x=1/L so that the preceding equation becomes Y/L=AF (1,K/L,H/L,N/L) Notice that Y/L is output per worker, which is a measure of productivity. This equation says that labor productivity depends on the amounts of physical capital per worker K/L, human capital per worker H/L & natural resources per worker N/L & on the state of technology, as represented by the variable .

CONCLUSION

The theories in this chapter come from some of the greatest economists of the 20th century. They teach us that inflation and unemployment are: unrelated in the long run. negatively related in the short run. affected by expectations, which play an important role in the economy's adjustment from the short-run to the long run

Efficiency wages

The theory of efficiency wages: Firms voluntarily pay above-equilibrium wages to boost worker productivity. Different versions of efficiency wage theory suggest different reasons why firms pay high wages. Four reasons why firms might pay efficiency wages: Worker health-In less developed countries, poor nutrition is a common problem. Paying higher wages allows workers to eat better, makes them healthier, more productive. Nutrition concerns may explain why firms maintain above-equilibrium wages despite a surplus of labor. Worker turnover-Hiring & training new workers is costly. Paying high wages above equilibrium level gives workers more incentive to stay, reduces turnover. Moreover, even after they are trained, newly hired workers are not as productive as experienced ones. Firms with higher turnover, therefore, will tend to have higher production costs. Worker quality-Offering higher wages above the level that balances supply & demand attracts better job applicants, increases quality of the firm's workforce. If the firm responded to a surplus of labor by reducing the wage, the most competent applicants—who are more likely to have better alternative opportunities than less competent applicants—may choose not to apply. Worker effort-Workers can work hard or shirk. Shirkers are fired if caught. Is being fired a good deterrent? Depends on how hard it is to find another job. If market wage is above eq'm wage, there aren't enough jobs to go around, so workers have more incentive to work not shirk. If the wage were at the level that balanced supply and demand, workers would have less reason to work hard because if they were fired, they could quickly find new jobs at the same wage. Unemployment is the result of wages above the level that balances the quantity of labor supplied and the quantity of labor demanded. Yet there is also an important difference. Minimum-wage laws and unions prevent firms from lowering wages in the presence of a surplus of workers.

Active Learning 1 Part C

The two scenarios from this exercise were: 1. Consumers save the full proceeds of the tax cut. 2. Consumers save 1/4 of the tax cut & spend the other 3/4. Which of these two scenarios do you think is more realistic? Why is this question important? This is important because investments of production & growth improve the quality of life & without them the standard of living falls. Tax cuts can cause a decrease in the quality of life because there's less money to invest. This causing an increase in interest rates.

What does the U-rate really Measure?

The u-rate is not a perfect indicator of joblessness or the health of the labor market: It excludes discouraged workers. It does not distinguish between full-time and part-time work, or people working part time because full-time jobs not available. Some people misreport their work status in the BLS survey. Despite these issues, the u-rate is still a very useful barometer of the labor market & economy. Movements into and out of the labor force are, in fact, common. More than one-third of the unemployed are recent entrants into the labor force. These entrants include young workers looking for their first jobs. They also include, in greater numbers, older workers who had previously left the labor force but have now returned to look for work. Moreover, not all unemployment ends with the job seeker finding a job. Almost half of all spells of unemployment end when the unemployed person leaves the labor force. Because people move into and out of the labor force so often, statistics on unemployment are difficult to interpret.

Summary

The unemployment rate is the percentage of those who would like to work who do not have jobs. Unemployment and labor force participation vary widely across demographic groups. The natural rate of unemployment is the normal rate of unemployment around which the actual rate fluctuates. Cyclical unemployment is the deviation of unemployment from its natural rate and is connected to short-term economic fluctuations. The natural rate includes frictional unemployment and structural unemployment. Frictional unemployment occurs when workers take time to search for the right jobs. Structural unemployment occurs when above-equilibrium wages result in a surplus of labor. Three reasons for above-equilibrium wages include minimum wage laws, unions, and efficiency wages.

Other info

The value of a stock to a stockholder is what she gets out of owning it, which includes the present value of the stream of dividend payments and the final sale price. Recall that dividends are the cash payments that a company makes to its shareholders. A company's ability to pay dividends, as well as the value of the stock when the stockholder sells her shares, depends on the company's ability to earn profits. Its profitability, in turn, depends on a large number of factors: the demand for its product, the amount and kinds of capital it has in place, the degree of competition it confronts, the extent of unionization of its workers, the loyalty of its customers, the government regulations and taxes it faces, and so on. If you want to rely on fundamental analysis to pick a stock portfolio, there are three ways to do it. One way is to do all the necessary research yourself by, for instance, reading through companies' annual reports. A second way is to rely on the advice of Wall Street analysts. A third way is to buy shares in a mutual fund, which has a manager who conducts fundamental analysis and makes decisions for you.

Where does the word economy come from?

The word economy comes from the Greek word oikonomos, which means "one who manages a household." Odd but in fact, households & economies have much in common.

Summary 5

There are great differences across countries in living standards and growth rates. Productivity (output per unit of labor) is the main determinant of living standards in the long run. Productivity depends on physical and human capital per worker, natural resources per worker, and technological knowledge. Growth in these factors—especially technological progress—causes growth in living standards over the long run. Policies can affect the following, each of which has important effects on growth: Saving and investment • International trade • Education, health & nutrition • Property rights and political stability • Research and development • Population growth Because of diminishing returns to capital, growth from investment eventually slows down, and poor countries may "catch up" to rich ones. (5)

Summary Why the AD Curve Slopes Downward

There are three distinct but related reasons a fall in the price level increases the quantity of goods and services demanded: 1. Consumers become wealthier, stimulating the demand for consumption goods. 2. Interest rates fall, stimulating the demand for investment goods. 3. The currency depreciates, stimulating the demand for net exports. The same three effects work in reverse: When the price level rises, decreased wealth depresses consumer spending, higher interest rates depress investment spending, & a currency appreciation depresses net exports. The fall in the price level leads to an increase in the quantity of g's & s's demanded. This relationship is what the downward slope of the aggregate-demand curve represents. Keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding "other things equal." In particular, our three explanations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. We've been considering how a change in the price level affects the demand for g's & s's, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of the money supply.

Cyclical Unemployment vs the natural rate

There's always some unemployment, though the u-rate fluctuates from year to year. Natural rate of unemployment-the normal rate of unemployment around which the actual unemployment rate fluctuates. Cyclical unemployment-the deviation of unemployment from its natural rate. associated with business cycles, which we'll study in later chapters.

Gross Domestic Income

Therefore, in addition to adding up total expenditure in the economy to calculate GDP, the government also adds up total income in the economy to arrive at gross domestic income (GDI). GDP & GDI give almost exactly the same number. (Why "almost"? The two measures should be precisely the same, but data sources aren't perfect. The difference between GDP & GDI is called the statistical discrepancy.)

CONCLUSION & Summary

This chapter has introduced some of the basic tools people use when they make financial decisions. The efficient markets hypothesis teaches that a stock price should reflect the company's expected future profitability. Fluctuations in the stock market have important macroeconomic implications, which we will study later in this course. The present value of any future sum is the amount that would be needed today, given prevailing interest rates, to produce that future sum. Because of diminishing marginal utility of wealth, most people are risk-averse. Risk-averse people can manage risk with insurance, through diversification, & by choosing a portfolio with a lower risk & lower return. The value of an asset equals the present value of all payments its owner will receive. For a share of stock, these payments include dividends plus the final sale price. According to the efficient markets hypothesis, financial markets are informationally efficient, a stock price always equals the market's best guess of the firm's value, & stock prices follow a random walk as new info becomes available. Some economists question the efficient markets hypothesis, & believe that irrational psychological factors also influence asset prices.

Conclusion

This chapter has introduced the model of aggregate demand and aggregate supply, which helps explain economic fluctuations. Keep in mind: these fluctuations are deviations from the long-run trends explained by the models we learned in previous chapters. In the next chapter, we will learn how policymakers can affect aggregate demand with fiscal and monetary policy.

Another PC Shifter: Supply Shocks

This time, the change in focus came not from two American economics professors but from a group of Arab sheiks. In 1974, the Organization of Petroleum Exporting Countries (OPEC) began to exert its market power as a cartel in the world oil market to increase its members' profits. The countries of OPEC, including Saudi Arabia, Kuwait, & Iraq, restricted the amount of crude oil they pumped & sold on world markets. Within a few yrs, this reduction in supply caused the world price of oil to almost double. A large increase in the world price of oil is an example of a supply shock. For example, when an oil price increase raises the cost of producing gasoline, heating oil, tires, & many other products, it reduces the quantity of g's & s's supplied at any given price level. In summary-Supply shock: an event that directly alters firms' costs and prices, shifting the AS and PC curves. Example: large increase in oil prices.

The Utility Function

This utility function shows how utility, a subjective measure of satisfaction, depends on wealth. As wealth rises, the utility function becomes flatter, reflecting the property of diminishing marginal utility. The more wealth a person has, the less utility she gets from an additional dollar.

Present Value: The Time Value of Money

To compare sums from different times, we use the concept of present value. The present value of a future sum: the amount that would be needed today to yield that future sum at prevailing interest rates. Related concept: The future value of a sum: the amount the sum will be worth at a given future date, when allowed to earn interest at the prevailing rate.

Investment from Abroad

To raise K/L and hence productivity, wages, and living standards, the govt can also encourage foreign direct investment: a capital investment (e.g., a factory) that is owned & operated by a foreign entity. foreign portfolio investment: a capital investment financed with foreign money but operated by domestic residents. Some of the returns from these investments flow back to the foreign countries that supplied the funds. Especially beneficial in poor countries that cannot generate enough saving to fund investment projects themselves. Also helps poor countries learn state-of-the-art technologies developed in other countries. For these reasons, many economists who advise governments in less developed economies advocate policies that encourage investment from abroad. Often, this means removing restrictions that governments have imposed on foreign ownership of domestic capital. An organization that tries to encourage the flow of capital to poor countries is the World Bank. This international organization obtains funds from the world's advanced countries, such as the United States, and uses these resources to make loans to less developed countries so that they can invest in roads, sewer systems, schools, and other types of capital.

The sacrifice ratio

To reduce the inflation rate, the Fed has to pursue contractionary monetary policy. When the Fed slows growth in the money supply, it contracts aggregate demand. The fall in aggregate demand, in turn, reduces the quantity of g's & s's that firms produce, and this fall in production leads to a rise in unemployment. Over time, as people come to understand that prices are rising more slowly, expected inflation falls, and the short-run Phillips curve shifts downward. Thus, if a nation wants to reduce inflation, it must endure a period of high unemployment and low output. The size of this cost depends on the slope of the Phillips curve and how quickly expectations of inflation adjust to the new monetary policy. Many studies have examined the data on inflation and unemployment to estimate the cost of reducing inflation. A typical estimate of the sacrifice ratio is 5. That is, for each percentage point that inflation is reduced, 5% of annual output must be sacrificed in the transition. Such estimates surely must have made Paul Volcker apprehensive as he confronted the task of reducing inflation. Inflation was running at almost 10% per year. To reach moderate inflation of, say, 4% per year would mean reducing inflation by percentage points. If each 6 percentage point costs 5% of the economy's annual output, then reducing inflation by 6 percentage points would require sacrificing 30% of annual output. According to studies of the Phillips curve and the cost of disinflation, this sacrifice could be paid in various ways. An immediate reduction in inflation would depress output by 30% for a single year, but that outcome was surely too harsh even for an inflation hawk like Paul Volcker. It would be better, many argued, to spread out the cost over several years. If the reduction in inflation took place over five years, for instance, then output would have to average only 6% below trend during that period to add up to a sacrifice of 30%. An even more gradual approach would be to reduce inflation slowly over a decade so that output would have to be only 3% below trend.

The principles of interactions among people are:

Trade can be mutually beneficial. • Markets are usually a good way of coordinating trade. • Govt can potentially improve market outcomes if there is a market failure or if the market outcome is inequitable.

The Tradeoff Between Risk and Return

Tradeoff: Riskier assets pay a higher return, on average, to compensate for the extra risk of holding them. E.g., over the past 200 years, average real return on stocks, 8%. On short-term govt bonds, 3%. Example: Suppose you are dividing your portfolio between two asset classes. A diversified group of risky stocks: average return = 8%, standard dev. = 20% A safe asset: return = 3%, standard dev. = 0% The safe alternative can be either a bank savings account or a govt bond. The risk & return on the portfolio depends on the percentage of each asset class in the portfolio... Normal random variable stays within 2 standards of deviation of its average about 95% of the time. When people increase the percentage of their savings that they have invested in stocks, they increase the average return they can expect to earn, but they also increase the risks they face.

Unemployment insurance

Unemployment insurance (UI): a govt program that partially protects workers' incomes when they become unemployed. UI increases frictional unemployment. To see why, recall one of the Ten Principles of Economics: People respond to incentives. UI benefits end when a worker takes a job, so workers have less incentive to search or take jobs while eligible to receive benefits. Benefits of UI: Reduces uncertainty over incomes. Gives the unemployed more time to search, resulting in better job matches and thus higher productivity.

Unions

Union: a worker association that bargains with employers over wages, benefits, and working conditions. Unions exert their market power to negotiate higher wages for workers. The typical union worker earns 20% higher wages and gets more benefits than a nonunion worker for the same type of work. When unions raise the wage above eq'm, (raising quantity of labor supplied) quantity of labor demanded falls and unemployment results. "Insiders" - workers who remain employed, are better off. "Outsiders" - workers who lose their jobs, are worse off. Some outsiders go to non-unionized labor markets, which increases labor supply and reduces wages in those markets. Some remain unemployed & wait for the chance to become insiders & earn the high union wage. Are unions good or bad? Economists disagree. Critics: Unions are cartels. They raise wages above eq'm, which causes unemployment and/or depresses wages in non-union labor markets. When unions raise wages above the level that would prevail in competitive markets, they reduce the quantity of labor demanded, cause some workers to be unemployed, and reduce the wages in the rest of the economy. The resulting allocation of labor, critics argue, is both inefficient & inequitable. It's inefficient because high union wages reduce employment in unionized firms below the efficient, competitive level. It's inequitable because some workers benefit at the expense of other workers. Advocates: Unions counter the market power of large firms, make firms more responsive to workers' concerns. Advocates contend that unions are a necessary antidote to the market power of the firms that hire workers. The extreme case of this market power is the "company town," where a single firm does most of the hiring in a geographical region. In a company town, if workers do not accept the wages and working conditions that the firm offers, they've little choice but to move or stop working. Claim that unions are important for helping firms respond efficiently to workers' concerns. Whenever a worker takes a job, the worker and the firm must agree on many attributes of the job in addition to the wage: hours of work, overtime, vacations, sick leave, health benefits, promotion schedules, job security, & so on. By representing workers' views on these issues, unions help firms provide the right mix of job attributes. Even if unions have the adverse effect of pushing wages above the equilibrium level & causing unemployment, they have the benefit of helping firms keep a happy & productive workforce. In the 1940s & 1950s, when union membership in the US was at its peak, about 33% of the U.S. labor force was unionized. Today less than 11% of U.S. workers belong to unions. In many European countries, however, unions continue to play a large role. In Belgium, Norway, & Sweden, more than 50% of workers belong to unions. In France, Italy, & Germany, a majority of workers have wages set by collective bargaining by law, even though only some of these workers are themselves union members. In these cases, wages aren't determined by the equilibrium of supply & demand in competitive labor markets.

Active Learning 2 Computing the GDP

Use the above data to solve these problems: A. Compute Nominal GDP in 2011- $30 x 900+$100 x 192=$46,200 B. Compute Real GDP in 2012- $30 x 1000+$100 x 200=$50,000 C. Compute the GDP deflator in 2013- Nominal GDP=$36 x 1050 + $100 x 205= $58,300 Real GDP=$30 x 1050 + $100 x 205= $52,000 GDP Deflator= 100 x ($58,300/$52,00)=112.1

Active Learning 2

Use the loanable funds model to analyze the effects of a govt budget deficit: Draw the diagram showing the initial equilibrium. Determine which curve shifts when the govt runs a budget deficit. Draw the new curve on your diagram. What happens to the equilibrium values of the interest rate & investment?

Active Learning 1 Part B

Use the numbers from the preceding exercise, but suppose now that the govt cuts taxes by $200 billion. In each of the following two scenarios, determine what happens to public saving, private saving, national saving, & investment. 1. Consumers save the full proceeds of the tax cut. If consumers save the full $200 billon, national saving is unchanged, so investment is unchanged. 2. Consumers save 1/4 of the tax cut & spend the other 3/4. If consumers save $50 billion & spend $150 billion, then national saving & investment each fall by $150 billion.

Active Learning 3

Valuing a share of stockIf you buy a share of AT&T stock today, you will be able to sell it in 3 years for $30. you will receive a $1 dividend at the end of each of those 3 years.If the prevailing interest rate is 10%, what is the value of a share of AT&T stock today?

Saving & Investment

We can boost productivity by increasing K, which requires investment. ▪ Since resources scarce, producing more capital requires producing fewer consumption goods. ▪ Reducing consumption = increasing saving. This extra saving funds the production of investment goods. ▪ Hence, a tradeoff between current and future consumption. Encouraging saving and investment is one way that a government can encourage growth &, in the long run, raise an economy's standard of living.

Measuring Risk

We can measure risk of an asset with the standard deviation, a statistic that measures a variable's volatility—how likely it is to fluctuate. The higher the standard deviation of the asset's return, the greater the risk.

Active Learning The aggregate-demand curve

What happens to the AD curve in each of the following scenarios? A. A ten-year-old investment tax credit expires. B. The U.S. exchange rate falls. C. A fall in prices increases the real value of consumers' wealth. D. State governments replace their sales taxes with new taxes on interest, dividends, and capital gains.

The consumer price index (CPI) & how is it calculated?

What it is measures the typical consumer's cost of living. the basis of cost of living adjustments (COLAs) in many contracts & in Social Security. a measure of the overall cost of the g&s's bought by a typical consumer How is it calculated? 1.Fix the "basket." The Bureau of Labor Statistics (BLS) surveys consumers to determine what's in the typical consumer's "shopping basket." 2. Find the prices. The BLS collects data on the prices of all the goods in the basket. 3. Compute the basket's cost. Use the prices to compute the total cost of the basket. 4. Choose a base year & compute the index. The CPI in any year equals 100 x cost of basket in current year/cost of basket in base year. 5. Compute the inflation rate. The percentage change in the CPI from the preceding period. Inflation rate=CPI this year - CPI last year/CPI last year x 100%.

Different scenarios with inflation and deflation

When Sara made her deposit, a ticket cost $10 . Her deposit of $1,000 was equivalent to 100 tickets. A year later, after getting her 10% interest, she has $1,100 . How many tickets can she buy now? Scenarios of different levels of inflation 0% inflation: If the price of a ticket remains at $10, the amount she can buy has risen from 100 to 110 tickets. The 10% increase in the number of dollars means a percent increase in her purchasing power. 6% inflation: If the price of a ticket rises from $10 to $10.60 , then the number of tickets she can buy has risen from 100 to approximately 104. Her purchasing power has increased by about 4%. 10% inflation:If the price of a ticket rises from $10 to $11, she can still buy only 100 tickets. Even though Sara's dollar wealth has risen, her purchasing power is the same as it was a year earlier. 12% inflation:If the price of a ticket increases from $10 to $11.20, the number of tickets she can buy has fallen from 100 to approximately 98. Even with her greater number of dollars, her purchasing power has decreased by about 2%. And if Sara were living in an economy with deflation—negative inflation or, more simply, falling prices—another possibility could arise: 2% deflation: If the price of a ticket fall from $10 to $9.80, then the number of tickets she can buy rises form 100 to approximately 112. Her purchasing power increases by about 12%. These examples show that the higher the rate of inflation, the smaller the increase in Sara's purchasing power. If the rate of inflation exceeds the rate of interest, her purchasing power actually falls. And if there is deflation, her purchasing power rises by more than the rate of interest.

What's in the CPI's Basket?

When constructing the consumer price index, the Bureau of Labor Statistics tries to include all the goods and services that the typical consumer buys. Moreover, it tries to weight these goods and services according to how much consumers buy of each item. The Bureau of Labor Statistics calls each percentage the "relative importance" of the category.

Asset Valuation

When deciding whether to buy a company's stock, you compare the price of the shares to the value of the company. If share price > value, the stock is overvalued. If price < value, the stock is undervalued. If price = value, the stock is fairly valued. Value of a share = PV of any dividends the stock will pay. + PV of the price you get when you sell the share. Problem: When you buy the share, you don't know what future dividends or prices will be. One way to value a stock: fundamental analysis, the study of a company's accounting statements & future prospects to determine its value. Undervalued stocks are a bargain because you pay less than the business is worth.

Active Learning 3

Which of the following would be most likely to reduce frictional unemployment? A. The govt eliminates the minimum wage. B. The govt increases unemployment insurance benefits. C. A new law bans labor unions. D. More workers post their resumes at LinkedIn.com, and more employers use LinkedIn.com to find suitable workers to hire. E. Sectoral shifts become more frequent.

Identifying positive vs. normative

Which of these statements are "positive" and which are "normative"? How can you tell the difference? a. Prices rise when the government increases the quantity of money. b. The government should print less money. c. A tax cut is needed to stimulate the economy. d. An increase in the price of burritos will cause an increase in consumer demand for music downloads. a. Prices rise when the government increases the quantity of money. Positive - describes a relationship, could use data to confirm or refute. b. The government should print less money. Normative - this is a value judgment, cannot be confirmed or refuted. c. A tax cut is needed to stimulate the economy. Normative - another value judgment. d. An increase in the price of burritos will cause an increase in consumer demand for music downloads. Positive - describes a relationship. Note that a statement need not be true to be positive.

Summary Why the Aggregate-Demand Curve Might Shift

Why Does the Aggregate-Demand Curve Slope Downward?-The Wealth Effect: A lower price level increases real wealth, stimulating spending on consumption. The Interest-Rate Effect: A lower price level reduces the interest rate, stimulating spending on investment. The Exchange-Rate Effect: A lower price level causes the real exchange rate to depreciate, stimulating spending on net exports. Why Might the Aggregate-Demand Curve Shift?-Shifts Arising from Changes in Consumption: An event that causes consumers to spend more at a given price level (a tax cut, a stock market boom) shifts the aggregate-demand curve to the right. An event that causes consumers to spend less at a given price level (a tax hike, a stock market decline) shifts the aggregate-demand curve to the left. (Any event that changes how much people want to consume at a given price level shifts the aggregate-demand curve. One policy variable that has this effect is the level of taxation.) Shifts Arising from Changes in Investment: An event that causes firms to invest more at a given price level (optimism about the future, a fall in interest rates due to an increase in the money supply) shifts the aggregate-demand curve to the right. An event that causes firms to invest less at a given price level (pessimism about the future, a rise in interest rates due to a decrease in the money supply) shifts the aggregate-demand curve to the left. (Another policy variable that can influence investment and aggregate demand is the money supply. Tax policy can also influence aggregate demand through investment. Any event that changes how much firms want to invest at a given price level also shifts the aggregate-demand curve.) Shifts Arising from Changes in Government Purchases: An increase in govt purchases of g's & s's (greater spending on defense or highway construction) shifts the aggregate-demand curve to the right. A decrease in government purchases on goods and services (a cutback in defense or highway spending) shifts the aggregate-demand curve to the left. (The most direct way that policymakers shift the aggregate-demand curve is through govt purchases.) Shifts Arising from Changes in Net Exports: An event that raises spending on net exports at a given price level (a boom overseas, speculation that causes a currency depreciation) shifts the aggregate-demand curve to the right. An event that reduces spending on net exports at a given price level (a recession overseas, speculation that causes a currency appreciation) shifts the aggregate-demand curve to the left. (Any event that changes net exports for a given price level also shifts aggregate demand. Net exports can also change because international speculators cause movements in the exchange rate.)

The Short-Run Aggregate-Supply Curve: Summary

Why Does the Short-Run Aggregate-Supply Curve Slope Upward?-1.The Sticky-Wage Theory: An unexpectedly low price level raises the real wage, causing firms to hire fewer workers and produce a smaller quantity of g's & s's. 2. The Sticky-Price Theory: An unexpectedly low price level leaves some firms with higher-than-desired prices, depressing their sales and leading them to cut back production. 3. The Misperceptions Theory: An unexpectedly low price level leads some suppliers to think their relative prices have fallen, inducing a fall in production. Why Might the Short-Run Aggregate-Supply Curve Shift?-1.Shifts Arising from Changes in Labor: An increase in the quantity of labor available (perhaps due to a fall in the natural rate of unemployment) shifts the aggregate-supply curve to the right. A decrease in the quantity of labor available (perhaps due to a rise in the natural rate of unemployment) shifts the aggregate-supply curve to the left. 2. Shifts Arising from Changes in Capital: An increase in physical or human capital shifts the aggregate-supply curve to the right. A decrease in physical or human capital shifts the aggregate-supply curve to the left. 3. Shifts Arising from Changes in Natural Resources: An increase in the availability of natural resources shifts the aggregate-supply curve to the right. A decrease in the availability of natural resources shifts the aggregate-supply curve to the left. 4. Shifts Arising from Changes in Technology: An advance in technological knowledge shifts the aggregate-supply curve to the right. A decrease in the available technology (perhaps due to government regulation) shifts the aggregate-supply curve to the left. 5. Shifts Arising from Changes in the Expected Price Level: A decrease in the expected price level shifts the short-run aggregate-supply curve to the right. An increase in the expected price level shifts the short-run aggregate-supply curve to the left.

Economic Growth and the PPF

With additional resources or an improvement in technology, the economy can produce more computers, more wheat, or any combination in between.

Job search

Workers have different tastes & skills, and jobs have different requirements. Job search is the process of matching workers with appropriate jobs. Sectoral shifts are changes in the composition of demand across industries or regions of the country. Such shifts displace some workers, who must search for new jobs appropriate for their skills & tastes. The economy is always changing, so some frictional unemployment is inevitable. For example, in the U.S. economy from 2006 to 2016, employment fell by 980,000 in construction and 1.8 million in manufacturing. During the same period, employment rose by 706,000 in computer systems design, 2.1 million in food services, and 3.8 million in healthcare. This churning of the labor force is normal in a well-functioning and dynamic economy. Because workers tend to move toward those industries in which they are most valuable, the long-run result of the process is higher productivity and higher living standards. But along the way, workers in declining industries find themselves out of work and searching for new jobs. The result is some amount of frictional unemployment. Changing patterns of international trade are also a source of frictional unemployment. If all workers and all jobs were the same, so that all workers were equally well suited for all jobs, job search would not be a problem. Laid-off workers would quickly find new jobs that were well suited for them. Information about job candidates and job vacancies is disseminated slowly among the many firms and households in the economy.

Why the AD Curve Slopes Downward

Y=C+I+G+NX Assume G is fixed by govt policy. To understand the slope of AD, must determine how a change in P affects C, I, and NX. Recall that an economy's GDP (which we denote as Y) is the sum of its consumption (C), investment (I), govt purchases (G), and net exports (NX). To understand the downward slope of the aggregate-demand curve, we must examine how the price level affects the quantity of g's & s's demanded for consumption, investment, & net exports.

Why LRAS Is Vertical

YN determined by the economy's stocks of labor, capital, & natural resources, & on the level of technology. An increase in P doesn't affect any of these, so it doesn't affect YN. (Classical dichotomy) In the long run, an economy's production of g's & s's (its real GDP) depends on its supplies of labor, capital, & natural resources & on the available technology used to turn these factors of production into g's & s's. Because the price level doesn't affect the long-run determinants of real GDP, the long-run aggregate-supply curve is vertical. In other words, in the long run, the economy's labor, capital, natural resources, & technology determine the total quantity of g's & s's supplied, and this quantity supplied is the same regardless of the price level. As noted earlier, most economists believe this principle works well when studying the economy over a period of many years but not when studying year-to-year changes. Thus, the aggregate-supply curve is vertical only in the long run. The vertical long-run aggregate-supply curve is a graphical representation of the classical dichotomy & monetary neutrality. As we have already discussed, classical macroeconomic theory is based on the assumption that real variables don't depend on nominal variables. The long-run aggregate-supply curve is consistent with this idea because it implies that the quantity of output (a real variable) doesn't depend on the level of prices (a nominal variable).

Applying the principles

You are selling your 1996 Mustang. You have already spent $1000 on repairs. At the last minute, the transmission dies. You can pay $600 to have it repaired, or sell the car "as is." In each of the following scenarios, should you have the transmission repaired? Explain. A. Blue book value (what you could get for the car) is $6500 if transmission works, $5700 if it doesn't B. Blue book value is $6000 if transmission works, $5500 if it doesn't. Answers Cost of fixing transmission = $600 A. Blue book value is $6500 if transmission works, $5700 if it doesn't Benefit of fixing transmission = $800 ($6500 - 5700). Get the transmission fixed. B. Blue book value is $6000 if transmission works, $5500 if it doesn't Benefit of fixing the transmission is only $500. Do not pay $600 to fix it Observations ▪ The $1000 you previously spent on repairs is irrelevant. What matters is the cost and benefit of the marginal repair (the transmission). ▪ The change in incentives from scenario A to scenario B caused your decision to change.

business cycle

fluctuations in economic activity, such as employment and production

Government Purchases (G)

is all spending on the g&s purchased by govt at the federal, state, & local levels. Includes the salaries of govt workers as well as expenditures on public works. Recently, the U.S. national income accounts have switched to the longer label government consumption expenditure & gross investment, but here we'll use the traditional & shorter term government purchases. Example: When the govt pays the salary of an Army general or a schoolteacher, that salary is included in govt purchases. G excludes transfer payments, such as Social Security or unemployment insurance benefits. (To avoid double counting because they already were counted in consumption). They aren't purchases of g&s. Not made in exchange for a currently produced good or service. They alter household income, but they don't reflect the economy's production. From a macroeconomic standpoint, they're like negative taxes.

Economy

is just a group of people dealing with one another as they go about their lives.

Consumption (C)

is total spending by households on g&s. Note on housing costs: For renters, consumption includes rent payments. For homeowners, consumption includes the imputed rental value of the house, but not the purchase price or mortgage payments. For rental housing, this value is easy to calculate—the rent equals both the tenant's expenditure & the landlord's income. The govt includes this owner-occupied housing in GDP by estimating its rental value. GDP is based on the assumption that the owner is renting the house to herself. The imputed rent is included both in the homeowner's expenditure & in her income, so it adds to GDP.

Investment (I)

is total spending on goods that will be used in the future to produce more goods. includes spending on-capital equipment (e.g., machines, tools) structures (factories, office buildings, houses) inventories (goods produced but not yet sold) Note: "Investment" doesn't mean the purchase of financial assets like stocks & bonds.

The Typical Basket of Goods and Services (from the textbook)

largest category is housing, which makes up 42% of the typical consumer's budget. This category includes the cost of shelter ( 33%), fuel & utilities (5%), and household furnishings & operation (4%). The next largest category, at 17%, is transportation, which includes spending on cars, gasoline, buses, subways, & so on. The next largest category, at 14%, is food and beverages; this category includes food at home (7%), food away from home (6%), and alcoholic beverages ( 1%). Next are medical care at 9%, education and communication at 7%, and recreation at 6%. Apparel, which includes clothing, footwear, and jewelry, makes up 3% of the typical consumer's budget. 3% for other goods and services. A catchall for consumer purchases (such as cigarettes, haircuts, and funeral expenses) that don't naturally fit into the other categories.

Population Growth

may affect living standards in 3 different ways: 1. Stretching natural resources 200 years ago, Malthus argued that pop. growth would strain society's ability to provide for itself. Since then, the world population has increased sixfold. If Malthus was right, living standards would have fallen. Instead, they've risen. Malthus failed to account for technological progress and productivity growth. 2. Diluting the capital stock Bigger population = higher L = lower K/L= lower productivity & living standards. This applies to H as well as K: fast pop. growth = more children = greater strain on educational system. Countries with fast pop. growth tend to have lower educational attainment. To combat this, many developing countries use policy to control population growth. China's one child per family laws. Contraception education & availability Promote female literacy to raise opportunity cost of having babies 3. Promoting tech. progress More people = more scientists, inventors, engineers = more frequent discoveries = faster tech. progress & economic growth Evidence from Michael Kremer: Over the course of human history, growth rates increased as the world's population increased. more populated regions grew faster than less populated ones. Elaborated version Population Growth-Large population= more workers to produce g's & s's. Example- tremendous size of the Chinese population is 1 reason China is such an important player in the world economy. Large population=more people to consume those g's & s's. Large population=larger total output of g's & s's, it need not mean a higher standard of living for the typical citizen. Both large & small nations are found at all levels of economic development. Beyond these obvious effects of population size/growth interacts with the other factors of production in more subtle ways & are open to debate. Stretching Natural Resources-Thomas Robert Malthus (1766-1834), an English minister & early economic thinker, famous for his book called An Essay on the Principle of Population as It Affects the Future Improvement of Society. Offering what may be history's most chilling forecast. He argued an ever-increasing population would continually strain society's ability to provide for itself. Result being, mankind was doomed to forever live in poverty. His logic was simple. He began by noting that "food is necessary to the existence of man" & "the passion between the sexes is necessary & will remain nearly in its present state." He concluded "the power of population is infinitely greater than the power in the earth to produce subsistence for man." According to him, the only check on p.g was "misery & vice." Attempts by charities or govts to alleviate poverty were counterproductive, he argued, because they merely allowed the poor to have more children, placing even greater strains on society's productive capabilities. Maybe he was correct about the world at the time when he lived, but fortunately, his dire forecast was far off the mark. World population has increased about 6 fold over the past 2 centuries, but living standards around the world have significantly increased too. As a result of economic growth, chronic hunger & malnutrition are less common now than they were in Malthus's day. Modern famines occur from time to time but more often result from income inequality or political instability than from inadequate food production. Where did Malthus go wrong? Growth in human ingenuity has offset the effects of a larger population. Pesticides, fertilizers, mechanized farm equipment, new crop varieties, & other technological advances that Malthus never imagined have allowed each farmer to feed ever greater numbers of people. Even with more mouths to feed, fewer farmers are necessary because farmers are much more productive. Diluting the Capital Stock (H.P.G-High population growth) (P.G-Population Growth) (R.P.G-rapid population growth)-Whereas Malthus worried about the effects of population on the use of natural resources, some modern theories of economic growth emphasize its effects on capital accumulation. These theories state, h.p.g reduces GDP per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly. In other words, when p.g is rapid, each worker is equipped with less capital. Smaller quantity of capital per worker leads to lower productivity & lower GDP per worker.Problem is most apparent in the case of human capital. Countries with h.p.g have large numbers of school-age children. Placing a larger burden on the educational system. It isn't surprising, therefore, that educational attainment tends to be low in countries with h.p.g. Differences in p.g around the world are large. Developed countries, like the U.S & those in Western Europe, the population has risen only about 1%/year in recent decades & is expected to rise even more slowly in the future. Contrast, in many poor African countries, population grows at about 3%/year. Currently, the population doubles every 23 years. This r.p.g makes it harder to provide workers with the tools & skills needed to achieve high levels of productivity. R.p.g isn't the main reason less developed countries are poor, but some analysts believe reducing the rate of p.g would help these countries raise their standards of living. Some countries, this goal is done directly with laws regulating the number of children families may have. For example, from 1980-2015, China allowed only 1 child per family; violation of this rule resulted in substantial fines. In countries with greater freedom, the goal of reduced p.g is accomplished less directly by increasing awareness of birth control techniques. Another way in which a country can influence p.g is to apply one of the 10 Principles of Economics: People respond to incentives. Bearing a child, like any decision, has an opportunity cost. When the cost rises, people choose to have smaller families. Women with good educations & employment prospects tend to want fewer children vs those with fewer opportunities outside the home. So, policies fostering equal treatment of women are 1 way for less developed economies to reduce their rates of p.g & raise their standards of living. Promoting Tech Progress-R.p.g may depress economic prosperity by reducing the amount of capital each worker has, but it may also have some benefits. Some economists have suggested that world p.g has been an engine of tech progress & economic prosperity. Simple mechanism: More people= more scientists, inventors, & engineers to contribute to tech advance, which benefits everyone. Economist Michael Kremer provided some support for this hypothesis in an article titled "Population Growth & Technological Change: One Million b.c. to 1990," published in the Quarterly Journal of Economics in 1993. He began by noting that over the broad span of human history, world growth rates have increased with world population. Example, world growth was more rapid when the world population was 1 billion (around the year 1800) vs when the population was only 100 million (around 500 b.c.). This fact is consistent with the hypothesis that a larger population induces more tech progress. His 2nd piece of evidence comes from comparing regions of the world. The melting of the polar icecaps at the end of the Ice Age around 10,000 b.c. flooded the land bridges, separating the world into several distinct regions that couldn't communicate with one another for thousands of years. If tech progress is more rapid when there are more people to discover things, then the more populous regions should've experienced more rapid growth. According to him, that's exactly what happened. The most successful region of the world in 1500 (when Columbus reestablished contact) comprised the "Old World" civilizations of the large Eurasia-Africa region. Next in tech development were the Aztec & Mayan civilizations in the Americas, followed by the hunter-gatherers of Australia, & then the primitive people of Tasmania, who lacked even fire-making, most stone & bone tools. The smallest isolated region was Flinders Island, a tiny island between Tasmania & Australia. With the smallest population, Flinders Island had the fewest opportunities for tech advance &, indeed, seemed to regress. Around 3000 b.c., human society on Flinders Island died out completely. The larger population, Kremer concluded, the greater the potential for tech advance.

What does margin mean?

means "edge,"

marginal cost

the increase in total cost that arises from an extra unit of production

GDP Does Not Value:

the quality of the environment leisure time non-market activity, such as the child care a parent provides at home an equitable distribution of income

Summary 3

• Gross Domestic Product (GDP) measures a country's total income and expenditure. • The four spending components of GDP include: Consumption, Investment, Government Purchases, & Net Exports. • Nominal GDP is measured using current prices. Real GDP is measured using the prices of a constant base year & is corrected for inflation. • GDP is the main indicator of a country's economic well-being, even though it is not perfect. People face tradeoffs. • The cost of any action is measured in terms of foregone opportunities. • Rational people make decisions by comparing marginal costs & marginal benefits. • People respond to incentives. (3)

The principles of decision making are:

• People face tradeoffs. • The cost of any action is measured in terms of foregone opportunities. • Rational people make decisions by comparing marginal costs and marginal benefits. • People respond to incentives.

FYI: Who Studies Economics?

▪ Ronald Reagan, President of the United States ▪ Barbara Boxer, U.S. Senator ▪ Sandra Day-O'Connor, Former Supreme Court Justice ▪ Anthony Zinni, Former General, U.S. Marine Corps ▪ Kofi Annan, Former Secretary General, United Nations ▪ Meg Witman, Chief Executive Officer, eBay ▪ Steve Ballmer, Chief Executive Officer, Microsoft ▪ Arnold Schwarzenegger, Former Gov. of California, Actor ▪ Ben Stein, Political Speechwriter, Actor, Game Show Host ▪ Mick Jagger, Singer for the Rolling Stones ▪ John Elway, NFL Quarterback ▪ Tiger Woods, Golfer ▪ Diane von Furstenburg, Fashion Designer