Midterm 2

CPI

(Expenditures in the current year)/(Expenditures in the base year )×100 Economists believe the CPI overstates true inflation by 0.5 to 1 percentage point (an improvement over previous methods).

To calculate the CPI in a given year, we need:

- A basket of goods - The cost to purchase the basket of goods in a base year - The prices in the current year

Variables That Shift the Short-Run Aggregate Supply Curve

- An increase in nominal Wage causes SRAS to shift to the left - An increase in the cost of raw materials (crude oil, lumber) causes SRAS to shift to the left

Undesirable Consequences of expansionary fiscal and monetary policy during the current recession

- Crowding Out Effect: Increased borrowing by the govt will necessitate an increase in long term interest rates which will stifle investment and economic growth. - Increased borrowing will cause the share of debt held by foreigners to increase - The increase in money supply can cause the inflation rate to increase

The Short Run and Long Run Effects of an Increase in Money Supply

- In the short run, an increase in Money Supply causes the AD to shift to the right and results in an increase in real GDP. - The economy goes from A to B along SRAS1 because nominal wage (W) is fixed in the short run along the SRAS. - In the long run, workers will ask for higher nominal wages. W increases and the SRAS shifts to SRAS2. The economy reaches C and returns to the potential GDP in the long run. - The net result: in the long run an increase in the money supply of say 50% causes nominal wage and price to increase in the same proportion (50%) . Real wage and real GDP do not change. An increase in money supply does not affect real variables. It only causes inflation in the long run.

Factors that shift the LRAS also shift the SRAS. So:

- Increase in capital stock and Technological improvement will shift both LRAS and SRAS to the right. - Increases in the Labor Force will shift SRAS and LRAS to the right.

What happens if you leave the economy alone when it is in a recession? This is the recommendation of the Classical Model.

- Suppose that in a recession the Fed does not use expansionary monetary policy which consists of : ↓ interest rates, ↑ money supply - And suppose that in a recession the govt does not use expansionary fiscal policy which consists of ↑ G, ↑ Transfer Payments, ↓ Taxes - How will the economy fix itself? - Answer: The recession will cause workers to accept lower nominal wages (W ↓). The SRAS will shift to the right and the GDP will return to full employment equilibrium. See diagram in class. - The economy will fix itself, but it will take a long time as it id during the Great Depression (1929-1933). - Keynesians' critique: "In the long run we are all dead." (Keynes, General Theory, 1936)

How does the exchange rate make the AD shift?Depreciation of the dollar

- Suppose the dollar depreciates from $1 = 114 yen in 2007 to $1 = 100 yen in 2008. - Imports by the US will decrease. Consider this example. Let a Sony TV cost 22,800 yen. Its dollar price is 22,800/114 = $200 in 2007. But its dollar price in 2008 will be 22,800/100 = $228. So if the dollar depreciates and everything else stays the same, the dollar price of imports will go up and imports will decrease. - Exports by the US will increase because: A pound of Idaho potatoes priced at $1 per pound would cost 114 yen in 2007 but only 100 yen in 2008. - So when the dollar depreciates: exports by the US ↑ and imports by the US ↓. So Y will ↑.

stagflation

- supply shock of the 1970s - A combination of inflation and recession, usually resulting from a supply shock, typically a large unexpected increase in crude oil price.

Interest Rates

-A cut in interest rates by the FOMC (Federal Open Market Committee) increases expenditure and increases aggregate demand. Firms borrow more and invest (I) more. Households borrow more (use of credit with credit cards increases as interest rates are low) and increase consumption(C). The AD shifts right. Why? Because interest rates are not on the vertical axis. So this is a shift, not a movement along the AD Analogously, if interest rates are raised, spending by households and firms decreases (The Fed puts a brake on spending). AD shifts left.

Changes in Foreign Variables

If firms and households in other countries buy fewer U.S. goods or if firms and households in the United States buy more foreign goods, net exports will fall, and the aggregate demand curve will shift to the left. If real GDP in the United States increases faster than real GDP in other countries, imports by the US increase and exports from the US fall (net exports will fall do AD shifts left So a recession in Europe implies AD in the US shifts left. An increase in foreign income increases the demand for U.S. exports and increases aggregate demand.

Changes in the Expectations of Households and Firms

If households become more optimistic about their future incomes and firms become more optimistic about the future profitability of investment spending, the aggregate demand curve will shift to the right. Conversely, if they become more pessimistic, the aggregate demand curve will shift to the left. If households expect the inflation rate to increase, AD will shift to the right. If households expect the inflation rate to decrease (especially when there is a deflation and prices are falling): AD will shift to the left since households will postpone buying until price falls.

What makes AD shift?

1. Changes in Monetary policy - interest rate - money supply 2. Changes in Fiscal policy - G - Taxes - Transfer Payments 3. Changes in the expectations of households and firms - expectation of future profits by firms - expectation of future income by households - expectation of future inflation by households 4. Changes in foreign variables - foreign income - exchange rates

Real Wage

= [Nominal wage/CPI]*100

Aggregate demand (AD) curve

A curve that shows the relationship between the price level and the quantity of real GDP demanded by households, firms, and the government.

Short-run aggregate supply (SRAS) curve

A curve that shows the relationship in the short run between the price level and the quantity of real GDP supplied by firms.

AD is downward sloping

All three effects discussed above show higher price levels P leading to lower values of components of real GDP (Y) and vice versa. since Y = C+I+G+ (X-M), the real GDP (Y) falls when P rises. This establishes that the aggregate demand curve slopes downward since what caused the change was the change in P. This is a movement along the AD curve. It is not a shift of the AD since nothing else such as Govt purchases (G), Taxes, Transfer payments, money supply or interest rates changed.

Money Supply

An increase in the money supply by the Federal Reserve increases aggregate demand. -The Federal Reserve (Fed) increases the money supply by buying existing govt bonds and paying for it by writing a check against itself. If the Fed buys a govt bond worth $100 from you it writes a check of $100 against itself for you. This increases bank reserves and bank lending to households and firms. Spending by households and firm increases. AD shifts right. -Analogously, when the Fed decreases the money supply, bank reserves decrease. Bank lending decreases. Spending by firms and households decreases and AD to shifts to the left.

Three types of equilibrium

Below full employment: the AD and SRAS intersect to the left of the LRAS. This is called a recessionary gap or recession. This is a short run equilibrium. The economy will not stay here forever. If the economy is left alone, price of raw materials and nominal wages will fall causing the economy to return to full employment. Above full employment: the AD and SRAS intersect to the right of the LRAS. This is called an inflationary gap or , overheated economy. This is a short run equilibrium. The economy will not stay here forever. If the economy is left alone, price of raw materials and nominal wages will increase causing the economy to return to full employment. At full employment or long run equilibrium: the AD and SRAS intersects at the LRAS. Here the economy is at full employment.

Outlet bias

CPI used to only survey prices at traditional retail outlets. Now it tries to minimize this bias by surveying people about where they actually buy products.

Substitution bias

Consumers may change their purchasing habits away from goods that have increased in price.

Increase in quality bias

Difficult to separate improvement in quality from increase in price, say in cars or computers.

The exchange rate is not on the axis of the AD curve. So a fall in the exchange rate (depreciation of the dollar) will cause AD to shift to the right.

Dollar depreciates: so X ↑ and M ↓ - Y ↑ = C + I +G+(X ↑ -M ↓)

How should the Fed respond to an oil price shock?

During the first oil shock the Fed accommodated the increase in the price of oil by increasing the money supply as the price of oil increased. This caused AD to shift to the right as SRAS shifted to the left. Ultimately, the shifting of AD to the right worsened the inflation (which ended up at roughly 14%) caused by the increase in the price of oil. In contrast the Central Bank of Japan did nothing (did not increase the money supply in response to the oil shock) and inflation in Japan was much less. Since then the Fed 's policy has been to NOT accommodate an oil price shock: the Fed's policy is NOT to increase money supply when the price of oil increases.

Formula for CPI:

Example for the CPI for the year 2012, using 2007 as the market fixed basket or base year: Numerator: Take quantities of 2007 and multiply by prices of 2012 and then sum up for all items Denominator: Take quantities of 2007 and multiply by prices of 2007 and then sum up for all items CPI for 2012 = (Numerator/denominator)*100 Measuring Inflation: The main purpose of the CPI is to measure inflation.

What economic policy measures were taken to fight the recession that began in 2007.

Fiscal Policy : The Fiscal Stimulus Package of $831 billion enacted by the American Recovery and Reinvestment Act of 2009 G ↑ Taxes ↓ Transfer Payments ↑ Monetary Policy Interest Rates ↓ Money Supply ↑

The wealth effect: how a change in the price level affects consumption

Household consumption is most strongly determined by income, but it is also affected by wealth. Some household wealth is held in nominal assets; so as price levels rise, the real value of household wealth ( i.e., purchasing power) of declines. This results in less consumption. Implication: higher price level (P)leads to lower consumption (C) and therefore lower GDP (Y) and vice versa. Remember: Y = C+I+G+(X-M)

Short Run and Long Run effects of an increase in money supply

In the short run, GDP or Y ↑. In the long run, real wage does not change because nominal wage and price increase in the same proportion as the increase in money supply. In the long run GDP or Y does not increase and the only result of an increase in money supply is inflation.

What is held constant (or fixed) along the SRAS?

In the short run, nominal wage (W) is fixed or "sticky" by contracts The price of raw materials and natural resources (crude oil) is also fixed.

Shifts of the Short-Run Aggregate Supply Curve versus Movements along It

It is important to remember the difference between a shift in a curve and a movement along a curve. You move along the SRAS when P changes. P↑, Y ↑ and vice-versa P ↓, Y ↓

Real vs. Nominal interest rate

Nominal interest rate is the stated interest rate • Real interest rate is the true cost of borrowing from the borrower's point of view or the true gain from lending from the lender's point of view • Real interest rate = the nominal interest rate minus the inflation rate. • 6% = 8% - 2%

Classical model

Origins in Adam Smith's Wealth of Nations (1776). Leave the economy alone in a recession. There is no need for fiscal or monetary policy to fix the recession. The economy will fix itself with the "invisible hand."

Why does the Fed take the punch bowl away just when the party gets going?

Party: refers to an overheated economy i.e. above full employment. •When the economy is above full employment equilibrium, the AD and SRAS intersect to the right of the LRAS. •The Fed worries that the overheated economy will cause inflation will increase. •To avoid this probable onset of inflation, the Fed acts proactively and puts brakes on the economy by increasing the interest rates and decreasing spending. •This shifts the AD to the left, back to full employment equilibrium.

What Makes the LRAS shift? In other words, what makes potential GDP increase or decrease.

Potential GDP increases or LRAS shifts right when: The labor supply increases, i.e., number of workers increases (population increases or immigration) The quantity of physical capital (machinery and equipment) or human capital (knowledge) increases Technology advances

Fiscal policy is of 3 types: G, Taxes, Transfer Payments

Remember G? Because government purchase of goods and services (G) is one component of aggregate demand, an increase in G (defense expenditure) increases aggregate demand. AD shifts right. (ii). A tax cut increases households' disposable income which is aggregate income minus retained earnings of corporations minus income taxes plus transfer payments. An increase in disposable income increases consumption expenditure and increases aggregate demand. AD shifts right. (iii). An increase in transfer payments increases households' disposable income. An increase in disposable income increases consumption expenditure and increases aggregate demand. AD shifts right. NOTE: the reverse is also true. AD shifts left when: G decreases, taxes increase, or transfer payments decrease.

The Short-Run Aggregate Supply (SRAS) Curve is positively sloped or upward sloping. Why?

Remember: real wage = W/P, where nominal wage is W, and Price level is P. NOMINAL WAGE IS FIXED (STICKY) IN THE SHORT RUN When price level increases, the real wage (W/P) falls, and firms will demand more labor since workers became cheaper to hire. As the quantity demanded of labor increases, the GDP produced (Y) increases, making SRAS positively sloped Another way of explaining why the SRAS is positively sloped is based on Microeconomic theory of rising Marginal Cost (MC): since MC of production increases as quantity produced increases, firms will need a higher price to produce higher quantities (my grapefruit tree example in class!).

New product bias

The basket of goods used to change only every 10 years. (Now it updates every 2 years.) There is a delay to including new goods like cell phones.

Scott Fitzgerald's salary in 2019 dollars =

Scott Fitzgerald's salary in 1924 dollars *(CPI 2019/CPI 1924)

In the long run, prices (P) and nominal wages (W) are perfectly flexible (are not sticky)

So, if the price level (P)doubles, the nominal wage will also double. Real wage =(W/P) will be unchanged (or constant) at the level where there is full employment equilibrium in the labor market. So the long run implies that there is enough time for the labor market to adjust so that the labor demand = labor supply . This is full employment equilibrium.

Deflation is much more dangerous for an economy than inflation. Why?

Suppose you are considering buying a car. You know the car will be cheaper next year, so you delay purchasing. But if everyone does the same, then many purchases are postponed, firms stop producing, people become unemployed, etc. This can create a dangerous downward-spiral, delaying economic recovery. Economists believe this occurred after the Great Depression of the 1930s and also in Japan in the 1990s. There were concerns that significant periods of deflation might have followed the recession of 2007-2009, but fortunately that did not occur.

LRAS

The Long-run aggregate supply curve LRAS is vertical because of the assumptions of the classical model The LRAS shows the relationship in the long run between the price level and the quantity of real GDP supplied.

Shifts of the aggregate demand curve vs. movements along it

The aggregate demand curve shows the relationship between the price level and real GDP demanded, holding everything else constant. Remember: if price level (P) changes we move along the AD because price level is on the axis (The wealth effect, interest rate effect, and international trade effect: are each caused by a change in Price Level, P ). If anything else (i.e., anything other than Price) that influences demand changes, the AD will shift. The main influences on aggregate demand that cause AD to shift are

Changes in Exchange Rate

The world economy influences aggregate demand in also by the changes in the value of the dollar (exchange rate) A depreciation of the US dollar or fall in the dollar's value lowers the price of US exports (Boeings) to the Japanese in yen and therefore increases exports of the US to Japan (see class example). Remember: exports increase GDP. A depreciation of the US dollar decreases imports by US (Honda cars), and increases aggregate demand in the US. AD shifts right. See class example. Remember: imports are subtracted from GDP.

The international-trade effect: how a change in the price level affects net exports

When U.S. price levels (P) rise, U.S. exports (X) become more expensive and imports (M) become relatively cheaper. Fewer exports and more imports means net exports falls (X-M). Implication: higher price level P leads to lower net exports(X-M) and therefore lower GDP (Y). since Y = C+I+G+(X-M). .Note: the reverse is also true: when P falls, Y increases.

The Problem with Unanticipated Inflation

When people cannot predict the rate of inflation, they find it hard to make good borrowing and lending decisions. For example, in 1980 banks were charging 18 percent or more on home loans because the rate of inflation was very high. People who bought homes were locked into high rates even when inflation subsided. On the other hand, if banks lend money at a low rate and then high inflation takes place, the real interest rate they receive may be zero or negative; thus the risk of inflation makes banks wary of lending. Unpredictable inflation makes borrowing and lending risky.

The interest-rate effect: how a change in the price level affects investment

When prices (P) rise, households and firms need more money to finance buying and selling. This increase in demand for money causes the "price" of money (the interest rate) to rise, discouraging firm investment (I). Implication: higher price level (P) leads to lower investment (I) and therefore lower GDP (Y) and vice versa. Remember: Y = C+I+G+(X-M)

Deflation

When the inflation rate is negative, it is called a deflation • Since Real interest rate = the nominal interest rate minus the inflation rate. - If the inflation rate is -3%, then the real interest rate = 8% - (-3%) = 8% + 3% = 11%. - Real interest rate (11%) is greater than the nominal interest rate (8%) in a deflationary environment - Deflation Destroys the Debtor (borrower)

The Recession of 2007-2009

With the end of the economic expansion that had begun in November 2001, several factors combined to bring on the recession in December 2007: • The end of the housing bubble. A speculative bubble—the expectation of an asset increasing in value despite its underlying value—contributed to the rapidly rising housing prices between 2002 and 2005 before deflating in 2006, as both new home sales and existing home values began to decline. The growth of aggregate demand slowed as spending on residential construction fell more than 60 percent over the next four years. • The financial crisis. The financial crisis led to a "credit crunch" that made it difficult for many households and firms to obtain the loans they needed to finance their spending, which contributed to declines in consumption spending and investment spending. • The rapid increase in oil prices during 2008. Although rising oil prices can result in a supply shock that causes the short-run aggregate supply curve to shift to the left, it did not shift as far to the left during 2008 as it had from the increases in oil prices 30 years earlier because many firms had since switched to less oil-dependent production processes.

What happens to the AD when the dollar appreciates?

X ↓ M ↑ Y ↓ = C + I +G+(X ↓ -M ↑) So, when the dollar appreciates, if everything else stays the same, the AD shifts to the left in the US.

GDP

Y = C+ I +G+(X-M)

The Consumer Price Index

calculated every month by the Bureau of Labor Statistics Housing is the largest component. How much? 42% roughly Transportation and food and beverages are the next largest component. Roughly 15% each.

3 types of Macroeconomic Equilibrium

recession (recessionary gap) full employment inflationary gap (overheated economy)

Revenue of Titanic in 2019 dollars =

revenue of Titanic in 1997 dollars * (CPI 2019/CPI 1997)

Appreciation of the dollar:

the dollar goes up in value or in price and it will take more yen to buy a dollar 1978: $1 = 200 Yen 1980: $1 = 250 Yen This will cause US exports to decrease. Why? Because American Boeings will become more expensive in terms of yen since it will now require more yen to buy the dollar. US exports are priced in dollars so the Boeings are priced in dollars. Example: if a Boeing airplane costs $100 million, it will cost $100 million times 200 = 20,000 million yen in 1978. It will cost $100 million times 250 = 25,000 million yen in 1980. So Japanese have to pay more yen for the Boeing and they will buy less Boeing airplanes. US exports decrease US imports will increase since the Toyota car will cost less in dollar terms in the US since it is priced in Japan in Yen. A Toyota car that cost 2000,000 yen will cost 2,000,000 / 200 = $10,000 in the US in 1978. It will cost 2,000,000 / 250 = $8,000 in the US in 1980 Since Toyota cars become cheaper, Americans will import more Toyota cars

inflation rate

the percentage change in the price level from one year to the next = [(CPI this period - CPI prior period)/CPI prior period] * 100.

Suppose you have unanticipated fall in the inflation rate from 2% to 1%

• Initially when inflation was expected to be 2%: - Real interest rate was 6% = 8%-2% • Instead of 2% inflation suppose we end up with 1% inflation. - Then the real interest rate rises to 7% = 8%-1%. • Debtors (i.e., borrowers) lose during unanticipated fall in inflation because the nominal interest rate stays fixed for the duration of the contract (a year). - So the true cost from borrowing rises from 6% to 7% - Unanticipated fall in inflation hurts debtors (borrowers) and benefits lenders

Suppose you have unanticipated rise in the inflation rate from 2% to 5%

• Initially when inflation was expected to be 2%: - Real interest rate was 6% = 8%-2% • Instead of 2% inflation suppose we end up with 5% inflation. - Then the real interest rate falls to 3% = 8%-5%. • Lenders lose during unanticipated inflation because the nominal interest rate stays fixed for the duration of the contract (a year). - So the true gain from lending falls - Unanticipated rise inflation hurts lenders and benefits borrowers Since lenders will not want to lend in an inflationary climate, a rise in the inflation rate will lead to a decrease in the availability of loanable funds and this will stifle investment and economic growth