ECON 101 Final Exam

Discount Rate Lending and the Term Auction Facility

A lender of last resort loans money to banks and other financial institutions when no one else will. When all other institutions have run out of funds or fear to lend, banks and other financial institutions may still turn to the Fed. A discount rate is the interest rate banks pay when they borrow directly from the Fed. The Fed lends to banks by simply adding extra dollars to their accounts at the Fed These loans increase the monetary base directly, and indirectly they may encourage banks to lend more money, increasing M1 and M2. When banks pay back these loans, the monetary base shrinks once again. Discount window borrowing therefore tends to be used for short-run "tide-me-overs" rather than for long-run monetary policy decisions. Market traders read the discount rate as a signal of the Fed's attitude or stand, the Fed's willingness to allow the money supply to increase. When the Fed lowers the discount rate, the market reads this as signaling an expansionary monetary policy. The lower discount rate doesn't directly affect the monetary base unless banks actually borrow more from the Fed. Most banks are not borrowing form the discount window. If a bank is in good health, it will borrow most of its credit needs from other banks or financial institutions, not the Fed. The discount window is intended to help banks in financial stress when they cannot borrow from the private sector. If the bank starts borrowing a lot from the discount window, it usually receives a rapid but discreet inquiry from the Fed, asking what is wrong. The discount window makes private bank loans work more smoothly, even if it isn't being used. The possibility of financial troubles at a bank stem from the nature of fractional reserve banking. Loans are the main asset of fractional reserve banks, so the value of the bank depends on how willing and able borrowers are to repay their loans. A solvency crisis occurs when banks become insolvent: the value of a bank's loans falls so far that the bank can no longer pay back depositors. Capital: Banks are required to hold some of their assets in relatively safe forms in order to provide a protective cushion to shield depositors against potential losses. The goal of recapitalization is to get banks on their feet again and thus get them lending again.

Liquid Asset

A liquid asset is an asset that can be used for payments or, quickly and without loss of value, but converted into an asset that can be used for payments. The more liquid an asset, the more it can serve as money. Currency is usually the most liquid asset since currency can be spent almost everywhere. Checkable deposits and reserves are also very liquid, since they can also be spent easily and they can be turned into currency without loss. Money market mutual funds and time deposits are less liquid since it takes time and trouble to turn these assets into currency or checkable deposits. The money supply can be defined in different ways depending on exactly which kinds of liquid assets are included in the definition. The monetary base (MB): Currency and total reserves held at the Fed. M1: Currency plus checkable deposits M2: M1 plus savings deposits, money market mutual funds, and small time deposits. The Fed has direct control over the monetary base. But it's other components of the money supply--M1 and M2--that have the most significant effects on aggregate demand. The Fed can increase bank reserves, but if the banks aren't lending, the increase in the reserves won't do much to increase aggregate demand. The central bank tries to control MB to influence M1 and M2, but there are many other influences on M1 and M2 so each monetary aggregate can shrink or grow independently of others. The Fed ultimately wants to steer aggregate demand, but once again its steering is sometimes wobbly because, although M1 and M2 influence aggregate demand, there are also other influences.

Liquidity Crisis

A liquidity crisis occurs when banks are illiquid. A bank might have a lot of good assets, but there is a potential problem if all depositors want their money back at once. How do depositors know whether a bank's assets are good? Fear can turn solvent banks into illiquid banks very quickly. To avoid this, the FDIC was created. The FDIC guarantees that bank deposits up to 250,000 for each depositor name on an account (in practice, the guarantee is often even larger in value). The Federal Reserve can act as a lender of last resort to help banks meet their obligations. If the Fed knows a bank is insolvent, usually the best thing to do is pay off depositors and close down that bank before it can incur any further losses.

The Negative Shock Dilemma

A negative real shock shifts the long-run aggregate supply (LRAS) curve to the left, moving the equilibrium. A higher rate of price inflation and a lower growth rate for GDP. One approach is to focus on the inflation rate, by decreasing M. Most central bankers are more likely to believe that a central bank should respond to a negative real shock by increasing aggregate demand but that too has its problems. The Fed can increase aggregate demand by increasing the money growth rate, but now the economy is less productive than before, due to the real shock. As a result, the increase in M will not move the economy back to original, but most increases in M will show up in inflation rather than in real growth/ An increase in M may increase the growth rate a little, but the inflation rate increases by a lot and, higher inflation now can cause a serious problem later. If inflation gets too high, the fed has to reduce inflation, creating a lot of unemployment. Why does inflation happen at all? Real shocks are often accompanied by aggregate demand shocks. With a real shock, the central bank faces a dilemma: It must choose between too low a rate of growth (with a high rate of unemployment) and too high a rate of inflation.

Monetary Policy: The Best Case

A negative shock in aggregate demand. Suppose that the rate of growth of the monetary supply, M, FALLS. Entrepreneurs will wish to borrow less, banks will wish to lend less, and the growth rates of M1 and M2 will fall, causing a fall in aggregate demand. In terms of basic AD/AS, the AD curve shifts down and to the left The negative shock means that the growth rate f output will decline. The real rate of output can even turn negative, bringing the economy into a recession. Eventually the economy will recover. If the shift in M is permanent, wage growth will decline. Wages are often sticky, so this may take time and considerable unemployment before the economy adjusts to the decline in M If the Fed increases the rate of growth in the money supply, reducing interest rates and encouraging more bank lending and investor borrowing, then the AD curve shifts back up and to the right. The Fed is then able to push AD back to its original position. Instead of allowing the economy to adjust to a decrease in AD, which may require lower growth and higher unemployment, the Fed quickly restores AD to previous level.

Aggregate Demand Shocks and the Short-Run Aggregate Supply Curve

An aggregate demand shock is a rapid and unexpected shift in the AD curve. An aggregate demand shock is a rapid and unexpected shift in spending. Positive shocks to spending increase output at first, but in the long run only increases prices. An increase in spending (M + v) must increase the inflation rate or the real growth rate. In the long run, the real growth rate will be equal to the Solow rate, which is not influenced by the inflation rate, so in the long run an increase in spending will increase the inflation rate alone. The inflation rate does not necessarily increase immediately in direct proportion to an increase in spending. In the short run, an increase in spending will be split between increases in inflation and increases in real growth. The short-run aggregate supply (SRAS) curve is upward-sloping. An upward-sloping SRAS means that in the short run, an increase in aggregate demand will increase both the inflation rate and the growth rate, and a decrease in demand will decrease both the inflation rate and the growth rate. Long-run equilibrium, which means that the inflation rate consumers and firms are expecting must be equal to the actual inflation rate and that the real growth rate must be at the Solow level. The rate of inflation that workers and producers expect is written Epi Nominal wage confusion occurs when workers respond to their nominal wage instead of their real wage, that is, when workers respond to the wage number on their paychecks rather than to what their wage can buy in goods and services (the wage after correcting for inflation). Prices don't move instantly to new long-run equilibrium because it is costly to change prices. Menu costs are the costs of changing prices. These also include the cost of upsetting customers , meaning that businesses don't like changing prices . In the long run, unexpected inflation always turns into expected inflation and the SRAS shifts to the left. As expectations and prices adjust, more of the increase in M is reflected in the inflation rate and less in the real growth rate. An increase in M increases real growth in the short run, during the period which prices and wages are sticky. In the long run, people will always come to expect the actual inflation rate is found where the LRAS curve intersects the AD curve. In the long run, the economy must always be on the LRAS curve, thus the SRAS curve is always moving toward the point where the LRAS curve interesects with the new AD curve. In the long-run equilibrium, growth is equal to the Solow rate--intuition in the long run, money doesn't influence real growth but does influence the inflation rate. It takes time for a decrease in spending to make its way through the economy: wages are sticky, menu costs and uncertainty make businesses reluctant to change prices immediately, and expectations take time to adjust. In the short-run, a fall in spending growth is a split between a fall in inflation rates and a fall in growth. Prices and wages are especially sticky in the downward direction: prices rise like rockets and fall like feathers. A decrease in spending that requires expected wage growth to decrease will tend to create a large decrease in the growth rate.

The Federal Reserve's control of the money supply is incomplete and subject to uncertain lags.

An increase in the money supply typically affects the economy with a lag that can vary in time from 6 to 18 months. If the Fed increases the monetary base because banks aren't willing to lend, the larger monetary aggregates and thus aggregate demand won't increase very much in response. if banks slow to lend, then the Fed can easily undershoot, generating a small shift in AD and a smaller increase in the rate of economic growth than is desirable. A lerger stimulus is not necessarily better because if the economy recovers before the money supply works its magic, the Fed can easily end up overshooting is goal--producing a higher rate of inflation that is desirable.

Why Changes in v Tend to Be Temporary

As consumers cut back on spending, consumption that remains becomes even more important and consumers stop cutting back. Also, their savings increase and they become more reassured about spending. An increase in government spending G shifts the AD curve out. Eventually government spending cannot grow faster than the rate of economic growth. Changes in C, I, G, or NX tend to be temporary. Changes in C, I, G, or NX do not change the rate of inflation in the long run. Long run or sustained inflation requires ongoing increases in the money supply.

Real Shocks and the GD

Bank failures were one real shock of the GD. A fall in M reduced aggregate demand, which led to bank failures, which led to a reduction in the productivity of financial intermediation, a real shock. The real shock reduced growth even further. Shocks to AD and shocks to the LRAS curve are linked in most recessions. Usually the shock to AD creates a real shock, in other cases a real shock creates a shock to AD. FED failed to use increase M to increase AD. The Smoot-Hawley Tariff increased tariffs on many imported goods. In principle, a tariff can boost demand for domestic goods. But the decline in world trade meant that the net effect of the tariff was to reduce aggregate demand. A tariff is a negative productivity shock. A tariff pushes capital and labor into lower productivity sectors, reducing total output. The Dust Bowl was a natural, real shock.

Shocks to Components of Aggregate Demand

Changes in M can create AD shocks and so can changes in v. v means increasing or decreasing in spending rate, M is constant. The national spending identity (Y = C + I + G + NX) shows spending is spending on something, so if v increases, the growth rate of C, I, G, or NX must increase. An increase iin v must be apportioned by an increase in C, I, G, or NX

Open Market Operations and Interest Rates

Conducting monetary policy by buying and selling government bonds. When bond prices go up, that is another way of saying interest rates go down, and when bond prices go down, that means interest rates go up. Thus, when the Fed buys or sells bonds, it changes the monetary base and influences interest rates at the same time. When the Fed buys bonds, it increases the demand for bonds, which pushes up the price of bonds, lowering the interest rate. When the Fed buys bonds, it increases the demand of bonds, lowering the interest rate. Buying bonds stimulates the economy through two distinct mechanisms: higher money supplies with lower interest rates. Buying bonds stimulates the economy with higher money supplies and lower interest rates. The increase in the money supply increases the supply of loans and the lower interest rates increase the quantity of loans demanded. When the Fed sells bonds, the money supply is reduced as people give up their reserves to buy bonds. Selling bonds also lowers the price of bonds, which means that interest rates increase. An open market sale of bonds will slow the economy. Quantitative easing is when the Fed buys longer-term government bonds or other securities. This is used when the economy requires an extra boost, beyond what is available from normal open market operations on short-term securities.

Consumption

Consumption spending is private spending on final goods and services. Most consumption spending is made by households. Consumption spending includes spending on health care whether spending comes from your pocket, insurance, or the government. Economists think of education as an investment in "human capital," but by the BEA it is included as consumption spending along MP3s and TVs.

The Limits to Fiscal Policy

Crowding Out: If government spending crowds out or leads to less private spending, then the increase in AD is reduced or neutralized on net. A Drop in the Bucket: The economy is so large that government can rarely increase spending enough to have a large impact. A Matter of Timing: It can be difficult to time fiscal policy so that the AD curve shifts at just the right moments. The fourth limit is that even if fiscal policy shifts AD, that may not solve the problem. The best case for fiscal policy is when a recession is caused by a decrease in aggregate demand. Sometimes the problem is that people don't have enough to spend. Some recessions are caused by real shocks. Fiscal policy doesn't work well at combating real shocks. Real shocks: Shifting AD doesn't help much to combat real shocks.

Crowding Out

Crowding out is the decrease in private spending that occurs when government increases spending. Crowding out means that the initial shift in AD is less

Incentives and the Increase in Female Labor Force Participation

Cultural factors such as the rise of feminism and the growing acceptance of equality for women have increased labor force participation. Changes in the economy such as the move from a manufacturing to a service economy have brought more women to work. There are almost three times as many male semiskilled factory and machine operators as female operators, but there are more female lawyers, professors, accountants, etc than there are male. As service sector increased and manufacturing sector decreased, there was less demand for machine operators and more demand for professionals. This raised wages in sectors where females had a comparative advantage, drawing more females into the labor force.

The Supply of Savings

Determinants of the Supply of Savings: Smoothing consumption, impatience, marketing and psychological factors, and interest rates.

The Long-Run Aggregate Supply Curve

Every economy has a potential growth rate given fundamental, or real, factors of production such as capital, labor, and productivity. We call the rate of growth, as given by the real factors of production, the "Solow" growth rate. The Solow growth rate is an economy's potential growth rate, the rate of economic growth that would occur given flexible prices and the existing real factors of production. In the long run money is neutral. Thus, when we put the inflation rate on the vertical axis of a graph and real growth (the growth rate of real GDP) on the horizontal axis, the long-run aggregate supply curve is very simple--it's a vertical line at the Solow growth rate. The fundamental growth rate of the economy depends on factors such as the amount and quality of labor and capital, not on the rate of inflation.

Fiscal Policy: The Best Case

Fear of a recession causes a decline in consumption growth, C. With less spending, equivalently v falls. Fall in C shifts the AD curve to the left and down, equilibrium point now in a recession. In the long run, prices and wages become "unstuck," fear will pass, and C will return to its normal growth rate so the economy will transition until it is out of a recession. An increase in G can shift the AD curve to the right and up, putting the economy on a transition path out of the recession. An increase in G means that the government is spending more money, commanding more real resources. The money comes from taxes or increased borrowing, which will reduce AD for some quarters, making an increase in G less effective.

Dealing with Asset Price Bubbles

Few people expected that a fall in housing prices would wreak as much havoc as it did on financial intermediaries and the general economy. There was a quick drop in stock prices due to the tech bubble that ended with the recession of 2001. The Fed may have believed that trying to reduce unemployment was worth the risk of generating a bubble in asset prices. It's not always easy to identify when a bubble is present. If prices rise a lot and then fall, this does not mean a bubble was present. Monetary policy is a crude means of "popping" a bubble. Monetary policy can influence aggregate demand or target credit markets at the aggregate level, but it can't push the demand for housing down and keep demand for everything else up. Thus, popping a bubble means reducing GDP growth rate for the whole economy. In addition to monetary policy, the Fed does have the power to regulate banks and it could have restrained some of the "subprime" mortgages that were sold that later defaulted.

Fiscal Policy

Fiscal policy is a federal government policy on taxes, spending, and borrowing that is designed to influence business fluctuations. Two general categories of fiscal policy are used to fight a recession: 1. The government spends more money. 2. The government cuts taxes, giving the people more money to spend. The goal is more spending.

GDP per capita

GDP divided by population

Problems with GDP as a Measure of Output and Welfare

GDP measures the market value of final goods and services, but we do not know the market value of many goods and services. Illegally produced goods and services are left out. We don't know the market value of goods and services not on the market, like clean air.

A Shock to C

If consumers become more fearful of their economy, they may withold cash. A decrease in consumption purchases will temporarily reduce spending growth, C. A negative shock to AD (decrease in spending growth) shifts the AD curve inward and to the left, reducing the real growth rate in the short run. With lower spending growth, wage growth should fall to match the reduction in price growth, but because wages are sticky, especially in downward direction, wage growth remains high so firms are unprofitable, employment falls, and the economy slows.

Hyperinflation and the Breakdown of Financial Intermediation

If inflation is moderate and stable, lenders and borrowers can forecast reasonably well and loans can be signed with rough certainty regarding the real value of future payments. When inflation is unpredictable, long-term loans become riskier. The real problem of unexpected inflation is not simply that it redistributes wealth, but that few long-term contracts will be signed when borrowers and lenders both fear unexpected inflation or deflation that could redistribute wealth. Any contract involving future payments will be affected by inflation. This includes wage agreements. Unexpected inflation redistributes wealth throughout society in many ways. When inflation is high and volatile, unexpected inflation is difficult to avoid and society suffers as long-term contracting grinds to a halt.

Open Market Operations

If the Fed wants to create money, it can simply print money or add numbers to bank accounts. How does this new money find its way into the economy? Instead of directly buying and selling goods to stir or suppress economic growth, the Fed buys and sells government bonds, usually short-term bonds called Treasury bills or T-bills. Government bonds can be stored and shipped electronically and the market for government bonds is liquid and deep, which means that the Fed can easily buy and sell billions of dollars worth of government bonds in a matter of minutes. If the Fed wants to change the money supply, it usually does so by buying or selling government bonds. This is called an open market operation. To pay for the T-bills, the Fed electronically increases the reserves of the seller, usually a bank or a large dealer in treasury securities. With more reserves on hand, the bank will respond by increasing its loans beginning the ripple process just described. Banks will make additional loans, and loans will in turn be used to buy goods and pay wages, and people will deposit some of these payments into other banks. These new deposits will increase the reserves of these other banks, which will now also be able to make more loans. Thus, the purchase of bonds by the Federal REserve leads to a ripple process of increasing deposits, loans, and so on. The change in the money supply is equal to the change in reserves multiplied by the money multiplier The multiplier is not fixed and is the inverse of the reserve ratio and the reserve ratio is determined by banks. When banks are confident and eager to lend, they will keep reserves low so the money multiplier is large. When banks are fearful and reluctant to lend, that is, when they wish to hold a high level of reserves, the money multiplier will be low and a change in the monetary base need not change the broader monetary aggregates much at all. The Fed can increase or decrease reserves at banks by buying or selling government bonds. The increase in reserves boosts the money supply through a multiplier process. The size of the multiplier is not fixed but depends on how much of their assets the banks want to hold as reserves.

The Multiplier

In the best case scenario, an increase in G doesn't have to be as large as the fall in C to restore economic growth, because the latter should increase with the earlier. EX: When customers cut back on spending, the owners of where they spent their money have to cut back too. But, this can be offset when someone else begins to spend with a new job. The government takes on that position. An increase in G stimulates an increase in income and thus an increase in C. Since the increase in C multiplies the effect of expansionary fiscal policy on AD, this effect is called the multiplier effect.

Marketing and Psychological Factors

Individuals save more if saving is presented as the natural or default alternative Behavioral economics combines economics, psychology, and neurology to study how people make decisions and how they can be helped to overcome biases in decision making.

The Costs of Inflation

Inflation also causes wages to increase. Inflation tends to be more variable and thus more difficult to predict when the rate is high. High rates of inflation do cause problems, but volatile or uncertain inflation is even more costly.

The Federal Reserve must operate in real time when much of the data about the state of the economy is unknown.

It takes time for data to be gathered, as data are released on a monthly or quarterly basis. Sometimes data are amended, after the fact. Then, it takes time for data to be interpreted and for problems to be recognized.

The Fed Controls a Real Rate only in the Short Run

Lending and borrowing decisions depend on the real interest rate, the interest rate after inflation. The Fed has influence on real interest rates only in the short run. Money is neutral in the long run--that neutrality includes interest rates. An increase in aggregate demand (AD) increases the real growth rate only in the short run. The long-run neutrality of money, the long-run neutrality of AD, and the long-run neutrality of the Fed influence over real rates are all different sides of the same "coin" The Federal Funds rate is the overnight lending rate from one major bank to another. Monetary policy is usually conducted in terms of the Federal Funds rate. If the Fed wants to increase the Federal Funds rate, it will sell bonds until the Federal Funds rate increases by the desired amount. The Fed usually focuses on the Federal Funds rate because it is a convenient signal of monetary policy and reacts quickly. The broader methods of money supply, such as M1 and M2 are more difficult to measure and monitor because they require data from many different corners of the banking system.

The Fed as Manager of Market Confidence

Market confidence is one of the Fed's most powerful tools, namely its influence over expectations, not its influence over the money supply. One reason we see a lot of time bunching or clustering of investments is that it pays to coordinate your economic actions with those of others--you want to be investing, producing, and selling at the same time that others are investing, producing, or selling. Uncertainty can create a bandwagon effect. Uncertainty drives people away from investment spending and toward assets like cash. Holding cash isn't very productive but cash and other similar assets are what you want when you are in "wait and see" mode. An increase in the demand for cash is indicated by a decrease in v. At the same time, increased uncertainty will lead to a fall in M, as both borrowers and lenders will cut back, M1 and M2 will grow at lower rates. Both the v and the M changes work to shift the aggregate demand curve inward or to the left. The Fed can reduce the bandwagon effect and stabilize expectations toward a more positive outcome. Monetary policy is often about changing expectations and perceptions, rather than manipulating numbers and equations.

Rules vs. Discretion

Monetary policy tries to adjust for shocks to aggregate demand, but it is often debated whether these adjustments are effective in reducing volatility of output. A monetary rule works best only when v, monetary velocity, doesn't change rapidly. Mv = Pv A monetary rule says keep M constant, or growing constantly, but that means the Fed must ignore changes in v. v can fall rapidly as consumers and businesses cut back on spending and banks reduce lending. If M is constant and v falls, P must fall or Y must fall. Because prices are sticky, the usual outcome is that both P and Y fall, and a fall in Y means a recession. The nominal GDP rule says keep Mv constant (or growing at a constant rate). If Mv doesn't change or grows smoothly, then so does PY, which would be ideal. This would require to Fed to increase M by as much as it takes to keep nominal GDP growing at around the same % a year. A rule such as nominal GDP rule might help to stabilize expectations, especially in normal times. If a rule suggest the Fed must do things it has never done before, market participants may wonder whether the Fed will really or if it can follow the rule.

The U.S. Money Supplies

Money is a widely accepted means of payment. Cash is just paper bills and coins, which serve as a quick and efficient way of making small transactions. But, currency is not so useful for larger transactions, especially between businesses. The most important assets that serve as means of payment in the U.S... Currency -- paper bills and coins Total reserves held by banks at the Fed Checkable deposits -- your checking or debit account Savings deposits, money market mutual funds, and small-time deposits Many other countries use the U.S. dollar as their official currency, which is why U.S. cash exists. "Total reserves" held by banks at the Fed are important in the financial system. All major banks have accounts at the Federal Reserve System--accounts they use for trading with other major banks and for dealings with the Fed itself. Checkable deposits are deposits that you can write checks on or access with a debit card. Often these are also called demand deposits because you can access this money "on demand" The largest means of payment are savings accounts, money markeet mutual funds, and small-time deposits (certificates of deposits or CDs). Each of these components will be used to pay for goods and services, but typically with a little bit of extra work or trouble. A money market mutual fund is a mutual fund investe in relatively safe short-term debt and government securities. These typically allow you to write some number of checks per year or you can sell part of your fund and transfer the money to a checkable account. Small-time deposits cannot be withdrawn without penalty before a certain time period has elapsed, 6 months to a year.

More Shocks

Oil and rainfall shocks are only two among many economic shocks. Other shocks include wars, terrorist attacks, regulations, tax changes, strikes, and new technologies. Economies are continually hit by many small shocks. In a typical year, good shocks outweigh the bad and the economy grows.

The Federal Reserve and Systemic Risk

Open market operations, lending, and the payment of interest on reserves. The Fed can go beyond these tools to address problems with financial systems that extend beyond banks. It can be a lender of last resort to companies as well. Systemic risk is the risk that the failure of one financial institution can bring down other institutions as well. Preventing the spread of systemic risk is something the Fed does. Whenever the Fed dos this, it insulates some banks from the consequences of their decisions. A moral hazard occurs when banks and other financial institutions take on too much risk, hoping that the Fed and regulators will later bail them out. The general tendency has been for the Fed to become more active and to assume greater powers in the case of emergency and perhaps in normal times as well.

The Demand to Borrow

People borrow to smooth consumption. EX: Student borrowing The life cycle theory of saving says that income starts out low during the college years and in the early work years. To finance oneself, people borrow. Entering the prime working years, they save to pay off their debts. As they get older, consumption is once again above income as dissaving. Governments also borrow money for reasons much like consumers. Governments may borrow to finance unusually large expenditures such as those required to pay for war.

Price Confusion and Money Illusion

Prices are signals and inflation makes that difficult to interpret. Confusing a nominal signal with a real signal has consequences. Opportunities can be missed because signals have become obscured. Money illusion is when people mistake changes in nominal prices for changes in real prices. Inflation usually confuses consumers, workers, firms, and entrepreneurs. When price signals are difficult to interpret, the market economy doesn't work as well--resources are wasted, opportunities are not take, and resources flow more slowly.

Real Shocks

Real shocks are rapid changes in economic conditions that increase or diminish the productivity of capital and labor, which in turn influences GDP and employment.

Why This is Important

Savings are necessary for capital accumulation, and the more capital an economy can invest, the greater is GDP per capita. Connecting savers and borrowers increases gains from trade and smooths the process of economic growth

Who Controls the Fed?

Seven-member Board of Governors The Fed is a quasi private, quasi public institution. Each regional bank is a nonprofit bank with nine directors. The power of the Fed is dispersed, no single president appoints all governors and governors do not have complete control over the Fed policy. An independent Federal Reserve is defended by most economists as part of the U.S. checks and balances system

Final Goods and Services

Sold to final users and then consumed or held in personal inventories. These are counted in GDP. EX: The production and machinery used to produce other goods is also part of GDP. A tractor may help to produce soybeans, but the tractor is not part of the final product of soybeans.

Shifts in the Long-Run Aggregate Supply Curve

The AD and the Long-Run Aggregate Supply curve (LRAS) explain how business fluctuations can be caused by real shocks, a way of thinking about business fluctuations often called "real business cycle." The equilibrium inflation rate and growth rate are determined by the intersection of the AD and LRAS curves. One reason that growth rate fluctuates is that economies are continually being hit by shocks, which shift the Solow growth rate. Real shocks, also called productivity shocks, is any shock that increases or decreases the potential growth rate. They increase or decrease an economy's fundamental ability to produce goods and services and, thus, they increase or decrease the Solow growth rate. A positive real shock shifts the LRAS curve to the right, increasing real growth. The increase in the supply of goods brought by a higher real growth rate reduces the inflation rate. A negative real shock shifts the LRAS curve to the left, decreasing real growth. The slower growth rate means fewer new goods to spend money on so the inflation rate increases. Shocks to the LRAS curve will change the growth rate and the inflation rate temporarily because the LRAS curve is always shifting back and forth as new shocks hit the economy. Growth rates fluctuate from quarter to quarter, as positive shocks increase growth temporarily and negative shocks reduce growth temporarily. Solow growth rate could be higher or lower depending on growth in the fundamentals--capital, labor, ideas, and institutions--but every economy will always be subject to real shocks so growth will always fluctuate. This way of looking at booms and recessions--the real business cycle (RBC) model or perspective--is a natural extension of the Solow growth model. In the RBC model, business fluctuations are simply changes in economic growth in the short run divided by shocks.

Shifts in the AD Curve

The AD curve for a spending growth rate of X% is all the combinations of inflation and real growth that add up to X%. If spending growth increases to Y%, either because of an increase in M or increase in V, then the AD curve shifts up and to the right (outward). Increased spending must flow to either a higher inflation rate or a higher growth rate. An increase in spending growth shifts the AD curve outward, up and to the right. A decrease in spending shifts the AD curve inward. Increased spending growth shifts the AD curve outward and decreased spending growth shifts the AD curve inward.

Payment of Interest on Reserves

The Fed can vary the rate of interest that it pays banks on reserves held at the Fed. In previous times, banks received no interest payments on reserves. Banks wish to minimize those holdings because they brought no profit. Banks sometimes worked as cross-purpose with the ed in doing so, especially when the Fed wanted to make sure that the banking system had plenty of reserves on hand for payment purposes. Now the Fed is paying interest on those reserves, and the Fed consciously varies that interest rate to help achieve the goals of monetary policy.

Takeaway Fed Rules

The Fed has some influence over the growth rate of GDP through its influence over the money supply and thus AD. An increase in M increases AD and a decrease in M decreases AD. When faced with a negative shock to AD, the central bank can restore AD through an expansionary monetary policy. Monetary policy is subject to uncertainties. If in responding to a recession the Fed increase M too much it may find that it later has to contract M when inflation becomes too high. Disinflation is painful in a recession, goes best when central bank has some credibility A central bank would like low unemployment and inflation, but it is not always possible. When a negative shock comes, the Fed must choose between allowing low rates of growth, excessively high rates of inflation, or some combination of both. Monetary policy is difficult in the worst of times and it's not easy. The Fed has significant power. Sometimes the central bank itself contributes to busts. How to recognize and respond to asset price booms is not obvious. Real shocks and aggregate demand shocks are always mixed and not easy to disentangle. The data which central bankers operate are often slow to arrive and subject to revision.

Takeaway Fed

The Fed is the government's bank and the banker's bank, and it has the power to create money, regulate the money supply, and potentially lend trillions of dollars means that the Fed has significant power to influence aggregate demand The Fed controls the money supply by buying and selling government bonds in what are called open markets. By buying and selling bonds, the Fed changes bank reserves. A change in reserves changes the money supply through a multiplier process of rippling loans and deposits. The money multiplier changes over time, so the Fed's influence over AD is subject to uncertainty in impact and timing. When the government buys securities, the interest rate decreases and that stimulates consumption and investment borrowing. The government sells securities, the interest rate increases, thereby reducing borrowing for either consumption or investment. The Fed focuses its attention on the Federal Funds rate, the interest rate on overnight loans between major banks. The Fed has the most influence over real rates of interest in the short run. The Fed has little influence over long-run real rates of interest. The Fed serves as a "lender of last resort" for banks and for major financial institutions taht find themselves in trouble. Preventing "systemic risk" or the spread of financial problems from one institution to another is another one of it's jobs.

Revisiting AD and Monetary Policy

The Fed ultimately wants to use its tools to infuence AD. To increase AD it chooses to buy bonds in an open market operations, because bond purchases increase the monetary base and decrease short-term interest rates. The increase in the base increases deposits and loans through the multiplier process, and the decrease in interest rates stimulates investment (and consumption) borrowing. As a result, AD increases. The Fed can buy bonds and increase the monetary base, but these actions do not increase AD since we don't know exactly how much M1 and M2 will go up in response to the higher monetary base. Nor do we know exactly how much the lower interest rates will stimulate investment spending, especially since the Fed has the most influence over short-term rates, while most investment spending will depend on longer-term rates. All of these processes take time and the lags form action to response are not fixed but may vary. In the meantime, economic conditions may change. Some of the things the Fed must try to predict and monitor are: Will banks lend out all the new reserves or will they lend out only a portion, holding the rest as excess reserves? How quickly will increases in the monetary base translate into new bank loans and thus larger increass in M1 and M2? Do businesses want to borrow? How low do short-term interest rates have to go to stimulate more investment borrowing? If businesses do borrow, will they promptly hire labor and capital, or will they just hold the money as a precaution against bad times?

3 Tool Reminder

The Fed... Opens market operations in which teh Fed buys bonds, which increases the money supply and reduces interest rates, or the Fed sells bonds, which decreases the money supply and increases interest rates Lends to banks and other financial institutions Changes in the interest rate paid on reserves.

The Term Auction Facility

The Term Auction Facility contrasts the discount rate. The discount rate sets an interest rate and then the Fed waits to see how many banks want to borrow. One problem with the discount rate is that banks may not borrow, for fear of admitting to the market that they are in a weak position. The Term Auction Facility had the Fed announce that it wanted to inject a certain quantity of reserves into banks; those funds were then auctioned until the rate was low enough that banks would borrow the money. The Fed then loosened collateral requirements for its loans and stressed to banks that tere would be no negative stigma from borrowing from the facility.

Takeaway AD

The aggregate demand and supply model can analyze business fluctuations, fuctuations in the growth rate of real GDP. Real shocks are analyzed through shifts in the LRAS curve. AD shocks are analyzed through shifts in the AD curve. The AD curve slopes downward and the SRAS slopes upward. The AD curve can be broken down into changes in M and v. Changes in v can be broken down into changes in C, I, G, or NX. Nominal wage and price confusion, sticky wages, sticky prices, menu costs, and uncertainty create an upward-sloped short run AS curve.

Aggregate Demand Curve

The aggregate demand curves shows all the combinations of inflation and real growth that are consistent with a specified rate of spending growth (M + v) M + v = P + Yr M is the growth rate of money supply V is the growth rate of velocity P is the growth rate of prices, that is, the inflation rate which can be written as pi Yr is the growth of real GDP, called GDP growth M + v = Inflation + Real Growth More spending plus the same goods equals higher prices. An AD curve tells us all the combinations of inflation and real growth that are consistent with a specified rate of spending growth (M + v). Inflation is caused when more money chases the same goods. So, if more money is chasing an increased quantity of goods, then, the inflation rate will be less than the increase in money growth. Any combination of inflation and real growth that adds up to X% is on the same AD curve.

Good and Bad News

The bad new sis that most of the world is poor and more than 1 billion people live on incomes of less than $2 per day. These people have greatly reduced prospects for health, happiness, and peace. For most of human history, people were poor and there was no economic growth. Economic growth has raised the standard of living of most people in developed nations many times above the historical norm.

AD Shocks and the Great Depression

The fall in stock prices was a wealth shock that made many people feel poorer so consumption, C, reduced. This, combined with the initial monetary contract, reduced money supply, so M. This reduced AD, shifting inward and to the left. The GD was primarily due to a fall in AD. Real shocks also played a role.

What Is the Federal Revere System

The federal reserve usually has more influence over aggregate demand than any other institution and shifts in aggregate demand can greatly influence the economy in the short one. The Federal Reserve acquires its power through its ability to issue money. The Federal Reserve is the only provider of money, so it creates money. This new money can be given away or lent out in a way that increases aggregate demand. The Fed is both the gov't bank and the banker's bank. As the gov't bank, the Fed maintains the bank account of the U.S. Treasury. In addition to receiving money, the U.S. treasury also borrows money and the Fed manages this borrowing. The Fed is also the banker's bank. Large private banks keep their own accounts at the Fed--because some banks are required to hold accounts with the federal reserve and in part because other banks and financial institutions want a safe and convenient place to hold their money. The Fed manages the nation's payment system--the system of accounts that makes it possible to write checks from one bank to another--and it protects financial consumers with disclosure regulations.

Goods and Services

The output of an economy includes both goods and services. Services provide a benefit to individuals without the production of tangible output. EX: Paying a consultant to fix a software problem on a computer is a service and its market value is included in GDP. So do haircuts, transportation, entertainment, and spending on medical care.

Investment

The purchase of new capital goods. EX: Tools, machinery, and factories. If Starbucks buys new espresso machines for its stores, that's investment. If John buys stock in Starbucks, that is not investment in the economic sense but merely a transfer of ownership rights of already existing capital (this is not investment). Most of the trading on stock exchanges is not investment because it simply transfers ownership of a stock from one person to another. Investments require a purchase of NEW capital.

How the Fed Controls the Money Supply

Three tools the fed usues to control the money supply... 1. Open market operations -- buy lending and selling U.S. government bonds on the open market 2. Discount rate lending to the term auction facility--federal reserve lending to banks and other financial instituions 3. Paying interest on reserves held by banks at the fed.

When the Fed Does Too Much

To combat high unemployment rate in 2001 and potential for lost consumer confidence due to 9/11, the Fed tried to increase aggregate demand through expansionary monetary policy. During this recession, the Fed pushed down the Federal Funds rate from 6.5% in 2000 to 2% in 2001. The low rates helped to make credit cheap throughout the economy. It was easy to borrow money and encouraged mortgages. Easy credit can start to intensify a bubble. A bubble arises when asset prices rise far higher, and more rapidly, than can be accounted for by the fundamental prospects of the asset. The low interest rates are signaling market participants that credit is easy and its a good idea to borrow money. Hayek and Mises said these are distorted price signals. A distorted price signal arises when government policy, here the Fed, moves a price in a manner that encourages investors to take risk. Eventually, the Fed began to raise interest rates. Since bank lending is a main generator of M1 and M2, this means lower rates of growth for money supply, so economic growth started to decline.

Aggregate Beginning

We can use average growth rates to focus on the deviations from average, the booms and the recessions. Business fluctuations are the fluctuations in the growth rate of real GDP around its trend growth rate. Recessions are significant, widespread declines in real income and employment. A recession is a time when all kinds of resources, not just labor but also capital and land, are not fully employed. Often unemployment exceeds the natural rate. When there are a lot of unemployed resources, resources are being wasted and the economy is operating below potential. An economy responds to two types of shocks, real shocks (aggregate supply shocks) and aggregate demand shocks.

Other AD Shocks

Wealth shocks can also increase or decrease AD. When prices fall, consumers realize their wealth has fallen too so they save more. A positive wealth shock, as stock market prices rises, consumers spend more today as their increasing wealth gives them confidence that they will have more in the future. Taxes also shift C and I. An increase in taxes reduce consumption growth and a decrease in taxes can increase consumption growth. Taxes targeted at investment spending can have a similar effect on investment growth. Big increases in growth rate of government spending will increase AD, decreases in government spending will reduce AD. If other countries increase their spending on our goods (exports) that increases our AD. If we shift our spending away from domestic and into foreign goods (imports), that reduces our AD.

Reversing Course and Engineering a Decrease in AD

What if the Federal Reserve overstimulates, pushing the aggregate demand curve too much. Inflation makes price signals more difficult to interpret, creates arbitrary redistribution of wealth, and makes long-term planning and contracting more difficult. We don't want inflation to be too high. But, bringing down the rate of inflation is costly because prices and wages are not fully flexible in the downward direction. A disinflation is a significant reduction in the rate of inflation. The tighter monetary policies were followed by declines in output. Sometimes a contraction is necessary to bring down the rate of inflation. A deflation is a decrease in prices, that is, a negative inflation rate. A monetary policy is credible when it is expected that a central bank will stick with its policy. A sufficiently radical disinflation leads to unemployment because wages and prices are sticky, especially in the downward direction. If nominal wage growth is too high, some workers will end up being very expensive and employers will choose to lay them off. The key to a less painful disinflation is to increase nominal wage flexibility. If a central bank announces a disinflation but no one believes it, nominal wages won't grow more slowly and when the disinflation comes, the unemployment cost will be high. If disinflation is expected, then workers will be prepared for slower wage growth and quickly adjust. If a central bank wishes to undertake a disinflation it has to be ready to stay the course and explain its polivy very publicly.

Fractional Reserve Banking, The Reserve Ratio, and the Money Multiplier

When you open a bank account, the bank holds a fraction of your account balance in reserve--hence the term fractional reserve banking--and it es the rest of your money to make loans. Fractional reserve banking means the banks hold only a fraction of deposits in reserve, lending the rest. Competition among banks to attract your funds means that if the bank lends out your money and charges 5% interest, the bank must in some way share some of that return with you. How much does the bank need to keep in reserve and how much does it lend? On one hand, banks need to keep some reserves around. In part, the law and the Federal reserve require them to. Banks need those reserves to meet ordinary depositor demands for currency and payment services. Banks also don't want to hold too many reserves because money held in reserve isn't being lent and lending is where banks earn most of their profits. There are opportunity costs to holding onto reserves. Banks balance these benefits and costs and thus they decide on the ratio between reserves to deposits. If $1 in cash is held in reserve for every $10 of deposits, the reserve ratio is 1/10 The reserve ratio, RR, is the ratio of reserves to deposits. The reserve ratio is determined primarily by how liquid banks wish to be. When banks worry that depositors might want to withrawl their cash or when loan's don't seem so profitable, they want a high reserve ratio. When banks worry about depositors demanding cash and when loans are profitable, they want a low reserve ratio. The money multiplier, MM is the amount of the money supply that expands with each dollar increase in reserves. MM = 1/RR As one bank increases its loans, leading to an increase in deposits in another bank, which in turn increases its loans, which leads to an increase in deposits in another bank, which increases its loans and so forth. Deposits eventually increase by the increase in reserves multiplied by the money multiplier. Changes in reserves * money multiplier = change in money supply.

Unemployment and Labor Force Participation

A growing economy is a changing economy and some unemployment is a necessary consequence of economic growth. High and long-lasting unemployment is unlikely to be caused by economic growth. During a recession, unemployment increases quickly and in many different industries at once and that too is unlikely to be caused by economic growth. There are different types of unemployment with different causes.

Real GDP Growth

A single indicator of current economic performance is best used as real GDP growth.

The GDP Per Capita Varies among Nations

About 10% of the world's population lived in a country with a GDP per capita of less than $1,500 in 2011. 67% of the world's population lived in a country with a GDP per capita equal to or less than $7,826. 75% of the world's population live in a country with a GDP per capita less than average. Most of the world's population is poor relative to the U.S. GDP per capita is an average, and there is a distribution of income within a country.

An Inflation Parable

An unexpected increase in the money supply can boost the economy in the short run, but firms and workers come to expect and adjust to the new influx of money, output will not grow any faster than normal.

Many Ways of Splitting GDP

Another way of understanding GDP is to study its components and how they fit together. National spending approach to GDP: Y = C + I + G + NX Factor income approach to GDP: Y = Wages + Rent + Interest + Profit

Real GDP Growth per Capita

Growth in real GDP per capita is the best reflection of changing living standards. Growth in real GDP gives the broad idea of how economic conditions are changing as growth in real GDP per capita, but there are differences for countries with changing populations. EX: Real GDP growth in Guatemala grew at 3.6%, at a time where population grew 2.8% a year, so real GDP grew at 0.8% a year. By comparison, real GDP per capita in the U.S. grows by 2.1% a year.

The Cause of Inflation

If Yr is fixed by real factors and v is stable, the only thing that can increase in P are increases in M, the supply of money. Inflation is caused by an increase in the supply of money. The quantity theory of money says that the growth rate of the money supply will be approximately equal to the inflation rate. Increase in Yr(real GDP) must lower prices. Changes in the velocity of money, like increase, can accelerate inflation. Deflation is a decrease in the average level of prices (a negative inflation rate). Decreases in monetary velocity can fuel this. Disinflation is a reduction in the inflation rate. This is caused by more moderate decreases in velocity or the growth rate of the money supply would reduce the inflation rate. The quantity theory of money assumes that changes in M cannot change Yr. This makes sense because GDP is determined by capital, labor, and tech. In the long run, money is neutral.

Takeaway GDP/GDP per capita

If we want to understand growth and fluctuations, we need some concept that defines and measures growth and fluctuations. The concept of gross domestic product was developed to quantify the ideas of economic growth and fluctuations. GDP, the market value of all final goods and services produced in a country in a year, is an estimate of the economic output of a nation over a year. When we say an economy is growing, we mean GDP or something like GDP per capita is growing. When we say an economy is booming or contracting, we mean that growth in real GDP is above or below its long-run trend. The national spending identity: Y = C + I + G + NX splits GDP according to different classes of income spending. The factor income approach: Y = employee compensation + Interest + Rent + Profit, splits GDP inter different classes of income receiving. GDP per capita is a rough estimate of the standard of living in a nation. Real GDP is GDP per capita corrected for inflation by calculating GDP using the same set of prices in every year. Growth in real GDP per capita tells us roughly how the average person's standard of living is changing over time. GDP does not include the value of leisure or goods bought and sold in the underground economy, nor does it include the value of goods that are difficult to price, such as the value of having polar bears in Alaska. GDP and GDP per capita also do not tell us anything about how equally GDP is distributed. GDP measures are imperfect but they have proven they are useful in estimating the standard of living and the scope of economic activity.

Factors that Affect Structural Unemployment

Large, long lasting shocks that require the economy to restructure EX: Oil shocks, globalization and global competition, technology shocks, shift from manufacturing to services. Labor Regulations EX: Unemployment benefits, minimum wages, powerful unions, employment protection laws. Polices that can reduce structural unemployment EX: Active labor market policies (job retraining, job-search assistance, work tests, early employment bonuses).

Insecure Property Rights

Some governments do not offer secure property rights to savers (saved funds are not immune from later confiscation, freezes, or other restrictions). If individuals expect that contracts will be broken, they will be reluctant to invest in stock markets as well. Law is one side of the equation, but custom and informal trust is the other. Shareholders expect that managers are interested in building their long-run reputations, rather than ripping off the company.

Inflation and the Breakdown of Financial Intermediation

Sometimes the government will restrict inflation by interest controls. When nominal interest rates are not allowed to rise and inflation is high, the real rate of return is negative. Bank savings accounts are wasting accounts. Negative real interest rates reduce financial intermediation and economic growth.

Thee Stock Market

Stocks or a share is a certificate of ownership in a corporation. Owners have a claim to the firm's profits, but remember that profit is revenue minus costs (left over after everyone else) They benefit directly if the firm pays out its profits in dividends or indirectly if the firm reinvests its profits in a way that increases the value of stock. Stocks are traded on organized markets called stock exchanges. NYSE is the largest. An initial public offering (IPO) is the first time a corporation sells stock to the public in order to raise capital. When a firm sells new shares to the public, it typically uses the proceeds to fund investment (buy new capital goods). Stock markets help people with great ideas become rich and encourage innovation.

Structural Unemployment

Structural unemployment is persistent, long-term unemployment caused by long-lasting shocks or permanent features of an economy that make it more difficult for some workers to find jobs. "Persistent, long-term unemployment" means that a substantial fraction of the unemployed have been unemployed for more than one year and that this problem has lasted fora long time. It remains to be seen whether the long-term unemployment in the U.S. will persist or whether this rate will fall to more traditional levels. One cause of structural unemployment is large, economy-wide shocks that occur relatively quickly. Adjusting to these shocks can create long-lasting unemployment as the economy takes time to restructure. Labor-saving technology can create unemployment in some fields, but as workers move to other fields, total output increases, which raises the average standard of living and usually leads to higher wages. It doesn't help that firms delay structural changes until falling profits force them to restructure or die. Big structural change soften happen during recessions, and it becomes difficult to distinguish structural unemployment from the more temporary unemployment correlated with the business cycle (cyclical unemployment) If long lasting enough, structural employment brings significant human costs in addition to the loss of economic output. Not only is the economy producing less but the unemployed suffer higher levels of stress, higher rates of suicide, and lower rates of measured happiness. It can be more difficult for an unemployed worker than for an employed worker to switch jobs. The longer a worker remains unemployed, the more their skills atrophy. Highering managers may regard unemployment as a sign of laziness or other problems.

How the Pill Increased Female Labor Force participation

The cost of earning a professional degree was lowered by giving women greater certainty about the consequences of sex. The availability of the pill and the increase in women entering college and professional degree programs do coincide.

Leverage

The difference between the value of a house and the unpaid amount on the mortgage is called the owner's equity, this is assets minus debt (E = V - D). Lenders want buyers to have home equity because this protects buyer defaults. Buyers equity gives the bank a cushion. In the 1990s and 2000s, lenders became convinced that house prices were unlikely to fall and they became willing to lend with much lower down payments. If house prices rose, they could borrow more or sell at a profit. If they fell, they could default and not lose any of their own money. Yet if house prices were to fall and buyers were to begin to default on their loans, the bank no longer would have a cushion. The leverage ration is the ration of debt to equity, D/E EX: If a buyer of a $400,000 house borrows $320,000 and spends $80,000 of their own savings, then the leverage ratio is 4 = 320000/80000 More leverage means the same force (your cash) can be used to move (buy) bigger and bigger assets. As the financial crisis approached, house buyers were using more and more leverage. Insolvent firm has liabilities that exceed its assets. This usually leads to bankruptcy. A high leverage ratio means that a small drop in assets would bankrupt, which means a small rise in price would mean large profits.

Frictional Unemployment

The difficulty of matching employees to employers creates friction in the labor market, and the resulting temporary unemployment is frictional unemployment. Frictional unemployment is short-term unemployment caused by the ordinary difficulties of matching employee to employer. Scarcity of information is one of the causes of frictional unemployment. Workers do not know all job opportunities available to them and employers do not know all the available candidates. Frictional unemployment usually doesn't last very long. If the economy is not in a recession, it might take a few weeks to find a new job, or for specialized workers perhaps a few months but not much longer. Long-term unemployment has been a much bigger problem in Europe than in the U.S. Frictional unemployment is typically a large share of total unemployment because the U.S. economy is dynamic. Creative destruction occurs at the level of the firm and the industry. Even in an industry with constant or increasing employment, the location of employment changes as uncompetitive firms disappear or shrink and others grow. Creative destruction happens at the level of the industry. The oil shocks required a fundamental reallocaiton of labor from industries that were heavily dependent on oil to industries less dependent on oil. But, it takes time (and thus more unemployment) for workers to move from one industry to another industry than to move from one firm to another firm in the same industry--this type of unemployment that occurs in response to deep changes in the economy is called structural unemployment.

Takeaway Labor Force

The economy is always changing and only through change is there growth. There is a difference between helping workers to adjust and trying to prevent adjustment--we can do the former but not the latter. Some labor market policies intend to protect workers but have increased structural unemployment in Western Europe compared to the U.S. Labor market policies make it easier for workers to retrain and move to employment have had greater success in keeping long-term unemployment low. Changing demographics and government policy such as taxes and benefits change the labor force participation rate. The labor force participation rate also responds to the incentive to work. Changes in the labor force participation rate can have large impacts on an economy. Failure to fully utilize the talents of women is an enormous loss to women and to these economies. The labor force participation rates of older workers will become a subject of increasing concern as more workers retire and place increasing demands on pensions and health systems not just in the U.S. but around the developing world.

Labor Regulations to Reduce Structural Unemployment

Active labor market policies work like tests, job search assistance and job retraining programs focus on getting unemployed workers back to work. Denmark does this by subsidizing employers who are willing to train unemployed workers. In the U.S., bonuses are given to unemployed workers who find work early. Europe has been slowly moving towards flexible labor markets by allowing some exceptions to collective bargaining agreements for certain categories of workers such as young, temporary, and part-time workers. "Insiders" have been very reluctant to give up their benefits for the same of unemployed "outsiders"

Banks

Banks receive savings from many individuals, pay them interest, and then loan these funds to borrowers, charging them interest. Banks earn profit by charging them more for their loans than they pay for the savings. By specializing in loan evaluation, they have a better idea than most of us which business ideas make sense. Banks coordinate lenders and minimize information costs. This is an example of the benefits of specialization and the division of labor. Banks also spread risk by spreading losses on default loans across many lenders who deposit money in the bank.

Borrowing is Necessary to Finance Large Investments

Businesses also borrow extensively. People with good ideas must borrow funds to start their careers as entrepreneurs. Businesses borrow to finance large projects. By borrowing, developers are able to invest now and develop many more buildings. A student who can't borrow many not be able to get an education even though the education would be a good investment. Borrowing plays an important role in the economy--the ability to borrow greatly increases the ability to invest, and higher investment increases the standard of living and the rate of economic growth.

Shifts in Supply and Demand

Changes in economic conditions will shift the supply or demand curve and change the equilibrium interest rate and quantity of savings. An increase in the supply of savings shifts the supply curve to the right and down (this means that more savings at any interest rate, or a willingness to save any give amount in return for a lower interest rate) A decrease in the supply of savings shifts the supply curve to the left and up (this means less savings at any interest rate, or a decrease in willingness to save any given amount in return for this interest rate) One of the key drivers of economic growth is a high rate of investment and capital accumulation When investors become less optimistic, this decreases the demand to invest and borrow. There is little investment during a recession, so a decrease in investment demand can help to spread and prolong the recession. To counteract the decrease in investment demand during a recession, governments can offer a temporary investment tax credit. An investment tax credit gives firms that invest in plants and equipment a tax break. The tax credit is usually temporary to encourage firms to invest quickly, when the recession is still in full force. This makes projects that were unprofitable before profitable, so at any given interest rate firms are willing to invest more when a tax credit is available.

Why Split?

Each of the ways of splitting GDP throws a different light on the economy. Economists who study business fluctuations are interested in splitting GDP according to the national spending identity because consumption, investment, government purchases, and net exports behave differently over time. Consumption spending tends to be more stable than investment spending. It is important to understand the causes and consequences of these differences. The factor income approach is useful if we think about how economic growth is divided between employee compensation, rent, interest, and profits. The largest payment in GDP is to labor, more than most people expect and larger than corporate profits, which are around 10%. The share of GDP going to labor has been stable over time, although some evidence suggests that this share has fallen slightly in recent years. Economists are interested in understanding what drives the relative sizes of these shares. It helps to have more than one way of counting GDP because different methods are subject to different errors. One could look at the market value of food versus all else, or break down GDP geographically.

What Happens When Intermediation Fails?

Economic growth cannot occur without savings and those savings must be processed and intermediated through banks, bond markets, stock markets, and so on. Countries without these institutions have smaller markets for loans and use their savings less effectively, and make fewer good investments. The bridge between savers and borrowers can be broken with insecure property rights, inflation and controls on interest rates, politicized lending, and massive bank failures. These problems can reduce the supply of savings, raise the cost of intermediation, and reduce the effectiveness of lending.

A Tale of Two Riots

Employment protection laws tend to have the most negative effects for young, already unemployed, minority workers. Unemployment protection laws create valuable insurance for workers with full-time jobs. Make labor markets less flexible and dynamic. Increase the duration of unemployment. Increase unemployment rates among young, minority, or otherwise "riskier" workers.

Price Indexes

For most Americans, the CPI is the measure of inflation that corresponds most directly with daily economic activity, so we focus on CPI unless otherwise indicated. The basked of goods and services bought by the average consumer is changing all the time. BLS periodically updates the basket of goods to reflect the introduction of new goods such as compact discs and MP3s. The BLS also tries to take into account new goods and better-quality goods, but it is challenging. Economists suggest that the CPI may actually overstate inflation by a little bit every year.

GDP Does Not Count Bads: Environmental Costs

GDP adds up the market value of final goods and services but does not subtract the value of bads. Pollution is a bad that is produced yearly, but is not counted in GDP statistics. The movement for "green accounting" has tried to reform GDP statistics to cover the environment more explicitly. GDP should measure the market value of all final goods and services even if those goods and services are not traded in markets. It is difficult to value nonpriced items. Thus, green accounting is restricted to the analysis of particular problems.

Cyclical and Short-Run Changes in GDP

GDP is a way to compare economic output across countries over long periods. GDP is also used to measure short-run fluctuations in an economy, namely the ups and downs in economic growth that occur within the space of a few years. A recession is a significant, widespread decline in real GDP and employment. A recession is widespread not only geographically but also across different sectors of the economy. A decline in real GDP is the best indicator of a recession, declines will also be observed in income, employment, sales, and other measures of economic health. Business fluctuations or business cycles are the short-run movements in real GDP around its long-term trend. Fluctuations of real GDP around its long-term trend or "normal" growth rate. The estimate of quarterly GDP is not ready for release until almost a month after the quarter is over. After that, additional rounds of updated estimates are published in the following two months.

Produced

GDP is meant to measure PRODUCTION so sales of used goods are not included in GDP. EX: The sale of a used care is not included in GDP. Sales of old houses and sales of financial securities like stocks and bonds are not included in the calculation of GDP. However, the services of real estate agents, used-car salespeople, and brokers do add to GDP because the services provided by these agents are produced in the year in which they are sold.

GDP Does Not Measure the Distribution of Income

GDP per capita is a rough measure of the standard of living in a country. If GDP per capita grows by 10%, this does not mean that everyone's income grows by 10%. GDP and GDP per capita grow y the same amount in each case, but different people feel different effects. Most of the time, growth in GDP per capita means everyone's income grows by approximately the same amount, so growth in real GDP per capita usually does tell us roughly how the average person's standard of living is changing over time.

Growth Rates

GDP tells us how much a country produced in a given year. The growth rate of GDP tells us how rapidly the country's production is rising or falling over time. To compute the growth rate, you need the GDP at the end of year 1 and at the end of year 2.

In a Year

GDP tells us how much the nation produced in a year, not how much the nation accumulated its entire history. Think of GDP as analogous to annual wages. Wages are not the same thing as wealth. Some retired people are wealthy even though their wages are low, and some with high wages have little wealth. National wealth refers to the value of a nation's entire stock of assets. A tractor built in 2005 and still operating is part of U.S. wealth but not GDP. GDP is thought of as yearly, but is calculated on a quarterly basis as well.

A Primer on Growth Rates

GDP that a growth rate is the percentage change in a variable over a given period. Economic growth means the growth rate of real per capita GDP. Even slow growth, if sustained, produces large differences in real GDP per capita. The rule of 70 determines the length of time necessary for a growing variable to double. Rule of 70: If annual growth rate of a variable is x%, then the doubling time is (70/x) years. At a growth rate of 1%, GDP per capita will double every 70 years (70/1 = 70) while at 2%, it will double every 35 years (70/2 = 35) The rule of 70 is just a mathematical approximation, but it bears out the key concepts that small differences in growth rates have large effects on economic progress. Another way of seeing how small changes in the rate of economic growth can lead to big effects is to think about how rich people will be in the future.

Intermediate Goods

Goods and services sold to firms then bundled or processed with other goods or services for sale at a later stage. EX: A computer chip is an intermediate good. If an Intel chip were counted in GDP when it was sold to Dell, and then counted again when a consumer buys the Dell computer, the value of the computer chip would be counted twice. To avoid double counting, only the final good is accounted for.

Government Purchases

Government purchases are spending by all levels of government on final goods and services. This includes both government consumption items (like toner cartridges for printers) and government investment items (like roads). Unemployment and disability insurance, welfare programs, and Medicare are part of transfer programs which are not included in government spending because of double-counting. Once those are spent, they would count as consumption. We count only government purchases of FINAL GOODS AND SERVICES. Transfers are just transferring wealth.

Politicized Lending and Government-Owned Banks

Government-owned banks are useful to authoritarian regimes that use the banks to direct capital to political supporters.

Bank Failures and Panic

Great Depression in part bc the Federal Reserve failed to prevent widespread bank failures.

Everyone Used to Be Poor

In the past, everyone was poor. GDP per capita is more than 50 times as large in the riches countries as in the poorest countries, today. GDP per capita was about the same in year 1 as it would be 1,000 years later and indeed about the same as it had been 1,000 years earlier. For most of human history, there was no long-run growth in real per capita GDP. Only beginning in the nineteenth century does it become clear that some parts of the world began to grow at a rate unprecedented in human history. Economic growth is unusual, but once it begins, it can some parts of the world rich.

Saving

Income that is not spent on consumption goods.

Takeaway Banking

Individuals save to prepare for their retirement, help fund large purchases, and to cushion swings in their income. Savins help individuals, firms, and governments to smooth their consumption over time. Borrow to finance large purchases, to invest in new capital, or for government to finance large expenditures. Borrowing helps agents smooth their consumption streams. Financial intermediaries bridge the gap between savers and borrowers. They also collect savings, evaluate investments, and diversify risks. Banks, bonds, and stock markets help finance new ideas. Financial intermediaries are a central part of this growth. Insecure property rights, inflation, politicized lending, and bank failures and panics can breakdown financial intermediation. The 2007 - 2008 crisis was brought about by high leverage and falling asset prices that created a panic in the shadow banking system that sharply reduced the amount of lending in the economy. This demonstrates the importance of intermediaries.

Takeaway Inflation

Inflation is an increase in the average level of prices as measured by a price index such as CPI. A price index can be used to convert a nominal price into a real price. In the long run, real GDP is determined by the real factors of production (tech, labor, capital) so changes in the money supply cannot permanently increase real GDP. In the short run, changes in the money supply can influence real GDP. Inflation makes price signals more difficult to interpret, especially from money illusions. Inflation is a type of tax, governments with few other sources of tax revenue often turn to inflation. Workers and firms will adjust to a predictable inflation by incorporating inflation rates into wage contracts and loan agreements. The tendency of the nominal interest rate to increase with expected inflation is called the Fisher effect. Inflation is redistributed from lenders to borrowers when it is greater than expected. When less than, it goes from borrowers to lenders. This makes lending and borrowing more risky. Anything above a mild sustained rate of inflation is generally bad for an economy.

Defining and Measuring Inflation

Inflation is an increase in the average level of prices. Measure the average level of prices with an index, the average price from a large and representative basked of goods and services. Thus, inflation is measured by changes in a price index and the inflation rate is the percentage change in a price index from one year to the next. Inflation rate is the percentage change in the average level of prices (as measured by a price index) over a period of time. Inflation Rate = (P2 - P1) / (P1) *100 An inflation rate of 10% means that prices will average 10% higher. Shifts in supply and demand push prices up and down, but inflation is an increase in the average level of prices.

Inflation Interacts with Other Taxes

Inflation leads people to paying capital gain taxes when they should not. The overall tax burden rises. The long-run effect is to discourage investment in the first place. Inflation can also push people into higher tax brackets or make corporations pay taxes on phantom profits. Inflation increases the costs associated with the tax system.

Inflation Redistributes Wealth

Inflation transfers real resources from citizens to the government--inflation is a type of tax. Inflation also redistributes wealth among the public, especially between lenders and borrowers. Inflation can reduce the real return lenders receive on their loans, transferring wealth form lenders to borrowers. Real interest rate = nominal rate - inflation rate Real = i - pi Real rate of return is the nominal rate of return minus the inflation rate Nominal rate of return is the rate of return that does not account for inflation The tendency of nominal interest rates to increase with expected inflation is called the Fisher effect. The fisher effect says that nominal interest rate is equal to the expected inflation rate plus the equilibrium interest rate. The Fisher effect also says that the nominal rate will rise with expected inflation. If (Epi > pi), that is if expected inflation is less than actual inflation, then the real rate of return will be less than the equilibrium rate and possibly negative. Wealth will be redistributed from lenders to borrowers. If (Epi > pi), if expected inflation is greater than actual inflation--"disinflation"--then the real rate of return will be higher than the equilibrium rate. Wealth will be redistributed from borrowers to lenders. When Epi = pi, when expected inflation is equal to actual inflation, then real return will be equal to equilibrium return. There will be no redistribution of wealth between borrowers and lenders. Monetizing the debt is when the government pays off its debts by printing money. If lenders expect the government will infiltrate its debt away, they will only lend high nominal rates of interest. To avoid this, government may try to make a credible promise to keep inflation low. People who buy government bonds are typically voters who would be upset if their real returns shrunk.

The Bond Market

Instead of borrowing from a bank, corporations can borrow directly form the public. A bond is a corporate IOU. It is a sophisticated IOU that documents who owes how much and when payments must be made. In some cases, all the money is owed on a single day (the day of maturity) and in others, periodic payments, called coupon payments, must be made in addition to the final payment. Large sums of money can be raised now and invested in long-lived assets such as railroad track. All bonds involve a risk that when the payments come due, the borrower will not be able to pay--this is called "default risk" Bond repayments are graded on likelihood, From AAA to D. Less than BBB are called "junk bonds." Risky companies to loan to receive higher interest rates. Collateral is something of value that by agreement becomes the property of the lender if the borrower defaults. The market for loanable funds is really a broad spectrum of markets; the interest rates differ depending on the borrower, repayment time, amount of the loan, type of collateral, and many other features of the loan. Greater risk can reduce the supply of funds to the market as a whole. When the government borrows a lot of money, private consumption and investment can be crowded out Crowding out is the decrease in private consumption and investment that occurs when government borrows more. A higher interest rate draws an additional savings into the market so total savings increases from X to Y. A higher interest rate also means that some investments and other projects are no longer profitable so at a higher interest rate, private borrowing falls. U.S. Treasury Bonds (T-bonds) are 30 year bonds that pay interest every 6 months. T-bills are bonds with maturities of a few days to 26 weeks that pay only at maturity. A bond that pays only at maturity is called a zero-coupon bond or a discount bond since these bonds sell at a discount to their face value. Short-term U.S. government securities tend to be safe assets, and very short-term vbonds, called commercial paper, issued by very large corporations as well. Treasury securities (especially T-bills) are important in monetary policy; the Fed buys and sells Treasury securities on a daily basis to influence the money supply.

Invest

Investment spending is private spending on tools, plant, and equipment that are used to produce future output. Most investment spending is made by businesses but an important exception is that new home production is counted as investment. By "investment," economists mean spending on tools, plant, and equipment (capital). When your university builds a new building, that is an investment. Buying IMB stock, is not, because this is change in ownership of preexisting capital.

Bond Prices and Interest Rates

It's convenient to express the price of a bond in terms of an interest rate; easiest to do with a zero-coupon bond. EX: A bond with very little risk exists that will pay $1,000 in one year's timie and this bond is selling for $950. If you were to buy this bond today and hold it until maturity, you would earn 50 (1000 - 950) or a rate of return of 5.26% = (1000 - 950) / 950 Every zero-coupon bond has an implied rate of return that can be calculated by subtracting the price from the value at maturity, often called the face value, and then dividing by the price. Rate of return for a zero-coupon bond = (face value - price) / price * 100 If the interest rate of a bond were to rise to 10%, the price of the bond must fall. EX: For the previous bond, it would fall to $909, because 10% = (1000 - 909) / 909. Thus, at a price of $909, sellers of bonds will be able to compete with banks, who are paying 10% on savings accounts, but at a higher price they won't find any buyers. Equally risky assets must have the same rate of return. If they don't no one would buy the asset with the lower rate of return and the price of that asset would fall until the rate of return was competitive with other investments. Arbitrage: The buying and selling of equally risky assets, ensures that equally risky assets earn equal returns. Interest rates and bond prices move in opposite directions. When interest rates go up, bond prices fall. When interest rates go down, bond prices rise. This inverse relationship tells us that in addition to default risk, people who buy bonds also face interest rate risk. Bond buyers are making bets that interest rates will fall (bond prices will rise). Bond sellers are betting that interest rates will rise.

Lifecycle Effects and Demographics

Labor force participation rates vary with age. Labor force participation peaks in prime working years, 25 - 54. After 65, most people retire. Lifecycle effects can interact with demographics to change national labor participation rates. Baby boomers are the people born during the high birthrate years, 1946 - 1964. Falling labor force participation means lower tax receipts. A natural response to rising life expectancies and better health at older ages is later retirement.

GDP Does Not Count Leisure

Leisure is omitted from GDP statistics. People value leisure, just as they value food and transportation. When people consume more leisure, GDP does not rise, but fall because people are not at work. With the progression of technology, the workweek and the level of work at home has declined becoming less energy and time-consuming. Growth in leisure is an improvement in well-being but not reflected in GDP. The longer workweek makes the U.S. look better off compared with Europe than is actually the case.

Consumer Price Index (CPI)

Measures the average price for a basket of goods and services bought by a typical consumer. The index covers some 80,000 goods and is weighted so that an increase in the price of a major item such as housing counts for more than an increase in the price of a minor item like kitty litter.

Producer Price Index (PPI)

Measures the average price received by producers. Unlike the CPI and GDP deflator, producer price indexes measure prices of intermediate as well as final goods. PPI exist for different industries and are often used to calculate changes in the cost of inputs.

Gross National Product (GNP)

Measures what is produced by the labor and property supplied by U.S. permanent residents whenever the world that labor or capital is located, rather than what is produced within the U.S. border.

GDP Does Not Count the Underground Economy

Nations that have greater levels of corruption and higher tax rates usually have higher levels of underground transactions. EX: In Haiti, it takes 203 days of fighting bureaucracy to start a legal business.

Net Exports

Net exports are the value of exports minus the value of imports. If a nation sells more final goods and services abroad than it buys form other nations, net exports will be positive. A nation that imports more than it exports has negative net exports. Imports contribute to the GDP of other nations--the locations where that value was produced--and we don't want to count that twice. Importing goods and services remains a valuable activity, but the purpose of GDP is to measure and evaluate DOMESTIC production.

GDP Does Not Count Nonpriced Production

Nonpriced production occurs when valuable goods and services are produced but no explicit monetary payment is made. If a son mows his parent's lawn, the service won't be in GDP. Social capital is not registered in GDP since they are not priced. Volunteering is not counted in GDP. This omission of nonpriced production introduces biases over time and biases across nations. The U.S. GDP in 2015 underestimates a little the real production of goods and services in 1950 relative to that of today because women were not paid for homework while today the nanny is. Many cultures discourage women from becoming part of the workforce. The output of the 72% of women not in the workforce of India is not included in Indian GDP, so there is underestimate in the real production of goods and services in India.

Market for Loanable Funds

Occurs when suppliers of loanable funds (savers) trade with demanders of loanable funds (borrowers). Trading in the market for loanable funds determines the equilibrium interest rate. The interest rate adjusts to equalize savings and borrowing in the same way and for the same reasons that the price of oil adjusts to balance the supply and demand for oil. In equilibrium, quantity of savings/borrowing demanded is equal to equilibrium interest rate. If the interest rate were higher than equilibrium, the quantity of savings supplied would exceed the quantity of savings demanded, creating a surplus of savings. With a surplus of savings, suppliers will bid the interest rate down as they compete to lend. If the interest rate were lower than equilibrium, the quantity of savings demanded would exceed the quantity of savings supplied, a shortage. With a shortage of savings, demanders would bid the interest rate up as they competed to borrow.

Inflation in the U.S. and Around the World

Over the past 10 years, inflation in the U.S. has averaged 2.4% CPI is often used to calculate "real prices." A real price is a price that has been corrected for inflation. real prices are used to compare the prices of goods over time. Most prices go up over time, but there are example. For example, pocket calculators.

Smooth Consumption

Path A: Consumption is high during your work years, but after retirement consumption drops precipitously--as a result, once you retire your income falls. Path B: Consumption is less than income during the working years because you save for retirement. But when retirement comes, consumption is greater than income as you spend your savings, or "dissave." Path B is "smoother" than Path A. The desire to smooth consumption over time is a reason to save, and also a reason to borrow. Savings are necessary to finance the capital accumulation that generates high standards of living. If there are no savings, investment dries up, economic growth declines, and the standard of living falls. Fluctuations in income are other reasons why people save.

Controls on Interest Rates

Price controls on interest rates cause the loanable funds market to malfunction. A maximum price ceiling on the interest rate that can be charged on a loan is called a "usury law: A binding and enforceable ceiling on interest rates would cause a shortage of credit, and many people who wish to borrow at the controlled interest rate cannot do so. This also reduces savings. This will also cause a misallocation of savings and a loss of potential gains from exchange. Investment, determined by the supply of savings, will fall below what it would be at market equilibrium.

The Role of Intermediaries: Banks, Bonds, and Stock Markets

Savers move their capital to find the highest returns. Entrepreneurs invest time and energy to find the right investments and the right loans. Equilibrium is brought by the assistance of financial intermediaries. Financial intermediaries such as banks, bond markets, and stock markets reduce the costs of moving savings from savers to borrowers and investors.

The GDP Deflator

The GDP Deflator is a price index that can be used to measure inflation. ((nominal GDP) / (real GDP)) * 100 The deflator is a ratio of prices.

Incentives

The choice to work depends on the difference between what work pays and what leisure pays. The choice to work can be influenced by taxes on workers and benefits paid to nonworkers. Taxes disourage work and benefits encourage nonwork. In the U.S., a worker of retirement age who continues working is not penalized. In many countries workers who work past the normal or early retirement age are, because many countries do not allow a worker to work and receive the same government pension. Countries with a high implicit tax have low labor force participation rate. Taxing older workers at significantly higher rates than younger workers does not benefit the older workers. Pushing older workers into retirement imposes significant costs on younger workers who must pay higher taxes because older workers are not contributing to GDP.

Employment Protection Laws

The employment at-will doctrine says an employee may quit and an employer may fire an employee at any time for any reason. There are many exceptions, but it is the most basic U.S. employment law. Many workers have contractually guaranteed severance packages and tenured university professors cannot be fired at will. Employees can also be restricted by contract. In most of Europe, the labor law is very different. Portugal's constitution forbids at-will employment and requires employers to notify the government whenever a worker is dismissed. It also needs government permission to lay off a group of workers. Hiring and firing costs make labor markets less flexible and dynamic. A European firm with an unexpected increase in orders will not be able to simply hire more workers. If the firm hires more workers and orders then decline, it would be stuck with workers it could not lay off without incurring great expenses. Thus, hiring and firing costs make firms more cautious and slower to act. Greater job security is valuable to workers with full-time jobs, but the more expensive it is to hire and fire workers, the more difficult it will be for new workers and unemployed workers to find jobs. It's more difficult to find a job when every job requires a long-term commitment from the employer. The World Bank calculates a "rigidity of employment index," which summarizes hiring and firing costs, as well as how easy it is for firms to adjust hours of work. A higher index number means that it is more expensive to higher and fire workers and more difficult to adjust hours. A higher number, more rigid. U.S. has the least rigid labor markets and one of the lowest rates of long-term unemployment.

Fire Sales

The financial crisis can be understood as a run on the shadow banking system similar in many respects to bank runs during the Great Depression. If investors feel the institution will go bankrupt, each lender will seek to withdraw his money or refuse to renew the loan, as soon as possible, just as depositors rush to withdrawal their money from failing banks Short-term loans disappear most quickly, and without those loans, the investment bank no longer has enough operating funds and it is forced to sell off assets quickly in a "fire sale" With many firms involved, fire sales can get quickly out of control. A high leverage ratio puts a bank in a very vulnerable position. A small decline in asset values can wipe out the equity cushion of the bank and push the bank to insolvency. Because mortgages had been bundled and so many times over in different combinations, no one knew which financial institutions faced the biggest losses. As a result, no one wanted to lend or invest. The high leverage of homeowners meant thatt defaults increased rapidly as house prices fell and the higher default rate on mortgages created losses for banks. Highly leveraged banks were quickly pushed to solvency. Shadow banks relied on short-term funding, which was not guaranteed so people stopped lending. The bundling and division of mortgages and the many sides bets mad eon securitized mortgages were complicated, so it wasn't clear who owned what or who faced the worst losses. it is now a general problem that the short-term loans for the shadow banking system can flee rapidly in times of crisis, causing some financial markets to shut down and credit to freeze up New financial regulations are bringing the shadow banking system out of the shadows. Key is to require banks to hold more equity, to reduce the amount of leverage.

Inflation is Costly to Stop

The government can reduce inflation by reducing growth in money supply, but then what? At first, firms may interpret lower rates as a reduction in real demand and reduce output and employment. Workers may be thrown out of work as the unexpected increase in their real wage makes them unaffordable.

Labor Force Participation

The labor force participation rate is the percentage of adult, noninstitutionalized, civilian population who are working or actively seeking works. Determinants of the labor force participation rate: lifecycle effects and demographics, and incentives.

Gross Domestic Product (GDP)

The market value of all final goods and services produced within a country in a given year. Measures an economy's total output, which includes millions of different goods and services. (Market value * Quantity)

Minimum Wages and Unions

The minimum wage raises the price of labor from the market wage to the minimum wage, and as labor becomes more expensive, firms reduce employment form market employment to minimum wage employment Qd. At minimum wage, the number of workers looking for work Qs exceeds the number of jobs Qd--thus, the minimum wage creates unemployment in the amount Qs - Qd The median wage is the wage such that one-half of all workers earn wages below the median and one-half of all workers earn wages above the median. In France, the minimum wage has been about 61% as large as the median wage. In the U.S., the minimum wage is only 32% as large as the median wage, so a minimum wage will affect more workers and create more unemployment in France than in the U.S. The minimum wage is only more likely to create unemployment among young workers who tend to be less productive. In both France and the U.S., unemployment rates are higher among the young than the old, but in 2005 21% of workers in France under 25 were unemployed, while in the U.S. 11% were unemployed. A Union is an association of workers that bargain collectively with employers over wages, benefits, and working conditions. Unions are more powerful in Europe than in the U.S. In the U.S., almost 87% of workers are not governed by a union contract; instead, they have an individual contract with employers. In many European countries, however, 80% of workers or more are governed by a union contract. Strong unions have very similar effects as minimum wages. Unions demand higher wages by using their power to prevent the firm from higher substitute labor. the union raises the price of labor from the market wage to the union wage. As labor becomes more expensive, firms reduce employment from market employment to union employment Qd. At union wage, the number of workers looking for work Qs exceeds the number of jobs Qd--thus, unions increase unemployment by the amount Qs - Qd

The Factors of Production

The most immediate cause of the wealth of nations: countries with a high GDP per capita have a lot of physical and human capital per worker and that capital is organized using the best technological knowledge and highly productive. Physical capital, human capital, and technological knowledge are called factors of production. Physical capital is the stock of tools including machines, structures, and equipment. More and better tools that make workers more productive. The typical worker in the U.S. works more than 100,000 worth of capital. A typical worker in India works 1/10th as much.

The Natural Unemployment Rate

The natural unemployment rate is the rate of structural plus frictional unemployment. Underlying rates of frictional and structural unemployment is thought to change slowly through time as major, long-lasting features of the economy change. Cyclical unemployment can increase or decrease dramatically in a period of months. The natural rate changes only slowly through time and the actual rate of unemployment varies around the natural rate. How well an economy absorbs misplaced workers (structural unemployment) depends on the overall strength of economic conditions. One type of unemployment can turn into another. Cyclical unemployment can turn into structural unemployment if workers remain unemployed for too long, leading to a decline in skills and employment prospects.

Defining Unemployment

Unemployed workers are adults who do not have a job but who are looking for work. To count as unemployed a person must be 16 years or older, not institutionalized, a civilian, and looking for work. The unemployment rate is the percentage of the labor force without a job. (Unemployed / unemployed + employed) * 100 = (Unemployed) / (Labor force) * 100 The labor force participation rate is the percentage of adults in the labor force

The Interest Rate

The quantity of funds that people want to borrow depend on the cost of the loan, or the interest rate. Businesses borrow when they expect that the return on their investment will be greater than the cost of the loan. If the interest rate is 10%, businesses will borrow only if they expect their investment will return more than 10%.

The Interest Rate

The quantity of savings depends on the interest rate, namely how much savers are paid to save. EX: If the interest rate is 10% per year, $100 saved today will be $110 a year from now and 5% would be $105. Higher interest rates usually call forth more savings. Why are prices on the horizontal axis? Think of interest rates as the price of savings. An interest rate of 5% means that the saver will be paid $5 for every $100 saved. Thus, we could say that when the price of lending is $5 per $100 saved, the quantity of savings is $200 billion. Interest rate is the market price and it has the same properties of market prices.

The Quantity Theory of Money

The quantity theory of money sets out the general relationship between money, velocity, real output, and prices. It also helps to explain the critical role of the money supply in determining inflation rate. EX: Every month you are paid $4,000 and you spend $4,000, so you spend $48,000 a year. Another way of figuring out yearly spending is to add up all the goods that you buy and multiply by their prices. This equation is... M * v = P * Yr M = The money you spend v = (velocity of money) the number of times in a year you spend M P = Prices Yr = a measure of the real goods and services you buy. A similar identity holds true for the nation as a whole, where... M = the supply of money v = the average number of times in a year that a dollar is spent on final goods and services P = the price level Yr = real GDP Mv = PYr Mv = total amount spent on final goods and services PYr = the price level times real GDP, both sides of this equation are also equal to nominal GDP. Over a period, real GDP is fixed by real factors of production (labor, capital, tech). Changes in real GDP don''t seem like a plausible candidate to explain large changes in price, because massive growth is hard. Changes in v do not seem like a plausible candidate for explaining large and sustained increases in price.

Nominal vs. Real GDP

The rate of growth by the previous formula does not adjust for price changes and is called the "nominal growth rate" Nominal GDP is calculated using prices at the time of sale. GDP in 2013 is calculated using 2013 prices and 2002 GDP is calculated using 2002 prices. Nominal variables have not been adjusted for changes in price. Only increases in production are true increases in the standard of living, not increases in price. Nominal GDP: Year 1 Price * Year 1 Quantity Real GDP: Year 2 Price * Year 1 Quantity Real variables have been adjusted for changes in prices by using the same set of prices in all time periods. If you want to compare GDP over time, we should always compare real GDP. GDP calculated using the SAME PRICES IN ALL YEARS. It doesn't matter what prices used to calculate real GDP so long as you use the same prices in all years. The more years that pass, the more difficult it is to determine how to adjust for those quality changes. A real variable is one that corrects for inflation, a general increase in prices over time.

GDP Deflator

The ratio of nominal to real GDP multiplied by 100. The GDP deflator covers all final goods.

Scuritization

The seller of a securitized assete gets up-front cash while the buyer gets the right to a stream of future payments. Sometimes mortgage loans are securitized, or bundled together and sold on the market as financial assets. The bank gets more liquid cash when securitize loans, and securitized assets can be held as investments by institutions with a long-term perspective. Too often banks securitize when they mad bad loans in the first place Once assets are securitized, the revenue streams from them can be sliced and diced and sold in all manner of ways. The increased ability to sell mortgages around the world kept interest rates low and seemed good for investors. In reality, securitized mortgages in some cases were sold on false terms or where the risk was obscured, partly by the credit rating agencies poor performance, and in part people simply estimated risk incorrectly by assuming that house prices would continue rising more or less indefinitely.

The Shadowing Banking System

The traditional banking system can be represented by a commercial bank, the bank where you keep your checking account. Commercial banks fund themselves through these deposits. In an investment bank, money comes from investors. Deposits are government guaranteed but investments are not, so there is much more prone to panic. The shadow banking system also includes hedge funds, money market funds, and a variety of others. What unites the shadow banking system is that these financial intermediaries act like banks (typically borrow short term to lend and invest in longer term and less liquid assets) but have traditionally been less heavily regulated and monitored than banks and unlike deposits, short term sources of funds (loans from investors) are not government guaranteed)) The shadow banking system grew in the shadow of traditional banking.

Unemployment Benefits

This includes unemployment insurance, but also other benefits such as housing assistance that may be available in some countries. A French worker who lost their job experiences a 20% pay cut, whereas in the U.S. they experience a 62% pay cut. Unemployment benefits last longer in Europe than in the U.S. In the U.S., unemployment benefits fall by more than half after one year. In France, Germany, and Spain, these benefits never decrease by so wide a margin. Long-term unemployment is more common in Europe than in the U.S. In Europe, the price of unemployment is low, so more unemployment is demanded. Workers in Europe can afford to remain unemployed for longer periods than workers in the U.S. Unemployment benefits reduce the incentive for workers to search for and take new jobs.

Individuals are Impatient

Time preference is the desire to have goods and services sooner rather than later.

Within a country....

US GDP is the market value of the goods and services produced by labor and capital LOCATED in the U.S., regardless of the nationality of the workers or the property owners. EX: A citizen of Mexico who works temporarily in the U.S. adds to U.S. GDP. By the same logic, a U.S. citizen who works temporarily in Mexico adds to Mexican GDP.

How Good an Indicator is the Unemployment Rate?

Unemployment can be financially and psychologically devastating. Unemployment means that the economy is underperforming--labor that could be used to produce valuable goods and services is being wasted. The unemployment rate is the single best indicator of how well the labor market is working in both of these sense, but is an incomplete indicator. Individuals without a job are not counted as unemployed if they are not actively looking for work. Discouraged workers are workers who have given up looking for work but who would still like a job. The BLS keeps statistics on one definition of discouraged workers, defined as workers who want are are available for work, and who have looked for a job sometime in the last year but not in the last month because they believe that no jobs were available for them. This number of discouraged workers in the U.S. is small compared to the number of total unemployed workers, so counting discouraged workers as unemployed increases the unemployment rate only modestly. The number of discouraged workers has increased since the recession in 2009, but the unemployment rate with and without discouraged workers is similar. The unemployment rate doesn't measure the quality of the jobs people take or how well workers are matched to their jobs. If we count part-time workers as partially employed, the unemployment rate would be higher. The underemployment rate is a BLS measure that include part-time workers who would rather have a full-time position and people who would like to work but have given up looking for a job. With imperfections in the official unemployment rate, economists look at other measures of labor underutilization and indicators of how well the labor market is performing, such as the labor for participation rate, the number of full-time jobs, and average wages. Most of these other indicators (and probably many other job characteristics that are more difficult to measure) correlate well with the unemployment rate so the unemployment rate is a good summary indicator of the state of the labor market.

Cyclical Unemployment

Unemployment correlated with the ups and downs of the business cycle. During every recession, unemployment increases dramatically. Low growth is usually accompanied with higher unemployment because when GDP is falling, firms often lay off workers, which increases unemployment. Also, higher unemployment means that fewer workers are producing goods and services. An economy with idle labor and idle capital cannot be maximizing growth, and that will hurt the ability of that economy to create more jobs. Faster growth is correlated with decreases in unemployment. Unemployment tends to fall when growth is above average and tends to rise when it's below average. The cause of cyclical unemployment is debatable, as are the causes of the business cycle. Some think a business cycle is the economic growth process in action (growth is volatile, not smooth). Others think cyclical unemployment is another example of frictional and structural unemployment. Other Keynesian economists think cyclical unemployment is caused by deficiencies in aggregate demand. This is the notion of cyclical unemployment as caused by a mismatch between the aggregate level of wages in an economy and the level of prices. The wages demanded by workers are out of sync with the level of prices, so workers are too expensive to hire from the point of view of rims. EX: Whether a firm wants to hire another worker depends on the wage of that worker and the wage relative to the price of the firm's product. If an iPod can be sold for $200, it is more likely to hire more workers than if it can be sold at $100. When potential workers make wage demands, they are not always aware of the prices and the profits available for employers. Wage demands can be too high relative to what firms find profitable, and this mismatch gives rise to cyclical unemployment. If aggregate demand for goods and services was higher, the higher wage demands could be justified and the workers could be hired.

Labor Regulations and Structural Unemployment

Unemployment in the U.S. tends to increase with a shock and then decrease, while in Europe, unemployment has increased with shocks and then remained at those levels. Structural unemployment has been a more serious problem in Europe than in the U.S. because of labor regulations. Unemployment benefits, minimum wages, unions, and employment protection laws benefit some workers, but these regulations can also increase unemployment rates. These regulations are more generous and wide-ranging in Europe than in the U.S., and that explains why structural employment is a more serious problem in Europe than in the U.S.

The Factor Income Approach

When a consumer spends money, the money is received by workers (employee compensation = wages + benefits), landlords (rent) owners of capital (interest), and business (profit). GDP: We can add up all the spending or add up all the receiving. The earlier is the spending approach, the latter is the factor income approach. The factor income approach: Y = Employee compensation + Rent + Interest + Profit Not every dollar spent on goods and services is a dollar received in income. Sales taxes are one exception with which you can identify. Sales taxes create a difference between what consumers pay and what businesses and workers receive so if we calculate GDP using the income approach, we need to add sales tax. Every dollar spent is a dollar of income received so if we are careful in our counting, we can measure GDP by summing up all the spending on final goods and services or by summing up everyone's income.

The National Spending Approach

Y = C + I + G + NX Consumption + Investment + Government Spending + Net Exports (Exports - Imports). To understand why this is equivalent to thinking of GDP as the market value of all final goods and services produced within a country in a year, note that produced goods can be consumed, invested, or purchased by governments or foreigners. Some consumed, invested, and government-purchased goods are imported. Imported goods are not part of GDP, so we subtract them. Y = nominal GDP (the market value of all final goods and services) C = the market value of consumption goods and services. I = the market value of investment goods, also called capital goods. G = The market value of government purchases. NX = Net exports, defined as the market value of exports minus the market value of imports.