ECON FINAL STUDY SET

base year

the year used for comparison in the determination of price changes using the GDP deflator price index; the deflator in a base year is always equal to =100=100equals, 100.

Labor Force

the part of the population that is either currently employed or looking for a job. The unemployed are the part of the labor force that is currently looking for a job. In the U.S., the labor force is measured as all persons 16 years or older who are (1) employed, or (2) actively looking for work, or (3) waiting to be recalled from a layoff.

Monetary Policy

Table 2 provides a summary o possible Fed actions and the effects on either the money supply or the money multiplier. Past Table

store of value

What if you have money, but don't know what you want to spend it on yet? But, suppose you had no idea what you wanted? You save that \$20$20dollar sign, 20 in your room and spend another day. That is money acting as a store of value. If money fails as a store of value, it will also fail as a medium of exchange. If money didn't keep its value for later, you would have to spend it immediately on something before it became worthless. That's pretty impractical!

Per capita GDP

is GDP divided by the number of persons in the economy.

Deflation

is a decrease in the price level, that is, a general decrease in the average of all prices. It is measured by a negative percentage change in a measure of the price level like the CPI. With deflation, the purchasing power of money increases, a deflation is a general decrease in dollar prices (most prices are decreasing.)

Aggregate (definition)

"Constituting or amounting to a whole; total." (dictionary.com)

rate of inflation (If the price level was 178 in 1980, 196 in 1981, and 207 in 1982, what is the rate of inflation? What characteristics of an economy does the rate of inflation describe?)

1980-1981: 10.11%, 1981-1982: 5.61%. The rate of inflation describes an increase in the average price level.

sensible (What are "sensible" fiscal policy responses to unemployment? To inflation?)

A "sensible" fiscal policy response to unemployment is increased government spending and/or decreased taxation. A "sensible" fiscal policy response to inflations is decreased government spending and/or increased taxation.

Restrictive countercyclical (fiscal policy)

A decrease in government spending and/or an increase in taxes decreases aggregate demand. Because of this effect, fiscal policy can be used to offset aggregate demand shocks that would otherwise lead to an inflation and a short-term increase in real output.

Demand (two interpretations)

A demand schedule or demand curve can be interpreted in two ways. First, it represents the maximum quantity that demanders wish to purchase at each price. Second, it represents the maximum amount of money that individuals would be willing to pay for any additional amounts, given the current level of purchases.

Common MIsperceptions (nominal vs. real interest rate)

A point of confusion some people have is whether nominal and real interest rates can be negative. Real interest rates can be negative, but nominal interest rates cannot. Real interest rates are negative when the rate of inflation is higher than the nominal interest rate. Nominal interest rates cannot be negative because if banks charged a negative nominal interest rate, they would be paying you to borrow money! This is called the "zero bound" on interest rates: the nominal interest rate can only go down to 0\%0%0, percent.

Consequences (Are there fiscal policies that might simultaneously increase aggregate demand and decrease aggregate supply? What would the consequences of such policies be?)

A war in Iraq, for example, would increase AD while decreasing long-run aggregate supply (as we lose lives and capital due to the war). A consequent of such policies will be a short-run increase in GDP at the cost of lowered future GDP.

cost-push inflation (What is a cost-push inflation? A demand-pull inflation?)

Cost-push inflation is inflation caused by adverse supply shocks that increase the costs of production. Demand-pull inflation is inflation caused by positive demand shocks.

Cyclical Unemployment

Cyclical unemployment is a consequence of coordination problems between aggregate supply and aggregate demand. During a downturn, there are fewer jobs openings available relative to the number of people searching for work. Both the number of people looking for work and the duration of unemployment increases. However, focusing only on reported unemployment numbers is somewhat misleading. Even though much of the unemployment will be cyclical during an economic downturn, unemployment occurs for reasons other than just an adverse aggregate demand shock. .

benefits (Inflation is a tax on holding money. If you hold a $100 bill and the price level increase by 10%, the purchasing power of money falls by 10%. Who benefits?)

During inflation debtors benefit at the expense of lenders.

biased statistics (In what ways are government unemployment statistics biased?)

Government unemployment statistics are biased for the reasons described in part 2.

(Why do individuals save part of their income rather than consuming it all?)

Individuals save and dissave in order to smooth consumption across their lifecycle.

Nominal

Refers to a measure in current dollars, whatever the purchasing power of the dollar.

Nominal and real (interest rates)

Sustained inflation will increase the nominal interest rate but it will not necessarily affect the real interest rate. Indeed, nominal interest rates will equal the real interest rate plus the rate of inflation.

Criteria (What criteria determine the potential real output of an economy?)

Technology, the labor force, the capital stock, and natural resources.

LRAS (What happens to long run aggregate supply when labor productivity increases over time?)

The LRAS curves shifts to the right as labor productivity increases.

true tax (What is the "true tax" created by the government deficit?)

The true tax on an economy is the resources that the government will use in a given year, i.e. government speding.

Why does the labor demand curve slope downward and to the right?

The labor demand curve slopes downward and to the right because the lower the price level in an economy, the more goods and services people demand (since their dollars are worth more).

Consumption

The largest component of aggregate demand is consumption. Consumption expenditures are relatively stable: individuals tend to smooth consumption over time, drawing from savings if they experience a sudden decrease in income or adding to their savings when their income unexpectedly increases. Aggregate consumption depends on aggregate real income, interest rates wealth, and expectations about future changes in income, wealth and interest rates.

interest rate (How does inflation affect interest rates?)

The nominal interest rate is equal to the real interest rate plus inflation. As a consequence, inflation increases the (nominal) interest rate

Monetary policy path

The path by which monetary policy affects the economy can be summarized as follows. Paste Pic

short run as (What happens to short run aggregate supply as the nominal wage increases? Decreases?)

The short run aggregate supply curve shifts up as the nominal wage increases and down as the nominal wage decreases.

Real Money Balances

The stock of money (M) available in an economy at any given time measured in terms of the purchasing power of a dollar (P)

Three Types (of unemployment)

There are three types of unemployment that economists describe: frictional, structural, and cyclical. During recessions and expansions, the amount of cylical unemployment changes. Cyclical unemployment is closely related to the business cycle, and causes the deviations of the current rate of unemployment away from the natural rate of unemployment.

Rational choice

While some choices may be based on tradition or others may be random, most choices are assumed to be purposeful or rational. To make rational choices individuals must make informed comparisons have consistent orderings choose the most preferred or best option

depression

a deep and prolonged recession

deflation

a sustained decrease in the overall price level in the economy; deflation occurs if the inflation rate is negative.

Sticky Wages

are nominal wage payments that do not change immediately in equal proportion to changes in price level.

Short-run aggregate supply

is the actual real output produced when the employment of resources changes as the price level changes.

real GDP

nominal GDP adjusted for changes in the price level, using prices from a base year (constant prices) instead of "current prices" used in nominal GDP; real GDP adjusts the level of output for any price changes that may have occurred over time

Structural Unemployment

occurs because skills that employers need from workers changes as the nature of the economy changes. This can occur when new types of goods or technologies are introduced. For example, if someone created a robot that could train fleas to dance, then people who worked in the flea performance industry no longer have skills that are valued. They become structurally unemployed until they learn a new skill.

medium of exchange

the ability for something be used to purchase something else, such as "I can use this \$5$5dollar sign, 5 bill to buy a grilled cheese and peanut butter sandwich"

potential output

the level of output an economy can achieve when it is producing at full employment; when an economy is producing at its potential output, it experiences only its natural rate of unemployment, no more and no less.

GDP

the market value of all final goods and services produced within a country in a given period

nominal GDP

the market value of the final production of goods and services within a country in a given period using that year's prices (also called "current prices")

impact (Show the first four rounds of spending caused by a decrease in investment of $400 million if the MPC equals .75 What ist he total of the first four rounds? What is the total of all rounds-- using the multiplier? )

A decrease of investment of $400 million will have the following impact on consumption: i. C declines by $300 ii. C declines by $225 iii. C declines by $168.75 iv. C declines by $126.56 The total change equals 400 X (1/(1-MPC)) = $1.6 billion

Market Power

A firm has market power if it can affect the market price by changing the amount that it produces. A firm that is large relative to the market for what it produces, in general, has market power. If a firm has market power, its marginal revenue is less than the price at which it can sell its output.

Short run

A firm must often make short-run decisions about production without being able to change its capital stock. Because the capital stock in these circumstances is fixed, the firm finds that its marginal cost increase as it increases production and decrease as it decreases production.

recesssionary gap

(sometimes called a negative output gap) when the current output is less than potential output

equal (Is it possible for actual investment to always equal actual saving, even though desired investment differs from desired savings?-- Hint: Consider the rule of inventories.)

Actual investment would only equal actual savings if there was neither an excess supply nor an excess demand for loanable funds. Since inventories (excess supply) of loanable funds are commonplace, actual savings do not always equal actual investment. 8

conditions (Under precisely what conditions will aggregate-demand changes be primarily responsible for fluctuations in real output?)

Aggregate demand fluctuations will only cause fluctuations in real output if the short run aggregate demand curve is upward sloping. One possible explanation of why the supply curve might slope upward in the short run is sticky wage theory. 6

Aggregate Demand

Aggregate demand is a graphical model that illustrates the relationship between the price level and all of the spending that households, businesses, the government, and other countries are willing to do at each price level. If that sounds familiar, it should! The components of aggregate demand are identical to the components that are used to calculate real GDP using the expenditures approach: Consumption Investments Government spending Net exports.

downward (Why does the aggregate demand curve slope downward?)

Aggregate demand slopes downward because a low price level implies an increased purchasing power of money. Economic agents respond to this increase in the purchasing power of their money holdings by purchasing more goods and services

countercyclical (stimulative countercyclical fiscal policy)

An increase in government spending and/or a decrease in taxes increases aggregate demand. As a consequence of this effect, fiscal policy, in principle, can be used to offset adverse aggregate demand shocks that would otherwise lead to a decrease in real output and an increase in unemployment.

Balanced-budget effects

An increase in government spending matched by an increase in tax revenues increase aggregate demand. A decrease in government spending matched by a decrease in tax revenues decrease aggregate demand. Thus, a balanced-budget change in fiscal activities will affect aggregate demand. This means that balanced-budget changes can be used for countercyclical policy.

Tax Increase Effect (Describe how an increase in taxes affects both aggregate demand and long-run aggregate supply.)

An increase in taxes reduces disposable income which lowers both consumption and savings. Since investment equals savings in equilibrium, investment must also fall. Consequently the economy's capital accumulation is slowed and, thus, so is long-run aggregate supply. Since consumption falls, so does aggregate demand.

Changes (How do changes in the price level affect potential real output?)

An increase in the price level has no effect on potential real output.

Reserve-requirment changes

An increase in the reserve requirement decreases the money supply; a decrease in the reserve requirement increase the money supply.

Frictional Unemployment

Frictional unemployment is the unemployment associated with looking for jobs, such as recent college graduates looking for their first jobs. Any innovation that makes finding a job easier, such as job-search websites or apps, decreases the amount of frictional unemployment.

Fiscal Activities

Government expenditures directly affect aggregate demand: tax policies indirectly affect aggregate demand because they change either desired investment or desired consumption. A budget deficit occurs when expenditures exceed tax revenues.

cause of inflation (What appears to be the primary cause of sustained inflation?)

Growth in the money supply seems to be the primary cause of sustained inflation.

Pessimistic (Suppose that firms become pessimistic. Describe the short-run effects on real GDP and the price level. Suppose that the price level doesn't change, how does your answer change?)

If firms become pessimistic, investment decreases, and GDP falls

Intermediaries

Intermediaries are individuals or firms that specialize in facilitating trades between other individuals or firms. Because intermediaries are specialists, the costs of trading through an intermediary are frequently lower than the costs of trading directly. Although intermediaries generally do not produce additional output, they increase individuals well-being by lowering the costs of transacting, thereby facilitating the movement of commodities from lower values to higher valued uses. In the important sense, intermediaries are productive.

Interest-sensitive (components of aggregate demand)

Investment by firms in new plant and equipment and by households in housing as well as household expenditures on consumer durables are sensitive to interest-rate changes to varying degrees. Lower interest rates increase desired investment by both firms and households, ceteris paribus; higher interest rates decrease desired investment

direction (The first column of the following table indicates a series of changes that might affect the economy. Indicate in the second column the component of aggregate demand most likely to be affected and indicate in the third column the direction of the effect Change: agg D component affected; direction of effect increase in population reduced money supply incrased income taxes recession abroad expected domestic recession rapid escalation in house prices stock markst crash cut in defense expenditures higher prices abroad)

NX,C decrease C,I decrease C increase C decrease G,C decrease NX,C increase

Common MIsperceptions ( Long run self-adjustment in the AD-AS model)

Not every recession needs government intervention, nor does every economic boom. Once prices adjust, the economy should return to the full employment output. Of course, the historical evidence of the Great Depression tells us that sometimes this self-correction mechanism breaks down. We'll talk more about why that breakdown occurs in upcoming lessons. It can be confusing to remember what is changing to cause the self-correction mechanism. Keep in mind that changes in SRAS drive the self-correction mechanism. As resource and output prices adjust to changes in the rate of inflation and unemployment, SRAS will shift to close an output gap.

Always operating (The economy is always operating somewhere along a short-run Phillips curve)

Like the production possibilities curve and the AD-AS model, the short-run Phillips curve can be used to represent the state of an economy. The table below summarizes how different stages in the business cycle can be represented as different points along the short-run Phillips curve.

Backing (In what sense does money have backing? Does this mean that it is not useful? What does this suggest about the intrinsic value of money?)

Money is backed by the confidence of people in the economy. Money is useful precisely because it is understood and commonly used as a medium of exchange. Whether or not it has intrinsic value is irrelevant.

Long-Run equilibrium

There is an important distinction between a short-run equilibrium and a long-run equilibrium. The short-run equilibrium says that this price adjustment hasn't happened yet, and so it just provides the real GDP that exists right now. Remember how the LRAS curve represented the idea that all prices have fully adjusted? Well, a long-run equilibrium means that everything that can change has changed. In other words, the current output is the same as the full employment output because all prices have fully adjusted. When the current output that is generated by the interaction of SRAS and AD is identical to the full employment output, all prices have adjusted in the economy. Graphically, this looks like the intersection of all three of our curves in the AD-AS model.

potential GDP (What determines potential GDP?)

Potential GDP is determined by the labor force, the capital stock, technology, and natural resources

Profits

Profits are total revenues minus total costs, where revenues are equal to the amount sold multiplied by the market price. Total costs are equal to the explicit and implicit costs of production, including the explicit costs associated with payments to input owners, the implicit costs associated with the use of previously purchased intermediate goods and resources, the value of depreciation, and the normal rate of return to the owners of the firm.

real output (Why should unemployment of labor (or any other resource) fall when real output increases?)

Since production is determined by the quantities of capital, labor, and resources we employ, an increase in production must follow from an increase in the employment of one or more of the resources and, thus, a decrease in unemployment. Typically, we look to the labor market for the source of the increased production.

Spend and Purchase (Is there a difference between the amount the government spends and the amount of goods and services the government purchases? Hint: Consider redistributive transfers from one household to another.)

Yes. If the government only spent money on goods and services, this would be true. The government also spends money through welfare programs that redistribute wealth. Since this component of government spending is neither a good nor a service, government spending is greater than the amount spent on goods and services.

Fiscal policy (Fiscal policy is usually conducted by changing taxes and expenditures. Could it be conducted by changing subsidies and expenditures just as easily?)

Yes. Subsidies are just a form of government spending and can be used to stimulate aggregate demand

disinflation

a slowing of the rate of inflation; for example if the rate of inflation is 5\%5%5, percent in 2016 and 3\%3%3, percent in 2017, there is still inflation in 2017.Prices are just not rising as fast as they were before.

long-run

a sufficient period of time for nominal wages and other input prices to change in response to a change in the price level; the long-run is not any fixed period of time. Instead, this refers to the time it takes for all prices to fully adjust

demand shock

an unexpected change that shifts AD; a positive demand shock (such as an increase in consumer confidence) increases AD, but a negative demand shock decreases AD.

Aggregate fixed investment

is the value of investment in buildings (also called plant) and equipment by all firms (aggregate business fixed investment) and of the value of new housing, housing remodels, and housing repairs by all households (aggregate residential fixed investment.)

current prices

the prices at which goods are sold in a nation in a particular year; current prices are used when calculating nominal GDP.

implementation (Why does it take a long time to implement fiscal policy? Do you suppose fiscal policy is ever implemented only for the purpose of stabilization? What other purposes might fiscal policy serve?)

"For example, it is a political decision whether to use a tax cut that may benefit corporations or the wealthy more than the poor or to use a spending increase that may benefit the poor and middle class more than the rich. Political processes and decision tend to move slowly." (pg. 486)

fiscal policy (Why does it take a long time to implement fiscal policy? Do you suppose fiscal policy is ever implemented only for the purposes of stabilization? What other purposes might fiscal policy serve?)

"The Fed must simply decide to engage in an open market operation and buy or sell T-bills (or announce changes in the reserve ratio or discount rate). This can be done in a matter of days or even hours." (pg. 487)

Lag (What are some of the reasons for the lag between the time that a demand--or supply- shock occurs and the time that we come to realize it?)

"The US economy is very large, with millions of transactions and tens of thousands of different markets and activities. As a consequence, gathering the information necessary to make forecasts takes time." (pg. 484)

full employment output

(also called potential output) the amount of real GDP that an economy would produce if it is using all of its factors of production efficiently

Okun's Law

(or rule-of-thumb_: For every 2 to 3 percent that actual output falls below potential real output, unemployment will increase by 1 percentage point.

inflationary gap

(sometimes called a positive output gap) when the current output is greater than potential output

Common Misperceptions ( Changes in the AD-AS model in the short run)

-Some people get confused about changes in the price level versus changes in expectations in the price level. A change in the price level leads to movement along the SRAS or AD curve, but changes in expectations shift the entire curve itself. If something happens that makes firms believe that inflation is coming, they will adjust their plans accordingly. For example, if firms expect they will have to pay higher wages in the future because of inflation, they start cutting back production today in anticipation of that inflation. As a result, the SRAS curve will decrease, even before any inflation has occurred. Expectations of inflation are, in effect, self-fulfilling prophecies!

Financing deficit (How might financing a deficit affect the economy?)

. Financing a deficit might produce a trade deficit, as described on page 494, but this will only happen if foreigners are willing to purchase the government's debt.

Wealth (What would happen to the level of wealth in an economy if the price level increased? What effect would this have on the demand for real output?)

. If the price level increased, wealth in the economy falls, decreasing the demand for real output.

interest rates (Nominal interest rates have declines since about 1983. What information would you need to know to find out if real interest rates have also decline?)

. Inflation. Remember the Fisher Equation.

cycle elimination (Is it likely that stabilization policies will ever completely eliminate the cycles in an economy? Under what conditions would such policies completely eliminate the cycles?)

. It is unlikely, if not impossible, that countercyclical policies will ever completely eliminate the business cycles, since doing so would require perfect information, including accurate information about current and future expectations.

Currency held (If individuals and firms wanted to increase the amount of currency they hold at Christmas every year, what would happen in the money market?)

. The demand for money would increase and the interest rate would increase. Consequently, investment would decrease.

upward (Why is the short run aggregate supply curve drawn with an upward--to the right-- slope?)

. The short run supply curve is upward sloping because of sticky wages (see 11).

short run tradeoff (Is there a short-run trade off between inflation and unemployment? Why or why not?)

. There may be a short-run tradeoff between inflation and unemployment. Increasing inflation unexpectedly, because of sticky wages, can "coax" more output out of the economy in the short run.

Stabilize GDP Cases (Assume that the Fed's goal is to stabilize the GDP. How should it respond to the following cases: a. Everyone believes that interest rates will fall in the near future and money demand falls. b. Many credible financial advisors recommend buying bonds. c. Tired of credit card debt, everyone begin to use credit cards less frequently. d. How will the interest rate by affected by the Fed's actions in each case? e. How will real GDP be affected by the Fed's actions in each case?)

. a. reduce the money supply (sell a T-bill, increase the RR, or DR) b. increase the money supply c. increase the money supply d. a - increase, b - decrease, c - decrease e. a - decrease, b - increase, c - increase

price level change (If there is a 5% inflation for 8 years, what is the total amount of inflation--that is, how much has the price level changed in the 8 years-- Hint: the answer is not 40%)

47.7455444%

Money supply (If the Fed wants to change the money supply, what factors do you think will influence its choice to do so by open market operations, by changing the discount rate, or by setting a new reserve requirement?)

?

Net taxes (Suppose that net taxes depend upon income, specifically, each time houshold income increases by $100, the government's net tax revenue increases by $25. What happens to the multiplier? Hint: Construct a table where you look at each round of induced consumption following a $1 increase in investment that incorporates taxes and the fact that in each round, the increase in disposable income will equal the increase in income minus any increase in taxes.)

?

sustained cost-push (Can there be sustained cost-push or demand-pull inflations?)

?

tax incentives (Can tax incentives to not raise prices, control inflation successfully?)

?

wage controls (Several countries have imposed wage and price controls to lower inflation. Under what circumstances can these policies control inflation successfully?)

?

more increase

A $1 increase in autonomous spending means more than $1 increase in real GDP Governments usually spend money if they have a reason, or an objective to spend it. They don't spend more money just because the economy is doing well and national income is increasing (in fact, we will learn later that it is usually the opposite). This kind of an increase in spending called an autonomous government spending. A change in autonomous spending will lead to a much larger final change in real GDP because of the multiplier effect. That spending will have a much larger final impact on real GDP. For example, if the government buys apples from Jack, Jack then uses that money to buy latte's from Jill, and Jill buys a computer from Pedro. The final impact of the government's purchase of apples will be bigger than just that purchase because we add up the apples, lattes, and computers in real GDP.

Tax Multiplier

A change in taxes also results in a multiplier effect. The tax multiplier tells you just how big of a change you will see in real GDP as a result of a change in taxes. For example, imagine government gives out a total of \$1 \text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n in tax refunds. As a result, there is a \$3\text{ million}$3 milliondollar sign, 3, space, m, i, l, l, i, o, n increase real GDP. Therefore, the tax multiplier is -3−3minus, 3. The tax multiplier is always one less in magnitude than the expenditure multiplier, and it is always a negative number. We can see how this plays out in the table shown below. Suppose of spending \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n on gerbil rockets, the government gave out \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n dollars in tax rebates to the employees at Rockets R Us. Why is it less? Notice that there is a round missing here: the initial \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n in tax rebates themselves are not counted. The impact of the tax is indirect, not direct. That missing initial amount is why the tax multiplier is always 1 less than the expenditure multiplier.

Discount-rate changes

A change in the discount rate will also change the money supply, but without any change in the amount of currency in circulation. A decrease in the discount rate makes it more attractive for banks to lend, thereby increasing the money supply; an increase in the discount rate makes it less attractive for banks to lend, thereby decreasing the money supply.

Substitution (and income effects of a price change)

A change in the relative price also changes the real income of consumers. For normal commodities, the substitution effect of a price change and the income effect of the real income change reinforce each other, leading to an inverse relationship between price and quantity demanded. For inferior commodities, however, the substitution effect and the income effect go in opposite directions. Thus, there will be an inverse relationship between price and quantity demanded for inferior goods only if the substitution effect is more important than the income effect. Empirical evidence suggests that this is so.

Commodity Tax

A commodity tax is an amoint of money per unit bought or sold that must be paid to the government. With a commodity tax, the price that demanders pay is greater than the amount that suppliers can keep. THe difference is the per-unit tax that must be given to the government. With the tax, the quantity bought and sold decreases. In terms of the efficient use of scarce resources, a commodity tax imposed on an otherwise competitive market leads to too little production. There is, as a consequence, a deadweight burden or loss to society.

Common MIsperceptions

A common misperception is that inflation is bad for everyone (who likes more expensive stuff?). But this is not the case. Inflation reduces the value of money. Because of that, people who have borrowed money benefit from a higher inflation rate when they pay the money back. The interest rate that a borrower pays is effectively lower thanks to inflation. Another common misperception is that disinflation and deflation are good for everyone (who doesn't enjoy cheaper stuff?). The problem is, deflation increases the purchasing power of money. People who have borrowed money are paying back that loan with money that is effectively worth more than the money they borrowed. Deflation effectively increases the interest rate that a borrower pays. A very common misperception is that inflation should always be avoided. Deflation has such a destructive impact on an economy that most policymakers agree that avoiding deflation is a far more important objective. As a result, the goal of policymakers is not zero inflation, but small and predictable inflation rates.

Barriers in international trade

A government can indirectly affect domestic markets by limiting imports or exports. There are a number of different that a government can interface with imports. The most common are tariffs, quotas and volunatry exports restraints. A tariff is a tax on an imported good that is not imposed on the same good when it is produced domestically. A tariff increases the price that domestic demanders must pay above the world price, reduces the quantity demanded, and the increases domestic production. A quota is a quantitative limit on the amount of imports. If the quota is less than what would be freely imported at the world price, the domestic price will increase, thereby benefiting domestic producers and hurting domestic consumers. A voluntary export restraint is a quantitative limit on the amount of exports one country sends to another country. If the VER is less than what the importing country would choose to purchase at the world price, the VER will increase the domestic price, benefiting domestic producers and hurting domestic consumers.

balanced budget (bb multiplier always equals 1)

A government has a balanced budget when its expenditures are equal to its revenues. In other words, if a government wants to spend \$20$20dollar sign, 20, but it also wants to maintain a balanced budget, then it needs to take in \$20$20dollar sign, 20 in taxes. Governments run deficits when spending is higher than tax revenue, and they run surpluses when spending is lower than tax revenue. Over time, those deficits accumulate into national debt. What if a government wants to use expansionary fiscal policy, but it also wants to maintain a balanced budget? If Burginvlle is in a recession and has a \$100$100dollar sign, 100 million negative output gap, it needs to use expansionary fiscal policy to close that gap. Because it has a spending multiplier of 101010, it decides to increase government spending by \$10$10dollar sign, 10 million to close that gap: 10 \times \$10 \text{million}=\$100 \text{million}10×$10million=$100million10, times, dollar sign, 10, m, i, l, l, i, o, n, equals, dollar sign, 100, m, i, l, l, i, o, n. However, to maintain a balanced budget, it also raises taxes by \$10$10dollar sign, 10 million. But wait . . . that will have its own multiplier effect! Remember that the tax multiplier is always one less than the spending multiplier, and negative.Therefore, if the spending multiplier is 101010, the tax multiplier is -9−9minus, 9. The impact of the tax increase will be: -9 \times \$10 \text{million} = \$-90\text{ million}−9×$10million=$−90 millionminus, 9, times, dollar sign, 10, m, i, l, l, i, o, n, equals, dollar sign, minus, 90, space, m, i, l, l, i, o, n. To find the final impact of these actions, we add them together: \$100 \text{million} + -\$90 \text{million} = \$10 \text{million}$100million+−$90million=$10milliondollar sign, 100, m, i, l, l, i, o, n, plus, minus, dollar sign, 90, m, i, l, l, i, o, n, equals, dollar sign, 10, m, i, l, l, i, o, n. Notice that the final impact is exactly equal to the increase in government spending. The balanced budget multiplier will always be equal to one. Why? Because if you increase spending by \$10$10dollar sign, 10 million, but then increase taxes by \$10$10dollar sign, 10 million to pay for that spending, the final impact on real GDP is only \$10$10dollar sign, 10 million.

Allocative Efficiency

A market is allocatively efficient when the maximum amount that individuals are willing to pay for any additional production is equal to the marginal cost of producing any additional goods. Alternatively, a market is allocatively efficient when the sum of consumer plus producer surplus is maximized. Competitive markets are allocatively efficient.

Long-run equilibrium

A market is in long-run equilibrium when the profits that any potential entering firm expects to earn are zero and when firms within the industry can expect to earn a normal rate of return. This means that a perfectly competitive market cannot be in long-run equilibrium unless any existing firm earns profits equal to what the owners of the firm's capital might earn if they used their capital elsewhere in the economy.

Market Subsidy

A market subsidy is an amount of money per unit bought or sold that is given by the government to either demanders or suppliers. With a market subsidy, the price that demanders actually pay is less than the amount that suppliers receive. The difference is the per unit subsidy provided by the government. With the subsidy, the quantity bought and sold increases. In terms of the efficient use of scarce resources, a subsidy provided in an otherwise competitive market leads to too much production. As a consequence, there is a deadweight burden or loss to society.

Price Ceiling

A price ceiling is a limit above which a market price may not legally move. Price ceilings below the market equilibrium price create excess demand because the market price no longer rations the amount produced among those willing to pay the most to purchase it. As a consequence, imposing a price ceiling means that the government must choose an alternative method for rationing, one that does not rely on willingness to pay. Put differently, since with a price-ceiling, market prices are no longer permitted to coordinate competing interests, alternative methods for coordinating interests must be devised. THe government faces a rationing problem. In terms of the efficient use of scarce resources, too little is produced when there is a price ceiling imposed on an otherwise competitive market. Once again, this means that there is a deadweight burden or loss imposed on society.

Price Floor

A price floor is a limit below which a market price may not legally move. Price floors above the market equilibrium price create excess supply. In this case, the government must choose some method for disposing of the surplus, one that will keep the price at or above the legal minimum. The government faces a disposal problem. In terms of the efficient use of scarce resources, too much is produced when a price floor is imposed on an otherwise competitive market, and there is a resulting deadweight burden or loss to society.

Prohibited Market

A prohibited market is one where the government has made transactions at any price illegal. The government must enforce the prohibition (1) against suppliers, in which case the market price increases and the quantity bought and sold decreases; (2) against demanders, in which case the market price decreases but the quantity bought and sold also decreases; or (3) against suppliers and demanders. If the government enforces simultaneously against both suppliers and demanders, the quantity bought and sold decreases but the effect on the market price is uncertain.

Restriction on entry

A restriction on entry is any governmental limitation on market participation by suppliers. Entry restrictions limit market adjustment. As a consequence, the market price is higher than would otherwise be the case. Suppliers currently in a market where entry has been limited, earn returns that are greater than the normal rate of return elsewhere in the economy at least for a while. Entry restrictions in otherwise competitive markets create a deadweight loss to society as a result of the difference between the actual market price and the lower market price that would have been possible without the restriction.

AD shocks (have a short-run impact on the three macroeconomic variables)

AD shocks have a short-run impact on the three macroeconomic variables We can summarize the impact of an AD shock as described in the table below: Demand shock impact on rGDP impact on unemployment impact on price level ↑ AD ↑ rGDP ↓ UR ↑ PL ↓ AD ↓ rGDP ↑ UR ↓ PL A change in any of the components of aggregate demand will cause AD to shift, creating a new short-run macroeconomic equilibrium. In other words, in our AD=C+I+G+NXAD=C+I+G+NXA, D, equals, C, plus, I, plus, G, plus, N, X equation, anything that increases C, I, G, or NX will shift AD to the right. Anything that decreases C, I, G, or NX will shift AD to the left. For example, suppose an economy is initially in long-run equilibrium. If the economy experiences a positive AD shock, it would be in the expansion phase of the business cycle and have a positive output gap. Increases in AD are the most frequent cause of increases in aggregate output in the business cycle. Positive output gaps are frequently called inflationary gaps because increases in AD also cause an increase in the price level.

Common Misperceptions (aggregate demand)

AD shows the relationship between the price level and real GDP, not the relationship between price level and nominal GDP. It might seem strange that changes in the wealth, interest rates, and exports can cause a movement along the AD curve, while also causing a shift of the entire AD curve. To tell whether it is a shift or a movement, consider what is causing the change. If the cause is a change in the price level, it is a movement along the curve. If the cause is something besides a change in the price level, the entire AD curve will shift. Some students have the misperception that taking shortcuts in labeling graphs is more efficient. But, this cannot be said enough: don't take shortcuts in labeling your graphs!

Relative Prices (and decentralized organization of economic activity)

Aggregate economic activity can be efficiently organized through decentralized individual responses to relative prices. That is, production on an aggregate PPF does not necessarily require centralized direction or control. Rather, individual, self-interested responses to relative prices can lead individuals to specialize in such a way that the economy spontaneously organizes itself and produces at its potential. Moreover, individual, self-interested responses to changes in relative prices can lead to a spontaneous reorganization of economic activity such that an economy produces at its potential, even though its output mix changes.

Aggregate quantity supplied (What is the difference between aggregate supply and aggregate quantity supplied? Hint: Review the distinction between market supply and market quantity supplied outlined in Chapter 3 and then extend the distinction by analogy.)

Aggregate quantity supplied is the amount of output supplied at a particular price level, whereas aggregate supply is the amount of output supplied at different price levels.

Slopes Down (AD)

Along the AD curve, real GDP increases and the price level decreases. In other words, AD slopes down. Changes in the price level will cause a movement along the AD curve. There are three main reasons why we would expect real GDP to increase in response to a decrease in the price level, and vice versa: the wealth effect interest rate effect the exchange rate effect

Deficits and Inflation

Alternatively, a deficit can be monetized. This occurs when the central bank purchased the newly-issued treasury bonds with currency. If this occurs when the economy is at full employment, inflation will result. A deficit doesn't cause inflation, but it may create an environment where there is political pressure to inflate prices.

Policy Implementation

Although fiscal and monetary policy appear to solve the problems of unemployment and inflation quite nicely, they are not simple to implement. 1. Shocks to the economy are not always easy to predict. As a consequence, it takes time to discover that an aggregate demand or aggregate supply shock has occurred. 2. Designing an appropriate policy requires knowledge of both the size of the shock to the economy and the magnitude of the effect on the economy that the policy response will have. 3. Appropriate stabilization policies must affect aggregate demand reasonably quickly and in predictable ways. In this regard, monetary policy, which can be implemented rapidly, affects the economy indirectly and slowly over time. Fiscal policy, which is usually difficult to implement rapidly, affects the economy directly and quickly. Even if the appropriate responses to an economic shock are understood and are "in principle" possible, they may do little good in practice. The economy may be able to move to full employment more rapidly than a policy can be designed, implemented, and have an effect. Indeed, if the timing of countercyclical monetary and fiscal policy is off, they may actually exacerbate economic cycles.

Money Market

Although individuals and firms demand money for use in transactions, there is an opportunity cost of holding money, namely, the interest that could be earned by holding another asset such as a savings account or a bond. At a higher interest rate, individuals will economize on money buiildings; at a lower interest rate, they will hold relatively more of their savings as money and less in other nonmoney assets. As a consequence, there is an inverse relationship between the demand for oney and the interest rate.

Supply Shocks

An adverse supply shock occurs when resources that are widely used suddenly become less available on increase dramatically in price. This shock causes a shift of the short-run aggregate supply curve to the let. Unemployment and the price level both increase at the same time.

Aggregate Production Possibilities

An aggregate production possibilities frontier represents the boundary between what an economy can produce, given its resources and available technologies, and what it simply does not have resources to produce. In this sense, an aggregate PPF represents the potential output mixes for an economy when its resources are fully and effectively employed, given the level of technological development of the economy (that is, producing efficiently) Changes in either the resources or technologies available to an economy will change the economy's production possibilities. When more resources are available or when there are technologies that allow for more to be produced with a given level of resources, the economy's production possibilities will increase.

Price Fixing

An agreement among otherwise competitive firms to fix prices, called horizontal price-fixing, generally does not allow for economic integration; thus collusion cannot lead to scale economies. Therefore, it makes sense to have a per se rule forbidding such an activity and, in fact, the courts have adopted a per se rule against horizontal price fixing.

(Changes in) net exports

An appreciation of an economy's currency in foreign exchange markets will make its exports appear more costly to foreigners and, generally, its exports will fall. Also, as just noted, an appreciation also makes imports from abroad appear less costly to domestic citizens, and, as a consequence, imports will increase. The combined effects of an appreciation, then, is that net exports will fall. If a country has balanced trade--that is, net exports are zero--then it will find itself with a trade deficit (net exports will be less than zero). If a country has a trade surplus--that is, its net exports are positive--the effect of the appreciation will be to reduce the size of the surplus. A depreciation of an economy's currency in foreign exchange markets will have the opposite effect: net exports will increase. In this case, an economy with balanced trade will find that now has a trade surplus; one with a trade deficit will find that the deficit falls or is eliminated. It follows that if a country's currency appreciates when it is running a trade surplus, the appreciation will tend to eliminate the surplus and if depreciation occurs when there is a trade deficit, the depreciation will tend to eliminate the deficit. For this reason, net exports can be persistently different from zero (e.g., negative) only if individuals in one economy choose to hold the currency or assets of another economy.

Economic Growth

An economy grows when it has the capacity to produce more. Production is based on how much capital, labor, natural resources, and technology it has to produce. Policies that encourage the accumulation of any of these leads to economic growth. We've already seen the capacity to produce represented in two models: the production possibilities curve and the long-run aggregate supply curve. Economic growth is a shift out of either of these curves.

short-run equilibrium

An economy is in short-run equilibrium when the aggregate amount of output demanded is equal to the aggregate amount of output supplied. In the AD-AS model, you can find the short-run equilibrium by finding the point where AD intersects SRAS. The equilibrium consists of the equilibrium price level and the equilibrium output. A good practice is to think of the short-run equilibrium as "how much real GDP is this economy creating right now, and what is the CPI an economy has right now?" In our analysis of markets, an economy in disequilibrium results in price adjusting until the market finds an equilibrium. The same general idea applies to a short-run macroeconomic equilibrium as well, but with a minor modification. If the amount of output demanded is greater than the amount of output produced, people chase after the limited goods available and drive up the price level. In response to the increase in the price level, producers create more goods and services. This continues until the amount of aggregate production equals the amount of aggregate demand. Suppose the aggregate output demanded and the aggregate output supplied at different price levels are as shown in the table below: Real output demanded price level real output supplied \$400$400dollar sign, 400 125125125 \$500$500dollar sign, 500 \$430$430dollar sign, 430 120120120 \$480$480dollar sign, 480 \$460$460dollar sign, 460 115115115 \$460$460dollar sign, 460 \$490$490dollar sign, 490 110110110 \$440$440dollar sign, 440 If the price level in this economy is only 110, for example, aggregate demand will exceed aggregate supply, leading to shortages. Buyers will compete with each other to get output, driving the price level up. Higher price levels will induce producers to increase their output. This price level adjustment will keep occurring until there is no incentive to change. After all, the definition of an equilibrium is "no tendency to change"! The opposite happens when the amount of output demanded is less than the amount produced. The amount of output supplied will be greater than aggregate demand. Prices will begin to fall to eliminate the surplus output. As prices fall, the amount of aggregate demand increases and the economy returns to equilibrium.

common misperceptions (business cycle)

An expansion is not necessarily economic growth. When an economy is recovering from a recession, it is in the expansion phase of the business cycle, but it is not experiencing economic growth. Economic growth occurs when the potential and actual output of a nation increases over time. That growth is either shown by the dashed, upward-sloping trend line (the growth trend) in the business cycle model, or by an outward shift of the PPC. [Explain] \$2dollar sign, 233\$1.9dollar sign, 1, point, 9 \$2dollar sign, 2 An economy can produce beyond its full employment level of output. Resources can be overutilized, such as workers working very, very long hours. However, as any student who has ever pulled an all-night study session for an exam knows, you can't sustain that kind of effort for long.

Common Misperceptions (Real vs Nominal GDP)

An increase in GDP does not necessarily mean a nation has produced more output; it must be specified whether the GDP in question is nominal or real. An increase in nominal GDP may just mean prices have increased, while an increase in real GDP definitely means output increased. The GDP deflator is a price index, which means it tracks the average prices of goods and services produced across all sectors of a nation's economy over time. With this index, changes in the average price level (inflation or deflation) can be calculated between years. However, this is not the most commonly used price index for tracking inflation and deflation. The consumer price index (CPI) is the most commonly used price index, which you'll learn more about later in this course.

Production Possibilities

An individual's production possibilities depend upon individual skill, the tools available to the individual, training and acquired skills, work effort, and the technology that combines ability, skills, tools, and resources. Because these differ for different individuals, individuals will typically have different opportunity costs. The ability to produce, the possible choices, and their costs can be represented by a production possibilities frontier. A PPF indicates the maximum amount that can be produced of any particular mix of goods and services.

GDP deflator (and real GDP)

Another method of calculating real GDP involves converting nominal GDP to real GDP by using the GDP deflator, which tracks price changes of a nation's output over time. Canada's GDP deflator for its base year of 2010 was 100100100 since this is the year against which prices are compared. By 2015 the deflator had increased to 107.4107.4107, point, 4, indicating that the average prices of Canada's output had increased by 7.4\%7.4%7, point, 4, percent. By expressing 2015's output in 2015 prices, therefore, Canada's output would appear to have increased by 7.4 more than it actually did. Canada's nominal GDP, which has been "inflated" by higher prices, can be "deflated" by dividing the country's nominal GDP of \text{CAN }\$1,994 \text{ billion}CAN $1,994 billionC, A, N, space, dollar sign, 1, comma, 994, space, b, i, l, l, i, o, n by the deflator expressed in hundredths.

Tacit Collusion

Antitrust policy has been much less successful in dealing with tacit collusion because it is, by nature, difficult to detect. Moreover, even if it could be shown with reasonable certainty that firms were tacitly colluding, prohibiting rational, profit-maximizing individual actions of firms is problematic.

Shifts (in aggregate demand)

Any change to a component of Aggregate Demand (AD) that is not in response to a change in the price level will cause AD to shift. An increase in AD would be a shift to the right. A decrease in AD would be a shift to the left. For example, if everyone gets an unexpected bonus added to their allowance on the same day, then consumption would increase and AD would shift right. Or, imagine if a central bank increases an important interest rate. In response, firms buy less capital and other interest-sensitive spending, which decreases Investments. As a result, AD will shift to the left. If American made cars were suddenly popular in China, then exports from the U.S. would increase and AD in the U.S. would increase, shifting to the right.

Changes in demand (for loanable funds)

Anything that changes investment demand will change the demand for loanable funds. Examples of events that can shift the demand for loanable funds are Changes in the anticipated rate of return earned on investment spending Government policies There is an important implication of that first determinant of investment demand: real interest rates are procyclical. When the economy is doing well, the rate of return on any investment spending will increase. That means the demand for loanable funds will increase, which leads to a higher real interest rate. In other words, we would expect to see an increase in real interest rates, and the quantity of loans made, when the economy is doing well. Some government policies, such as investment tax credits, basically lower the cost of borrowing money at every real interest rate. Such policies would increase the demand for loanable funds. Other policies, such as budget deficits, might increase the demand for loanable funds.

Effects of change (other than price)

Anything that changes the environment within which individuals make decisions will also affect market demand. These include changes in individual incomes, changes in the prices of other goods, changes in the number of persons desiring to purchase some commodity, changes in transaction costs, changes in expectations, and changes in tastes or preferences. These changes will increase or decrease demand, shifting the demand curve either to the right or the left.

Natural Rate (of unemployment and the long-run Phillips Curve)

Anything that changes the natural rate of unemployment will shift the long-run Phillips curve. Recall that the natural rate of unemployment is made up of: Frictional unemployment Structural unemployment For example, if frictional unemployment decreases because job matching abilities improve, then the long-run Phillips curve will shift to the left (because the natural rate of unemployment decreases). Or, if there is an increase in structural unemployment because workers' job skills become obsolete, then the long-run Phillips curve will shift to the right (because the natural rate of unemployment increases).

Changes in supply (of loanable funds changes)

Anything that impacts savings behavior impacts the supply of loanable funds. Some examples of that are: Changes in saving behavior, such as preferences for saving or having more wealth Changes in capital inflows Changes in public savings

adverse supply shock (if inflation is the primary concern)

Appropriate policy responses to an adverse supply or price shock (if inflation is the primary concern) are: Fiscal: Holding government spending at its current level Holding or increasing taxes Monetary: Holding the money supply at its current level

Adverse supply shock (policy responses; unemployment primary concern)

Appropriate policy responses to an adverse supply or price shock (if unemployment is the primary concern) are: Fiscal: Increasing government spending; Decreasing taxes Monetary: Increasing the money supply by an open market purchase; Lowering the discount rate; Lowering the reserve requirement

Inflationary (policy responses)

Appropriate policy responses to an inflationary aggregate demand shock include: Fiscal Decreasing government spending; increasing taxes Monetary: Decreasing the money supply by an open market sale; Raising the discount rate; Raising the reserve requirment.

automatic stabilizers

Are the lags, or delays, in discretionary fiscal policy frustrating you Don't worry, if lags are causing policymakers to be slow to act, automatic stabilizers will help in the meantime. In a previous lesson, we learned that policymakers can use discretionary fiscal policy as a tool to end recessions or inflationary booms. But delays in putting those plans in place are common, and may even destabilize an economy even more. Luckily, there are mechanisms in place called automatic stabilizers. These mechanisms will kick in immediately to soften the swings of the business cycle, even if policymakers can't act quickly. Automatic stabilizers are tools built into federal budgets that reduce the impact of the business cycle. They are "automatic" because they happen without requiring anyone to take any action. When aggregate demand decreases, two actions kick in automatically. First, income taxes will go down because the amount of income has decreased. At the same time, transfer payments like unemployment compensation and welfare benefits will increase. As a result, consumption will not decrease by as much as it would have.

inflation affect (How does a constant, sustained rate of inflation affect real output?)

As long as expectations about inflation are consistent with the actual inflation, the economy should have full employment and produce at its potential even though the price level is increasing

decrease (Wages decrease; no change in unemployment Wages are fully flexible in the long run and will adjust to the price level in an economy. A negative demand shock increases unemployment and lowers inflation in the short run, but in the long run, wages will fall, and unemployment will return to its natural rate as the country's output returns to full employment.)

Assume the country of Libertyville is currently producing at its full employment output. What will be the long-run impact of a negative aggregate demand shock on the wage rate and the level of unemployment in Libertyville?

support (Automatic stabilizers support the economy during downturns and prevent overheating during booms)

Automatic stabilizers might not smooth out the business cycle completely, but they do make the swings of the business cycle less extreme. Automatic stabilizers are any part of the government budget that offsets fluctuations in aggregate demand. They offset fluctuations in demand by reducing taxes and increasing government spending during a recession, and they do the opposite in expansion.

Fractional reserve banking

Banks are more than just a vault to keep money in. If banks just acted as a storage facility for money, that wouldn't be a very profitable business. The \$100$100dollar sign, 100 you deposited from your groundbreaking verses will be used to make loans. Banks profit from making loans by charging interest. But the new First Bank of Pulitzer has a problem. They want to make loans (because that is how they earn a profit). But at some point, they also need to pay back the money that people have deposited into the bank. This is where reserves come in. Reserves are the amount of money that banks keep in vaults, and they are a fraction of all deposits made. In most countries, banks are heavily regulated and are required to keep a minimum percentage of all deposits, just in case someone wants to withdraw some money. This minimum percent is the reserve requirement. For example, suppose the reserve requirement is 20\%20%20, percent. The bank would need to keep \$20$20dollar sign, 20 of your \$100$100dollar sign, 100 on hand. We can break this down in our T-account: Assets Liabilities Required reserves \$20$20dollar sign, 20 \$100$100dollar sign, 100 Your Deposit The rest of the cash \$80$80dollar sign, 80

money multiplier (determines the size of the expansion)

Banks can't create an unlimited amount of money. The money multiplier determines the limit of how much money a bank can create. The money multiplier is how much the money supply will change if there is a change in the monetary base. There are several reasons that the actual increase in the money supply will be smaller than the simple money multiplier predicts, including: People decide not to deposit money into banks, so money "leaks" out of the banking system Banks decide not to loan out everything and keep some excess reserves

Federal Funds Market

Banks generally do not borrow from the Fed but from each other in the federal funds market. Banks who happen to have excess reserves at the close of the day are suppliers; banks who happen to be short on reserves at the close of the day are demanders. The interaction of supply and demand determines the federal funds rate, which fluctuates day-by-day.

Assets and Liabilities

Banks, like any other business, need to keep track of their assets and liabilities. T-accounts are tables that banks use to keep track of assets and liabilities. Let's create a T-account for a bank that has just opened for business, First Bank of Pulitzer. Nobody has deposited any money yet, so other than its obligations to the bank owners and the real assets that the bank has (like the bank building itself), the bank's T-account is empty: Assets Liabilities \$0$0dollar sign, 0 \$0$0dollar sign, 0 Now suppose you win \$100$100dollar sign, 100 in a poetry writing competition. Congratulations! You deposit your winnings in a First Bank of Pulitzer checking account. That deposit creates two entries on the bank's balance sheet. The \$100$100dollar sign, 100 in cash creates an entry on the asset side because the money is an asset for the bank (because they can put that money to use by loaning it out). But, the bank must give you back that money as well. That obligation is a liability, so there is a \$100$100dollar sign, 100 entry on the liabilities side as well. The bank's balance sheet now looks like this: Assets Liabilities Cash \$100$100dollar sign, 100 \$100$100dollar sign, 100 Your Deposit

Price Level ( and aggregate real output demanded)

Because individuals hold money-fixed assets, wealth will change with changes in the price level. Consumption will change as a consequence. In addition, the real money supply will change with changes in the price level. Changes in the real money supply will lead to changes in interest rates. Two aggregate-demand effects will follow: First, desired investment will change with price-level induced changes in interest rates. Second, consumption with price-level induced changes with changes in interest rates. Finally, changes in the price level affect net exports. Thus, aggregate real output demanded will change with changes in the price level. Because the changes are caused by changes in the price level rather than by changes in desired investment or consumption or net exports that are independent of price-level changes, however, these price-level-induced changes determine the slope of the aggregate demand curve.

supply curve (Why does the short-run aggregate supply curve slope upward to the right whereas the long-run aggregate supply curve--potential real output-- is vertical?)

Because of sticky wages, there is a positive correlation between the price level and real output in the short run. This is shown by an upward-sloping short run supply curve. In the long run, however, all markets clear and nominal variables have no effect on the potential output of the economy. Therefore, real output will be determined independently of the price level. This is shown by a vertical longrun supply curve.

Increasing relative costs

Because resources are not equally effective in all uses, increasing the production of one commodity will become increasingly costly. That is, an aggregate PPF is generally characterized by increasing relative costs (bows outward) .

Costs

Business cycles impose _____ on society. Unemployment lowers the incomes of the unemployed, redistributes income, and creates a loss of labor resources that can never be recovered. Price level changes redistribute incomes, increase transaction costs, divert resources away from production activities, and create uncertainties that adversely affect the decisions of households and firms.

lending rates (Central banks usually target overnight interbank lending rates with OMOs)

Central banks might influence any number of rates directly. So what exactly is a central bank targeting? Open market operations target the rate that banks charge other banks, usually for very short-term loans (such as over a single night). In the United States, this is called the Fed Funds rate. LIBOR is the overnight interbank rate in the U.K., and SHIBOR is the overnight interbank rate in Shanghai, China. It might sound weird that a bank would want to borrow money from another bank, but it happens all the time. For example, sometimes banks have an unexpected withdrawal and fall below their required reserves. A bank could borrow money from another bank with excess reserves to meet that requirement. A bank might have a customer that wants to borrow money from it, but doesn't have the excess reserves to do so. That bank can borrow money from another bank that does have excess reserves, and then make the loan to its customer.

three tools

Central banks usually have three monetary policy tools: Open market operations: buying or selling bonds Changing the discount rate: changing the rate that the central bank charges banks to borrow money Changing the reserve requirement: changing how much money a bank must keep in reserves Open market operations ("OMOs") are the central bank's primary tool of monetary policy. If the central bank wants interest rates to be lower, it buys bonds. Buying bonds injects money into the money market, increasing the money supply. When the central bank wants interest rates to be higher, it sells off bonds, pulling money out of the money market and decreasing the money supply.

Substitution

Central to the inverse relationship between relative price and quantity demanded is the ability to substitute. Identifying some goods as substitutes may be obvious: Pepsi is a substitute for Coke, and vice versa. Some substitutes may be not as obvious: time devoted to planning shopping trips when the price of gasoline increases is a substitute for higher-priced gasoline. Or, perhaps, even more subtle: if expenditures on a wide variety of commodities are cut back when the price of a good that is more necessary increases in price, it implies that individuals are substituting as well.

fiscal absence (In the absence of fiscal activities by the government, are changes in aggregate demand caused primarily by changes in involvement or by changes in consumption? Why?)

Changes in aggregate demand are more likely to be caused by fluctuations in investment than fluctuations in consumption because people tend to smooth their consumption over their lifetime.

Relative prices (and distribution)

Changes in relative prices lead to changes in an economy's production mix. In addition, however, changes in relative prices often change the distribution of income and jobs within an economy. These changes will mater, as we will see later, in the development of public policies and pose important distributional and adjustment problems with which each society must deal.

Fiscal policy

Consider a tale of two economies. Marthlandia has an economic boom which has been going on for awhile. But as a result, Marthlandia struggles with high inflation. Burginville, on the other hand, has been in a recession for quite some time, with high unemployment causing widespread suffering. But the self-correction mechanism isn't kicking in for either country. Is there anything that can be done? Yes! Both governments can use fiscal policy as a tool to bring their countries back to "normal." For example, they can use fiscal policy (changes in government spending or taxes), which will impact output, unemployment, and inflation. Burginville needs to increase output to end its recession. Their government can increase output by using expansionary fiscal policy. Expansionary fiscal policy tools include increasing government spending, decreasing taxes, or increasing government transfers. Doing any of these things will increase aggregate demand, leading to a higher output, higher employment, and a higher price level. Marthlandia's inflation is caused by producing more than is sustainable, so reducing output would fix its problem. Instead, they can draw on contractionary fiscal policy tools, such as increasing taxes or decreasing government spending or government transfers. Doing any of these things will decrease Marthlandia's aggregate demand, which leads to lower output, lower employment, and a lower price level. Usually, governments engage in expansionary fiscal policy during recessions, and contractionary fiscal policy when they are concerned about inflation. Altogether, this lesson is about how government spending and taxes have different impacts on aggregate demand (AD). Government spending impacts AD directly, while taxes impact AD indirectly. Because government spending immediately impacts AD, but some fraction of a change in taxes will be saved rather than spent, there is a difference in impact. If we want to know the amount of taxes that will close an output gap, we need to use the tax multiplier to figure that out. If we want to use government spending to close an output gap, we need to use the spending multiplier to figure that out.

policies (What policies can the government pursue to reduce cyclical unemployment? Structural unemployment? Frictional unemployment?)

Countercyclical fiscal or monetary policy will reduce cyclical unemployment. Job training will reduce structural unemployment. Job search programs can reduce frictional unemployment.

Countercyclical fiscal policy (Will countercyclical fiscal policy affect both aggregate demand and aggregate supply? Why?)

Countercyclical fiscal policy will affect both aggregate demand and aggregate supply because increases in government spending or decreases in taxes will crowd out investment in the long run, lowering the capital stock and the economy's longrun productivity.

Difference

Cyclical unemployment is the deviation of the actual rate of unemployment from the natural rate.

Money (definition, measurement, and functions of money)

Defining money is almost as tricky as defining love. It's something we use every day, but most people don't stop to think about what money is. Money is hard for most people to describe because, at its core, money is an idea. Conceptually, anything is considered money if it functions as: 1) a medium of exchange, 2) a store of value, and 3) a unit of account. Given that money can have such a broad interpretation, we use monetary aggregates to measure the money supply, with categories based on liquidity.

Demand Change

Demand will change with changes in the following: The income of demanders The prices of other, related commodities Transaction costs Property rights Expectations about the future Population, and Demander's preferences.

Demand

Demanders, in general, will purchase more if the price is lower. The maximum amount that demanders wish to purchase at all possible market prices is the market demand. The quantity demanded, by contrast, is the amount that demanders are willing to purchase at a specific market price. Quantity demanded is inversely related to the relative price, ceteris paribus. This relationship is often called the First Law of Demand

Production mix (and economic growth)

Different production mixes will will matter not just in terms of their possible effects on the distribution of income but also because a society can influence its rate of growth by choosing to consume less than it produces (thereby, saving), using the remaining resources to build new capital, thereby increasing its aggregate production possibilities through time. The cost of greater potential output in the future is, however, less consumption in the present.

Common Misperceptions (automatic stabilizers)

Discretionary fiscal policy and automatic stabilizers are frequently confused with each other. If a government has to take any action to make it happen, it is discretionary fiscal policy. If it is something that happens on its own, it is an automatic stabilizer. Some students think transfer payments are in the "G" category ("government spending) of aggregate demand, but this is not correct. Transfer payments and tax rebates do not count directly in real GDP. They impact real GDP indirectly through their effect on consumption. When Holly gets a \$200$200dollar sign, 200 tax rebate from the government, it is not counted as government spending because the government is not buying anything from her. But when she spends that money on veggie burgers and baseball gear, it gets counted in consumption.

Common MIspercepton (short-run aggregate supply)

Don't forget what shifts SRAS. Anything that makes production more expensive or more difficult, or any belief by firms that this will happen, will cause the SRAS to shift to the left. On the other hand, anything that makes production cheaper or easier to produce will cause the SRAS curve to shift to the right. When learning economics for the first time, some learners think that the different models in macro have nothing to do with each other, but this is not the case. Often one model is closely related to another model. (Spoiler Alert: We will see the short-run relationship between the inflation and unemployment that captured by the SRAS curve come up again! Much later in the course, you will learn about a new model (called the Phillips Curve) that also shows this inverse relationship in the short run. For now, though, you just need to know that this relationship exists, and we can see it in the SRAS curve.)

Usury laws (Usury laws place ceilings on interest rates in particular loan markets. How might usury laws create difficulties during periods of inflation?)

During periods of inflation, a ceiling on the interest rate will cause an excess demand for loanable funds and reduce the quantity of loans below the market equilibrium.

Property Rights (and incentives)

Economic activity can be effectively organized and the gains from exchange and specialization fully realized only if individuals have both present and future interests. Otherwise, resources will be used too intensively and there will be too little investment. Getting incentives right requires property rights, which include the right to exclude, the right to use with minimal restrictions, and the right to transfer.

Contracts

Economic activity can be effectively organized and the gains from exchange and specialization fully realized only if resources can easily move from lower-valued uses to higher-valued uses. Because some trades are complex, however, there is the possibility that the movement of resources from lower-valued to higher-valued uses may be undermined by opportunistic behavior. Hence, an economy has to develop institutional arrangements, rules and enforcement mechanisms that prevent or minimize opportunistic behavior. Chief among these are formal contracts enforceable in a judicial system.

Money

Economic activity can be effectively organized and the gains from exchange and specialization fully realized only if transaction costs, particularly those associated with the problem of coincident wants, are minimized. As a consequence, a commonly traded third commodity, money, has evolved in virtually every economy. Instead of trading goods for goods, individuals trade goods and resources for money and then trade money for goods and resources.

Sources (of economic growth)

Economic growth is an increase in the capacity to produce. Therefore anything that increases that capacity is economic growth. The ability to produce depends on: The stock of capital per worker: All else equal an economy with more physical capital can produce more than an economy with less physical capital. Because savings and investment add to the stock of capital, more investment in capital leads to more economic growth. The amount and quality of labor: As long as the capital per worker does not decrease, more labor leads to more production. For example, 4 people that each have a waffle maker make fewer waffles than 10 people that each have a waffle maker. Also, improvements in human capital, such as education and health, improve the productivity of that labor. The level of technology - the know how to combine labor, capital, and natural resources to produce is an important aspect of production. Improvements in technology increase productivity.

Common Misperceptions

Economic growth is the long-run trend of an increase in output over time, not just a temporary fluctuation in output or using previously underutilized resources.

Increase (increase in real GDP is not necessarily economic growth)

Economic growth means that an economy has increased its ability to produce more. When an economy is producing beyond potential output, it might have experienced an increase in real GDP, but that is not economic growth. Similarly, an economy that is recovering from a recession might experience an increase in real GDP, but that is not economic growth.

Price-level changes

Economies also have periods when _______ are not stable. When the price level increases, there is inflation; when it decreases there is deflation. When the rate of inflation falls, there is disinflation. The U.S. has had over its history, periods of stable prices, inflation, and deflation. Since World War 2, however, there has been a sustained inflation--the rate of inflation has changed with the business cycle, but with exception of one or two very short periods, the price level has not fallen during downturns in nearly 60 years since the war.

Cycles

Economies have ________. As a consequence, at times real output is less than potential real output. When it is, labor resources are unemployed. These fluctuations in employment and real output--commonly called business cycles--are also accompanies by fluctuations in capital utilization, inventory holdings, and investment.

Cyclical Unemployment

Economists primarily focus on three types of unemployment: cyclical, frictional, and structural. Cyclical unemployment is the unemployment associated with the ups and downs of the business cycle. During recessions, cyclical unemployment increases and drives up the unemployment rate. During expansions, cyclical unemployment decreases and drives down the unemployment rate

sticky (If wages and prices are completely sticky, what will happen to employment and real output when aggregate demand increases?)

Employment and real output will increase.

flexible (If wages and prices are completely flexible, what will happen to employment and real output when aggregate demand increases?)

Employment and real output will not change.

Entry and Substitution

Entry by new firms and substitution by demanders both undermine market power and limit the strategies that firms might pursue as they seek to exploit their market power. This means that the reliance on market forces is a policy option for dealing with monopolies or firms that collude explicitly or tacitly.

Real vs Nominal GDP

Even GDP needs to keep it real. When we calculate GDP using today's prices, we are creating a measure called nominal GDP. However, prices can change even if output doesn't change. Because of that, our measure of output might get distorted by something like inflation. We account for this using real GDP, which is a measure of GDP that has been adjusted for the price level. In this way, real GDP is a truer measure of output in an economy. There are two approaches to adjusting nominal GDP to get real GDP: 1) using the same prices every year or 2) using the GDP deflator.

Coase Theorem

Externlaities arise because property rights are not clearly defined. If transaction costs are low, strategic bargaining problems avoidable, and private valulations accurate, then once property rights are clearly defined resources will move to the highest-valued use, thus eliminating externalities, regardless of to whom the property rights are assigned. Or, conversely, even when property rights are clearly defined, if transaction costs are high, strategic bargaining problems serious, or private valuations inaccurate, resources might not move to the highest-valued use. In this case, externalities might not be eliminated without more, direct public policy responses.

exchange rate effect

Finally, the intuition behind the exchange rate effect is that a decrease in the price level in country A makes its goods cheaper to country B, so country B buys more of country A's exports. When the price level in one country goes down, its goods are suddenly more attractive to every other country. It's like the whole country is on sale! Since that country's goods are suddenly cheaper, their exports go up. Of course, as with the other explanations for the downward-sloping aggregate demand curve, the opposite will happen when the price level increases. Country A's goods will be less attractive to Country B's consumers and the quantity of aggregate output demanded will decrease. One important note: in all three of these effects, the changes in the amount of AD are brought about by a change in the price level. But if wealth, interest, or exports change for some reason besides a change in the price level, this would actually represent a shift in AD, not a movement along the curve. [got it!]

temporary layoffs (Why might firms and workers prefer temporary layoffs to wage cuts when aggregate demand falls?)

Firms and workers might prefer temporary layoffs to wage cuts when aggregate demand falls because "if firms ask workers to take wage cuts, workers may not understand that aggregate demand has declined and refuse, noting that the employer loses nothing with a wage cut. " (see pg. 445 of text)

supply shock policy (What kinds of policies should be pursued if there is a supply or price shock and the government wants to foster economic growth?)

Fiscal - increasing government spending or decreasing taxes. Monetary - increasing the money supply by an open market purchase, lowering the discount rate or lowering the reserve requirement.

combination (of fiscal and monetary policies can be used to restore an economy to full employment)

Fiscal and monetary policies are frequently used together to restore an economy to full employment output. For example, suppose an economy is experiencing a severe recession. One possible solution would be to engage in expansionary fiscal policy to increase aggregate demand. The central bank can also do its part by engaging in expansionary monetary policy. On the other hand, we can't assume that the government and the central bank will always see eye-to-eye on the economy, and it is possible that these two entities work against each other. For example, suppose a government wants to increase output and decrease unemployment by increasing government spending. If the economy is operating on an upward sloping aggregate supply curve (in other words, if prices are sticky), then this is also going to lead to inflation. Recall that most central banks operate under a dual mandate to encourage full employment and control inflation. If the central bank believes that the unemployment rate is lower than the natural rate of unemployment and there is inflation, it might take action to counteract what the government is doing to control inflation. For example, if the government engages in expansionary fiscal policy that leads to inflation, the central bank might decrease the money supply to lower inflation.

inflation creation (Can fiscal policy--spending increased or tax cuts--create inflation? Can they create sustained inflation?)

Fiscal policy can create inflation, but not sustained inflation. This is because there is an upper bound on government spending and a lower bound on taxes. As a percentage of GDP government spending cannot exceed (or even approach) 100 percent. If sustained inflation were because of government spending, every year the amount of government spending, as a fraction of GDP, would have to be increasing, which is not possible over long periods of time.

Countercyclical policy (Multipliers, elasticities, and the effectiveness of countercyclical policy)

Fiscal policy is more effective if there is a large aggregate-demand multiplier and if desired investment is inelastic with respect to interest rates. If desired investment is highly sensitive to interest-rate changes, however, countercyclical increases in the deficit tend to crowd out private investment. Monetary policy is more effective if there is a large aggregate-demand multiplier, the demand for money is not very sensitive to interest rates and desired investment is sensitive to interest rates. By contrast, if the demand for money is highly sensitive to interest rates or desired investment is not very sensitive to interest rates, then countercyclical increases in the money supply must be very large to have even small effects on short run aggregate real output and employment.

Tax Multiplier

For a lump-sum tax is the change in aggregate demadn taht follows a $1 change in lump-sum taxes. In its simplest form, this multiplier is equal to MPC/(1-MPC)

Fractional reserves (Precisely what is fractional reserve banking? What kinds of vulnerabilities does it create for an economy? Would banks prefer to have fractional reserves or 100 percent reserves against checking accounts?)

Fractional reserve banking is a banking system in which banks hold only a fraction of their demand deposits as reserves. As a consequence, if a greater number than expected of people decided to withdraw their funds, their would not be enough money to cover their withdrawal. Banks prefer fractional reserve banking since they can make money by issuing loans. It would not be profitable to be a banker if they were required to hold 100% of their demand deposits.

frictional unemployment (What is frictional unemployment?)

Frictional unemployment occurs when, in a dynamic economy, individuals entering the labor force or changing jobs do not immediately find a job even though there are jobs available.

Full employment (What determines full employment of labor? When will an economy have full employment?)

Full employment of labor is determined by the real wage. The economy will have full employment when the quantity of labor supplied at the prevailing wage equals the quantity of labor demanded at that wage.

demand decrease (Suppose the economy starts in long run equilibrium, and aggregate demand decreases. a. Show the change in the price level, real output, the real wage rate, and unemployment in the short run. b. Show the change in the price level, real output, the real wage rate, and unemployment in the long run.)

GRAPH a. Price level falls, real output falls, the real wage rate increases, and unemployment increases. b. Price level falls even more, real output increases to its original level, the real wage rate decreases to equilibrium, and unemployment decreases.

Intervention (Suppose you are president of the U.S. and are faced with the following situation: output is too low and the price level is increasing--relative to a beginning position of full employment-- What sort of fiscal and/or monetary policy wold you consider appropriate to move the economy back to full employment? Be as complete as possible, outlining what the effects of your policy decision will be, using graphs, explanations, etc.)

GRAPH. This situation is indicative of an adverse supply shock. To correct this, increase the money supply or increase government spending (or some combination of the two).

Government policies (can impact economic growth)

Government policies play a big part in encouraging (or discouraging) economic growth. Some examples of economic policies that contribute to economic growth are: Investing in infrastructure: infrastructure, like highways or bridges, are physical capital that is available to everyone. By investing in infrastructure, governments add to the capital stock of a country. But infrastructure depreciates, just like any other capital. That means governments must replace depreciated infrastructure to maintain it. Policies that affect productivity and labor force participation - Encouraging a higher labor force participation rate, such as tax incentives on labor for participation, can lead to more economic growth. Policies that encourage capital accumulation and technological change - Policies that encourage savings, and therefore investment in capital, lead to higher economic growth. Similarly, policies that encourage technological change, such as tax credits for research and development, also lead to more economic growth.

by one (Which of the following would be a government spending and tax multiplier for a country?)

Government spending multiplier equal 9 and tax multiplier equals -8 The government spending multiplier is always greater than the tax multiplier by one, and the tax multiplier is always negative. This is because changes in government spending affect aggregate demand directly, but changes in taxes affect aggregate demand indirectly.

Government Budget Constraint

Government spending, that is, government use of real resources, must be funded in some way. For the federal government, the level of expenditures , g, can be funded in one of three ways: direct taxes on income, consumption, or investment (t); or indirect taxes on capital formation through deficits (B); or indirect taxes on money and money-fixed assets through inflation (M)

Phillips Curve

Helen of Troy may have had "the face that launched a thousand ships," but Bill Phillips had the curve that launched a thousand macroeconomic debates. Bill Phillips observed that unemployment and inflation appear to be inversely related. The original Phillips curve demonstrated that when the unemployment rate increases, the rate of inflation goes down. Since Bill Phillips' original observation, the Phillips curve model has been modified to include both a short-run Phillips curve (which, like the original Phillips curve, shows the inverse relationship between inflation and unemployment) and the long-run Phillips curve (which shows that in the long-run there is no relationship between inflation and unemployment). Any change in the AD-AS model will have a corresponding change in the Phillips curve model. We can also use the Phillips curve model to understand the self-correction mechanism. Perhaps most importantly, the Phillips curve helps us understand the dilemmas that governments face when thinking about unemployment and inflation.

Business Cycles

Heraclitus once said, "Change is the only thing that is constant.". This certainly applies to national economies. Every nation's economy fluctuates between periods of expansion and contraction. These changes are caused by levels of employment, productivity, and the total demand for and supply of the nation's goods and services. In the short-run, these changes lead to periods of expansion and recession. But in the long-run, economic growth can occur, allowing a nation to increase its potential level of output over time.

Direct and indirect (Government spending directly affects AD; taxes indirectly affect AD)

How are the effects of government spending and taxes different? When a government engages in fiscal policy using government spending, the effect is immediate because government spending is itself a component of AD. For example, if the government buys 600600600 pounds of rice for \$1000$1000dollar sign, 1000 from a farmer in Burginville, that \$1000$1000dollar sign, 1000 counted in the G component of AD and real GDP, and then the spending multiplier kicks in. But when government spending engages in fiscal policy by using taxes or transfers, the impact is indirect. If the government of Burginville gives that farmer a \$1000$1000dollar sign, 1000 tax refund instead of buying something from him directly, the impact of that action won't have any effect until the farmer actually does something with that refund. In fact, if he puts all of that refund under his mattress, there would be no impact at all! But, if the farmer saves \$200$200dollar sign, 200 and spends the rest on airline tickets to Florida, the \$800$800dollar sign, 800 is counted in consumption spending. The purchase of the plane ticket then triggers the multiplier effect. Remember: the tax multiplier is always less than the spending multiplier because some of that amount is saved, and not spent, in the first step.

Tax Multipliers

How can \$1$1dollar sign, 1 more in spending lead to more than \$1$1dollar sign, 1 more of GDP? Because of a thing called the multiplier effect. A dollar spent by one person is income for a different person. But if the person who receives that dollar is going to spend some of it, and save some of it, then this sparks a process that magnifies (or "multiplies") that initial change. The fraction of how much is spent will determine the ultimate increase that the initial dollar will cause—the higher the fraction that is spent, the bigger the multiplier. That means that if there is a change in autonomous spending, such as the government decides to increase government spending, the final impact on real GDP will depend on the fraction that is spent instead of saved.

Nominal Interest (Nominal interest is the sum of the expected real interest rate and the expected inflation rate)

How does a bank decide what interest rate to charge? It needs to consider two important things: How much interest is enough to make it worthwhile for the bank to loan the money (the real interest rate they earn)? How much of the interest's purchasing power might be lost to inflation? For example, suppose a bank wants to earn 10\%10%10, percent interest, but it thinks there will be 3\%3%3, percent inflation. If they don't factor that inflation into what they change in interest, they will effectively earn only 7\%7%7, percent (because they will lose 3\%3%3, percent of the purchasing power of an interest rate of 10\%10%10, percent). Instead, banks factor inflation into their interest rates. To account for inflation, this bank would charge 13\%13%13, percent interest. Remember from a previous lesson that inflation results in winners and losers? Suppose the bank thought inflation would be 3\%3%3, percent, but inflation turned out to be 4\%4%4, percent. We can figure out the real inflation that the bank actually earned in retrospect: \begin{aligned}\text{real interest rate}&=\text{nominal interest rate}-\text{inflation}\\\\ &=13\%-9\%\\\\ &=9\%\end{aligned} real interest rate ​ =nominal interest rate−inflation =13%−9% =9% ​ The bank was hurt by the unexpected inflation because they only got a return of 9\%9%9, percent, not the 10\%10%10, percent they hoped for. On the other hand, the borrower ended up only paying 9\%9%9, percent real interest. The borrower got the better deal! This is an important takeaway: it was the unanticipated aspect of the inflation that hurt the bank and helped the borrower. If the bank had anticipated the higher rate of inflation, they would have simply charged a higher nominal interest rate to ensure they got the real interest rate. This is the basic idea behind something called the Fisher Effect. When expected inflation changes, the nominal interest rate will increase. However, inflation will not effect the real interest rate.

Common Misperceptions (long run)

How long is the long-run? Long enough! That might seem a little vague, but that is kind of the point. The long-run isn't actually a specific time frame. It's just "long enough" for prices to fully adjust. If prices haven't fully adjusted, then it's not the long-run yet. - It might be helpful to think of the full employment output as a hypothetical and ideal quantity of real GDP. What if it was a perfect world where there was no excess unemployment, and what if all prices have adjusted perfectly? Then full employment output is how much would be produced. Not too little. Not too much. But ut just right! -Remember that the SRAS was related to another model in the short run called the Short Run Phillips Curve? Well, the LRAS has a buddy in that model too: the Long-Run Phillips Curve (LRPC), which you'll learn about in more depth later in this course (spoiler alert!). In that model, the LRPC curve shows that, just like in the LRAS, there is no relationship between inflation and unemployment rate in the long run.

Long-Run Aggregate Supply

How much an economy is able to produce ultimately depends on that country's resources. In the lesson on short-run aggregate supply, we learned that producers respond to changes in the price level in the short-run, which is why we have the SRAS curve. But the SRAS curve is based on the idea that prices can't adjust easily. In the short-run prices may have a hard time adjusting, but that might not be true in the long run. While in the short run some input prices are fixed, in the long run all prices and wages are fully flexible. Because of this flexibility, there isn't a long-run trade-off between inflation and output. Rather, in the long-run, the output an economy can produce depends only on the resources and technology that the country has available. This is the idea embodied in the long-run aggregate supply curve (LRAS), which is vertical at the economy's potential output. Once prices have had enough time to adjust, output should return to the economy's potential output.

Not change (Nominal wages will not change, or will change in an amount smaller than the change in the price level The short run in macroeconomics is described as the "sticky-wage" or "fixed-wage" period. In the short run, wages do not decrease in response to decreases in the price level.)

How will nominal wages respond to a decrease in the price level in the short run?

(Deficits and ) Crowding Out

IN theory, countercyclical fiscal policy calls for running a deficit during and economic downturn and a surplus in an economic boom, but the federal government has consistently run deficits over the past three decades. As explicit taxes have become politically less acceptable as a means of funding government spending, however, deficits have increased and become a persistent fact of economic life. If the economy is producing at or near its potential, the deficit financing of government expenditures increase interest rates. Interest sensitive spending, such as investment, will be displaced or crowded out by the increased government spending. In this case, the deficit is an implicit tax on the future because the economy accumulates less capital then it otherwise would, thus adversely affecting economic growth.

Ideas (as public goods)

Ideas and innovations are also important public goods. As a consequence, in certain circumstances, they will be underproduced by markets. Patents, copyrights, and registered trademarks are important ways of protecting investments in the development of ideas and, therefore, provide incentives for individuals to be innovative and creative. Each may also create market power, however. When they do, public policy confronts a trade-off of the gains from stimulating innovation and creative activity against the deadweight loss of monopoly.

Perfectly Competitive Market

If a firm sells its output in a perfectly competitive market, then it will find that no decision it makes about how much to produce will affect the price at which it can sell its output.

Reserve (If all banks were required to keep 100 percent of the deposits in checking account on reserve, what would happen in the economy if a $1,000 note dropped from a helicopter?)

If all banks were required to keep 100 percent of their deposits in checking accounts on reserve, a $1,000 note dropped from a helicopter would increase the money supply by precisely $1,000.

Profits (losses and incentives)

If all firms in an industry earn economic profits, there will be incentive for new firms to enter the market and for existing firms to expand. Entry or expansion brings new capital to the market. If, on the other hand, most firms in an industry incur economic losses, there will be an incentive for existing firms to leave the market or to contract. Exit or contraction moves capital away from the market and toward other activities.

Aggregate Demand

If desire consumption or desired investment or net exports (or some combination of the three) increases, aggregate demand increases. Hence, anything that affects desired consumption or desired investment or net exports will also affect aggregate demand.

full employment (What determines full employment of labor?)

If every worker that wants to work at the market wage is able to get a job at that wage, we say the economy is in full employment.

saving (Suppose we all suddenly want to save more. Is it possible that as a consequence, we might actually save less in aggregate?-- HInt: Consider what would happen to real output if everyone decided to save more. Then consider what might happen to aggregate savings as a consequnece of the change is real output.)

If everyone wants to save more, everyone would be consuming less, which would decrease aggregate demand, resulting in a short-run decline in real output. Consequently, income would fall, resulting in a decrease in both savings and consumption.

optimistic (What will happen to aggregate demand if firms become more optimistic about the future? Why? What might make firms more optimistic about the future?)

If firms become more optimistic about the future, investment will increase, resulting in an increase in aggregate demand. Firms might become more optimistic about the future if they expect an increase in government spending, for example.

pessimistic (What will happen to aggregate demand if firms become more pessimistic about the future?)

If firms become more pessimistic about the future, investment will decline, resulting in a decline in aggregate demand. Firms might become more pessimistic about the future if they expect political instability, for example.

Exchange and specialization

If individuals have different preferences, exchanging goods that they value less for goods that they value more increases the well-being of all parties to such exchanges. As long as individuals freely trade, exchange is guided by an invisible hand--both parties to the exchange will be better off. Thus, exchagne is a way of coordinating competing interests. Exchange allow individuals to specialize. Specialization depends upon relative production costs: the cost to one person of producing something relative to the cost of producing the same thing to someone with whom the person might trade. That is, specialization depends on comparative advanatage. An individual has a comparative advantage in the production of a good if his or her relative costs of producing that good are lower than those of someone with whom the individual might trade. Specialization consistent with comparative advantage will increase the amount of goods and services available to an economy without using additional resources. Hence, specialization coordinates competing interests in a useful and productive way. Moreover, the gains to an individual from specialization do not depend upon being absolutely better at some activity than other individuals. All that matters is that an individual be relatively better or have a comparative advantage. So long as individuals are different from one another, each will have a comparative advantage. Exchange and specialization lead to a kind of spontaneous order, in which competing interests are cooridanted in ways that have the potential to beefit all participants.

redistribution (If inflation redistributes wealth, who is likely to gain? Who is likely to lose? Is such a redistribution a cost associated with inflation?)

If inflation redistributes wealth, debtors are likely to gain. (Imagine how you would feel about your credit card debt of $1000 if, because of inflation, $1000 only bought a hamburger and fries). Consequently, creditors would lose. Yes, such a redistribution of wealth is a cost of inflation

Price Stability (If there are tradeoffs between price stability and unemployment of between price stability and economic growth, would your goals remain the same?)

If less price stability means more unemployment and vice-versa, I might allow for less price stability, in order to increase employment. The same goes for a tradeoff between economic growth and price stability.

Short-run aggregate supply

If nominal wages and prices do not adjust quickly or do not adjust in tandem in response to changes in the economy that push the price level up or down, such changes will create cycles in the economy. Unemployment and a decrease in real output below potential real output, or overemployment and an increase in real output above potential real output, can result fro sticky wages and prices. Thus, changes in aggregate demand affect real output only if prices do not adjust quickly to changes in aggregate demand or wages do not move with changes in price levels.

Taxes (How do taxes affect the investment or government-spending multipliers?)

If taxes distort spending vs. saving incentives, the investment or governmentspending multipliers will change. For example, a sales tax will make consumption relatively more costly, perhaps decreasing the MPC. Consequently, the multiplier will decrease.

Externality

If the costs or benefits of a decision to purchase or supply a commodity are not fully and accurately considered by a person or firm making a decision, an externality exists.

Stabilization policy (For stabilization policy, what is the difference between a change in government spending on goods and services and a change in government transfer payments?)

If the government spending increases because of additional goods and services purchased, the multiplier will increase the size of the shift in AD. If, on the other hand, the government spending increases because of additional transfer payments, the multiplier will not be relevant, since the consumption of some individuals will decrease in tandem with the increase of other individuals' consumption.

National Debt Impact (How might a large national debt limit the ability of the government to pursue fiscal or other domestic policies?-- Hint: consider the interest payments on the debt.)

If the national debt becomes large enough, interest payments on the debt might become too burdensome to decrease taxes or increase government spending at all.

Monopoly

If the output to a market is provided by a single firm, that firm is a monopoly. A monopoly has market power. When a monopolist adjusts its production to maximize profits, the price at which it can sell its output is greater than its marginal cost. A monopolist produces less than a group of competitive firms would produce when confronting exactly the same market demand. It follows that the price in a monopolized market is higher than the competitive price would be.

Price level response (If the price level doesn't respond when aggregate demand decreases, what are some possible consequences?)

If the price level does not respond when aggregate demand decreases, recession will follow.

Specialization (and comparative advantage)

If the price of a commodity is higher outside of an economy than inside, domestic firms have an incentive to export part or all of what they produce. Conversely, if the world price for a commodity is lower than the domestic price, individuals have an incentive to import part or all of what they consume. Responding to differences in prices will lead to nations to specialize consistent with comparative advantage. International trade and domestic specialization between economies consistent with comparative advantage increases the overall level of output available to each economy. These gains do not come without consequences, however. International trade and domestic specialization imply interdependence and integration in an international or global economy. In addition, since changes in relative prices sometimes alter the distribution of economic rewards within an economy and the allocation of jobs across an economy, international trade and domestic specialization will also have income distributional effects.

(Demand, supply, and) equilibrium

If the quantity demanded is greater than the quantity supplied at a particular price, there is excess demand. If the quantity demanded is less than the quantity supplied at a particular price, however, there is excess supply. If the market price increaes when there is excess demand, and decreases when there is excess supply, a market coordinates the differing interests of demanders and suppliers. Specifically, the price moves to equate the quantity that suppliers willingly provide to the market with the quantity that demanders want to purchase. When the price is such that there is neither excess demand nor excess supply, the amount that demanders wish to purchase will be equal to the amount that suppliers wish to sell: the market is in equilibrium at that price. Changes in the desires of either suppliers or demanders will lead to predictable changes in price: 1. An increase in demand, if nothing else happens, will lead to an increase in the market price. 2. An increase in supply if nothing else happens will lead to a decrease in the market price. 3. A decrease in demand, if nothing else happens, will lead to a decrease in the market price. 4. A decrease in supply, if nothing else happens, will lead to an increase in the market price.

Economic rents

If there are unique, scarce inputs whose supply cannot be easily increased and if there is competition for the use of these inputs, economic rents will be created. Generally, competition among firms employing these inputs will mean that the economic rents will go to the owners of the unique inputs.

Common Misperception (CPI)

If there is 2\%2%2, percent inflation every year for five years, then after ten years the price level has gone up to 20\%20%20, percent, right? No! Inflation compounds over time. For example, suppose a chicken coop costs \$100$100dollar sign, 100 and there is 2\%2%2, percent inflation, that means that after a year the chicken coop will cost \$102$102dollar sign, 102. If inflation continues at 2\%2%2, percent for another year, the \$102$102dollar sign, 102 grows by 2\%2%2, percent, not the original price. In fact, if there is 2\%2%2, percent inflation every year for 10 years, the chicken coop will cost \$121.90$121.90dollar sign, 121, point, 90, 21.9\%21.9%21, point, 9, percent more than the original price. The term "index" might sound strange, but an index is simply any measure that compares a value in one period to the value in a base year. Another common misperception is that once we calculate the CPI, we have the rate of inflation between any two years. That is a necessary step, but it is not the final step. We must then use the CPI in both years to calculate the rate of inflation. There are actually several different price indices used to calculate the rate of inflation. The CPI is the one that is used to calculate the official rate of inflation, which is why you'll often hear it reported in the news.

Money Market

If we want to buy things, we need money to do so. But, by keeping our wealth in the form of money, we give up the opportunity to earn interest by keeping our wealth in the form of some other asset. This tradeoff is the source of the demand for money: as interest rates decrease, it makes more sense for us to keep money in the form of money and not other assets. At the same time, there is only so much money that exists at any given time. The money supply (M1M1M, 1) is a fixed amount that doesn't change just because interest rates have changed. The money supply changes when either the monetary base changes or banks make loans. If you are thinking to yourself, "Wait, supply and demand for something sounds a lot like a market," you are absolutely correct! Just like every other market we have seen, there are four important elements: equilibrium price equilibrium quantity supply demand. The price of money is the nominal interest rate, the quantity is how much money people hold, supply is the money supply, and demand is the demand for money.

(Governments usually pay for deficit spending by) borrowing

If you want to spend \$50$50dollar sign, 50 on pizzas, but you only have \$10$10dollar sign, 10, you can't afford it unless you take out a loan. Governments have an advantage you do not, though, in that they can print money. However, this is a tactic that governments rarely take because it leads to inflation or even hyperinflation. Instead, just like you, governments borrow money. What if you want to borrow \$40$40dollar sign, 40 and the government wants to borrow \$50$50dollar sign, 50, but there is only \$60$60dollar sign, 60 available to borrow? Now you and the government are competing to buy something that is scarce, which will drive prices up. As the real interest rate goes up, you decide you don't really need a pizza that much. As a result of the government competing with you, and with any other private borrower, the interest rate goes up, and there is less private spending. Your pizza dilemma illustrates the crowding out effect: when governments borrow it crowds out private sector borrowing. Less of that borrowing means less investment spending and interest-sensitive consumption in the short run. Ultimately, the extent of crowding out depends on whether the economy can accommodate additional borrowing. If an economy is in a recession, there is less private investment spending to compete with, and crowding out is less of a concern. On the other hand, if an economy is near full employment output, there is likely to be more private investment; as a result, there is more potential for crowding out.

achieve (Fiscal policy is used to achieve macroeconomic goals)

Imagine a government wants to fix a recession or dial back an expansion. Its concrete goals would be to return the economy to full employment, or to control inflation, respectively. Fiscal policy can help them achieve their goals. The tools of fiscal policy are government spending and taxes (or transfers, which are like "negative taxes"). You want to expand an economy that is producing too little, so expansionary fiscal policy is used to close negative output gaps (recessions). Expansionary fiscal policy includes either increasing government spending or decreasing taxes. An economy that is producing too much needs to be contracted. In that case, contractionary fiscal policy (either decreasing government spending or increasing taxes) is the correct choice. For example, if Burginville is experiencing a recession, the government might give everyone a tax refund (an example of expansionary fiscal policy). Here's what will play out: the tax refund leads to an increase in disposable income An increase in disposable income causes an increase in consumption, the increase in consumption increases aggregate demand An increase in aggregate demand leads to an increase in output and a decrease in unemployment As a side effect of the decrease in unemployment and the increase in output, inflation will increase. Marthlandia is experiencing a boom and inflation. They cut government spending. Here's what will play out in Marthlandia: First, the cut in government spending leads to a decrease in aggregate, because government spending is a component of AD. The decrease in AD leads to a decrease in output, because the decrease in AD will lead to a new short-run equilibrium with a lower output, higher unemployment rate, and lower price level.

cause (Automatic stabilizers can cause budget deficits during downturns and surpluses during expansions)

Imagine two countries that have the same tax revenues and government spending. Salvania starts out in long-run equilibrium and a balanced budget, with \$500$500dollar sign, 500 million in government outlays paid for with \$500$500dollar sign, 500 million in tax revenues collected every year. Suddenly, the stock market crashes in Salvania causing widespread panic and decreased consumption. Luckily, the automatic stabilizers kick-in. Tax revenues decrease to \$300$300dollar sign, 300 million, while the government is now paying for \$700$700dollar sign, 700 million in government spending and transfer payments. Salvania is now facing a budget deficit of \$400$400dollar sign, 400 million. On the other hand, Nadyaland's long-run equilibrium is interrupted by a boom. When the automatic stabilizers kick in, tax revenues increase to \$600$600dollar sign, 600 million and spending falls to \$400$400dollar sign, 400 million. As a result of the stabilizers, Nadyaland has a budget surplus of \$200$200dollar sign, 200 million. In the real world, there are a lot of other reasons that a country might run a budget deficit or a budget surplus. But, automatic stabilizers contribute to those deficits and surpluses too. For example, the United States was in a recession during 1982. That year it ran a deficit of around \$182$182dollar sign, 182 billion. But if you remove the effect of automatic stabilizers that had kicked in, the deficit was actually only \$72$72dollar sign, 72 billion. Similarly, during the expansion in 1999, the United States had a budget surplus of around \$126$126dollar sign, 126 billion, but if you remove the effect of automatic stabilizers, the surplus was actually around \$39$39dollar sign, 39 billion. [Source: CBO]

National Savings

In a closed economy, national savings is the sum of private saving and the public saving. In an open economy, national saving is the sum of private savings, the public saving, and net capital inflows. For example, suppose the nation of Florin has: a national income of \$100$100dollar sign, 100 million, taxes of \$10$10dollar sign, 10 million, consumption spending of \$30$30dollar sign, 30 million government spending of \$8$8dollar sign, 8 million, and net capital inflows of \$4$4dollar sign, 4 million. The national savings that they have available is therefore: \begin{aligned}\text{National savings}&=Private savings + Public savings + NCI\\\\ &=(\$100 \text{ million income} - \$10 \text{ million taxes} - \$60 \text{ million consumption}) + (\$10 \text{ million taxes} - \$8 \text{ million government spending}) + \$4 \text{ million NCI}\\\\ &=\$30 \text{ million} + \$2 \text{ million} + \$4 \text{ million} \\\\ &=\$36 \text{ million} \end{aligned} National savings ​ =Privatesavings+Publicsavings+NCI =($100 million income−$10 million taxes−$60 million consumption)+($10 million taxes−$8 million government spending)+$4 million NCI =$30 million+$2 million+$4 million =$36 million ​ National savings would be \$36$36dollar sign, 36 million in Florin. That means there is \$36$36dollar sign, 36 million in savings that could be turned into loans that could fund investment spending.

Crowding Out

In a previous lesson, we learned that fiscal policy can be used to close a recessionary gap. This sounds like great news! A country could just engage in deficit spending and spend its way out of a recession, right? Not so fast! When countries run budget deficits, they typically pay for them by borrowing money. When governments borrow, they compete with everybody else in the economy who wants to borrow the limited amount of savings available. As a result of this competition, the real interest rate increases and private investment decreases. This is phenomenon is called crowding out. Most economists agree that deficit spending is not in itself a problem. In fact, deficit spending might even be necessary during severe recessions. But most economists also recognize the possibility that there may be long-term consequences of deficits and debts. The reduced spending on investment means that a country's capital stock will not grow as fast. As a result, crowding out can reduce a country's future potential output.

Adjusts (The nominal interest rate adjusts until the money market is in equilibrium)

In any market, an equilibrium occurs when the quantity supplied is equal to the quantity demanded. Prices adjust until the market is in equilibrium. The money market is no exception. The only difference between the markets we saw in Unit 1 and the money market is: The price is the nominal interest rate The supply curve is vertical In the money market, the nominal interest rate adjusts until the quantity of money that people want to hold is the same as the quantity of money that exists. If the nominal interest rate is above equilibrium high, people reduce their holdings of cash. If the nominal interest rate is below equilibrium, they increase their holdings of cash.

Common Misperceptions (Phillips curve)

In many models we have seen before, the pertinent point in a graph is always where two curves intersect. So you might think that the economy is always operating at the intersection of the SRPC and LRPC. However, this assumption is not correct. Any point along the SRPC could be where an economy is operating. The only time the economy is at the point where the SRPC and LRPC intersect is when it is in long-run equilibrium. Sometimes new learners confuse when you move along an SRPC and when you shift an SRPC. Changes in cyclical unemployment are movements along an SRPC. Changes in the natural rate of unemployment shift the LRPC. In many models we have seen before, the pertinent point is always where two curves intersect. So you might think that the economy is always operating at the intersection of the SRPC and LRPC. However, this is not correct. Any point along the SRPC could be where an economy is operating. The economy only has the unemployment rate where these two curves intersect when it is in long-run equilibrium. Changes in cyclical unemployment are movements along an SRPC. Changes in the natural rate of unemployment shift the LRPC.

constantly produce (In order for the economy to constantly produce more than potential real output, what must happen to the price level?)

In order for the economy to constantly produce more than potential real output, the price level must be not only increasing but accelerating (increasing by more than what is expected).

Lags (can complicate fiscal policy in the real world)

In reality, four things can slow down a fiscal policy's implementation and e effectiveness: Data lag This is the time to collect information about the economic conditions in a country. Suppose there is some shock to an economy, such as a decline in consumer confidence. A policymaker might not notice this until data on real GDP and unemployment rate are collected. Recognition lag This is the time it takes to realize there might be a problem. The policy-maker gets handed a report from their intern that says unemployment is up and real GDP is down. But is this a temporary thing? Or is the start of a long-run trend? If it is temporary, there isn't any need to take any action. If it is a long-run trend, that trend has already started by the time it is recognized. Decision lag Our policymaker reviews all of the evidence and decides that action is definitely needed. Ok, now what? Should the government take a wait-and-see approach and let the self-correction mechanism kick in? Even if they decide that the self-correction mechanism might take too long or, even deciding to actually do something will take time. Should we lower taxes? Increase spending? Now the legislature needs to get together to decide the actual policy action to take. That will take awhile. Implementation lag Now that the legislature passed a spending bill, it will take time to put it into place. A new agency might need to be set up to coordinate the spending. Burginville decides to implement a new infrastructure development program, building bridges and roads. Which river needs a bridge? Where should we build the road? Deciding on this will take time too. [I'm still stuck on the notion of lags.

changes (What evidence is there that changes in output and unemployment usually result from changes in aggregate demand rather than from aggregate supply shocks? )

In the event of aggregate supply shocks, increases in the price level are accompanied by decreases in output and decreases in the price level are accompanied by increases in output. While this is sometimes the cases, the price level generally moves in tandem with output fluctuations.

Fiscal and Monetary (Fiscal and monetary policy actions in the short run)

In the last unit, we learned that either fiscal policy or monetary policy could be used to close output gaps. As it turns out, we aren't bound to have one or the other! A combination of these policies can be used to restore an economy to full employment output. Perhaps even more intriguing is the possibility that these actions might not be coordinated, and the result might be fiscal policy and monetary policy working against each other.

long run tradeoff (Is there a long-run tradeoff between inflation and unemployment? Why or why not?)

In the long run, politicians will not be able to "coax" more output out of the economy through inflation since that inflation will be anticipated and corrected for in the long run.

Per capita real income (If potential real output increases because of an increase in the capital stock, natural resources, or because of technological developments, but there there is no change in the population, does this necessarily mean that per capital real income increases?)

In the long run, yes. Per capita real income is total output divided by the population. Since the long run output of the economy is increasing while the population is remaining constant, per capita real income must increase.

Stimulate (Fiscal policy stimulates the economy by increasing aggregate demand. Does this cause inflation? If so, are there policies that stimulate the economy but that are not inflationary?)

Increasing aggregate demand does cause inflation. Supply side policies (that is, policies designed to increase aggregate supply) increase real output without causing inflation.

same time (Can the inflation rate be decreasing at the same time that the price level is increasing? Can the inflation rate be increasing at the same time the price level is decreasing? Explain.)

Inflation can be decreasing while the price level is increasing as long as inflation is positive but falling. If the inflation rate is negative and moving toward zero, inflation is increasing at the same time the price level is decreasing (albeit at a slower rate each period).

Inflation Reputation

Inflation can get a bad rap. For instance, some people think inflation makes everyone worse off. But it turns out that there are both winners and losers from inflation. In general, if you owe money that has to be paid back with a fixed amount of interest, you are going to benefit from unexpected inflation. On the other hand, if someone owes you money, when there is unexpected inflation the money you are paid back won't be worth as much as the money you loaned out.

Information (as a public good)

Information is a particularly important public good. Because of its public good characteristics, certain kinds of information will be underproduced in a market economy. Sometimes the government solves this problem by providing the information. At other times, individuals overcome the problem by producing information themselves through search. If enough people search over service and quality, the information on each will be reflected in the market prices. When information is reflected in the market price, markets are, in a sense, collecting the information and conveying it, via prices, to all market participants.

instability (Why does investment add to the instability created by changes in aggregate demand? Does consumption have the same effect?)

Investment adds to the instability created by aggregate demand fluctuations because changes in aggregate demand will change firms' expectations about the future. Thus, fluctuations in aggregate demand are exacerbated by changes in investment. Consumption also adds to the instability, since changes in aggregate demand will lead to short-run changes in real output, or national income, and, consequently, consumption.

Consumption

Is the part of aggregate real output, purchased by households and individuals, which is used to increase their material well-being.

Aggregate Demand

Is the sum of the amount that agents in an economy are prepared to purchase for consumption, investment, net exports, and government spending purposes at different price levels.

Common MIsperceptions

Isn't it impossible to exceed your potential? No! The best analogy to this is staying up all night to study for an exam or finish a project. It might be possible to exceed your sustainable production occasionally, but the key phrase here is "sustainable production." It wouldn't be possible to keep up that kind of activity for very long. That's the idea behind the positive output gap. You can think of this at the economy-wide level as factories running 24 hours a day and workers taking a lot of extra hours at work. A common misperception is that you can label an equilibrium as the intersection point itself. But this is not the case . . . you need to label the equilibrium price level and equilibrium output on the axes. This is a convention in economics, and its important to follow that convention. So, when you label PL and current output, make sure you indicate these by making a dotted line from the intersection of AD and SRAS to the axes, and then put your labels on the axes. [Can you show me the way?] Some people think that these models are all independent of each other, but that is not the case. Every model in macroeconomics is closely intertwined with every other model. We can summarize the relationship between our AD-AS model and all of the models we have encountered so far (the business cycle and PPC model) as given in the table below:

equilibrium (Which of the following best describes a nation that is producing at its short-run macroeconomic equilibrium?)

It has a price level and output associated with the intersection of aggregate demand (AD) and short-run aggregate supply (SRAS) This is the definition of short-run equilibrium: it is price level and output at which the quantity of aggregate output demanded is equal to the quantity of aggregate output supplied. Graphically, this is the output and price level associated with the intersection of AD and SRAS.

difficult definition (Is it difficult to define full employment? Why?)

It is difficult to define full employment because it is hard to determine the level of voluntary unemployment (see 6 above)

Common Misperceptions (monetary policy)

It might seem like a time-saver to skip steps when describing the chain of events involved in monetary policy, but taking an extra minute or two is worth it. If you want to save time, use abbreviations and arrows rather than skipping steps. For example, if you want to communicate this: "*An increase in the money supply will lower interest rates, which will increase investment and aggregate demand. As a result, output will increase, the price level will increase, and the unemployment rate will decrease." You could write instead: "Ms ↑ → n.i.r. ↓ → I ↑ → AD ↑ → (Y ↑ PL ↑ UR ↓)" If a question asks you for an open market operation, you might think it's a good idea to list all of the tools of monetary policy. This is not a good idea, because you haven't answered the question that was asked and you won't get any credit. Instead, only give an answer to the question you are asked so you get full credit.

Common Misperceptions (loanable funds)

It might seem strange that we are using the word "investment" to talk about borrowing money when people usually use the word "investment" as a place to put their savings. Remember that in economics the word "investment" refers to spending by businesses on physical capital, inventories, and other business expenditures. That business capital will require borrowing, so investment requires loans. The Fisher effect describes a change in nominal interest rates, not real interest rates. Expected inflation will be incorporated into the nominal interest rates, but the real interest rate is not impacted by inflation.

more output (Only increases in LRAS will lead to more output in the long-run)

It's not all about shocks! How much you can produce sustainably has more to do with your resources than with shocks. The self-adjustment mechanism occurs because the amount of output that a country can sustainably produce ultimately depends on its stock of resources, not on AD or SRAS. Recall that the LRAS is vertical at the full employment output. This is the amount of output associated with any point on the PPC. Unless the amount of resources a country changes, that maximum sustainable output won't change either. For example, if a country has 100100100 workers working 8-hour shifts every day, that's 800800800 hours worth of labor being used to produce. You might be able to temporarily make everyone work overtime and squeeze out 1{,}0001,0001, comma, 000 hours worth of effort, but that isn't sustainable. Unless the number of workers increases, you are stuck with however much output 800800800 hours worth of labor will produce. If you did get more workers, then the PPC would shift out and the LRAS curve would also shift out. That shift in LRAS represents economic growth. Temporarily pushing output past that amount doesn't count as economic growth.

Key Terms

Key Terms Key term Definition deficit when government spending exceeds tax revenues debt the accumulated effect of deficits over time crowding out when a government's deficit spending, and borrowing to pay for that deficit spending, leads to higher real interest rates and less investment spending

Key Terms

Key Terms Key term Definition economic growth a sustained increase in real GDP per capita over time output per capita (also called real GDP per capita) output divided by population; for example, if real GDP per capita is \$100$100dollar sign, 100 million and the population is 222 million, real GDP per capita is \$50$50dollar sign, 50 per person. productivity (also called labor productivity) the amount of output produced per unit of labor human capital improvements in education, knowledge, and wealth that make each unit of labor more productive supply-side policies government policies that promote rightward shifts of aggregate supply, such as increasing labor force participation and incentives to save and invest

key terms (monetary policy)

Key Terms Key term Definition monetary policy the use of the money supply to influence macroeconomic aggregates, such as output, inflation, and unemployment dual mandate the two objectives of most central banks, to 1) control inflation and 2) maintain full employment contractionary monetary policy monetary policy designed to decrease aggregate demand, decrease output, and increase unemployment expansionary monetary policy monetary policy designed to increase aggregate demand, increase output, and decrease unemployment; open market operations the buying and selling of securities, such as bonds, by a central bank to change the money supply Federal Reserve (nicknamed the "Fed") the central bank of the United States of America; the Federal Reserve is responsible for the maintaining the health of the financial system and conducting monetary policy. discount rate the name given to the interest rate that the Federal Reserve sets on loans that the Fed makes to banks; changing the discount rate is a tool of monetary policy, but it is not the primary tool that central banks use. reserve ratio the amount of reserves that banks are required to keep on hand by a central bank; changing the reserve ratio is a tool of monetary policy, but it is rarely changed and is rarely used to conduct monetary policy. Fed Funds rate the interest rate that banks charge each other for short-term loans; when the Federal Reserve changes the money supply, it changes the Fed Funds rate

Key Equations

Key equations The government budget \begin{aligned} \text{Budget Balance} &= T-G, \text{where}\\\\ T&=\text{ tax revenue}\\\\ G&= \text {government spending}\end{aligned} Budget Balance T G ​ =T−G,where = tax revenue =government spending ​ For example, if a country collects \$100$100dollar sign, 100 million in taxes and spends \$100$100dollar sign, 100 million, the budget balance is zero. Sometimes you will also see this referred to being "in balance" rather than "the budget balance is zero." In either case, this is the formula: \$100 \text{ million} - \$100 \text{ million} = 0$100 million−$100 million=0dollar sign, 100, space, m, i, l, l, i, o, n, minus, dollar sign, 100, space, m, i, l, l, i, o, n, equals, 0 But, if a government spends more than it takes in, it has a deficit. So if tax revenue is \$100$100dollar sign, 100 million, but government spending is \$120$120dollar sign, 120 million: \$100 \text{ million} - \$120 \text{ million} = -\$20 \text{ million}$100 million−$120 million=−$20 milliondollar sign, 100, space, m, i, l, l, i, o, n, minus, dollar sign, 120, space, m, i, l, l, i, o, n, equals, minus, dollar sign, 20, space, m, i, l, l, i, o, n The budget is short \$20$20dollar sign, 20 million, so the government will need to borrow that money. If the government runs the same deficit every year for three years, it will accrue a debt of \$60$60dollar sign, 60 million: \begin{aligned}\text{Debt} &= Deficit_{yr1} + Deficit_{yr2} +Deficit_{yr3}\\\\ &= \$20 \text{ million} + \$20 \text{ million} + \$20 \text{ million}\\\\ &=\$60 \text{ million}\end{aligned} Debt ​ =Deficit yr1 ​ +Deficit yr2 ​ +Deficit yr3 ​ =$20 million+$20 million+$20 million =$60 million ​

Key Terms

Key terms Key term Definition Phillips curve model a graphical model showing the relationship between unemployment and inflation using the short-run Phillips curve and the long-run Phillips curve short-run Phillips curve ("SPRC) a curve illustrating the inverse short-run relationship between the unemployment rate and the inflation rate long-run Phillips curve ("LRPC") a curve illustrating that there is no relationship between the unemployment rate and inflation in the long-run; the LRPC is vertical at the natural rate of unemployment.

Key Terms

Key terms Key term definition Velocity the number of times in a year that an "average" dollar gets spent on goods and services; for example, if the velocity of money is 2, then every dollar in an economy gets used twice in a year. Money neutrality the concept that money only impacts nominal variables, not real variables, in the long run; in other words, increasing the money supply might decrease the nominal interest rate, but it won't have an impact on the real interest rate. Monetarism a way of analyzing the impact of monetary and fiscal policy actions based on the equation of exchange the equation of exchange a mathematical identity that describes the relationship between the money supply and nominal GDP the quantity theory of money a theoretical model that when the velocity of money is fixed and real output is limited to full employment output, any increase in the money supply causes an increase in the price level

calculated (CPI)

Let's use the example above of the "basket of goods" consisting of 2 bottles of cod liver oil, 10 loaves of bread, and 8 dog food treats. Once the prices of the goods are calculated, the price of the basket in that year is compared to the price of the basket in some base year

M/P (How would you explain to someone who had not taken economics the intuitive meaning of M/P?)

M/P is the amount of money in the economy adjusted for inflation. By dividing by the price index, one can compare M/P from different years, since the value of the dollar changes from year to year.

MB-M2

MB M1 M2 ​ =cash and coins in circulation + bank reserves =cash and coins in circulation + checkable bank deposits + travelers checks =M1 + savings accounts + small CDs + money market mutual funds ​

Long-run vs short-run

Macroeconomics and microeconomics have slightly different definitions of what the long run means. But they have an important idea in common: long run means long enough for pretty much anything to change. But in macroeconomics specifically, the long run means long enough for all prices to fully adjust to any kind of change. For example, suppose the price of gas goes up so much it takes a really big chunk of money out of your budget. But it's Monday morning, and you still have to get to school, so you wince and fill up your tank. It might mean you have to give up something else today to fill your tank. But, if the price stays high and you know it will stay that high forever, eventually you can find a way to change something. Maybe you organize a carpool to spread costs, or start taking the bus, or find a more fuel efficient car. The short run is how you react when you see the higher price on Monday morning. The long run is however long it takes for you to adapt to that price shock.

Influence (Monetary policy influences aggregate demand, real output, the price level, and interest rates)

Many central banks have a legal requirement to ensure price stability and full employment. This means that central banks use monetary policy to influence key variables like X and Y. We can summarize the impact monetary policy has on these variables as done in the table below: Monetary policy effect on interest rates effect on AD effect on real output (Y) effect on the price level (PL) effect on unemployment Expansionary monetary policy n.i.r. ↓ AD ↑ Y ↑ PL ↑ UR ↓ Contractionary monetary policy n.i.r. ↑ AD ↓ Y ↓ PL ↓ UR ↑

Government (Government policies and institutions can act as automatic stabilizers)

Many countries have government agencies that help out when people are out of work, such as welfare payments or unemployment compensation. Spending on these programs increase during recessions and decrease during expansions. That spending isn't directly part of GDP (remember that transfer payments do not count in the government spending component). However, spending on programs like these does have an indirect effect on GDP through consumption. Suppose you lose your \$1000$1000dollar sign, 1000 per week salary because you lose your job. Without unemployment compensation, your spending might fall dramatically, which would lower the consumption part of GDP. However, if it turns out that you can get \$400$400dollar sign, 400 per week in unemployment benefits, your consumption would not fall as dramatically.

Common Misperceptions (fiscal and monetary)

Many new learners incorrectly assume that because central banks operate in an official capacity, they will always take the same action as a government when it comes to policy. This is incorrect because most central banks have autonomy to conduct operations that are in line with their mandate, which frees them to operate without political pressures such as election cycles.

Barriers to Entry

Market forces tend to undermine a monopoly. IN particular, entry in response to monopoly profits reduces a monopoly's market power. This means that a monopoly can persist for a long time only if there is a some barrier to the entry of new firms. A barrier to entry is a condition that prevents new firms from entering a market in response to the economic profits that existing firms are making. Barriers to entry include economies of scale, limited ownership of natural resources, and legal restrictions limiting competition and entry. In addition, a monopolist can make entry less attractive for potential rivals by limit pricing, predatory pricing, and making organizational choices that may raise the cost of entry by rival firms.

Decrease (Is it possible for market interest rates to decrease when the government has increased the deficit?)

Market interest rates can increase even when the government has increased its deficit as long as foreigners are willing to provide loans to domestic firms.

Mergers

Mergers provide potential benefits as well as harm and are scrutinized under a rule-of-reason approach. The enforcement of the antitrust laws, however, frowns on mergers of firms that are large relative to their market, as a way of obtaining potential economies of scale. Growth within the firm can also obtain economies of scale.

Common Misperceptions (money)

Monetary aggregates might be easy to confuse with each other. An easy way to remember them is that the higher the number on the aggregate is, the less liquid that kind of money is. M2 is less liquid than M1. It might be confusing that checking accounts are considered narrow money, but savings accounts are considered near money. The reason for this is that savings accounts tend to have some limitations on them that checking accounts usually do not. Most checking accounts are demand deposit. Savings accounts frequently will have limitations such as being only able to make five withdrawals per month or having to wait ten days after you deposit money to get them. You might see a reference to an even broader monetary aggregate in your textbook or class and be confused why it isn't here. The monetary aggregate M3 is tracked in some countries, but not others (the U.S. stopped tracking this category in 2006). If you see M3 elsewhere, the most important thing to remember about it is that M3 is less liquid than M2. In fact, you might even see a broader category called L, which is even less liquid than M3. -Are cryptocurrencies money? There is actually some debate about whether cryptocurrencies (such as bitcoin) are money or just a financial asset. In fact, central banks around the world are grappling with this question right now, and there isn't any consensus on this issue. A main sticking point to argue that cryptocurrencies aren't money is that they generally cannot be used as legal tender (in other words, to buy stuff). Not a lot of stores are equipped to take cryptocurrencies to buy goods and services, at least not yet. As of right now, cryptocurrencies aren't included in either the narrow or broad definition of the money supply.

Limitations (of monetary policy)

Monetary policy, like fiscal policy, suffers from lags that might hamper how effective it can be at closing an output gap. First of all, it takes time to recognize that there is a problem in the economy and react appropriately. Second, even if the interest rate changes quickly when OMOs are carried out, the impact of the interest rate change takes time. Recall that OMOs impact the overnight rate. It takes time for changes in the overnight rate to pass through to other interest rates. Even once other interest rates have adjusted, the investment response to a new interest rate takes time For example, suppose Inigo is thinking about buying a new home, but banks aren't willing to lend any money right now because they are fully loaned out. Then, the central bank of Florin buys bonds, which increases the amount of funds available to loan out and decreases the interest rate banks charge each other. Eventually, this changes the interest rate charged for home loans, too. Inigo sees that his local mortgage lender is offering lower interest rates. He takes out a loan and hires a builder to build his dream home. Only once he pays the builderwill real GDP change.

Expansion of money supply (banking and the expansion of the money supply)

Money is created when the government prints it, right? That's only partially true because banks create money too. Banks don't literally print their own currency (save for a few banks in Scotland, who do just that). So how does a bank "create" money? Recall that the narrowest definition of the money supply is M1, which includes money in circulation (not held in a bank) and demand deposits held inside banks. In the United States, less than half of M1 is in the form of currency—much of the rest of M1 is in the form of bank accounts. Every time a dollar is deposited into a bank account, a bank's total reserves increases. The bank will keep some of it on hand as required reserves, but it will loan the excess reserves out. When that loan is made, it increases the money supply. This is how banks "create" money, by increasing the money supply, which we understand with the money multiplier.

three functions (of money)

Money is just one of many types of assets. What makes money different from other assets is its ability to do more than just store value. Most importantly, for an asset to be considered money, it must be accepted as a form of payment. Interestingly, almost anything can be money as long as it can act as: a medium of exchange a store of value a unit of account

Vertical Relationships

Most vertical relationships among independent firms are considered by courts under a rule-or-reason approach, balancing potential harms and benefits. An exception is vertical price-fixing (better known as resale price maintenance), which is per se illegal. Tie-in sales have sometimes been ruled per se illegal and sometimes been considered under a rule-of-reason approach.

movements (Why might the movements in nominal wages differ from changes in the price level?)

Movements in the nominal wage may differ from changes in the price level because firms and workers are unable to view the price level in real time. Each may see changes in the price of the output as a change in relative price rather than a general price increase

wages (If all prices and wages are completely flexible, will there be unemployment in the economy? What if wages are not flexible, but are sticky?)

No. If wages are sticky, however, there will be short-run unemployment

Reserve requirement (If the Fed decreases the reserve requirement, must the supply of money increase? Would your answer be any different for a decrease in the discount rate? What about an open market purchase?)

No. The reserve requirement is the minimum allowable ratio of funds banks must hold as reserves, not the maximum. As a result, banks may choose to hold more than the ratio specified by the reserve requirement. Therefore, a decrease of the reserve requirement does not necessarily increase the money supply. The same goes for the discount rate. An open market purchase, however, will always increase the money supply.

Definitions (of nominal v. real GDP)

Nominal GDP is a measure of how much is spent on output. For example, in Canada during 2015, \text{CAN }\$1,994.9\text{ billion}CAN $1,994.9 billionC, A, N, space, dollar sign, 1, comma, 994, point, 9, space, b, i, l, l, i, o, n was spent on the goods and services produced in Canada. Nominal GDP measures aggregate output (meaning the value of all of the final goods and services produced) using current prices. In other words, these figures reflect the amount spent on Canada's output in the country's prices in 2015.

difference (What is the difference between real and nominal GDP?)

Nominal GDP is a measure of output of the economy in a given year, in terms of the dollar of that year, whereas real GDP measures output of the economy in terms of dollars in a base year. In other words, real GDP corrects for inflation while nominal GDP does not.

Common Misperceptions (of unemployment)

Not everyone who is out of work is unemployed. In order to be counted as unemployed you have to be out of work, looking for work, and able to accept a job if one is offered to you. If you are out of work and not looking, then you are considered "not in the labor force" rather than unemployed. We tend to think of unemployment as an undesirable thing, but a certain amount of unemployment is actually part of a healthy economy. Structural unemployment occurs when new industries are created and old industries become obsolete. For example, when we moved from using horses and buggies to using cars to get around, this put a lot of buggy makers in the structurally unemployed category . Frictional unemployment might not seem very fun, but consider what it means to have zero unemployment—nobody ever looks for a job, they just remain in whatever job they are given! In fact, a number of dystopian novels have been written in which everyone in a society is automatically assigned a fixed career (such as the Divergent series). Those societies have zero frictional unemployment, but they are also quite unpleasant if you are unhappy with that career! A decrease in the unemployment rate isn't necessarily a sign of an improving economy. When people stop looking for jobs and drop out of the labor force as discouraged workers, the unemployment rate will decrease even though the true employment situation hasn't gotten any better. This is why it is important to look at both changes in the unemployment rate and changes in the labor force participation rate. Looking at both changes let's you get a more complete idea about changes in the employment situation.

Disinflation

Occurs when the rate of inflation declines. For example, when the inflation rate falls from 10 percent to 4 percent, a disinflation is occurring. Notice that the price level may still continue to rise, but it does so at a slower rate. That is, the rate of inflation is lower.

Structural Unemployment

Occurs when there are individuals who would be willing to work but who do not have the skills, training, or education necessary to fill available job vacancies.

Sustained Inflation (and real output)

Once an economy has become accustomed to continual inflation, actual changes in the price level will not affect real output if they are anticipated because individuals will plan for them. For example, if inflation has been 5 percent every years for the last five years and is increase. Only when the inflation rate unexpectedly exceeds 5 percent will unemployment be less than the natural rate. It was once believed that there was a tradeoff between inflation and unemployment (an economy could have high inflation and low unemployment or low inflation and high unemployment, but not low inflation and low unemployment). However, any tradeoff appears to hold only in the short run. In the long run, the economy will produce at its potential with any rate of inflation, if inflation is anticipated and modest.

(positive and negative) gaps

One of the goals of macroeconomics is to explain why business cycles occur. We can use the AD-AS model to capture the different stages of the business cycle. The AD-AS model helps compare our current output (the short-run equilibrium) to the full employment output. The difference between current output and the full employment output is called a "gap". Negative output gaps mean that an economy is producing less than full employment, while positive output gaps mean that an economy is producing more than full employment output. Positive output gaps are sometimes called "inflationary gaps" because producing more than full employment is usually associated with a higher price level.

unemployment rate difference (What is the difference between the measured unemployment rate and the real unemployment rate?)

Our measure of unemployment tends to be inaccurate because of discouraged workers, involuntary part-time workers, workers looking for a job at too high a wage, and because of changes in the labor force participation rate.

impact of changes (in the money supply will depend on whether the economy is at full employment or not)

Previously, we learned that a central bank can influence output by increasing the money supply. At first glance, it might seem like the quantity theory of money contradicts this, because when the money supply increases only the price level change. The important assumption that drives this result is that output (YYY) is fixed. This might be true in the long-run, but not in the short-run. In the short-run, an increase in the money supply decreases the nominal interest rate, which increases investment and real output. However, according to the self-correcting mechanism, the accompanying inflation will eventually lead to a decrease in short-run aggregate supply (SRASSRASS, R, A, S). The decrease in SRASSRASS, R, A, S returns the economy to full employment and a new, permanently higher price level. The impact of a change in the money supply on real output ultimately depends on the shape of the aggregate supply curve. If the aggregate supply curve is vertical (as it is assumed to be in the long run) then an increase in the money supply will only impact inflation. If the aggregate supply curve is relatively flat, then there might be large increases in output that result from an increase in the money supply and relatively little impact on the price level.

Price Discrimination

Price discrimination occurs when a firm charges different customers different prices for the same commodity, or charges the same customer different prices for the same commodity as his or her consumption increases. In order to price discriminate, a firm must (1) have market power, (2) be able to prevent resale between customers, and (3) be able to easily determine who is willing to pay a higher price for a commodity and who is not. Price discrimination is evidence of market power, but it is not evidence of monopoly. Even though monopolies frequently price-discriminate, price discrimination is pervasive and provides interesting evidence that firms with even a little market power base their pricing policies on the assumption that quantity demanded is inversely related to price. With price discrimination, the output of a firm with market power generally increases, thereby moving toward the firm's output toward that which would be provided in a perfectly competitive market. In this important sense, price discrimination may partially offset the market failure that would otherwise occur because of market power.

Prices and Profits

Price ration scarce commodities among competing interests. Prices convey information. Prices and profits provide incentives to move or reallocate resources from activities of lesser value to activities of greater value, where value is determined by the willingness of individuals to pay. Prices and profits also link markets together through substitution and arbitrage. Prices and profits coordinate competing interests also to allow an economy to capture the gains from specialization and exchange. In particular, competitive markets allocate goods and services to the highest-valued users and resources to their most productive use.

Real GDP (weighs output using prices from a base year)

Real GDP is a measure of how much is actually produced. Real GDP measures aggregate output using constant prices, thus removing the effect of changes in the overall price level. For example, in 2015 the value of Canada's output expressed in constant 2010 prices was \text{CAN }\$1,857\text{ bilion}CAN $1,857 bilionC, A, N, space, dollar sign, 1, comma, 857, space, b, i, l, i, o, n. Here's another way to think about Real GDP: if we add up all of the output that was produced in Canada during 2015 by using the prices that these goods sold for in 2010, the value of GDP in Canada is \$1,857\text{ billion}$1,857 billiondollar sign, 1, comma, 857, space, b, i, l, l, i, o, n. But if we add up all of the output that was produced in Canada during 2015, using the prices that they sold for in 2015, the value of GDP in Canada is \$1,995\text{ billion}$1,995 billiondollar sign, 1, comma, 995, space, b, i, l, l, i, o, n. This means prices must have increased between 2010 and 2015. However, there is a slight problem with the method above. Calculating real GDP by weighting final goods and services by their prices in a base year can lead to an overstatement of real GDP growth because the prices of some goods decrease over time. Therefore, this method overstates growth in real GDP because it makes it seem like goods make up a bigger share of spending than they really do.

Real GDP

Real aggregate output can be measured by dividing the dollar value of aggregate output measured using current market prices (nominal GDP) by a suitable price index. Real GDP is the real value of aggregate or total output htat an economy actually produces, with output valued using a base-period price level to eliminate the effects of inflation or deflation.

Adjusting

Real variables are nominal variables deflated by the price level. Examples of real variables are a real wage or a real interest rate. For instance, the sign at the bank says that they are paying 8\%8%8, percent interest, but what are really earning? If we want to find the real interest rate (the one that reflects what people are actually earning on money deposited in the bank), then we want to take away the effect of inflation. We do so because inflation reduces the purchasing power of the money deposited. If the interest rate the bank gives us (the nominal interest rate) is 8\%8%8, percent, but the rate of inflation is 5\%5%5, percent, we are really earning 8\%-5\%=3\%8%−5%=3%8, percent, minus, 5, percent, equals, 3, percent on the money that we put in the bank. Why? Because that is how much more we can buy when we take our money out after a year.

mitigate (Monetary policy can be used to mitigate the impact of fiscal policy on interest rates)

Recall that the relationship between nominal and real interest rates is: \text{Nominal interest rate} = \text{real interest rate} + \text{expected inflation}Nominal interest rate=real interest rate+expected inflationN, o, m, i, n, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, equals, r, e, a, l, space, i, n, t, e, r, e, s, t, space, r, a, t, e, plus, e, x, p, e, c, t, e, d, space, i, n, f, l, a, t, i, o, n For example, suppose that initially the real interest rate is 4% and the expected rate of inflation is 2%, resulting in a nominal interest rate of 6%: \begin{aligned}\text{Nominal interest rate} &= \text{real interest rate} + \text{expected inflation} \\\\ &= 4\%+2\%\\\\ &=6\%\end{aligned} Nominal interest rate ​ =real interest rate+expected inflation =4%+2% =6% ​ Now, suppose that a government increased its spending. This expansionary fiscal policy would increase aggregate demand, which leads to more output, a lower rate of unemployment, and higher inflation. If people adjust their expectations, and expected inflation increases from 2% to 5%, then the nominal interest rate becomes: \begin{aligned} \text{nominal interest rate} &=\text{real interest rate} + \text{expected inflation}\\\\ &= 4\%+5\%\\\\ &=9\%\end{aligned} nominal interest rate ​ =real interest rate+expected inflation =4%+5% =9% ​ Uh-oh! An increase in interest rates might undo some of the intended effects of the expansionary fiscal policy-so the central bank might simultaneously engage in expansionary monetary policy to lower the nominal interest rate back to its initial level.

Exports and imports

Sales abroad by domestic firms are exports. Purchases abroad by domestic firms or individuals are imports. Exports from one country are imports to other countries with whom they trade. For a single economy, net exports are the difference between the value of its exports and the value of its imports. In symbols, net exports = x-m (where x is the "value of exports" and m is the "value of imports").

Reduce Money Supply (Suppose that the money supply is $1 trillion. The Fed decides that it wishes to reduce the money supply by $100 billion. If the required reserve ratio is .05, what does the Fed have to do to carry out its wishes?)

Sell a T-bill for $5 billion. The multiplier is (1/.05)=20. As a result, the money supply would decrease by $100 billion.

correct (How short-run shocks to aggregate demand correct in the long run)

Shocks are unanticipated changes in economic conditions. Demand shocks are unanticipated changes that impact the Aggregate Demand (AD) curve. The basic idea of the self-correction mechanism is that shocks only really matter in the short run. If AD changes, then output and unemployment will change in the short run, but not in the long run. Output gaps due to a change in AD exist in the short run only because prices haven't had a chance to fully adjust to that change yet. Once those prices have fully adjusted in the long run, the output gap will close. Let's walk through how a shock to AD in the short run can be corrected in the long run. First, the shock: Everyone in Hamsterville woke up one morning filled with optimism and confidence that incomes were going to increase, and that this increase will be permanent. ¡Viva Hamsterville! This optimism triggers an increase in consumer spending, causing a positive shock to AD. An increase in consumer spending will cause the AD curve to increase. As a result, output increases and unemployment decreases. Unfortunately, this positive AD shock also means that inflation increases. An increase in AD leads to an increase in real GDP and the price level. How is shock corrected in the long run? Inflation has made everyone's real wages decrease. Boo! As a result, workers demand higher wages. This drives up the cost of labor. Rising labor costs causes SRAS to decrease. This happens because expectations of further inflation and higher resource costs lead firms to produce less and charge higher prices. Output decreases and the price level increases. Output keeps falling and price level keeps rising until real GDP returns to full employment output. As long as output is higher than full employment output, an unemployment rate that is higher than the natural rate will put upward pressure on wages and prices. The long-run outcome is that real GDP returns to the full employment level of output and the unemployment rate is equal to the natural rate. The price level, however, is now permanently higher.

interest sensitivity (Why does the interest sensitivity of investment provide another avenue for the government to make policy?)

Since firms' investment depends on the interest rate, and since changes in the money supply can change the interest rate, the Federal Reserve can increase aggregate demand through monetary policy.

Equilibrium (in the AD-AS model)

So far we have learned to measure real GDP, but how do we end up with that real GDP? Of all of the different amounts of national income and price levels that might exist, how do we gravitate toward the one that gets measured each year as real GDP? In short, it is the interaction of the buyers and producers of all output that determines both the national income (real GDP) and the price level. In other words, the intersection of aggregate demand (AD) and short-run aggregate supply (SRAS) determines the short-run equilibrium output and price level. Once we have a short-run equilibrium output, we can then compare it to the full employment output to figure out where in the business cycle we are. If current real GDP is less than full employment output, an economy is in a recession. If current real GDP is higher than full employment output, an economy is experiencing a boom. If the current output is equal to the full employment output, then we say that the economy is in long-run equilibrium. Output isn't too low, or too high. It's just right.

Monopolistic behavior

Some kinds of individual strategies the firms might adopt to enhance or maintain market power also pose problems for antitrust policy. In examining predatory pricing it is difficult to know when lower prices result from lower costs and competition, rather than one firm's attempts to drive others from the market or prevent entry by pricing below cost.

underemployed

Someone is underemployed if they are working part-time when they want full-time work or have jobs they are overqualified for. Not counting underemployed workers means that the official rate of unemployment makes the employment situation seem better than it is.

Scarcity (choice, and costs)

Something is scarce if we want more than is available and, as a consequence, possibilities are limited. Scarcity implies that individuals must make choices. In particular, scarcity forces each of us (1) to choose how we will allocate out time between leisure and works; (2) to choose the mix of things that we will consume; and (3) to choose between consumption now and consumption in the future.

Common Misperceptions (crowding out)

Sometimes new learners confuse the terms deficit and debt. Deficits are a shortage of funds in any given year. Debts are shortages that have accumulated over many years. A mnemonic that might help keep them straight is that de\color{red}bbstart color red, b, end color redt \color {red}bbstart color red, b, end color reduilds up but de\color{blue}ffstart color blue, f, end color blueicits are \color{blue}ffstart color blue, f, end color blueor right now.

Supply

Suppliers, in general, will provide more to a market if the price is higher. The maximum amount that suppliers wish to sell at all possible market prices is the market supply. The quantity supplied is the amount that suppliers will prove to the market at a specific market price. Quantity supplied is directly or positively related to the relative price, ceteris paribus.

How short-run shocks to SRAS correct in the long run

Supply shocks are a little different from demand shocks. In this case, the long run impact will depend on whether those shocks are temporary or permanent. For example, suppose an increase in the price of oil leads to a negative supply shock (because an increase in input prices will cause SRAS to decrease). Here's what will happen: As a result of the negative supply shock, output goes down, but inflation and unemployment go up. The increase in unemployment will theoretically lead to lower wages (because their is less competition for labor, so firms do not have to compete for workers with higher wages). SRAS increases once wages have adjusted, because a decrease in the price of a input to production will lead to an increase in SRAS. Output returns to the full employment output. On the other hand, if a shock is permanent, there is an entirely different impact. Suppose that there is a permanent negative supply shock that makes the entire economy less productive, such as stricter regulations on production. Here's what will happen: The capacity of the economy has decreased, so LRAS shifts to the left. Because such regulations make the cost of production higher, SRAS will also decrease until output has returned to the full employment output. In this case, output is permanently lower and the price level permanently higher.

Supply Change

Supply will change with the following: Changes in the prices of inputs Technological innovations Organizational innovations Changes in the prices of other, related outputs Changes in transaction costs Changes in expectations about the future, and Changes in the number or size of firms.

Downward Sloping (demand for money)

Suppose you live in a world where you can only store your wealth in bonds or cash, and you have \$1000$1000dollar sign, 1000 in cash. You can earn a 10\%10%10, percent return if you buy a bond, but the return to holding your wealth in the form of money is zero. That bond sounds pretty attractive, so you spend all of your money buying bonds. Now you have a slight problem: all of your wealth is in the form of bonds and you are hungry. You take the bonds to the donut shop but they only accept cash. The donut shop holder wants to be paid now, not a year from now when those bonds mature! So you have a choice: sell your bonds and eat, or keep your bonds and earn interest. The tradeoff between keeping your assets liquid (in the form of cash) or in some other asset (bonds) is called liquidity preference. The amount you are willing to hold in the form of cash is going to depend on a lot of things, such as the price of donuts, how hungry you are, and how easy it is to move wealth between cash and bonds. Your liquidity preference will also depend on the interest rate. If the interest rate suddenly went down to less than 1\%1%1, percent, then holding onto these bonds doesn't make as much sense as it did at 10\%10%10, percent. This inverse relationship between liquidity preference and the interest rate means that the demand for money is downward sloping.

Government Spending (and tax multipliers)

Taken by itself, an increase in government spending increases aggregate demand by the change in government-spending multiplied by the government-spending multiplied by the government-spending multiplier. The government-spending multiplier is the same as the investment multiplier and, in its simplest form, is equal to 1/1-MPC Taken by itself, an increase in taxes decreases aggregate real output demanded at a given price level by the change in taxes multiplied by the tax multiplier. The tax multiplier is smaller than the goverment-spending multiplier because of the indirect effect of changes in taxes on aggregate demand. The tax multiplier, in its simplest form, is equal to MPC/ 1-MPC

Fiscal Policy Effects (What effects does fiscal policy have on the division of the real-output "pie"? Do the effects on the division matter in evaluation the overall effects of fiscal policy?)

Tax breaks and government spending will favor certain groups at the expense of others. Therefore, fiscal policy does change how the real-output "pie" is divided. The overall effects of fiscal policy, however, are unaffected by equity concerns such as these.

Double increase (Are there fiscal policies that might simultaneously increase aggregate demand and increase aggregate supply? What would the consequences of such policies be?)

Tax breaks that reduce the existing disincentives to work caused by a progressive tax system would simultaneously increase aggregate demand (since consumers would spend more) and aggregate supply (since the labor force would grow). The consequences of such policy would be a short-run and long-run increase in GDP. This cannot be done forever, however, since a tax break without a simultaneous decrease in government spending will increase the deficit, which will have to be paid sooner or later.

Taxes (are automatic stabilizers)

Taxes work as an automatic stabilizer by increasing disposable income in downturns and decreasing disposable income during booms. Let's think about this at the individual level. Suppose you make \$1000$1000dollar sign, 1000 per week and pay 20\%20%20, percent in income taxes, so you have to pay \$200$200dollar sign, 200 in taxes and have \$800$800dollar sign, 800 to spend. All of a sudden there is a serious recession. The bad news is your pay got cut in half, so now you only make \$500$500dollar sign, 500 per week. The good news is that your take-home pay did not get cut in half! It turns out that you live with a progressive tax system, so when your pay got cut, your tax rate fell to 10\%10%10, percent. So instead of your disposable income falling to \$400$400dollar sign, 400, it only falls to \$450$450dollar sign, 450. The same concept works in reverse. Suppose there is a positive shock to aggregate demand, and you get a \$1000$1000dollar sign, 1000 bonus. However, that pushes you to a higher tax rate of 30\%30%30, percent, so even though your paycheck doubles, your take-home pay does not.

Public Policies

Taxing activities that create negative externalities and subsidizing activities that create positive externalities move markets toward a more efficient of scarce resources if the dollar magnitude of the externality can be determined. There is no easy way to gather information about the "true" social costs or social benefits associated with a particular externality, however. As a consequence, governments frequently adopt target quantities for allowable pollution rather than using taxes or fees. In order to allocate a target reduction in pollution efficiently, firms or other sources with differing marginal costs of pollution reduction must reduce pollution by differing amounts. Both effluent taxes (or emission fees) and transferable pollution permits will allocate a specified amount of pollution in a cost-effective way, although their use need not necessarily result in the efficent amount of pollution.

Firms

Teams are often more productive than individuals working alone. However, team production creates opportunities for individual workers to shirk. Shirking can be reduced, and the substantial gains from team production realized, if some people monitor the work effort of others. Since these monitors have, in turn, incentives to shirk ,firms are organized where there is a hierarchy of monitors. Thus, the typical pyramidal organization of a firm evolved to reduce or minimize the shirking problem. Likewise, the rich array of compensation schemes (e.g., wages, salaries, commissions, tips, bonuses, stock options, etc.) evolved as ways to eliminate or reduce the costs of shirking and monitoring.

Deficits (Do deficits cause a shift in supply or demand?)

That's an interesting question! There are actually two points of view: Deficits increase the demand for loanable funds; surpluses decrease the demand for loanable funds. The logic of this point of view is that if the government runs a deficit, it has to borrow money just like everyone else. So, if there is a deficit, the demand for loanable funds will increase because the government gets in line to borrow money just like all of the other borrowers. Deficits decrease the supply of loanable funds; surpluses increase the supply of loanable funds. The logic of this point of view is that national savings includes public savings (T-G), and national savings is the source of the supply of loanable funds. So anything that makes T-G smaller (like a deficit) or bigger (like a surplus) will shift the supply of loanable funds But that doesn't mean both curves shift? Supply and demand do not have the same determinants in any market. Your graphical model should reflect only one point of view. In the end, both points of view have the same impact on the real interest rate: deficits increase the real interest rate and surpluses decrease the real interest rate.

Size (of the price elasticity)

The "size" of the elasticity of demand depends upon three things: (1) the ease of substitution, (2) the proportion of typical person's income spent on the commodity, and (3) the period of time since the price change. The elasticity of demand will be higher when substitution is easier, when expenditures on a particular commodity represent a larger fraction of a person's income; and when the period of adjustment to the price change is longer (the Second Law of Demand)

Aggregate Demand Curve

The AD curve is one part of a three-part model that describes something called "National Income Determination." That's quite a mouthful, but remember that national income is real GDP. In other words, part of what determines national income is all of the spending done by households (consumption), firms (investment), government (government spending), and the rest of the world (net exports). AD shows the amount of that spending at various price levels.

ASsr curve (Suppose that wages are sticky downward but not sticky upward-- ie., they are slow to adjust down, but fast to adjust up. What would the ASsr curve look like? How would this affect an economy's adjustment to aggregate demand shocks compared to the analysis provided in the text?)

The ASsr curve would be upward sloping until it intersects the LRAS, after which point it would be vertical. Positive aggregate demand shocks would have a neutral effect on output, and adverse demand shocks would have the same detrimental effect.

Consumer Price Index (CPI)

The Consumer Price Index (CPI) measures the change in income a consumer needs to maintain the same standard of living over time. The CPI is meant to reflect changes in the cost of living for a typical urban household. For example, suppose every household buys 222 bottles of cod liver oil, 101010 loaves of bread, and 888 dog treats every week. A consumer price index tracks changes in the price of this unchanging collection of goods over time to measure changes in the cost of living for this household. Once the CPI is calculated for two years, we can to calculate the rate of inflation.

Federal Reserve (Control of the nominal money supply)

The Fed has significant control over the money supply because it can change the amount of currency in circulation through open market operations, or it can change the reserve requirement (the legal limit on the fraction of deposits that banks can lend out), or it can change the discount rate at which firms can borrow reserves.

Open Market Operations

The Fed's most common method of monetary control is an open market operation in which it purchases or sells U.S. government bonds in the open financial market. A purchase of bonds (an open market purchase) increases the amount of currency in circulation and increases bank reserves. Hence, an open market purchase increases the money supply. By contrast, a sale of bonds (an open market sale) decreases the amount of currency in circulation and eventually decreases bank reserves. As a consequence, the money supply decreases.

Key Model (LRAS Curve)

The LRAS curve represents the potential output (Y_fY f ​ Y, start subscript, f, end subscript) that an economy can produce LRAS and the PPC Remember the PPC? In that model, an economy was using all of its resources efficiently if it was operating at a point on the PPC, as shown in Figure 3. This economy is producing the combination of capital and consumption goods Y_fY f ​ Y, start subscript, f, end subscript. Why did we label it Y_fY f ​ Y, start subscript, f, end subscript? Because this combination of output represents full employment output. You can think of the LRAS curve as taking that dot (which represents a certain amount of capital goods and a certain amount of consumption goods), figuring out the real value of that output, and then graphing the real value of that output in a new model. Imagine you can take that single dot on the PPC and then stretch it out into a vertical line . . . that is the LRAS! What determines the

vertical (The LRAS is vertical at a value of real GDP that represents a point on the PPC)

The LRAS represents a point on a country's PPC, translated into the AD-AS model. Every point on the PPC represents the maximum sustainable capacity for production in an economy. This value of real GDP represents the economy's maximum sustainable capacity given its current stock of resource The LRAS is vertical because, in the long-run, the potential output an economy can produce isn't related to the price level. There are only two things that matter for potential output: 1) the quantity and the quality of a country's resources, and 2) how it can combine those resources to produce aggregate output. When an economy is producing exactly its full employment output, the rate of unemployment is equal to the natural rate of unemployment. The LRAS curve is also vertical at the full-employment level of output because this is the amount that would be produced once prices are fully able to adjust. In the short-run, some prices are sticky. This means that producers might respond to changes in the price level by changing their output. However, in the long-run, those prices get "unstuck," and once they have fully adjusted the economy will produce the efficient, full employment output. Economists tended to assume that prices were fully flexible before the Great Depression. In times of high unemployment, they believed, wages will go down and restore full employment. There was just a slight problem: that didn't happen during the Great Depression! High unemployment and output persisted for a long time. The logical conclusion is that wages (and other prices) are temporarily rigid.

placement

The PPC tells us what an economy can produce if that economy is using all of its resources efficiently. That means this amount of production ultimately depends on what resources an economy has, and the value of the output that can be produced with those resources. For example, if an economy can produce \$150$150dollar sign, 150 million in real GDP by using all of its resources efficiently, then the LRAS will be vertical at a real GDP of \$150$150dollar sign, 150 million.

tradeoff (between inflation and unemployment)

The SRAS curve tells us that firms will respond to inflation by producing more. If you want to produce more, you will need to hire more workers, so the unemployment rate decreases. In this way, the SRAS captures the tradeoff between inflation and unemployment. When the price level increases, producers are willing to make more and hire more workers because sticky wages make them a better bargain. On the other hand, when the price level decreases, producers are willing to make less because sticky wages make workers not as good of a deal and producers sell less. The SRAS curve shows that as the price level increases and you move along the SRAS, the amount of real GDP that will be produced in an economy increases. An increase in the SRAS is shown as a shift to the right. Remember the importance of labeling this model: price level (PLPLP, L) is on the vertical axis, and real GDP (or rGDPrGDPr, G, D, P) is on the horizontal axis. SRAS shows that the short-run relationship between price level and aggregate output is positive, so this should always be an upward sloping curve.

US Debt (How did the United States accumulate its national debt? To whom is it owed?)

The United States accumulated its national debt by spending more than it taxed during periods of recession and periods of prosperity. The debt is held mostly by foreigners—currently China holds a large portion.

long run (unemployment equilibrium)

The actual unemployment rate equals the natural rate of unemployment when an economy is in long-run equilibrium. An economy is in long-run equilibrium when the output it produces is equal to the full employment output. The current output is the short-run equilibrium: where the aggregate demand (AD) curve intersects the short-run aggregate supply (SRAS) curve, and in this graph the output currently produced is Y_1Y 1 ​ Y, start subscript, 1, end subscript. The full employment output is the output where LRAS is vertical, and in this graph that is Y_fY f ​ Y, start subscript, f, end subscript. Since Y_1Y 1 ​ Y, start subscript, 1, end subscript is equal to Y_fY f ​ Y, start subscript, f, end subscript, the economy is in long-run equilibrium.

aggregate demand curve

The aggregate demand curve shows the inverse relationship between the price level spending on real GDP. Figure 1 shows an economy that responds to a decrease in the price level by increasing the amount of aggregate demand. The price level decreases from 120120120 to 102102102 and, in response, spending on output increases from \$16 \text{ trillion}$16 trilliondollar sign, 16, space, t, r, i, l, l, i, o, n to \$17 \text{ trillion}$17 trilliondollar sign, 17, space, t, r, i, l, l, i, o, n.

Multiplier difference (What is the difference between the aggregate demand multiplier and the money multiplier?)

The aggregate demand multiplier has to do with the fact that one person's expenditure is another person's income, and people spend a fraction of their income

Aggregate model (In what specific ways is the aggregate model of an economy presented in this chapter different from the market supply-demand model used in earlier chapters?)

The aggregate model of an economy presented in this chapter differs from the market supply-demand model in the following ways: The quantity in our aggregate model refers to one unit of GDP (an abstract notion) instead of a single apple or pizza. The price on the vertical axis is a price index, not a single relative price. The supply curve is vertical in the long run and upward sloping in the short run, instead of always being upward sloping.

business cycle model

The business cycle model shows the fluctuations in a nation's aggregate output and employment over time. The model shows the four phases an economy experiences over the long-run: expansion, peak, recession, and trough. The business cycle curve is represented by the solid line in the model shown in Figure 1, and the growth trend is represented by the dashed line in Figure 1. Output gaps are represented by the difference between actual output. During an expansion, the business cycle line is above the growth trend. During a recession, the business cycle is below the growth trend.

Changes (in the supply and demand for money)

The central bank controls the money supply, so it can take actions to increase the money supply and decrease the money supply. Changes in the money supply lead to changes in the interest rate. But what about the demand for money, can it change? Absolutely! There are a few reasons why the demand for money might change: Changes in national income - when real GDP increases, there are more goods and services to be bought. More money will be needed to purchase them. On the other hand, a decrease in real GDP will cause the money demand curve to decrease. Changes in the price level (inflation or deflation) - if the price of everything increases by 20\%20%20, percent, you need 20\%20%20, percent more money in order to buy things. When there is an increase in the price level, the demand for money increases. Conversely, when there is a decrease in the price level, the demand for money decreases. Changes in money technology - the demand for money is driven by the transactions motive (we want money so we can buy things). When new technologies make it easier to convert wealth into money, we keep less of it on hand.

price (What determines the change in real output when prices are flexible? When prices are sticky?)

The changes in real output when all prices are completely flexible must be attributed to changes in aggregate supply. When wages are sticky, fluctuations can be attributed to either supply or demand fluctuations.

Income elasticity (and cross-price elasticity)

The concept of elasticity can be used to measure the responsiveness of demand to the change of anything that affects consumer's decisions. We considered two changes that affect consumers' decisions: (1) changes in income, and (2) changes in the prices of other commodities. The elasticity associated with the latter is called the cross-price elasticity of demand and for the former, the income elasticity of demand. A positive cross-price elasticity indicates that two commodities are substitutes; a negative cross-price elasticity indicates that two commodities are complements. The income elasticity of demand is positive for normal commodities and negative for inferior commodities.

Unemployment Costs (Would the costs associated with unemployment be the same for a teenager as for a head of a household? Do the unemployment statistics treat these two persons differently? Should they?)

The costs of unemployment for a teenager are certainly lower than those for the head of a household, but this difference is not measured by the unemployment statistics. A measure of unemployment that included this difference would be more informative

deficit burden (In what sense is the deficit a burden on future generations?)

The deficit is a burden on future generations because it contributes to the national debt which must ultimately be repaid.

Net Exports

The demand for exports increases aggregate demand; the demand for imports reduces aggregate demand. Whether there is an effect on aggregate demand depends upon the relationship of exports to imports. If exports increase relative to imports, aggregate demand wil increase; if imports increase relative to exports, aggregate demand will decrease. If no one wants to hold either the currency or foreign assets, then exports will equal imports (net exports will equal 0). Foreigners may wants to hold US dollars or US dollar assets, however, in which case the US will have a trade deficit and will import financial capital and have a capital account surplus.

inversely related (Why is the demand for money inversely related to the interest rate?)

The demand for money is inversely related to the interest rate because the interest rate is the opportunity cost of holding money. The higher the interest rate, the more potential earnings one forgoes by holding money.

Effects (on the mix of real output produced)

The division of output between consumption, investment, and government uses is affected by the mix of fiscal and monetary policies a government chooses, because (in part) the mix affects interest rates. Different macroeconomic stabilization policies directed at aggregate demand also affect potential real output and hence have different effects on the long-term economic growth prospects of an economy. Macroeconomic stabilization policies affect the potential real output of an economy as they affect labor-leisure or saving-consumption choices.

Long run self-adjustment (in the AD-AS model)

The economy of Petmeckistan has been thrown into a recession due to widespread pessimism by households and firms. Should the government leap into action and try to fix it? Some economists think so, believing that policymakers should take an active approach to stabilize an economy. But other economists believe that intervention isn't necessary most of the time. Rather, they believe that things will sort themselves out without immediate action needed. In this case, policy interventions might further stabilize an economy, so should only be used in extreme circumstances . This second, "hands-off" approach assumes that there is a long-run self-adjustment mechanism. The long-run self-adjustment mechanism is one process that can bring the economy back to "normal" after a shock. The idea behind this assumption is that an economy will self-correct; shocks matter in the short run, but not the long run. At its core, the self-correction mechanism is about price adjustment. When a shock occurs, prices will adjust and bring the economy back to a long-run equilibrium.

Elasticity of demand

The elasticity of demand is defined as the percentage change in quantity demanded divided by the percentage change in price. If the percentage change in quantity demanded is small relative to the percentage change in price, this ratio will be less than one and demand is said to be inelastic. If the percentage change in quantity demanded is large relative to the percentage change in price, the ratio will be greater than one and demand is said to be elastic.

Expenditure Multiplier

The expenditure multiplier shows what impact a change in autonomous spending will have on total spending and aggregate demand in the economy. To find the expenditure multiplier, divide the final change in real GDP by the change in autonomous spending. For example, if the government spends \$1\text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n to send the first gerbil into space, and this increase in government spending results in a \$4 \text{ million}$4 milliondollar sign, 4, space, m, i, l, l, i, o, n increase in real GDP, then the multiplier is 444. How does that happen? The government buys a rocket from Rocket's R Us for \$1 \text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n, which gets counted in government spending. Rocket's R Us uses this to pay their employees. Those employees will save some of that \$1 \text{ million}$1 milliondollar sign, 1, space, m, i, l, l, i, o, n, but spend the rest on t-shirts. The t-shirt sellers then spend the income earned selling t-shirt on kayaking lessons, and so on.

Per Se (and rule-of-reason approaches)

The first of the two approaches to antitrust rules, per se, defines an action or activity as illegal. The second, the rule of reason, allows a court or enforcement agency to weigh the potential benefits against the potential harms of an action or activity. These different approaches to antitrust policy can be rationalized because some activities or actions that create market power are unambiguously harmful, but others can provide the benefits of lower costs through scale and other economies while possibly creating market power. Thus, sensible public policy should require that courts and enforement agencies consider both potential harms and potential benefits.

Increase frictional rate (Economists have suggested that the frictional rate of unemployment has increased during the past two decades. Why might this have occurred?)

The frictional rate of unemployment might increase as labor becomes more specialized. The increased specialization would require more time for workers to find the appropriate job for them.

Natural Rate of Unemployment

The frictional rate of unemployment represents a kind of natural rate to which the economy returns. It appears, however, that the natural unemployment rate increased from 1970 to 1990, and then, perhaps, decreased. Several reasons have been suggested for these changes: First, the composition of the labor force has shifted in the 1970s and 1980s toward younger workers and more women: both groups have traditionally had higher unemployment rates. Second, unemployment compensation has increased over time, thereby reducing the costs of being unemployed somewhat and increasing the rate of frictional unemployment as a consequence. Third, the increase in dual-income households has reduced the costs for one of the income earners to be unemployed. As a consequence, the frictional unemployment rate increased. Its apparent decline in the 1990s is more puzzling.

define and calculate (How does the government define and calculate unemployment?)

The government calculates unemployment by surveying adults and asking them if they are employed and if they have recently looked for employment. Someone who does not have a job but has recently looked for one is considered unemployed. See page 439 of the text for more detail.

Appropriate (countercyclical policies)

The government can pursue one of two broad types of policy in response to unanticipated shifts in aggregate demand or aggregate supply. The first of these, fiscal policy, affects aggregate demand directly, through the expenditure decisions of the government, and indirectly, through the taxation decisions of the government. Monetary policy, however, only affects aggregate demand indirectly through changes in the interest rate. The appropriate policy responses to a deflationary aggregate demand shock include: Fiscal Increasing government spending; decreasing taxes Monetary: Increasing the money supply by an open market purchase; Lowering the discount rate; Lowering the reserve requirement.

Government spending multiplier (What is the government-spending multiplier?)

The government spending multiplier is used to calculate the total impact on aggregate demand that an increase of government spending would have, due to increased consumption. It is 1/(1-MPC).

menu costs

The idea behind "menu costs" is that output prices are sticky too. Suppose you own a restaurant called Sticky's Tacoland. One of your many costs of being in business is printing paper menus. When inflation occurs, you could respond by raising prices. But to do that, you would have to incur the cost of printing new menus that reflect the higher prices. So maybe you don't raise your prices. Now, your taco prices seem relatively cheaper, and you sell more tacos. The aggregate effect of this is that you, and every other firm that kept their prices sticky, will sell more stuff when inflation goes up. Good decision not to raise your prices!

difficulties (What difficulties might arise in actually implementing "sensible" fiscal policies?)

The impact and timing of fiscal policies depend on factors that are not precisely known (consumption patterns, expectations, etc.), and so "sensible" fiscal policies may have a different magnitude and/or timing than expected, which could potentially worsen economic fluctuations. Additionally, complicated political processes involved in determining how tax money should be spent can further reduce the efficacy of "sensible" fiscal policy.

Inefficiency (of a monopolized market)

The important difference between a competitive market and a monopoly market is that marginal revenue for a monopolist is less than the market price whereas for a competitive firm, the marginal revenue is equal to the market price. This means that at the monopoly market price, the consumer's willingness to pay for additional output is greater than the marginal cost to society of providing the commodity. This is a market failure in the sense that the monopoly outcome is inefficient. A monopolist produces too little relative to the efficient competitive market outcome and, as a consequence, charges too high a price. That is, a monopoly imposes a deadweight burden on society.

Differences (between short-run and long-run)

The important difference between an economy's response in the short run and the long run is that, in the long run, wages and prices are flexible and can respond to changes in market supplies and demands as well as to changes in the overall price level. In the short run, wages are sticky and cannot adjust fully to changes in supply and demand or to changes in the overall price level. The failure of prices and wages to adjust immediately in the short run and wages to adjust immediately in the short run means that adjustments occur in the actual output produced and, hence, in the the actual output produced and, hence, in the employment of labor and other resources. At times, therefore, actual real output will deviate from potential real output. Hence, both changes in output as well as changes in prices are an important part of the macroeconomic adjustment process.

(the importance of) long-run adjustments

The important point of this chapter is that the market price can adjust so that the quantity supplied to the market is exactly equal to the quantity demanded--a short-run equilibrium--yet market adjustments continue. This is because profits and losses create incentives for additional market adjustments. If, at a short-run equilibrium, both old and new firms can expect to make profits, entry will occur and the market price will decline. Or if at a short-run equilibrium firms are incurring losses, they will exit as soon as they can dispose of their capital and the market price will increase. Thus, market prices will no longer change only when both the quantity supplied is exactly equal to the quantity demanded and expected profits are zero for any firm that enters or leaves the market. That is, a market is in long-run equilibrium only when supply is equal to demand and profits are zero.

calculate (rate of inflation from CPI)

The inflation rate is determined by calculating the percentage change in a price index (such as CPI or the GDP deflator). The inflation rate tells us the percentage by which the price level is changing from period to period. [Thanks!] To calculate the rate of inflation, you implement this formula: \text{inflation rate} = \dfrac{CPI_2-CPI_1}{CPI_1}\times 100\%inflation rate= CPI 1 ​ CPI 2 ​ −CPI 1 ​ ​ ×100%

interest rate effect

The intuition behind the interest rate effect is that when the price level decreases, you need less money in your pocket to buy stuff. The less money you need to keep on hand to buy stuff, the more money you are going to keep in a bank. Banks pay interest to try to lure people to deposit their money in banks. So, if you are going to keep more money in the bank anyway, banks don't have to offer as much interest in order to convince you; that drives interest rates down. As a result, businesses and households spend more money on investment and "big ticket" items that are interest sensitive, like X, Y, and Z. So, once again, a decrease in the price level will increase real GDP. On the other hand, a higher price level will drive up interest rates. Remember how a higher price level would make everyone's dollars are worth less, and they cut back on consumption? Well, what if they didn't want to cut back on consumption. Instead, maybe they sell off some other asset like a bond to try to get more money. The problem is, every other bondholder is also trying to sell off their bonds, so there are no buyers! Anyone who wants to issue a new bond is going to have to do something to try to attract buyers. The way to do that is to raise the interest rate that is offered. All of that excess demand for money leads to an increase in the interest rate.

wealth effect

The intuition behind the real wealth effect is that when the price level decreases, it takes less money to buy goods and services. The money you have is now worth more and you feel wealthier. So, in response to a decrease in the price level, real GDP will increase. More formally, this means that when households' assets are worth more in terms of their purchasing power, they are more likely to purchase more goods and services. The opposite happens when the price level increases. If the price of everything increases, but the number of dollars you have doesn't, then you have to cut back on spending. Some shorthand of this chain of events can help us wrap our heads around this: PL\downarrow \rightarrow \text{real wealth }\uparrow \rightarrow \text{consumption increases} \rightarrow \text{move right along AD curve}PL↓→real wealth ↑→consumption increases→move right along

Labor Force Participation rate

The labor force participation rate (LFPR) is another measure of labor market activity in the economy. The LFPR is the percentage of the adult population that is in the labor force. The labor force includes everyone who is either employed or unemployed. The adult population is defined as anyone who is over the age of 16 who potentially could be part of the labor force. Anyone who is less than 16 years old, is in the military, or is institutionalized is not considered to be potentially part of the labor force and is excluded from this calculation. When people enter the labor force the LFPR increases, and when people exit the labor force the LFPR decreases. A decrease in the LFPR that occurs at the same time as a decrease in the unemployment rate can signal that there are more discouraged workers.

Long-run supply

The long-run supply curve is perfectly elastic if there are constant long-run costs; it slopes downward if there are decreasing long-run costs; and it slopes upward if there are increasing long-run costs. These correspond to constant returns to scale, increasing returns to scale, ad decreasing returns to scale, respectively. What the long-run supply curve for any particular industry looks like is an empirical matter that depends on the specific characteristics of that industry.

Marginal Analysis

The marginal benefit associated with a choice is the additional benefit obtained by increasing the activity level a small amount. The marginal cost associated with a choice is the additional choice incurred when the activity level is increased by a small amount. Thus, marginal utility is the additional satisfaction obtained when consumption of some good or service is increased by a small amount. Similarly, marginal revenue is the additional revenue obtained by the sales some output are increased by a small amount.

MPC (What precisely is the marginal propensity to consume? Why might it be important?)

The marginal propensity to consume is a measure of what percentage of an additional dollar households consume, rather than save, on average. The MPC is important in determining the multiplied effect of policy changes, such as a tax break or an increase in government spending.

Marginal Propensity (to consume and the aggregate demand multiplier)

The marginal propensity to consume is the amount by which consumption changes when income changes by $1. The investment multiplier is the amount by which aggregate demand changes when desired investment changes. Since a dollar spent within the economy increases the demand for the output an economy produces regardless of whether it's a dollar increase in desired investment or a dollar increase in net exports, the net export multiplier is the same as the investment multiplier. Both the investment multiplier and the net export multiplier are, in their simplest form, equal to 1.0/(1.0-MPC). SInce they are identical, (1/1-MPC) is generally referred to as the aggregate demand multiplier.

MPC (and the MPS)

The marginal propensity to consume is the change in spending that occurs when income changes, divided by that change in disposable income. If someone spends \$75$75dollar sign, 75 when they have \$100$100dollar sign, 100 more in income, the MPCMPCM, P, C is .75.75point, 75. There are only two things you can do with money: spend it or save it. That means whatever proportion not spent must be saved. Economists call this the marginal propensity to save (MPSMPSM, P, S). So if the MPCMPCM, P, C is 0.750.750, point, 75, the MPSMPSM, P, S is 0.250.250, point, 25. The sum of MPCMPCM, P, C and MPSMPSM, P, S is always 111.

Behavior (The loanable funds market describes the behavior of savers and borrowers.)

The market for loanable funds is a way of representing all of the potential savers and all of the potential borrowers in an economy. It has the same features of other markets that we have seen before, but with a few twists: Quantity - loans are being "bought" and "sold" in this market. The "quantity" in this market is really the quantity of loans or, more formally, the quantity of loanable funds. Why? It's not how many loans are being made, but how much loaning is going on. Price - the cost of borrowing is the real interest rate, and the reward for savings is the real interest rate. Therefore, we use the real interest rate (rather than price) in the market for loanable funds. Supply - The supply of loanable funds represents the behavior of all of the savers in an economy. The higher interest rate that a saver can earn, the more likely they are to save money. As such, the supply of loanable funds shows that the quantity of savings available will increase as the interest rate increases. Demand - The demand for loanable funds represents the behavior of borrowers and the quantity of loans demanded. The lower the interest rate, the less expensive it is to borrow. Equilibrium - The equilibrium in the market for loanable funds is achieved when the quantities of loans that borrowers want are the same as the quantity of savings that savers provide. The interest rate adjusts to make these equal.

Vertical (Money Supply)

The money supply is ultimately determined by the monetary base and the money multiplier. In most countries, that country's central bank determines the size of the monetary base. Remember that the monetary base includes reserves in vaults and currency in circulation outside of banks. For example, central banks might change the reserve requirements to change the monetary base. The money supply doesn't depend on the interest rate, it only depends on the central bank. Because of this, the money supply curve is vertical at the quantity of the money supply, not upward sloping or downward sloping.

Money supply (What reasons can you think of for the money supply to increase somewhat with interest rates?)

The money supply would increase somewhat with the interest rate because people would choose to hold more of their wealth in interest bearing checking accounts or savings accounts. Consequently, banks could issue more loans and the money supply would increase

MPC (and multipliers)

The more that is spent out each dollar, the bigger the multiplier will be. Why? Because if money is spent, that money becomes income to another agent who then spends it, and that continues with a chain reaction of spending. The more that is spent out each dollar, the bigger the multiplier will be. Why? Because if money is spent, that money becomes income to another agent who then spends it, and that continues with a chain reaction of spending.

medium of exchange

The most important function of money is its use as a way of buying things, in other words, as a medium of exchange. If your grandmother sends you \$20$20dollar sign, 20 tucked in a birthday card, you can take that and buy whatever you want with that money. Well, up to \$20$20dollar sign, 20 worth of whatever you want. Thanks, Grammie!

Natural rate hypothesis (What is the natural rate hypothesis?)

The natural rate hypothesis is that 5 or 6 percent of unemployment is frictional and the rest is due to the business cycle.

Changes (in the natural rate of unemployment)

The natural rate of unemployment (NRU) can gradually change over time due to events such as changes in labor force characteristics. The NRU can change due to changes in structural and frictional unemployment. For example, a firm may want to hire fewer workers because the skills of those workers are not needed as much as they used to be. That will cause more structural unemployment, and the natural rate of unemployment will increase.

Money Growth (and Inflation)

The nobel prize winning economist Milton Friedman once said that "Inflation is always and everywhere a monetary phenomenon." The evidence to back his claim was pretty clear: whenever countries experience very high inflation for a sustained period of time, those countries also experience a rapid increase in the rate of growth of their money supply. At the same time, increases in the money supply in those countries isn't associated with sustained increases in output that we would have predicted with monetary policy. It seems that in the short run, increases in the money supply lead to increases in output, but in the long run increases in the money supply just cause inflation.

output gap

The output gap is the difference between actual output and potential output in the business cycle. Potential output is what a nation could be producing if all of its resources were being used efficiently. In the business cycle model, a nation's potential output at any given time is represented as the long-run growth trend. Output gaps exist whenever the current amount that a nation is producing is more or less than potential output. In the business cycle model, whenever the business cycle curve is above the growth trend that means an economy is experiencing a positive output gap. Whenever the business cycle curve is below the growth trend that means the economy is experiencing a negative output gap. When actual output is above the potential output, aggregate demand has grown faster than aggregate supply, causing the economy to overheat. Overheating in this instance means output is occurring at an unsustainably high level, at which the unemployment rate is lower than the natural rate of unemployment. Eventually, the business cycle will reach a peak and enter a recession. When actual output is below the potential output, aggregate demand or aggregate supply have fallen, causing a fall in employment and output. When a negative output gap exists, the unemployment rate will be higher than the natural rate of unemployment. Eventually, the business cycle will reach a trough and enter a recovery and expansion.

Substitution

The price elasticity of demand reflects the responsiveness of quantity demanded to a change in the market price. Or, in other words, it reflects the ease of substitution of other things for the commodity whose price has changed. A high elasticity of demand indicates that there are many substitutes for a particular commodity; a low elasticity of demand indicates that substitution is more difficult.

Price level (How does the price level differ from the price of a Big Mac or a CD?)

The price level is a measure of prices generally and indicates the purchasing power of a dollar, whereas the price of a Big Mac or CD is a relative price, indicating the tradeoff between consuming the music or the burger instead of other goods and services.

Quantity Theory of Money

The quantity theory of money M \times V = P \times YM×V=P×YM, times, V, equals, P, times, Y Where V, the velocity of money, is constant. The quantity theory of money has these important implications: If output (YYY) is increasing and velocity is constant, the money supply will have to increase to keep the price level from decreasing; and An increase in the money supply (MMM) without an increase in output (YYY) causes the price level to change by the same change in the money supply. In other words, output doesn't change, but when the money supply doubles, the price level also doubles. For example, suppose we had a really simple economy that only produced mangoes. The velocity of money is 5 and there are 100 mangoes: M \times 5 = P \times YM×5=P×YM, times, 5, equals, P, times, Y What will the price be if there is \$20$20dollar sign, 20 in the money supply? \begin{aligned} \$20 \times 5 &= P \times 100\\\\ \$100 &= P \times \$100\\\\ \$1 &= P\end{aligned} $20×5 $100 $1 ​ =P×100 =P×$100 =P ​ So, according to this theory, each mango will cost \$1$1dollar sign, 1. What if instead there is \$40$40dollar sign, 40 in the money supply? \begin{aligned}\$40 \times 5 &= P \times 100\\\\ \$200 &= P \times 100\\\\ P&=\$2\end{aligned} $40×5 $200 P ​ =P×100 =P×100 =$2 ​ When there was no accompanying increase in output, the price level doubled.

growth (of the money supply determines the growth of the price level in the long run)

The quantity theory of money treats money as neutral. That doesn't mean that changes in the money supply have no impact. Rather, "neutral" means that changes in the money supply have no impact on one variable in particular: real output. In the long run, real output will depend on resources and technology, not the money supply. This means that changes in the price level (and therefore the rate of inflation) depend primarily on changes in the money supply. We can summarize the relationship between increases in the money supply and economic growth as: ## Key misperceptions Some people assume that money neutrality means monetary policy is pointless.In fact, Milton Friedman, the father of monetarism, believed that the lack of monetary policy contributed to the severity of the Great Depression. Rather, money neutrality states that monetary policy has limits to its appropriate uses. The money supply should grow enough to support any increase in the natural rate of output (in other words, support economic growth), and during severe downturns. However, the money supply shouldn't be used to attempt to smooth out the business cycle

Reserve Requirement (and fractional reserve banking)

The supply of money is determined in part by the Fed and in part by the banks, who play an important role in money creation by holding only a fraction of the deposits made to checking accounts as reserves (a system called fractional reserve banking). The maximum amount of money that the banking system can create is determined by the money multiplier. 1/RR

tools and outcomez (monetary policy)

The tools and outcomes of monetary policy The table below summarizes the tools and outcomes of monetary policy: Recessionary gaps (Y<Y_f \text{ and }UR>UR_n)(Y<Y f ​ and UR>UR n ​ )left parenthesis, Y, is less than, Y, start subscript, f, end subscript, space, a, n, d, space, U, R, is greater than, U, R, start subscript, n, end subscript, right parenthesis Inflationary gaps (Y>Y_f\text{ and } UR<UR_n)(Y>Y f ​ and UR<UR n ​ )left parenthesis, Y, is greater than, Y, start subscript, f, end subscript, space, a, n, d, space, U, R, is less than, U, R, start subscript, n, end subscript, right parenthesis Why full employment price stability How increase money supply decrease the money supply Tools used (primary tool in bold) 1) open market purchases (buy bonds), 2) decrease discount rate, 3) decrease reserve ratio 1) open market sales (sell bonds), 2) increase discount rate, 3) increase reserve ratio Impact on interest rates decrease nominal interest rate increase the nominal interest rate Impact on output increase Y decrease Y Impact on unemployment UR decreases UR increases Impact on price level/inflation inflation increases inflation decreases

Market versus laws

The use of antitrust laws has been surrounded with controversy from their inception. Some critics argue that most of the problems associated with market power are better solved by relying on market forces. Others argue that the laws have the wrong mix of per se and rule-of-reason approaches, and debate vigorously about the kinds of potential harms and benefits that ought to be considered in a rule-of-reason approach. Still other critics are concerned with whether antitrust laws protect competitors, thereby reducing, rather than ehancing, competition. IN this regard, there is concern that a frim can get the antitrust laws to get in court what it cannot get in the marketplace. And others argue that there ought to be more vigorous enforcement, even more use of per se illegal rules, because the goal is not efficiency alone, but protection of society's interests in fair competion.

Inflation and money

There is overwhelming evidence that sustained inflation is created by sustained growth in the money supply, growth that is under almost direct control of the government or central bank. Tax cuts, government spending increases, supply shocks, and the like can cause a one-time increase in the price level, but only on expanding money supply can create persistent and sustained inflation. This conclusion is in accord with the empirical evidence from many countries and times.

Short-run Aggregate Supply

Think of something that is stuck. It's fixed in place and, if it's moving, it's doing so really slowly! When things don't move or adjust quickly, economists will often refer to them as "sticky." For instance, if market prices or wages don't adjust quickly to changes in the economy, they are called sticky prices. And when faced with things like sticky wages and prices, an economy might not produce its full employment output. The short-run aggregate supply curve (SRAS) lets us capture how all of the firms in an economy respond to price stickiness. When prices are sticky, the SRAS curve will slope upward. The SRAS curve shows that a higher price level leads to more output. There are two important things to note about SRAS. For one, it represents a short-run relationship between price level and output supplied. Aggregate supply slopes up in the short-run because at least one price is inflexible. Second, SRAS also tells us there is a short-run tradeoff between inflation and unemployment. Because higher inflation leads to more output, higher inflation is also associated with lower unemployment in the short run.

rate of change

Think of this formula this way—any rate of change (such as the rate of change of prices, which is what the inflation rate is measuring) can be calculated as: "new minus old, over old": \text{Rate of change} = \dfrac{\text{new value}-\text{old value}}{\text{old value}} \times 100\%Rate of change= old value new value−old value ​ ×100%R, a, t, e, space, o, f, space, c, h, a, n, g, e, equals, start fraction, n, e, w, space, v, a, l, u, e, minus, o, l, d, space, v, a, l, u, e, divided by, o, l, d, space, v, a, l, u, e, end fraction, times, 100, percent. Suppose that you had previously calculated that the CPI in 2015 is 175 and the CPI in 2016 is 183. We calculate the rate of inflation between 2015 and 2016 as \begin{aligned} \text{Rate of inflation} &= \dfrac{183-175}{175}\\\\ & = 4.57\%\end{aligned} Rate of inflation ​ = 175 183−175 ​ =4.57% ​

unit of account

This function makes transactions easier to carry out because it means money can give a specific value to something. Suppose there are three people with goods to trade. Caleb wants to sell a snake habitat in exchange for three pizzas, Cadell wants to sell a pizza in exchange for two movie tickets, and Caprice wants to sell four movie tickets in exchange for two snake habitats. Trying to untangle these exchange prices would cause quite a headache. Instead, it's much easier to value these goods using a single, common currency

(Other notions of) efficiency

Three additional notions of efficiency are important: adjustment efficiency, informational efficiency, and dynamic efficiency. For the first, the important question is whether markets adjust to changes and shocks more quickly than can alternatives. For the second, the important question is whether markets gather and transmit information about demands and supplies more quickly than can alternatives. For the third, the important question is whether markets stimulate and reward individual initiative to change and innovate.

Excess Reserves (allow expansion of the money supply)

To understand how banks create money, let's take a step back. What if that poetry competition money was the only money that existed in the economy. Before you deposit the money in the bank, let's calculate the money supply: \begin{aligned} M1&=\text{currency in circulation} + \text{deposits}\\\\ &=\$100 + \$0\end{aligned} M1 ​ =currency in circulation+deposits =$100+$0 ​ Once you deposit your money in the bank, M1 doesn't change; only the composition of the money supply changes: M1=\$0 + \$100M1=$0+$100M, 1, equals, dollar sign, 0, plus, dollar sign, 100 How does the First Bank of Pulitzer bank create more money out of this \$100$100dollar sign, 100? Our bank now has \$80$80dollar sign, 80 just sitting around. This is the bank's excess reserves - the extra money beyond what they must keep in required reserves. The bank can do one of two things with that money: Keep it in the bank (just in case you want to withdraw more than \$20$20dollar sign, 20) Loan it out In the real world, your deposit wouldn't be the only deposit in the bank. Usually, only a small number of people want to withdraw their money on a given day. So, the bank might want to loan out that money to earn a profit. Now, suppose Sylvia shows up at the bank and wants to borrow \$50$50dollar sign, 50. Let's see how the bank's loan to Sylvia impacts their T-account and the money supply: Assets Liabilities Required reserves \$20$20dollar sign, 20 \$100$100dollar sign, 100 Your Deposit Loan to Sylvia \$50$50dollar sign, 50 Excess reserves \$30$30dollar sign, 30 M1 has changed as well. Remember, your \$100$100dollar sign, 100 deposit is still your money. If you check your account balance, it still says you have \$100$100dollar sign, 100. But Sylvia now has \$50$50dollar sign, 50 in cash in her pocket, too: \begin{aligned} M1 &= \text{cash in circulation} + \text{deposits}\\\\ &=\$50 + \$100\\\\ &=\$150\end{aligned} M1 ​ =cash in circulation+deposits =$50+$100 =$150 ​ By loaning out from excess reserves, the bank has added to the money supply.

Public-good problem

Too little of a commodity will be provided by a market if it is not possible to exclude those who do not pay for it from using the commodity, or if consumption of the commodity by one person does not affect the consumption of the commodity by someone else. Commodities with these characteristics are public goods. From an efficiency perspective, a market economy will fail to produce enough public goods. Unfortunately, determining how much is enough is a particularly difficult problem because the information necessary to make this judgement is not readily available.

redistribution effects (of disinflation and deflation)

Unanticipated disinflation or deflation, when the inflation rate is lower than it was expected to be (or even negative), has the opposite effect as unanticipated inflation: lenders are helped and borrowers are hurt. Lenders are helped by unanticipated disinflation or deflation because the money they get paid back has more purchasing power than the money they expected it to be when they loaned it out. Borrowers are hurt by deflation in particular because they have to pay back their debts with money worth more than the money they borrowed in the first place! Most policies that target inflation are aimed at maintaining small and predictable rates of inflation. Inflation that is too close to zero runs the risk of becoming negative, and deflation becomes a possibility. Deflation has a very damaging impact on an economy and is associated with particularly severe recessions and depressions. If you hear about policymakers talking about "lowering inflation," their objective is slowing down the rate of inflation (in other words, disinflation), not deflation.

Frictional Unemployment

Unemployment also occurs because people are entering or reentering the labor market or because some individuals are dissatisfied with their jobs and quite to find better ones. This kind of unemployment is independent of aggregate demand shocks and occurs because findings jobs (and finding employees) even when they are available takes time. Countercyclical policies will not affect the frictional rate of unemployment. Frictional unemployment will be affected, however, by anything--including public policies--that change the costs and benefits of searching for either individuals or firms.

Long-run effects

Unemployment is a short-run phenomenon. Whatever the reasons for stickiness in prices and nominal wages, price and wage adjustment over time will move an economy toward its potential real output. Economists disagree on how long it takes for an economy to adjust back to full employment and stable prices after an adverse shock. Just because an economy is stable in the sense that it moves toward full employment does not mean that it does so quickly.

voluntary (To what extend is unemployment voluntary)

Unemployment is voluntary to the extent that people often forgo a job in hope of a better job.

Redistribution

Unexpected inflation arbitrarily redistributes wealth from one group to another group, such as from borrowers to lenders. When people decide to borrow money or lend money, they often consider what they think the rate of inflation will be. When the rate of inflation is different than anticipated, the amount of interest repaid or earned will also be different than what they expected. Lenders are hurt by unanticipated inflation because the money they get paid back has less purchasing power than the money they loaned out. Borrowers benefit from unanticipated inflation because the money they pay back is worth less than the money they borrowed.

shortcomings (of CPI)

Using the CPI as a measure of inflation has some shortcomings. That can cause the CPI to overstate the true inflation rate. For example, substitution bias causes the CPI to overstate increases in the cost of living. When the prices of goods go up, people will substitute other similar goods in place of the good that is now more expensive. But because the CPI assumes that the basket of goods never changes, it makes it appear that people always buy the same amount of a good that is now more expensive. Another shortcoming of CPI is that it fails to account for changes in quality. For example, one of the reasons a 2013 Volvo Station Wagon costs more than a 1973 Volvo Station Wagon is that the newer model has things like seatbelts in the backseat, FM radio, and air conditioning. The CPI, however, treats these vehicles as identical, which overstates the true rate of inflation.

Another Example

We can better understand how the self-adjustment mechanism plays out by thinking about all of the coffee shops in Hamsterville. An increase in AD means coffee shops can sell more goods at higher prices. Coffee shops raise the price of a latte 10\%10%10, percent from \5 to \$5.50$5.50dollar sign, 5, point, 50. At the same time, the baristas making those lattes see the prices all around them rising too. But their paycheck hasn't changed. They are able to buy less stuff, so effectively their real wages have decreased. At the same time, they see help wanted ads all over the place from other firms desperate to hire workers because the unemployment rate is so low. The baristas all quit and find better-paying jobs. Now the coffee shop owners have to hire more workers. In order to attract workers, they have to raise wages too. Eventually, every firm in Hamsterville is paying higher wages. At the national level, increases in wages and other input costs mean the SRAS will decrease (because SRAS decreases when input prices increase or are expected to increase). Output returns to full employment output, and unemployment returns to the natural rate of unemployment. However, the economy also ends up with a higher price level. In the long-run, the price level increased, but output didn't and the unemployment rate is once again equal to the natural rate of unemployment.

SRAS shocks (have a short-run impact on our key macroeconomic variables)

We can summarize the impact of a shock to SRAS as described in the table below: Supply shock impact on rGDP impact on unemployment impact on price level ↑SRAS ↑rGDP ↓ UR ↓ PL ↓SRAS ↓rGDP ↑ UR ↑ PL Remember the mnemonic "SPITE" to summarize the things that can cause a shift in SRAS: Subsidies for businesses Productivity Input prices Taxes on businesses Expectations about future inflation For example, suppose an economy is initially in long-run equilibrium (current output is equal to full employment output). If the economy then experiences a positive SRAS shock, such as a decrease in Input prices. Now it would be in the expansion phase of the business cycle and experiences a positive output gap. On the other hand, if the economy starts in long-run equilibrium and then experiences a negative SRAS shock, it would be in the recession phase of the business cycle and experience a negative output gap. The combination of low output and high inflation that is caused by a decrease in SRAS is so unusual that it gets its a special name: stagflation. This word is a mashup of "stagnation" and "inflation." Shifts in SRAS represent the best and the worst outcomes for an economy. If SRAS increases, we end up with lower prices, less unemployment, and more output! On the other hand, decreases in SRAS give us more of what we like the least: less stuff, more unemployment, and higher prices.

Changes (in the AD-AS model in the short run)

We know from previous lessons that business cycles are deviations of GDP away from the long run trend. In other words, real GDP is increasing over time, but its a bumpy road along the way with lots of ups and downs. But why do business cycles exist in the first place? This question continues to fascinate macroeconomists. In our last lesson, we learned how we can use the AD-AS model to describe what real GDP is today. Now, we will use the same model to describe why real GDP might change. Anything that shifts AD or SRAS will create a new macroeconomic equilibrium. We can use the AD-AS model to help explain the business cycle (in other words, the recessions and booms that we have seen in the real world). When AD or SRAS curves shift, we call these "shocks". Why a shock? Because the change come as a complete surprise! An unexpected change in the economy will shift either the aggregate demand (AD) or short-run aggregate supply (SRAS) curve. Negative shocks decrease output and increase unemployment. Positive shocks increase production and reduce unemployment. The effect on inflation, however, will depend on whether the shock was a supply shock or a demand shock.

impact (Fiscal and monetary policy can impact output, inflation, unemployment, and interest rates)

We know from previous lessons that monetary and fiscal policies can influence output, inflation, the unemployment rate, and interest rates. We can summarize the short-run impact of different combinations of fiscal and monetary policy as shown in the table below: Fiscal and monetary policy can impact output, inflation, unemployment, and interest rates We know from previous lessons that monetary and fiscal policies can influence output, inflation, the unemployment rate, and interest rates. We can summarize the short-run impact of different combinations of fiscal and monetary policy as shown in the table below: Expansionary monetary policy (open market purchases) Contractionary monetary policy (open market sales) Expansionary fiscal policy (increase government spending/decrease taxes) G and/or C ↑→AD↑MS↑i↓→AD↑Output↑UR↓PL↑ G and/or C↑→AD↑MS↓i↑→AD↓Output ? UR ? PL ? Contractionary fiscal policy (decrease government spending/increase taxes)

Monetary Policy

We learned in a previous lesson that governments use fiscal policy to close output gaps. But central banks also have a tool to smooth the business cycle: monetary policy. Most central banks have a dual mandate to maintain stable prices and to promote full employment. Central banks use the money supply to meet these two objectives. When a central bank changes the money supply, it changes interest rates, and changes in interest rates impact investment and aggregate demand.

Open Market Operations (change the monetary base, but the impact on the money supply is larger due to the money multiplier)

When a central bank performs an open market operation, such as buying bonds, they pay for those bonds by depositing money into a bank's reserves. For example, suppose that the central bank buys \$1{,}000$1,000dollar sign, 1, comma, 000 worth of bonds. The central bank then increases bank's reserve balances by \$1{,}000$1,000dollar sign, 1, comma, 000. Remember that money in vaults is counted as part of the monetary base, but not as part of the money supply. Now the bank has \$1{,}000$1,000dollar sign, 1, comma, 000 in excess reserves. Central banks either pay no interest on those reserves, or they pay such a low interest rate that makes it not worthwhile to a bank to keep excess reserves. That means a bank will usually not want to leave money idle in bank vaults unless it absolutely has to. Instead, banks will make loans using that money. In fact, it can loan the entire \$1{,}000$1,000dollar sign, 1, comma, 000 because the \$1{,}000$1,000dollar sign, 1, comma, 000 is not part of a demand deposit liability. As soon as it makes the loan, the money is now in circulation and is counted in M1M1M, 1. We can use the money multiplier to predict the maximum change in the money supply that will occur as a result of the OMO. If the money multiplier is 4, then the money supply will increase by up to \$4{,}000$4,000dollar sign, 4, comma, 000.

Short-run (competitive supply for a firm)

When a firm finds its capital is fixed and that it sells in a competitive market, the marginal cost schedule (or curve) for the firm becomes the firm's short-run competitive supply schedule (or curve) as long as the market price is greater than average variable cost. If the market price is below the firm's average variable cost, the firm will shut down. The output provided to the market (market supply) is the sum of the amount each competitive firm is willing to produce at each possible market price. Short-run competitive market supply is positively related to the market price--sloping upward to the right--because in the short run each firm will find that, as it attempts to increase production in response to higher market prices, marginal cost increases. Short-run market supply is also positively related to the market price because as the market price increases, firms that chose not to produce when the market price was below their average variable cost and left their capital idle, now find that it is once again profitable to use their capital. In doing so, they reenter the market.

Right amount (choosing the right amount)

When a gap is negative, you want output to get bigger, and so expansionary fiscal policy the right choice. When a gap is positive, you want output to get smaller, and so contractionary fiscal policy is the right choice. Once you decide on the type of policy (expansionary or contractionary), you can then decide on which tool to use (taxes or spending). Policymakers also have to be careful to "mind the gap." If they want to close an output gap, they need to know how much stimulus is necessary. Too little stimulus and you won't close the gap. Too much stimulus and you may cause a different kind of gap. For example, suppose that the economy of Burginville has an output gap of \$20$20dollar sign, 20 billion. They need to take a policy action that causes exactly the amount of change. The good news is that they don't actually have to spend \$20$20dollar sign, 20 billion to close that gap. Why? Because they can count on multipliers. Recall that the spending multiplier gave us the final impact on AD of an increase in any category of spending. If the spending multiplier is 4, then an increase in government spending of \$20$20dollar sign, 20 billion would increase real GDP by 4x\$20=\$804x$20=$804, x, dollar sign, 20, equals, dollar sign, 80 billion. The tax multiplier is always one less than the spending multiplier (and is negative). If the spending multiplier is 444, the tax multiplier must be -3−3minus, 3. That means that if the government cuts taxes by \$20$20dollar sign, 20 billion, the final impact will be -3x-\$20=\$60−3x−$20=$60minus, 3, x, minus, dollar sign, 20, equals, dollar sign, 60 billion. In either of these cases, increasing output by too much will cause output to be higher than full employment output.

Common Misperceptions (Fiscal Policy)

When first learning about stabilization policies, some people think that the objective of stabilization policies is to eliminate the business cycle. But that is not the case. The objective of stabilization policy is not to "fine-tune" the economy. The goal of stabilization isn't to make the business cycle go away completely, but to make the ups and downs less dramatic. In other words, we don't want to make the budget cycle a flat line, just less "bumpy". Some people mistakenly assume that fiscal policy (or any kind of discretionary policy) is as easy as some simple calculations. Unfortunately, that isn't very realistic. Lags make active stabilization policy tricky. For one, the self-correction mechanism may be working in the background, so by the time a policy is finally implemented, it might not be the correct action anymore. Another problem is they make it longer before a corrective action kicks in. One potential solution is to have some form of passive, or automatic, stabilizers that will kick in automatically when a problem arises. We learn more about those in the next lesson. Some learners confuse two important types of stabilization policy: fiscal policy and monetary policy. Fiscal policy is the domain of governments. Monetary policy is the domain of central banks (which are usually independent of government budgetary actions). Another common misperception is that if government spending increases by the same amount as a tax increase, they completely cancel each other out. A \$100$100dollar sign, 100 million increase in government spending that is paid for by increasing taxes by \$100$100dollar sign, 100 million won't completely cancel each other out. The balanced budget multiplier is equal to one, not zero. When there is a balanced budget, the final impact on real GDP is a \$100$100dollar sign, 100 million increase as a result of the balanced budget multiplier. When first learning about discretionary stabilization policies, it can be tricky to remember what specific actions are expansionary and what are contractionary. The table below can be your guide:

Supply-Side policy effects

When public policies reduce the amount of labor employed, they also lower the potential real output for an economy. Moreover, when policies make adjustments longer or more difficult, the adjustment of short-run aggregate supply to long-run aggregate supply will be slower. Supply-side economic policies are advocated as an effort to lessen or minimize such distortions and to increase the potential output from an economy, given its resources, or to hasten adjustment to demand shocks.

Positive externality

When some of the benefits of a decision are not considered, there will be a positive externality. In this case, one person's decisions beneficially affects others. The market will not account for these beneficial effects, so it will produce too little. As a consequence, the market outcome is inefficient, and there is a deadweight loss imposed on the economy.

Negative Externality

When some of the costs of a decision are not considered, there will be a negative externality. That is, one person's decision will detrimentally affect others. The market will not account for these detrimental effects, so it will produce too much. As a consequence, the market outcome is inefficient, and there is a deadweight loss imposed on the economy.

shifts (in SRAS)

When the price level changes and firms produce more in response to that, we move along the SRAS curve. But, any change that makes production different at every possible price level will shift the SRAS curve. Events like these are called "shocks" because they aren't anticipated. For example, imagine the price of labor unexpectedly gets more expensive. In response to that shock, the SRAS curve decreases (shifts to the left). Interestingly, this happens if firms expect that this will happen too. If you see it coming, you adjust your expectations accordingly! If factors of production get cheaper, or producers think they will get cheaper, then SRAS increases. You can easily remember all of the shocks that shift SRAS by thinking of SPITE: Subsidies for businesses Productivity Input prices Taxes on businesses Expectations about inflation

Price (and quantity demanded)

When the price of a commodity or activity increases, less will be demanded because individuals will substitute other commodities or activities for the one whose price has increased; conversely, when the price of a commodity or activity decreases, more will be demanded because individuals will substitute this commodity or activity for other things that have become relatively more expensive. Thus, there is an inverse relationship between relative price and quantity demanded. This is known as the First Law of Demand.

achieve goals ( Monetary policy can be used to achieve macroeconomic goals)

When there is macroeconomic instability, such as high unemployment or high inflation, monetary policy can be used to stabilize the economy. The goals and appropriate monetary policy can be summarized as shown in the table below: What the central bank might want to fix The appropriate monetary policy for that fix Output that is too low, unemployment that is too high, or inflation that is too low expansionary monetary policy Output that is too high, unemployment that is too low, or inflation that is too high contractionary monetary policy

Direct Regulation

When too little is produced because of a monopoly, the government can provide an incentive for the monopolist to increase its output, thereby moving the market toward the efficient level of output, by regulating the monopolist's prices. Setting the maximum price that a monopoly can charge below what it would set on its own will force the monopolist to increase its output, as long as the marginal cost curve is below the demand curve. The maximum price is set below the point at which the marginal cost curve is equal to the demand curve, a monopolist will decrease its output and the quantity demanded will increase, thus creating a shortage. The efficient outcome can be obtained if the regulated price is set equal to marginal cost, as long as marginal cost is greater than or equal to average total cost. For a natural monopoly, setting price equal to marginal cost will lead to losses because, in this case, marginal cost is less than average total cost. In this case, a regulatory agency has no choice but to set price at or above average total cost. If the regulated price is set equal to average total cost, a regulated natural monopoly will break even, but will not operate at the efficient scale. Setting the regulated price equal to either marginal cost or average total cost is, in general, a difficult matter because a regulated firm's costs are not easy to observe.

Banks reserves increase ( When a central bank buys bonds, it pays for them by depositing money into banks' reserves, which causes reserves to increase.)

Which of the following be the FIRST change to occur when a central bank conducts open market purchases of bonds?

adjust (Wages fall when the price level falls and rise when the price level rises Wages, as well as other input prices, can adjust to the price level in the long run. This is what makes long-run aggregate supply vertical. The short-run aggregate supply curve is not vertical because input prices cannot adjust to the price level quickly.)

Which of the following best describes how wages respond to changes in the price level in the long run?

positive relationship (The positive relationship between the price level and the quantity of output produced The SRAS curve illustrates the idea that as the price level increases, the amount of goods and services produced in an economy increases. In other words, producers will respond to inflation by producing more in the short-run. This results in an upward sloping SRAS curve:)

Which of the following best describes the relationship illustrated by the short-run aggregate supply (SRAS) curve? Choose 1 answer: Choose 1 answer:

eventually adjust (Nominal wages eventually adjust to changes in the price level The long run is long enough for wages to adjust fully. If the unemployment rate is different from the natural rate of unemployment, there will be pressure on wages to adjust. The natural rate of unemployment is the unemployment rate when a country is producing full employment output. This is why the LRAS curve is vertical at the full employment level of output.)

Which of the following best explains why the long-run aggregate supply (LRAS) curve is vertical?

increase and decrease (An increase in AD and a decrease in SRAS Either of these shifts alone would lead to a higher price level. If both occur at the same time, these shifts would both put upward pressure on the price level as there is simultaneously more overall demand and less overall supply of the nation's output.)

Which of the following shift in aggregate demand and short-run aggregate supply would cause an unambiguous increase in inflation?

more easily ( People are able to access money more easily An increase in technology that makes money easier to access, such as the invention of the ATM machine, decreases the demand for money. When the demand for money decreases, the interest rate decreases.)

Which of the following would cause an unambiguous decrease in nominal interest rates?

Stick Wages (and sticky prices)

Why would producers see inflation and think, "let's all make more stuff"? After all, during inflation, shouldn't producers be scared to produce more? Let's start with the first reason producers might continue despite deflation: sticky input prices. Economists used to believe that all prices were flexible. That means that if conditions change, like a recession happens, prices will quickly adapt to that change. For example, if there is a recession, high unemployment will quickly drive down wages. Lower wages make firms more willing to hire more workers. More workers mean more output, so flexible prices (like wages) mean that recessions should mostly fix themselves. Or so the thinking was at the time! The Great Depression made us question the idea that all prices are flexible. After all, if prices adjust so well, why wasn't the depression going away? Economists had to rethink what they thought they knew about how well prices adjust. Price adjustment might work well in the long run, but the short run is a different story altogether. This developed into an idea called "short-run nominal price rigidity," which is just an economist's way of saying "prices don't adjust quickly." Today, most economists believe that prices are sticky (at least in the short run). After all, wages are usually set for long time periods because of labor contracts. Businesses might lock themselves into long-term purchase agreements for other resources too. If there is unanticipated inflation, firms benefit from those long-term contracts because they are paying wages (and other resource prices) using dollars that aren't worth as much, so the real wages they are paying decrease.

Real Output (Is it possible for real output to be falling even while there is an inflation? Is it possible for real output to be increasing even while there is a deflation? Why?)

Yes. If there is an adverse aggregate supply shock, output will decrease and prices will rise. If there is a positive supply shock, real output will increase while prices fall (graph each of these to be fully persuaded).

expectations (If both firms and individuals have the same expectations, can there be unemployment? Why or why not?)

Yes. If wages and firms agree on a nominal wage and there is an adverse demand shock, the price level falls, the real wage increases above equilibrium, the quantity of labor demanded decreases, and unemployment results. This is not because of asymmetric expectations, but rather due to inaccurate expectations (that is, nominal wage contracts not indexed for changes in the price level).

Investment

__________________ is highly variable because it is sensitive to expectations about the profitability of new capital. These expectations will change as expectations regarding future revenues and future costs change. Aggregate investment also depends upon the interest rate. When the interest rate increase, investment projects become less attractive. Finally, aggregate investment depends upon the rate of change of aggregate real output. Thus, small changes in the rate of growth of real output lead to larger changes in desired investment. Indeed, it is possible that desire investment may decrease, even when real output itself does not decrease, but instead increases at a reduced rate.

LRAS

a curve that shows the relationship between price level and real GDP that would be supplied if all prices, including nominal wages, were fully flexible; price can change along the LRAS, but output cannot because that output reflects the full employment output.

money supply

a curve that shows the relationship between the amount of money supplied and the interest rate; because the central bank controls the stock of money, it does not vary based on the interest rate, and the money supply curve is vertical.

discretionary fiscal policy

a fiscal policy action that requires a deliberate act, such as passing a spending bill or a tax plan

reserve requirement

a legal obligation to keep a minimum amount of reserves; if the reserve requirement is 20\%20%20, percent and you deposit \$100$100dollar sign, 100 in a bank, the bank must keep \$20$20dollar sign, 20 of that in its vaults, but it can loan out the rest.

price index

a measure that calculates the changing cost of purchasing a particular (and unchanging) combination of goods (called a "market basket") each year; the consumer price index and the producer price index are examples.

business cycle model

a model showing the increases and decreases in a nation's real GDP over time; this model typically demonstrates an increase in real GDP over the long run, combined with short-run fluctuations in output.

GDP deflator

a price index used to adjust nominal GDP to find real GDP; the GDP deflator measures the average prices of all finished goods and services produced within a nation's borders over time

base year

a reference year to which variables are compared; for example, the current CPI in the United States uses 1983 as its base year, so all values of the CPI compare the current to 1983.

Federal deficit

a short fall in the government's budget that occurs when the federal expenditures are greater than federal revenues

inflation

a sustained increase in the overall price level in the economy, which reduces the purchasing power of a dollar

Loan Situation (Your fiend comes to you and asks to borrow $2000 from you to be repaid in exactly 1 year. He agrees to pay you interest equal to the expected inflation rate over the next year, which is 4%. You agree to loan him the money. a. How much will your friend pay you in 1 year? b. Suppose that inflation turns out to be 8% over the next year. 1. if you had invested your $2000 in an account earnings 8% interest and made no withdrawls, how much money would be in your account after 1 year? 2. Who benefited from the unanticipated increase in inflation, you, or your friend? 3. How much money did your friend save on the $2000 loan because of the difference in expected and actual inflation rates?)

a. $2080. b. i. $2260. ii. your friend iii. $80.

Bank reserves (Suppose that bank reserves are $100 billion, the required reserve ratio is .2 and banks are fully loaned up. a. What is the total number of deposits in the economy? b. suppose the reserve ratio is reduced to .1 and banks are once again fully loaned up with no excess reserves. c. What is the new level of demand deposits)

a. $500 billion (assuming nobody holds any cash). b.c. $1 trillion (again assuming nobody holds any cash).

Fisher Equation (The Fisher Equation states that the nominal interest rate is the sum of the real interest rate and in expected inflation over a period. a. If inflation is expected to be 3% over the next year and the current annual nominal interest rate is 7%, what is the real interest rate? b. Suppose that the real interest rate hasn't changed but the nominal interest rate has increased by 2%. Explain how this could happen.)

a. 4% b. an 2% increase in inflation.

Circulation (Explain: a. Why the amount of money in circulation of the amount of currency the Fed prints and puts into circulation. b. how the Fed measures the amount of money in circulation and why the Fed employs several different measures. c. the difference between the discount rate and the federal funds rate. d. how the Fed can increase the amount of money in the economy without actually printing a thing.)

a. Banks can loan out more than the amount of currency they have in their reserves, effectively creating money. b. The Fed uses several measures. M1 includes currency, travelers checks, checking accounts, and other demand deposits. It is the measure of the most liquid of money holdings. M2 includes certain short term bonds and other less liquid money holdings. The higher the number on the measure of the money supply, the less liquid the money holdings. c. The discount rate is the rate of interest at which the Fed lends funds to banks that need to meet the reserve requirement. The federal funds rate is the rate of interest at which banks lend each other the funds necessary to meet the reserve requirement. It is above the discount rate since banks prefer to borrow and lend from each other to borrowing from the Fed. d. The Fed can increase the amount of money by simply allowing banks to hold less of their demand deposits in reserves. The money supply increases as a consequent without the Fed having to print a thing.

Reserve ratio (Suppose that the required reserve ratio is .2. a. If the Fed purchases $20 billion in bonds, how much can demand deposits increase? b. Is your answer different if the required reserve ratio is .1? c. Why or why not?)

a. Demand deposits can increase by as much as $100 billion. b. If the reserve ratio is .1, demand deposits could increase by as much as $200 billion. c. It is different because a lower reserve ratio means that each bank can lend out more of its demand deposits, increasing the amount of money banks are capable of creating.

effect (For each of the following explain why each option is correct or incorrect: a. y>c+I at y*, so that y will increase b. y<c+i at y*, so that y will increase c. y>c+i at y*, so that y will decrease d. y<c+i at y*, so that y will decrease If savings is greater than desired investment at y*, then inventories will a. decrease, casing y to increase b. increase, causing y to increase c. decrease, causing y to decrease d. increase, causing y to decrease )

a. FALSE- y<c+i at y*, so y will increase b. TRUE c. FALSE d. FALSE a. FALSE b. FALSE c. FALSE d. TRUE

long run equilibrium (Suppose the economy starts in long run equilibrium. a: Graph the effect of an increase in government spending. b. Graph the effect of a decrease in the income tax rate)

a. GRAPH - The AD curve shifts outward, resulting in a short-run increase in prices and output. In the long run, prices increase further, and output returns to its previous level. b. GRAPH - same as part a (but less in magnitude).

Ways to Decrease (Suppose that the government has decided to decrease aggregate demand by $400 million to reduce inflation. The MPC = .75, the RR= .10 and every $1 decrease in the money supply will raise the interest rate enough to reduce desired investment by $2. a. How many dollar's worth of bonds should the Fed buy or sell? b. If the government wanted to use fiscal policy instead, by how much should they increase or reduce government spending?)

a. The Fed should sell $20 million of bonds, decreasing the money supply by $200 million, which decreases desired investment by $400 million (and, therefore, AD decreases by the desired amount). b. The government should increase government spending by $100 million.

components (Look at graph a. What is the equilibrium level of aggregate demand? b. At that level , what would be i,s,g-t, m-x c. If the economy were closed, what would be the equilibrium level of aggregate demand? d. Opening the economy increases, decreases or leaves unchanged aggregate demand? e. What is the MPC? f. What is the multiplier? g. If investment increased by $250, what would happen to AD if the economy were closed? h. If the economy were ope, AD would increase by how much? i. Verify your approach by determining GDP, i, s, g-t, m-x? h. Suppose x falls to 0 would AD increase/ decrease/remain the same? By how much? i. Suppose x increase by 100 and imports decrease by 30, what has happend to the currecny? j. The new equilbrium would be?)

a. The equilibrium level of aggregate demand is at GDP = 1500 b. At this level, i=200, s=300 (y-t-c), g-t=0, m-x=-100. c. If the economy were closed (x-m=0), the equilibrium level of AD is at GDP=1250 d. Opening the economy increases aggregate demand e. MPC = .6 f. the multiplier is 2.5 g. AD would increase by 625 h. ? i. ? h. If x fell from 250 to 0, AD would fall by 625 i. If x increases by 100 and imports decrease by 30, the currency has depreciated j. ?

Government bonds (In July 1989, the Fed began purchasing government bodns and the interest rate fell. a. How did the Fed's purchase of bonds issued by the Treasury lead to a lower interest rate? b. Suppose that the Fed hadn't purchased the T-bonds, would the Treasury have issued fewer (or more) of them? c. What would have happened to the interest rate in this case?)

a. When the Fed purchases a bond, it increases the money supply. An increase in the supply of loanable funds decreases the interest rate. b. The Treasury would have issued fewer T-bonds if the Fed hadn't purchased them. c. If the Treasury issues fewer T-bonds, the interest rate would increase.

Bond Price (A bond promises to pay $500 one year from now. Given the following: bond price-amount paid in one year- interest payment--interest rate $375 $500 $425 $500 $450 $500 $500 $500 a. What are the corresponding interest payments and interest rates that the bond offers at each price. b. As the price of the bond rises, what happens to the bond's interest rate? c. Explain why)

a. bond price amount paid in one year interest payment interest rate $375.00 $500.00 $125.00 33.3% $425.00 $500.00 $75.00 17.6% $450.00 $500.00 $50.00 11.1% $500.00 $500.00 $0.00 0.0% b. As the price of the bond rises, the interest rate falls. c. This is because the interest payment is the difference between the price of the bond and the amount paid in one year. The higher the price, the lower the interest payment and, therefore, the interest rate.

Money market (Discuss the effects of the following on the money market: a: An open market sale of U.S. Treasure bonds by the Fed b. An increase in the discount rate c. An increase in the reserve requirement)

a. decrease b. decrease c. decrease

Aggregate Demand (Discuss the effects of the following on aggregate demand: a. An open market purchase of U.S. Treasure bonds by the Fed b. A decrease in the discount rate c. A decrease in the reserve requirement)

a. increase b. increase c. increase

Tax Cut Effects (Suppose that a tax cut is given to every taxpayer in a country. Assume that wages are sticky. a. Will disposable income for the nation's taxpayers increase or decrease? Explain your answer. b. Will consumption increase or decrease? Explain your answer. c. Will the Aggregate Demand Curve shift in or shift out? Explain your answer. d. Will the price level increase or decrease? Explain your answer. e. Will unemployment increase or decrease? Explain your answer. )

a. increase. Disposable income is GDP less taxes. If taxes decrease, disposable income goes up. b. increase. People consume more when they have more disposable income. c. out. Consumption is a component of aggregate demand. If it increases, so must AD. d. increase. If the demand for output increases, the price must increase to equilibrate supply and demand. e. decrease. If the price level increases, real wages fall, increasing the quantity of labor demanded and resulting in over-employment.

Fed Buying Effect (Suppose that the Federal Reserve buys several million dollars in bonds on the open market. Assume that wages are sticky. a. Will the money supply increase or decrease? Explain your answer. b. Will the real interest rate increase or decrease? Explain your Answer c. Will investment in the economy increase or decrease? Explain your answer d. Will short-run real output (assuming a close economy) increase or decrease? Explain your answer)

a. increase. When the Fed buys bonds, it pays for them with dollars, increasing the money supply. b. decrease. When the supply of loanable funds increases, the price of loanable funds decreases. c. increase. When the price of investing decreases, firms invest more. d. increase. Investment is one of the components of AD. If it increases, so must AD.

economic growth

an increase in an economy's ability to produce goods and services; in the AD-AS model economic growth is represented by an increase in the LRAS.

consumer price index (CPI)

an index that calculates the cost of a market basket of goods purchased by a typical family that lives in an urban area; the purpose of the CPI is to track changes in the cost of living over time.

supply shock

an unexpected change that shifts SRAS; a positive supply shock increases SRAS, but a negative supply shock decreases SRAS.

shock

an unexpected change that will shift either the AD or SRAS curve; if a change is anticipated, that anticipation would already have been incorporated into the curve, so a change must be unexpected in order to cause a change.

money

any asset that can serve the three functions of money; if a group of people got together and agreed that bubble gum wrappers serve as a 1) medium of exchange, 2) a store of value, and 3) a unit of account, then bubble gum wrappers are now money.

Money

anything commonly used in virtually all transactions to trade for goods, services, or resources. Consequently, it is frequently it is frequently referred to as a medium of exchange. Money can be used as a unit of account, that is, as a way of measuring economic activity in the economy.

Money aggregates

as defined by the Federal Reserve Board include M1 (currency, checking account deposits, and traveler's checks); M2 (M1 plus money- market deposit accounts and money-market mutual-fund shares, savings accounts under $100,000 held by individuals, dollar accounts held in foreign banks (Eurodollars), and overnight repurchase aggrements); M3 (M2 plus large denomination time deposits such as certificates of deposit or CD's, long-term repurchase agreements, and institiutional money-market mutual-fund shares)

M1

assets that can be directly used to carry out the transactions motive of money; M1M1M, 1 is sometimes called "narrow money" because this is the narrowest definition of the money supply.

Structural unemployment (Structural unemployment occurs when a. there is friction between management and unions. b. changes in the economy mean that some skills are no longer demanded. c. the economy may move more slowly to full employment. d. firms and workers have incomplete information.)

b

Markets (markets for foreign currencies)

because there is not a single currency that is accepted for transactions everywhere in the world, trade between nations leads to markets for foreign exchange in which individuals and firms buy and sell the currencies of other countries. The exchange rate is the price of one currency in terms of another currency. Exchange rates are determined by interactions of supply and demand in foreign exchange markets, although governments sometimes intervene to manipulate the foreign exchange value of their currencies. Changes in the foreign exchange value of a currency change the price of imports from the perspective of domestic importers. Changes in the exchange rate also change the price of exports from the perspective of foreigners. More precisely, if the dollar appreciates relative to the yen, each dollar will purchase more yen. The prices of imports from Japan to the United States decrease from the perspective of US consumers and the prices of exports from the United States to Japan increase from the perspective of Japanese consumers. If the dollar purchases fewer yen (the dollar depreciates), the opposite occurs.

Cyclical unemployment (Cyclical unemployment occurs when a. there is friction between management and unions b. changes in the economy mean that some skills are no longer demanded. c. the economy may move more slowly to full employment. d. firms and workers have incomplete information.)

c

Frictional unemployment (Frictional unemployment occurs when: a. there is friction between management and unions. b. changes in the economy mean that some skills are no longer demanded. c. the economy may move more slowly to full employment. d. firms and workers have incomplete information.)

d

Growth

defined in two quite different ways. It can be thought of as changes over time in aggregate or total real output an economy produces or it can be thought of in terms of a change over time in per capita real output. Even seemingly small rates of growth lead to substantial effects on the level of GDP when the growth rates are compounded over a number of years. It is these are compounded over a number of years. It is these small, but persistent, rates of economic grwoth that have allowed the industrialized countries of the world to achieve their present economic positions. Similarly, it is the small, but persistent, growth rates in per capita income that have created the high standard of living enjoyed, on average, by people living within these economies. Several factors determine the rate of growth in an economy. Historically, the growth of inputs--capital, land, and labor--have been quite important. More recently, economic growth has largely been accounted for by increases in productivity.

M2

financial assets that aren't directly used for a medium of exchange, but can be converted into cash or a checking account; M2M2M, 2 is sometimes called "near money" because it is nearly as liquid as M1M1M, 1, but not quite as liquid.

automatic stabilizers

fiscal policy actions that require no action and will occur automatically based on the current phase of the business cycle; the most common automatic stabilizers are progressive tax systems and transfer payments.

discretionary fiscal policy

fiscal policy that requires an action by a government to occur; for example, if a government has to pass a law to change government spending or taxes. A future lesson in this course discusses automatic stabilizers, which are fiscal policies that require no action to be taken.

Tax Multiplier

for a lump-sum tax is the change in aggregate demand that follows a $1 change in lump-sum taxes. In its simplest form, this multiplier is equal to MPC/(1-MPC)

Best Describe (Which of the following best describes what is included in the natural rate of unemployment (NRU)?)

frictional unemployment and structural unemployment Even when an economy is producing full employment output, we would still expect some people to be searching for the perfect job for them (the frictionally unemployed) and changes in industries that lead to different skills being demanded by employers (causing structural unemployment).

Price Index

in period t is It =Pt/Pb * 100 where b is the base year, pb is the price of a market basket in period t. A price index is a measure of the overall price level in an economy. Commonly used price indices for the U.S. economy include the consumer price index (CPI) and the producer price index (PPI).

aggregate supply shock

is a dramatic change in the productive resoruces available to an economy that changes the amount that firms are willing to produce at a given price level.

Potential real GDP

is a measure of the aggregate or total real output that an economy could produce it it used its scarce resources fully and efficiently, that is, it is a measure of potential real output.

CPI (consumer price index)

is a measure of what is happening, in general, to the prices of a market basket of goods and services commonly purchased by households.

Open market operation

is a purchase or sale of U.S. government securities by the Fed. When the Fed purchases government securities, the money supply increases; when it sells government securities, the money supply decreases.

Potential Real Output

is determined by the resources available to an economy. Changes in these resources will change the _________. of an economy. Thus, increases or improvements in natural resources, the capital stock, the labor supply, or in the technologies that combine these inputs in productive ways will increase potential real output. The effect of labor on potential real output is both straightforward and subtle. Any change in the number of people actually employed will change the amount of people actually employed will change the amount the economy actually produces. However, the number of people actually employed will be determined by the demand for labor, the supply of labor, expectations that demanders and suppliers have about price levels and real wages, and contracts between suppliers and demanders. When households and firms have the same expectations and contracts have fully adjusted to market conditions, the labor market will be in equilibrium. The amount of labor provided to the economy when this amount of labor is employed will determine the potential real output for the economy. Changes in the equlibrium level of employment in the labor market will lead to changes in potential real output. Not all persons will be employed when the labor market is in equilibrium, only those willing to work at the equilibrium real wage. When the labor market is in equilibrium, however, actual output and potential real output coincide.

Real Asset

is one whose purchasing power does not necessarily change with changes in the price level. The price of the real asset may increase as the price level increases (or decrease as the price level decreases), although it does not necessarily do so.

Potential Real Output

is that output an economy can produce when it employs its resources fully and efficiently. Thus, an economy's potential real output is determined by its natural resources available, the technologies that is has developed or acquired, the amount of capital that it has accumulated, and the amount of labor that individuals are willing to provide. If an economy fully and efficiently employees its scarce resources, the aggregate output supplied to the economy will be equal to the economy's potential real output.

Government Spending (g)

is that part of the aggregate real output of an economy that is purchased by the government and use do to provide good and services to its citizens.

Net Exports (Ne)

is that part of the domestic aggregate real output use dot produce commodities purchased by foreigners less that part of the aggregate real output of other countries used to produce commodities purchased by individuals and firms resident within the economy. When the dollar value of exports is greater than the dollar value, net exports are positive. Net exports are negative when the dollar value of imports is greater than the dollar value of exports, however. If exports are equal to imports, the claim on domestic real resources for foreign uses is offset, one for one, by the claim on foreign real resources for domestic uses.

Natural rate of unemployment

is that rate of unemployment equal to the frictional rate of unemployment, that is, where the number of job vacancies is equal to the number of individuals with the right skills who are looking for jobs.

Aggregate Supply

is the aggregate or total output an economy produces at different levels.

aggregate supply (What is aggregate supply?)

is the aggregate or total output an economy produces at different price levels.

Real Interest Rate

is the amount of additional goods that can be purchases when $1.00 is saved for one year.

Price Level

is the average of prices which are measured in dollar terms, or more generally in money terms

aggregate ppf

is the boundary between what an economy cna produce and what it is unable to produce because of resource and technological constraints. That is, an aggregate PPF shows all possible combinations of output that an economy might produce if its resources were used in the best possible way.

Balanced-budget multiplier

is the change in aggregate demand that occurs when government sending increases by $1 and tax revenues increase by $1 or when government spending decreases by $1. In its simplest form, the balanced budget multiplier is 1.0. That is, a $1 increase in government spending funded by a $1 increase in taxes increases aggregate real output demanded at a given price level by $1.

Government-spending multiplier

is the change in aggregate demand that occurs when government spending changes by $1.00. In its simplest form, it is equal to 1/(1-MPC_.

investment multiplier

is the change in aggregate demand that occurs when investment changes by $1.00. In its simplest form, it is equal to 1/(1-MPC)

MPC (marginal propensity to consume)

is the change in consumption per dollar change in income.

Net export multiplier

is the change in the aggregate demand that occurs when net exports change by $1.00. In its simplest form, it is the same as the investment multiplier: 1/(1-MPC)

Aggregate Inventory

is the dollar value of inventories aggregated or summed over all firms and industries in an economy.

Accelerator Effect

is the fluctuation in desired investment that occurs when there are changes in the rate of increase in real output. If firms attempt to keep a relatively constant relationship between their production and their capital stock, real output must grow at a constant rate to keep investment stable.

Required Reserve Ratio (RR)

is the minimum fraction of checking account deposits that the Fed determines a bank must hold in the from of reserves.

Gross domestic produce (GDP)

is the money value of the aggregate or total output that an economy actually produces measured over a given period of time (such as one year), with output valued using prices prevailing during that period.

Investment

is the production of new capital. Aggregate investment (i) is the use of aggregate real output to produce capital. Investment (i) is that part of aggregate real output purchased by firms in the form of capital goods.

Real Wage

is the purchasing power of the dollar wage payment.

aggregate demand (What is aggregate demand)

is the sum of the amount that agents in an economy are prepared to purchase for consumption, investment, net exports, and, government spending purposes at different price levels.

Economic Growth

is the sustained increase in real GDP or real GDP per capita over time.

aggregate consumption (What is aggregate consumption?)

is the total consumption of consumers in an economy.

aggregate investment

is the total investment of firms in an economy

National Debt

is the total value of outstanding government obligations. The deficit is the increase in the national debt in a particular year and is equal to the short-fall between government expenditures and government revenues (g-t).

Fiscal policy

is the use of taxes and expenditures to stabilize the economy and promote economic growth.

Net (What does net mean in #7)

means the amount of exports remaining after subtracting imports.

fiat money

money that gets its value entirely from its status as a means of payment; paper money is fiat money because its value for its use as a currency is far higher than the intrinsic value of a small scrap of paper.

commodity backed money

money that has no inherent value, but it has a value guaranteed by a promise that it can be converted into something of value; for example, if the nation of Johnsrudia uses bubble gum wrappers as its currency, but you can exchange those for their equivalent value in gold, this would be commodity backed money.

Full Employment

occurs when all workers who desire employment at current wages are employed or, if unemployed, do not immediately find a job even though there are jobs available.

Cyclical Unemployment

occurs when changes in aggregate demand or aggregate supply create fewer jobs vacancies than the number of individuals who would be willing to work.

federal surplus

occurs when federal revenues are greater than federal taxes.

Aggregate Savings

occurs when individuals choose to consume less than the economy produces.

Common Misperceptions (Expansion of the money supply)

ome learners get confused about what the simple money multiplier represents. The simple multiplier \dfrac{1}{rr} rr 1 ​ start fraction, 1, divided by, r, r, end fraction is the maximum change in the money supply. In all probability, the final increase in the money supply will be far smaller due to leakages from the financial system. Printing money and creating money is not the same thing. Printing money creates currency, but the amount of money that exists at any point in time (in other words, the money supply) is cash and deposits. The pivotal moment in the creation of money is lending: when loans are made, money is created. It might seem strange that a bank account is a liability. To you, the owner of the account, the account is an asset. But to the bank, who has to return that money to you on demand, it is a liability. -As a new learner, it might be confusing about which stage in this process creates money. It is the loan. If a bank does not loan out from a deposit, no new money is created.

Okun's Law (Okun's law says that for each 2% decrease in GDP, unemployment increases by 1%. Given the following information, complete the column for the predicted unemployment rate.)

starting year ending year pot GDP% act GDP% initial UE % predicted UE% 1960 1961 3.3 2.2 5.5 -1.1 1965 1969 3.3 6 4.8 -3 1970 1971 3.3 -0.2 3.5 0.1 1975 1976 3.3 -1.1 5.6 0.55 1981 1982 2.7 -1.3 7.5 0.65

Natural rate of hypothesis

states that the economy deviates form the natural frictional rate of unemployment only when wages are stick,y and hence, in the long run (when wages and prices can adjust fully), the economy will have unemployment equal to the natural frictional rate.

Fisher Effect

tates that an increase in expected future inflation will increase nominal interest rates by exactly the amount of expected inflation. Expected inflation will have no impact on either the quantity of loanable funds or the real interest rate. For example, suppose the current rate of inflation is 2% and the real interest rate is 5%. Then the current nominal interest rate is 7%: \begin{aligned}\text{Nominal interest rate} & = \text{real interest rate} + \text{inflation}\\\\ &=5\%+2\%\\\\ &=7\%\end{aligned} Nominal interest rate ​ =real interest rate+inflation =5%+2% =7% ​ If people expect inflation to increase by 1%, then both savers and borrowers will take this into account, and they will incorporate this into their expected rate of inflation: \begin{aligned} \text{Nominal interest rate} & =\text{ real interest rate} + \text{expected inflation}\\\\ &=5\% + 8\%\\\\ &=13\%\end{aligned} Nominal interest rate ​ = real interest rate+expected inflation =5%+8% =13% ​

(short-run equilibrium) price level

the aggregate price level that will exist when an economy is in short-run equilibrium; remember that the price level is a measure such as the CPI.

classical assumption

the belief that it is possible for all prices to fully adjust; prior to the Great Depression, economists generally assumed that prices weren't stuck, which meant that the "old school" way of thinking about aggregate supply was that it was a vertical line like the LRAS.

stagflation

the combination of a stagnating (falling) aggregate output and a higher price level (inflation); stagflation occurs when SRAS decreases.

negative output gap

the difference between actual output and potential output when an economy is producing less than full employment output; when there is a negative output gap, the rate of unemployment is greater than the natural rate of unemployment and an economy is operating inside its PPC.

positive output gap

the difference between actual output and potential output when an economy is producing more than full employment output; when there is a positive output gap, the rate of unemployment is less than the natural rate of unemployment and an economy is operating outside of its PPC.

required reserves

the fraction of money a bank is required to put aside and not use for loans or any other purpose, usually required by banking regulations; this fraction is based on the amount of money that has been deposited into the bank, such as 20\%20%20, percent of all deposits.

real interest rate

the interest rate earned that reflects the actual purchasing power of that interest; for example if a bank pays 3\%3%3, percent interest, but there is 2\%2%2, percent inflation, you really have only gained 1\%1%1, percent interest because the purchasing power of your interest has decreased.

Productivity

the level of output that can be produced by a specified set of inputs. Workers in the UNited States are highly productive (that is, output per worker is high). Increases in per capita income when there is a growing population depend upon growth in productivity. The rate of productivity growth was low for much of the last quarter of the twentieth century. With this decline in productivity growth, economic growth rates frell of as well. As a consequence, per capita income increase by less in the 1970's and 1980's than it had in earlier decades--indeed, there was little change in per capita income between the early 1970's and the mid 1990's. Beginning in the mid-1990's, the economic growth rate picked up once again.

inflation rate

the pace at which the overall price level is increasing; this is the percentage increase in the price level from one period to the next.

Participation Rate (Labor Force)

the percentage of the working-age population that is in the labor force.

recession

the phase of the business cycle during which output is falling

Expansion

the phase of the business cycle during which output is increasing

constant prices

the prices from a base year that are used to calculate real GDP in other years; this allows for a more accurate measure of how a country's actual output changes over time, because using constant prices cancels out any changes in the price level between years.

(long-run) self-adjustment

the process through which an economy will return to full employment output even without government intervention

MPS (marginal propensity to save)

the proportion of any additional income that is saved; note that MPC+MPS=1MPC+MPS=1M, P, C, plus, M, P, S, equals, 1.

MPC (marginal propensity to consume)

the proportion of any additional income that is spent; for example, if your MPCMPCM, P, C is 0.750.750, point, 75 that means for every \$1$1dollar sign, 1 more income you get, you will save 252525 cents and spend 757575 cents.

(short-run equilibrium) output

the quantity of aggregate output produced in the short-run macroeconomic equilibrium; this is the amount of real GDP that will exist when AD intersects SRAS.

money multiplier

the ratio of the money supply to the monetary base (money in bank vaults and money in circulation); the money multiplier tells us how many additional dollars will be created with each addition to the monetary base, such as when there is a \$1$1dollar sign, 1 increase in a bank's reserves.

tax multiplier

the ratio of the total change in real GDP caused by a change in taxes; for example, if the tax multiplier is -4−4minus, 4, then a \$100$100dollar sign, 100 tax increase will decrease real GDP by \$400$400dollar sign, 400. For example, if the government has an output gap of \$400$400dollar sign, 400 million and the tax multiplier is -4−4minus, 4, then the government can close that gap by decreasing taxes by only \$100$100dollar sign, 100 million.

growth trend

the straight line in the business cycle model, which is usually upward sloping and shows the long-run pattern of change in real GDP over time

aggregate demand

the total demand for a nation's output, including household consumption, government spending, business investment, and net exports

Aggregate net exports

the total dollar amount of foreign purchasers of domestic goods and services.

Aggregate government spending

the total spending by the government in an economy

aggregate supply

the total supply of goods and services produced by a nation's businesses

trough

the turning point in the business cycle between a recession and an expansion; during a trough in the business cycle, output that had been falling during the recession stage of the business cycle bottoms out and begins to increase again.

peak

the turning point in the business cycle between an expansion and a contraction; during a peak in the business cycle, output has stopped increasing and begins to decrease.

monetary policy

the use changes in the money supply or the interest rate to stabilize an economy; fiscal policy is policy by governments, while monetary policy is policy by central banks.

contractionary fiscal policy

the use of fiscal policy to contract the economy by decreasing aggregate demand, which will lead to lower output, higher unemployment, and a lower price level. Contractionary fiscal policy is used to fix booms.

expansionary fiscal policy

the use of fiscal policy to expand the economy by increasing aggregate demand, which leads to increased output, decreased unemployment, and a higher price level. Expansionary fiscal policy is used to fix recessions.

stabilization policy

the use of policy (such as fiscal policy or monetary policy) to reduce the severity of recessions and excessively strong expansions; the goal of stabilization policy is not to eliminate the business cycle, just to smooth it out.

fiscal policy

the use of taxes, government spending, and government transfers to stabilize an economy; the word "fiscal" refers to tax revenue and government spending.

other terms

transfer payments payments made to groups or individuals when no good or service is received in return; transfers are the opposite of a tax (you receive transfers from the government, but pay taxes to the government). lag another way of saying "delay"; fiscal policy is associated with data lags, recognition lags, decision lags, and implementation lags. data lag the time it takes to get macroeconomic data such as real GDP or the unemployment rate recognition lag the delay in fiscal policy caused by the time that it takes to realize that there is a problem to be corrected decision lag the delay in fiscal policy caused by the time that it takes to decide on a course of action implementation lag the time it takes to put action into practice balanced budget when expenditures equal income; a government has a balanced budget when tax revenue collected exceeds government spending. deficit when expenditures exceed income; when the government spends \$10\text{m}$10mdollar sign, 10, m more than it collects in tax revenue in a year, it has a $10mdollar sign, 10, m deficit that year. debt the accumulated deficits over time; when the government runs a \$10\text{m}$10mdollar sign, 10, m deficit every year for three years, it accumulates \$30\text{m}$30mdollar sign, 30, m in debt. balanced budget multiplier the spending multiplier that will exist when any change in government spending is offset entirely by an equal change in taxes; the balanced budget multiplier is always equal to one.

real variables

variables that are adjusted for the rate of inflation that represent the true value of something (such as real interest, real income, or real GDP); for example if your boss gives you a 10\%10%10, percent raise, but the purchasing power of your money has decreased by 8\%8%8, percent because of inflation, your raise is really only worth 2\%2%2, percent.

recovery

when GDP begins to increase following a contraction and a trough in the business cycle; an economy is considered in recovery until real GDP returns to its long-run potential level.

multiplier effect

when a change in spending leads to a much larger change in real GDP than the initial change; for example, if a government spends \$100$100dollar sign, 100, and that change in spending leads to real GDP increasing by \$400$400dollar sign, 400, then the multiplier effect has multiplied the initial impact four times.

long-run (macroeconomic equilibrium)

when the current output is equal to potential output; graphically, this would be the price level and real GDP associated with the intersection of AD, SRAS, and LRAS.

short-run (macroeconomic equilibrium)

when the quantity of aggregate output supplied is equal to the quantity of aggregate output demanded; graphically, this is the price level and real GDP associated with the intersection of the SRAS and AD curves.

calculate real (GIven the following data, calculate the real interest rate for years 2, 3, and 4. year CPI NIR Real IR 1 100 2 110 15% 3 120 13% 4 115 8% If you loaned $1000 to a friend at the beginning of year 2 at an interest rate of 15% and your friend repaid the loan at the end of year 2, plus interest, did you benefit or lose from the deal? )

year CPI nominal interest rate real interest rate inflation 1 100- - 2 110 0.15 0.054761905 0.095238 3 120 0.13 0.043043478 0.086957 4 115 0.08 0.122553191 -0.04255 You gained from the deal since inflation fell between year 2 and 3 and so did the nominal interest rate.

Market Economy (Why should a market economy move toward full employment in the long run?)

A market economy should move toward full employment in the long run because of the market pressures on disequilibrium wages. As discussed in previous chapters, if the market price is "too high" there will be an excess supply which will put downward pressure on the price. In the long run, wages will adjust since individuals would prefer working at a lower wage than being unemployed at a higher wage.

increase (What are the ways that an economy can increases its potential real output? If its potential real output is increasing, is the standard of living also increasing? Explain.)

An economy can increase its potential real output by increasing the labor force (more laborers or more hours laboring), increasing the capital stock, increasing technology, or acquiring more natural resources (conquering and pillaging their foes).

(The effects of) exit and entry

As firms exit or enter, the market supply changes. With entry and expansion, market supply increases, and the market price falls from its short-run level. With exit and contraction, market supply decreases, and the market price increases from its short-run level.

Banks create money (In what ways do banks "create money?)

Banks "create" money by issuing loans.

Induced Changes (in consumption)

Because consumption is determined in part by real income changes in income (such as those that follow changes in desired investment) will induce changes in desired consumption. As a consequence, small changes in desired investment can sometimes lead to large changes in aggregate real output demanded.

stabilization policies (Why might it be highly likely that stabilization policies will overshoot, as some economists have argued?)

Because of the cyclical, up and down, nature of real GDP, and since there is an unforeseeable lag in implementation of countercyclical policy, it is likely that the effects of the countercyclical policy are not felt until after the end of the current cycle. At that point the countercyclical policy destabilizes.

(consumer and) producer surplus

Consumer surplus is the difference between the amount that individuals are willing to pay for what they currently purchase minus the amount that they actually have to pay. Because the market price is determined by the amount that individuals are willing to pay for the last or marginal unit purchased, markets create a consumer surplus. Producer surplus is the difference between what firms receive for producing a certain output and what they would have been willing to receive and still make the same production decision. Because the market price is determined by the minimum price that firms must recieve to produce the last or marignal unit provided to the market, markets create a producers' surplus as well. Competitive markets maximize the sum of consumer surplus plus producer surplus. Thus, given scarce resources, competitive markets make consumers and producers, taken together, as well as off possible.

money supply increase (We have emphasized the effects of monetary policy on interest rates and, by way of interest rates, its effects on private investment. What else might be affected when the money supply increases?)

Consumption might change with changes in the money supply, since high interest rates provide an incentive to save and, thus, a disincentive to consume.

Firms (that are too large)

Dealing with firms that have become too large is more problematic. The antitrust laws do not make bigness or even monopoly illegal, but rater consider the illegal actions ("monopolization") that might follow from bigness or monopoly. Efforts to split large firms into small firms remain controversial, in part because such efforts require lengthy and costly legal procedures.

Economic growth (Would economic growth increase or decrease with a decrease in the birth rate? With a change in the rate of immigration?)

Economic growth would decrease with a decrease in the birth rate. The same goes for a decrease in the rate of immigration. Per capita economic growth, however, might not increase. Whether it increases or decreases depends on the productivity of the nascent or immigrant workers.

desired investment (Do we understand why desired investment changes?-- Is it really helpful to know that desired investment decreases when firms become pessimistic or that it increases when firms become optimistic?)

Even though we may not understand exactly why investors may become pessimistic about the future, it is useful to know that investment is fluctuating, in order to pursue appropriate counter-cyclical policies

discouraged

If unemployed workers give up looking for jobs, they become "discouraged" workers and are no longer considered part of the labor force. But since they are no longer unemployed the nation's unemployment rate actually decreases. In such a scenario, a decrease in the unemployment rate is actually a sign of a tough job market (and a weak economy).

no tradeoff ( In the long-run there is no tradeoff between inflation and unemployment)

In a previous lesson, we learned that there was a short-run tradeoff between inflation and unemployment. That might be true in the short-run, but not the long-run. Of course, inflation can temporarily impact employment. But once prices have a chance to adjust, inflation no longer impacts employment. The LRAS illustrates this well. Output is tied to employment on the LRAS, so if output doesn't change in response to the price level, neither will employment.

Loanable Funds (market for)

Investment spending is an important category of real GDP. Not only is it usually the most volatile part of real GDP, but investment spending on physical capital is also an important contributor to economic growth. So, if a firm wants to build a new factory, where does it get the funds to build it? Usually, firms borrow that money. The market for loanable funds describes how that borrowing happens. The supply of loanable funds is based on savings. The demand for loanable funds is based on borrowing. The interaction between the supply of savings and the demand for loans determines the real interest rate and how much is loaned out.

eliminate (Is it possible to eliminate frictional unemployment?)

It is not possible to eliminate all frictional unemployment, though job search programs can reduce it.

(Crowding out might have) long-run effects

Long-run crowding out might slow the rate of capital accumulation. Recall that part of investment spending is businesses buying new equipment, and businesses usually borrow money to do that spending on new equipment. Therefore higher interest rates mean less borrowing, and less borrowing means less equipment (in other words capita) is purchased. If there is less borrowing, less capital accumulation will occur. More capital contributes to an economy's ability to produce goods and services in the long run. Therefore, a potential long-run impact of deficits and debts is a slower rate of economic growth because the deficit has crowded out private investment in capital.

Always stabilize (Will government fiscal policy always stabilize the economy? Why?)

No, government fiscal policy will not always stabilize the economy because the government is unable to tell whether aggregate demand shocks or aggregate supply shocks have occurred, how long the policy will take to reach its full impact, or how long the economic instability will persist.

Large and growing (Does the active use of fiscal policy imply that the government must be large and growing?)

No. Fiscal policy can also be used to stabilize the economy. If the government increases spending during recessions and reduces spending during boom periods, active fiscal policy does not necessitate a growing government

Frictional Unemployment

Occurs when, in a dynamic economy, individuals entering the labor force or changing jobs do not immedately find a job even though there are jobs available.

Overemployment

Occurs whenever the amount of labor employed by firms exceeds that which individuals would be willing to provide, compared with a period when the nominal wage changes in the same proportion as the increase in the price level.

potential output

Potential output is also called full-employment output. Potential output is the level of real GDP that would be produced if all resources are used efficiently. For example, if labor is used efficiently, the actual rate of unemployment will be equal to the natural rate of unemployment. When there is a positive output gap, an economy is producing beyond its long-run potential and the unemployment rate will be lower than the NRU. During a recession, real GDP falls below its potential and the unemployment rate is higher than the NRU. The actual unemployment rate is different than the natural rate of unemployment, at different points along the business cycle, because cyclical unemployment changes along the business cycle. Cyclical unemployment increases due to reduced output during recessions, and cyclical unemployment decreases due to increased output during expansions.

population (If the population in a country increases at a moderate rate through time, what will happen to potential real output?)

Potential real output will rise with the increase in the population. (The only way this would not be true is if the people entering the economy were unwilling or unable to work such that they contribute nothing to output).

Scarcity (competition, and coordination)

Scarcity leads to competition among individuals. As a consequence, there is within any economy or society a coordination problem. In this regard, scarcity forces a group of individuals to ask (1) how they will coordinate their possibly competing interests, (2) how they will distribute things among themselves, (3) who will decide, and (4) how disputes will be settled.

Markets

Some individuals have money that they wish to exchange for goods, services, or resources; others have goods, services, or resources that they wish to exchange for money. The former are demanders; the latter, suppliers. A market is created when suppliers exchange with demanders. More formally, a market is a set of related transactions for a specific commodity, usually sing money as a medium of exchange.

Common Misperceptions (the money market)

Some students get confused about what interest rate is represented in the money market:real or nominal? It's the nominal rate. Think of the nominal interest rate as the interest rate on the sign outside of a bank. A sign that says, "Now paying higher interest rates!" is advertising a higher nominal interest rate. The real interest rate is that nominal interest minus the rate of inflation. It might seem odd that the money supply curve is always perfectly vertical. Keep in mind what the vertical money supply curve is saying: the central bank determines the monetary base, and therefore the money supply. This money creation might change interest rates, but it is not being done in response to interest rates, so the supply of money is perfectly vertical.

Taxes (Which of the following best describes how taxes work as an automatic stabilizer during a recession?)

Tax revenues automatically decrease as GDP falls, which prevents consumption and real GDP from falling further When real GDP falls, incomes tend to fall. When incomes fall, taxes on that income will also fall. The disposable income that households have will not be affected as much as they would have if the taxes had stayed the same, so consumption does not decrease by as much as it would have. As a result, the decrease in tax revenue offsets some of the impact of a recession.

upward sloping (SRAS curve)

The SRAS curve shows the positive relationship between the price level and output. Wait a minute, does that mean that firms respond to inflation by producing more output? Surprisingly, it does! SRAS might look a lot like a supply curve in a product market, but some key differences make SRAS different than "supply." In the market model, supply slopes up because of the profit motive of individual firms. If a firm gets a higher price, they will make a higher profit by selling more, so quantity supplied increases when price increases. The SRAS curve slopes up for two reasons: sticky input prices (like wages) and sticky output prices (also called "menu costs").

(The best or) optimal choices

The best or optimal level of activity is where the marginal benefit associated with a particular choice is just equal to the marginal cost of the choice. When there are a number of different activities from which to choose, marginal opportunity costs must be considered. In this case, the best or optimal mix of choices is the one where the marginal benefit per additional dollar cost is the same over all choices made. Best or optimal choices are unaffected by sunk costs. That is, the only things that can matter when trying to find the best or optimal choice are those that can actually be affected by the choice. As a consequence, past expenditure cannot matter. In short, to optimize: Equate the marginal benefit per additional dollar cost for each choice across all possible choices, and Ignore past expenditures or sunk costs.

Longer affect (Why might it take longer for the monetary policy than fiscal policy to affect the economy?)

The end effect of monetary policy is not felt until desired investment and desired consumption have completely adjusted, which can take months.

goals (In your opinion, what should the goals for macroeconomic policy be? Why? )

The goals of macroeconomic policy should be to keep inflation under control and to (perhaps) stimulate or suppress aggregate demand in order to reduce the severity of fluctuations in output.

nominal wages (What happens to long run aggregate supply as the nominal wage increases? Decreases?)

The long run aggregate supply is unchanged by nominal wages.

vertical (Why is the long run aggregate supply curve drawn vertical?)

The long-run aggregate supply curve is vertical because, in the long run, changes in the price level do not affect real output.

Money multiplier (What is the money multiplier? What determines the multiplier in practice?)

The money multiplier is used to determine how large of an effect on the money supply an increase in currency will have. It is determined, in practice, by the fraction of demand deposits banks hold as reserves.

Natural Rate (of unemployment)

The natural rate of unemployment (NRU) is the unemployment rate that exists when the economy produces full-employment real output. NRU is equal to the sum of frictional and structural unemployment. When an economy is producing an efficient amount of output (meaning it is operating on its PPC), the unemployment rate will be equal to the natural rate of unemployment. Even though an economy may be operating efficiently, there will still be some unemployment. Because of that, the natural rate of unemployment is never equal to zero.

Unemployment Rate

The percentage of the labor force that is unemployed.

Cartels and Mergers

The profits to be gained from monopoly pricing are an incentive for otherwise competitive firms to collude, thus creating a cartel or, when possible, to merge into a single firm. Market forces tend to undermine cartels. In particular, the higher prices following an effective cartel's restrictions on output provide substantially higher profits for any firm that cheats on the cartel aggeement, refuse to enter the cartel agreeement, or enters the market after the creation of the cartel but stays outside the cartel. As a consequence, cartels are unstable--they can persist only if they can effectively prevent cheating or entry. Often this means that long-lived cartes are either organized or policed by a governemnt.

Limitations (of the unemployment rate)

The unemployment rate as it is measured officially is often criticized for understating the level of joblessness because it excludes anyone working at all or people who aren't looking for work. In particular, the official unemployment rate leaves out discouraged workers and the underemployed. People who have given up looking for work because they are convinced that they cannot find jobs are considered discouraged workers. Some people are counted as employed because they are working part-time, even though they really want full-time work.

Flexible ("If all prices and wages are flexible, aggregate demand changes will not affect real output." Comment)

This is true.

(Elasticity of demand and) total expenditures

Total expenditures are equal to the market price multiplied by the amount bought and sold in the market. Changes in total expenditures when the market price chnages are closely related to the elasticity demand: if demand is elastic, total expenditures will increase when the price decrease and total expenditures will decrease when the price increases. If, however, demand is inelastic, total expenditures will move with the price change. If demand is elastic for a particular commodity, that is ed>1, total expenditures will move in a direction opposite to a price change. On the other hand, if demand is inelastic, that is e<1, total expenditures will move in the same directions as a price change.

Structural Unemployment

Unemployment also occurs because some individuals do not have the skills necessary to fill available job openings. Countercyclical policies will not affect structural unemployment. Structural unemployment can be affected by training and (re)educational programs that help individuals acquire the skills necesary to qualify for jobs.

Bad (Is unemployment unambiguosuly bad, or does it serve some useful purpose in the economy?)

Unemployment is not unambiguously bad because people should search for jobs before settling for the first one available.

W/P (How would you explain to someone who had not had any economics the intuitive meaning of W/P?)

W is how many dollars per hour you make. P is how many dollars you need to buy something that cost 100 dollars during one time. W/P is a measure of how much your making that takes into consideration increased prices. (Why I would be explaining the meaning of W/P to someone who has not had any economics, however, is beyond me ).

Uncertainty

When information is imperfect, either inherently or because searching is too costly, decisions will bem ade in partial ignorance. This creates uncertainty or risk. The degree to which individuals prefer less risk will be reflected by a demand for insurance against the risk. A supply of insurance is possible if some people are tolerant of risks and become speculators who are willing to assume risks for some payment. A supply of insurance is also possible if risks can be pooled so that firms can take advantage of the law of large numbers. However, certain kinds of risks, notably those that are not independent, and certain kinds of behavior, notably moral-hazard or adverse-selection, make it more difficult to supply insurance. In some cases, these difficulties can be overcome by selecting risk pools carefully, by offering contracts with deductibles, by requiring coinsurance, or by all-or-nothing insurnace pools.

Short-Run (aggregate supply)

Whether countercyclical policies have any effect on real output depends on the shape of the short-run aggregate supply curve.

Inflation

an increase in the price level, as measured by the increase in a price index such as the CPI. With inflation, the purchasing power of money decreases.

Money Supply Situations (For each of the following determine whether the money supply will increase, decrease, or stay the same: a. Depositors become concerned about the safety of banks and begin withdrawing cash. b. The Fed lowers the required reserve ratio. c. The economy enters a recession and banks have a hard time finding credit-worthy borrowers. d. The Fed sells $100 million in bonds to a bank in Utah.)

a. decrease b. increase c. decrease d. decrease

consumption (Suppose that consumption at potential output y* increase by $100. a. Will y be greater or less than c+i? b: What will happen to inventories? c: What will happen to real output?)

a. y will be less than c+i, since it was previously equal (assuming g and nx =0). b. inventories will be drawn down, since demand is greater than supply. c. prices will increase, and, if wages are sticky, so will output.

nominal asset (or money-fixed)

an asset whose future payoff is a fixed amount of money; hence, its purchasing power necessarily changes with changes in the price level.

Fiscal Activities

are the expenditures, taxes, and subsidies of government

Shocks

are unplanned changes in either aggregate demand or aggregate supply

Saving

is foregone consumption. Essential, saving allows individuals to transfer income from today to the future.

lump-sum taxes

taxes that do not depend on the taxpayer's income; an example of a lump-sum tax would be paying a fixed dollar amount in taxes that doesn't depend on your income.

nominal variables

variables such as wages, income, or interest that have not been adjusted for the rate of inflation; you can think of nominal variables as the "sticker price." The bank tells you they will pay you 3\%3%3, percent interest, but the real interest rate that tells you what you are actually earning.