Macro Unit 5

Budget deficit

A budget deficit occurs when a government's revenue is less than its spending in a given year Almost always rises when the unemployment rate rises and falls when the unemployment rate falls

Phillips curve

A curve representing the negative SR relationship between the UR and the interest rate As more people work (UR goes down) the national output increases, thus causing wages to increase. This causes consumers to have more money to spend, more resulting in consumers demanding more goods and services (increase in AD), thus causing the prices of goods and services to increase (increase in PL) Decrease in UR → Increase in INF Decrease in INF → Increase in UR The equation only holds in the short term (only in SR is there a tradeoff)

Aggregate production function

A hypothetical function that shows how productivity (output per worker) depends on the quantities of physical capital per worker and human capital per worker as well as the state of technology Helps to isolate factors of production to determine their individual influences on economic growth

Monetarism

A movement that assets that GDP will grow steadily if the money supply will grow steadily The policy stated that the central bank was to target a constant rate of growth, i.e. 3%, and to maintain the target regardless of any fluctuations in the economy Monetarism retained many Keynesian ideas GDP will steadily grow if money supply increases steadily Fed should target consistent MS growth, regardless of fluctuations in economy Crowding out does not occur at same level as it does with fiscal policy Avoids political process Monetarism asserted that GDP will grow steadily if the money supply grows steadily. It called for a shift from monetary policy rule to that of a discretionary monetary policy. It argued that GDP would grow steadily if the money supply grew steadily. Monetarism was influential for a time, but was eventually rejected by many macroeconomists.

Political intervention in economy

A political business cycle results when politicians use macroeconomic policy to serve political ends A political business cycle can be avoided by placing monetary policy in the hands of independent banks. The political business cycle is also a reason to limit the use of discretionary fiscal policy to extreme circumstances

Taylor Rule for monetary policy

A rule for setting the federal funds rate that takes into account both the inflation rate and the output gap Economist, John Taylor, suggested that monetary policy should follow a simple rule that takes into account concerns about the business cycle and inflation. Generally, it adequately predicts the Fed's actual behavior (changes in predicted IR rates and actual IR rates are the same; suggests that Fed is using some form of Taylor rule) Taylor rule adjusts monetary policy in response to past inflation

Hyperinflation

A situation where the price increases are so out of control that the concept of inflation is meaningless. Keeping the unemployment rate below the NAIRU leads to hyperinflation and cannot be maintained To avoid hyperinflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation

Quantity theory of money

A theory emphasizing the positive relationship between the price level and the money supply It relies on the velocity equation M x V = P x Y M = money supply, V = velocity, P = aggregate price level, Y = real GDP The theory relies on the concept of velocity of money (the ratio of nominal GDP to the money supply)

Contractionary Fiscal Policy

Defined as a decrease in government expenditures and/or an increase in taxes Under contractionary policies, government's budget deficits will shrink or budget surpluses will grow.

Diminishing returns to physical capital

An aggregate production function exhibits diminishing returns to physical capital when, holding the amount of human capital per worker and the state of technology fixed, each successive increase in the amount of physical capital per worker leads to a smaller increase in productivity Diminishing returns to physical capital can only be measured correctly if factors like technology and human capital are held constant

Automatic stabilizers

An approach in fiscal policy to stabilize the economy A budget policy that automatically changes to stabilize fluctuations in GDP. When the economy begins to go through an economic fluctuation, automatic stabilizers immediately respond without any official or government body having to take action. Automatic stabilizers are limited in that they focus on managing the aggregate demand of a country.

Discretionary policy

An approach in fiscal policy to stabilize the economy A macroeconomic policy based on the judgment of policymakers in the moment as opposed to policy set by predetermined rules These acts do not follow a strict set of rules, rather, they use subjective judgment to treat each situation in unique manner Discretionary policies can target specific areas of the economy, rather than aggregate demand With discretionary policy there is a significant time lag before action can be taken.

AS/AD influence on Phillips curve

Changes in aggregate demand cause movements along the Phillips curve, all other variables held constant. If there is an increase in aggregate demand, such as what is experienced during demand-pull inflation, there will be an upward movement along the Phillips curve. As aggregate demand increases, real GDP and price level increase, which lowers the unemployment rate and increases inflation.

Problems/benefits of governments running debts/deficits

Debt: a government that runs persistent large deficits will have a rising debt-GDP ratio when debt-grows faster than GDP Deficit: large deficits are usually caused in part by a depressed economy - years of large budget deficits also tend to be years when the economy has a large recessionary gap

Relationship between unemployment VS inflation

Decrease in UR → Increase in IR Decrease in IR → Increase in UR As more people work (UR goes down) the national output increases, thus causing wages to increase. This causes consumers to have more money to spend, more resulting in consumers demanding more goods and services (increase in AD), thus causing the prices of goods and services to increase (increase in PL)

How can government policy affect economic growth?

Economists use growth accounting to estimate the contribution of each major factor in the aggregate production function of economic growth Growth accounting, which estimates the contribution of each factor to a country's economic growth, has shown that rising total factor productivity is key to long-run growth. It is usually interpreted as the effect of technological progress. The amount of physical capital per worker grows 3% a year.

Monetary policy

Expansionary monetary policy (p. 307) A type of monetary policy that increases AD (shifts to right) When the Fed adopts expansionary monetary policy and increases MS: Increase in MS → Lower interest rate → Higher investment spending raises income → Higher consumer spending (via multiplier) → Increase in AD and AD curve shifts to the right

What do modern economists agree on?

Fiscal and monetary policy? In recession? Due to any change in the business cycle? The modern consensus is that monetary and fiscal policy are both effective in the short run but that neither can reduce the unemployment rate in the long run. Discretionary fiscal policy is considered generally unadvisable, except in special circumstances.

Expansionary Fiscal Policy

Governments combats recessions by either lowering taxes or increasing government spending To pay off, the government must eventually increase tax receipts, cut spending, borrow additional funds or print more dollars. Not all economists agree about the net effect of expansionary fiscal policy on the budget in the long run. In the short run, either surpluses will shrink or deficits will grow. Thus, when the government finances a deficit by borrowing, it is adding to the national debt

What is real GDP per capita? Why is it used to measure economic growth?

Growth is measured as changes in real GDP per capita (real GDP / population) in order to eliminate the effects of changes in the price level and changes in population size.

What is economic growth / how is it measured?

Growth is measured as changes in real GDP per capita (real GDP / population) in order to eliminate the effects of changes in the price level and changes in population size. Labor productivity leads to economic growth in the long run Long-run economic growth is normally a gradual process, in which real GDP per capita grows at most a few percent per year. The key to long-run economic growth is rising labor productivity, or just productivity, which is output per worker.

How output and unemployment are related

If GDP increases, unemployment rate will decrease and vise versa. Because GDP means total goods production by respected country within their boundary so more GDP means more production and more employment.

Inflationary expectations

If workers and employers expect inflation to persist in the future, they will increase their (nominal) wages and prices now. (See real vs. nominal in economics.) This means that inflation happens now simply because of subjective views about what may happen in the future.

Printing money

Inflation tax is caused by inflation. It is a reduction in the value of money held by the public, by printing money to cover its budget deficit and creating inflation. When the government imposes an inflation tax, they are in essence printing more money → money supply increases (recall graph from last time, increase in money supply causes increase in AD, which causes an increase in PL) By printing more money, the government is reducing the value of the money held by the public (because they proportionately hold less now → hence their purchasing power goes down)

Cost push inflation

Inflation that is caused by a significant increase in the price of an input with economy wide importance Example: In the 1970s, the oil crisis led to an increase in energy prices (leftward shift in aggregate supply, increasing aggregate PL)

Demand pull inflation

Inflation that is caused by an increase in aggregate demand When a rightward shift of aggregate AD leads to an increase in aggregate PL, the economy is experiencing demand pull inflation The aggregate demand for goods and services is outpacing the aggregate supply and driving up goods and services (too much demand, not enough supply)

Long term interest rates

Interest rates on financial assets that mature over multiple years

Factors that lead to economic growth

Labor productivity: Amount of output a worker can produce in a given time period Technology: The technical means for the production of goods and services Human capital: The improvement of labor created by the education and knowledge of members in the work force Physical capital: Capital consisting of human-made goods such as buildings and machines used to produce other goods and services

Contractionary monetary policy

Monetary policy that reduces AD (shifts to left) When the Fed adopts contractionary monetary policy and reduces MS: Decrease MS → Higher interest rate → Lower investment spending reduces income → Lower consumer spending (via multiplier) → Decrease in aggregate demand and AD curve shifts to the left

Inflation targeting

Occurs when the central bank sets an explicit target for the inflation rate and sets monetary policy in order to hit that target Instead of using Taylor rule to set monetary policy, the desired interest rate is announced, and policy is set in place to achieve it. Inflation targeting is based on a forecast of future inflation Argued advantages: Transparency: economic uncertainty is reduced because the public knows the objective of an inflation-targeting central bank Accountability: the central bank's success can be judged by seeing how closely actual inflation rates have match the inflation target, making central bankers accountable

Classical economics

Prices are flexible, making the aggregate supply curve vertical even in the SR All things equal, an increase in the money supply leads to a proportional rise in the aggregate price level, with no effect on Prices and wages = fully flexible Aggregate supply is vertical even in SR Increase in MS, other things equal, leads to increase in PL Big idea is that an increase in the MS causes inflation, not any change in output Classical economics asserted that monetary policy affected only the aggregate price level, not aggregate output. Classical macroeconomics asserted that the short run was unimportant. According to the classical model, prices are flexible, making the aggregate supply curve vertical even in the short run. As a result, an increase in the money supply leads, other things equal, to an equal proportional rise in the aggregate price level, with no effect on aggregate output. Increases in the money supply lead to inflation, and that's all.

Short-run/Long-run effect of monetary policy

Short run: monetarists argue that expansionary monetary policies may increase the level of real GDP by increasing aggregate demand Long‐run: expansionary monetary policies only lead to inflation and do not affect the level of real GDP.

LRPC

The LRPC shows the relationship between unemployment and inflation, after expectations have had time to adjust to experience Why is it vertical? Any unemployment rate below the NAIRU leads to ever accelerating-inflation (the LRPC shows that there are limits to expansionary policies because an UR below the NAIRU cannot be maintained in the LR)

Monetary neutrality

The concept of monetary neutrality states that changes in the money supply have no real effects on the economy In the LR, the only effect of an increase in the money supply is to raise the aggregate price level by an equal percentage If MS falls 25%, aggregate PL will fall 25% in the LR Economists argue that money is neutral in the long run (remember: in the LR, changes in the MS do not affect real GDP, interest rates, or anything else except for price level)

Velocity of money

The ratio of nominal GDP to the money supply Velocity is the number of times the average dollar bill in the economy turns out per year between buyers and sellers; this gives rise to the velocity equation It relies on the velocity equation M x V = P x Y M = money supply, V = velocity, P = aggregate price level, Y = real GDP Monetarists believed that V was stable, so they believed that if the Federal Reserve kept M on a steady growth path, nominal GDP would also grow steadily (Growth in GDP) However, the velocity of money proved to be unstable

Inflation tax

The reduction in the value of money held by the public caused by inflation By printing more money, the government is reducing the value of the money held by the public (because they proportionately hold less now → hence their purchasing power goes down)

Keynesian economics

The theory was created by John Maynard Keynes A theory that focuses on the ability of shifts in aggregate demand to influence aggregate output in the short run Prices and wages inflexible downward. Wages / price are sticky SR is significant SR AD/AS shocks change in PL and output in the SR Government should use fiscal and monetary policy to smooth business cycle Keynesian economics reflected two innovations: Short-run effects of shifts in aggregate demand on aggregate output. Keynes argued that other factors than money are mainly responsible for business cycles. The main practical consequence of Keynes's work was that it legitimized macroeconomic policy activism—the use of monetary and fiscal policy to smooth out the business cycle.

National debt

The total amount of money that a country's government has borrowed, by various means The sum of government deficits over time

NAIRU or Natural rate of unemployment

The unemployment rate at which inflation does not change over time Keeping the unemployment rate below the NAIRU leads to accelerating inflation and cannot be maintained, whereas any unemployment rate above the NAIRU leads to decelerating inflation. To avoid accelerating inflation over time, the unemployment rate must be high enough that the actual rate of inflation matches the expected rate of inflation Most economists believe that there is a NAIRU and that there is no long-term trade off between unemployment and inflation

Fiscal policy

The use of either government spending or tax policy to stabilize the economy (recessions = increase in spending, cutting taxes, or both), (inflation = reducing spending, increasing taxes) When the government increases spending or cuts taxes, aggregate demand increases When the government reduces spending or raises taxes, aggregate demand decreases