Econ 2002.01 Exam #3

Crowding Out and Crowding In

*Crowding out* is the tendency for an expansionary fiscal policy to reduce other components of aggregate demand. -Increased government spending raises interest rates causing less consumption and investment. *Crowding in* is the tendency for a contractionary fiscal policy to increase other components of aggregate demand. -Less government spending lowers interest rates causing more consumption and investment.

Cyclical Unemployment

*Cyclical Unemployment:* unemployment above the natural level occurs if, at a given real wage, the quantity of labor supplied exceeds the quantity of labor demanded. -Failure to achieve equilibrium is a short-run phenomenon. -In the long run, wages and prices will adjust so that the real wage reaches its equilibrium level. Employment reaches its natural level. Some argue that a real wage that achieves equilibrium in the labor market may never be reached. -Firms may deliberately pay a wage greater than equilibrium to boost productivity. -Efficiency wage theory is based on the idea that firms may hold to a real wage greater than the equilibrium wage.

The Equation of Exchange

*Equation of exchange* is the money supply (M) times its velocity (V) equals nominal GDP. *Velocity* is the number of times the money supply is spent to obtain the goods and services that make up GDP during a particular time period. MV=PY=nominal GDP V=PY/M M=money supply V=velocity P=price level Y=index of real expenditures (real GDP) P=nominalGDP/realGDP

National Debt

*National debt* is the sum of all past federal deficits, minus any surpluses.

Phillips Curve in History

1960s: the trade-off the Phillips curve implied existed. Mid-1960s: economy moved into an inflationary gap as unemployment fell below its natural level. Late 1960s: unemployment at 3.5% was substantially below its natural level (5.6%). It was time to move back down the Phillips curve, trading a reduction in inflation for an increase in unemployment. 1970: the effort to nudge the economy back down the Phillips curve resulted in unemployment increasing AND inflation increasing. When considering Unemployment and Inflation (U.S.) from 1961-2008 the data is not always consistent with the theory behind the Phillips curve.

Government Balance Budget

A *budget surplus* is a situation that occurs if government revenues exceed expenditures. A *budget deficit* is a situation that occurs if government expenditures exceed revenues. A *balanced budget* is a situation that occurs if the budget surplus equals zero.

Transfer Payments

A transfer payment is the provision of aid or money to an individual who is not required to provide anything in exchange (e.g. social security, food stamps, welfare). Transfer payment spending relative to GDP tends to fluctuate with the business cycle. -When economic activity falls, incomes fall, people lose jobs, and more people qualify for aid. -When the economy expands, incomes and employment rise, and fewer people qualify for welfare or unemployment benefits. Transfer payments fluctuate with the business cycle, rising in times of recession and falling during times of expansion. (Lecture 19 7/39)

Automatic Stabilizers

An *automatic stabilizer* is any government program that tends to reduce fluctuations in GDP automatically (e.g. various transfer payments and income taxes). Example: transfer payments and income taxes (as incomes fall, people pay less in income taxes). Increases in income tax rates and unemployment benefits have enhanced their importance as automatic stabilizers. Automatic stabilizers act swiftly to reduce the degree of changes in real GDP because they directly affect disposable personal income (thus consumption).

Changes in Business Taxes

An *investment tax credit* allows a firm to reduce its tax liability by a percentage of the investment it undertakes during a particular period. -With an investment tax credit of 10% a firm that engaged in $1 million worth of investment during a year could reduce its tax liability for that year by $100,000. -The investment tax credit was initially introduced by the Kennedy administration, reintroduced during the Reagan administration in 1981, and reinstated again by the Bush administration. An investment tax credit is intended to stimulate additional private sector investment (which in turn affects aggregate demand). An increase in the investment tax credit, or a reduction in corporate income tax rates, will increase investment and shift the aggregate demand curve to the right. -Real GDP and the price level will rise. A reduction in the investment tax credit, or an increase in corporate income tax rates, will reduce investment and shift the aggregate demand curve to the left. -Real GDP and the price level will fall.

An Increase in Government Purchases

An economy is initially in equilibrium at a real GDP of $12,000 billion and a price level of P1. An increase of $200 billion in the level of government purchases (ΔG) shits the aggregate demand curve to the right by $400 billion. The equilibrium level of real GDP rises to $12,300 billion, while the price level rises to P2.

Monetary Policy and Rational Expectations

Lecture 20 22/29

Choice of Policy

Because the decision makers who determine fiscal policy are all elected politicians, the choice among the policy options available is a political matter. For example: -Those who believe that government is too big would argue for tax cuts to close recessionary gaps and for spending cuts to close inflationary gaps. -Those who believe that the private sector has failed to provide adequately a host of services that would benefit society, such as better education or public transportation systems, tend to advocate increases in government purchases to close recessionary gaps and tax increases to close inflationary gaps. *Supply side economics* is the school of thought that promotes the use of fiscal policy to stimulate long run aggregate supply. -Supply-siders tend to favor tax cuts over increases in government purchases or increases in transfer payments. -President Reagan advocated tax cuts in 1981 on the basis of their supply-side effects.

Other Issues

Central Banks--Inflation and Independence. -There does seem to be a link between inflation rates in high income countries and the level of independence of the central bank. -This suggests that central banks need to remain relatively independent. -Some have suggested that the Fed worked too closely with the Treasury Department during the Great Recession. Also, when interest rates are kept low by monetary policy, it makes it easier for the government to keep running large deficits.

Changes in Transfer Payments

Changes in transfer payments alter the disposable personal income of households and thus affect their consumption, which is a component of aggregate demand. A change in transfer payments will result in a smaller change in real GDP than would a change in government purchases of the same amount. -This is because consumption will change by less than the change in disposable personal income.

Inflation Rates and Economic Growth

Conclusion: In the long run, the inflation rate is determined by the relative values of the economy's rate of money growth and of its rate of economic growth. If they money supply increases more rapidly than the rate of economic growth, inflation is likely to result. A money growth rate equal to the rate of economic growth will, in the absence of a change in velocity, produce a zero rate of inflation. A money growth rate that falls short of the rate of economic growth is likely to lead to deflation.

Money, Nominal GDP and Price Level Changes

Consider if velocity is constant: MVbar=PY Implications of a constant velocity: Nominal GDP could change only if there were a change in the money supply. Other kinds of changes, such as a change in government purchases or a change in investment, could have no effect on nominal GDP. A change in the money supply would always change nominal GDP, and by an equal percentage. If velocity were constant, the quantity of money would determine nominal GDP; nothing else would matter. The relationship between money growth and nominal GDP seems quite strong. %Δ=growth rate %ΔM+%ΔV≈%ΔP+%ΔY %ΔM≈%ΔP+%ΔYsubP %ΔM-%ΔYsubP≈%ΔP The *quantity theory of money* states that in the long run, the price level moves in proportion with changes in the money supply, at least for high inflation countries.

Trump Plan

Cut taxes: -Eliminates the estate tax completely. -Close tax loopholes. -Child care deduction that would cover average cost of childcare. -Cut taxes for everyone. -Reduce number of tax brackets. -Reduce top rate of tax. -Reduce U.S. corporate tax rate. Would reduce amount of income collected by $4.4 trillion over next decade. Spending: -No significant reductions in spending on social security and healthcare. Trade: -Renegotiate trade deals such as NAFTA. -Get tough with China. -35% tariff on Mexican goods. -45% tariff on Chinese goods. -Against Trans-Pacific Partnership Employment: -Invest in infrastructure. -Cut trade deficit. -Lower taxes. -Remove regulations. -Increase manufacturing jobs. -Create 25 million jobs over 10 years. -Achieve economic growth of 3.5%

Problems and Controversies with Monetary Policy

Despite the apparent ease with which the Fed can conduct monetary policy, it still faces difficulties in its efforts to stabilize the economy. -Lags. -Choosing Targets. -Political Pressure. -Degree of Impact on the Economy. -Rational Expectations.

Lags

Discretionary fiscal policy is subject to the same lags as monetary policy. The *recognition lag* (time it takes to realize a recessionary or inflationary gap exists), *implementation lag* (time it takes to implement fiscal policies) and *impact lag* (the time that goes by before the policy has it's full effect) also impact fiscal policy. Example: -A tax cut was proposed to presidential candidate John F. Kennedy in 1960 as a means of ending the recession that year. -JFK recommended it to Congress in 1962. -It was not passed until 1964, three years after the recession had ended, so the recognition lag. The implementation lag results partly from the nature of bureaucracy itself.

Short Run Curve For Every Expected Inflation Rate

Each expected inflation rate is a different SRPC. When the inflation rate is actually at the expected level, the unemployment rate is at the natural rate of unemployment. The SRPC will intersect the LRPC at the expected rate of inflation. When the economy is at full employment output, and the natural rate of inflation, the expected inflation rate is the actual inflation rate in the short run.

Do Workers Really Understand This?

Economists believe that inflation will lead to an increase in wages, but there is not agreement on how quickly this will happen. Workers tend to NOT believe that this will happen, and that their purchasing power will decrease for an extended period of time. If workers don't expect their wages to keep up with inflation, then firms can increase wages by less than inflation.

Monetary Policy and Macroeconomic Variables

Economists mostly agree that the tools of monetary policy (buy or sell federal government bonds through open-market operations, changing the discount rate, or changing reserve requirements) affect the economy. Economists sometimes disagree on the precise mechanisms through which this occurs, on the strength of those mechanisms, and on the ways in which monetary policy should be used.

Areas of Agreement (For Trump and Clinton)

End corporate inversion--when companies move headquarters abroad to avoid U.S. taxes. Eliminate carried interest tax--benefits hedge fund investors. Oppose TPP

The Composition of Federal, State, and Local Revenue

Federal receipts come primarily from payroll taxes and from personal taxes such as the personal income tax. State and local tax receipts come from a variety of sources; the most important are property taxes, sales taxes, income taxes, and grants from the federal government. Lecture 18 10/30.

Federal, State and Local Purchases Relative to GDP

Government purchases were generally above 20% of GDP from 1960 until the early 1990s and then below 20% of GDP except during the 2007-2009 recession. Lecture 18 7/30.

What Do Expectations Have To Do With Monetary Policy?

If workers and firms adjust their expectations based on the idea that inflation will be the same as it was the period before, they have adaptive expectations. Monetary policy can work well in this case. If workers and firms have rational expectations, they will anticipate the actions of the central bank and adjust their expectations. In this case, monetary policy would not be effective. -This would suggest a vertical SRPC, too.

Phillips Curve

In 1958, Almarin Phillips reported that his analysis of a century of British wage and unemployment data suggested a trade-off between rates of increase in wages and British unemployment. The *Phillips curve* is a curve that suggests a negative relationship between inflation and unemployment.

History of Phillips Curve Evidence

In 60s, inflation was low (about 1.5%). Everyone expected this to continue, but inflation actually increased in late 60s to 4.5% because of expansionary policies. This increase in inflation was unexpected, so there was movement along SRPC to higher inflation and lower unemployment rates (3.5%). Eventually, workers and firms adjusted their expectations to inflation rate of 4.5%. -Workers demanded higher wages to compensate for the increased inflation, and the economy returned to potential GDP, with unemployment at its natural rate of 5%. This is represented by a shift of the SRPC to the right so that the SRPC intersects the LRPC at the expected rate of inflation.

An Expansionary Fiscal Policy of Crowding Out

In an economy, increased government purchases are financed through the sale of bonds, lowering their price level. The higher interest rate causes the exchange rate to rise, reducing net exports. Increased government purchases would shift the aggregate demand curve to the right if there was no crowding out. Crowding out of investment and net exports, however, causes the aggregate demand curve to shift only a little to the right. Then a higher price level means that GDP rises only a little bit.

Significance of Phillips Curve

In the 1960s, some economists believed that the Phillips curve was a structural relationship. The data made the relationship between inflation and unemployment seem quite stable. This would mean that the government could choose a point on the curve and permanently trade higher inflation for lower unemployment. BUT the relationship doesn't hold in the long run. The short run Phillips curve moves over time. By the late 1960s, most economists agreed that the long-run aggregate supply curve was vertical. -A vertical long-run aggregate supply curve means a vertical long-run Phillips curve. Economists Milton Friedman and Edmund Phelps argued that this implied the long-run Phillips curve was also vertical: in the long run, employment is determined by output, which in the long run does not depend on the price level.

Review of Fed Policies

In the 1970s, the economy was dealing with an oil price shock. -a negative supply shock. This would be depicted as a shift to the right of the SRAS curve in our AD/AS model. This creates stagflation--both inflation and unemployment rose. What do you do in this situation? Monetary policy will improve one at the expense of the other. The Fed chose expansionary policy. They focused on bringing down the unemployment rate at the expense of a higher inflation rate. This new inflation rate was built into people's expectations, and shifted the curve up. The unemployment rate came down, but high inflation was still hurting the economy. A new Chair--Paul Volcker--began using contractionary policy. People should have adjusted their expectations to a lower SRPC, but it didn't seem to move. Lecture 22 30-31/32

The Phillips Curve: Increasing Aggregate Demand

In the AD/AS model, a small AD increase leads to low inflation and high unemployment. A stronger AD increase leads to lower unemployment, but more inflation. The higher the level of real GDP, the lower the unemployment rate. That is because the production of more goods and services requires more employment. For a given labor force, a higher level of employment implies a lower rate of unemployment.

Changes in Income Taxes

Income taxes affect the consumption component of aggregate demand. An increase in income taxes reduces disposable personal income --> -Reduces consumption (but by less than the change in disposable personal income) --> -Shifts the aggregate demand curve leftward by an amount equal to the initial change in consumption that the change in income taxes produces times the multiplier. A reduction in income taxes increases disposable personal income --> -Increases consumption (but by less than the change in disposable personal income) --> -Increases aggregate demand.

Fiscal Policy

Inflationary Gap: -Temporary tax increase -Cuts in government purchases Recessionary Gap: -Tax cut -Increased defense spending (government spending) -Increase disposable personal income/Boost consumption -Increase investment (?)

How Long Does It Take To Get Back To The Long Run?

It depends. It depends on how quickly everyone adjusts their expectations regarding inflation. If inflation is low, the adjustment is slow. People tend to ignore inflation. If inflation is moderate, but stable, the adjustment is quick. This type of inflation is easily incorporated into what people expect. If inflation is high and unstable, the adjustment is quick. People will use all available information to predict inflation. They form rational expectations.

Lags

It may take several months before anyone even realizes that a particular macroeconomic problem is occurring. -When monetary authorities become aware of a problem, they can act quickly to inject reserves into the system or to withdraw reserves from it. -It may be a year or more before the action affects aggregate demand. *Recognition lag* is the delay between the time a macroeconomic problem arises and the time at which policy makers become aware of it. -Primarily stems from problems in collecting data as data is only available after the conclusion of a particular period and economic indicators are subject to revision. *Implementation lag* is the delay between the time at which a problem is recognized and the time at which a policy to deal with it is enacted. -For monetary policy changes, the implementation lag is short as FOMC meets 8 times a year and open-market operations can be put into effect immediately. *Impact lag* is the delay between the time a policy is enacted and the time that policy has its impact on the impact -The impact lag for monetary policy occurs because: --It takes some time for the deposit multiplier process to work itself out. --Firms need some time to respond to the monetary policy with new investment spending--if they respond at all. --A monetary change is likely to affect the exchange rate, but that translates into a change in net exports only after some delay. The problem of lags suggests that monetary policy should respond not to statistical reports of economic conditions in the recent past but to conditions expected to exist in the future. Estimates of the length of time required for the impact lag to work itself out range from six months to two years; this can vary.

Discretionary Policy Tools

Most of the government's taxing and spending is for purposes other than economic stabilization. -Example: the increase in defense spending in the early 1980s under President Ronald Reagan and in the administration of George W. Bush were undertaken to promote national security. -Here we focus on discretionary fiscal policy that is undertaken with the intention of stabilizing the economy. Discretionary government spending and tax policies can be used to shift aggregate demand. -Expansionary fiscal policy might consist of an increase in government purchases or tranfer payments, a reduction in taxes, or a combination of these tools to shift the aggregate demand curve to the right. -A contractionary fiscal policy might involve a reduction in government purchases or transfer payments, an increase in taxes, or a mix of all three to shift the aggregate demand curve to the left.

Money Growth Rates and Inflation Over the Long Run

Numerous studies point to the strong relationship between money growth and inflation, especially for high-inflation countries.

Nominal, Expected and Actual Wages

Remember (Nominal/CPI)*100=Real -If actual inflation is greater than expected inflation, the actual real wage is less than the expected real wage, and the unemployment rate falls. -If actual inflation is less than expected inflation, the actual real wage is greater than the expected real wage, and the unemployment rate increases.

Supply Side Economics

Supply of money, labor, and goods or services creates demand. Opposite of Keynesian theory where demand is primary driving force. Recommends lower tax rates and deregulation to boost economic growth. A corporate tax cut gives businesses more money to hire workers, invest in capital and produce more. Income tax cut increases dollars per hour worked increasing incentive to work. Labor increases leading to economic growth. Also called Trickle Down Economics. Based on work of Arthus Latter in 1979. Put into practice in 1980s by Reagan to combat stagflation. Top tax rate cut from 70% to 28% for income. Top corporate tax rate cut from 46% to 40%. Helped economy recover. BUT also increase spending on defense and doubled national debt. Bush also cut taxes, and economy grew, but expansionary monetary policy was being implemented at the same time. Does it work? Depends on who receives tax cuts. Lower income families have higher marginal propensity to consume (MPC). Treasury Department showed that Bush tax cuts would increase annual GDP by 0.7% but the model assumed that lost revenue was offset by reduced spending. National Bureau of Economic Research found that tax cuts did not work to improve the economy.

Federal Reserve Act

When the Fed was established in 1943, the legislation that created the Fed provided limited guidance. The stated purpose was: "An Act to provide for the establishment of Federal reserve banks, to furnish an elastic currency, [to make loans to banks], to establish a more effective supervision of banking in the United States, and for other purposes."

Taxes

Taxes affect: -The relationship between real GDP and personal disposable income --> thus affecting consumption. -The profitability of investment decisions --> thus affecting the levels of investment firms will choose.

Clinton Plan

Taxes: -Keep taxes same for most. -Add additional bracket for top earners to pay for free tuition. -Close tax loopholes. -Plan would add $1.1 trillion in revenue over the next 10 years. Spending: -No significant reductions in spending on social security and healthcare. Trade: -Does not support punitive tariffs. -Does not support Trans-Pacific Partnership. -Wants to offer tax incentives to companies that build here rather than barring imports. Employment: -Increase jobs training. -New infrastructure spending. -Investment in new energy.

Rational Expectations

The *rational expectations hypothesis* states that individuals form expectations about the future based on the information available to them, and they act on those expectations.

What Does This Mean For Monetary Policy?

The Fed cannot permanently buy a lower rate of unemployment at the cost of permanently higher inflation. The Fed would have to keep increasing inflation. People's expectations will keep adjusting.

Degree of Impact on The Economy

The Fed does not know with certainty when and to what extent its policies will affect the macroeconomy. -A *liquidity trap* is a situation that exists when a change in monetary policy has no effect on interest rates. -*Quantitative easing* is a policy in which a bank convinces the public that it will keep interest rates very low by providing substantial reserves for as long as is necessary to avoid deflation. -*Credit easing* is a strategy that involves the extension of central bank lending to influence more broadly the proper functioning of credit markets and to improve liquidity.

Monetary Policy in The US

The Fed is one of the most powerful makers of economic policy in the United States. -It sets and carries out monetary policy. -The Federal Open Market Committee (FOMC) can set monetary policy in a day and see that policy implemented within hours. -The Board of Governors can change the discount rate or reserve requirements at any time. The impact of the Fed's policies on the economy can be quite dramatic. -The Fed can push interest rates up or down. -The Fed can promote a recession or an expansion. -The Fed can cause the inflation rate to rise or fall.

Choosing Targets

The Fed sets of targets that it wants to achieve --> failure of the economy to achieve one of the Fed's targets would then trigger a shift in monetary policy. Interest Rates. -The FOMC engages in operations to nudge the federal funds rate up or down. -The current operating procedures of the Fed focus explicitly on interest rates. -When the Fed lowers the target for the federal funds rate, it buys bonds. When it raises the target for the federal funds rate, it sells bonds. Money Growth Rates. -Recently the Fed has placed more importance on the federal funds rate; thus, the money growth targets tended to fall by the wayside. Price Level or Expected Changes in The Price Level -The Fed could target a particular price level or a particular rate of change in the price level and adjust its policies accordingly.

The Employment Act of 1946

The Great Depression of the 1930s had instilled in people a deep desire to prevent similar calamities in the future. In 1936 John Maynard Keynes' described a prescription for avoiding such problems through government policy (The General Theory of Employment, Interest and Money). This led to the Employment Act of 1946, which declared that: -the federal government should "use all practical means...to promote maximum employment, production and purchasing power." The act also created the Council of Economic Advisers (CEA) to advise the president on economic matters.

Changes in Government Purchases

The aggregate demand curve shifts to the right by an amount equal to the initial change in government purchases times the multiplier. -The multiplied effect of a change in government purchases occurs because the increase in government purchases increases income, which in turn increases consumption.

What Might Change The Natural Rate of Unemployment?

The natural rate of unemployment can change over time. This would shift the LRPC. If the demographic makeup of the labor force changes, the natural rate will change. Younger, well skilled workers have higher unemployment rates. If the institutions of the labor market change, i.e., unemployment insurance, legal barriers to firing workers, this will change the natural rate. If unemployment rates were higher int eh recent past, workers' skills may deteriorate. This can change the natural rate.

Federal Reserve Policies and Goals

The clearest way to see the Fed's goals is to observe the policy choices it makes: Since 1979, the Fed's primary goal is to keep inflation under control. Given this, the Fed will also use stimulative measures to attempt to close recessionary gaps. From 1979 to the early 1980s, the Fed ran a program of reducing the inflation rate. -The annual inflation rate fell from 13.3% in 1979 to 3.8% in 1982. -Unemployment soared past 9% during the recession. In 1983 the Fed shifted to a stimulative policy early when inflation rate went below 4%. In 1990 the Fed engaged in aggressive open-market operations to stimulate the economy at the start of the recession, despite the fact that the inflation rate had jumped to 6.1%. -The increase in the inflation rate resulted form an oil-price boost that came in the wake of Iraq's invasion of Kuwait that year. -A jump in prices that occurs at the same time as real GDP is slumping suggests a leftward shift in short-run aggregate supply, a shift that creates a recessionary gap. Once the recovery was clearly under way, the Fed shifted to a neutral policy, seeking neither to boost nor to reduce aggregate demand. Early in 1994, the Fed shifted to a contractionary policy, selling bonds to reduce the money supply and raise interest rates. In 1997, the Fed tightened monetary policy due to concerns that inflationary pressures were increasing. In 1998, the Fed reduced the goal for the federal funds rate to 4.75% (due to concern about slow growth in Europe and Asia). In 1999, the Fed raised the goal of the federal funds rate to 5.3% (due to brisk real GDP growth and concerns that inflation would increase). The goal increased in 1999 and again in 2000. From 2001 onwards, the Fed began lowering the federal funds rate to stimulate the economy. From 2004-2006, the Fed began to increase rates when growth began picking up and inflation was a concern again. In 2007, the Fed began lowering the federal funds rate, mostly in larger stepsor 0.5 to 0.75 percentage points. By the end of 2008, the rate was targeted at between 0% and 0.25%. The Fed went on record to say that it intended to keep the federal funds rate at extremely low levels so long as the unemployment rate stayed above 6.5% and possibly even if it went below that, assuming that inflation remained in check.

The Full Employment and Balance Growth Act of 1978

The clearest, and most specific, statement of federal economic goals. Also known as the Humphrey-Hawkins Act. The act stated that by 1983 the federal government should achieve an unemployment rate among adults of 3% or less, a civilian unemployment rate of 4% or less, and an inflation rate of 3% or less. The act provided specific goals but little in terms of practical policy guidance. -The last time the civilian unemployment rate in the United States fell below 4% was 1969, and the inflation rate that year was 6.2%. The Act requires that the chairman of the Fed's Board of Governors report twice each year to Congress about the Fed's monetary policy.

Expansionary Monetary Policy

The economy has a recessionary gap. An expansionary monetary policy could seek to close this gap by shifting the aggregate demand curve to the right. The Fed buys bonds, shifting the demand curve for bonds to the right and increasing the price of bonds. By buying bonds, the Fed increases the money supply. The Fed's action lowers interest rates. The lower interest rate also reduces the demand for and increases the supply of dollars, reducing the exchange rate. The resulting increases in investment and net exports shift the aggregate demand curve (to the right?).

Contractionary Monetary Policy

The economy has an inflationary gap. A contractionary monetary policy could seek to close this gap by shifting the aggregated demand curve to the left. The Fed sells bonds, shifting the supply curve for bonds to the right, and lowering the price of bonds. The lower price of bonds means a higher interest rate. The higher interest rate also increases the demand for and decreases the supply of dollars, raising the exchange rate, which will increase net exports. The decreases in investment and net exports are responsible for decreasing aggregate demand.

The Goals of Monetary Policy

The goals of monetary policy should include: -the maintenance of full employment -the avoidance of inflation or deflation -the promotion of economic growth Conflicting Goals? -A monetary policy that helps to close a recessionary gap and thus promotes full employment may accelerate inflation. -A monetary policy that seeks to reduce inflation may increase unemployment and weaken economic growth.

Government Revenue and Expenditure As A Percentage of GDP

The government's budget was generally in surplus in the 1960s, then mostly in deficit since, except for a brief period between 1998 and 2001.

Government Payments

The government-purchases component of aggregate demand includes all purchases by government agencies of goods and services produced by firms, as well as direct production by government agencies themselves. While government spending has grown over time, government purchases as a share of GDP declined from over 20% until the early 1990s to under 18% in 2001 and began to increase back toward 20% and then beyond.

Political Pressures

The institutional relationship between the leaders of the Fed and the executive and legislative branches of the federal government is structured to provide for the Fed's independence. Members of the Board of Governors are appointed by the president, with confirmation by the Senate. -However 14-year terms of office provide a considerable degree of insulation from political pressure. Chairman of the Board of Governors is selected by the president and appointment carries a four-year term. Neither the president nor Congress has any direct say over the selection of the presidents of Federal Reserve district banks. The men and women who serve of the Board of Governors and the FOMC are not immune to the pressures that can be placed on them by members of Congress and by the president. The Fed was created by the Congress; its charter could be altered--or even revoked--by that same body.

The National Debt and The Economy

The national debt relative to GDP was at its peak during World War II and then fell dramatically over the next few decades. The ratio of debt to GDP rose from 1981 to 1996 and fell in the last years of the 20th century; it began rising again in 2002, markedly so since 2009.

Expansionary and Contractionary Fiscal Policy to Shift Aggregate Demand

When an economy faces a recessionary gap, an expansionary fiscal policy seeks to shift aggregate demand to the right to close the gap. When an economy faces an inflationary gap, a contractionary fiscal policy seeks to reduce aggregate demand (shift it to the left) to close the gap.

LRPC--Natural Rate of Unemployment

The natural rate of unemployment is the level of unemployment that exists at potential GDP. In the AD/AS model, potential GDP is the base point for the LRAS curve. In the long run, the economy will always return to its potential output. In the long run, the unemployment rate, therefore, will always return to the natural rate of unemployment. This is the rate of unemployment that exists when we are operating at potential GDP. The Long Run Phillips curve is a vertical line at the natural rate of unemployment.

Why The Quantity Theory of Money is Less Useful in Analyzing the Short Run

The stability of velocity in the long run underlies the close relationship we have seen between changes in the money supply and changes in the price level. Velocity is NOT stable in the short run. The factors that cause velocity to fluctuate are those that influence the demand for money (interest rate and expectations about bond prices and future price levels). We can gain insight about the demand for money and its significance by considering this equation for money demand: M=(PY)/V Other things unchanged: increase in money demand reduces velocity, and a decrease in money demand increases velocity.

Could The SRPC Be Vertical?

This idea has been suggested by Robert Lucas and Thomas Sargent. Evidence of the 50s and 60s suggested the downward sloping SRPC. Lucas and Sargent claimed this was due to the Fed not being transparent with its policies. Critics of this argue that people cannot entirely anticipate inflation, and their expectations might not be entirely rational. Add to this the idea of sticky wages. This suggests that there is still a downward sloping SRPC.

Expectations of Inflation

This notion contradicts the idea of a tradeoff between inflation and unemployment that seemed to exist in the 50s and 60s. What explains a short run tradeoff? Workers' and firms' expectations of inflation. Sometimes they expect inflation to be higher than what it is, and sometimes they expect it to be lower than what it is. Wage contracts are made using expectations about inflation.

Government Spending As A Percentage of GDP

Three major categories of government spending as percentages of GDP: government purchases, transfer payments, and net interest. Lecture 18 8/30.

Unemployment in The Long Run

Three types of unemployment: frictional, structural, and cyclical unemployment. -Frictional and Structural exist at all times (even when the economy operates at its potential) and determine the natural rate of unemployment. -In the long run, the economy will operate at potential, and the unemployment rate will be the natural rate of unemployment. -In the long run the Phillips curve will be vertical at the natural rate of unemployment. An economy operating at potential has no cyclical unemployment. Lecture 22 20/34

Unemployment and Inflation

We have learned the policy tools that are available to move the economy. But there are tradeoffs involved in using these tools. Let's look at a model that examines both the short run and long run relationship between inflation and unemployment.

Federal Reserve Policies and Goals (Cont.)

What can we infer from these episodes in the 1980s, 1990s, and the first decade of this century? The Fed focuses on preventing the high inflation rates of the 1970s from occurring again. When the inflation rate is within acceptable limits, the Fed will undertake stimulative measures in response to a recessionary gap or even in response to the possibility of a growth slowdown.

Inflation Rate in The Long Run

What factors determine the inflation rate? The price level is determined by the intersection of aggregate demand and short-run aggregate supply; anything that shifts either of these two curve changes the price level and thus affects the inflation rate. These shifts can generate different inflation--unemployment combinations in the short run. In the long run, the rate of inflation will be determined by two factors: 1. the rate of money growth. 2. the rate of economic growth. The rate of money growth is one determinant of an economy's inflation rate in the long run. -MV=PY. -Money supply times the velocity of money equals the price level times the value of real GDP. %ΔM+%ΔV≈%ΔP+%ΔY If velocity is stable in the long run (%ΔV=0) then, %ΔP≈%ΔM-%ΔY In the long run, real GDP moves to potential level, YsubP; then, %ΔP≈%ΔM-%ΔYsubP

Liquidity Trap

When a change in the money supply has no effect on the interest rate, the economy is said to be in a liquidity trap.