econ 3

Classical View

1. Natural phases in an otherwise healthy economy 2. Temporary in duration 3. "Leave the economy alone (Laissez Faire)" and wait for recovery to occur naturally

Keynesian View

1. Signs of "inherently unstable" nature of the economy, particularly the private sector 2. Can be prolonged 3. Use government intervention to stimulate ("shock") the economy when necessary

Price level:

A general or average measure of the prices of all goods and services in the economy. It is usually measured using a price index.

Inflation:

A sustained increase in the price level

Inflation rate:

Percentage change in the price level. In particular, Inflation rate = [(CPIcp - CPIpp) / CPIpp] x 100 where, CPI = Consumer Price Index, cp = current period, and pp = prior period. Suppose, CPI2002 = 125 and CPI2000 = 115. Then, inflation rate between 2000 and 2002 = [(125 - 115)/115] x 100 = 8.7%

Automatic stabilizers

Revenue and spending items in the federal budget that change automatically with swings in the economy. Revenue decreases or spending increases during recessions while revenue increases or spending decreases during inflationary periods.

Classical vs. Keynesian view of fiscal policy

• Classical view: There is no need for government intervention in terms of fiscal policy. • Keynesian view: Government intervention may be needed by applying appropriate fiscal policy.

Expected vs. actual inflation

• Expected inflation: Inflation that is expected to occur in the future. • Actual inflation: Inflation that has already occurred or is currently occurring. • There is a time lag involved in the determination of actual inflation. The actual inflation that is currently occurring is not known until it is measured sometime in the future. Thus, actual inflation ends up being a measure of past inflation and current decisions need to incorporate expected inflation, which is forward looking, along with the knowledge of actual inflation, which is backward looking.

Stagflation:

Simultaneous occurrence of contraction or stagnation in the economy's aggregate output and inflation - - is an economic phenomenon marked by slow economic growth and rising prices. In the 1970s, the phenomenon hit hard, as rising inflation and slumping employment put a damper on economic growth. As a result, for investors in equity markets, "stagflation" can be a hard word to hear.

What is a fiscal policy?

Fiscal policy refers to the use of government purchases, transfer payments, taxes, and borrowing to change macroeconomic outcomes.

What does fiscal policy attempt to achieve?

- Fiscal policy attempts to increase national output (GDP), employment, and income during recessions because the corresponding increase in the price level is not a concern. - Fiscal policy attempts to decrease the price level during inflationary periods because the corresponding decrease in GDP, employment, and income is not a concern.

Fiscal policy tools

- Increase government purchases, transfer payments, and borrowing, and/or decrease taxes during recessions. - Decrease government purchases, transfer payments, and borrowing, and/or increase taxes during inflationary periods.

CPI ( Consumer price index)

A measure of the overall cost of the goods and services bought by a typical consumer.

Demand pull vs. cost-push inflation

AD is the real total quantity of all goods and services demanded in the economy in a given time period. • AS is the real total quantity of all goods and services supplied in the economy in a given time period. • Demand-pull inflation: A rising AD (outward shifting AD curve) pulls up the price level while reducing unemployment. • Cost-push inflation: A decreasing AS (inward shifting AS curve) pushes up the price level while reducing aggregate output.

Demand-side economics:

Economic approach that focuses on how changes in aggregate demand would promote full employment.

Supply-side economics:

Economic approach that focuses on how lowering federal taxes would increase after-tax earnings, increase the supply of resources, and expand aggregate supply.

Aggregate Expenditure

In economics, Aggregate Expenditure is a measure of national income. Aggregate Expenditure is defined as the current value of all the finished goods and services in the economy. The aggregate expenditure is thus the sum total of all the expenditures undertaken in the economy by the factors during a given time period.

Why is Keynesian approach ineffective in combating Stagflation?

Keynesian approach, which focuses on aggregate demand, is ineffective in combating stagflation because stagflation is caused by a decrease in aggregate supply

What are the phases of a business cycle?

• A business cycle has four phases: Expansion, peak, contraction, and trough. • In the U.S., expansions have generally lasted longer than contractions since 1933

The impacts of changes in autonomous net taxes on real GDP

• A change in net taxes would change disposable income, a change in disposable income would change consumption (C), and a change in consumption would change real GDP. Thus, changes in net taxes impact GDP indirectly through consumption. • Changes in NT and C are inversely related. Thus, an increase in NT decreases C and vice versa. • Change in real GDP = TM x Change in NT • Change in NT necessary to cause a desired change in real GDP = Desired change in real GDP / TM • Suppose, MPC = 0.90 and NT decreases by $200. Increase in real GDP = TM x Δ in NT = -MPC / (1 - MPC) x (-200) = -0.90 / (1 - 0.90) x (-200) = (-9) x (-200) = $1,800. This means that a $200 decrease in NT can increase real GDP by $1,800, if MPC = 0.90. On the other hand a $200 increase in NT can decrease real GDP by $1,800, if MPC = 0.90. • Suppose, MPC = 0.90 and desired increase in real GDP = $5,000. Change in NT necessary = Desired Δ in real GDP / TM = Desired Δ in real GDP / [-MPC / (1 - MPC)] = 5,000 / [-0.90 / (1 - 0.90)] = 5,000 / (-9) = -$556. This means that a $556 decrease in NT would be needed to increase real GDP by $5,000, if MPC = 0.90. On the other hand, a $556 increase in NT would be needed to decrease real GDP by $5,000, if MPC = 0.90.

Difference between anticipated and unanticipated inflation; which one is more detrimental?

• Anticipated inflation: Widely expected by decision makers. • Unanticipated inflation: Comes as a surprise to most decision makers. • Unanticipated inflation is more detrimental because decision makers are not prepared for it. Some decision makers end up being winners (e.g., debtors) whereas others end up being losers (e.g., creditors) as a result of unanticipated inflation.

Fiscal policy and government budgets

• Budget deficit means revenue is less than expenditures. • Budget surplus means revenue is greater than expenditures. • Balanced budget means revenue is equal to expenditures. • Expansionary fiscal policy may cause budget deficit or reduce existing budget surplus. • Contractionary fiscal policy may cause budget surplus or reduce existing budget deficit

What is the major difference between CPI and GDP Deflator?

• CPI measures changes over time in the cost of buying a "market basket" of goods and services. • GDP deflator measures changes over time in the level of prices of all output included in GDP. • CPI is based on a market basket (sample) of consumer goods and services in the U.S., including imports, whereas GDPPI is based on all domestically produced goods and services. • GDPPI (gross domestic product price index) is a more comprehensive measure of the price level than CPI. • CPI is more commonly used to calculate inflation rate than GDPPI.

What are the causes of inflation?

• Causes of inflation: Increase in aggregate demand (AD), decrease in aggregate supply (AS), or a combination. • Demand-pull inflation: A rising AD (outward shifting AD curve) pulls up the price level while reducing unemployment. • Cost-push inflation: A decreasing AS (inward shifting AS curve) pushes up the price level while reducing aggregate output.

Classical vs. Keynesian approach to closing a contractionary or an expansionary gap

• Classical approach: Leave the economy alone (Laissez faire) because it will self-correct to take care of economic fluctuations through adjustments in wages, prices, and interest rates, which are assumed to be flexible. • Keynesian approach: Use external shocks to the economy as needed because it may not self correct given that (a) wages and prices are relatively inflexible and interest rates would not fall fast enough to restore full employment, and (b) business expectations may at times become so grim that even very low interest rates would not induce firms to invest enough to move the economy to full employment.

Discretionary fiscal policy: -Definition and examples

• Definition: Deliberate changes in government purchases, transfer payments, and taxes to promote macroeconomic goals. • Examples: Increased spending on highway projects, increased farm subsidies, temporary extension of unemployment benefits, and tax rebates or temporary reductions in personal income taxes during recessions; the opposite during inflationary periods.

Fiscal policy tools to close contractionary or expansionary gaps

• Fiscal policy tools to close contractionary gaps involve boosting AE by increasing government spending (G), decreasing net taxes (NT), or a combination of the two. Such fiscal policy is called expansionary fiscal policy. • Fiscal policy tools to close expansionary gaps involve reducing AE by decreasing government spending (G), increasing net taxes (NT), or a combination of the two. Such fiscal policy is called contractionary fiscal policy. • Because of the effect of spending multiplier (SM) or simple tax multiplier (TM), the amount of change in AE or its component required is less than the corresponding contractionary or expansionary gap

Relative strengths of the impacts of changes in AE or NT on real GDP

• For the same MPC, SM is larger than TM because the effects of changes in AE or its components on real GDP are direct whereas the effects of changes in NT are indirect (Refer to the two preceding topics). • Thus, to change real GDP by $5,000, a $500 change would be needed in AE or its component vs. a $556 change needed in NT, if MPC = 0.90.

Why is inflation so unpopular?

• Inflation is unpopular because it: ➢ affects practically everyone, ➢ is viewed as a penalty that unjustly robs people of purchasing power, ➢ arbitrarily redistributes income and wealth from one group to another, ➢ cannot be anticipated with complete accuracy and reduces the ability to make long-term plans, and ➢ forces decision makers to pay more attention to prices than to productive activities.

Relationship between inflation and purchasing power

• Inflation reduces the purchasing power of a given amount of nominal or current income because it takes more dollars to buy the same good than before. The reduction in purchasing power is also referred to as a reduction in real income. • Deflation, which is a sustained decrease in the price level, increases real income and the purchasing power. • An increase in nominal income may not necessarily result in an increase in real income depending on the rate of inflation. Suppose, one's nominal income increased by 4% during a period while inflation ran about 5%. The person's real income decreased by 1% during the period despite a 4% increase in nominal income. On the other hand, the person's real income would have increased by 1% if inflation rate were 3%.

What do economic indicators show?

• Leading economic indicators signal forthcoming changes in the economy. They move ahead (usually by six months) the overall economic cycle. Examples include consumer confidence, stock market prices, business investment, and orders for durable goods. • Lagging economic indicators signal past changes in the economy. They trail behind the overall economic cycle. Examples include the average length of unemployment, labor cost per unit of manufacturing output, the average prime rate, the consumer price index, and commercial lending activity. • Coincident economic indicators signal current changes in the economy. They move with the overall economic cycle. Examples include the unemployment rate, personal income levels, and industrial production.

How does inflation affect lending, borrowing, contracts, and overall economic activities?

• Lenders charging fixed interest rates lose because they receive repayments with reduced purchasing power. • Borrowers paying fixed interest rates gain because they make payments that have reduced purchasing power. • Contractors without inflation clause lose because they face rising costs of goods or services they are obligated to deliver. • Overall economic activity is dampened because economic participants spend more time on fighting inflation than on expanding economic activities. • When inflation fluctuates widely, economic efficiency is reduced because of uncertainty about changes in relative prices.

How does nominal interest rate account for expected inflation?

• Nominal interest rate (i) = Real interest rate (r) + Inflation rate (ρ). Because decision makers want to maintain the real interest rate at a desired level, inflation rate is added to the desired real interest rate as a premium when calculating the nominal interest rate. • The higher the expected inflation rate, the higher the nominal interest rate. The interest rates quoted or posted by financial institutions are nominal rates. • Real interest rate, r = i - ρ. Because the interest received at a point in time is nominal interest, inflation rate is subtracted from the nominal interest rate to calculate the real interest rate. • Real interest rate is known after the fact; that is, after inflation has occurred. • Suppose, decision makers want to maintain a real interest rate of 3% and expect inflation rate to be 2% in the coming year. They will want a nominal interest = 3% + 2% = 5% to invest their money for the year. • If the actual inflation rate differs from the expected inflation rate at the end of the period, investors will end up better or worse off than expected. In the above example, suppose the actual inflation rate turned out to be 3% instead of 2% as expected. Then, real interest rate = 5% - 3% = 2% instead of the desired rate of 3%. Thus, investors will be 1% worse off in terms of the real interest rate earned. On the other hand, if the actual inflation rate ended up at 1%, real interest rate = 5% - 1% = 4%, leaving investors 1% better off in terms of the real interest rate earned.

Nominal interest rate vs. real interest rate

• Nominal interest rate= real interest rate + inflation rate. Interest rate that incorporates expected inflation in order to maintain the purchasing power of interest received. • Real interest rate= Nominal interest rate - inflation rate. Interest rate that reflects the purchasing power of interest received.

Automatic stabilizers: Definition, examples, and the intended impacts on the business cycle

• Once adopted, automatic stabilizers are built into the structure of the economy. • Examples: Unemployment insurance, progressive income tax, and transfer payments. • Intended impacts: Stabilize the economy by making both upswings and downswings smaller than what they would be.

What do economic fluctuations reflect?

• Periodic swings in the level of aggregate economic activity relative to the economy's long-term growth trend. • Each cycle of downswing and upswing, along with the bottom and the peak, is called a business cycle

What is a recession? How does it differ from a depression?

• Recession: Decline in national output, employment, and income usually lasting at least two consecutive quarters. • Depression: Sharp decrease in national output accompanied by high unemployment lasting more than a year. • Depression is a severe and prolonged form of recession.

Spending multiplier and the impacts of changes in AE or its components on real GDP

• SM is the amount by which a change in government spending would multiply in terms of a change in real GDP, other things constant. • SM = 1 / (1 - MPC). Alternatively, SM = 1 / MPS. • Change in real GDP = SM x Change in AE or its component such as government spending (G). • Change in AE or its component necessary to cause a desired change in real GDP = Desired change in real GDP / SM.

Simple tax multiplier (TM)

• Simple tax multiplier (TM) is the amount by which a change in net taxes (NT) would multiply in terms of a change in real GDP, other things constant. • TM = -MPC / (1 - MPC)

General flow of the effects of changes in AE vs. NT on real GDP

• Suppose, G increases by $1. ➢ G ↑ $1 => AE ↑ $1 => GDP ↑ $10, if MPC = 0.9, because Δ in GDP = SM x Δ in AE. The opposite is true if G decreases by $1. • Suppose, NT decreases by $1. ➢ NT ↓ $1 => Y ↑ $1 => C ↑ $0.9 => AE ↑ $0.9 => GDP ↑ $9, if MPC = 0.9, because Δ in GDP = SM x Δ in AE or its component. Alternatively, Δ in GDP = TM x Δ in NT = (-9) x (-1) = $9. The opposite is true if NT increases by $1.

Interpreting the values of CPI and GDP Deflator

• The values of both CPI and GDP deflator for a given year are interpreted relative to the value of 100 set for the base year. • The value of CPI equal to 150 in a given year means that the price level increased by 50% between the base year and the current year. • The values of CPI equal to 250 in one year and 300 in the next year mean that the annual rate of inflation as measured by the CPI is approximately 20%. • The value of CPI equal to 100 in a given year means that the price level in this year is the same as it was in the base year. • A specific value of GDP deflator in a given year is interpreted similarly.

Factors that can adversely impact the implementation of fiscal policy or its desired outcome: Time lag, temporary nature of effects, budget deficits

• Time lags in approval and implementation weaken fiscal policy as a tool of economic stabilization. • Temporary fiscal policy, e.g., a temporary tax cut, would not be effective in stimulating aggregate demand if people based their decisions on policies that would generate permanent benefits, e.g., permanent income. • Large federal budget deficits make it difficult to use discretionary fiscal policy.