Macro Econ

Inequality

Per capita GDP provides a measure of the living standards of the "average" citizen in a country - Averages are useful, but often hide other relevant information related to the entire distribution - Two countries with identical per capita GDP can have income distributions that are very different. One way economists measure inequality is using the "Gini index" or "Gini coefficient" - Details on calculation are not important - 0 = perfect equality - 1 (or 100) = perfect inequality - Higher numbers imply greater inequality ¨

Growth Rates of M1 and M2

Since M2 includes M1, you might expect them to be highly correlated. That is not always true Notice that growth rate increase in recessions: that is monetary policy at work. The Fed is engaging in policy intended to increase these growth rates and get spending (AD) growing again. Again, stay tuned Sometimes, the growth rate of M1 and M2 increase in tandem, sometimes they move in opposite directions Note what is going on with the money supply. The Fed does not have complete control, but when they want it to go up or down, they can certainly do that. Just not precisely The monetary authority doesn't directly control the money supply? That is correct. The way the money supply evolved also depends on the behavior of banks, household and firms, as we will see.

Slack versus Overheating

Slack means that there are underutilized resources, such as labor and capital (unemployment, excess capacity, etc.) Overheating means that aggregate demand exceeds the productive capacity of the economy (aggregate supply).

Total reserves in the banking system are required reserves plus excess reserves.

TR = RR + ER

U.S. NAIRU

The NAIRU is the "full employment" unemployment rate. According to theory, if the unemployment rate falls below the NAIRU, then inflation will accelerate. Non-Accelerating Inflation Rate of Unemployment ("Natural Rate of Unemployment") The NAIRU is a measure of the "natural" rates of structural and frictional unemployment at any time. The NAIRU is estimated from models (CBO models of the U.S. economy, in this case). It does not reflect the results of the household or establishment surveys conducted by the BLS. •The "unemployment gap" is the difference between the actual unemployment rate and the NAIRU (u*). It is also referred to as "cyclical unemployment". •When the actual unemployment rate exceeds the NAIRU, the unemployment gap is positive (cyclical unemployment is positive). •When actual unemployment is less than the NAIRU, the unemployment gap is negative (cyclical unemployment is negative is another way of saying the same thing).

The Bank Lending Channel

The channel of the monetary policy transmission mechanism in which changes in policy affect aggregate expenditure through their impact on banks' willingness to make loans. Open market operations increase reserves in the banking system and banks want to lend them, regardless of whether the interest rate actually changed. If you give banks reserves, they don't want to hold, they will make loans and spending will increase, just not by as much as if interest rates fell as well.

Beveridge Curve

The curve shifts out when there is a change in the types of job (coal jobs changing) •The Beveridge Curve is also referred to as the U/V curve, where V is the rate of "job vacancies," which is another way of saying "job openings rate." "Search Models" of unemployment rely on the Beveridge Curve to demonstrate the implications of their theories •The curve shifts out when job search is less effective and when "mismatch" is more of a problem. •Mismatch describes a situation when job seekers are not qualified for current job openings.

The Monetary Transmission Mechanism

The process by which changes in the money supply influence the amount that households and firms wish to spend on goods and services. We know how the money supply increases and decreases (decreases would be engineered by an open market sale that reduces reserves in the banking system instead of injecting more reserves, but since the money supply normally expands with the growing economy, these are less frequent) and we know that the effectiveness of the influence in M1 is given by the magnitude of the money multiplier. Monetary Transmission Mechanisms are the "channels" of monetary policy whereby changes in the money supply then influence spending, or AD.

The Term Structure of Interest Rates

The relationship between bond yields and maturities Short term equilibrium is shorter than long term (upward sloping yield curve) Short term and long term yields are positive correlated Increase in demand (demand curve shifts up for both ST and LT) leads to yield curve rising upwards; ST increases correlated w/ LT increases (generate upward shifting yield curve)

Money Multiplier Overtime

The slide shows the M1 money multiplier back to 2000. Note the dramatic decrease as a result of Quantitative Easing. This was entirely anticipated and is part of the rational for QE policies, as we will discuss later. It is a reflection of the fact that banks are holding vast quantities of excess reserves, unlike the old days when they held almost none.

True/False: Some values must be imputed

There is no "market price" for many of the components of GDP, so imputations are used Examples: police services, public education services, financial services, food and fuel consumed on family farms, and many others.

Calculating GDP

Three Measurement Approaches Expenditure Approach - Sum spending on all "final" goods and services nFinal goods and services are not used to produce other good or service (note: avoiding double counting) Value Added Approach -Sum the "value added" at each production stage nValue added is revenue less costs of material inputs Income Approach -Sum the "returns" to all productive factors nReturns are the wages and salaries to labor and interest, dividends, rents and royalties paid to investors (note: with some adjustments for depreciation and taxation)

Takeaways

To measure the size of the economy, as well as its growth rate, GDP is the preferred measure GDP can be calculated in three ways, but the most common and useful way is the expenditure method To compare GDP in different years, we remove the effects of inflation by calculating real GDP To compare GDP across countries, we use real GDP per capita or GDP per capita in PPP terms There are many issues with the use of GDP as a measure of living standards ¤What is being measured? ¤How it is being measured? ¤Is this truly a reflection of living standards?

The "Missing Inflation Puzzle"

U < U*, but inflation not increasing

per capita GDP

When comparing living standards across countries, aggregate measures such as real GDP are not sufficient - If two countries have the same real GDP but different populations, the citizens of the country with a smaller population are clearly better off - Total pie of the same size is distributed to fewer people, so each gets a larger share of the pie ¨Per Capita GDP is a measure of living standards for the average citizen of a country. - Real GDP per capita = Real GDP/population

M1 = Cu + D

When the Fed wishes to increase or decrease the money supply, its intermediate goal is to influence M1 and M2. When the Fed conducts monetary policy, it changes reserves in the banking system (the Monetary Base) and then the actions of the public and the banking system determine the impact on M1 and M2.

Recession

a period of temporary economic decline during which trade and industrial activity are reduced, generally identified by a fall in Real GDP in two successive quarters.

Disinflation

a reduction in the rate of inflation

Fisher's Equation

i real = i nominal - inflation I = R + Pi (Expected) : Fisher Equation - Takeaway: Part of the nominal interest rate is compensation for inflation - The higher the expected inflation, the higher nominal interest rates - This is a simplification - When inflation is low and interest rates are low, this model is more accurate - Expected inflation and nominal interest goes up by the same amount (r is a constant) - 1 for 1 correlation - This is not accurate in real life, but there is still a strong positive correlation between inflation and nominal interest rates

The TED Spread

• The TED Spread is the difference between 3-Month LIBOR (unsecured private, interbank debt market) and 3-month T-bills (safe, government yield). Risky - Safe • The Baa-Treasury spread is the difference between the Moody's Seasoned Baa Corporate Bond Yield and the 10-year Treasury Rate.

Using the CPI

•Let's say that your first job out of college paid $35,000 in 2012, and you want to know the equivalent value in today's dollars. •The CPI-U in May 2012 = 228.713 •The CPI-U in May 2020 = 255.768 •Then the equivalent wage today would be 35k (255.768/228.713) = 39.14 k

Real versus Nominal Interest Rates

•Nominal interest rate: rate at which the nominal value of an interest-bearing asset increases over time •Notation: nominal interest rate = i •Real interest rate: rate at which the real value of an asset increases over time •Takes into account the effects of inflation on the value of an asset and that asset's return. •Two versions: •Ex ante (expected) real interest rate: re = i - πe •Ex post real (realized) real interest rate: r = i - π •The actual real interest rate is the ex ante real interest rate (which is not discussed in your textbook). •When we make our savings decisions, we know the nominal interest rate, typically, but not the inflation rate that will prevail during the future horizon. •We must form an expectation, or forecast of the inflation rate, referred to as expected inflation.

Fed Discount Window

the facility where banks are able to borrow reserves directly from the Fed ("Discount Loans") on an overnight basis. • The Discount Rate is the rate on loans to banks from the Fed This is not a market-determined rate. It is just set by the Fed and then any bank can borrow from them at that rate if they are low on reserves. Since the rate is always set to be higher than the Fed Funds target range, no banks typically borrow from the Fed - they can borrow at a lower rate from other banks. Only banks that are "in trouble" and can't get a loan in the fed funds market would use the discount rate in normal times. And that is a bad signal to give. But ... the discount rate then provides an upper bound on the fed funds rate. If the fed funds rate ever increased to where it was above the discount rate, then banks that need to borrow would choose to borrow from the Fed.

Underemployed person

• A person that has insufficient paid work or a job that does not make full use of skills • Working part time, but want full time • Can't find a job that fits qualifications, and must work at job that is inadequate with respect to training • Just because the unemployment rate is low doesn't mean that there can't be significant distress in labor markets. Measuring Underemployment •The BLS actually publishes 6 different measures of "labor underutilization." •Our official definition of unemployment is called U-3. •Many people use U-6 as a measure of "underemployment"

Short term yields are more variable than long term yields

• As the yield curve shifts, the short end shifts more than the long end, and the yield curve could even invert. As it shifts up, it tends to flat, but it can even invert. Below is a picture showing an inverting yield curved. (Potential indicator for a recession). When demand increases for credit, and short end increases more than long end.

The Loanable Funds Model

• Concerned with the lending of credit (SUPPLY AND DEMAND FOR CREDIT) • i* is the equilibrium nominal interest rate • Nominal or Real Interest Rate can be put in the vertical axis

The "Taper Tantrum"

• Fed Reserve Chairman, Ben Bernanke, said that the Fed may soon start slowing the growth ("tapering") of the Fed balance sheet before the end of that year, so long as the economy strengthened as expected. (Balance Sheet growth is going to slow down. We won't buy as much as we used to. People freaked out, and interest rates spiked over night). Quantitative Easing was keeping markets going, and people felt the market needed this • Attempt to pre-emptively stabilize the market by preparing it for the policy change • What ensued was exactly the opposite • Resulting sell-off in Treasuries resulted in the market value of Treasuries falling by about 10 percent in the next few weeks, ranking it among the 15 worst Treasury sell-offs in 50 years of market history. •The prospect of another version of a taper tantrum is a topic of serious commentary and analysis currently, as the Fed implement its normalization plans that will reduce the size of the Fed balance sheet • Other central banks have announced or signaled similar plans in the not-too-distant future. • Soon for Bank of Canada and Bank of England. • ECB should follow within months • So far, any spikes in bond yields have been attributed to political uncertainty, not worries over central banks • Although longer-term bond yields have risen in recent weeks, the trend for the year has been down, not up.

- Nominal variables: measured in "current dollars" - Real variables: measured in "constant dollars" (which means "using base year prices")

- For nominal variables measured in "levels," divide by appropriate measure of the price level to convert to real terms. - For variables measures as rates, such as interest rates and growth rates of nominal variables, subtracting the inflation rate from this nominal growth rate gives a close approximation to the real rate. Nominal: We are valuing all production at market prices. -Calculating nominal GDP is analogous to calculation total revenue, but the price will be an economy-wide price level and the quantity will be some measure of all the final goods and services produced. •Real variables are intended to measure quantities, but often, that is impossible, so we "net out" the effects of prices to get a measure that effectively measures those quantities.

Imports/Exports

- Imported/exported intermediate goods are included in the calculation, so that only the value-added in the U.S. counts toward GDP - This necessary complication ensures that we keep track of imports/exports correctly. - Just counting final goods would obviously undercount imports (e.g., steel is an imported intermediate good, and the imported steel content in a U.S. made car would not count as an import if we only counted imports of final goods). - The final value of the car contributes to GDP. So the total value to GDP is the value of the car less the value of the imported inputs.

Real GDP

- Real GDP measures the actual output of the economy, free from the influence of prices -This is more complex than it sounds, since it is not possible to add up the quantity of different goods and services. We only have monetary values to work with -Instead of an individual price for a good or services, we have a measure of the price level for the economy. -Note that there is more than one measure of the price level, which we will discuss when we cover inflation -Here, our measure of the price level is will be an average price for all the goods and services that satisfy the definition of GDP -This measure of the price level is referred to as the GDP Deflator.

Problems with CPI

- Substitution bias: When the price of an item in the basket increases, consumers may purchase items not in the basket, or in greater weights than specified in the basket - Unmeasured technical change: Some goods and services are more effective or efficient than previous generations. So the "cost of living" may not have increased as much as the prices of these goods and services. - Introduction of new goods: Changing consumption patterns are only reflected with a lag, since the basket is only updated periodically.

GDP deflator

- The GDP deflator for any year is found by dividing nominal GDP by real GDP for that year. •The GDP deflator is our first measure of the price level •There is more than one way to measure the "price level" - The GDP deflator also has a "base year" that must be reported. - The GDP deflator is an an example of an "index number." It has no direct interpretation and merely tells us how much lower or higher prices are in any year compared to the base year. •The GDP deflator reflects average prices for all final goods and services that satisfy the definition of GDP (which is based on the expenditure approach to calculating nominal GDP) - Normally, index numbers are based on a scale of 100.0, so to calculate the GDP deflator, divide nominal GDP by real GDP and multiply by 100.0. - E.g., for 2013, the GDP deflator is P = (39,150/38,000) x 100.0 = 103.0 - This tells us that prices in 2013 were 3.0% higher than they were in the base year, 2012.

Goals of Quantitative Easing

1. Encourage bank lending and safety by providing excess liquidity 2. Reduce long-term nominal interest rates •In recent years, positive correlation between short term and long-term rates had broken down (Greenspan's "bond market conundrum") •QE allowed Fed to manipulate long term rates directly •Normal open market operations in involve T-bills •QE involved longer-term government bonds and other securities 3.Increase inflationary expectations (reduce long term real interest rates) •Even though the Fed was successful in reducing long-term nominal rates, real rates stayed stubbornly high due to low inflationary expectations •QE increased inflationary expectations and reduced long-term, real interest rate •According to the Quantity Theory of Money, increases in the growth rate of the money supply are inflationary, and historically, there is a positive correlation. •In recent decades, this correlation has fallen fairly dramatically, but it is still positive. •The public still associates increases in the money supply with inflation.

There are three major criticisms of the GDP measure:

1. Omits non-market goods and services - E.g., work of stay-at-home mothers and fathers not included in GDP 2. No accounting for "bads" such as crime and pollution - E.g., crime is a detriment to society, but there is no subtraction from GDP to account for it - International organizations have recommended calculations of GDP that include measures of environmental degradation, resource use, and sustainability. Some countries have adopted these. 3. No correction for quality improvements - E.g., technological improvements are beneficial to the economy, but nothing is added to GDP to account for them Despite these drawbacks, GDP is still considered the best economic indicators for measuring the size of the economy. Gross Private Domestic Investment excludes deductions for depreciation. While reductions owing to disasters such as hurricanes and floods are recorded, no attempt is made to account for "the value of wear and tear, obsolescence, accidental damage, and aging." ITS NOT A "NET" MEASURE

Two types of unemployment

1.Structural Unemployment •Unemployment caused by structural factors •Changing industry composition of the economy (i.e., coal jobs disappearing as tech jobs increase) •Societal norms and values, regulations, minimum wage laws, etc. 2. Frictional Unemployment •Unemployment due to the time it takes to "match" employers with job seekers •Due to frictional unemployment, the economy will never experience a zero-percent unemployment rate. •There are always some people looking for jobs, even in a hot economy.

The Taylor Rule

A rule developed by John Taylor that links the Fed's target for the federal funds rate to economic variables •In 1993, John Taylor proposed the following "rule" describing how the Fed may set the Federal Funds rate. Taylor Rule says that the Fed should increase the Fed Funds target when inflation is above normal or when output is above potential, and quantifies the increase. .5 weights on the inflation and output gaps are arbitrary Initially, Taylor intended this as a description of Fed behavior, but over time, he and other advocates began to advocate for its use to set policy, and began criticizing the Fed for allowing deviations from the rule

Open Market Operations involve Fed purchases and sales of Treasury securities from the banking system. • These operations occur with a defined set of bank counter-parties referred to as the Fed's primary dealers

An open market purchase is a purchase of Treasuries by the Fed. The Fed pays for the Treasuries by crediting the reserve accounts of the banks that sold them. Ex: Monetary base has risen by $10,000 •Reserves have increased by $10,000 •No change in currency held by public The primary dealer sold $10,000 of Treasuries and replaced them with $10,000 of reserves. • Everything balances, as is necessary So, the primary dealer, a bank, finds itself with 10,000 in reserves. These reserves are all excess reserves since the bank was assume to already holding the required amount. Since this is not a customer deposit, they don't have to hold any of the $10,000 on reserve. They are free to lend the whole thing. And because traditionally, reserves earned no interest, there was a strong incentive to lend them out. So that's what the primary dealer would do: make a loan or a series of loans totaling $10,000. This loan goes to a household or firm in the private sector, which starts off the process referred to as the deposit expansion process. An open market sale is a sale of Treasuries by the Fed. The bank's pay for the Treasuries when the Fed debits their reserve accounts.

Money Supply and Demand

As the interest rate increases: The opportunity cost of holding money increases... The relative expected return of money decreases... ...and therefore the quantity demanded of money decreases. •Assume that the supply of money is controlled by the central bank •An increase in the money supply engineered by the Federal Reserve will shift the supply curve for money to the right • The money supply curve is assumed to be vertical wherever the Fed "sets the money supply," which can be measured as either M1 or M2. We have already learned that the Fed does not control this perfectly, and this diagram is drawn assuming it can. That's just another simplification. Allowing for more complexity does not aid the overall lesson

Wage Inflation

As we will discuss when we investigate the Phillips Curve in, historically, there has been a negative correlation between the unemployment rate and the rate of inflation. •This relationship was tightest with respect to wage inflation. •However, in recent years, the unemployment rate has been very low by historical standards, and has continued to decline. (Yet wages have not increased much at all until recently, and there is no sign this will continue) •We will return to this question when we turn to labor markets as our next topic. •Generally, nominal wages have only barely kept up with inflation in the long term, so real wages have not increased much at all in recent decades, despite continued increases in labor productivity. As unemployment rate gets too low, wage inflation starts

How has the U.S. economy grown?

But the answer requires some caveats: - How do we deal with changes in prices over time? - Converting "nominal" to "real" GDP - Accounts for GDP changes due to inflation or deflation - How do we deal with changes in population? - Divide GDP by population to compute a "GDP per capita" - As population (and the labor force) grow, GDP will naturally increase, so how is the portion attributable to each citizen affected? - This is a measure of the average living standard of the population

• Calculate nominal GDP for all three years (base year 2012) • Calculate real GDP for all three years • Calculate the GDP deflator for all three years • Calculate the inflation rate for 2013 and 2014

Calculating Nominal GDP - Multiply price by quantity for each product and sum. - E.g., for 2013, nominal GDP is (105)(150) + (42)(200) + (200)(75) = $39,150 Calculating Real GDP - Multiply quantity for each year by price in the base year. - E.g., our base year in the example is 2012. Real GDP in 2013 is then 2012 prices times 2013 quantities (100)(150) + (40)(200) + (200)(75) = $38,000 - Note that in the base year, nominal GDP and real GDP must be equal.

Changes in Inventories

Changes in Inventories Changes in inventories are either positive or negative, and are one component of investment expenditure, I. If a good or service is produced in one quarter, but not sold until the next, then in the quarter it was produced, it is "sold into inventory" (an increase in I). When it is sold to a customer the next quarter, it is "sold out of inventory" (a corresponding decrease in I). In this way, the value of the good is recorded in the quarter it was actually produced: - Produced and sold into inventory in Q1: ΔI > 0 - Sold out of inventory to a household in Q2: ΔI < 0, ΔC > 0 and ΔI + ΔC = 0. - GDP increases in Q1, and there is no effect on GDP in Q2

Causes of Inflation

Cost-Push Inflation •Firms increasing prices because the cost of inputs (materials, labor, etc.) is increasing. •Wages, oil prices, prices of imported inputs (due to tariffs, for example), etc. Demand-Pull Inflation •Inflation caused my increase in aggregate demand. •Think of what you learned in microeconomics: if demand increases while supply stays fixed, then the price of the good or service must increase. •Here, that principle is being applied on aggregate, not just for single goods or services •Economists believe that this is the primary driver of inflation, and therefore, policies are intended to influence aggregate demand, or spending.

discount loans

Discount Loans are loans from the Fed to banks Historically, banks can borrow directly from the Fed, which fulfills the most important role that central banks play in the economy, that of lender of last resort to the banking system discount lending has essentially been zero, which is why the font is "shadowed out." New policies have removed the need for banks to borrow from the Fed. That is, until a pandemic hit the economy. Now, the discount window is open and flourishing

Modeling the Federal Funds Market

Discount rate is an upper bound on the fed funds rate. No bank would borrow from another bank at a rate higher than this. Interest on reserves is a lower bound or "floor" on the fed funds rate. No bank would lend to another at a rate below IOER when they can just hold reserves and earn IOER. As with overall money demand, the opportunity cost of holding reserves is the interest that could be earned by lending them out. This implies that Reserve Demand has a negative slope. Before interest rates, lower bound was 0

Fed Response to Financial Crisis

Due to the massive increase bank reserves generated by QE, M1 continued to increase despite the collapse of the M1 money multiplier, preventing further contraction of the economy or even a full-blown collapse. This is exactly what the Fed did NOT do during the Great Depression, the length of which is often blamed on the Fed. Now, reserve injections from QE have resulted in a spike in M1. This is expansionary, so the Fed is attempting to keep the economy from collapsing and then stimulating AD once that danger has passed.

Term Structure Of Interest Rates

Essentially, term structure of interest rates is the relationship between interest rates or bond yields and different terms or maturities. When graphed, the term structure of interest rates is known as a yield curve, and it plays a crucial role in identifying the current state of an economy. The term structure of interest rates reflects expectations of market participants about future changes in interest rates and their assessment of monetary policy conditions. Upward sloping—long term yields are higher than short term yields. This is considered to be the "normal" slope of the yield curve and signals that the economy is in an expansionary mode. Downward sloping—short term yields are higher than long term yields. Dubbed as an "inverted" yield curve and signifies that the economy is in, or about to enter, a recessive period. Flat—very little variation between short and long term yields. Signals that the market is unsure about the future direction of the economy.

U.S. Money Supply Growth Rates

Fed has waived reserve requirements to encourage banks to make loans

Federal Open Market Committee (FOMC)

Federal Reserve committee that makes key decisions about interest rates and the growth of the United States money supply. Most important policy group at the fed Approximately every seven weeks, the FOMC meets and sets the target for the fed funds rate, then conducts daily open market operations, influencing the supply of reserves in the banking system so as to hit the target rate. Following very FOMC meeting for several years, the Fed has released forecasts of key economic variables into the future. Once of these is the fed funds rate, which is issued using the now infamous "dot plot,"

Federal funds rate

Federal funds rate is the target interest rate set by the Federal Open Market Committee (FOMC) at which commercial banks borrow and lend their excess reserves to each other overnight. Credibility is very important for the fed

Holding large quantities of excess reserves has two implications for banks:

First, reserves are now being used to facilitate minimum solvency requirements. These are essentially "capital controls"that ensure the solvency of the banking system and they were made more stringent following the financial crisis. holding reserves also has costs for banks. They are being forced to hold these capital buffers by banking regulators, and they don't want to add to those reserves.

What causes business cycles. That is, what is the cause of expansions and recessions?

Fluctuations of AD (total spending in the economy)

4 Measures to Account for Inflation

Four important price indexes 1. GDP deflator •Measure of the change in prices of all final goods and services 2. Consumer price index (CPI) •Measure of the change in the cost of a "basket" of goods purchased by typical U.S. household •A weighted average of consumer prices where the weights reflect consumer purchasing patterns 3. Personal consumption expenditure (PCE) price index •Alternative measure of the change in the cost of living for households. Includes everything in Personal Consumption Expenditures from the national accounts •"Core" version of PCE index excludes food and energy. (which are highly volatile) •The inflation rate calculated using the Core PCE index is targeted by the Fed in the conduct of monetary policy. (PCE better than CPI according to Fed) •The PCE Index is similar to the GDP Deflator, but only includes consumption goods and services, (the "C" component of the expenditure approach to GDP) •Instead of being based on a "basket" of goods that are determined to be the items and amounts consumed by typical households, the PCE index is constructed using all final consumption goods and services •Then, the "core" version of the PCE index removes volatile food and energy prices •From the Fed's perspective, the PCE price index is superior to the CPI because it avoids substitution bias and is revised when better data are available 4. Producer Price Index (PPI) •Measures the change in the cost of a "basket" of goods and services purchased by typical U.S. firms. (Captures the cost of production for a typical firm) •Basket includes raw materials and semi-finished goods. •Viewed as a leading indicator of consumer inflation, but highly volatile •PPI comes out before CPI (If PPI goes up, CPI will go up after. PPI signals changes to come in the CPI and is thus closely watched by policymakers) •Viewed as leading indicator of consumer price inflation •Over the long term, the CPI and the PPI have similar trends, but PPI is much more volatile.

GNP

GNP (gross national product) = output produced by domestically owned factors of production (labor, capital, technology, human capital, etc.) regardless of location GDP = output produced within a nation by factors of production owned domestically or not. GDP = GNP - NFP NFP = net factor payments from abroad = payments to domestically owned factors located abroad minus payments to foreign factors located domestically •Recall that factor payments are payments to owners of factors of production. Wages, rents, dividends and other payments, interest, royalties, etc

permanent fed changes

If the Fed wants to permanently lower the federal funds rate, it can use an open market purchase to permanently increase the reserves in the banking system. The other two slides showed basic "defensive" open market operations allowing the Fed to respond to changes in the demand for reserves so as to hit the predetermined target

situation where the demand for reserves has fallen and the effective federal funds rate is below target.

If the effective Federal Funds rate is below the Fed's target, then the Fed will engage in an open market sale to reduce reserves in the banking system. Reduces reserves in the banking system - therefore monetary base and M1 comes down by the effects of the money multiplier

Purchasing Power Parity

In order to compare differences in living standards across countries, we often use real GDP converted to U.S. dollars using market exchange rates - This introduces an important bias: in many developing countries, for example, most goods and services are much less expensive than they are in the U.S. or other developed economies nIf you have $25 in the U.S., you can get a haircut - If you have $25 in Thailand, you can convert it to Thai baht and purchase 10 haircuts - $25 dollars goes much further in Thailand than in the U.S., so a dollar's worth of GDP represents more goods and services in Thailand than it does in the U.S. To correct for these differences, calculate GDP in other countries using U.S. prices. - Although not at all perfect, this provides a better comparison of living standards across counties

Expenditure Approach

In practice, we almost always think of GDP in terms given by the expenditure approach The expenditure approach divides GDP (Y) into categories by who does the spending. C is consumption -- final goods and services purchased by households (2/3 of economy) I is investment - final goods and services purchased by firms. Investments mean creating new capital (purchases of new capital such as machines, equipment, and any other thing we consider to be capital) G is government spending - final goods and services (either C or I) purchased by government NX - net purchases of goods and services by foreigners nX - dollar value of exports nM - dollar value of imports nNX = X - M Y = C + I + G + NX Consider this equation your good friend. We will use it in another context later in the course.

JOLTS Data

Job Openings (procyclical) •A specific position exists and there is work available. •Full time or part time job could start within 30 days •There is active recruiting from outside the establishment Hires (procyclical) •Newly hired and rehired employees •Full-time or part-time •Permanent, short-term, seasonal or intermittent •Transfers from other locations •Recalls after >7 day layoff Separations •Quits (procyclical) •Left job voluntarily (not including retirements) •Layoffs and Discharges (countercyclical) •Layoffs with no intent to rehire •Positions eliminated •Mergers, downsizing or plant closings •Firings •Terminations of seasonal employees •Layoff lasting more than 7 days •Other Separations (acyclical) •Retirements, transfers to other locations, deaths, separations due to disability

M2

M2 are assets that are less liquid, but still fairly liquid. They can fairly easily be converted to M1 and used to finance transactions M2 are assets that are less liquid, but still fairly liquid. They can fairly easily be converted to M1 and used to finance transactions M2 = M1 + savings accounts + money market savings accounts + retail money market mutual funds + retail certificates of deposit • Savings accounts are just what you think they are. • Money market savings accounts are just a special type that invests savings in money market instruments, like commercial paper and repos. • Retail money market mutual funds are mutual funds for typical households that invest only in money market instruments (safe, short term debt instruments like those give in previous bullet). Normally, these allow a certain number of transactions per month to be paid from the account, but beyond that, account holders will be penalized. • Retail CDs are just another type of savings account, but one that locks up your money for a period of time in exchange for higher interest. Obviously, that is less liquid than M1.

Y = real GDP P = GDP deflator PY = nominal GDP

Nominal GDP: Also referred to as "GDP in current prices" because values current output in each year using the actual market prices in that year. Real GDP: Also referred to as "GDP in constant prices" because it values current output in each year using the prices from a single year, called the base year -Choice of base year is arbitrary -The base year must be reported along with real GDP figures (same goes for any real variable)

Commercial Bank Balance Sheets

Note that as customers of commercial banks, our deposits are a liability to the bank. commercial banks hold reserves. Those reserves are on account at the Fed, because each commercial bank has its own bank account, with its bank being the Fed itself. So, the reserves that a bank has on account with the Fed are an asset to the bank (and a liability to the Fed). Bank capital is a liability - If the bank suffers losses on the asset side, then these can be "absorbed" by losses on bank capital without affecting depositors at all. Safety cushion tied up as bank capital. The bank is safer the more capital it holds, because depositors can be "kept whole" even when the bank is in difficulty due to defaulting loans.

Real GDP Measures Living Standards

Note that nominal GDP is the product of two things: 1. Real GDP (Y): a measure of the total "stuff" being produced in the economy - If real GDP is increasing, then the economy is producing more output, and on average, we can say that living standards are increasing 2. Price level (P): a measure of the average prices of all the final goods and services contained in Y - If nominal GDP is increasing because the price level is increasing, then people in the U.S. economy are not better off. Things are just getting more expensive, which is not a source of economic growth.

interest on reserves

Technically, the new policy implemented in 2008 allowed the Fed to set different rates on required reserves, IORR, than on excess reserves, (IOER). But these have been set to be the same since implementation, and so we will just call it IOER. Under normal conditions (which don't apply now), IOER is a lower bound on the fed fund rate because no bank would lend reserves to another bank in the fed funds market at a rate lower than they can earn by just holding the reserves.

The Deposit Expansion Process

Previous Example: $10,000 reserve injection wound up increasing Deposits in the banking system by ten times that amount o Note that spending (AD) increased immediately in response to the policy (purchasing securities)

sticky prices

Prices that do not always adjust rapidly to maintain equality between quantity supplied and quantity demanded. Propagation Mechanism: •Whatever the actual source of the decline in spending, in order for a recession to be the result, this "shock" to spending must be propagated through the economy for it to result in a decline in real GDP, Y. •Sticky Prices" can play this role. •If all firm's prices (and wages and interest rates) were "fully flexible", then changes in demand for any individual good or service could just be met with a change in price, with no affect on output. •I.e., there would be no business cycles •Price stickiness, or rigidity, solves this issue in theory Alternative mechanisms: •Other business cycle models emphasize the role of "financial frictions" in propagating changes in AD into changes in Y. •Whatever idea is "more correct," the main point here is that for economic models to realistically replicate the economy, there must be some "grit in the system" - some market imperfection that prevents markets from fully "clearing", or adjusting to the shock to AD. Otherwise, there will be on effect on real GDP in the model, so no business cycles.

Real GDP:

Real GDP "nets out" the effects of inflation so as to capture just the changes in total production in the economy Steps to calculation real GDP 1. Pick a base year 2. Get prices for all final goods and services in that year 3. Calculate GDP in each year using base year prices instead of actual, current prices The answer then tells how GDP in each year compares to the base year. In each year, we say "GDP is $XX trillion measured in 2010 dollars" if 2010 is the base year. Choice of base year can influence the outcome. - In recent years, GDP has been calculated using "chain weighting,", which effectively updates the base year as time elapses. We will discuss this in class.

Recessions

Recessions are defined by real GDP, not nominal GDP. Note that in most U.S. recessions, nominal GDP continues to increase. Two notable exceptions are the Great Recession of Dec. 2007 - June 2009 and the current recession, both of which are more severe than any recession since the Great Depression of the 1930s.

GDP

The market value of final goods and services, newly-produced during a specific time period within the country's borders. GNP is defined similarly, but replaces "within the country's borders" with "by factors of production owned by the citizens of that country, wherever located." More on this below.

Liquidity Premium Theory (or "Term Premium Theory")

Term Premium Theory is more common - nothing to do w/ liquidity • Long term rates are simply the average of the expected future short-term rates (forward rates), plus a term premium that compensates for the interest rate risk ,or duration risk, of holding a longer term bond. • The Liquidity Premium Theory states that longer term interest rates are a function of the shorter term interest rates expected to prevail over the longer-term horizon, plus a term premium that increases with the time to maturity. • More risk the longer the term of the bond (from other market interest risks - duration risk) • Now, we have a theory that predicts that the yield curve will normally be upward-sloping, since we are adding something positive to each yield predicted by the Pure Expectations Hypothesis, and that something increases with longer maturities. • Term premium is the excess yield that investors require to commit to holding a a long-term bond instead of a series of short term bonds. • Negative term premium: For example, if some purchasers of long term debt, such as pension funds, are interested in locking in a fixed rate of return for a long period of time, the could be willing to accept a lower yield on long term securities (negative term premium) in order to avoid the risks associated with rolling over their investment in a series of short term bonds with uncertain, fluctuating interest rates.

Asset Price Channel:

The channel of the monetary policy transmission mechanism where changes in policy affect aggregate expenditure through their impact on stock prices and the value of real estate. As interest rates fall, asset values increase. That is just a simple fact that their cash flows are discounted at a lower rate, but also reflects the fact that interest-bearing assets are not as desirable, so the demand for other assets like stocks will increase (those two arguments are really the same thing). When the value of your stock portfolio increases, that is an increase in wealth, not income. Wealth can't be spent, so theoretically, it doesn't have to increase AD. But when our wealth increases, we DO increase our spending, for reasons I am sure you can understand ("my savings are now higher than they were, so I can afford to spend more of my paycheck today").

The Monetary Transmission Mechanism: 3 ways •Liquidity Effect (The "Interest Rate Channel")

The diagram shows an increase in the money supply (such as would occur from on open market purchase, as we showed above). The liquidity effect refers to the negative relationship between changes in the money supply and changes in nominal interest rates. When the Fed injects reserves into the system using an open market purchase and the money supply increases, short term nominal interest rates will fall. When the Fed reduces reserves in the system using an open market sale and the money supply decreases (or, more realistically, it's growth rate declines), short-term nominal interest rates will increase. Liquidity Effect: quite simply, when the money supply increases and interest rates fall, the cost of borrowing falls. Households and firms will spend more, so both consumption and investment will increase (C & I)

Inflation Takeaways

The inflation rate is the proportional (or percentage) change in the price level. Normally, this is measured using the CPI. The CPI is the most commonly used price level used to measure changes in the cost of living, but it has certain weaknesses that should be taken into account

Liquidity Effect Graph

The liquidity effect is the negative correlation between changes in the money supply and nominal interest rates

Classical Macroeconomics

The view that the market economy works well, that aggregate fluctuations are a natural consequence of an expanding economy, and that government intervention cannot improve the efficiency of the market economy Real economic activity (real GDP, employment, unemployment, etc.) is determined by the amounts and qualities of the fundamental factors of production and technology. Factors of production are land, labor, capital and human capital •Technology is total factor productivity, the efficiency with which these factors of production are combined to product output •Classical economic theory posits that business cycles are caused by essentially unexplainable fluctuations in these factors and/or technology •Prices, wages and other aspects of the economy are fully flexible. There is no "stickiness" in prices or wages or other "rigidities" caused by market failures. •Economy is always at "full employment", and even if there are temporary deviations, the economy will "self-correct" and return to full employment/natural rate quickly Real Business Cycle Theory •Modern variation on classical theory •Economic fluctuations are driven by "technology shocks" For the most part, RBC theory has been marginalized •Unable to tell convincing stories of what drives these technology shocks. •Are recessions caused by people forgetting things and becoming less productive, or by computers and factories suddenly becoming less productive for whatever reason? •The empirical evidence points to fluctuations being driven by demand (spending) changes •RBC theorists made significant contributions to economic modeling by being the first to using computational simulations of the economy, as well as other methodological advancements. •But they are also blamed for their dogmatic approach, which has infiltrated the profession and caused much recent consternation. • Overall, Classical Economics get it wrong

The Fed's new ONRRP rate

TheFed sets the "reserve"ONRRP(the highest interest rate it will give to banks)rate and then the actual rates emerge from the auction process.It normally sets that reserve rate just below the current value of the Effective Federal Funds rate. if the Effective Federal Funds rate fell below the ONRRP rate, the lenders discussed above will now lend to the Fed instead. They withdraw the supply of credit that they lend to other banks, decreasing the supply of credit and causing the interest rate to rise. Some may even be borrowing from others at the Effective Federal Funds rate and lending to the Fed at the ONRRP rate, earning a profit on the difference. But this arbitrage opportunity will disappear immediately as other banks attempt to engage in the same strategy, driving the profits to zero (when ONRRP = the Effective Federal Funds rate) •The Fed's new ONRRP rate was initially sold as a new lower bound by the Fed, but in actuality, it tracks the Fed Funds rate quite closely, so it is exerting some control in that the Fed sets the ONRRP rate. •So if the Fed Funds rate is tracking it, then it can effectively serve as a mechanism to help control the Fed Funds rate and keep it from falling too far.

The "Floor" System in Theory

Under the channel system, IOER (interest on reserves paid by the Fed to commercial banks) was an a lower bound on the Effective Federal Funds rate. Under the floor system, IOER is an upper bound on the Effective Federal Funds rate. o Now, other players are participating in the Fed Funds market, including the government-sponsored entities (GSEs), Fannie Mae and Freddie Mac and money market mutual funds. These institutions do not face reserve requirements, but they may have reserve accounts with the Fed just like banks. They are willing to lend at interest rates lower than IOER in the overnight Fed Funds market. So long as there are wiling borrowers, the market can then be active with borrowing and lending occurring on a daily basis. •IOER is now used to keep the Effective Federal Funds rate from reaching its upper bound. •The Fed now sets IOER somewhat below the upper bound. •This is another tool that keeps the Effective Federal Funds rate from exceeding the Fed's upper bound. • If the Effective Federal Funds rate increased above IOER, some banks would now be willing to lend in the Federal Funds Market, increasing the supply of funds in the Federal Fund Market. The Effective Federal funds rate should never increase past IOER as a result

The Money Supply M1

We have two primary monetary aggregates that we use to measure the money supply, M1 and M2 M1 consists of assets that are normally used to finance transactions. M1 = currency + demand deposits + other checkable deposits + travelers checks. • Currency consists of notes and coins as described above •Demand deposits are just checking accounts. Your money is in an account at a bank, and you can access it on demand by writing a check, making a debit card purchase and certain other ways. Note that financing transactions in this manner involves no cash at all, just debits and credits in the appropriate accounts. Other checkable deposits are just other types of checking accounts. As regulations changed to allow interest on checking and other non-traditional features, the Fed needed a new classification to distinguish from traditional checking accounts. For our purposes, the distinction is unimportant, and we will just call them all demand deposits or checkable deposits Travelers checks are still counted because they have always been, but they are rarely used in this world of cross-border credit and ATM transactions. What distinguishes M1 from M2 is the liquidity of the included components. Liquidity is the ease and costlessness of converting an asset into currency, which is the most liquid asset. Everything in M1 can be used to finance a transaction.

The M1 Money Multiplier (Redux)

With QE, banks were (and still are to a certain extent) holding vast quantities of reserves, unlike the "old days." This is a "leakage" from the deposit expansion process because those are funds that are not lent out by banks, so they won't be deposited in another bank, and so on. This leakage dramatically reduces the value of the money multiplier, so monetary policy (open market operations) will be less effective at influencing M1.

liquidity trap

a situation in which conventional monetary policy is ineffective because nominal interest rates are up against the zero bound •In periods of very low nominal interest rates (close to or at the "zero lower bound"), the effectiveness of monetary policy through normal channels is diminished. •Note that when interest rates are zero, agents will prefer to hold money instead of interest-bearing securities. •A liquidity trap occurs when the demand for money (a highly liquid and safe asset) is not being met by the supply of money. I.e., money demand is perfectly elastic at the prevailing nominal interest rate. •This reduces the effectiveness of any increase in the money supply via the traditional channels of monetary policy. •So, in the absence of further fiscal policy stimulus, something new was needed ... negative nominal interest rates has happened (- YTM). Why would anyone buy it? If interest rates increase, bond prices fall, implying a capital loss on bonds. If nominal interest rates were already zero (or close to zero), then already, quantity demand of bonds will be low (might as well hold money). Prospect of capital loss also

The Liquidity Preference Model

idea that the quantity of money people want to hold is a function of the interest rate But since money provides services that bonds don't, you need to have some of that, too. This means that the demand for money is negatively related to the nominal interest rate: the higher the interest rate, the more of your wealth will be in bonds (or some other interest-bearing or return-earning account). Why not the real interest rate, which is what I said matters for many decisions? Because inflation, or expected inflation, affects the return to all assets that same way. Inflation eats away the value of your return regardless of the asset. Money earns no interest, so it's real return or real interest rate is minus the rate of inflation, or more consistent with our definition of the real interest rate, the expected rate of inflation. As with any demand curve, it shows a "price" or other measure of value on the vertical axis and a quantity on the horizontal axis. It's just that in this case, the "price" is the return you earn on bonds, and the higher it goes, the less money you want to hold. That gives the money demand curve ("liquidity preference" is what Keynes called it) a negative slope.

When does inflation occur?

inflation occurs if the AD outstrips the productive capacity of the economy (potential GDP and the NAIRU are the critical measures, recall). The Fed can certainly "slow down" and "speed up" growth in AD, and so it has influence over inflation the inflation target is a guideline, and not really a precise target. If inflation is less that 2% measured by the PCE core, then the Fed should stimulate (open market purchase) and if inflation is above that and the economy could overhead, then should slow the growth of AD with an open market sale.

The Federal Funds Rate

is the interest rate on loans of reserves between commercial banks. A commercial bank is essentially required to meet its reserve requirement on a daily basis. If a bank is low on reserves, they can borrow from a bank that has excess reserves in an overnight lending market called the Federal Funds market. the fed funds rate is a market-determined rate Fed has the ultimate influence over the total supply of reserves in the banking system, so it has a very high degree of control, but not perfect control, over this rate The fact that the Fed targets the fed funds rate means that it cannot control it directly, and it if loses control entirely, the rate may not be anywhere near the target. This actually happens from time to time If the Fed loses control of the fed funds rate, then their target loses credibility, and financial markets will begin to assume that the Fed is unable to hit the target. That means they may act contrary to the way the Fed wants. Central banks covet credibility, and the fact that there are upper and lower bounds on the fed funds rate lends credibility to the target What happened in the top box? Quarterly corporate tax payments and

Ultimate Goals of Monetary Policy

it is all about influencing how much consumers and firms are spending, that is, AD. the ultimate goal of monetary policy is to stimulate AD when there is "slack," It is also to slow down spending when the economy is in danger of overheating. The Fed uses Open Market Operations to increase or decrease the money supply. When they do so, they are hoping that ultimately, it affects AD and therefore real GDP (and, of course, from the Phillips Curve, the extent to which it does depends on whether there is "slack" in the economy). there are different "channels" or "transmission mechanisms" whereby monetary policy can influence AD. •Increases/decreases in the Money Supply are engineered by the Fed using Open Market Operations •Open market operations are purchases or sales of Treasury securities by the Fed with commercial banks. •This increases/decreases the amount of Reserves being held by commercial banks and can have four separate impacts (or even more!), referred to as Channels of Monetary Policy, or Transmission Mechanisms, which we return to below. In 2012, the Fed began paying interests to banks on the reserves they hold. This was done in response to the policies implemented in response to the crisis,

Simplified Fed Balance Sheet (Old Days)

reflects reality prior to the Great Recession Currency is also a liability to the Fed. This is part of M1, recall, and it reflects that basic fact that the money supply in the U.S. is backed by safe promises of the U.S. Treasury. The Treasury has never defaulted, so globally, these are considered one of the safest assets in the world. Basically, this means that the Fed cannot increase the money supply beyond the level backed by Treasury securities. The Fed clearly has control over the amount of currency in the economy. But that is not how they conduct monetary policy. As we will see, the Fed influences the supply or Reserves in the banking system, and that in turn impacts M1 and M2

short-run Phillips curve

represents the negative short-run relationship between the unemployment rate and the inflation rate - downward sloping because of sticky prices If there is a recession (u > u*), the Fed could potentially lower interest rates to stimulate the economy. (Increase AD, stimulate GDP - more output, and lower unemployment - firms will hire more. There will be little increase in inflation. Sticky prices makes this possible since output will change, not price). If someone stimulates the economy when u < u*, unemployment may go down and inflation will increase, but expected inflation will also rise. This will cause the curve to shift up. (New higher inflation expectation). Expected inflation is constant along the curve, so the new expectation will shift the curve up. Model can't show how we get to long run equilibrium (when u = u*). In the long run, sticky prices go away (cost to change prices - monetary or opportunity). According to the theory, in the long run, all prices are flexible.

Long Run Phillips Curve

shows the relationship between unemployment and inflation after expectations of inflation have had time to adjust to experience

Prior to quant easing Sometimes this does not happen, leading to quant easing (which influence long term rates directly)

the Fed conducted open market operations by buying and selling Tbills: short term Treasury securities (maturities of 30 days and 90 days). Monetary policy attempted to influence short term interest rates in the economy. Since long term rates are more important, the Fed relied on the theories of the yield curve that long term rates were correlated with short term rates, so the latter would change in the same direction.

Monetary Base = Currency + Reserves. MB = Cu + R.

the Fed does not have close control over the overall money supply, which is still do be defined. It conducts monetary policy by influencing the monetary base (MB), and in particular, by influencing the amount of reserves held by banks.

situation where reserve demand has increase, and the effective fed funds rate is now above target.

the Fed wants to increase the supply of reserves using an open market purchase, shifting the supply curve out until the target is attained. If the effective Federal Funds rate is above the Fed's target, then the Fed will engage in an open market purchase to "inject" reserves into the banking system. (Deposit expansion process)

The Monetary Base

the sum of currency in circulation and bank reserves MB = Cu + R •is the sum of Currency (Cu) and Reserves (R) •R = RR + ER (Total reserves = required reserves + excess reserves) • Commercial banks hold reserves at the Fed (the fed is also a bank for banks). •The primary assets are Treasury Securities •Currently, the Fed balance sheet shows the Fed holding some unusual assets, things they would not normally purchase. These are the legacy of Quantitative Easing, which we return to below. •The Monetary Base is also referred to as "High Powered Money". (fed has some control over this with the reserves). Fed has most control of the monetary base.

Quantitative Easing

when the Fed buys longer-term government bonds or other securities •Quantitative Easing is open market operations on steroids •Instead of just purchasing T-bills from the primary dealers to expand reserves, the Fed expanded the allowable assets to include long term government bonds, bonds issued by Government Sponsored Agencies (GSEs) like Fannie Mae and Freddie Mac, as well as and mortgage-backed securities (MBS) issued by those same GSEs •The number of counter parties for Fed transactions was greatly expanded •Instead of just transacting with the primary dealers, the set of counter parties for QE transactions was expanded to include over 200 additional financial institution •Fed's trading infrastructure was greatly expanded •Amounts purchased by Fed, and thus reserves injected into banking system, greatly exceeded those from normal open market purchases. So, under QE, the Fed purchased 1.New and and different types of securities ... 2.From a broader set of financial institutions (not just Primary Dealers) ... 3.In unprecedented amounts. GSE = "Government Sponsored Entities". Mostly Fannie Mae and Freddie Mac, these were the quasi-governmental agencies charged with buying and securitizing mortgages. Mostly engaged in the prime market, but also dabbled in subprime, especially with mortgage guarantees. MBS = mortgage-backed securities. Bundles of mortgages, the underlying payments on which are securitized and sold to investors as new assets.

bank run

widespread panic in which great numbers of people try to redeem their paper money If the market value of the loans the bank has made and holds on its balance sheet falls because of a lower probability of repayment, then the bank is subject to failure because those loans are assets to the bank. During the Great Depression, banks started to fail, and so other banks were subject to "runs" where people went to the bank as quickly as they could to withdraw their funds because if the bank failed, their money was gone.

Pure Expectations Hypothesis

• Long term rates are simply the average of the expected future short-term rates (forward rates or yields). • If I buy a 10 year bond or a 1 year bond and re-enroll for 10 years, I should be indifferent. We don't know what the 1 year rate will be from a year for now •The Here, int is the known yield on a n-year bond purchase in year t. •1+i_(1t+1)^e is the expected yield on a one-year bond issues one year from today, and so on. •To keep this simple, the short-term bonds are assumed to mature in one year, but this can go all the way down to the shortest maturities. •The theory implies that when short-term rates are expected to increase or decrease, longer-term rates will also increase or decrease, because the latter are a function of the former. •But since interest rates are normally expected to be as likely to increase as decrease, the Pure Expectations Hypothesis implies that the yield curve on average should have a flat slope, which we know is not the case.

The Risk Structure of Interest Rates

• Risky securities pay a higher expected return than safe assets • When economic uncertainty increases, market participants move wealth from risky market to safe markets • The diagrams below illustrate a "flight to safety" or a "flight to quality." • During economic and financial crises, the spread between risky and safe returns can widen appreciably due to this behavior (supply increases in the safe market and decreases in the risky market); The spread between the safe and risky widens

A Different Measure of Yield Curve Slope Inverted Yield Curve

• This is the difference between the 10 year and the 3-month Treasury yield. • Some commentators point to this as the better measure of the slope of the yield curve. • This one is currently inverted. • Inversion is a predictor of a recession

Greenspan's "Bond Market Conundrum"

•As you will have learned in other classes, the prevailing theory of the term structure of interest rates is the Liquidity Premium Theory. •Long term rates are the average of the short term rates expected to prevail over the relevant maturity horizon, plus a term premium, or liquidity premium to compensate for the interest rate risk from holding longer-term bonds. •So absent a contrary move in the term premium, long term rates should rise along with short term rates •Historically, the perception was that this had been the case •Recent analysis by Matthew Klein reveals this may not have been the case, but it is certainly accepted wisdom •However, during the period in question, long-term rates did not increase as predicted by the theory •Mortgage rates did not rise as planned, and the housing bubble continued, eventually contributing to the Global Financial Crisis and the Great Recession. •In Congressional testimony, Greenspan referred to this episode as the "bond market conundrum" to defray criticism of the Fed for contributing to the bubble.

Stimulate AD if U > U* If there is a recession (u > u*), the Fed could potentially lower interest rates to stimulate the economy. •The increase in spending means more workers are hired and the unemployment rate falls to the NAIRU. Open Market Purchase: •The increase in spending means more workers are hired and the unemployment rate falls to the NAIRU. • Interest Rates Fall as Money Supply Increases

•At point A, there is significant slack in the economy. •If policymakers stimulate AD in this situation, real GDP will increase, causing a decline in unemployment. •When unemployment is above the NAIRU, the Phillips Curve is flat, and the economy can be stimulated with little increase in the inflation rate. •This diagram is suitable to explain almost every recession in the U.S. economy going back to the Great Depression (with one exception) •Declines in AD caused the unemployment rate to increase. •Policy responses were varied, but intent is to stimulate AD using monetary or fiscal policy. •The increase in spending means more workers are hired and the unemployment rate falls to the NAIRU. - Anchoring inflationary expectations has been a key goal for banks

When u < u*

•At point B, the labor market is "tight" and the economy is running above capacity. It is in danger of overheating. •If policymakers attempt to stimulate the economy, there will be no significant decrease in u, but inflation will increase rapidly. •Instead, policymakers should be reducing AD, causing inflation to fall without a significant increase in u, since when u < u*, the Phillips Curve is steep. •This diagram may be suitable for our current economic situation, at least until the end of last year. •The Fed was slowly raising rates, attempting to restrict spending in the economy so AD will not grow as fast. •They were engaging in pre-emptive policy to prevent overheating, which could result in a hard landing and therefore more severe future recession. •This year, the Fed abruptly reversed course and decided to emphasize the inflation target, which we had been below since it was first announced. •Now, they have reduced interest rates to stimulate AD •This course correction confused markets. It is unusual for the Fed to go from emphasizing one thing (slowing the economy) to the exact opposite (speeding it up).

Labor Force Metrics

•Civilian Non-Institutional Population (POP): 260,558,000 •Who is not included? •Anyone under 16 years of age •Active-duty military •Anyone committed to an institution •Labor Force (LF): 160,838,000 •Employed persons, full or part time (E): 147,228,000 •Unemployed persons (U): 13,550,000 •To be counted among the unemployed, a person must have actively sought employment in the past 4 weeks •Not in Labor Force: 99,720,000 •Unemployment Rate: u = U / LF •Labor Force Participation Rate: LF/POP •Employment-Population Ratio: E/POP •This is sometimes referred to as the "employment rate." As was discussed in the video, the unemployment rate can be decomposed into 𝒖=𝟏−𝑬𝒑𝒐𝒑 / 𝑳𝑭𝒑𝒐𝒑

Federal Reserve Repos

•Definition: Repo - a loan collateralized by Treasury securities that is reversed (paid back) at a specified time. •Repos are typically overnight or "term" (maturity specified in contract). Normally used for short-term financing or to "park" funds overnight. •Financial institutions borrow overnight by "selling" Treasury securities to investors (other financial institutions) and then buying them back the next day at a premium. •The Fed has conducted repo transactions with primary dealers for decades. •Primary dealers borrow reserves from Fed and give Fed Treasuries as collateral •In the following day or days, the Fed returns the Treasuries and credits the reserves back to the primary dealers •This is used under normal conditions to temporarily increase the monetary base (reserves) in response to temporary decreases that would otherwise affect the federal funds rate. •Under the channel-corridor system, the Fed used Repos and Reverse Repos (next slide) to conduct Temporary Open Market Operations, adjusting the supply of reserves on a temporary basis in order to hit the target for the Federal Funds rate on a daily basis.

Federal Reserve Reverse Repos

•Definition: Reverse Repo (RRP) •These are also conducted by the Fed and just reverse the counter-parties •Now, the primary dealers lend reserves to the Fed overnight in exchange for Treasuries as collateral. •The monetary base decreases temporarily •Fed Reverse Repurchase Facility •New facility extends reverse repos to many more financial institutions throughout the U.S., both term and overnight •Reserve rate set by fed, then actual rate determined in auction •In the Channel-Corridor System, the Overnight rate RRP (ONRRP) sets floor on effective fed funds rate, since all institutions that are allowed to lend into fed funds market can lend to fed instead at a higher rate.

Bond Market Conundrum Redux

•During the year's preceding the housing crisis that led to the Great Recession, the Fed raised its Fed Funds target several times in an effort to slow down spending, especially on housing. Unfortunately, long term rates did not increase as expected, a phenomenon the Fed chair, Alan Greenspan later dubbed "the bond market conundrum" in testimony to Congress. •This provided another rationale for Fed QE policies, which are intended to influence long-term rates directly instead of indirectly.

Nominal GDP is our measure of Aggregate Demand.

•Expansions and recessions are almost always caused by changes in AD (spending) •In the U.S. economy, both C and I decline during recessions, and the end of the recession depends on one or both of these recovering from the downturn. •Certain other economies are more export-dependent as a driver of GDP. In those countries, recessions can be caused by recessions experienced by their trading partners, since this means X will decline. •Whatever the proximate cause, significant declines in spending by household and/or firms are the cause of almost all recessions. •So "government" policy is intended to counteract these decreases in spending •Fiscal policy can be used to increase government purchases directly, or to influence C or I by cutting personal or business taxes, which has an indirect effect on spending •Monetary policy attempt to influence spending mostly through its influence on interest rates, which influence the cost of borrowing and therefore have an indirect effect on spending by households and firms.

the structure of our banking system *Only for commercial banks, not investment banks

•Fractional Reserve Banking System •Commercial banks face reserve requirements •A certain fraction of customer deposits must be held "on reserve" •Traditionally, these reserves earn no interest •So, when a customer makes a deposit, the bank holds a fraction of that deposit on reserve, and lends the rest to a household or business. It could also buy safe assets such as Treasury securities. •Reserve requirements have been waived by the Fed during the pandemic. •Before the pandemic, reserve requirements were: •0% on deposits between 0 and $15.5 million •3% on deposits between $15.5 million and $115.1 million •10% on deposits over $115. million •Total Reserves = Required Reserves + Excess Reserves •Banks typically hold at least a small amount above their reserve requirement so as to meet unexpectedly large withdrawals without violating reserve req.

Natural Rate Hypothesis

•Fundamental theory underlying the theoretical Phillips Curve and the Keynesian/Classical synthesis •The economy tends toward its "natural rate" •Natural rate of unemployment (NAIRU) and natural rate of output (Potential GDP). The natural rates are determined by the underlying fundamentals of the economy: •Quantity and quality of labor and capital •State of technology •Institutions, norms, custom, disinflation law •If the economy deviates from the natural rate, there are forces at work in the economy that will bring it back in the long run. •If the economy is "above the natural rate," because AD exceeds the productive capacity of the economy (aggregate supply) inflation will result. •Below the natural rate causes •Monetary and fiscal policy can only influence AD in the short run. In the long run, policies are ineffective and the economy just reverts to the natural rate.

Price Level

•Generically, the price level is some measure of average prices in the economy •But since prices for individual goods and services are for different things, we can't just calculate the average as we would a normal, arithmetic average •Because the economy is comprised of many different goods and services, the price level is calculated as an "index number" with 100.0 being the price level in the "base year" •In years before the base year, prices will normally be lower on average than they are in the base year, so the price level will be a number less than 100.0 •In years after the base year, the price level will be higher on average than 100.0.

The 1960s Phillips Curve

•Here is the Phillips Curve for the U.S. in the 1960s. •Note that the emphasis had changed to price inflation (vertical axis) as opposed to wage inflation •You can imagine the delight of policy-makers in the Fed and elsewhere when they viewed this as a policy-tradeoff. When the unemployment rate is high, the Fed can stimulate AD, reducing unemployment with very little cost in terms of increased inflation (note the flat slope when u is high). •What could possibly go wrong? "Lets just pick the point we want to be on". •Once policy makers attempted to exploit the statistical trade-off, it largely disappeared. •Only later did economists realize the importance of expected inflation in influencing the behavior of firms and consumers. •If the Fed stimulates AD, and the public perceives that this will increase expected inflation, the Phillips Curve will shift up. •For example, if people expect higher inflation in the future, then they will demand higher nominal wages and salaries to compensate. •Higher wages means firms are less willing to hire, so the unemployment rate will be higher than otherwise. •So now, the inflation rate consistent with any particular rate of unemployment is higher than previously, meaning the curve shifted upward. •Clearly, we needed a better theory to explain these facts.

The Modern Phillips Curve

•In practice, of course, most of the theoretical aspects of the Phillips Curve and its relationship to different schools of thought is ignored, and and analysts need a model to put into action. •Now, we are interested in the Phillips Curve as a model, not just the empirical relationship between inflation and unemployment. •The modern Phillips Curve that is normally used for most purposes essentially ignores the short-run, long-run distinction. •It is flat at unemployment rates below the NAIRU, and then steepens to vertical or near vertical at the NAIRU. •This recognizes that increases in AD cannot stimulate the economy effectively below the NAIRU. But with unemployment greater than the NAIRU, stimulating AD can stimulate output and reduce unemployment, with little increase in the inflation rate.

Theory is not working in reality

•In recent quarters, there has been no tradeoff between inflation and unemployment. •With unemployment so low, the natural rate hypothesis says that inflation should be higher as workers demand higher wages and salaries. •Again, this picture is inconsistent with the Natural Rate Hypothesis. •Next, we discuss monetary and fiscal policy. Both types of policies are intended to influence AD. •If the economy is in danger of overheating, monetary and/or fiscal policy can slow down the growth of AD. •If there is excess slack in the economy, monetary and/or fiscal policy can be used to stimulate AD.

Why has labor force participation declined since the late 1990s?

•Increase in average age of working age population •Baby boomers started retiring in early 2000s •Increase in average education level •Careers start later •Increased participation by women •Some men choose to stay at home

Gross vs. Net Investment

•Investment as we have defined it in the definition of GDP is Gross Investment. •Definition: Net investment = Gross Investment - Depreciation •Depreciation is the reduction in the capital stock due to use and age •Note that it is possible that if a firm or country is not investing much in new plant and equipment and the depreciation of existing plant and equipment is high (e.g., old, obsolete factories), then net investment could be negative. •If net investment is negative, then the stock of capital in the economy declines. This is bad for productivity and economic growth. •Definition: Net GDP = GDP - Depreciation •Alternative measure of GDP •Not often used, due to difficulty in measuring depreciation

Real Wages and Productivity

•Labor productivity is defined as Real GDP/Total Hours Worked or Real GDP minus depreciation/Total Hour Worked. •According to classical economic theory, real wages are tied to labor productivity •Up until the 1970s, this theoretical relationship was reflected in reality. •But beginning in the mid-70s and accelerating in the 1980s, real wages and productivity became decoupled. •The result has been a fairly dramatic decrease in "labor's share" of GDP, which is the primary reason for the increase in inequality in the U.S. and elsewhere.

Expected inflation is constant along the curve

•Lastly, each Phillips Curve assumes a constant rate of expected inflation. •In the previous two diagrams, we drew the Phillips Curve consistent with the inflation rate consistent with u*, which here is labeled as π* •But if policy-makers attempt to continue to stimulate the economy to keep the unemployment rate lower than u* and they are unable to anchor expected inflation, the curve will shift up, making the tradeoff "less favorable." •Now, each unemployment rate is associated with a higher level of unemployment. •To alleviate this, policymakers must convince people that inflation will be lower in the future, and this must be credible. •This is why central bankers are so concerned with "anchoring" inflationary expectations. •Most central banks now announce an "inflation target" so as to anchor inflationary expectations. Otherwise, they may be trying to hit a moving target as the Phillips Curve shifts up and down.

The Classical-Keynesian Synthesis

•Mainstream macroeconomic theory combines elements of both schools of thought •Almost all economists agree that since WWII, all U.S. recessions but one were driven by reductions in demand •Positive correlation between real activity and inflation is only consistent with the demand story •Proximate cause may be different in different recessions, as we have already discussed. •The one exception is the stagflation episode in the 1970s •Stagflation - recession accompanied by higher inflation •Negative correlation can only be caused by a "supply shock."

Other Measures of Distress

•Marginally Attached •Adults that have not sought work in the past four weeks, but have sometime in the past year •Discouraged Workers •A subset of the marginally attached •These people report that they have not sought work in the past four weeks due to "economic reasons" •They have sought work in the past, but are unable to find an acceptable job •Working Part-Time for Economic Reasons •People that work fewer then 35 hours per week due to "slack work or unfavorable business conditions" or due to "seasonal declines in demand."

Yield Curve Control

•One proposal that has been offered up as a target for monetary policy is "yield curve control.": •This is really a fancy name for putting an upper bound on longer-term yields, then buying the securities in amounts necessary to prevent yields from exceeding that upper bound. •The Bank of Japan began targeting "yield curve control" in 2016 •From the NY Fed blog "Liberty Street": BoJ introduced a framework it labeled Quantitative and Qualitative Easing with Yield Curve Control (QQE with YCC). The BoJ reaffirmed that the rapid pace of asset purchases would continue until inflation had moved above its 2 percent target "in a stable manner." But now, the BoJ would also set a target for ten-year JGB yields of "around zero percent," near the prevailing rate at the time. •The Fed actually targeted yield curve control during WWII in order to keep debt service obligations lower. •The Fed pegged "short-term" interest rates at 3/8% and 25-year and longer yields at 2.5% (these were somewhat arbitrary and reflected rates prior to 1942. •Yield curve control was the topic of research presentations and discussion at the June 9-10, 2020 FOMC meeting, but the committee did not recommend it be implemented, with some members stating that given the Fed's commitment to continued forward guidance, it may not be necessary.

Who Participates in Fed Funds Market?

•Originally, only commercial banks participated in the federal funds market. •Now, other entities besides the primary dealers and other commercial banks are permitted to lend in this market in the event that some commercial banks seek to borrow reserves. •Who are the new lenders? •Government money market funds •Prime and tax-exempt money market funds •GSEs (Fannie Mae and Freddie Mac) •These entities are not banks, so they do not face reserve requirements •However, as with any other financial institution, they may have excess funds that require high liquidity on which they want to earn at least some return. •So these entities are willing to lend in the Fed Funds market at rates below IOER. •But who wants to borrow in the Fed Funds market in the era of "ample reserves"? •Answer: Foreign banks, who do not earn interest on reserves. Foreign banks are not allowed to take deposits from customers, so they don't face reserve requirements of any sort, obviously. But they do want to borrow cheaply, and they can do so in the FedFunds market.

Keynesian Economics

•Real economic activity is determined by aggregate demand (a.k.a., expenditure or spending) •The Great Depression was clearly not caused by any sort of supply shock as posited by Classical theory •Correlation between real GDP and inflation rate can only be consistent with business cycles being driven by demand changes •Spending fell dramatically following the over-leveraging and resulting asset-price bubbles of the "Roaring 20s" •Great Depression was the only period of sustained deflation in modern U.S. history •When demand falls, firms produce less, lay off workers, etc., all of which causes spending to fall further •Prices and wages can be "sticky" and other "rigidities" prevent the economy from fully adjusting to shocks to demand in the short run

The Recent "Bond Market Conundrum"

•Recently, we have been experiencing a bond market conundrum in reverse. •The Fed has been increasing its target since the end of 2015 •Long-term rates finally started increasing in July 2016, culminating in an upward spike associated with the election (the "Trump trade") •But since then, despite continued increases in the Fed Funds rate and other short term rates, the trend in long term rates this year has been down. •Matthew Klein at the FT (Barron's) says that Greenspan just had a "bad memory," and this was normal beginning in the 1990s, when the Fed began targeting the Federal Funds rate •The term premium apparently moves in the opposite direction to short term rates, and in sufficient amount to reverse the correlation between short term and long term rates. •So what determines the term premium and therefore, what makes in move the way it does in response to changes in short term rates? •This is the million dollar question. There are many attempt to answer this question, but none have done so adequately.

Yield Curve

•Shows the relationship between maturity and yield. •That is what we mean by "term structure." •Most common yield curves are for government bonds. In the U.S., the "Treasury yield curve." •The yield curve is normally upward-sloping (90%): long-term yields are normally higher than short-term yields. The picture attached is upward slopping. •When interest rates change, the yield curve shifts up and down, it does not normally pivot over itself: this means that changes in short-term interest rates are typically positively correlated with changes in long-term interest rates. •Modern theories of the term structure of interest rates are based on the idea that long term rates are an average of the short term rates expected to prevail over the longer-term horizon. •So the yield on a 5-year bond is based on the short-term yields expected to prevail over that 5-year horizon. • Usually tends to go directly up or down (not very gradual)

Schools of Thought in Macroeconomics:

•Since the Great Depression, macroeconomics has been divided into two camps •Classical - just about everyone before Keynes Keynesian •These schools of thought differ in fundamental ways regarding what causes economic fluctuations and what to do about them, if anything •To a degree, categorizing economists and economic theory in this way is a caricature •Keynes changed everything, and even those economists that do not consider themselves Keynesian have adopted many of Keynes' ideas •Keynes himself incorporated those elements of the classical model that he believed were useful •Current dominant paradigm in macroeconomics is referred to as the New Keynesian school.

Costs of deflation

•Sustained deflation can essentially destroy an economy •Deflation increases the real value of debt •Note that for any variable in levels, the real value is just the nominal value divided by the price level, usually the CPI. •So the real value of any loan, i.e., the debt burden, is increased. •For rates, such as the real interest rate, the real value is obtained by subtracting expected inflation. If this is expected deflation, instead, then real interest rates will increase. •While declines in prices sound beneficial, sustained declines in average prices indicate macroeconomic crisis. •Deflation signals a dramatic decline in spending, or aggregate demand. Deflation is self-fulfilling effect: •People and firms have reduced spending, causing prices to fall •But falling prices delays spending even further, as consumers and firms wait for prices to fall further before buying. All prices falling means demand has collapsed (economy is sick)! Terrible impacts from sustained deflation (economic crisis - great depression, Japan in the 90s)

Where can we get a prediction of the inflation rate so that we may discern expected inflation?

•TIPS ("Treasury Inflation Protected Securities") •Unlike normal government bonds, the principal amount on TIPS is adjusted upward by the rate of CPI inflation. •Since coupon payments (interest payments) are based on this principal amount, the interest paid on TIPS is also adjusted upwards by the CPI inflation rate. •The interest rate paid on TIPS is then the real interest rate. •Since the interest rate paid on the same maturity Treasury is the nominal interest rate, the difference between the Treasury yield and the yield on the same maturity TIPS is the inflation rate expected to prevail on average for each year of the maturity horizon. •For example, the difference between the 10-year Treasury yield today and the 10-year TIPS yield today is the rate of inflation expected to prevail in the market, on average, over the next 10 years. •Note that it is not perfect: it doesn't tell us precisely what the inflation rate will be next year, for example.

Fed Dot Plot

•The "dot plot" is released at the end of every FOMC meeting, along with other projections. •It shows projections for the midpoint of the Fed Funds target range for each voting member of the FOMC

The Modern Phillips Curve

•The NAIRU (u*) is the critical unemployment rate, below which inflation begins to accelerate •Note that the exact value for u* will be uncertain. •This is why economists debate what the NAIRU may be •Estimates can differ. •In the long run, an economy in and expansion or recession will return to u* on its own. •So why rely on fiscal or monetary policy to get us out of recessions? •Because ...

The Original Phillips Curve

•The Phillips Curve summarized the positive relationship between inflation and real economic activity •But correlation emphasized by Phillips Curve is the negative correlation between inflation and unemployment •The statistical correlation is evident from the data •Can this statistical correlation be thought of as a "policy tradeoff?" That is, can monetary or fiscal policy be used to encourage spending and real activity, tolerating higher inflation rates so as to reduce unemployment? •Although there used to be significant debate about this between the two dominant paradigms in economics, called the "classical school" and the "Keynesian school," that debate has largely been won by the Keynesians. The current dominant paradigm in macroeconomics is referred to as the "New Keynesian School."

Long-Term Unemployment

•The duration of unemployment is another indicator of distress in labor markets •During recessions, the duration of unemployment increases. •Normally, the higher the percentage of unemployment that is long term (6 months or more), the longer it takes for the unemployment rate to come down and the economy to recover •Long term unemployed suffer from skill deterioration and a deterioration of personal habits. Whether real or perceived, this limits their ability to find work. •Long-term unemployment perceived as an indicator of low productivity. •Loss of network, etc.

Calculating Inflation Rate

•The give the proportional change in the price level, which can be converted to percentage terms just by multiplying by 100% •Three scenarios to define: •Inflation: prices rising (inflation is positive, which is normal) •Disinflation: prices are rising, but at a decreasing rate. Inflation is slowing. •Deflation: falling prices (inflation is negative, which is bad, especially if the condition sustains itself) •Hyperinflation: extremely high inflation

The Money Multiplier

•The money multiplier determines the effectiveness of Fed monetary policy in affecting M1. ΔM1 = money multiplier × Δ reserves (initial) •For a given increase or decrease in bank reserves, the money multiplier tells us how much the aggregate money supply will change. •So this is the first step in assessing the effectiveness of monetary policy: how much does M1 (and/or M2) change when we change the level of reserves in the banking system? The answer is the money multiplier. We must also allow for leakages (loans not spent or establishments holding the cash or banks holding excess reserves). Cu/D is the currency-deposit ratio, which tells us how much cash is being held relative to checking account deposits. (originally, I used the symbol C in what I posted, which was an error. That was our symbol for consumption, and we already defined Currency Held by the Public as Cu) • RR/D is just a function of reserve requirements, which are set by law. • ER/D is the fraction of deposits that banks are holding as excess reserves The higher Cu/D and ER/D, the lower the M1 money multiplier. So, the more cash is held and the more banks hold in excess reserves, the smaller the effect on M1 of any reserve injection engineered by the Fe

Aggregate Demand

•Total spending on final goods and services for the entire economy •Also referred to simply as "spending" or "expenditure" •This is consistent with the expenditure approach to measuring GDP, which we annotated as Y = C + I + G + NX •Each variable on the right hand side represents a component of total spending in the economy, recall. This is what we mean by Aggregate Demand •Formally, GDP is intended to measure the value of total production, but as we discussed previously, the national accounts are set up so that the value of total production in any year equals the value of aggregate demand. • Nominal GDP calculated using the expenditure approach is our measure of Aggregate Demand. •So Y is real GDP. •But spending, per se, as we normally think of it, is a nominal variable •"I spent $35,000 on a car" •"Total sales this quarter reached $30 million" •"The government spent $1b on a new weapons program" •These are all nominal variables. •The bottom line is that aggregate demand should be thought of as a nominal variable, so Y becomes PY, where P is the GDP deflator. •Note that Warren Buffet has stated that the best long run predictor of the performance of equity markets is growth of nominal GDP.

Tools of Monetary Policy

•Traditionally, the Fed has had 3 primary tools that it could use to influence the monetary base. 1.Open market operations 2.Changes in discount rate 3.Changes in reserve requirements •Of these tools, the only one that is actively used by the Fed is Open Market Operations. Fed open market operations are conducted daily by the Fed so as to hit its target for the Federal Funds rate. •In 2008, a fourth policy tool was added: Interest on reserves •The Fed now pays interest to banks on the reserves they hold at the Fed. •Again, this has not been used actively to control the monetary base, but is an important element of Fed policy in response to the Great Recession and beyond (more on this coming).

The Role of "Sticky Prices"

•Wages and prices are "sticky" when they don't adjust completely and immediately to changes in AD. •So when an economy enters a recession, it is uncommon for employers to attempt to reduce nominal wages. •There are several potential reasons for this, including the fact that many wages and salaries are set by contract •Instead of reducing wages, employers lay off workers, who then become part of the unemployed •Likewise, when the economy enters a recession and AD falls, many firms do not respond by cutting the prices they charge. Instead, output falls. •Again, there are several candidate explanations for this behavior, but it comes down to the fact that there is some reason a firm maintaining its price in the face of a fall in demand results in less profit loss than what would occur if the firm reduced its sale price. •One explanation is called "menu costs" which are actual monetary costs faced by firms in the event they want to change their sale prices (think of catalogue-sales as one example), but there are several others, as well.

Costs of Inflation/Deflation

•When inflation is unexpected, it results in a transfer of wealth between workers and firms, and between borrowers and lenders. •If workers expect inflation to be low in the future, they won't demand large wage increases when they bargain over a new contract. •But once that contract is signed, if inflation is higher than anticipated, then workers lose and employers gain. •Likewise, if lenders expect low future inflation, then will lend money at lower interest rates. If the inflation rate turns out to be higher than anticipated, then the lender loses and borrowers gain. •Cost of inflation, even when expected, involves confusion over relative prices, resulting in misallocation of resources •When we make our purchase decisions, savings decisions, etc., we take into account not absolute prices, but relative prices. •E.g., prices relative to costs, price of one good relative to another, price of one good relative to the overall price level, etc. •As we will see later in the course, not all firms exhibit the same pricing behavior. Some have "sticky prices" and change prices infrequently. •The higher the inflation rate, the more firms are required to change their prices. But since firms do this in different ways and at different times which are not known to customers or competitors, confusion over relative prices ensues. •When consumers and firms are confused about relative prices, then they will making purchases when they otherwise would not, or delaying purchases when they otherwise would not, etc. •This implies that resources are misallocated (not always being used by those that value them the highest) which imposes efficiency costs on the economy.