Econ 2 Final

The Misperceptions Theory (Why the Aggregate-Supply Curve Slopes Upward in the Short Run)

According to this theory, changes in the overall price level can temporarily mislead suppliers about what is happening in the individual markets in which they sell their output. As a result of these short-run misperceptions, suppliers respond to changes in the level of prices, and this response leads to an upward-sloping aggregate-supply curve. To see how this might work, suppose the overall price level falls below the level that suppliers expected. When suppliers see the prices of their products fall, they may mistakenly believe that their relative prices have fallen; that is, they may believe that their prices have fallen compared to other prices in the economy. For example, wheat farmers may notice a fall in the price of wheat before they notice a fall in the prices of the many items they buy as consumers. They may infer from this observation that the reward for producing wheat is temporarily low, and they may respond by reducing the quantity of wheat they supply. Similarly, workers may notice a fall in their nominal wages before they notice that the prices of the goods they buy are also falling. They may infer that the reward for working is temporarily low and respond by reducing the quantity of labor they supply. In both cases, a lower price level causes misperceptions about relative prices, and these misperceptions induce suppliers to respond to the lower price level by decreasing the quantity of goods and services supplied. Similar misperceptions arise when the price level is above what was expected. Suppliers of goods and services may notice the price of their output rising and infer, mistakenly, that their relative prices are rising. They would conclude that it is a good time to produce. Until their misperceptions are corrected, they respond to the higher price level by increasing the quantity of goods and services supplied. This behavior results in a short-run aggregate-supply curve that slopes upward.

M1

Currency, demand deposits, traveler's checks, other checkable deposits

Two problems with fractional reserve banking

The first problem is that the Fed does not control the amount of money that households choose to hold as deposits in banks. The more money households deposit, the more reserves banks have, and the more money the banking system can create. The less money households deposit, the less reserves banks have, and the less money the banking system can create. To see why this is a problem, suppose that one day people lose confidence in the banking system and withdraw some of their deposits to hold more currency. When this happens, the banking system loses reserves and creates less money. The money supply falls, even without any Fed action. The second problem of monetary control is that the Fed does not control the amount that bankers choose to lend. When money is deposited in a bank, it creates more money only when the bank loans it out. Because banks can choose to hold excess reserves instead, the Fed cannot be sure how much money the banking system will create. For instance, suppose that one day bankers become more cautious about economic conditions and decide to make fewer loans and hold greater reserves. In this case, the banking system creates less money than it otherwise would. Because of the bankers' decision, the money supply falls.

Insurance

The general feature of insurance contracts is that a person facing a risk pays a fee to an insurance company, which in return agrees to accept all or part of the risk. In a sense, every insurance contract is a gamble. It is possible that you will not be in an auto accident, that your house will not burn down, and that you will not need expensive medical treatment. In most years, you will pay the insurance company the premium and get nothing in return except peace of mind.

Money supply demand graph

The horizontal axis shows the quantity of money. The left vertical axis shows the value of money, and the right vertical axis shows the price level. The supply curve for money is vertical because the quantity of money supplied is fixed by the Fed. The demand curve for money slopes downward because people want to hold a larger quantity of money when each dollar buys less. At the equilibrium, point A, the value of money (on the left axis) and the price level (on the right axis) have adjusted to bring the quantity of money supplied and the quantity of money demanded into balance. Notice that the price-level axis on the right is inverted: A low price level is shown near the top of this axis, and a high price level is shown near the bottom. This inverted axis illustrates that when the value of money is high (as shown near the top of the left axis), the price level is low (as shown near the top of the right axis). The two curves in this figure are the supply and demand curves for money. The supply curve is vertical because the Fed has fixed the quantity of money available. The demand curve for money slopes downward, indicating that when the value of money is low (and the price level is high), people demand a larger quantity of it to buy goods and services. At the equilibrium, shown in the figure as point A, the quantity of money demanded balances the quantity of money supplied. This equilibrium of money supply and money demand determines the value of money and the price level. When the Fed increases the supply of money, the money supply curve shifts from MS1 to MS2. The value of money (on the left axis) and the price level (on the right axis) adjust to bring supply and demand back into balance. The equilibrium moves from point A to point B. Thus, when an increase in the money supply makes dollars more plentiful, the price level increases, making each dollar less valuable. The immediate effect of a monetary injection is to create an excess supply of money. Before the injection, the economy was in equilibrium. At the prevailing price level, people had exactly as much money as they wanted. But after the helicopters drop the new money and people pick it up off the streets, people have more dollars in their wallets than they want. At the prevailing price level, the quantity of money supplied now exceeds the quantity demanded. People try to get rid of this excess supply of money in various ways. They might use it to buy goods and services. Or they might use this excess money to make loans to others by buying bonds or by depositing the money in a bank savings account. These loans allow other people to buy goods and services. In either case, the injection of money increases the demand for goods and services. The economy's ability to supply goods and services, however, has not changed. Thus, the greater demand for goods and services causes the prices of goods and services to increase. The increase in the price level, in turn, increases the quantity of money demanded because people are using more dollars for every transaction. Eventually, the economy reaches a new equilibrium at which the quantity of money demanded again equals the quantity of money supplied. In this way, the overall price level for goods and services adjusts to bring money supply and money demand into balance.

Confusion and Inconvenience

The job of the Federal Reserve is a bit like the job of the Bureau of Standards—to ensure the reliability of a commonly used unit of measurement. When the Fed increases the money supply and creates inflation, it erodes the real value of the unit of account. Earlier, we discussed how the tax code incorrectly measures real incomes in the presence of inflation. Similarly, accountants incorrectly measure firms' earnings when prices are rising over time. Because inflation causes dollars at different times to have different real values, computing a firm's profit—the difference between its revenue and costs—is more complicated in an economy with inflation. Therefore, to some extent, inflation makes investors less able to sort successful from unsuccessful firms, which in turn impedes financial markets in their role of allocating the economy's saving to alternative types of investment.

Why the Aggregate-Supply Curve Slopes Upward in the Short Run

The key difference between the economy in the short run and in the long run is the behavior of aggregate supply. The long-run aggregate-supply curve is vertical because, in the long run, the overall level of prices does not affect the economy's ability to produce goods and services. By contrast, in the short run, the price level does affect the economy's output. That is, over a period of a year or two, an increase in the overall level of prices in the economy tends to raise the quantity of goods and services supplied, and a decrease in the level of prices tends to reduce the quantity of goods and services supplied. As a result, the short-run aggregate-supply curve slopes upward In the short run, a fall in the price level from P1 to P2 reduces the quantity of output supplied from Y1 to Y2. This positive relationship could be due to sticky wages, sticky prices, or misperceptions. Over time, wages, prices, and perceptions adjust, so this positive relationship is only temporary. Why do changes in the price level affect output in the short run? Macro-economists have proposed three theories for the upward slope of the short-run aggregate-supply curve. In each theory, a specific market imperfection causes the supply side of the economy to behave differently in the short run than it does in the long run. The following theories differ in their details, but they share a common theme: The quantity of output supplied deviates from its long-run, or natural, level when the actual price level in the economy deviates from the price level that people expected to prevail. When the price level rises above the level that people expected, output rises above its natural level, and when the price level falls below the expected level, output falls below its natural level.

Worker turnover

The more a firm pays its workers, the less often its workers will choose to leave. Thus, a firm can reduce turnover among its workers by paying them a high wage. Why do firms care about turnover? The reason is that it is costly for firms to hire and train new workers. Moreover, even after they are trained, newly hired workers are not as productive as experienced ones.

Shifts in Aggregate Demand Arising from Changes in Government Purchases

The most direct way that policymakers shift the aggregate-demand curve is through government purchases. For example, suppose Congress decides to reduce purchases of new weapons systems. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, if state governments start building more highways, the result is a greater quantity of goods and services demanded at any price level, so the aggregate-demand curve shifts to the right.

The Interest-Rate Effect

The price level is one determinant of the quantity of money demanded. When the price level is lower, households do not need to hold as much money to buy the goods and services they want. Therefore, when the price level falls, households try to reduce their holdings of money by lending some of it out. For instance, a household might use its excess money to buy interest-bearing bonds. Or it might deposit its excess money in an interest-bearing savings account, and the bank would use these funds to make more loans. In either case, as households try to convert some of their money into interest-bearing assets, they drive down interest rates. Interest rates, in turn, affect spending on goods and services. Because a lower interest rate makes borrowing less expensive, it encourages firms to borrow more to invest in new plants and equipment, and it encourages households to borrow more to invest in new housing. (A lower interest rate might also stimulate consumer spending, especially spending on large durable purchases such as cars, which are often bought on credit.) Thus, a lower interest rate increases the quantity of goods and services demanded. This logic gives us the second reason the aggregate-demand curve slopes downward. A lower price level reduces the interest rate, encourages greater spending on investment goods, and thereby increases the quantity of goods and services demanded. Conversely, a higher price level raises the interest rate, discourages investment spending, and decreases the quantity of goods and services demanded.

Equity finance

The sale of stock to raise money

Population growth

The size of the labor force: A large population means more workers to produce goods and services. The tremendous size of the Chinese population is one reason China is such an important player in the world economy. A large population means more people to consume those goods and services. So while a large population means a larger total output of goods and services, it need not mean a higher standard of living for the typical citizen.

Quantity theory of money

a theory asserting that the quantity of money available determines the price level and that the growth rate in the quantity of money available determines the inflation rate

Union

a worker association that bargains with employers over wages, benefits, and working conditions. A union is a type of cartel. Like any cartel, a union is a group of sellers acting together in the hope of exerting their joint market power. When a union raises the wage above the equilibrium level, it raises the quantity of labor supplied and reduces the quantity of labor demanded, resulting in unemployment. Workers who remain employed at the higher wage are better off, but those who were previously employed and are now unemployed are worse off. Indeed, unions are often thought to cause conflict between different groups of workers—between the insiders who benefit from high union wages and the outsiders who do not get the union jobs. Thus, when unions raise wages in one part of the economy, the supply of labor increases in other parts of the economy. This increase in labor supply, in turn, reduces wages in industries that are not unionized. In other words, workers in unions reap the benefit of collective bargaining, while workers not in unions bear some of the cost. o It is inefficient because high union wages reduce employment in unionized firms below the efficient, competitive level. It is inequitable because some workers benefit at the expense of other workers. o A union may balance the firm's market power and protect the workers from being at the mercy of the firm's owners. o Whenever a worker takes a job, the worker and the firm must agree on many attributes of the job in addition to the wage: hours of work, overtime, vacations, sick leave, health benefits, promotion schedules, job security, and so on. By representing workers' views on these issues, unions allow firms to provide the right mix of job attributes. o Even if unions have the adverse effect of pushing wages above the equilibrium level and causing unemployment, they have the benefit of helping firms keep a happy and productive workforce.

Fact 1: Economic Fluctuations Are Irregular and Unpredictable

Fluctuations in the economy are often called the business cycle. As this term suggests, economic fluctuations correspond to changes in business conditions. When real GDP grows rapidly, business is good. During such periods of economic expansion, most firms find that customers are plentiful and that profits are growing. When real GDP falls during recessions, businesses have trouble. During such periods of economic contraction, most firms experience declining sales and dwindling profits. Economic fluctuations are not at all regular, and they are almost impossible to predict with much accuracy

Inflation is bad, but deflation may be worse

Friedman rule: Some economists have suggested that a small and predictable amount of deflation may be desirable. Milton Friedman pointed out that deflation would lower the nominal interest rate (via the Fisher effect) and that a lower nominal interest rate would reduce the cost of holding money. The shoeleather costs of holding money would, he argued, be minimized by a nominal interest rate close to zero, which in turn would require deflation equal to the real interest rate. This prescription for moderate deflation is called the Friedman rule. Just as a rising price level induces menu costs and relative-price variability, so does a falling price level. Moreover, in practice, deflation is rarely as steady and predictable as Friedman recommended. More often, it comes as a surprise, resulting in the redistribution of wealth toward creditors and away from debtors. Because debtors are often poorer, these redistributions in wealth are particularly painful. Deflation is often a symptom of deeper economic problems. Falling prices result when some event, such as a monetary contraction, reduces the overall demand for goods and services in the economy. This fall in aggregate demand can lead to falling incomes and rising unemployment.

Why the Aggregate-Demand Curve Slopes Downward

GDP equation: Y = C+I+G+NX To understand the downward slope of the aggregate-demand curve, we must examine how the price level affects the quantity of goods and services demanded for consumption, investment, and net exports.

Balance sheet

accounting statement where assets and liabilities exactly balance

Interest on reserves

when a bank holds reserves on deposit at the Fed, the Fed now pays the bank interest on those deposits. This change gives the Fed another tool with which to influence the economy. The higher the interest rate on reserves, the more reserves banks will choose to hold. Thus, an increase in the interest rate on reserves will tend to increase the reserve ratio, lower the money multiplier, and lower the money supply.

Rule of 70

if some variable grows at a rate of x percent per year, then that variable doubles in approximately 70/x years

Common knowledge technology

after one person uses it, everyone becomes aware of it Once henry ford successfully introduced assembly-line production, other carmakers adopted it quickly

Accounting

refers to how various numbers are defined and added up. A personal accountant might help an individual add up his income and expenses. A national income accountant does the same thing for the economy as a whole. The national income accounts include, in particular, GDP and the many related statistics.

Index funds

buy all the stocks in a given stock index Perform somewhat better on average than mutual funds that take advantage of active trading by professional money managers. The explanation for the superior performance of index funds is that they keep costs low by buying and selling very rarely and by not having to pay the salaries of professional money managers.

Stock

represents ownership in a firm and is, therefore, a claim to the profits that the firm makes. For example, if Intel sells a total of 1,000,000 shares of stock, then each share represents ownership of 1/1,000,000 of the business.

Reserves

deposits that banks have received but have not loaned out

Leverage ratio

the ratio of the bank's total assets to bank capital. A leverage ratio of 20 means that for every dollar of capital that the bank owners have contributed, the bank has $20 of assets.

Diversification

the reduction of risk achieved by replacing a single risk with a large number of smaller, unrelated risks

Bank's assets

the reserves it holds in its vaults

Bank capital

the resources a bank's owners have put into the institution

Inflation rate in year 2

((GDP deflator in year 2 - GDP deflator in year 1)/GDP deflator in year 1) * 100

Malthus: Stretching Natural Resources

-Malthus argued that an ever-increasing population would continually strain society's ability to provide for itself. As a result, mankind was doomed to forever live in poverty. -He began by noting that "food is necessary to the existence of man" and that "the passion between the sexes is necessary and will remain nearly in its present state." He concluded that "the power of population is infinitely greater than the power in the earth to produce subsistence for man." According to Malthus, the only check on population growth was "misery and vice." Attempts by charities or governments to alleviate poverty were counterproductive, he argued, because they merely allowed the poor to have more children, placing even greater strains on society's productive capabilities. -Malthus may have correctly described the world at the time when he lived, but fortunately, his dire forecast was far off the mark. The world population has increased about sixfold over the past two centuries, but living standards around the world are on average much higher. As a result of economic growth, chronic hunger and malnutrition are less common now than they were in Malthus's day. Modern famines occur from time to time but are more often the result of an unequal income distribution or political instability than inadequate food production. -Pesticides, fertilizers, mechanized farm equipment, new crop varieties, and other technological advances that Malthus never imagined have allowed each farmer to feed ever greater numbers of people. Even with more mouths to feed, fewer farmers are necessary because each farmer is much more productive.

Diluting the capital stock

-Some theories suggest high population growth reduces GDP per worker because rapid growth in the number of workers forces the capital stock to be spread more thinly. In other words, when population growth is rapid, each worker is equipped with less capital. A smaller quantity of capital per worker leads to lower productivity and lower GDP per worker. -Countries with high population growth have large numbers of school-age children. This places a larger burden on the educational system. It is not surprising, therefore, that educational attainment tends to be low in countries with high population growth. -Bearing a child, like any decision, has an opportunity cost. When the opportunity cost rises, people will choose to have smaller families. In particular, women with the opportunity to receive a good education and desirable employment tend to want fewer children than those with fewer opportunities outside the home. Hence, policies that foster equal treatment of women may be one way for less developed economies to reduce the rate of population growth and, perhaps, raise their standards of living.

Sally deposited $1000 with 10% interest when DVD's costed $10 so she could buy 100 DVD's. A year later, she has $1100, but has the price of DVD's changed?

-Zero inflation: If the price didn't change, she can buy 110 DVD's and 10 more than she could before, meaning she increased her purchasing power by 10%. -6% Inflation: DVD price went from $10 to $10.60, she can buy 104 DVD's. Her purchasing power raised by 4 percent. -10% inflation: DVD price went from $10 to $11, she can still only buy 100 DVD's, her purchasing power is the same. -12% inflation: DVD price went from $10 to $11.20, she can buy 98 DVD's and her purchasing power decreased by 2 percent. -If sally lived in an economy with deflation instead of inflation: - 2% deflation: DVD price went from $10 to $9.80, she can buy 112 DVD's and her purchasing power increased by 12% The higher the rate of inflation, the smaller the increase in Sally's purchasing power, If the inflation rate exceeds the rate of interest, her purchasing power decreases. If there's deflation, her purchasing power rises by more than the rate of interest.

2 differences cause GDP deflator and CPI to diverge

1. GDP deflator reflects the prices of all goods and services produced domestically, and CPI reflects the prices of all goods and services bought by consumers. Example: Volvos made in Sweden aren't part of GDP. But US consumer buy them, so they're in the typical consumer's basket of goods and price changes are reflected in the CPI and not in the GDP deflator. The US produces some oil but mostly it's imported, so oil spending makes up a larger part of consumer spending than of GDP, so CPI raises much more than GDP deflator 2. How various prices are weighted to yield a single number for the overall level of prices. The CPI uses a fixed basket and rarely alters the basket. The GDP deflator compares the price of currently produced goods and services to the price of the same goods and services in the base year. The goods and services used to compute GDP deflator changes automatically over time.

3 functions of money

1. Medium of exchange - an item that buyers give to sellers when they purchase goods and services. 2. Unit of account - the yardstick people use to post prices and record debts. We use money as the unit of account. 3. Store of value - an item that people can use to transfer purchasing power from the present to the future

3 problems with CPI

1. Substitution bias- Some prices rise more than others from one year to the next. Consumers respond by buying less of the goods whose prices raised a lot and more of the goods whose prices didn't raise very much or have even fallen. If a price index is computed assuming a fixed basket of goods, it ignored the possibility of consumer substitution and overstates the increase in the cost of living from one year to the next. Example: in the base year, apples are cheaper than pears so consumer buy more apples. In the next year, pears are cheaper than apples so people buy more pears, but the basket assumes that people continue buying the expensive apples in the same quantities as before, and therefore the index will measure a much larger increase in cost of living than is true 2. Introduction of new goods- New goods cause more variety. The increased set of possible choices makes each dollar more valuable. Because the CPI is based on a fixed basket, it doesn't reflect the increase in the value of the dollar that arises from the introduction of new goods. 3. Unmeasured quality change - If the quality of a good deteriorates from one year to the next, the value of a dollar falls. If the quality increases, the value of a dollar rises. When quality changes, the BLS adjusts the price of the good to account for the quality change.

Adverse selection

A high-risk person is more likely to apply for insurance than a low-risk person because a high-risk person would benefit more from insurance protection.

Foreign direct investment

A capital investment that is owned and operated by a foreign entity. Ford Motor Company might build a car factory in Mexico. Capital investment- capital investment refers to funds invested in a firm or enterprise for the purpose of furthering its business objectives. Capital investment may also refer to a firm's acquisition of capital assets or fixed assets such as manufacturing plants and machinery that is expected to be productive over many years. Alternatively, an American might buy stock in a Mexican corporation (that is, buy a share in the ownership of the corporation), and the corporation can use the proceeds from the stock sale to build a new factory.

Efficiency wages

According to this theory, firms operate more efficiently if wages are above the equilibrium level. Therefore, it may be profitable for firms to keep wages high even in the presence of a surplus of labor. Efficiency-wage theory states that such a constraint(preventing firms from lowering wages in the presence of a surplus of workers) on firms is unnecessary in many cases because firms may be better off keeping wages above the equilibrium level.

The Sticky-Wage Theory (Why the Aggregate-Supply Curve Slopes Upward in the Short Run)

According to this theory, the short-run aggregate-supply curve slopes upward because nominal wages are slow to adjust to changing economic conditions. In other words, wages are "sticky" in the short run. To some extent, the slow adjustment of nominal wages is attributable to long-term contracts between workers and firms that fix nominal wages, sometimes for as long as 3 years. In addition, this prolonged adjustment may be attributable to slowly changing social norms and notions of fairness that influence wage setting. An example can help explain how sticky nominal wages can result in a short-run aggregate-supply curve that slopes upward. Imagine that a year ago a firm expected the price level today to be 100, and based on this expectation, it signed a contract with its workers agreeing to pay them, say, $20 an hour. In fact, the price level turns out to be only 95. Because prices have fallen below expectations, the firm gets 5 percent less than expected for each unit of its product that it sells. The cost of labor used to make the output, however, is stuck at $20 per hour. Production is now less profitable, so the firm hires fewer workers and reduces the quantity of output supplied. Over time, the labor contract will expire, and the firm can renegotiate with its workers for a lower wage (which they may accept because prices are lower), but in the meantime, employment and production will remain below their long-run levels. The same logic works in reverse. Suppose the price level turns out to be 105 and the wage remains stuck at $20. The firm sees that the amount it is paid for each unit sold is up by 5 percent, while its labor costs are not. In response, it hires more workers and increases the quantity of output supplied. Eventually, the workers will demand higher nominal wages to compensate for the higher price level, but for a while, the firm can take advantage of the profit opportunity by increasing employment and production above their long-run levels. In short, according to the sticky-wage theory, the short-run aggregate-supply curve slopes upward because nominal wages are based on expected prices and do not respond immediately when the actual price level turns out to be different from what was expected. This stickiness of wages gives firms an incentive to produce less output when the price level turns out lower than expected and to produce more when the price level turns out higher than expected.

Open economies

Actual economies are open economies—that is, they interact with other economies around the world.

Moral hazard

After people buy insurance, they have less incentive to be careful about their risky behavior because the insurance company will cover much of the resulting losses

3 theories of Why the Aggregate-Supply Curve Slopes Upward in the Short Run

All three theories suggest that output deviates in the short run from its natural level when the actual price level deviates from the price level that people had expected to prevail. We can express this mathematically as follows: Quantity of output supplied = Natural level of output + a(Actual price level - Expected price level) where a is a number that determines how much output responds to unexpected changes in the price level. Notice that each of the three theories of short-run aggregate supply emphasizes a problem that is likely to be temporary. Whether the upward slope of the aggregate-supply curve is attributable to sticky wages, sticky prices, or misperceptions, these conditions will not persist forever. Over time, nominal wages will become unstuck, prices will become unstuck, and misperceptions about relative prices will be corrected. In the long run, it is reasonable to assume that wages and prices are flexible rather than sticky and that people are not confused about relative prices. Thus, while we have several good theories to explain why the short-run aggregate-supply curve slopes upward, they are all consistent with a long-run aggregate-supply curve that is vertical.

Stock market

Although corporations use both equity and debt finance to raise money for new investments, stocks and bonds are very different. The owner of shares of Intel stock is a part owner of Intel, while the owner of an Intel bond is a creditor of the corporation. If Intel is very profitable, the stockholders enjoy the benefits of these profits, whereas the bondholders get only the interest on their bonds. And if Intel runs into financial difficulty, the bondholders are paid what they are due before stockholders receive anything at all. Compared to bonds, stocks offer the holder both higher risk and potentially higher return. After a corporation issues stock by selling shares to the public, these shares trade among stockholders on organized stock exchanges. In these transactions, the corporation itself receives no money when its stock changes hands. The prices at which shares trade on stock exchanges are determined by the supply of and demand for the stock in these companies. The demand for a stock (and thus its price) reflects people's perception of the corporation's future profitability. When people become optimistic about a company's future, they raise their demand for its stock and thereby bid up the price of a share of stock. Conversely, when people's expectations of a company's prospects decline, the price of a share falls.

Formula for turning dollar figures from year T into today's dollars

Amount in today's dollars = Amount in year T dollars * (Price level today/Price level in year T)

Shifts in Long-Run Aggregate-Supply Arising from Changes in Natural Resources

An economy's production depends on its natural resources, including its land, minerals, and weather. The discovery of a new mineral deposit shifts the long-run aggregate-supply curve to the right. A change in weather patterns that makes farming more difficult shifts the long-run aggregate-supply curve to the left. In many countries, crucial natural resources are imported. A change in the availability of these resources can also shift the aggregate-supply curve. For example, as we discuss later in this chapter, events occurring in the world oil market have historically been an important source of shifts in aggregate supply for the United States and other oil-importing nations.

Shifts in Long-Run Aggregate-Supply Arising from Changes in Capital

An increase in the economy's capital stock increases productivity and, thereby, the quantity of goods and services supplied. As a result, the long-run aggregate-supply curve shifts to the right. Conversely, a decrease in the economy's capital stock decreases productivity and the quantity of goods and services supplied, shifting the long-run aggregate-supply curve to the left. Notice that the same logic applies regardless of whether we are discussing physical capital such as machines and factories or human capital such as college degrees. An increase in either type of capital will raise the economy's ability to produce goods and services and, thus, shift the long-run aggregate-supply curve to the right.

Foreign portfolio investment

An investment that is financed with foreign money but operated by domestic residents In both cases, Americans provide the resources necessary to increase the stock of capital in Mexico. That is, American saving is being used to finance Mexican investment. Benefits: -Some benefits flow back to the foreign capital owners -Increase the economy's stock of capital -Higher productivity and higher wages -State-of-the-art technologies developed in other countries -Especially good for poor countries that cannot generate enough saving to fund investment projects themselves

Shifts in Aggregate Demand Arising from Changes in Investment

Any event that changes how much firms want to invest at a given price level also shifts the aggregate-demand curve. For instance, imagine that the computer industry introduces a faster line of computers and many firms decide to invest in new computer systems. Because the quantity of goods and services demanded at any price level is higher, the aggregate-demand curve shifts to the right. Conversely, if firms become pessimistic about future business conditions, they may cut back on investment spending, shifting the aggregate-demand curve to the left. Tax policy can also influence aggregate demand through investment. For example, an investment tax credit (a tax rebate tied to a firm's investment spending) increases the quantity of investment goods that firms demand at any given interest rate and therefore shifts the aggregate-demand curve to the right. The repeal of an investment tax credit reduces investment and shifts the aggregate-demand curve to the left. Another policy variable that can influence investment and aggregate demand is the money supply. As we discuss more fully in the next chapter, an increase in the money supply lowers the interest rate in the short run. This decrease in the interest rate makes borrowing less costly, which stimulates investment spending and thereby shifts the aggregate-demand curve to the right. Conversely, a decrease in the money supply raises the interest rate, discourages investment spending, and thereby shifts the aggregate-demand curve to the left. Many economists believe that throughout U.S. history, changes in monetary policy have been an important source of shifts in aggregate demand.

Shifts in Aggregate Supply Arising from Changes in Net Exports

Any event that changes net exports for a given price level also shifts aggregate demand. For instance, when Europe experiences a recession, it buys fewer goods from the United States. This reduces U.S. net exports at every price level and shifts the aggregate-demand curve for the U.S. economy to the left. When Europe recovers from its recession, it starts buying U.S. goods again and the aggregate-demand curve shifts to the right. Net exports can also change because international speculators cause movements in the exchange rate. Suppose, for instance, that these speculators lose confidence in foreign economies and want to move some of their wealth into the U.S. economy. In doing so, they bid up the value of the U.S. dollar in the foreign exchange market. This appreciation of the dollar makes U.S. goods more expensive compared to foreign goods, which depresses net exports and shifts the aggregate-demand curve to the left. Conversely, speculation that causes a depreciation of the dollar stimulates net exports and shifts the aggregate-demand curve to the right.

Shoeleather costs

As we have discussed, inflation is like a tax on the holders of money. The tax itself is not a cost to society: It is only a transfer of resources from households to the government. Yet most taxes give people an incentive to alter their behavior to avoid paying the tax, and this distortion of incentives causes deadweight losses for society as a whole. Like other taxes, the inflation tax also causes deadweight losses because people waste scarce resources trying to avoid it. Because inflation erodes the real value of the money in your wallet, you can avoid the inflation tax by holding less money. One way to do this is to go to the bank more often. For example, rather than withdrawing $200 every four weeks, you might withdraw $50 once a week. By making more frequent trips to the bank, you can keep more of your wealth in your interest-bearing savings account and less in your wallet, where inflation erodes its value.

The Exchange-Rate Effect

As we have just discussed, a lower price level in the United States lowers the U.S. interest rate. In response to the lower interest rate, some U.S. investors will seek higher returns by investing abroad. For instance, as the interest rate on U.S. government bonds falls, a mutual fund might sell U.S. government bonds to buy German government bonds. As the mutual fund tries to convert its dollars into euros to buy the German bonds, it increases the supply of dollars in the market for foreign-currency exchange. The increased supply of dollars to be turned into euros causes the dollar to depreciate relative to the euro. This leads to a change in the real exchange rate—the relative price of domestic and foreign goods. Because each dollar buys fewer units of foreign currencies, foreign goods become more expensive relative to domestic goods. The change in relative prices affects spending, both at home and abroad. Because foreign goods are now more expensive, Americans buy less from other countries, causing U.S. imports of goods and services to decrease. At the same time, because U.S. goods are now cheaper, foreigners buy more from the United States, so U.S. exports increase. Net exports equal exports minus imports, so both of these changes cause U.S. net exports to increase. Thus, the fall in the real exchange value of the dollar leads to an increase in the quantity of goods and services demanded. ♣ This logic yields the third reason the aggregate-demand curve slopes downward. When a fall in the U.S. price level causes U.S. interest rates to fall, the real value of the dollar declines in foreign exchange markets. This depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded. Conversely, when the U.S. price level rises and causes U.S. interest rates to rise, the real value of the dollar increases, and this appreciation reduces U.S. net exports and the quantity of goods and services demanded.

Other mechanisms for banks to borrow from it

At times, the Fed has set up other mechanisms for banks to borrow from it. For example, from 2007 to 2010, under the Term Auction Facility, the Fed set a quantity of funds it wanted to lend to banks, and eligible banks then bid to borrow those funds. The loans went to the highest eligible bidders—that is, to the banks that had acceptable collateral and offered to pay the highest interest rate. Unlike at the discount window, where the Fed sets the price of a loan and the banks determine the quantity of borrowing, at the Term Auction Facility the Fed set the quantity of borrowing and competitive bidding among banks determined the price. The more funds the Fed made available, the greater the quantity of reserves and the larger the money supply. The Fed lends to banks not only to control the money supply but also to help financial institutions when they are in trouble.

Banks

Banks are the financial intermediaries with which people are most familiar. A primary job of banks is to take in deposits from people who want to save and use these deposits to make loans to people who want to borrow. Banks pay depositors interest on their deposits and charge borrowers slightly higher interest on their loans. The difference between these rates of interest covers the banks' costs and returns some profit to the owners of the banks.

Why the Long-Run Aggregate-Supply Curve Might Shift

Because classical macroeconomic theory predicts the quantity of goods and services produced by an economy in the long run, it also explains the position of the long-run aggregate-supply curve. The long-run level of production is sometimes called potential output or full-employment output. To be more precise, we call it the natural level of output because it shows what the economy produces when unemployment is at its natural, or normal, rate.

Worker health

Better-paid workers eat a more nutritious diet, and workers who eat a better diet are healthier and more productive. A firm may find it more profitable to pay high wages and have healthy, productive workers than to pay lower wages and have less healthy, less productive workers.

Patent system

By allowing inventors to profit from their inventions—even if only temporarily—the patent system enhances the incentive for individuals and firms to engage in research. When a person or firm creates an innovative product, such as a new drug, the inventor can apply for a patent. If the product is deemed truly original, the government awards the patent, which gives the inventor the exclusive right to make the product for a specified number of years. In essence, the patent gives the inventor a property right over her invention, turning her new idea from a public good into a private good.

The Wealth Effect (Why the Aggregate-Demand Curve Slopes Downward)

Consider the money that you hold in your wallet and your bank account. The nominal value of this money is fixed: One dollar is always worth one dollar. Yet the real value of a dollar is not fixed. If a candy bar costs one dollar, then a dollar is worth one candy bar. If the price of a candy bar falls to 50 cents, then one dollar is worth two candy bars. Thus, when the price level falls, the dollars you are holding rise in value, which increases your real wealth and your ability to buy goods and services. This logic gives us the first reason the aggregate-demand curve slopes downward. A decrease in the price level raises the real value of money and makes consumers wealthier, which in turn encourages them to spend more. The increase in consumer spending means a larger quantity of goods and services demanded. Conversely, an increase in the price level reduces the real value of money and makes consumers poorer, which in turn reduces consumer spending and the quantity of goods and services demanded.

Constant returns to scale (production function)

Constant returns to scale - if you double all inputs, all outputs double. Mathematically, we write that a production function has constant returns to scale if, for any positive number x, xY = AF(xL, xK, xH, xN) A doubling of all inputs would be represented by x =2, the right side shows the inputs doubling, and the left side shows output doubling

Why a fall in the price level increases the quantity of goods and services demanded

Consumers are wealthier, which stimulates the demand for consumption goods. Interest rates fall, which stimulates the demand for investment goods. The currency depreciates, which stimulates the demand for net exports. The same three effects work in reverse: When the price level rises, decreased wealth depresses consumer spending, higher interest rates depress investment spending, and a currency appreciation depresses net exports. It is important to keep in mind that the aggregate-demand curve (like all demand curves) is drawn holding "other things equal." In particular, our three explanations of the downward-sloping aggregate-demand curve assume that the money supply is fixed. That is, we have been considering how a change in the price level affects the demand for goods and services, holding the amount of money in the economy constant. As we will see, a change in the quantity of money shifts the aggregate-demand curve. At this point, just keep in mind that the aggregate-demand curve is drawn for a given quantity of the money supply.

M2

Everything in M1, savings deposits, small time deposits, money market mutual funds, a few minor categories

Using Aggregate Demand and Aggregate Supply to Depict Long-Run Growth and Inflation

Having introduced the economy's aggregate-demand curve and the long-run aggregate-supply curve, we now have a new way to describe the economy's long-run trends. Figure 5 illustrates the changes that occur in an economy from decade to decade. Notice that both curves are shifting. Although many forces influence the economy in the long run and can in theory cause such shifts, the two most important forces in practice are technology and monetary policy. Technological progress enhances an economy's ability to produce goods and services, and the resulting increases in output are reflected in continual shifts of the long-run aggregate-supply curve to the right. At the same time, because the Fed increases the money supply over time, the aggregate-demand curve also shifts to the right. As the figure illustrates, the result is continuing growth in output (as shown by increasing Y) and continuing inflation (as shown by increasing P). This is just another way of representing the classical analysis of growth and inflation we conducted in earlier chapters. As the economy becomes better able to produce goods and services over time, primarily because of technological progress, the long-run aggregate-supply curve shifts to the right. At the same time, as the Fed increases the money supply, the aggregate-demand curve also shifts to the right. In this figure, output grows from Y1990 to Y2000 and then to and the price level rises from P1990 to P2000 and then to P2010. Thus, the model of aggregate demand and aggregate supply offers a new way to describe the classical analysis of growth and inflation. The purpose of developing the model of aggregate demand and aggregate supply, however, is not to dress our previous long-run conclusions in new clothing. Instead, it is to provide a framework for short-run analysis, as we will see in a moment. As we develop the short-run model, we keep the analysis simple by omitting the continuing growth and inflation shown by the shifts in Figure 5. But always remember that long-run trends are the background on which short-run fluctuations are superimposed. The short-run fluctuations in output and the price level that we will be studying should be viewed as deviations from the long-run trends of output growth and inflation.

Worker effort

High wages make workers more eager to keep their jobs and thus motivate them to put forward their best effort. If the wage were at the level that balanced supply and demand, workers would have less reason to work hard because if they were fired, they could quickly find new jobs at the same wage. Therefore, firms may raise wages above the equilibrium level to provide an incentive for workers not to shirk their responsibilities.

Budget deficit

If the government spends more than it receives in tax revenue, then G is larger than T. Public saving (T − G) is a negative number Because the budget deficit does not influence the amount that households and firms want to borrow to finance investment at any given interest rate, it does not alter the demand for loanable funds. Thus, a budget deficit shifts the supply curve for loanable funds to the left The budget deficit reduces the supply of loanable funds, drives up the interest rate, and crowds out borrowers trying to finance capital investments. Investment falls

The inflation fallacy

If you ask the typical person why inflation is bad, he will tell you that the answer is obvious: Inflation robs him of the purchasing power of his hard-earned dollars. When prices rise, each dollar of income buys fewer goods and services. Thus, it might seem that inflation directly lowers living standards. Yet further thought reveals a fallacy in this answer. When prices rise, buyers of goods and services pay more for what they buy. At the same time, however, sellers of goods and services get more for what they sell. Because most people earn their incomes by selling their services, such as their labor, inflation in incomes goes hand in hand with inflation in prices. Thus, inflation does not in itself reduce people's real purchasing power. A worker who receives an annual raise of 10 percent tends to view that raise as a reward for his own talent and effort. When an inflation rate of 6 percent reduces the real value of that raise to only 4 percent, the worker might feel that he has been cheated of what is rightfully his due. In fact, as we discussed in the chapter on production and growth, real incomes are determined by real variables, such as physical capital, human capital, natural resources, and the available production technology. Nominal incomes are determined by those factors and the overall price level. If the Fed were to lower the inflation rate from 6 percent to zero, our worker's annual raise would fall from 10 percent to 4 percent. He might feel less robbed by inflation, but his real income would not rise more quickly.

The Effects of a Shift in Aggregate Supply

Imagine once again an economy in its long-run equilibrium. Now suppose that suddenly some firms experience an increase in their costs of production. For example, bad weather in farm states might destroy some crops, driving up the cost of producing food products. Or a war in the Middle East might interrupt the shipping of crude oil, driving up the cost of producing oil products. To analyze the macroeconomic impact of such an increase in production costs, we follow the same four steps as always. First, which curve is affected? Because production costs affect the firms that supply goods and services, changes in production costs alter the position of the aggregate-supply curve. Second, in which direction does the curve shift? Because higher production costs make selling goods and services less profitable, firms now supply a smaller quantity of output for any given price level. Thus, as Figure 10 shows, the short-run aggregate-supply curve shifts to the left, from AS1 to AS2. (Depending on the event, the long-run aggregate-supply curve might also shift. To keep things simple, however, we will assume that it does not.) When some event increases firms' costs, the short-run aggregate-supply curve shifts to the left from AS1 to AS2. The economy moves from point A to point B. The result is stagflation: Output falls from Y1 to Y2, and the price level rises from P1 to P2. The figure allows us to perform step three of comparing the initial and the new equilibrium. In the short run, the economy goes from point A to point B, moving along the existing aggregate-demand curve. The output of the economy falls from Y1 to Y2, and the price level rises from P1 to P2. Because the economy is experiencing both stagnation (falling output) and inflation (rising prices), such an event is sometimes called stagflation. Stagflation - a period of falling output and rising prices Now consider step four—the transition from the short-run equilibrium to the long-run equilibrium. According to the sticky-wage theory, the key issue is how stagflation affects nominal wages. Firms and workers may at first respond to the higher level of prices by raising their expectations of the price level and setting higher nominal wages. In this case, firms' costs will rise yet again, and the short-run aggregate-supply curve will shift farther to the left, making the problem of stagflation even worse. This phenomenon of higher prices leading to higher wages, in turn leading to even higher prices, is sometimes called a wage-price spiral. At some point, this spiral of ever-rising wages and prices will slow. The low level of output and employment will put downward pressure on workers' wages because workers have less bargaining power when unemployment is high. As nominal wages fall, producing goods and services becomes more profitable and the short-run aggregate-supply curve shifts to the right. As it shifts back toward AS1, the price level falls and the quantity of output approaches its natural level. In the long run, the economy returns to point A, where the aggregate-demand curve crosses the long-run aggregate-supply curve. This transition back to the initial equilibrium assumes, however, that aggregate demand is held constant throughout the process. In the real world, that may not be the case. Policymakers who control monetary and fiscal policy might attempt to offset some of the effects of the shift in the short-run aggregate-supply curve by shifting the aggregate-demand curve. This possibility is shown in Figure 11. In this case, changes in policy shift the aggregate-demand curve to the right, from AD1 to AD2 —exactly enough to prevent the shift in aggregate supply from affecting output. The economy moves directly from point A to point C. Output remains at its natural level, and the price level rises from P1 to P3. In this case, policymakers are said to accommodate the shift in aggregate supply. An accommodative policy accepts a permanently higher level of prices to maintain a higher level of output and employment. Faced with an adverse shift in aggregate supply from AS1 to AS2, policymakers who can influence aggregate demand might try to shift the aggregate-demand curve to the right from AD1 to AD2. The economy would move from point A to point C. This policy would prevent the supply shift from reducing output in the short run, but the price level would permanently rise from P1 to P3. This story about shifts in aggregate supply has two important lessons: Shifts in aggregate supply can cause stagflation—a combination of recession (falling output) and inflation (rising prices). Policymakers who can influence aggregate demand can potentially mitigate the adverse impact on output but only at the cost of exacerbating the problem of inflation.

Shifts in Long-Run Aggregate-Supply Arising from Changes in Labor

Imagine that an economy experiences an increase in immigration. Because there would be a greater number of workers, the quantity of goods and services supplied would increase. As a result, the long-run aggregate-supply curve would shift to the right. Conversely, if many workers left the economy to go abroad, the long-run aggregate-supply curve would shift to the left. The position of the long-run aggregate-supply curve also depends on the natural rate of unemployment, so any change in the natural rate of unemployment shifts the long-run aggregate-supply curve. For example, if Congress were to raise the minimum wage substantially, the natural rate of unemployment would rise and the economy would produce a smaller quantity of goods and services. As a result, the long-run aggregate-supply curve would shift to the left. Conversely, if a reform of the unemployment insurance system were to encourage unemployed workers to search harder for new jobs, the natural rate of unemployment would fall and the long-run aggregate-supply curve would shift to the right.

The Assumptions of Classical Economics

In a sense, money does not matter in a classical world. If the quantity of money in the economy were to double, everything would cost twice as much, and everyone's income would be twice as high. But so what? The change would be nominal (by the standard meaning of "nearly insignificant"). The things that people really care about—whether they have a job, how many goods and services they can afford, and so on—would be exactly the same. This classical view is sometimes described by the saying, "Money is a veil." That is, nominal variables may be the first things we see when we observe an economy because economic variables are often expressed in units of money. But what's important are the real variables and the economic forces that determine them. According to classical theory, to understand these real variables, we need to look behind the veil.

Investment

In the language of macroeconomics, investment refers to the purchase of new capital, such as equipment or buildings. When Moe borrows from the bank to build himself a new house, he adds to the nation's investment. (Remember, the purchase of a new house is the one form of household spending that is investment rather than consumption.) Similarly, when the Curly Corporation sells some stock and uses the proceeds to build a new factory, it also adds to the nation's investment. For the economy as a whole, saving must be equal to investment

Real interest rate (in context of Fed)

In the long run over which money is neutral, a change in money growth should not affect the real interest rate. The real interest rate is, after all, a real variable. For the real interest rate not to be affected, the nominal interest rate must adjust one-for-one to changes in the inflation rate. Thus, when the Fed increases the rate of money growth, the long-run result is both a higher inflation rate and a higher nominal interest rate. This adjustment of the nominal interest rate to the inflation rate is called the Fisher effect

Why the Aggregate-Supply Curve Is Vertical in the Long Run

In the long run, an economy's production of goods and services (its real GDP) depends on its supplies of labor, capital, and natural resources and on the available technology used to turn these factors of production into goods and services. We learned that if two economies were identical except that one had twice as much money in circulation, the price level would be twice as high in the economy with more money. But since the amount of money does not affect technology or the supplies of labor, capital, and natural resources, the output of goods and services in the two economies would be the same. Because the price level does not affect the long-run determinants of real GDP, the long-run aggregate-supply curve is vertical, as in Figure 4. In other words, in the long run, the economy's labor, capital, natural resources, and technology determine the total quantity of goods and services supplied, and this quantity supplied is the same regardless of what the price level happens to be. In the long run, the quantity of output supplied depends on the economy's quantities of labor, capital, and natural resources and on the technology for turning these inputs into output. Because the quantity supplied does not depend on the overall price level, the long-run aggregate-supply curve is vertical at the natural level of output. The vertical long-run aggregate-supply curve is a graphical representation of the classical dichotomy and monetary neutrality. As we have already discussed, classical macroeconomic theory is based on the assumption that real variables do not depend on nominal variables. The long-run aggregate-supply curve is consistent with this idea because it implies that the quantity of output (a real variable) does not depend on the level of prices (a nominal variable). As noted earlier, most economists believe this principle works well when studying the economy over a period of many years but not when studying year-to-year changes. Thus, the aggregate-supply curve is vertical only in the long run.

Fact 2: Most Macroeconomic Quantities Fluctuate Together

It turns out, however, that for monitoring short-run fluctuations, it does not really matter which measure of economic activity one looks at. Most macroeconomic variables that measure some type of income, spending, or production fluctuate closely together. When real GDP falls in a recession, so do personal income, corporate profits, consumer spending, investment spending, industrial production, retail sales, home sales, auto sales, and so on. Because recessions are economy-wide phenomena, they show up in many sources of macroeconomic data. Although many macroeconomic variables fluctuate together, they fluctuate by different amounts. In particular, as panel (b) of Figure 1 shows, investment spending varies greatly over the business cycle. Even though investment averages about one-sixth of GDP, declines in investment account for about two-thirds of the declines in GDP during recessions. In other words, when economic conditions deteriorate, much of the decline is attributable to reductions in spending on new factories, housing, and inventories.

Inflation-Induced Tax Distortions

Many taxes become even more problematic in the presence of inflation. The reason is that lawmakers often fail to take inflation into account when writing the tax laws. Economists who have studied the tax code conclude that inflation tends to raise the tax burden on income earned from savings. One example of how inflation discourages saving is the tax treatment of capital gains—the profits made by selling an asset for more than its purchase price. Suppose that in 1988 you used some of your savings to buy stock in IBM for $30 and that in 2016 you sold the stock for $130. According to the tax law, you have earned a capital gain of $100, which you must include in your income when computing how much income tax you owe. But because the overall price level doubled from 1988 to 2016, the $30 you invested in 1988 is equivalent (in terms of purchasing power) to $60 in 2016. When you sell your stock for $130, you have a real gain (an increase in purchasing power) of only $70. The tax code, however, does not take account of inflation and assesses you a tax on a gain of $100. Thus, inflation exaggerates the size of capital gains and inadvertently increases the tax burden on this type of income. Another example is the tax treatment of interest income. The income tax treats the nominal interest earned on savings as income, even though part of the nominal interest rate merely compensates for inflation. To see the effects of this policy, consider the numerical example in Table 1. The table compares two economies, both of which tax interest income at a rate of 25 percent. In Economy A, inflation is zero and the nominal and real interest rates are both 4 percent. In this case, the 25 percent tax on interest income reduces the real interest rate from 4 percent to 3 percent. In Economy B, the real interest rate is again 4 percent but the inflation rate is 8 percent. As a result of the Fisher effect, the nominal interest rate is 12 percent. Because the income tax treats this entire 12 percent interest as income, the government takes 25 percent of it, leaving an after-tax nominal interest rate of only 9 percent and an after-tax real interest rate of only 1 percent. In this case, the 25 percent tax on interest income reduces the real interest rate from 4 percent to 1 percent. Because the after-tax real interest rate provides the incentive to save, saving is much less attractive in the economy with inflation (Economy B) than in the economy with stable prices (Economy A). The taxes on nominal capital gains and on nominal interest income are two examples of how the tax code interacts with inflation. There are many others. Because of these inflation-induced tax changes, higher inflation tends to discourage people from saving. Recall that the economy's saving provides the resources for investment, which in turn is a key ingredient to long-run economic growth. Thus, when inflation raises the tax burden on saving, it tends to depress the economy's long-run growth rate. There is, however, no consensus among economists about the size of this effect. One solution to this problem, other than eliminating inflation, is to index the tax system. That is, the tax laws could be rewritten to take account of the effects of inflation. In the case of capital gains, for example, the tax code could adjust the purchase price using a price index and assess the tax only on the real gain. In the case of interest income, the government could tax only real interest income by excluding that portion of the interest income that merely compensates for inflation. To some extent, the tax laws have moved in the direction of indexation. For example, the income levels at which income tax rates change are adjusted automatically each year based on changes in the consumer price index. Yet many other aspects of the tax laws—such as the tax treatment of capital gains and interest income—are not indexed.

GDP

Measures the total income of everyone in the economy and the total expenditure on the economy's output of goods and services. For an economy as a whole, income must equal expenditure. This is because every transaction has the buyer and seller party. Every dollar of spending by some buyer is a dollar of income for some seller. GDP = C + I + G + NX

Minimum wage laws

Minimum-wage laws matter most for the least skilled and least experienced members of the labor force, such as teenagers. Their equilibrium wages tend to be low and, therefore, are more likely to fall below the legal minimum. It is only among these workers that minimum-wage laws explain the existence of unemployment. If the wage is kept above the equilibrium level for any reason, the result is unemployment. The need for job search is not due to the failure of wages to balance labor supply and labor demand. When job search is the explanation for unemployment, workers are searching for the jobs that best suit their tastes and skills. By contrast, when the wage is above the equilibrium level, the quantity of labor supplied exceeds the quantity of labor demanded, and workers are unemployed because they are waiting for jobs to open up.

The Reality of Short-Run Fluctuations

Most economists believe that classical theory describes the world in the long run but not in the short run. Most economists believe that, beyond a period of several years, changes in the money supply affect prices and other nominal variables but do not affect real GDP, unemployment, and other real variables—just as classical theory says. When studying year-to-year changes in the economy, however, the assumption of monetary neutrality is no longer appropriate. In the short run, real and nominal variables are highly intertwined, and changes in the money supply can temporarily push real GDP away from its long-run trend. Hume observed that when the money supply expanded after gold discoveries, it took some time for prices to rise, and in the meantime, the economy enjoyed higher employment and production.

Menu costs

Most firms do not change the prices of their products every day. Instead, firms often announce prices and leave them unchanged for weeks, months, or even years. One survey found that the typical U.S. firm changes its prices about once a year. Menu costs include the costs of deciding on new prices, printing new price lists and catalogs, sending these new price lists and catalogs to dealers and customers, advertising the new prices, and even dealing with customer annoyance over price changes. Inflation increases the menu costs that firms must bear. In the current U.S. economy, with its low inflation rate, annual price adjustment is an appropriate business strategy for many firms. But when high inflation makes firms' costs rise rapidly, annual price adjustment is impractical. During hyperinflations, for example, firms must change their prices daily or even more often just to keep up with all the other prices in the economy.

Shifts in Long-Run Aggregate-Supply Arising from Changes in Technological Knowledge

Perhaps the most important reason that the economy today produces more than it did a generation ago is that our technological knowledge has advanced. The invention of the computer, for instance, has allowed us to produce more goods and services from any given amounts of labor, capital, and natural resources. As computer use has spread throughout the economy, it has shifted the long-run aggregate-supply curve to the right. Although not literally technological, many other events act like changes in technology. For instance, opening up international trade has effects similar to inventing new production processes because it allows a country to specialize in higher-productivity industries; therefore, it also shifts the long-run aggregate-supply curve to the right. Conversely, if the government passes new regulations preventing firms from using some production methods, perhaps to address worker safety or environmental concerns, the result is a leftward shift in the long-run aggregate-supply curve.

National saving/saving

S = Y - C - G, or S = (Y - T - C)+(T - G) Y-C-G is the total income in the economy that remains after paying for consumption and government purchases. It is denoted as S, so we can write S = I, meaning that savings equals investment. T= the amount that the government collects from households in taxes minus the amount it pays back to households in the form of transfer payments (social security & welfare)

Two Causes of Economic Fluctuations

Shifts in aggregate demand and shifts in aggregate supply. Output and the price level are determined in the long run by the intersection of the aggregate-demand curve and the long-run aggregate-supply curve, shown as point A in the figure. At this point, output is at its natural level. Because the economy is always in a short-run equilibrium, the short-run aggregate-supply curve passes through this point as well, indicating that the expected price level has adjusted to this long-run equilibrium. That is, when an economy is in its long-run equilibrium, the expected price level must equal the actual price level so that the intersection of aggregate demand with short-run aggregate supply is the same as the intersection of aggregate demand with long-run aggregate supply. The long-run equilibrium of the economy is found where the aggregate-demand curve crosses the long-run aggregate-supply curve (point A). When the economy reaches this long-run equilibrium, the expected price level will have adjusted to equal the actual price level. As a result, the short-run aggregate-supply curve crosses this point as well.

Unemployment

Short term unemployment isn't really a problem. Most spells of unemployment are short, but most unemployment observed at any given time is long-term. 95 percent of unemployment spells end in one week So, even though 95 percent of unemployment spells end in one week, 75 percent of the unemployment observed at any moment is attributable to those individuals who are unemployed for a full year. The unemployment rate never falls to zero; instead, it fluctuates around the natural rate of unemployment. On the one hand, some of those who report being unemployed may not, in fact, be trying hard to find a job. They may be calling themselves unemployed because they want to qualify for a government program that gives financial assistance to the unemployed or because they are working but paid "under the table" to avoid taxes on their earnings

Friedman rule

Some economists have suggested that a small and predictable amount of deflation may be desirable. Milton Friedman pointed out that deflation would lower the nominal interest rate (via the Fisher effect) and that a lower nominal interest rate would reduce the cost of holding money. The shoeleather costs of holding money would, he argued, be minimized by a nominal interest rate close to zero, which in turn would require deflation equal to the real interest rate. This prescription for moderate deflation is called the Friedman rule.

Random walk

Stock prices follow a random walk- the path of a variable whose changes are impossible to predict A stock price only changes in response to new information ("news") about the company's value. News cannot be predicted, so stock price movements should be impossible to predict. It is impossible to systematically beat the market. By the time the news reaches you, mutual fund managers will have already acted on it.

Store of value

Stocks and bonds, like bank deposits, are a possible store of value for the wealth that people have accumulated in past saving, but access to this wealth is not as easy, cheap, and immediate as just writing a check or swiping a debit card. For now, we ignore this second role of banks, but we will return to it when we discuss the monetary system later in the book.

Shifts in Aggregate Demand Arising from Changes in Consumption (Why the Aggregate-Demand Curve Might Shift)

Suppose Americans suddenly become more concerned about saving for retirement and, as a result, reduce their current consumption. Because the quantity of goods and services demanded at any price level is lower, the aggregate-demand curve shifts to the left. Conversely, imagine that a stock market boom makes people wealthier and less concerned about saving. The resulting increase in consumer spending means a greater quantity of goods and services demanded at any given price level, so the aggregate-demand curve shifts to the right. Thus, any event that changes how much people want to consume at a given price level shifts the aggregate-demand curve. One policy variable that has this effect is the level of taxation. When the government cuts taxes, it encourages people to spend more, so the aggregate-demand curve shifts to the right. When the government raises taxes, people cut back on their spending and the aggregate-demand curve shifts to the left.

Saving

Suppose that Larry earns more than he spends and deposits his unspent income in a bank or uses it to buy some stock or a bond from a corporation. Because Larry's income exceeds his consumption, he adds to the nation's saving. Larry might think of himself as "investing" his money, but a macroeconomist would call Larry's act saving rather than investment. For the economy as a whole, saving must be equal to investment

The Effects of a Shift in Aggregate Demand

Suppose that a wave of pessimism suddenly overtakes the economy. The cause might be a scandal in the White House, a crash in the stock market, or the outbreak of war overseas. Because of this event, many people lose confidence in the future and alter their plans. Households cut back on their spending and delay major purchases, and firms put off buying new equipment. A fall in aggregate demand is represented with a leftward shift in the aggregate-demand curve from AD1 to AD2. In the short run, the economy moves from point A to point B. Output falls from Y1 to Y2 , and the price level falls from P1 to P2. Over time, as the expected price level adjusts, the short-run aggregate-supply curve shifts to the right from AS1 to AS2, and the economy reaches point C, where the new aggregate-demand curve crosses the long-run aggregate-supply curve. In the long run, the price level falls to P3, and output returns to its natural level, Y1. With this figure, we can perform step three: By comparing the initial and the new equilibrium, we can see the effects of the fall in aggregate demand. In the short run, the economy moves along the initial short-run aggregate-supply curve, AS1, going from point A to point B. As the economy moves between these two points, output falls from Y1 to Y2 and the price level falls from P1 to P2. The falling level of output indicates that the economy is in a recession. Although not shown in the figure, firms respond to lower sales and production by reducing employment. Thus, the pessimism that caused the shift in aggregate demand is, to some extent, self-fulfilling: Pessimism about the future leads to falling incomes and rising unemployment. Now comes step four—the transition from the short-run equilibrium to the new long-run equilibrium. Because of the reduction in aggregate demand, the price level initially falls from P1 to P2. The price level is thus below the level that people were expecting (P1) before the sudden fall in aggregate demand. People can be surprised in the short run, but they will not remain surprised. Over time, their expectations catch up with this new reality, and the expected price level falls as well. The fall in the expected price level alters wages, prices, and perceptions, which in turn influences the position of the short-run aggregate-supply curve. For example, according to the sticky-wage theory, once workers and firms come to expect a lower level of prices, they start to strike bargains for lower nominal wages; the reduction in labor costs encourages firms to hire more workers and expand production at any given level of prices. Thus, the fall in the expected price level shifts the short-run aggregate-supply curve to the right from AS1 to AS2 in Figure 8. This shift allows the economy to approach point C, where the new aggregate-demand curve (AD2) crosses the long-run aggregate-supply curve. In the new long-run equilibrium, point C, output is back to its natural level. The economy has corrected itself: The decline in output is reversed in the long run, even without action by policymakers. Although the wave of pessimism has reduced aggregate demand, the price level has fallen sufficiently (to P3) to offset the shift in the aggregate-demand curve, and people have come to expect this new lower price level as well. Thus, in the long run, the shift in aggregate demand is reflected fully in the price level and not at all in the level of output. In other words, the long-run effect of a shift in aggregate demand is a nominal change (the price level is lower) but not a real change (output is the same). What should policymakers do when faced with a sudden fall in aggregate demand? In this analysis, we assumed they did nothing. Another possibility is that, as soon as the economy heads into recession (moving from point A to point B), policymakers could take action to increase aggregate demand. As we noted earlier, an increase in government spending or an increase in the money supply would increase the quantity of goods and services demanded at any price and, therefore, would shift the aggregate-demand curve to the right. If policymakers act with sufficient speed and precision, they can offset the initial shift in aggregate demand, return the aggregate-demand curve to AD1, and bring the economy back to point A. If the policy is successful, the painful period of depressed output and employment can be reduced in length and severity. The next chapter discusses in more detail the ways in which monetary and fiscal policy influence aggregate demand, as well as some of the practical difficulties in using these policy instruments. In the short run, shifts in aggregate demand cause fluctuations in the economy's output of goods and services. In the long run, shifts in aggregate demand affect the overall price level but do not affect output. Because policymakers influence aggregate demand, they can potentially mitigate the severity of economic fluctuations.

Relative-Price Variability and the Misallocation of Resources

Suppose that the Eatabit Eatery prints a new menu with new prices every January and then leaves its prices unchanged for the rest of the year. If there is no inflation, Eatabit's relative prices—the prices of its meals compared to other prices in the economy—would be constant over the course of the year. By contrast, if the inflation rate is 12 percent per year, Eatabit's relative prices will automatically fall by 1 percent each month. The restaurant's relative prices will be high in the early months of the year, just after it has printed a new menu, and low in the later months. And the higher the inflation rate, the greater is this automatic variability. Thus, because prices change only once in a while, inflation causes relative prices to vary more than they otherwise would. Why does this matter? The reason is that market economies rely on relative prices to allocate scarce resources. Consumers decide what to buy by comparing the quality and prices of various goods and services. Through these decisions, they determine how the scarce factors of production are allocated among industries and firms. When inflation distorts relative prices, consumer decisions are distorted and markets are less able to allocate resources to their best use.

How banks create money/affect the money supply

Suppose the borrower from First National uses the $90 to buy something from someone who then deposits the currency in Second National bank. After the deposit, this bank has liabilities of $90 (deposits). If it also has a reserve ratio of 10%, it keeps assets of $9 in reserve and makes $81 in loans. In this way, Second National bank creates an additional $81 of money. If this $81 is eventually deposited in Third National bank, which also has a reserve ratio of 10%, this bank keeps $8.10 in reserve and makes $72.90 in loans. The process goes on and on. Each time that money is deposited and a bank loan is made, more money is created. The Fed can change the money supply by changing the quantity of reserves. The fed alters the quantity of reserves in the economy either by buying or selling bonds in open-market operations or by making loans to banks (or by some combination of the two) The Fed conducts open-market operations when it buys or sells government bonds. To increase the money supply, the Fed instructs its bond traders at the New York Fed to buy bonds from the public in the nation's bond markets. The dollars the Fed pays for the bonds increase the number of dollars in the economy. Some of these new dollars are held as currency, and some are deposited in banks. Each new dollar held as currency increases the money supply by exactly $1. Each new dollar deposited in a bank increases the money supply by more than a dollar because it increases reserves, and thereby, the amount of money that the banking system can create. To reduce the money supply, the Fed does just the opposite: It sells government bonds to the public in the nation's bond markets. The public pays for these bonds with its holdings of currency and bank deposits, directly reducing the amount of money in circulation. In addition, as people make withdrawals from banks to buy these bonds from the Fed, banks find themselves with a smaller quantity of reserves. In response, banks reduce the amount of lending, and the process of money creation reverses itself. Open-market operations are the tool of monetary policy that the Fed uses most often The Fed can also increase the quantity of reserves in the economy by lending reserves to banks. Banks borrow from the Fed when they feel they do not have enough reserves on hand, either to satisfy bank regulators, meet depositor withdrawals, make new loans, or for some other business reason.

Fed influencing reserve ratio

The Fed changes the money supply by influencing the reserve ratio and thereby the money multiplier. The Fed can influence the reserve ratio either through regulating the quantity of reserves banks must hold or through the interest rate that the Fed pays banks on their reserves. One way the Fed can influence the reserve ratio is by altering reserve requirements. Reserve requirements influence how much money the banking system can create with each dollar of reserves. An increase in reserve requirements means that banks must hold more reserves and, therefore, can loan out less of each dollar that is deposited. As a result, an increase in reserve requirements raises the reserve ratio, lowers the money multiplier, and decreases the money supply. Conversely, a decrease in reserve requirements lowers the reserve ratio, raises the money multiplier, and increases the money supply. The Fed changes reserve requirements only rarely because such changes disrupt the business of banking. When the Fed increases reserve requirements, for instance, some banks find themselves short of reserves, even though they have seen no change in deposits. As a result, they have to curtail lending until they build their level of reserves to the new required level. Moreover, in recent years, this particular tool has become less effective because many banks hold excess reserves (that is, more reserves than are required).

Federal Open Market Committee

The Federal Open Market Committee is made up of the seven members of the board of governors and five of the twelve regional bank presidents. All twelve regional presidents attend each FOMC meeting, but only five get to vote. Voting rights rotate among the twelve regional presidents over time. The president of the New York Fed always gets a vote, however, because New York is the traditional financial center of the US economy and because all Fed purchases and sales of government bonds are conducted at the New York Fed's trading desk. The Fed's policy decisions are key determinants of the economy's rate of inflation in the long run and the economy's employment and production in the short run

Why do the central banks of some countries choose to print so much money that its value is certain to fall rapidly over time (aka causing inflation)?

The answer is that the governments of these countries are using money creation as a way to pay for their spending. When the government wants to build roads, pay salaries to its soldiers, or give transfer payments to the poor or elderly, it first has to raise the necessary funds. Normally, the government does this by levying taxes, such as income and sales taxes, and by borrowing from the public by selling government bonds. Yet the government can also pay for spending simply by printing the money it needs.

The Sticky-Price Theory (Why the Aggregate-Supply Curve Slopes Upward in the Short Run)

The sticky-price theory emphasizes that the prices of some goods and services also adjust sluggishly in response to changing economic conditions. This slow adjustment of prices occurs in part because there are costs to adjusting prices, called menu costs. These menu costs include the cost of printing and distributing catalogs and the time required to change price tags. As a result of these costs, prices as well as wages may be sticky in the short run. To see how sticky prices explain the aggregate-supply curve's upward slope, suppose that each firm in the economy announces its prices in advance based on the economic conditions it expects to prevail over the coming year. Suppose further that after prices are announced, the economy experiences an unexpected contraction in the money supply, which (as we have learned) will reduce the overall price level in the long run. What happens in the short run? Although some firms reduce their prices quickly in response to the unexpected change in economic conditions, many other firms want to avoid additional menu costs. As a result, they temporarily lag behind in cutting their prices. Because these lagging firms have prices that are too high, their sales decline. Declining sales, in turn, cause these firms to cut back on production and employment. In other words, because not all prices adjust immediately to changing conditions, an unexpected fall in the price level leaves some firms with higher-than-desired prices, and these higher-than-desired prices depress sales and induce firms to reduce the quantity of goods and services they produce. Similar reasoning applies when the money supply and price level turn out to be above what firms expected when they originally set their prices. While some firms raise their prices quickly in response to the new economic environment, other firms lag behind, keeping their prices at the lower-than-desired levels. These low prices attract customers, which induces these firms to increase employment and production. Thus, during the time these lagging firms are operating with outdated prices, there is a positive association between the overall price level and the quantity of output. This positive association is represented by the upward slope of the short-run aggregate-supply curve.

Efficient Markets Hypothesis

The theory that each asset price reflects all publicly available information about the value of the asset

Inward-oriented policies

These policies attempt to increase productivity and living standards within the country by avoiding interaction with the rest of the world.

Not in the labor force

This category includes those who fit neither of the first two categories, such as full-time students, homemakers, and retirees.

Unemployed

This category includes those who were not employed, were available for work, and had tried to find employment during the previous four weeks. It also includes those waiting to be recalled to a job from which they had been laid off.

Employed

This category includes those who worked as paid employees, worked in their own business, or worked as unpaid workers in a family member's business. Both full-time and part-time workers are counted. This category also includes those who were not working but who had jobs from which they were temporarily absent because of, for example, vacation, illness, or bad weather.

Unemployment insurance

This program is designed to offer workers partial protection against job loss. The unemployed who quit their jobs, were fired for cause, or just entered the labor force are not eligible. Benefits are paid only to the unemployed who were laid off because their previous employers no longer needed their skills. The terms of the program vary over time and across states, but a typical worker covered by unemployment insurance in the United States receives 50 percent of his former wages for 26 weeks. While unemployment insurance reduces the hardship of unemployment, it also increases the amount of unemployment. People respond to incentives. Because unemployment benefits stop when a worker takes a new job, the unemployed devote less effort to job search and are more likely to turn down unattractive job offers. In addition, because unemployment insurance makes unemployment less onerous, workers are less likely to seek guarantees of job security when they negotiate with employers over the terms of employment.

Bond market

When Intel, the giant maker of computer chips, wants to borrow to finance construction of a new factory, it can borrow directly from the public. It does this by selling bonds. A bond is a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. Put simply, a bond is an IOU. It identifies the time at which the loan will be repaid, called the date of maturity, and the rate of interest that will be paid periodically until the loan matures. The buyer of a bond gives his money to Intel in exchange for this promise of interest and eventual repayment of the amount borrowed (called the principal). The buyer can hold the bond until maturity, or he can sell the bond at an earlier date to someone else.

Worker quality

When a firm pays a high wage, it attracts a better pool of workers to apply for its jobs and thereby increases the quality of its workforce. If this influence of the wage on worker quality is strong enough, it may be profitable for the firm to pay a wage above the level that balances supply and demand.

Trade off between risk and return

When people increase the percentage of their savings that they have invested in stocks, they increase the average return they can expect to earn, but they also increase the risks they face. The choice of a particular combination of risk and return depends on a person's risk aversion, which reflects her own preferences

Fact 3: As Output Falls, Unemployment Rises

When real GDP declines, the rate of unemployment rises. This fact is hardly surprising: When firms choose to produce a smaller quantity of goods and services, they lay off workers, expanding the pool of unemployed. When the recession ends and real GDP starts to expand, the unemployment rate gradually declines. Because there are always some workers between jobs, the unemployment rate never approaches zero. Instead, it fluctuates around its natural rate of about 5 or 6 percent.

Political instability

When revolutions and coups are common, there is doubt about whether property rights will be respected in the future. If a revolutionary government might confiscate the capital of some businesses, as was often true after communist revolutions, domestic residents have less incentive to save, invest, and start new businesses. At the same time, foreigners have less incentive to invest in the country. Even the threat of revolution can act to depress a nation's standard of living. Thus, economic prosperity depends in part on political prosperity. A country with an efficient court system, honest government officials, and a stable constitution will enjoy a higher economic standard of living than a country with a poor court system, corrupt officials, and frequent revolutions and coups.

Price level

When the price level rises, people have to pay more for the goods and services they buy. Alternatively, we can view the price level as a measure of the value of money. A rise in the price level means a lower value of money because each dollar in your wallet now buys a smaller quantity of goods and services. P = price level, measures the number of dollars needed to buy a basket of goods and services. The quantity of goods and services that can be bought with $1 equals 1/P. In other words, if P is the price of goods and services measured in terms of money, 1/P is the value of money measured in terms of goods and services. Just as the supply and demand for bananas determines the price of bananas, the supply and demand for money determines the value of money. Most fundamentally, the demand for money reflects how much wealth people want to hold in liquid form. Many factors influence the quantity of money demanded. The amount of currency that people hold in their wallets, for instance, depends on how much they rely on credit cards and on whether an automatic teller machine is easy to find. The quantity of money demanded depends on the interest rate that a person could earn by using the money to buy an interest-bearing bond rather than leaving it in his wallet or low-interest checking account. The higher prices are, the more money the typical transaction requires, and the more money people will choose to hold in their wallets and checking accounts. That is, a higher price level (a lower value of money) increases the quantity of money demanded. In the long run, money supply and money demand are brought into equilibrium by the overall level of prices. If the price level is above the equilibrium level, people will want to hold more money than the Fed has created, so the price level must fall to balance supply and demand. If the price level is below the equilibrium level, people will want to hold less money than the Fed has created, and the price level must rise to balance supply and demand. At the equilibrium price level, the quantity of money that people want to hold exactly balances the quantity of money supplied by the Fed.

Fractional-reserve banking

a banking system in which banks hold only a fraction of deposits as reserves (if the flow of new deposits is roughly the same as the flow of withdrawals, it only needs to keep a fraction of its deposits in reserve) When banks hold only a fraction of deposits in reserve, the banking system creates money. Example: Reserve ratio is 10%. Money supply is $100 of deposits. When they lend out these deposits, the money supply increases. The depositors still have demand deposits totaling $100, but now the borrowers hold $90 in currency. The money supply (which equals currency plus demand deposits) equals $190 As a bank creates the asset of money, it also creates a corresponding liability for those who borrowed the created money. Loans give the borrowers some currency and thus the ability to buy goods and services. Yet the borrowers are also taking on debts, so the loans do not make them any richer. At the end of this process of money creation, the economy is more liquid in the sense that there is more of the medium of exchange, but the economy is no wealthier than before.

Junk bond

a bond from a financially shaky corporation that has a very high interest rate. Buyers of bonds can judge credit risk by checking with various private agencies that evaluate the credit risk of different bonds. For example, Standard & Poor's rates bonds from AAA (the safest) to D (those already in default).

Bond

a certificate of indebtedness that specifies the obligations of the borrower to the holder of the bond. A bond is an IOU

Public good

a commodity or service that is provided without profit to all members of a society, either by the government or a private individual or organization. Knowledge is a public good. That is, once one person discovers an idea, the idea enters society's pool of knowledge and other people can freely use it. Just as government has a role in providing a public good such as national defense, it also has a role in encouraging the research and development of new technologies.

Aggregate supply curve

a curve that shows the quantity of goods and services that firms choose to produce and sell at each price level

Aggregate demand curve

a curve that shows the quantity of goods and services that households, firms, the government, and customers abroad want to buy at each price level

Crowding out

a decrease in investment that results from government borrowing That is, when the government borrows to finance its budget deficit, it crowds out private borrowers who are trying to finance investment.

Risk averse

a dislike of uncertainty, people dislike bad things more than they like comparable good things.

Fiat money

a fiat is an order of decree, and fiat money is established as money by government decree The paper dollars printed by the US govt vs. Monopoly paper dollars. The reason you can only use the first one is because the US govt has decreed its dollars to be valid money Other factors(other than decree) are required for success, like expectations and social convention. When Russia started using cigarettes, the govt never undecreed the ruble

Capital requirement

a government regulation specifying a minimum amount of bank capital. It ensures that banks will be able to pay off their depositors (without having to resort to government-provided deposit insurance funds) If the bank holds safe assets such as government bonds, regulators require less capital than if the bank holds risky assets such as loans to borrowers whose credit is of dubious quality. Economic turmoil can result when banks find themselves with too little capital to satisfy capital requirements. In 2008, banks realized they had incurred sizable losses on some of their assets - specifically, mortgage loans and securities backed by mortgage loans. The shortage of capital induced the banks to reduce lending, a phenomenon called a credit crunch, which in turn contributed to a severe downturn in economic activity. The US treasury and Federal Reserve put billions of dollars of public funds into the banking system to increase the amount of bank capital, which temporarily made the US taxpayer a part owner of many banks.

CPI

a measure of the overall cost of the goods and services bought by a typical consumer. CPI: cost in current year/cost in base year Denominator is always cost from base year Inflation rate in year 2: (CPI in year 2- CPI in year 1)/CPI in year 1 * 100

Utility

a person's subjective measure of well-being or satisfaction The more wealth a person has, the less utility she gets from an additional dollar. The utility function gets flatter as wealth increases. Because of diminishing marginal utility, the utility lost from losing $1000 bet is more than the utility gained from winning it.

T-account

a simplified accounting statement that shows changes in a bank's assets and liabilities

Inflation

a situation in which the economy's overall price level is rising

100-percent reserve banking

all deposits are held as reserves If banks hold all deposits in reserve, banks do not influence the supply of money.

Stock index

an average of a group of stock prices. Because stock prices reflect expected profitability, these stock indexes are watched closely as possible indicators of future economic conditions.

Identity

an equation that must be true because of the way the variables in the equation are defined. Identities are useful to keep in mind, for they clarify how different variables are related to one another. Here we consider some accounting identities that shed light on the macroeconomic role of financial markets. GDP equation is an identity

Central bank

an institution designed to oversee the banking system and regulate the quantity of money in the economy The Fed is run by its board of governors, which has seven members appointed by the president and confirmed by the senate. The governors have 14 year terms. Fed governors are given long terms to give them independence from short-term political pressures when they formulate money Among the seven members of the board of governors, the most important is the chair. The chair directs Fed staff, presides over board meetings, and testifies regularly about fed policy in front of congressional committees. The president appoints the chair to a 4-year term. Fed monitors each bank's financial condition and facilitates bank transactions y clearing checks. It also acts as a bank's bank. The fed makes loans to banks when banks themselves want to borrow. When financially trouble banks find themselves short of class, the Fed acts as a lender of last resort - a lender to those who cannot borrow anywhere else - to maintain stability in the overall banking system.

Mutual funds

an institution that sells shares to the public and uses the proceeds to buy a selection, or portfolio, of various types of stocks, bonds, or both stocks and bonds. - The shareholder of the mutual fund accepts all the risk and return associated with the portfolio. If the value of the portfolio rises, the shareholder benefits; if the value of the portfolio falls, the shareholder suffers the loss. - The primary advantage of mutual funds is that they allow people with small amounts of money to diversify their holdings. Don't put all your eggs in one basket. - Because the value of any single stock or bond is tied to the fortunes of one company, holding a single kind of stock or bond is very risky. By contrast, people who hold a diverse portfolio of stocks and bonds face less risk because they have only a small stake in each company. - With only a few hundred dollars, a person can buy shares in a mutual fund and, indirectly, become the part owner or creditor of hundreds of major companies. For this service, the company operating the mutual fund charges shareholders a fee, usually between 0.25 and 2.0 percent of assets each year. - Mutual funds give ordinary people access to the skills of professional money managers. The managers of most mutual funds pay close attention to the developments and prospects of the companies in which they buy stock. These managers buy the stock of companies they view as having a profitable future and sell the stock of companies with less promising prospects. This professional management, it is argued, should increase the return that mutual fund depositors earn on their savings. - Financial economists, however, are often skeptical of this argument. With thousands of money managers paying close attention to each company's prospects, the price of a company's stock is usually a good reflection of the company's true value. As a result, it is hard to "beat the market" by buying good stocks and selling bad ones

Medium of exchange

an item that people can easily use to engage in transactions. They facilitate purchases of goods and services by allowing people to write checks against their deposits and to access those deposits with debit cards

Demand deposits

balances in bank accounts that depositors can access on demand simply by writing a check or swiping a debit card at a store Bank depositors cannot write checks against the balances in their savings account, but they can easily transfer from savings to checking Depositors in money market mutual funds can often write checks against their balances.

Excess reserves

banks hold reserves above the legal minimum so they can be more confident that they will not run short of cash.

Dividends

cash payments that a company makes to its shareholders. Depends on the company's ability to earn profit, which depends on: the demand for the product, how much competition it faces, how much capital it has in place, whether workers are unionized, how loyal its customers are, what kinds of government regulations and taxes it faces, etc.

Nominal GDP

normal GDP with current year prices. Price * quantity of hot dogs + Price * quantity of hamburgers

Production function

describes the relationship between the quantity of inputs used in production and the quantity of output from production. Y is quantity of output, L is quantity of labor, K is quantity of physical capital, H is quantity of human capital, N is quantity of natural resources, A reflects the available production technology(as technology improves, A rises). F() is a function that shows how the inputs are combined to produce output. Y = AF (L, K, H, N) Output = Available Production Technology * Function (Quantity of labor, Quantity of physical capital, Quantity of human capital, Quantity of natural resources) Y/L = AF (1, K/L, H/L, N/L) Y/L= output per worker, which is a measure of productivity. This equation says that labor productivity depends on physical capital per worker (K/L), human capital per worker (H/L), and natural resources per worker (N/L). Productivity also depends on the state of technology, as reflected by the variable A. Thus, this equation provides a mathematical summary of the four determinants of productivity we have just discussed The curve becomes flatter as the amount of capital increases because of diminishing returns to capital.

Investment in human capital

education and expenditures that lead to a healthier population. - Investment in human capital, like investment in physical capital, has an opportunity cost. When students are in school, they forgo the wages they could have earned as members of the labor force. In less developed countries, children often drop out of school at an early age, even though the benefit of additional schooling is very high, simply because their labor is needed to help support the family. - Other things being equal, healthier workers are more productive. The right investments in the health of the population provide one way for a nation to increase productivity and raise living standards.

Default

failure to pay some of the interest or principal

Financial intermediaries

financial institutions through which savers can indirectly provide funds to borrowers. The term intermediary reflects the role of these institutions in standing between savers and borrowers.

Investment tax credit

gives a tax advantage to any firm building a new factory or buying a new piece of equipment. First, would the law affect supply or demand? Because the tax credit would reward firms that borrow and invest in new capital, it would alter investment at any given interest rate and, thereby, change the demand for loanable funds. By contrast, because the tax credit would not affect the amount that households save at any given interest rate, it would not affect the supply of loanable funds. Because firms would have an incentive to increase investment at any interest rate, the quantity of loanable funds demanded would be higher at any given interest rate. Thus, the demand curve for loanable funds would move to the right If a reform of the tax laws encouraged greater investment, the result would be higher interest rates and greater saving.

Discouraged workers

individuals who would like to work but have given up looking for a job. Do not show up in unemployment statistics. They have not looked for a job in 4 weeks (or longer), but they would like a job and are available for work.

Natural resources

inputs into production that are provided by nature, such as land, rivers, and mineral deposits. -Renewable resource- forest. When one tree is cut down, a seedling can be planted in its place to be harvested in the future. -Nonrenewable resource- oil. Oil is produced by nature over many millions of years, so there's a limited supply. Once the supply is depleted, it is impossible to create more. -Differences in natural resources are responsible for some of the differences in standards of living around the world. The historical success of the US was because in part the large supply of land well suited for agriculture. Some countries in the middle east, such as Kuwait and Saudi Arabia, are rich because they have some of the largest pools of oil in the world. -Natural resources aren't necessary for an economy to be highly productive. Japan is one of the richest countries in the world, but has few natural resources. International trade makes Japan's success possible.

Outward-oriented policies

integrate these countries into the world economy. International trade in goods and services can improve the economic well-being of a country's citizens. Trade is, in some ways, a type of technology. When a country exports wheat and imports textiles, the country benefits as if it had invented a technology for turning wheat into textiles. A country that eliminates trade restrictions will, therefore, experience the same kind of economic growth that would occur after a major technological advance.

Proprietary technology

it is known only by the company that discovers it -Only coca-cola knows the secret recipe for coke -Sometimes temporary- When a pharmaceutical company discovers a new drug, the patent system gives that company a temporary right to be its exclusive manufacturer, but when the patent expired, other companies are allowed to make the drug.

Real GDP

measure of the total quantity of goods and services the economy is producing that is not affected by changes in the prices of those goods and services. What would be the value of the goods and services produce this year if we valued the goods and services at the prices that prevailed in some specific year in the past? By evaluating current production using prices that are fixed at past levels, real GDP shows how the economy's overall production of goods and services changes over time. Real GDP uses a base year for prices only. Price in base year * quantity of hot dogs + Price in base year * quantity of hamburgers

Standard deviation

measures how much a variable is likely to fluctuate. The higher the standard deviation of a portfolio's return, the more volatile its return is likely to be, and the riskier it is that someone holding the portfolio will fail to get the return that she expected.

Growth rate

measures how rapidly real income per person grew in the typical year Example: American income in 1870 was $4,264, and in 2014 it was $55,860. It grew 1.80 percent per year. It didn't actually grow 1.80 percent each year, some years it rose by more or less, but the growth rate ignores short run fluctuations around the long run trend and represents an average rate of growth for real income per person over many years

Producer Price Index (PPI)

measures the cost of a basket of goods and services bought by firms rather than consumers

GDP Deflator

measures the current level of prices relative to the level of prices in the base year. Nominal GDP/Real GDP * 100

Labor force participation rate

measures the percentage of the total adult population of the US that is in the labor force Labor force participation rate = Labor force/Adult population * 100

Commodity money

money that takes the form of a commodity with intrinsic value. Intrinsic value means that the item would have value even If it were not used as money. Gold has intrinsic value because it's used in industry and making of money. When an economy uses gold as money(or uses paper money that is convertible into gold on demand), it is said to be operating under a gold standard. Cigarettes were used in prisoner of war camps during WWII and by the soviet union in the late 80's. Nonsmokers did it too because they knew they could use a cigarette to buy something else

Market Irrationality

o Economist John Maynard Keynes suggested that asset markets are driven by the "animal spirits" of investors—irrational waves of optimism and pessimism. o Thus, a person might be willing to pay more than a stock is worth today if she expects another person to pay even more for it tomorrow. When evaluating a stock, you have to estimate not only the value of the business but also what other people will think the business is worth in the future. o Believers in market irrationality point out (correctly) that the stock market often moves in ways that are hard to explain on the basis of news that might alter a rational valuation. o Believers in the efficient markets hypothesis point out (correctly) that it is impossible to know the correct, rational valuation of a company, so one should not quickly jump to the conclusion that any particular valuation is irrational.

A Special Cost of Unexpected Inflation: Arbitrary Redistributions of Wealth

o Unexpected inflation redistributes wealth among the population in a way that has nothing to do with either merit or need. These redistributions occur because many loans in the economy are specified in terms of the unit of account—money. o Consider an example. Suppose that Sam Student takes out a $20,000 loan at a 7 percent interest rate from Bigbank to attend college. In 10 years, the loan will come due. After his debt has compounded for 10 years at 7 percent, Sam will owe Bigbank $40,000. The real value of this debt will depend on inflation over the decade. If Sam is lucky, the economy will have a hyperinflation. In this case, wages and prices will rise so high that Sam will be able to pay the $40,000 debt out of pocket change. By contrast, if the economy goes through a major deflation, then wages and prices will fall, and Sam will find the $40,000 debt a greater burden than he anticipated. o This example shows that unexpected changes in prices redistribute wealth among debtors and creditors. A hyperinflation enriches Sam at the expense of Bigbank because it diminishes the real value of the debt; Sam can repay the loan in dollars that are less valuable than he anticipated. Deflation enriches Bigbank at Sam's expense because it increases the real value of the debt; in this case, Sam has to repay the loan in dollars that are more valuable than he anticipated. If inflation were predictable, then Bigbank and Sam could take inflation into account when setting the nominal interest rate. (Recall the Fisher effect.) But if inflation is hard to predict, it imposes risk on Sam and Bigbank that both would prefer to avoid. o Inflation is especially volatile and uncertain when the average rate of inflation is high. This is seen most simply by examining the experience of different countries. Countries with low average inflation, such as Germany in the late 20th century, tend to have stable inflation. Countries with high average inflation, such as many countries in Latin America, tend to have unstable inflation. There are no known examples of economies with high, stable inflation. This relationship between the level and volatility of inflation points to another cost of inflation. If a country pursues a high-inflation monetary policy, it will have to bear not only the costs of high expected inflation but also the arbitrary redistributions of wealth associated with unexpected inflation.

Classical dichotomy

o the theoretical separation of nominal and real variables o Relative prices are real variables. In our example, we could say that the price of a bushel of corn is 2 bushels of wheat. This relative price is not measured in terms of money. When comparing the prices of any two goods, the dollar signs cancel, and the resulting number is measured in physical units. o According to classical analysis, nominal variables are influenced by developments in the economy's monetary system, whereas money is largely irrelevant for explaining real variables. Changes in the supply of money, according to classical analysis, affect nominal variables but not real ones. When the central bank doubles the money supply, the price level doubles, the dollar wage doubles, and all other dollar values double. Real variables, such as production, employment, real wages, and real interest rates, are unchanged.

Closed economies

one that does not interact with other economies. Does not engage in international trade in goods and services, nor does it engage in international borrowing and lending. Because a closed economy does not engage in international trade, imports and exports are exactly zero. Therefore, net exports (NX) are also zero. We can now simplify the identity as Y= C + I + G

Why the Short-Run Aggregate-Supply Curve Might Shift

shifts in the long-run aggregate-supply curve normally arise from changes in labor, capital, natural resources, or technological knowledge. These same variables shift the short-run aggregate-supply curve. For example, when an increase in the economy's capital stock increases productivity, the economy is able to produce more output, so both the long-run and short-run aggregate-supply curves shift to the right. When an increase in the minimum wage raises the natural rate of unemployment, the economy has fewer employed workers and thus produces less output, so both the long-run and short-run aggregate-supply curves shift to the left. The important new variable that affects the position of the short-run aggregate-supply curve is the price level that people expected to prevail. As we have discussed, the quantity of goods and services supplied depends, in the short run, on sticky wages, sticky prices, and misperceptions. Yet wages, prices, and perceptions are set based on the expected price level. So when people change their expectations of the price level, the short-run aggregate-supply curve shifts. To make this idea more concrete, let's consider a specific theory of aggregate supply—the sticky-wage theory. According to this theory, when workers and firms expect the price level to be high, they are likely to reach a bargain with a higher level of nominal wages. Higher wages raise firms' costs, and for any given actual price level, higher costs reduce the quantity of goods and services supplied. Thus, when the expected price level rises, wages are higher, costs increase, and firms produce a smaller quantity of goods and services at any given actual price level. Thus, the short-run aggregate-supply curve shifts to the left. Conversely, when the expected price level falls, wages are lower, costs decline, firms increase output at any given price level, and the short-run aggregate-supply curve shifts to the right. A similar logic applies in each theory of aggregate supply. The general lesson is the following: An increase in the expected price level reduces the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the left. A decrease in the expected price level raises the quantity of goods and services supplied and shifts the short-run aggregate-supply curve to the right. As we will see in the next section, the influence of expectations on the position of the short-run aggregate-supply curve plays a key role in explaining how the economy makes the transition from the short run to the long run. In the short run, expectations are fixed and the economy finds itself at the intersection of the aggregate-demand curve and the short-run aggregate-supply curve. In the long run, if people observe that the price level is different from what they expected, their expectations adjust and the short-run aggregate-supply curve shifts. This shift ensures that the economy eventually finds itself at the intersection of the aggregate-demand curve and the long-run aggregate-supply curve.

Present value

the amount of money today that would be needed, using prevailing interest rates, to produce a given future amount of money

Technological knowledge vs. human capital

technological knowledge refers to society's understanding about how the world works. Human capital refers to the resources expended transmitting this understanding to the labor force. -Technological knowledge is the quality of society's textbooks, while human capital is the amount of time that the population has devoted to reading them

Core CPI

the CPI for all goods and services excluding food and energy

Reserve requirement

the Fed sets a minimum amount of reserves that banks must hold

Property rights

the ability of people to exercise authority over the resources they own. For this reason, courts serve an important role in a market economy: They enforce property rights. Through the criminal justice system, the courts discourage theft. In addition, through the civil justice system, the courts ensure that buyers and sellers live up to their contracts In many countries, the system of justice does not work well. Contracts are hard to enforce, and fraud often goes unpunished. In more extreme cases, the government not only fails to enforce property rights but actually infringes upon them. To do business in some countries, firms are expected to bribe government officials. Such corruption impedes the coordinating power of markets. It also discourages domestic saving and investment from abroad. Courts serve an important role in a market economy: They enforce property rights. Through the criminal justice system, the courts discourage theft. In addition, through the civil justice system, the courts ensure that buyers and sellers live up to their contracts. Thus, economic prosperity depends in part on political prosperity. A country with an efficient court system, honest government officials, and a stable constitution will enjoy a higher economic standard of living than a country with a poor court system, corrupt officials, and frequent revolutions and coups

Bank's liabilities

the amount it owes to its depositors

Private saving

the amount of income that households have left after paying their taxes and paying for their consumption. In particular, because households receive income of Y, pay taxes of T, and spend C on consumption, private saving is Y − T − C.

Future value

the amount of money in the future that an amount of money today will yield, given prevailing interest rates If you put $100 in the bank today, how much will it be worth in N years? What will be the future value? (1+r) * $100 after 1 year (1+r)^2 * $100 after 2 years etc... If r is the interest rate, then an amount X to be received in N years has a present value of X/(1+r)^N

Money multiplier

the amount of money the banking system generates with each dollar of reserves 1/R It turns out that even though this process of money creation can continue forever, it does not create an infinite amount of money. If you laboriously add the infinite sequence of numbers in the preceding example, you find that the $100 of reserves generates $1000 of money. In this imaginary economy, where the $100 of reserves generates $1000 of money, the money multiplier is 10. The money multiplier is the reciprocal of the reserve ratio. If R is the reserve ratio for all banks in the economy, then each dollar of reserves generates 1/R dollars of money. The higher the reserve ratio, the less of each deposit banks loan out, and the smaller the money multiplier. In the special case of 100-percent reserve banking, the reserve ratio is 1, the money multiplier is 1, and banks do not make loans or create money.

Public saving

the amount of tax revenue that the government has left after paying for its spending. The government receives T in tax revenue and spends G on goods and services. T-G If positive, adds to national saving and the supply of loanable funds. If negative, it reduces national saving and the supply of loanable funds.

Federal Reserve

the central bank of the US

Informationally efficient

the description of asset prices that rationally reflect all available information Each stock price reflects all available information about the value of the company. When good news about the company's prospects becomes public, the value and the stock price both rise. When the company's prospects deteriorate, the value and price both fall. But at any moment in time, the market price is the best guess of the company's value based on available information.

Cyclical unemployment

the deviation of unemployment from its natural rate Almost half of all spells of unemployment end when the unemployed person leaves the labor force.

Liquidity

the ease with which an asset can be converted into the economy's medium of exchange. Money is the most liquid asset, stocks and bonds are relatively liquid, selling a house/painting/baseball card is less liquid

Human capital

the economist's term for the knowledge and skills that workers acquire through education, training, and experience. -Includes the skills accumulated in early childhood programs, grade school, high school, college, and on the job training for adults in the labor force. -Like physical capital, human capital raises a nation's ability to produce goods and services and it is a produced factor of production -Producing human capital requires inputs in the form of teachers, libraries, student time, etc. -Students can be viewed as workers who have the important job of producing the human capital that will be used in future production

Externality

the effect of one person's actions on the well-being of a bystander. An educated person, for instance, might generate new ideas about how best to produce goods and services. If these ideas enter society's pool of knowledge so that everyone can use them, then the ideas are an external benefit of education.

Reserve ratio

the fraction of deposits that banks hold as reserves

Budget surplus

the government receives more money than it spends. If T exceeds G When the government collects more in tax revenue than it spends, it saves the difference by retiring some of the outstanding government debt. This budget surplus, or public saving, contributes to national saving. Thus, a budget surplus increases the supply of loanable funds, reduces the interest rate, and stimulates investment. Higher investment, in turn, means greater capital accumulation and more rapid economic growth.

Factors of production

the inputs used to produce goods and services, like labor, capital, etc. Human capital, physical capital, natural resources, technological knowledge

Financial markets

the institutions through which a person who wants to save can directly supply funds to a person who wants to borrow. The two most important financial markets in our economy are the bond market and the stock market.

Federal funds rate

the interest rate at which banks make overnight loans to one another. The short-term interest rate that banks charge one another for loans. If one bank finds itself short of reserves while another bank has excess reserves, the second bank can lend some reserves to the first. The loans are temporary—typically overnight. The price of the loan is the federal funds rate. Although the actual federal funds rate is set by supply and demand in the market for loans among banks, the Fed can use open-market operations to influence that market. For example, when the Fed buys bonds in open-market operations, it injects reserves into the banking system. With more reserves in the system, fewer banks find themselves in need of borrowing reserves to meet reserve requirements. The fall in demand for borrowing reserves decreases the price of such borrowing, which is the federal funds rate. Conversely, when the Fed sells bonds and withdraws reserves from the banking system, more banks find themselves short of reserves, and they bid up the price of borrowing reserves. Thus, open-market purchases lower the federal funds rate, and open-market sales raise the federal funds rate. When the Fed announces a change in the federal funds rate, it is committing itself to the open-market operations necessary to make that change happen, and these open-market operations will alter the supply of money. Decisions by the FOMC to change the target for the federal funds rate are also decisions to change the money supply. They are two sides of the same coin. Other things being equal, a decrease in the target for the federal funds rate means an expansion in the money supply, and an increase in the target for the federal funds rate means a contraction in the money supply.

Real interest rate

the interest rate corrected for inflation Real interest rate = Nominal interest rate - inflation rate

Discount rate

the interest rate on the loans that the Fed makes to banks When the Fed makes such a loan to a bank, the banking system has more reserves than it otherwise would, and these additional reserves allow the banking system to create more money. The Fed can alter the money supply by changing the discount rate. A higher discount rate discourages banks from borrowing reserves from the Fed. Thus, an increase in the discount rate reduces the quantity of reserves in the banking system, which in turn reduces the money supply. Conversely, a lower discount rate encourages banks to borrow from the Fed, increasing the quantity of reserves and the money supply

Nominal interest rate

the interest rate that measures the change in dollar amounts Nominal interest rate= Real interest rate + inflation rate

Term

the length of time until the bond matures. Some bonds have short terms, such as a few months, while others have terms as long as 30 years. The interest rate on a bond depends, in part, on its term. Long-term bonds are riskier than short-term bonds because holders of long-term bonds have to wait longer for repayment of principal. If a holder of a long-term bond needs his money earlier than the distant date of maturity, he has no choice but to sell the bond to someone else, perhaps at a reduced price. To compensate for this risk, long-term bonds usually pay higher interest rates than short-term bonds.

The Model of Aggregate Demand and Aggregate Supply

the model that most economists use to explain short-run fluctuations in economic activity around its long-run trend On the vertical axis is the overall price level in the economy. On the horizontal axis is the overall quantity of goods and services produced in the economy. According to this model, the price level and the quantity of output adjust to bring aggregate demand and aggregate supply into balance. The quantity that our model is trying to explain—real GDP—measures the total quantity of goods and services produced by all firms in all markets. To understand why the aggregate-demand curve slopes downward and why the aggregate-supply curve slopes upward, we need a macroeconomic theory that explains the total quantity of goods and services demanded and the total quantity of goods and services supplied.

Natural rate of unemployment

the normal rate of unemployment around which the unemployment rate fluctuates

Fisher effect

the one-for-one adjustment of the nominal interest rate to the inflation rate Keep in mind that our analysis of the Fisher effect has maintained a long-run perspective. The Fisher effect need not hold in the short run because inflation may be unanticipated. A nominal interest rate is a payment on a loan, and it is typically set when the loan is first made. If a jump in inflation catches the borrower and lender by surprise, the nominal interest rate they agreed on will fail to reflect the higher inflation. But if inflation remains high, people will eventually come to expect it, and loan agreements will reflect this expectation. To be precise, therefore, the Fisher effect states that the nominal interest rate adjusts to expected inflation. Expected inflation moves with actual inflation in the long run, but that is not necessarily true in the short run.

Strike

the organized withdrawal of labor from a firm by a union

Currency

the paper bills and coins in the hands of the public. It is clearly the most widely-accepted medium of exchange

Inflation rate

the percentage change in some measure of the price level from one period to the next Inflation rate in year 2: (CPI in year 2- CPI in year 1)/CPI in year 1 * 100 ((GDP deflator in year 2 - GDP deflator in year 1)/GDP deflator in year 1) * 100

Unemployment rate

the percentage of the labor force that is unemployed Unemployment rate = Number of unemployed/Labor force * 100

Credit risk

the probability that the borrower will fail to pay some of the interest or principal. Borrowers can (and sometimes do) default on their loans by declaring bankruptcy. When bond buyers perceive that the probability of default is high, they demand a higher interest rate as compensation for this risk. Because the U.S. government is considered a safe credit risk, government bonds tend to pay low interest rates.

Collective bargaining

the process by which unions and firms agree on the terms of employment When a union bargains with a firm, it asks for higher wages, better benefits, and better working conditions than the firm would offer in the absence of a union.

Job search

the process by which workers find appropriate jobs given their tastes and skills Frictional unemployment is inevitable simply because the economy is always changing. The faster information spreads about job openings and worker availability, the more rapidly the economy can match workers and firms. The Internet, for instance, may help facilitate job search and reduce frictional unemployment. Government programs try to facilitate job search in various ways. One way is through government-run employment agencies, which give out information about job vacancies. Another way is through public training programs, which aim to ease workers' transition from declining to growing industries and to help disadvantaged groups escape poverty.

Catch up effect

the property whereby countries that start off poor tend to grow more rapidly than countries that start off rich. In poor countries, workers lack even the most rudimentary tools and, as a result, have low productivity. Thus, small amounts of capital investment can substantially raise these workers' productivity. By contrast, workers in rich countries have large amounts of capital with which to work, and this partly explains their high productivity. Yet with the amount of capital per worker already so high, additional capital investment has a relatively small effect on productivity. Poor countries tend to grow at faster rates than rich countries. Economic growth over the last several decades has been much more rapid in South Korea than in the United States, but GDP per person is still higher in the United States.

Diminishing returns

the property whereby the benefit from an extra unit of an input declines as the quantity of the input increases. As the stock of capital rises, the extra output produced from an additional unit of capital falls. when workers already have a large quantity of capital to use in producing goods and services, giving them an additional unit of capital increases their productivity only slightly. In the long run, the higher saving rate leads to a higher level of productivity and income but not to higher growth in these variables. Because of diminishing returns, an increase in the saving rate leads to higher growth only for a while. As the higher saving rate allows more capital to be accumulated, the benefits from additional capital become smaller over time, and so growth slows down

Monetary neutrality

the proposition that changes in the money supply do not affect real variables When a central bank doubles the money supply, all prices double, and the value of the unit of account falls by half. A similar change would occur if the government were to reduce the length of the yard from 36 to 18 inches: With the new, shorter yardstick, all measured distances (nominal variables) would double, but the actual distances (real variables) would remain the same. The dollar, like the yard, is merely a unit of measurement, so a change in its value should not have real effects. Monetary neutrality may not apply in the short run Yet classical analysis is right about the economy in the long run. Over the course of a decade, monetary changes have significant effects on nominal variables (such as the price level) but only negligible effects on real variables (such as real GDP). When studying long-run changes in the economy, the neutrality of money offers a good description of how the world works.

Open market operation

the purchase and sale of US government bonds

Productivity

the quantity of goods and services produced from each unit of labor input

Money supply

the quantity of money available in the economy - the Fed's second & more important job is to control the quantity of money that is made available in the economy

Money stock

the quantity of money circulating in the economy

Velocity of money

the rate at which money changes hands. In economics, the velocity of money refers to the speed at which the typical dollar bill travels around the economy from wallet to wallet. V = (P * Y)/M Velocity = (price level/gdp deflator * output/real gdp)/ quantity of money To see why this makes sense, imagine a simple economy that produces only pizza. Suppose that the economy produces 100 pizzas in a year, that a pizza sells for $10, and that the quantity of money in the economy is $50. Then the velocity of money is V = (10 * 100) / 50 = 20 In this economy, people spend a total of $1,000 per year on pizza. For this $1,000 of spending to take place with only $50 of money, each dollar bill must change hands on average 20 times per year. Quantity equation - the equation which relates the quantity of money, the velocity of money, and the dollar value of the economy's output of goods and services M * V = P * Y The quantity equation shows that an increase in the quantity of money in an economy must be reflected in one of the other three variables: The price level must rise, the quantity of output must rise, or the velocity of money must fall. We now have all the elements necessary to explain the equilibrium price level and inflation rate. They are as follows: The velocity of money is relatively stable over time. Because velocity is stable, when the central bank changes the quantity of money (M), it causes proportionate changes in the nominal value of output (P × Y). The economy's output of goods and services (Y) is primarily determined by factor supplies (labor, physical capital, human capital, and natural resources) and the available production technology. In particular, because money is neutral, money does not affect output. With output (Y) determined by factor supplies and technology, when the central bank alters the money supply (M) and induces proportional changes in the nominal value of output (P × Y), these changes are reflected in changes in the price level (P). Therefore, when the central bank increases the money supply rapidly, the result is a high rate of inflation.

Natural level of output

the rate of production toward which the economy gravitates in the long run. the production of goods and services that an economy achieves in the long run when unemployment is at its normal rate

Shoeleather cost of inflation

the resources wasted when inflation encourages people to reduce their money holdings. The actual cost of reducing your money holdings is not the wear and tear on your shoes but the time and convenience you must sacrifice to keep less money on hand than you would if there were no inflation. The day he was paid 25 million pesos, a dollar cost 500,000 pesos. So he received $50. Just days later, with the rate at 900,000 pesos, he would have received $27. As this story shows, the shoeleather costs of inflation can be substantial. With the high inflation rate, Mr. Miranda does not have the luxury of holding the local money as a store of value. Instead, he is forced to convert his pesos quickly into goods or into U.S. dollars, which offer a more stable store of value. The time and effort that Mr. Miranda expends to reduce his money holdings are a waste of resources. If the monetary authority pursued a low-inflation policy, Mr. Miranda would be happy to hold pesos, and he could put his time and effort to more productive use.

Inflation tax

the revenue the government raises by creating money The inflation tax is not exactly like other taxes, however, because no one receives a bill from the government for this tax. Instead, the inflation tax is subtler. When the government prints money, the price level rises, and the dollars in your wallet become less valuable. Thus, the inflation tax is like a tax on everyone who holds money. Almost all hyperinflations follow the same pattern as the hyperinflation during the American Revolution. The government has high spending, inadequate tax revenue, and limited ability to borrow. As a result, it turns to the printing press to pay for its spending. The massive increases in the quantity of money lead to massive inflation. The inflation ends when the government institutes fiscal reforms—such as cuts in government spending—that eliminate the need for the inflation tax.

Debt finance

the sale of bonds

Money

the set of assets in the economy that people regularly use to buy goods and services from each other. Includes only those few types of wealth that are regularly accepted by sellers in exchange for goods and services

Monetary policy

the setting of the money supply by policymakers in the central bank. At the federal reserve, monetary policy is made by Federal Open Market Committee (FOMC). FOMC meets about every 6 weeks to discuss the condition of the economy and consider changes in monetary policy

Physical capital

the stock of equipment and structures used to produce goods and services When woodworkers make furniture, they use saws, lathes, and drill presses. More tools allow the woodworkers to produce their output more quickly and accurately than a worker with only basic hand tools

Fundamental analysis

the study of a company's accounting statements and future prospects to determine its value The goal of fundamental analysis is to take all these factors into account to determine how much a share of stock in the company is worth: the demand for the product, how much competition it faces, how much capital it has in place, whether workers are unionized, how loyal its customers are, what kinds of government regulations and taxes it faces, etc. 3 ways to do fundamental analysis: -Do the research yourself -Rely on the advice of a Wall Street analyst -Buy shared in a mutual fund, which has a manager who conducts fundamental analysis and makes the decision for you

Labor force

the sum of the employed and unemployed Labor force = Number of employed + Number of unemployed

Market-risk

the uncertainty associated with the entire economy, which affects all companies traded on the stock market. For example, when the economy goes into a recession, most companies experience falling sales, reduced profit, and low stock returns. Diversification reduces the risk of holding stocks, but it does not eliminate it.

Firm-specific risk

the uncertainty associated with the specific companies

Technological knowledge

the understanding of the best ways to produce goods and services 100 years ago, most Americans worked on farms because farm technology required a high input of labor to feed the entire population. But today because of advances in farming technology, a small fraction of the population can produce enough food to feed the entire country, making labor available to produce other goods and services

Leverage

the use of borrowed money to supplement existing funds for purposes of investment. Whenever someone uses debt to finance an investment project, they are applying leverage.

Tax treatment

the way the tax laws treat the interest earned on the bond. The interest on most bonds is taxable income; that is, the bond owner has to pay a portion of the interest he earns in income taxes.

Frictional unemployment

unemployment that results because it takes time for workers to search for the jobs that best suit their tastes and skills

Structural unemployment

unemployment that results because the number of jobs available in some labor markets is insufficient to provide a job for everyone who wants one. This occurs when the quantity of labor supplied exceeds the quantity demanded. his kind of unemployment results when wages are set above the level that brings supply and demand into equilibrium.

Nominal variables

variables measured in monetary units. The income of corn farmers is a nominal variable because it is measured in dollars

Real variables

variables measured in physical units. The quantity of corn farmers produce is a real variable because it is measured in bushels.

Indexed for inflation

when some dollar amount is automatically corrected for changes in the price level by law or contract o Used between firms and unions - partial or complete indexation of wage to the CPI(this is a provision called cost-of-living-allowance)- automatically raises the wage when the CPI rises o Social security benefits are adjusted every year o The brackets of the federal income tax - the income levels at which the tax rates change - are indexed for inflation

Municipal bond

when state and local governments issue bonds. The bond owners are not required to pay federal income tax on the interest income. Because of this tax advantage, bonds issued by state and local governments typically pay a lower interest rate than bonds issued by corporations or the federal government.

Policy 1: Saving incentives

♣ Many economists have used this principle to suggest that the low rate of saving is at least partly attributable to tax laws that discourage saving. The U.S. federal government, as well as many state governments, collects revenue by taxing income, including interest and dividend income. To see the effects of this policy, consider a 25-year-old who saves $1,000 and buys a 30-year bond that pays an interest rate of 9 percent. In the absence of taxes, the $1,000 grows to $13,268 when the individual reaches age 55. Yet if that interest is taxed at a rate of, say, 33 percent, the after-tax interest rate is only 6 percent. In this case, the $1,000 grows to only $5,743 over the 30 years. The tax on interest income substantially reduces the future payoff from current saving and, as a result, reduces the incentive for people to save. ♣ In response to this problem, some economists and lawmakers have proposed reforming the tax code to encourage greater saving. For example, one proposal is to expand eligibility for special accounts, such as Individual Retirement Accounts, that allow people to shelter some of their saving from taxation. • Because the tax change would alter the incentive for households to save at any given interest rate, it would affect the quantity of loanable funds supplied at each interest rate. Thus, the supply of loanable funds would shift. The demand for loanable funds would remain the same because the tax change would not directly affect the amount that borrowers want to borrow at any given interest rate. • Because saving would be taxed less heavily than under current law, households would increase their saving by consuming a smaller fraction of their income. Households would use this additional saving to increase their deposits in banks or to buy more bonds. The supply of loanable funds would increase, and the supply curve would shift to the right • Thus, if a reform of the tax laws encouraged greater saving, the result would be lower interest rates and greater investment.

Loanable funds

♣ all income that people have chosen to save and lend out, rather than use for their own consumption, and to the amount that investors have chosen to borrow to fund new investment projects. In the market for loanable funds, there is one interest rate, which is both the return to saving and the cost of borrowing. • The supply of loanable funds comes from people who have some extra income they want to save and lend out. This lending can occur directly, such as when a household buys a bond from a firm, or it can occur indirectly, such as when a household makes a deposit in a bank, which then uses the funds to make loans. In both cases, saving is the source of the supply of loanable funds. • The demand for loanable funds comes from households and firms who wish to borrow to make investments. This demand includes families taking out mortgages to buy new homes. It also includes firms borrowing to buy new equipment or build factories. In both cases, investment is the source of the demand for loanable funds. • The interest rate is the price of a loan. It represents the amount that borrowers pay for loans and the amount that lenders receive on their saving. Because a high interest rate makes borrowing more expensive, the quantity of loanable funds demanded falls as the interest rate rises. Similarly, because a high interest rate makes saving more attractive, the quantity of loanable funds supplied rises as the interest rate rises. In other words, the demand curve for loanable funds slopes downward, and the supply curve for loanable funds slopes upward. • The adjustment of the interest rate to the equilibrium level occurs for the usual reasons. If the interest rate were lower than the equilibrium level, the quantity of loanable funds supplied would be less than the quantity of loanable funds demanded. The resulting shortage of loanable funds would encourage lenders to raise the interest rate they charge. A higher interest rate would encourage saving (thereby increasing the quantity of loanable funds supplied) and discourage borrowing for investment (thereby decreasing the quantity of loanable funds demanded). Conversely, if the interest rate were higher than the equilibrium level, the quantity of loanable funds supplied would exceed the quantity of loanable funds demanded. As lenders compete for the scarce borrowers, interest rates would be driven down. In this way, the interest rate approaches the equilibrium level at which the supply and demand for loanable funds exactly balance.