Random extra study questions for exam 2

Depreciation in the currency exchange

fall in value of exchange rate - exchange rate becomes weaker makes buying foreign items more expensive may discourage foreigners to travel here makes imports more expensive (cost push inflation) inflation increases US goods are more attractive (demand pull inflation)

Nominal Gross Domestic Product (GDP)

has inflation included

Laffer curve (voodoo economics)

high marginal income tax rates could reduce work and investment incentives and increase tax evasion to the point government revenues are lower than they would be at some lower marginal income tax rate. o When marginal tax rates are low, increasing marginal fed tax rate will increase fed tax revenues. o At higher tax rates, more tax evasion, shift to underground economy, etc., and fed tax revenues will fall. o It may depend on the type of taxes.

Consequences of high unemployment

sends stock prices lower. society loses potential output of goods when productive resources are idle. Potential consumption is reduced. Loss of efficiency when people willing to work are idle.

Rule of 70

• 70/growth rate = # years to double (interest rate and growth rate are the same) • Exponential process as growth is compounded • Little differences in growth rates are big from long term perspective • Growth rate = change in real GDP / base year GDP

Welfare effects of a tariff

* Consumers of the imported good are worse off (compared to free trade) *Producers of the imported good are better off *the government gains some revenue *Total surplus decreases, because the loss to consumers is larger than the gains to the producers and to the government *The decrease in total surplus is called the deadweight loss

Factors that contribute to economic growth:

* Increases in capital goods increase labor productivity * Countries with higher investment rates tend to have higher growth rates. * Allow people and businesses to trade freely with foreign producers and consumers *Publicly fund a reasonable quantity of high-quality education *Establish and enforce strong property rights.

The Federal Reserve System (the Fed)

12 Federal reserve banks Each has its own board of directors act in unison on major policy issues Board of Governors and Federal Open Market Committee controls major policy decisions • Fed's ties to the executive branch - historically the Fed's operations have considerable independence from both executive and legislative branches of government • Central banks with greater independence appear to have lower annual inflation rate. • Due to staggered appointments, practically impossible for a single president to appoint a majority of the members of the board. Banks are not required to belong to the Fed, but virtually no difference exists between member and non-member banks. Private ownership is essentially meaningless because FRBOG is appointed by President of US. Privately owned but publicly controlled.

The short-run aggregate supply curve slopes upward because: A - firms normally can purchase some inputs at prices that are temporarily fixed in the short run. B - Firms purchase inputs that increase in price as the price level rises in the short run. C - firms seek maximum profits and always try to increase output level in the short run. D - All of the above are correct.

A - Firms normally can purchase some inputs at prices that are temporarily fixed in the short run

Aggregate Demand

AD = C + I + G + (X-M) Consumption + Investment + Government + (exports - imports) Government spending effects: o Reduction - reduces disposable income and decreases consumer spending o Increase - (decrease in taxes or increase in transfer payment) can increase disposable income and increase consumer spending. o Influences investment spending through business taxes (increase or decrease) Increase money supply by the Fed

Factors influencing exchange rates

An exchange rate is determined by the supply and demand for the currency. If there was greater demand for the dollar, it would cause the value to increase. Example: An appreciation in the exchange rate could occur if the US has: • Higher interest rates. Higher interest rates makes it more attractive to save in the US, therefore more investors will switch to US banks, therefore the value of the dollar will increase. • Lower inflation. If US goods become more competitive, there will be greater demand causing the value to increase.

Consumer Price Index (CPI) - A measure of the cost of a market basket that represents the consumption of a typical household.

Cost of market basket in current year divided by cost of market basket in base year, times 100

Contractionary fiscal policy

Decrease government spending Increase taxes decrease government transfer payments reduces inflation

Supply-side policies

Impact of supply-side policies - encourage the government to reduce individual and business taxes, deregulate, and increase spending on research and development. These policies could generate greater long-term economic growth by stimulating personal income, savings, and capital formation.

What is money?

Money is anything that is generally accepted in exchange for goods and services. • Using commodities as money has several disadvantages, the most important of which is that many commodities deteriorate easily after a few trades. • Precious metal coins have been used for money for millennia, partly because of durability.

Chairperson of the Federal Reserve System

One of the most important policymakers in the country

Increase in price level and aggregate demand

People demand more money increase in the money demand curve higher interest rate decrease in the quantity of RGDP demanded

Measurement of standard of living

Real GDP per capita = real GDP/population. The effect of increased population, ceteris paribus, will lower the standard of living because more people will be sharing a fixed real GDP. • To increase standard of living Real GDP > population

arguments for tariffs

Temporary trade restrictions help infant industries grow can reduce domestic unemployment are necessary for reasons of national security protect against dumping

Government income

The government takes in the bulk of its tax revenues from three taxes: • Personal income taxes • Corporate income taxes • Payroll taxes (like Social Security and Medicare)

Federal Funds Rate

The interest rate that banks charge each other for short-term loans

Real Gross Domestic Product (GDPr)

The market value of all final goods and services produced in the country during a year. Value of goods and services is determined by the market prices at which they sell. (doesn't measure economic well-being)

The Equation of Exchange and velocity of money

The relationship between money and price level M x V = P x Q (Money x velocity of money = Price level x real output (RGDP) (Price level x rGDP = nominal GDP) • Velocity of money refers to its "turnover" rage or the intensity with which money is used. Specifically, the average number of times that each dollar is used in purchasing final goods or services in a one-year period. o The faster money circulates, the higher the velocity o Velocity is defined as the nominal or current dollar value of output divided by the money supply or: V = Nominal GDP/M o 200 quantity product sold per year @ $5. Quantity of money in economy is $100. Using the equation above we get: V=Nominal GDP / M OR V = (P x Q) / M or V = ($5 x 200) / $100 = 10; The people spend $100 per year on product. If there is only $100 in economy, each dollar must change hands on average 10 times per year. Velocity is 10.

Movement along the aggregate demand curve is caused by price level changes:

Wealth effect, interest rate effect, and open economy effect result in movement along the aggregate demand curve - reactions to changes in the general price level.

How do banks make profits?

banks make loans and create checkable deposits to make profits. They collect higher interest payments on loans than they pay depositors for those funds.

Reserve requirements

banks want to make large volumes of loans. Stockholders want largest profits possible. • Reserve requirements - The government regulatory authorities limit the loan issuance of banks by imposing reserve requirements. Banks required to keep on hand a quantity of cash or reserve accounts with the Federal Reserve equal to a prescribed proportion of their checkable deposits.

unanticipated inflation

borrower receives greater benefit Loaner is paid back at lower value than when the money was loaned.

Supply-side effect of tax cuts

o Some believe that individuals will save less, work less, and provide less capital when taxes, gov. transfer payments, and regulations are too burdensome on productive activities. They believe fiscal policy can work on the supply side as well as demand side.

Vertical equity (tax)

people with different levels of income should be treated differently

Benefits received principle

the individuals receive the benefits are those who pay for them. Gas tax - more gas, more tax, upkeep on roads, o Works well for private goods but not as well for public goods such as national defense and judicial system because we collectively consume those.

Multiplier formula

the total impact of the initial increase in government purchases on additional consumption can be figured by using the multiplier formula: Multiplier = 1/(1-MCP)

Ability to pay principle (tax)

those with the greatest ability to pay taxes (richer people) should pay more than those with the least ability to pay taxes (poor). o Federal income tax is an example of the ability to pay principle, because the rich pay a larger percentage of their income in taxes. - richest 20% of households pay more than 60% of income tax but roughly 85% of federal income tax. The poorest 40% actually pay negative taxes through tax credits.

Burden of national debt

• National debt rises when government runs a budget deficit. • Issuance of debts involves intergenerational transfer of income • The governments activities should have benefits that are greater than their costs.

Institutional structures that promote economic growth

• Strong property rights • Patents & copyrights • Efficient financial institutions • Literacy & widespread education • Free trade • Competitive market system

Bonds traders, money supply, and interest rates

• When Fed Bond traders buy gov. bonds, this increases the money supply and lowers the interest rate • If FOMC raises the target for the federal funds rate, its bonds traders sell gov. bonds which decreases the money supply and raises the interest rate

Nominal interest rate

• not adjusted for inflation • When Nominal interest rate is high, inflation rates tend to be high. Borrowers offer and lenders demand higher nominal interest rates to compensate for the falling future value of money • When nominal interest rates are low, inflation rates tend to be low. Borrowers offer and lenders demand lower nominal interest rates because the value of money (purchasing power) is falling less quickly. • Nominal interest rates and inflation rates tend to move together. o During periods of high unexpected inflation, the nominal interest rates can be high when the real interest rates are low or even negative

Real interest rate

• take the nominal rate of interest and subtract the inflation rate • In most economic decisions, it is the real rate of interest that matters, because this is the rate that shows how much borrowers pay and lenders receive in terms of purchasing power.

Excise tax (sin tax)

sales tax on individual items such as alcohol, tobacco, and gas. • Considered most unfair type because it tends to be most regressive. Lower income tends to spend more of their income on those items than high-income families. • May lead to economic inefficiencies by isolating a few products and subjecting them to discriminatory taxes, can be politically manipulated, leading to inefficiencies.

Natural rate of unemployment also called full employment

median or typical unemployment rate is at or slightly above 5%. Above natural rate is considered abnormally high unemployment. Below natural rate is considered abnormally low unemployment. 5% roughly equals the sum of frictional and structural unemployment when at their maximums. When UR is below the natural rate - reflects existence of below-average levels of frictional and structural unemployment. When UR is above natural rate - reflects existence of cyclical unemployment. Natural rate is NOT fixed - because it can change with demographic changes over time. Full Employment = not zero but rather frictional plus structural unemployment.

Expansionary fiscal policy:

increase government purchases increase taxes increase transfer payments to increase RGDP and the price level. Raise government spending (2 forms, purchases of goods and services and transfer payments) decrease taxes increase transfer payments Increases aggregate demand Reduces unemployment Increases

The burden of the corporate income tax

o Generally popular amongst voters - but corporations don't' pay taxes, people pay taxes in reduced stock prices - lower investor rates of return, higher prices to consumers. o Less investment leads to less capital for workers, lowering productivity and real wages. o Take care to distinguish who legally pays the tax and who incurs the burden of the taxes.

National Debt- (public debt)

the federal government's indebtedness at a moment in time. • when government spending exceeds tax revenues a budget deficit results. • When tax revenues are greater than gov. spending, a budget surplus exists. • A balanced budget occurs through deliberate efforts that are a matter of public policy. • Accumulates debts by running deficits and reduces debt by running surpluses How the government finances the national debt • Printing more money - highly inflationary and undermines confidence in government • Finance by issuing debt - fed. Gov. borrows an amount necessary to cover the deficit by issuing bonds or IOUs payable typically at some maturity date (borrowing from the public) • Sells debt to investors in private sector - domestic and abroad. • When it runs a surplus, it uses receipts to reduce its outstanding debt.

Marginal propensity to consume (MPC)

the fraction of additional disposable (after tax) income that a household consumes rather than saves. MPC is = to the change in consumption spending divided by the change in disposable income. If you have $100 extra dollars and spend $75, your MPC is $75. o Marginal refers to the fact that you received an extra amount of disposable income - an addition to your income - not your total income. o Propensity to consume refers to how much you tend to spend on consumer goods and services out of your additional income.

Changes in the MPC affect the multiplier process:

the larger the marginal propensity to consume, the larger the multiplier effect: if Multiplier is ¾: Multiplier = 1/(1 - ¾) = 1(1/4) = 4 Multiplier is ½: Multiplier = 1//(1 - ½) = 1/(1/2) = 2 The multiplier is very small - close to zero when the economy is at or near full employment.

Aggregate Expenditure Approach: GDP = Aggregate Income

• Aggregate Income = GDP = DI (disposable income) + NT (net taxes) o Net taxes = taxes - transfer payments (payments by government with nothing expected in return - grants, welfare, etc.) o DI (disposable income) = GDP - NT o DI = C(consume) + S(save) •C + I + G + X - M = C + S + NT (Consumption + investment + government + Foreign sector = Consumption + Savings + Net taxes. • Take away the C's = I + G + X = S + NT + M (Injections = leakages) (Income + Government payments + Imports = Savings + New Taxes + Imports)

Things that can shift both the long and short-rang aggregate supply curves are changes in productivity, technology, quantity and quality of resources, capital

Capital - • Changes in the stock of capital will alter the amount of goods and services the economy can produce. • Investing in capital improves the quantity and quality of capital stock with lowers the cost of production in the short run, this shifts the short-run aggregate supply curve right and firms will supply more output at every price level, allowing output to be permanently greater than before, shifting long-run ASC rightward also. • Change in human capital can alter aggregate supply curve - education, vocational programs, on-the-job training all cause human productivity to rise - SRASC shifts to right and LRASC also shifts to right. Land (encompasses all natural resources) - • An increase in natural resources, such as successful oil exploration, lowers costs of production and expand economy's sustainable rate of output shifting both SRASC and LRASC to the right. • A decrease in available natural resources would shift both SRASC and LRASC to left. (when OPEC raised world oil prices, both SRASC and LRASC shifted to left when cartel reduced production of oil) Labor force - • The addition of workers to the supply can increase aggregate supply. This tends to depress wages and increase SRAS. The expanded labor force also increased the economy's potential output, increasing LRAS. • Aging population can cause a decrease in the labor force - causing a leftward shift in LRASC. Technology & entrepreneurship - • Development of innovative technology can lead to cost savings and increased productivity. These shift both the SRASC and LRASC to the right by lowering costs and expanding output possibilities.

Close inflation or expansionary gap

Pursue fiscal policy to de-stimulate the economy or remove spending from the economy we could raise taxes or decrease spending. The AD curve will shift to the left which will go from e' to e* so the actual rate of unemployment is equal to the natural rate of unemployment. These reduce household's disposable incomes reducing purchases of consumption goods and services, and higher business taxes will reduce investment purchases. The reduction will shift the aggregate demand curve leftward, lower the price level, and bring RGDP back to the full employment level at RGDPnr resulting in a new short-and long-run equilibrium. Inflationary gap is closed.

Short-run equilibrium level of real output

The Short-run equilibrium level of real output and the price level are given by the intersection of the aggregate demand curve and the SRASC. When this equilibrium occurs at the potential output level, the economy is operating at full employment on the LRASC as shown on the left. • Only a short-run equilibrium that is at potential output is also a long-run equilibrium. • Short-run equilibrium can change when the aggregate demand curve or the SRASC shifts rightward or leftward • The long-run equilibrium level of RGDP only changes with the LRAS curve shifts. • These can be anticipated or occur unexpectedly (shift shocks). • The economy can be either at a point where actual and potential RGDP are equal at REGP or the economy can be at a point where RGDP and actual RGDP are not equal. (see exhibit 13.9) • A boom is where actual RGDP is greater than potential RGDP. • A recession is where actual RGDP is less than potential RGDP. • Economy doesn't often stray too far from potential RGDP except during financial crises.

Currency

Currency consists of coins and/or paper that some institution or government has created to be used in the trading of goods and services and the payment of debts. • Metal coins used throughout the world. Has disadvantages - bulk, certain types of metals traditionally used in coins are not available in quantities to meet needs. • Coins have been supplemented by paper currency, often in the form of bank notes. o In the US, the Federal Reserve System (the Fed) issues Federal Reserve notes in various denominations, and this w/coins, provides the basis for most transactions of relatively modest size. Currency as legal tender - in US and most of world, metallic coins and paper currency are the only forms of legal tender. - officially declared to be money - • Acceptable for the settlement of debts incurred in financial tractions. • Legal tender is fiat money - a means of exchange that has been established not by custom and tradition or because of the value of the metal in a coin but by government fiat, or declaration.

Government spending (expenditures)

equals the sum of government purchases and government transfer payments.

Multiplier and the Aggregate Demand Curve

• Find the MCP then 1/(1-MCP) = ? ? x increase in government purchase = shift in ADC • Government has 20 million increased spending & MPC = 0.6 then 1 / (1 - 0.6) = 1 / (.4) = 2.5; 2.5 x 20 million = 50 million increase in ADC.

There are four main categories of unemployed workers.

1. Job losers - temporarily laid off or fired (account for 50%-60% of unemployed) 2. Job leavers - those who quit 7% 3. Reentrants - those who worked before and are reentering the labor force 27% 4. New entrants - those entering labor force for first time - primarily teens. 11%

Fiscal policy

G = Government purchases TR = Transfer payments T = taxes Borrowing

Decrease in price level and aggregate demand

decrease in the money demanded lower interest rates increase in the quantity of RGDP demanded

Shifts in the aggregate demand curve

o An increase/decrease in any component of the GDP - (C, I, G, or X-M) will cause the aggregate demand curve to shift left or right. o A non-price level determinant that causes total spending to increase will cause a shift of the curve to the right o A non-price level determinant that causes total spending to decline, will cause a shift of the curve to the left. o If something other than the price level changes it can shift the aggregate demand curve. Anything that affects the four sectors that changes GDP will shift AD curve • Consumers (private sector) (.changing consumption) - o Shift to right: Increase in consumer confidence, wealth, or tax cut can increase consumption and shift the ADC to the right. government subsidies. An increase in population will also increase the aggregate demand because consumers will be spending more money on goods and services increased government spending Increase research and development (permanent shift) o Shift to left: Decreases in consumption demand. Consumers sense that the economy is headed for a recession, government imposes a tax increase. Consuming less results in saving more, so an increase in savings will shift aggregate demand to the left. Consumer debt can cause consumers to delay additional spending. • Businesses (investment sector) o Increases in demand for investment goods will shift to the right Increased business confidence Real interest rates fall Business investment increases or expected increase in rate of return in investment causes shift to right. Reduction in business taxes o Shifts to left caused by increase in business taxes or interest rates. • Government sector - changing government purchases o Increase in purchases causes a shift to the right o Reduction of purchases shifts aggregate demand to the left. • foreign sector (X-M) Changing Net imports and exports o If other countries economies do poorly and can't afford to import US goods, our AD will decrease. Causing a shift left o If other countries economies do well and increase imports, our AD will increase causing a shift right.

Calculating Real GDP

once price index has been calculated dollar you can calculate real GDP. Nominal GDP ÷Price Index (GDP deflator) x 100 = Real GDP

Dumping

when a foreign country sells its products at prices below their cost or below the prices for which they are sold on the domestic market. • Short-term losses from selling below cost may be offset by the long-term economic profits from employing this strategy.

Five measures of production and income

• Gross National Product - the income earned worldwide by US firms and residents. • Net National Product (NNP) - deduct depreciation from GNP - Depreciation payments are annual allowances set aside for the replacement of worn-out plant and equipment. This gives us the Net National Product • National Income - a measure of the income earned by owners of resources - factor payments. Includes payments for labor services (wages, salaries, fringe benefits), payments for use of land and buildings (rent), money lent to finance economic activity (interest) and payments for use of capital resources (profits) o before national income can be measured 3 adjustments must be made to the GDP 1. First look at net income of foreigners - add any income earned abroad by US citizens or firms and subtract any income earned in the USA by foreign firms and citizens. (GNP) 2. Second - deduct depreciation from GNP. 3. Third - subtract Indirect Business Taxes - (sales tax, excise taxes, gasoline taxes) • Personal Income - is the income received by households before income taxes • Disposable Personal Income - is the personal income available to individuals after taxes

Growth in government spending caused by:

• National defense spending fluctuates with international tension. • Global recession expanded government expenditures further • Obama's greater role in health care and energy expanded government • Baby boomers aging will cause greater demand on public pensions and health care • 37% went to social security and income security programs • 24% health care and Medicare • 20% national defense • 6% interest on national debt • 13% misc. - foreign aid, agriculture, transportation, housing

domestic economic impact of an import quota

• Number of imports is much smaller than it would be without the import quota. • Domestic producers are better off (gain in area C) • domestic consumers are worse off (loss in areas c + d + e + f) • government does not gain any revenues • benefits the foreign producer who is lucky enough to receive an import license o lucky because they can sell their allotted output at higher domestic price rather than lower world price. o Licenses given to producers of clothes, and lesser extent sugar. o Similar to tariff if the fee is the difference between the domestic and world price. o Deadweight loss is even greater with quotas than with tariffs

Short-run and long-run effects of an increase in the budget deficit

• Short run - larger deficit is the same as running expansionary fiscal policy - either tax cuts or increase in gov purchases will shift the AD curve to the right resulting in higher price level and higher RGDP. An aggressive program of deficit spending can avert a recession • Long run - deficit borrowing/financing causes real interest rates to rise. Higher real interest rates crowd out private investment by households and firms. Higher private investment increases in capital formation. o Increasing budget deficit leads to higher real interest rate, reduces growth of capital stock, retards growth rate of potential GDP.

The money market and the aggregate demand curve

• When price level rises people demand more money and the money demand curve shifts up. Many goods and services will have higher prices so people will want to hold more money. • During an increase in demand for money, coupled with a fixed money supply (vertical line - controlled by Fed), causes higher interest rate. Cost of borrowing and return to savings are higher. Fewer households will be borrowing and fewer firms investing. RGDP demanded falls. • Lower prices level leads to decrease in demand for money because goods and services cost less. Reduction in demand for money causes a reduction in interest rate which encourages consumption and investment that leads to increases RGDP demanded. o Lower price level leads to increase in RGDP demanded Rising national income increases the demand for money, shifting the money demand curve to the right and leading to a higher equilibrium interest rate

Functions of the central bank

• is a "bankers bank" where commercial banks maintain their own cash deposits - their reserves • performs service functions for commercial banks: o transferring funds and checks between various commercial banks in the banking system • typically serves as the primary bank for the central government, handling payroll accounts • Manages transactions with other countries. buys and sells foreign currencies and generally assists in the completion of financial transactions with other countries • serves as the "lender of last resort" for helping banking institutions in financial distress • Maintains the stability of the banking system and the money supply which results from the loan decisions of banks o can and does impose regulations on private commercial banks o regulates the size of the money supply and influences the level of economic activity o implements monetary policy which along with fiscal policy forms the basis of efforts to direct the economy to perform in accordance with macroeconomic goals

Is it good or bad to have a devaluation in the exchange rate?

A falling exchange rate can be beneficial if the economy is uncompetitive and stuck in a recession. A devaluation helps to increased demand for exports and create jobs. In a recession, inflation is unlikely to be a problem. However, in a boom, a devaluation could lead to inflation. Also, a devaluation does reduce living standards as imports become more expensive. An appreciation in the exchange rate is beneficial if it is caused by the economy becoming more productive and competitive. However, if there is an appreciation due to speculation, then it could be harmful as exporters will not be able to compete. E.g. The Swiss intervened to prevent the Swiss France becoming too strong in recent Euro crisis.

Free trade and imports

Domestic consumers gain more than domestic producers lose The world supply to the domestic market curve is perfectly elastic - the producers of the world can supply all that domestic consumers are willing to by at the going price. Who wins and who loses from free trade and imports? • Domestic consumers benefit from paying lower prices for imports. • Before trade, domestic consumers only received area A in consumer surplus. • After trade, consumer surplus increased to area a + b + d. a gain of b + d. • Domestic producers lose, because they lose area b after imports. • Area B represents a redistribution from domestic producers to consumers.

Free trade and exports

Domestic producers gain more than domestic consumers lose If world price is set above domestic equilibrium, then the domestic economy has a comparative advantage because it can produce at a lower relative price than the rest of the world can. So you sell some domestically and some in the world market. The price after trade (Pat) is higher than the price before trade (Pbt). Because the world market is huge, the demand from the rest of the world at the world price (Pat) is assumed to be perfectly elastic. Domestic farmers can sell all the wheat they want at the world price. This means domestic prices for domestic consumers will rise.

Federal Funds Market

Federal Funds Market - when banks need short-term loans to meet reserve requirements (sometimes overnight), they are more likely to take a loan from another bank.

Monetary policy in the open market

Global economy does affect domestic monetary policy • Expansionary policy - Feds buy bonds in open market o The money supply increases and interest rates fall. o With lower domestic interest rates, some domestic investors will invest funds in foreign markets, exchanging dollars for foreign currency, which leads to a depreciation of the dollar (decrease in value). o The depreciation of the US dollar makes the US market more attractive to foreign buyers o Makes foreign markets relatively less attractive to domestic buyers. o Shift means an increase in net exports - fewer imports, and greater exports o An increase in the RGDP in the short run • Contractionary monetary policy - fed sells bonds on open market o Reduces money supply o Interest rates rise o Foreign investors will convert their currencies to dollars to take advantage of the relatively higher interest rates o This leads to an appreciation of the US dollar (increase in value) o Makes US goods and services more expensive o Foreigners will import less and domestic consumers will buy more exports o Result is a decrease in net exports and reduction in RGDP in short run

Comparative Advantage

The country (person) that can produce a good or service at a lower opportunity cost can gain by specializing in that and has a comparative advantage. Does not have to be an absolute advantage.

Money and inflation

There is a positive relationship between the moneys supply, the price level, the growth in the money supply and the inflation rate The Inflation rate and the Growth in the Money Supply - • In the long run, the amount of money in circulation and the overall price level are closely linked. • Almost impossible to have sustained inflation without a rapid growth in money supply • Higher money growth connected to higher inflation rate

Balance sheet

a financial photograph of the bank at a single moment. Money is created when banks make loans. • Assets - items of value that he bank owns (cash, reserves at the Federal reserve, bonds, and its buildings), including contractual obligations of individuals and firms to pay funds to the bank (loans) o The largest asset item for most banks is loans. o Interest earned on payment of loans are the primary means of revenue. o Some assets are kept in the form of non-interest-bearing cash and reserve accounts at the Federal Reserve to meet legal reserve requirements (and meet cash demands of customers) most reserves kept here o Little is kept in the form of paper currency in bank's vault or teller's windows. o Banks usually also keep some assets as bonds that are quickly convertible into cash (secondary reserves) • Liabilities - all banks have substantial liabilities which are financial obligations that the bank has to other people. o The predominant one is deposits. - depositor has right to demand cash for that deposit at any time. o Time deposits similarly constitute a liability of banks. • Capital stock - what it owns must exceed its liabilities or what it owes others. o The difference between a bank's assets and its liabilities constitutes its capital o Capital stock is equity owned by shareholders both in and out of the community. o Any time the aggregate amount of bank assets changes, the aggregate amount of liabilities and capital must also change by the same amount.

Tariffs

a tax on imported goods. • Usually relatively small revenue producers that retard the expansion of trade. • Bring about higher prices and revenues for domestic producers • Bring about lower sales and revenues for foreign producers. • Leads to higher prices for domestic consumers • Gains to producers are more than offset by the losses to consumers.

Quantity theory of Money and prices Growth version and Inflation version

a theory of the connection between the money supply and the price level when the velocity of money is constant • If velocity (V) and Real GDP (Q) both remain constant then a 10% increase in Money supply will lead to an 10% increase in price level. • Growth version - M x V = P x Q becomes: o Growth rate of the money supply + Growth rate of velocity = Growth rate of the price level (inflation rate) + growth rate of real output o Money growth is 5%/year, growth of real output is 3%/year, velocity hasn't changed - 0%. Inflation rate would be: growth rate of M (5%) + growth rate of V (0%) = growth rate of prices ? + growth rate of Q (3%). ? = 2%. M = P x Y ÷ V V = P x Y ÷ M P = M x V ÷ Y Y = M x V ÷ P • Inflation version: o Inflation rate = Growth rate of the money supply - growth rate of real GDP Three possible scenarios: • If money supply grows faster rate than real GDP, Inflation • If money supply grows slower rate than real GDP, Deflation • If money supply grows same rate as real GDP, price level is stable

The Reserve Requirement

although open market operations are most important, they are not the potentially most powerful tool • The Fed possesses the power to change the reserve requirements of member banks by altering the reserve ratio. o Can have immediate and significant impact on ability of member banks to create money Lowering reserve ratio allows banks to have more excess reserves (lowering rate from 15% to 10% frees up reserve money) which it can loan out. o The Fed seldom uses this tool because it is so powerful. Has advantages and disadvantages Change in number of excess reserves can disrupt the economy Frequent changes in reserve requirement would make it difficult or banks to plan • If reserve requirements increase - banks might not have enough reserves if all excesses were loaned out. If loans are made, opportunity to earn income on loans is lost o Fed pays interest on reserves held with the Fed. Both required and excess reserves. If the Fed raises interest rate on reserves, banks will hold more in excess reserves, decreasing the size of the money multiplier, and reducing the money supply. If the Fed wants to increase money supply, it could decrease the interest rate it pays on reserves, lowering holdings of excess reserves and increasing the money multiplier

Equilibrium changes in the foreign exchange market

can change many times daily - can be quite significant • Consumer tastes for goods, income levels, relative real interest rates, relative inflation rates, speculation. • Increased tastes for foreign goods - demand for foreign currencies is derived from demand for foreign goods. o Any change in US demand for foreign goods will shift the demand schedule for foreign currency in the same direction. • Relative income increases or reductions in US tariffs

The money market

equilibrium in money market is found by combining the money demanded and money supply curves. Money market equilibrium occurs at that nominal interest rate where the quantity of money demanded equals the quantity of money supplied. • Money market equilibrium - • Interest rates rise - people buy bonds and other interest-raising accounts and want to hold onto less than is available from the banking system (surplus). Bond sellers can pay less interest but still attract enough buyers. • Lower interest rates - people want to hold more money than is available from banking system. Reduce their holding of bonds or other interest-bearing assets

Fractional reserve system

even in the absence of regulations restriction the creation of checkable deposits, a prudent bank would put some limit on their loan (and deposit) volume. • For people to accept checkable deposits as money, the checks written must be generally accepted in exchange for goods and services. • People will only accept checks if they are quickly convertible at face value for legal tender. So banks must have adequate cash reserves on hand. • Our banking system is call FRS because banks, by law, as well as by choice, find it necessary to keep cash on had and reserves at the Federal Reserve equal to some fraction of their checkable deposits. • This prevents "run on the bank" • While banks must meet their reserve requirements, they do not want to keep any more of their funds as additional reserves than necessary for safety, because those do not earn interest. So banks keep some of their assets in highly liquid investments, such as US Government bonds. • Secondary reserves - highly liquid, interest-paying investments

Discount rate:

if banks are having trouble meeting their reserve requirements, they can borrow funds directly from the Fed at its discount window. • If bank has too few reserves to meet the reserve requirements • If it recently experienced an unexpectedly high amount of withdrawals • Fed can control money supply by altering the discount rate • If Fed raises the discount rate, making it more costly to borrow money, it discourages banks from borrowing - contracting the money supply • If the Fed is promoting expansion of money and credit, it will lower the discount rate making it cheaper for banks to borrow, increasing reserves, and the money supply • Discount rate sometimes changes fairly frequently - several times a year. Significance of the Discount Rate - a relatively unimportant tool. Mainly because member banks don't rely heavily on the Fed for borrowed funds and often the Fed will not lend them all they want to borrow. • Reserved for real emergencies • Federal Funds Market - when banks need short-term loans to meet reserve requirements (sometimes overnight), they are more likely to take a loan from another bank. o In recent years, the Federal Reserve has increased focus on federal funds as primary indicator of its stance on monetary policy. o Affects all interest rates throughout the economy, auto loans, mortgages, etc. • Generally discount rate is set 1.0 % point above federal funds rate target to keep banks from turning to this source.

Appreciation in the currency exchange

increase in value of exchange rate - exchange rate becomes stronger. makes imports cheaper for consumers (increase) makes exports more expensive tends to reduce aggregate demand likely to reduce inflation firms have more incentives to cut costs

Open Market Operations

involves the purchase and sale of government bonds by the Federal Reserve System • Most important method the Fed uses to influence the money supply for several reasons: o can be implemented quickly and cheaply - The Fed calls an agent who buys or sells bonds. o Can be done quietly without a lot of political debate or public announcement o Powerful tool as any given purchase or sale of bonds has an ultimate impact several times the amount of the initial transaction. o Can use this tool to change the money supply by a small or large amount on any given day

Import Quotas

legal limit on the imported quantity of a good directly restrict imports, • leads to reductions in trade • prevents nations from fully realizing their comparative advantage. higher prices and loss in consumer surplus loss in government revenue Rent seeking (efforts by producers to gain profits from government protections) Arguments for quotas: weaker than the case for tariffs • people view them as being less protectionist than tariffs. Arguments against quotas: • US government does not collect any revenue as a result of the import quota • Results in higher consumer prices - loss of consumer surplus

Required reserve ratio

o Deposits x Reserve Ratio = Required Reserves the percentage of deposits that a bank must hold at the Federal Reserve Bank or in bank vaults. o Bank must keep in reserve the percentage of the RRR in cash on hand or at the Federal Reserve Bank equal to that percentage of its deposits. o The remaining percentage of cash is called excess reserves Total demand deposit x Required Reserve Ratio = Required reserves ; Total demand deposit minus (-) required reserves = excess reserves o Reserves in the form of cash and reserves at the Fed Res., earn no revenue for the bank; no profit is made from holding cash. Banks will invest these excess reserves in interest-earning assets, sometimes bonds, but usually loans.

Excess reserves

o Excess reserves = Actual Reserves - Required Reserves The amount of cash a bank has on hand that is outside the required reserve Total demand deposit x Required Reserve Ratio = Required reserves ; Total demand deposit minus (-) required reserves = excess reserves

Supply curve for a foreign currency

o Supply curve is upward sloping As the price or value of the euro increases relative to the dollar, US products will be come relatively less expensive to European buyers who will increase the quantity of dollars they demand Europeans will then increase the quantity of euros supplies to the US by buying more US products

Money, Interest Rates, and Aggregate Demand -

the Federal Reserve's policies with respect to the money supply have a direct effect on short-run nominal interest rates and accordingly on the components of aggregate demand. Money market - the market in which money demand and money supply determine the equilibrium nominal interest rate. - What is responsible for the demand for money? • Transactions demand for money - primary purpose o Want to keep money for everyday predictable expenses. • Precautionary demand for money - unexpected expenses like medical, that require an unusual overlay of cash. o Amount held depends partly on person's income and opportunity cost of holding money. Higher interest rates = higher opportunity costs = holding less financial wealth as money. • Asset demand for money - liquidity - people prefer more liquid assets to easily convert their money into goods and services. Demand for money and the nominal interest rate - quantity of money demanded varies inversely with the nominal interest rate. - • If price level increases - buyers will need more money to purchase their goods and services • If price level decreases - people need less money to purchase goods and services

Exchange rates

the price of one unit of a country's currency in terms of another country's currency • Changes in exchange rates affect the domestic demand for foreign goods - If $1 = 1EU, then prices are equivalent. If $2 = 1EU, then the US dollar is worth half the amount of the EU - US demands for imports would decrease. • Derived Demand for a foreign currency - demand for a foreign currency derives mostly from the demand for foreign goods and services or foreign investment. o The more foreign goods are demanded, the more of that country's currency is needed to pay for those goods o The increased demand for the currency will push up the exchange value of that currency relative to other currencies. • Supply of foreign currency is provided by foreigners who want to buy the exports of a particular nation. • Determining exchange rates - it is the supply and demand for foreign currency that determines the equilibrium price (exchange rate) of that currency

Balance of payments 3 main sections: Current account Financial Account Error term

the record of international transactions in which a nation has engaged over a year. • Shows the outflow of funds to foreign nations or an inflow of funds from other nations. • Provides information about nation's world trade position. • Divided into three main sections; o Current account (imports, and exports of goods and services) - record of country's imports and exports of goods and services, net investment income, and net transfers. Exports: • Foreign purchaser of US goods pays usually in US dollars • FP has to buy exchange units of their currency at foreign exchange dealer for US $. • All exports of US goods are considered a credit + item in US balance of payments. • Foreign currencies are later exchangeable for goods and services made in the country that purchased the US exports Imports: • US importer must pay foreign producer in that nation's currency • Imports are a debit (-) item in the balance of payments • Dollars sold to buy foreign currency add to foreign claims for foreign goods which are later exchangeable for US gods and services. • US imports provide means by which foreigners can buy US exports Services: • Imports and exports aren't only thing exchanged - also services. - Tourism • US travel abroad included in "imports" (debit) • Foreign tourism in US included in "Exports" (credit) Net transfer payments and net investment income - • Private and government grants and gifts to and from other countries. • US gives foreign aid - (debit) • Private citizens send money/gifts abroad (debit) • Net transfers from US are usual in deficit because we give more than we receive in aid • Net investment income - o US investors holding foreign assets receiving payments (credit) o Payments made by US residents are subtracted (debit) Balance of trade - the net surplus or deficit resulting from the level of exportation and importation of merchandise - • US exports less than imports - deficit balance o Financial account - records the foreign purchases or assets in the domestic economy (a monetary inflow) and domestic purchases of assets abroad (a monetary outflow) International bank loans, purchases of corporate securities, government bond purchases, direct investments in foreign subsidiary companies • Foreign-owned assets in US and US-owned assets abroad o Error term (statistical discrepancy) - credits and debits MUST equal 0 Every credit eventually creates a debit of equal magnitude. Sometimes there are discrepancies (sometimes large) and are entered as statistical discrepancies.

Increase in the money supply & equilibrium interest rates and the aggregate demand

• A Federal reserve policy change that increased money supply is depicted as a shift in the money curve to the right, interest rates fall, Increases RGDP demanded at every price level o As a result of this shift, the equilibrium quantity of money demanded increases as equilibrium interest rates fall o This decreases interest rates. o Since money demand curve hasn't changed, the interest rate falls to new equilibrium level. o Induces people to hold the additional money supplied by the banking system. o Leads to an increase in AD for goods and services at current price level. • A Federal Reserve policy change that decreased the money supply, interest rates would rise, lower RGDP demanded at each and every price level

Federal reserve and monetary policy

• Deliberate changes in money supply can affect the aggregate demand and lead to short-run changes in the output of goods and services as well as the price level. • Monetary policy can be an effective tool for helping to achieve and maintain price stability, full employment, and economic growth.

Demand curve for a foreign currency

• Demand curve for foreign money has negative slope because as the price of euro falls relative to the dollar, European products become relative less expensive to US consumers who will then buy more European goods. o The quantity of euros demanded by US will increase as US consumers buy more European goods as the price of the euro falls. o The demand for foreign currencies is considered to be a derived demand

Equilibrium in the foreign money exchange

• Equilibrium is reached where the demand and supply curves for a given currency intersect. o If dollar price of euros is higher than equilibrium price, - excess quantity will be supplied (surplus of euros) o If dollar price of euros is less than equilibrium price - excess quantity will be demanded at that price and a shortage of euros will occur. - pushing price of euros up toward equilibrium

How the Fed increases the money supply

• FMOC tells trading desk at the Federal Reserve Bank in NY to buy US gov. bonds from the public in the nation's bond market. • The seller likely deposits their new funds in the bank, increasing excess reserves • New reserves lead to new loans and checking account deposits putting the money multiplier in motion and ultimately increasing the money supply If the Fed wants to increase money supply, it could decrease the interest rate it pays on reserves, lowering holdings of excess reserves and increasing the money multiplier Lower reserve requirements If the Fed is promoting expansion of money and credit, it will lower the discount rate making it cheaper for banks to borrow, increasing reserves, and the money supply

How the Fed decreases the money supply

• FMOC tells trading desk to sell US gov. bonds to the public in the nation's bond market. • Buyers would pay with checks drawn from their bank • The reserves at the bank would fall • The decrease in reserves would lead to fewer loans and checkable account deposits setting the money multiplier in motion in reverse leading to a reduction in the money supply If the Fed raises interest rate on reserves, banks will hold more in excess reserves, decreasing the size of the money multiplier, and reducing the money supply. If Fed raises the discount rate, making it more costly to borrow money, it discourages banks from borrowing - contracting the money supply

How does the Federal Reserve change the money supply? Three major methods

• Federal Reserve BOG and FMOC (Federal Open Market Committee) are the prime decision makers for U.S. monetary policy. o Decide whether to expand money supply and Real level of economic activity o Contract money supply hoping to cool inflationary pressures • The Fed has three major methods by which to control the supply of money: o Engage in open market operations - most important o Change reserve requirements o Change its discount rate

Interest rates effect on foreign currency exchange

• If country A's interest rates are higher than country B's, country A's money will depreciate against country Bs. • If interest rates on country A is consistently below interest rates of country B, country A's money value will appreciate against country Bs.

Difficulties controlling the money supply

• In fractional reserve banking system, Fed cannot precisely control the money supply because of two problems: o Money - can't control amount of $ people want to hold as currency in circulation versus deposits in their financial institution. The more they deposit, the more the bank can loan and more money is created The less they deposit, it reduces banks' excess reserves, reducing lending and supply of money. o Banks- can choose not to lend out all of their excess reserves. Banks may hold back excess reserves because of caution with economic climate and To avoid risk This can cause the money supply to fall

Why does the Fed target the Federal Funds Rate?

• Monetary policy decisions may be enacted through the money supply or through the interest rate. • contractionary monetary policy -( reduction in AD) o Can take form of reduction in the money supply or higher interest rate • Expansionary monetary policy - (increase in AD) o Can take form of increase in money supply or lower interest rate • Why is interest rate used? o Primary effects of monetary policy are felt through the interest rate o Money supply is difficult to measure accurately o Changes in demand for money may complicate money supply targets. o People are more familiar with changes in the interest rate than with changes in the money supply

Does the Fed influence the Real Interest rate in the short run?

• Most economist believe in the short run the Fed can control the nominal interest rate and the real interest rate. • Real interest rate is equal to the nominal interest rate minus the expected inflation rate. • Change in nominal interest rate tends to change real interest rate by the same mount, because the expected inflation is slow to change in the short run • If the expected inflation rate does not change, the relationship between the nominal and real interest rates is a direct relationship. • In the long run, after several years after the inflation rate has adjusted, the equilibrium real interest rate will be given by the intersection of the demand and supply of loanable funds curves.

The economic impact of subsidies

• Revenue is given to producers for each exported unit of output which stimulates exports. • Although not a barrier to trade like tariffs and quotas, subsidies can distort trade patterns and lead to inefficiencies. • Government transfers income from taxpayers to exporter - Society has same opportunity costs as before. • Subsidizes producers who relative to other countries, are inefficient. • Causes exporting of products in which the country does not have a comparative advantage • Gains from trade are eliminated or reduced by subsidies.

Does the Fed target the money supply or interest rates?

• The Fed controls the money supply, but not the money demanded. The money demanded is controlled by households and firms. • The Fed cannot simultaneously pursue policies of no monetary growth and monetary expansion. It must chose a higher interest rate, a greater money supply, or a combination of both. • The Fed cannot completely control both the growth in the money supply and the interest rate. • If it attempts to keep the interest rate steady in the face of increased money demand, it must increase the growth of the money supply. • If it tries to keep the growth of the money supply in check in the face of increased money demand, the interest rate will rise. • When Fed Bond traders buy gov. bonds, this increases the money supply and lowers the interest rate • If FOMC raises the target for the federal funds rate, its bonds traders sell gov. bonds which decreases the money supply and raises the interest rate

The Money Multiplier:

• To find the size of the money multiplier, simply divide by 1 by the Reserve requirement: 1/RR • Potential money creation = initial deposit x money multiplier. • The larger the reserve requirement, the smaller the money multiplier • Every new loan gives rise to excess reserves which lead to still further lending and deposit creation. • Each round of lending is smaller than the preceding one because come of the new money created must be kept as required reserves. • It is only Potential´ money creation - the impact of creating loans and deposits out of excess reserves. - some banks could choose not to lend all their excess reserves. o borrowers may not spend all their newly acquired bank deposits, or they may wait a considerable period before doing so. Others may put $ into time deposits instead of checkable deposits which would reduce M1 expansion but not the m2 expansion process. o This is why with leakages and time lags in the expansion process it usually means that the actual monetary impact of an initial deposit created out of excess reserves within a short time is less than that indicated by the money multiplier.

domestic economic impact of tariffs

• With tariffs, domestic price is greater than world price. • World supply curve is perfectly elastic - we can buy all we want at world price • At world price, domestic producers only willing to provide quantity Qs but domestic consumers are willing to buy Qd - more than domestic producers are willing to supply. Imports make up the difference • Imposition of tariffs shifts the perfectly elastic supply curve from foreigners to domestic consumers upward from Sworld to Sworld+tariff, but it does not alter the domestic supply or demand curve. • At hgher domestic price, (Pw+t) domestic suppliers are willing to supply more Q`s, but domesic consumers are willing to buy less Q`d. • At new equilibrium, domestic price (Pw+t) is higher and the quantity demanded (Q`d) is lower. • At new price domestic quantity demanded is lower and the quantity supplied domestically is higher reducing the quantity of imports. • Overall, tariffs lead to: 1. Smaller total quantity sold 2. Higher price for domestic consumers 3. Greater sales of at higher prices for domestic producers 4. Lower foreign sales • Although domestic producers do gain more sales and higher earnings, consumers lose much more. • Welfare gain to producers resulting from the tariff. • Import tariff - the revenue government collects from foreign countries on imports. 1. Consumers lose more than producers and government gain from tariffs. 2. Deadweight loss associated with tariff is represented by area d + f

Adjusting to recessionary gap

• many recoveries are due to increases in aggregate demand, business confidence picks up, government lowers taxes and/or interest rates to stimulate the economy. Results in rightward shift in the aggregate demand curve and takes the economy back to potential output RGDPnr. • Self-correcting - corrections in the market due to declining wages and prices. o Firms lay off workers to avoid inventory accumulation o Firms may cut prices to increase demand for their product o Unemployed workers and other input suppliers may bid down their wages and prices resulting in lower production costs o This shifts the SRAS right o Eventually the economy returns to a long-run equilibrium at the new RGDPnr and new lower price level • Downward adjustments in recessionary gap o Wages and prices may be slow to adjust, especially downward. This can prolong the duration of a recessionary gap Firms may not legally be able to cut wages because of long-term contracts Legal minimum wage Efficiency wages - employers pay higher than equilibrium wage in belief it increases productivity and lowers turnover and training costs and improves moral. • Quantity of labor willing is greater than quantity demanded resulting in more unemployment. • Can cause wages to be inflexible downward due to reluctance to cut wages Menu costs may cause price inflexibility - costs associated with changing prices in inflationary market • Because businesses are not likely to change all prices at once, it is said to be sticky. • Aggregate demand unexpectedly decreases - could lower price level. Some firms may adjust slowly, others quickly.

Costs of anticipated and unanticipated inflation

• Menu costs Firms incur costs whether inflation is anticipated or not as a result of needing to change prices, ex: printing new catalogues, print new menus, etc. • Holding money - purchasing power can erode when money is held on to for daily transactions as inflation raises • Shoe-leather cost - cost of going to and from the bank to check on your assets (wear out your shoes). o High rates of inflation erode the value of a currency so they will hold less currency - going to ATM weekly instead of monthly. - keeping in ban rather than allowing to depreciate in pocket. o Cost of time and convenience to keep less money on hand. o Costs are modest in countries with low inflation rates but can be quite large in countries where inflation is substantial. • If people can correctly anticipate inflation, they will behave in a manner that will largely protect them against loss • If not anticipated correctly - will still redistribute income.

Calculating Real GDP per capita

divide real GDP/total population = value of real output of final goods and services per person. o A higher GDP per capital would seemingly make people better off, improving their standard of living. o Economic growth is usually considered to have occurred anytime the real GDP per capita has risen. o Falling GDP per capita can bring on many human hardships such as rising unemployment, lower profits, stock market losses, and bankruptcies. • Why is the measure of per capita GDP so important? - relates human desires to output. o If population grows as fast as GDP, output remains virtually unchanged.

Marginal propensity to save (MPS)

is the flip-side of MPC. The proportion of an addition to your income that you would save, or not spend on goods and services today. MPS is equal to the change in savings divided by the change in disposable income. If you have $100 extra dollars and you save $25, your MPS is $25.

Recessionary gap

less than the potential output of the economy, RGDP Aggregate demand is insufficient to fully employ all of society's resources, so unemployment will be above the normal rate. We are inside the frontier of the production possibilities curve during a recession. We are not producing what we have the capability of producing due to unemployment rate being higher than the natural rate of employment. So if unemployment is high and you ask for a raise, you will be denied because others want your job. The employers have the power, so wages will start to go down. That makes it more profitable to produce, and the aggregate supply curve will then shift to the right and they get back to long run. Expansionary monetary policy in a recessionary gap • If fed engages in expansionary monetary policy to combat recessionary gap, the increase in the money supply will lower the interest rate o The lower interest rate reduces the cost of borrowing and the return to saving o Firms invest in new plants and equipment o Households increase their investment in housing at lower interest rate o When the Fed increases the money supply, interest rates fall, and quantity demanded of goods and services increases at each and every price level o The AD shifts RIGHT o There is an increase in RGDP at a higher price level at E2 o The Fed has eliminated the recession and RGDP is equal to potential level of output at RGDPnr o Increases consumer confidence, increases AD, increases output and employment to long-run equilibrium

Circular Flow Model

households trade money for goods and services they buy in the product market, and firms exchange money for input they buy to produce the goods and services they sell in factor markets.

Factor Payments

incomes received by people providing goods and services are actually payments to the owners of productive resources. These include: • wages for the use of labor services • rent for land • use of capital goods in the form of interest • profits for entrepreneurs who put labor, land and capital together.

The long-run level of RGDP changes whenever the aggregate demand curve shifts

F

Inflationary gap - temporarily beyond RGDP

Inflationary gap is at the short-run equilibrium (Esr) where aggregate demand is so high that the economy is temporarily operating beyond full capacity; this gap will lead to inflationary pressure, and unemployment will be below the normal rate. An inflationary gap means that in the short run you are producing beyond your potential. This cannot be sustained in the long run. If we are producing at a greater level than full employment, this is called an inflationary gap. • AD is very high and unemployment is very low - you ask for a raise, and you are likely to get it because they can't afford to lose you and try to find someone to train. • Employers have the market power because of low unemployment, o wages start to increase, this increases cost of production, o as production costs increase it decrease profits, so producers produce less output. o Which shifts the AS curve to the left, o as it shifts to left, it gets back to long-range aggregate of supply, getting back to long-range equilibrium but at a higher price. • When the Fed decreases the money supply, it raises interest rates and decreases the quantity of goods and services demanded at every price level o Fed engages in open market sale of bonds. o This leads to a decrease in the money supply o Causes interest rates to rise o Higher interest rate means that borrowing is more expensive and the return to saving is higher o Firms find it more costly to invest in plants and equipment o Households find it more costly to invest in hew homes. o The AD curve shifts LEFTWARD. o The result is a lower RGDP and a lower price level at E2.

Consumer Price Index (CPI) vs Gross Domestic Product Deflator (GDP)

• The two measures tend to move in the same direction but the CPI tends to be more volatile. It bounces around more than the GDP deflator. • Both measures overstate the inflation rate • Important Difference - GDP deflector measures the price of all goods and services produced domestically while CPI measures goods and services bought by consumers. (a Porsche will show up on CPI but not on GDP deflator since not produced in USA). o Most import is this is also true of imported oil. This is fully captured in CPI but only partially captured in GDP deflator - partially captured because increases add to cost of production. o Airplane or aircraft carrier produced domestically will show up in GDP deflator but not in the CPI.

Problems with using GDP as a measure of economic welfare because GDP excludes:

• Used goods - only counted the year produced • Non-market activity - no money is exchanged - cutting your own lawn (paying someone else would be included), taking care of your own kids (nanny would), volunteer activity. Single Most important transaction omitted her is services of housewives/househusbands - not paid, but performed, preparation of meals, housework, home gardens, etc. • Underground activity - work for cash, illegal drug sales, gambling, etc. Impossible to know the magnitude. Unreported income from legal or illegal activities. Self-employment. Estimates are 4-20%. Underground grows when taxes rise. • Leisure - time spent not working - not adding to production. Opportunity cost of leisure is income foregone by not working. o GDP may fall, but economic well-being may rise. o Leisure has a positive value that doesn't show up in GDP accounts. • Externalities - Type of output - manufacturing process, etc. could be using most environmentally unfriendly practices that creates output but harms environment- doesn't matter (unless externality has been internalized). Production of a vaccine is counted, but externality of improved lives is not. GDP measures goods and services, but not the "goods and bads" of the service. • Quality • Other measures of economic well-being: life expectancy, infant mortality rate, education and environmental quality, levels of discrimination and fairness, health care, low crime rates, minimum traffic congestion, etc.

The long-range aggregate supply curve is vertical because Wages and other input prices are not constant. There is long enough a period for the price of all inputs to fully adjust to changes in the economy.

• When moving along the LRAS curve, we are looking at the relationship between RGDP produced and the price level once input prices have been able to respond to changes in output prices. Two sets of prices are changing - price of outputs and price of inputs LRAS curve in insensitive to price level. The level of RGDP producers are willing to supply is not affected by changes in the price level. Always positioned at the natural rate of output where all resources are fully employed. In the long run, firms will always produce at the maximum level allowed by their capital, labor, and technological inputs, regardless of price level. The long-run equilibrium level is where the economy will settle when undisturbed and when all resources are fully employed. The economy will always be at the intersection of aggregate supply and aggregate demand; but that point will not always be at the natural rate of output RGDP. Long-run equilibrium will only occur where the aggregate supply and aggregate demand curves intersect along the long-run aggregate supply curve at the natural, or potential, rate of output.

There are four phases of the business cycle

1. Expansion - when output (real GDP) is rising significantly. Usually unemployment is falling and both consumer and business confidence is high. Investment is rising as are expenditures for expensive durable consumer goods such as cars and appliances. Measured from trough to the peak 2. Peak - point in time when expansion comes to an end, hen output is at the highest point in the cycle. 3. Contraction - period of falling real output and usually accompanied by rising unemployment and declining business and consumer confidence. The contraction phase is measured from peak to trough. 4. Trough (Recession - a period of significant decline in output and employment lasting more than a few months) - Two or more consecutive quarters of declining real GDP- The point in time when output stops declining and business activity is at its lowest point in the cycle. Investment spending and expenditures on consumer durable goods falls sharply in a typical contraction. Unemployment is relatively high at the trough although the actual maximum amount of employment may not occur exactly at the trough. Often, unemployment remains fairly high well into the expansion phase

There are three types of unemployment.

1. Frictional unemployment - nurses, accountants, doctors - their skills are needed anywhere the move to or live. Temporary unemployment that results from the search time when people are searching for suitable jobs and firms are seeking suitable workers. Is a result of normal turnover in the labor market. Unusual for it to be less than 2%. Tends to be greater in periods of low unemployment when job opportunities are plentiful. Stimulates mobility. 2. Structural unemployment - when your skills are no longer needed in the economy and you need to be retrained. - telephone operators. Related to occupational movement or mobility - specifically lack of mobility. Workers lack necessary skills for available jobs or have particular skills that are no longer in demand. Given this, it is wise to look at both unemployment and job vacancy statistics in assessing labor market conditions. Reflects dynamic dimension of changing economy. Many recommend government-subsidized retraining programs to reduce SE. Low-skilled workers are frequently unable to find desirable long-term employment. Low-skilled jobs frequently don't last long. Not said to be "between jobs." Last longer and is more serious than frictional unemployment because workers don't have marketable skills. Dimensions are debatable and difficult to calculate. 3. Cyclical Unemployment - unemployment caused by the business cycle - jobs hinge on economy - may need retraining as businesses change.- constant change in economy. Occurs during years of relatively high unemployment - short-term cyclical fluctuations in the economy. When unemployment rate is greater than normal, such as during a recession, it is due to cyclical unemployment. Economics costs are a forgone output when the economy is not producing at its potential level. Seasonal unemployment - job tied to seasons, ski instructor, roofer in MN, etc.

There are three categories of economic indicators

1. Leading economic indicators - designed to predict activity in US economy 6-9 months into future and can be useful as short-term predictors of the economy. The Department of Commerce combines the below into an "index of leading indicators". Can be unreliable - government may respond too soon a. The stock market (S&P 500 index) is one of the leading economic indicators. Stock market often turns downward before recession and usually begins to improve before economy recovers from slump b. New consumer goods orders - consumers reduce spending on big-ticket items before recession c. Interest rates - have strong effect on consumer and business spending d. Length of average work week e. Initial claims for unemployment f. New building permits g. New orders for plant and equipment h. The extent of delayed deliveries i. Money supply (M2) 2. Coincident economic indicators - helps to predict peaks and troughs. They change with real GDP. As real GDP increases we expect an increase in total employment, personal income, industrial production, and sales 3. Lagging economic indicators Follow economic activity. They change after real GDP changes. As real GDP rises and economy begins to recover, it may take many months before the average time unemployed workers remain unemployed falls. Others are interest rates, the unemployment rate, consumer price index

straight-line demand curve

A straight-line demand curve with constant slope will change elasticity continuously as you move up or down it due to the change in the two variables (P & Q), while the elasticity is the ratio of percentage changes in the two variables.

Three reasons for failure of wages to balance the labor demand and labor supply equilibrium:

1. Minimum wage - (hourly wage floor) a. Unskilled labor - labor market for workers with little experience and job skill. b. At MW, quantity of labor supplied grows because more people are willing to work at higher wage. c. At MW, quantity of labor demanded falls because some employers find it unprofitable to hire low-skilled workers at the higher wage d. Because minimum age workers (majority 25 y/o or less) is small portion of labor force, most economists believe the effect of minimum wage on unemployment is small. 2. Unions - Negotiate wages and benefits collectively through officials in a process called collective bargaining. a. If through CB, unions are able to increase wages, unemployment will rise in union sector. b. If wages raised above equilibrium level, quantity of union labor demanded will decrease and quantity of union labor supplied will increase. - Union workers will be unemployed. UWs who still have jobs will be better off, but others will be unemployed or seek non-union jobs or wait to be recalled to union sector. c. Many economists believe this is why wages are approximately 15% higher in union jobs even when nonunion workers have comparable skills. d. Even though wages are typically higher, it doesn't necessarily lead to greater unemployment, because workers can find jobs in non-union sectors. e. Less than 10% of private sector jobs are unionized. 3. Efficiency wage theory - belief that higher wages lead to greater productivity a. In economics it is generally believed that as productivity rises, wages rise, and workers can raise their productivity through investments in human capital such as education and on-the-job training. b. In efficiency wage model, employers pay their employees more than equilibrium wage to be more efficient. c. Believe that this attracts most productive workers, fewer job turnovers, and higher moral, leading to lower hiring and training costs. d. Higher-paid workers tend to be healthier (better diets) and therefore more productive. - particularly true in developing countries. e. Because firms are paying higher than equilibrium wage - there are fewer jobs. Shirkers might face prolonged unemployment. f. Ford Motor Company instituted EF. Result was more productivity, less absenteeism, lower turnover, less shirking. Also resulted in higher labor costs, which were more than offset by increase in worker productivity and company profits. g. Some argue positive effects are unique to assembly-line production and worker interdependence. h. Can lead to surplus of workers who want jobs and can't find them. This leads to unemployment.

There are four major factors that contribute to productivity growth

1. Physical Capital - goods such as tools, machinery, and factories that have already been producing and are now producing other goods and services. Combined with workers makes workers more productive. Increased capital per worker increases output per worker but at a diminishing rate. The curve eventually becomes flatter as more capital/worker is added - diminishing returns If economy has little capital, adding an extra unit leads to relatively large increase in output If economy has a great deal of capital, adding an extra unit leads to a relatively smaller increase in output In the long run, the benefits of a higher saving rate and additional capital stock become smaller and the rate of growth slows • Catch up effect - in Capital rich countries an increase in capital has small effect; in capital poor countries, small increases in capital investment can have large effect 2. Human Capital - learning new skills increases output. - education or on-the-job training. Human capital may be more important than physical capital as a determinant of labor productivity. Includes improvements in health. 3. Natural Resources, fertile soil, raw materials, timber, oil. Can affect the initial development process, but sustained growth is influenced by other factors. 4. Technology - Many economists believe progress in technology drives productivity. Innovation - the adoption of the product or process. Allows savings on labor - one machine can do work of many employees Can save land or other natural resources or even capital savings. Reduction in travel time reduces pollution and oil consumption and allows or better reduction of stock for businesses. Inventions - semiconductor chips, post-it-notes, barcode scanners, internet, medicine. Better organization and production methods lead to increases in labor productivity. Introduction must weigh perceived estimates of benefits against estimates of costs. - entrepreneur is important economic factor in growth process Technology can shift per-worker production curve upward producing more output per worker with the same amount of capital per worker. Allows the economy to escape the full impact of diminishing marginal returns to capital, so an economy must experience technological advance in order to improve its standard of living and overcome diminishing marginal returns to capital.

Close recessionary or contradictory gap

Activist fiscal policy to increase AD includes decreasing taxes or increase government spending which will have a stimulating effect and shift the AD curve to the right back to potential output so actual unemployment rate has fallen and we are back to the LRAS. The effect of this depends on the position of the equilibrium before the government stimulus. If timed right, this expansionary fiscal policy might stimulate the economy, pull it out of the contraction and/or recession, and result in full employment at RGDPnr. The recessionary gap is then closed.

automatic stabilizers

Automatic stabilizers are expenditures that kick in automatically during recessionary situations - • Unemployment insurance - more UI paid out making more $ available to spend and stabilizing economy. • Federal income taxes - as incomes go up, tax brackets go up. When economy falls, income falls and tax rate falls. • The goal is to try to minimize the business cycle so highs aren't too high and lows not too low. • Take out spending during inflationary times and inject money in recessionary times. • Tax system is the most important automatic stabilizer. o Personal income taxes vary directly in amount with income and rise or fall by greater percentage than income itself. o Big increases and decreases in GDP are both lessened by automatic changes in income tax receipts. o In a recession, people earn less and pay less in income and payroll taxes reducing government revenues. This reduced tax burden partially offsets the magnitude of the recession. o Public assistance (temporary) also rises and falls with economy and is an important automatic stabilizer. o Automatic stabilizers are not strong enough to completely offset a serious recession but can reduce the severity without the problem of lags.

Ceteris paribus, which of the following would cause the aggregate demand curve to shift to the left? A - greater stock market wealth B - a reduction in transfer payments C - lower personal taxes D - a rise in consumer confidence

B - a reduction in transfer payments

Which of the following does not increase U.S. aggregate demand? A - lower interest rates B - an increase in imports C - an increase in real wealth D - a decrease in the exchange rate value of the dollar.

B. an increase in imports

How banks create money

How do banks create money? - when the bank lends money, it typically doesn't give the borrower cash, it gives them the funds by issuing a check or by adding funds to an existing checking account. Commercial banks - biggest players in banking industry - financial institutions organized to handle everyday financial transactions of business and household through demand deposit accounts and savings accounts and by making short-term commercial and consumer loans. • These banks account for 2/3 of all deposits in the banking industry. • They maintain almost all the demand deposits and close to half the savings accounts • Nearly 1000 commercial banks operate in the US - other countries have fewer banks holding more assets each Savings and loan associations - provide many of the same services as commercial banks including checkable deposits, a variety of time deposits, and money market deposit accounts • 2000 associations typically invested most of their savings deposits in home mortgages Credit unions - cooperatives made up of depositors with some common affiliation, such as the same employer or unions The functions of financial institutions - • offer a large number of financial functions. Automatic withdrawals for payments, administer estates, rent safe-deposit boxes, etc. • most important, are depositories for savings and liquid assets that are used by individuals and firms for transaction purposes. • They create money by making loans. Act as intermediaries (middle persons) between savers who supply funds and borrowers who seek to invest.

How is money backed?

How was money backed? - • until recently, made from precious metals, usually gold or silver. • Until 1933, USA was on an internal gold standard meaning the dollar was defined as equivalent in value to certain amount of gold, and paper currency or demand deposits could be freely converted to gold coin. - now phased out. • Price of gold and silver soared so high the metal in the coins was worth more than its face value leading people to hoard coins and/or melt them down. • When two forms of money are available, people prefer to spend the less valuable form. • Gresham's law - cheap money drives out dear money What really backs our money now? • No meaningful precious metal backing gives our money value today. • The true backing behind money in the US is faith that people will take it in exchange for goods and services. • As long as people have confidence in something's convertibility into goods and services, "money" will exist and no further backing is necessary. • When people lose faith in exchangeability of pieces of paper that the government decrees as money, even legal tender loses its status as meaningful money. • Much of value of money is created by private businesses in the pursuit of profit. • Majority of US money is in the form of deposits at privately owned financial institutions

Production possibilities curve

Improvements in and greater stocks of land, labor, capital, and entrepreneurial activity will shift the production possibility curve outward (increased potential output)

near money and not money

Savings accounts - non-transaction deposits. Fund accounts against which the depositor cannot directly write checks,. • People like them because they usually pay higher interest than checking accounts. • Two types of non-transaction deposits: o Savings accounts o Time deposits (CDs - certificates of deposit) • Many argue that non-transaction deposits are near money assets but not money itself because they cannot be used directly to purchase a good or service. They are not a direct medium of exchange. However, they can quickly be converted into money at the face value of the account. • Savings accounts are highly liquid assets Money Market Mutual Funds - interest-earning accounts provided by brokers who pool funds into investments such as Treasury bills. Invested in short-term securities, and depositors are allowed to write checks against the accounts with certain limitations. Highly liquid assets. Considered to be near money because easily converted. Stocks and bonds - not considered money • Can take a few days to receive payment for sale of stock and cannot turn the asset into cash quickly • Most importantly - stock value fluctuates over time and there is no guarantee that you will be able to obtain original nominal value at any time.

Stagflation & Cost-Push Inflation:

Stagflation - a situation in which lower growth and higher prices occur together • Can be caused by a leftward shift in the short-run aggregate supply curve. Cost-push Inflation - a price-level increase due to a negative supply shock or increases in input prices. • If the aggregate demand curve did not increase significantly but he price level did, then the inflation was caused by supply-sided forces - cost-push inflation. • economy initially at full-employment equilibrium at point E1. Sudden increase in input prices shifts the SRAS curve to left - from SRAS1 to SRAS2. As a result of the shift, in short-run aggregate supply, the price level rises to PL2 and real output falls from RGDPnr to RGDP2. Firms demand fewer workers as a result of higher input costs which leads to higher prices, lower real output, and more unemployment - a recessionary gap.

Multiplier effect

a chain reaction of additional income and purchases that results in total purchases that are greater than the initial increase in purchases. • Any one of the major spending components of aggregate demand (C, I, B, or X-M) can initiate changes in aggregate demand, thereby producing a new short-run equilibrium. • When the government purchases something, like an aircraft carrier, the supplier of that has income, their employees have income all of whom can spend their income on more goods and services, contributing to more consumption and raising the AD. • With each successive round of consumption purchases occurs, the feedback (ME) becomes smaller and smaller.

Self-correcting mechanism

a classical school of argument. The economy will self correct itself. Where there are shortages prices will rise; where there are surpluses prices will decrease. It should be the same for the whole economy.

Progressive tax

a tax designed so that those with higher incomes pay a greater proportion of their income in taxes. • Certain types of income are excluded from income for taxation purposes, such as interest on municipal bonds and income in kind - food stamps or Medicare

Flat tax

a tax that charges all income earners the same percentage of their income. • Household simply reports its income, multiplies tax rate, send in payment. No deductions - possibly exempt below poverty line. • Tax is progressive if the program allows individual taxpayers to take a standard allowance. - lower & middle-income families will pay more. • Advantages is lack of deductions - and their abuses. • Many argue simpler and would collect the same amount of revenue. - no loopholes. • Some skeptical it would raise enough revenue • Some versions hurt some groups - mortgage interest deduction - tax accountants, charitable contributions, • People living off interest and dividends would pay no taxes.

How to save Social Security

argument against privatization is some may make poor choices and government winds up supporting anyway. • Increase payroll taxes to a rate closer to 15% than current 10.4% • Increase the age of full-time benefits to age 70 (seniors already have difficult time finding employment and doing physical work expected of them) • Implement "means testing" - reduce the benefits to retirees who have "sufficient means" for retirement • Increase the return to Social Security funds. o Invest part of the SS into the stock market. - has potential for political abuse to favor some firms and punish others • Put some payroll tax on an individual retirement plan and let individuals manage their own funds • Let individuals choose to continue with the current SS system or contribute a minimum of their wages (10-20%) to a private investment fund. Tried in other countries, and almost 90% of workers choose to leave government SS programs.

Regressive tax

as a person's income rises, the amount his or her tax as a proportion of income falls. • Takes a greater proportion of the income of lower-income groups than higher-income groups. • SS contributions are imposed as a fixed proportion (usually 6.2%) on employees and an equal amount on employers on incomes up to $110,100. Above is not taxed. • Self-employed pay the entire amount. • Wealthy persons have relatively more income from dividends and interest that aren't subject to payroll taxes. • FICA Federal Insurance Contribution Tax - employers pass on most of the tax in the form of lower wages to employees. (workers are relatively unresponsive to wage rage - inelastic labor supply) • Congress may have intended an even split however due to price elasticity of supply and demand is more burden on worker.

Tax cuts and the multiplier

o Initial increase in consumption spending from tax cut would be: (MPC x tax cut) = multiplier effect o The cumulative change in spending is found by plugging the initial effect of the changed consumption into the original formula: 1 / (1-MPC) x tax multiplier effect = cumulative change • Government can stimulate business and consumer spending through tax cuts. • How much of an AD shift do we get from tax changes? - it depends on the marginal propensity to consume.(MPC) • The tax multiplier is smaller than the government spending multiplier because government spending has a direct impact on aggregate demand whereas a tax cut only has an indirect impact on AG. Taxes and investment spending - taxes can stimulate investment spending. • Cuts in corporate-profit taxes leads to expectations of greater after-tax profits and additional investment spending. • Tax cuts designed for consumers and investors can stimulate both the C & I components of aggregate demand. Reduction in government purchases and tax increases - multiplied by the multiplier effect. • Initial cutback would have multiplying effect through the economy leading to an even greater reduction in AD. • Tax hikes would leave consumers with less disposable income, to they would cut back on consumption which would lower AD and set off the multiplier process, leading to an even larger cumulative effect on AD.

Aggregate Demand Curve

o Reflects the total amount of real goods and services that all groups together want to purchase in a given time period. - Indicates the quantities of real gross domestic product demanded at different price levels. o Slopes downward Inverse the relationship between the price level and real GDP demanded. Three reasons it slopes downward: • Real wealth effect (real balance effect) - changes in consumer spending - o a higher price level: decrease in consumer spending and a decrease in quantity of real GDP demanded. Higher price level, your purchasing power for the price level goes down. o The Real Wealth Effect is also called real balance effect. At higher price level - purchasing power goes down so you buy less. o At a lower price level your purchasing power is greater, so you buy more. • Interest rate effect - o higher price level raises interest rate, discourages investment as people must spend their money on necessities. Since spending decreases the quantity of real GDP demanded. In order to afford what you want at higher prices, you will have to borrow money. As more people borrow money the interest rates go up. • Open economy effect- International trade effect (based on exports/imports) - A higher price level in the U.S. - pushes back upward on the demand curve because it is more expensive for foreign companies to purchase US goods and services. o U.S. exports will fall (moves upward on curve) and U.S. imports will rise o Net exports will fall, reducing the amount of real GDP purchased in the US

Keynes's criticism of Classical school model

o not all income generated from output need be used to buy goods and services, it can be saved, hoarded, or taxed away. o Supply does not automatically create adequate demand o Wage inflexibility prevents the market solution from working rapidly enough to avert a prolonged recession o Wages and prices are inflexible downward. This can be from long-term contracts, untions, minimum wage laws. o If wages and prices have sufficient excess capacity then the SRASC is flat, because full employment of all resources is not reached until RGDPnr. o With resources idle, producers do not have to compete with each other for machinery or labor and input prices will stay flat

Demand-Pull Inflation

occurs when the price level rises as a result of an increase in aggregate demand. • An increase in consumer optimism results in a corresponding increase in aggregate demand. This causes an increase in the price level and an increase in real output. The movement is along the SRAS curve from point E1 to E2 and causes an inflationary gap. • An increase in output occurs as a result of the increase in price level in the short run because firms have an incentive to increase real output when prices of goods sold are rising faster than costs of inputs of production. • Economy can operate beyond its potential temporarily, as firms encourage workers to work overtime, extend hours of part-time workers, hire recently retired workers, reduce frictional unemployment, etc. It CANNOT be sustained in the long run.

Productivity - key to higher standard of living

productivity is the amount of goods and services a worker can produce per hour. It determines a countries standard of living - sustained economic growth occurs when worker's productivity rises. • Slow growth of capital investment can lead to lower labor productivity & consequently lower wages • Increases in productivity and higher wages can occur as a result of policies that stimulate investment or encourage research and development.

Four important functions of money in the economy

• As a medium of exchange - primary function o To facilitate transactions and to lower transaction costs. o Only medium that is generally accepted, but not the only medium o In the absence of money, people would barter Bartering is the direct exchange of goods and services without the use of money. Inefficient - the buyer may not have appropriate items of value to the seller. Several trades may have to take place before the desired goods are received. Requires a double coincidence of wants which money provides. Extremely expensive over long distances. - cheaper to send check than products or services. • A unit of account - a common yardstick o In barter system, people don't know what precisely items are worth in relation to each other. o By providing a universally understood unit of account, money serves to lower information costs involved in making transactions. o Money is used as a unit of account when we measure and record economic value • A store of value - a means of saving or "storing" things of value in an efficient manner. o Physical goods of value would be tied up in unproductive use for many years without money. o With money, you save a piece of paper that can be used to purchase goods and services. It is cheaper and safer to store paper than products. • A means of deferred payment - money makes it easier to borrow and repay loans. o With barter, lending is cumbersome and subject to an added problem, that the item might be more or less valuable than when loaned. o Fluctuations in value of money can also occur, but money fluctuates far less than the value of many individual commodities o Lending in money imposes fewer risks on buyers and sellers than lending in commodities.

Classical Macroeconomic model (Say's Law)

• Classical and Say's Law o Say's law - Supply creates its own demand. The production of goods and services creates income for owners of inputs used in production which in turn creates a demand for good. Full employment can be maintained because total spending will be great enough for firms to sell all the output a fully employed economy can produce. o Joblessness could be eliminated by market forces in the same way that surpluses are eliminated by movement in relative prices of those goods. o All markets adjust to their equilibrium values. o Full employment doesn't mean zero unemployment - rather zero cyclical unemployment - some structural and frictional unemployment occurs naturally. o The actual output the economy produces need not be the same as potential output. o According to Say, prolonged unemployment is impossible in the long-run classical model. Prices, wages, and interest rates adjust quickly keeping workers and resources fully employed at natural rate of real output RDGPnr. o Classical model makes little distinction between short and long run models. o Prices, wages, and interest rates are completely and quickly flexible.

Problems with Consumer Price Index

• Difficult to calculate. Economists believe the BLS improvement have cut inflationary bias in half and is now estimated to be less than % per year. • If CPI doesn't measure accurately, cost-of-living adjustments, wages, social security benefits, and alimony and child support will be distorted. • There are 4 biases: 1. Substitution bias - CPI measures the price changes of a fixed basket of goods and services, it assumes consumers purchase the same amount of each product in basket. Doesn't capture savings that households enjoy when they change spending in response to relative price changes. If basket if fixed - misses people substituting away from higher priced goods and overstates the increased cost of living. 2. Quality bias - some price increases may be due to quality increases rather than pure price increase. Ex: medical care, computers, 3. New Outlet Bias - similar to substitution bias - refers to where households shop rather than to what they purchase. - Costco & Sam's help lower expenditures. Online shopping. Versus full-price retail stores. The CPI overstates the prices some buyers actually spend. 4. New Product Bias - new products not introduced into index until they are commonplace. This means the substantial price decreases and quality increases that occur during early years following introduction are not captured by index

GDP Expenditure Approach: GDP = C + I + G + (X-M)

• GDP = Consumption + Investment + Government + (X-M is foreign sector: X = exports, -M = imports) o Consumption - services (don't change much), non-durable goods (food, etc., doesn't change), durable goods (most variable - first to be given up). Purchase of consumer goods and services by households.(doesn't include purchases by businesses or government) o Investment (Business investment) - creation of new capital, new housing (included because it provides a stream of services for a long number of years - used houses not included), inventory (businesses "buy up" their inventory at the end of the year in order for it to be included in that year's GDP not the next year's - the year it was produced, not sold) Considered the most volatile category. Tends to fluctuate considerably with changing business conditions. o Government - (what he government buys). Salaries of employees, payments to private firms for contracts. Transfer payments (social security, welfare, farm subsidies, etc) are not included in government purchases because it isn't going to purchase newly produced goods or services but is rather a transfer of income. o Exports (X-M) exports (sold to other countries) are included in the DGP. Imports (produced in other countries and purchased in USA - a negative number because money is leaving USA) are not counted in GDP.

Decrease in aggregate demand and recessions

• Just as cost-push inflation can cause a recessionary gap, so can a decrease in aggregate demand. o In the short run, this fall in aggregate demand causes higher unemployment and a reduction in output and can lead to recessionary gap. Tax cuts and increased government spending can shift the aggregate demand curve back to the right reducing the impact of the recession. o Most post-war recessions have been caused by negative demand shocks. o Negative supply shocks have been relatively few, but quite severe in terms of unemployment rates.

The money supply M1 & M2

• M1 - the narrow definition of money - currency, checkable deposits, and traveler's checks • M2 - the broader definition of money - M1 plus savings deposits, time deposits (except for some large-denomination CDs), and non-institutional money market mutual fund shares • The difference between M1 & M2 is striking as evidence by the different sizes of the total stock of money depending on which definition is used. M2 is 4x the magnitude of M1. People strongly prefer to keep the bulk of their liquid assets in the form of savings accounts of various kinds.

Demand deposits and other checkable deposits

• Most of the money we use for day-to-day transactions are not official legal tender, but a monetary instrument that has become "generally accepted" in exchange over the years and has now, by custom and tradition, become money. o Demand deposits- balances in bank accounts that depositors can access on demand by simply writing checks. o Transaction deposits they can be easily converted into currency or used to buy goods and services directly o Traveler's Checks - like currency and demand deposits, are easily converted into currency or used directly as means of payment. Popularity of Demand Deposits and other checkable deposits - have replaced paper and metallic currency as the major source of money used for larger transactions in the US and most other well-developed countries due to ease and safety of transactions, lower transaction costs, and transaction records. • Ease and safety of transactions - paying with checks is easier (cheaper) and less risky than paying with paper money. Paper money easily transferable (and easily stolen). If someone steals a check, thief probably has difficulty using it. An element of insurance or safety exists in the use of transaction deposits instead of currency. • Lower transactions costs - easier/cheaper to mail check than coins. Safer, and easier too. Transaction deposits are popular because they lower transaction costs. They are safer and more convenient. In small transactions, the gains in safety and convenience of checks are outweighed by the time and cost required to write and process a check. Paper and metallic currency will not likely disappear entirely. Credit and debit cards - generally acceptable in exchange for goods and services. • CC payment is actually a guaranteed loan available on demand to the cardholder, which merely defers the cardholder's payment for a transaction using a demand deposit. • Credit means you're receiving money today with a promise to pay back tomorrow. A short-term loan. • A credit card is not money, but rather a convenient tool for carrying out transactions that minimizes the physical transfer of checks or currency. • CC is A substitute for the use of money in exchange and allows the cardholder to use any given amount of money in future exchanges. • Debit card is a card that lets you access your money via your checking account, but the debit card is not money. They reduce or debit your bank account directly when you use them. • DCs area convenient and may be safer than credit cards because they require a PIN. • DCs have no grace period and immediately reduce the amount of money in your bank account. • DCs - consumers have less leverage when disputing a purchase. With check, you can stop payment, and with CC you have a grace period.

Arguments for and against a balanced budget amendment

• No - o BBA would be ineffective because it is impossible to guarantee that revenues and expenditures will always match up on annual basis o At worst, BBA would reduce fiscal flexibility of the fed. Gov. making it more difficult to respond to changing economic circumstances. o If public would support balancing the budget, it would already have been done by elected officials. o Counterproductive to balance budget every year - in recession would have to raise taxes & cut spending which would deepen recession. • Yes - o In absence of fiscal restraints, excessive spending will occur because of private advantages that each of us realizes from spending on "our" Gov. Programs that are paid for mostly by other taxpayers. = o No advantage from reducing our individual demands on the government treasure as log as we continue to pay for programs for others. - a spending free-for-all with penalties for fiscally responsible and rewards for fiscally irresponsible. o BBA could be written to all for deficits during times of emergencies such as war and natural disaster. o BB would mean greater national saving, investment, and economic growth. o Smaller debt would be less of burden on future generations of taxpayers. Some say best way would be to link growth of government spending with the growth in GDP.

Why run a budget deficit?

• Provide the federal gov. flexibility to respond appropriately to changing economic circumstances. o During special emergencies - military involvements, natural disasters, o Avoid economic downturn • Historically, largest budget deficits and growing government debt during war years when defense spending escalates and taxes typically don't rise as rapidly as spending. o When war is over, gov. spending declines, public debt as percentage of GDP falls. o Appropriate to operate in deficit during war because it keeps taxes smooth over time rather than raise taxes sharply to cover war costs. • During recessions - taxes are cut and gov. spending increases. • As population ages and more elderly on SS & Medicare - gov. spending increases - this plus today's trend toward smaller families leads to fewer taxpayers to support the elderly. • Healthcare costs (Medicare & Medicaid) will continue to rise as new/better health care costs more. • Reducing budget deficit one of greatest challenges to come. • If federal debt continues to expand faster than the economy, growth of people's income will slow, share of federal spending paying interest on debt will rise, risk of fiscal crisis will increase.

Who loses with inflation?

• Retirees - inflation lowers income in real terms for people on fixed-dollar incomes • Creditors - low fixed interest rate means loss of money when paid back during times of high inflation. Dollars have less purchasing power. • Income tied to long-term contracts - wage agreements signed which don't take into accurate account of rise in inflation. Wage gains equate to losses in long term. • Wages that rise slower than inflation rate • Some economists believe that significant costs are incurred when individuals and firms devote resources to protecting themselves against expected future inflation. • Uncertainty can discourage investment and economic growth. • Inflation can raise one nation's price level relative to price levels in other countries. - can make purchase of foreign goods difficult or decrease the value of the national currency relative to that of other countries.

Public policy factors that can influence economic growth

• Savings rate - one of the most important determinants of economic growth. To consume more in future, must save more now. o Without savings, there will be no money for businesses to build new plants or replace worn out capital. Without investment in capital stock there will be no economic growth. o Capital can increase as a result of injections of capital from abroad (foreign direct investments) but the role of national saving rates in economic growth is of particular importance. o Economic growth hinges on type of investments as well as in human capital and improvements in technology. • Infrastructure - critical to economic coordination and activity. Some is public some is private. • Research and Development - believed by some to be understated. Consists of the activities undertaken to create new products and processes that will lead to technological progress. • The protection of property rights - Economic growth rates tend to be higher in countries where the government enforces property rights - legal right to keep or sell their properties: land, labor, or capital. Rule of Law. o The reason some nations succeed and others don't comes down to soundness and transparency of their government institutions - the ability of citizens to own property, freely elect representatives, and live without fear of crime and corruption. • Free trade and economic growth - Free trade can lead to greater output because of the principle of comparative advantage - both parties benefit from engaging in trade. Total output will rise. • Education - investment in human capital. May be just as important as in physical capital. o College graduate in USA can expect to earn 2x what high school graduate earns. o Government subsidizing of education can increase the skill level of the population and raise the standard of living. o Even if individual doesn't benefit - the society may - lower crime rates, new ideas, more informed voters. o With economic growth, illiteracy rates fall and formal education grows. o Correlation between per capita output and the proportion of population that can read/write is striking. o Reduces barriers to flow of information. o In poor developing countries, the high opportunity costs of education presents an obstacle. Children in school are not working in the fields.

Supply-side and demand-side effects of a tax cut.

• Tax cut can lead to greater incentives to work and save - an increase in aggregate supply (long and short run) AND to demand-side stimulus from the increased disposable income (after taxes) and an increase in aggregate demand. • The amount of the effect is not known for sure. • Tax cuts that lead to the strongest incentives to work, save, and invest will lead to the greatest economic growth and will be least inflationary.

Changes that Only shift the short-range supply curve:

• The most important factors that shift on SRAS are: o Wages and other input prices If wages increase without a corresponding increase in labor productivity, it will become more costly (less profitable) for suppliers to produce goods and services at every price level, causing the SRAS curve to shift to the left. Non-labor input prices - • a decrease in non-labor input, like oil, will lower production costs making firms more profitable and firms will be more willing to increase supply at every given price level shifting the SRAS curve to the right. • An increase in prices of steel or oil (or other input) will make it more expensive to do business because production costs rise, resulting in leftward shift in SRASC. The LRAC will not shift as long as the capacity to make steel has not been reduced. • Changes in expected future price level - if workers and firms believe that the price level is going to increase in near future, they will try to adjust their wages and other input to compensate for the price level increase. This will cause a SRASC to shift to the left. • If price is lower, the adjustment will shift the SRAS curve to the right. o Productivity o Unexpected supply shocks - unexpected temporary events that can either increase or decrease aggregate supply. Negative - major widespread flooding, earthquakes, droughts, other natural disasters increase the costs of production and shift the SRASC to the left. Also disruptions in trade from war or labor strikes. Once the temporary effects of these disasters have been felt, no appreciable change in the economy's productive capacity has occurred, so there is no shift in LRASC. Positive - temporary price reductions of imported resources like oil can lower production costs and shift the SRASC right. Creation of internet temporarily shifted to the right.

Short-run aggregate supply curve slopes upward because:

• at higher price levels, producers are willing to supply more real output. o Profit effect - input costs (wages and rents) are relatively constant in short run as input suppliers often enter long-range contracts at prearranged prices. These contracts do not adjust quickly to output price level changes. o So when prices rise relative to input prices (costs) raising producers' short-run profit margin. It is thus in their interest to increase production and sales at higher price levels. o At lower price levels, they are willing to supply less real output. Because profits tend to fall. o Lower prices = lower profit per unit of output. And lower RDGP supplied because wages and other input prices can be slow to adjust in the short run. o It is more difficult for producers to cover their input costs so reduce their levels of output o Misperception effect - If everyone's product prices are rising at the same time/level that yours are, then it might be a reflection of inflation in the economy, rather than demand, and you shouldn't produce more. The relative price of the good or service wasn't rising, there was inflation. The same can be said if prices are falling. If the price level is rising, a worker may notice that his nominal wages (current dollars) is rising and mistakenly believe that it is a reward for work & increase in quantity of labor supplied. Only later to realize that all goods and services have risen and their real wages (adjusted for inflation) have not risen. They are fooled into supplying more of their labor into the market. • if cost of production is greater, suppliers will decrease production and result in higher prices and less output. • If costs fall, price will fall and price level will fall. • Boom economy, real GDP is increasing and AS is increasing. • When AD falls there is less inflation and real GDP falls.