AP Macro AP Macro Economics Economics

ReviewReview

AP Macro AP Macro Economics Economics

ReviewReview

Production Possibility CurveProduction Possibility Curve

A

C

F

B

D

E

W

Capital Capital goods goods

Consumer goodsConsumer goods

B2

D

Capital Capital goods goods

Consumer goodsConsumer goods

D2

B

Market EquilibriumMarket EquilibriumMarket EquilibriumMarket Equilibrium

DemandDemand

SupplySupply

Pe

QeQuantity

Price

A change in Demand versus a change in A change in Demand versus a change in the Quantity Demandedthe Quantity Demanded

Change in DemandChange in Demand

√ √ Moves the curveMoves the curve

•IncomeIncome

•Future ExpectationsFuture Expectations

•# of Buyers# of Buyers

•Consumer InformationConsumer Information

•Taste and PreferenceTaste and Preference

•Substitues and ComplementsSubstitues and Complements

Change in Quantity Change in Quantity DemandedDemanded

√ √ Moves Along the Moves Along the SAMESAME curvecurve

• • Caused only by Price Caused only by Price change.change.

A change in Supply versus a change in A change in Supply versus a change in the Quantity Suppliedthe Quantity Supplied

Change in SupplyChange in Supply

√ √ Moves the curveMoves the curve

•Costs of ProductionCosts of Production

•Future ExpectationsFuture Expectations

•# of Sellers# of Sellers

•Taxes and SubsidiesTaxes and Subsidies

•Prices of goods using same resourcesPrices of goods using same resources

•Time period of productionTime period of production

Change in Quantity Change in Quantity SuppliedSupplied

√ √ Moves Along the Moves Along the SAMESAME curvecurve

• • Caused only by Price Caused only by Price change.change.

The Rule of 70 is a device that can find the The Rule of 70 is a device that can find the number of years it will for some amount to number of years it will for some amount to double. double.

# of yrs to double the real GDP = 70# of yrs to double the real GDP = 70 annual rate of growthannual rate of growth

Take the growth rate in 2004 of 4.0 Take the growth rate in 2004 of 4.0 70/4.0 = 17.5 years for Real GDP to double70/4.0 = 17.5 years for Real GDP to double

Imagine that the rate of growth was 10%? Imagine that the rate of growth was 10%? Only 7 years to double!Only 7 years to double!

Economic growthEconomic growthEconomic growthEconomic growth

GROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCT

Market ValueMarket Value of the of the total total

goods and servicesgoods and services produced produced

within the boundaries of the within the boundaries of the

USUS whether whether by Americans or by Americans or

foreignersforeigners in one year. in one year.

Defining…Defining…

+

+

+

++

++

GROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCTGROSS DOMESTIC PRODUCT

ConsumptionConsumptionby Householdsby Households

InvestmentInvestmentby Businessesby Businesses

GovernmentGovernmentPurchasesPurchases

ExpendituresExpendituresby Foreignersby Foreigners

Expenditures ApproachExpenditures Approach Income ApproachIncome ApproachWagesWages

RentsRents

InterestInterest

ProfitsProfits

StatisticalStatisticalAdjustmentsAdjustments

= =GDP

NOMINAL GDP vs. REAL GDPNOMINAL GDP vs. REAL GDP

Nominal GDPNominal GDP … … reflects the current price level of goods and services and reflects the current price level of goods and services and ignores the effect of inflation on the growth of GDP. ignores the effect of inflation on the growth of GDP. … … this measure is called Current Dollar GDP. this measure is called Current Dollar GDP.

Real GDP Real GDP … … measures the value of goods and services adjusted for measures the value of goods and services adjusted for change in the price level. It will reflect the real change in change in the price level. It will reflect the real change in output.output. … … This measure is called the Constant Dollar GDP. This measure is called the Constant Dollar GDP. … … indicates what the GDP would be if the purchasing power of indicates what the GDP would be if the purchasing power of the dollar has not changed from what it was in a base year. The the dollar has not changed from what it was in a base year. The government currently uses 2000 as its base year for Real GDP government currently uses 2000 as its base year for Real GDP measurement. measurement.

GDP Price IndexGDP Price Index

Price IndexPrice Indexin a givenin a given

yearyear==

Price of market basketPrice of market basketin specific yearin specific year

Price of same marketPrice of same marketbasket in base yearbasket in base year

x 100x 100

Real GDPReal GDP ==Nominal GDPNominal GDP

Price IndexPrice Index(in hundredths)(in hundredths)

Price Index(in hundredths)

=Nominal GDP

Real GDP

An Alternative MethodAn Alternative Method

Disposable IncomeDisposable Income

By subtracting from Personal Income, By subtracting from Personal Income, the dollars lost to taxes, we have the the dollars lost to taxes, we have the Disposable Income. Disposable Income. This is the “bottom” This is the “bottom” line of national income accounting.line of national income accounting.

Disposable Income = C + SDisposable Income = C + S

√ √ by not counting non market transactionsby not counting non market transactions

√ √ by not measuring Improved Product Qualityby not measuring Improved Product Quality

√ √ by not considering Leisure Time by not considering Leisure Time

GDP understates the well-being…GDP understates the well-being…

GDP Overstates the well-being…GDP Overstates the well-being…

√ √ by ignoring the Composition and by ignoring the Composition and Distribution of OutputDistribution of Output

√ √ GDP and the EnvironmentGDP and the Environment

Per Capita GDP measures the GDP in terms of goods and services per person

Unemployment Rate = Unemployment Rate = UnemployedUnemployedLabor ForceLabor Force

Frictional – “temporary”, “transitional”, Frictional – “temporary”, “transitional”, “short-term” (“between jobs” or “search” “short-term” (“between jobs” or “search” unemployment)unemployment)Structural – “technological” or “long term”. Structural – “technological” or “long term”. basic changes in the “structure” of the labor basic changes in the “structure” of the labor force which make certain “skills obsolete”.force which make certain “skills obsolete”.Cyclical – “economic downturns” in the Cyclical – “economic downturns” in the business cycle.business cycle.

The Full employment rate of The Full employment rate of unemployment or the unemployment or the Natural Natural

Rate of Unemployment (NRURate of Unemployment (NRU) is ) is present when the economy is present when the economy is

producing its potential output.producing its potential output.

The Natural Rate of Unemployment The Natural Rate of Unemployment exists when the cyclical unemployment exists when the cyclical unemployment

is zero.is zero.

GDP Gap and Okun’s LawGDP Gap and Okun’s LawGDP Gap and Okun’s LawGDP Gap and Okun’s Law√ √ The basic loss of unemployment is forgone The basic loss of unemployment is forgone output.output. √ √ Potential GDPPotential GDP is the capacity of the is the capacity of the economy assuming the Natural Rate of economy assuming the Natural Rate of Unemployment. The growth of the Potential GDP Unemployment. The growth of the Potential GDP assumes the normal growth rate of the real GDP.assumes the normal growth rate of the real GDP.

GDP GAP is the amount by which actual GDP falls GDP GAP is the amount by which actual GDP falls short of potential GDPshort of potential GDPFor every 1% the unemployment rate exceeds For every 1% the unemployment rate exceeds the natural rate…Approximately a 2% GDP Gap the natural rate…Approximately a 2% GDP Gap occurs.occurs.

Inflation A rising of the general level of prices

=

Price of the same marketbasket in 2000

x 100CPIPrice of the market basket in the particular year

Producer Price Index (PPI)Producer Price Index (PPI) Prices at the wholesale or production level which are early indicators of inflation.

70 divided by rate of inflation (expressed as whole numbers) will yield the number of years for the price level to double.

Theories of InflationTheories of Inflation::Demand PullDemand Pull

√ √ Excess of total demandExcess of total demand√ √ prices are bid upward by the excess demandprices are bid upward by the excess demand√ √ economy is seeking a point beyond its PPC economy is seeking a point beyond its PPC when full employment-full production is when full employment-full production is evidentevident

Qf

Increases in total spending

Quantity

Range 2Range 2

Range 3Range 3PPrriiccee

lleevveell

Range 1Range 1

Theories of Inflation:Cost PushTheories of Inflation:Cost Push

√ √ prices rising when output and employment are prices rising when output and employment are

both decliningboth declining

√ √ aggregate demand not excessiveaggregate demand not excessive

√ √ Per unit production costs are rising due to raw Per unit production costs are rising due to raw

materials, energy, labor, etc.materials, energy, labor, etc.

√ √ High per unit costs cause decline in profit; hence, High per unit costs cause decline in profit; hence,

the price level is “pushed up” by these costs.the price level is “pushed up” by these costs.

Abrupt increases in the costs of raw materials or Abrupt increases in the costs of raw materials or energy inputs drive up per-unit production costs energy inputs drive up per-unit production costs and hence prices. and hence prices.

Those who benefitThose who benefit Those who loseThose who lose

Flexible IncomeFlexible Income Fixed IncomeFixed Income

SpendersSpenders SaversSavers

DebtorsDebtors CreditorsCreditors

Unanticipated InflationUnanticipated Inflation

COLA-helps to stay up with COLA-helps to stay up with rising pricesrising prices

Real and Nominal IncomeReal and Nominal IncomeNominal incomeNominal income … is the number of dollars … is the number of dollars

earned as rent, wages, interest or profitearned as rent, wages, interest or profitReal incomeReal income… measures the amount of … measures the amount of

goods and services nominal income can buy.goods and services nominal income can buy.

√ √ If nominal income rises faster than price If nominal income rises faster than price level, real income will rise. level, real income will rise.

√ √ If the price level increases faster than If the price level increases faster than nominal income, then real income will fall.nominal income, then real income will fall. √ √ Your real income falls only when nominal Your real income falls only when nominal income fails to keep up with inflation.income fails to keep up with inflation.

o

PLPL11

ASASsrsrASASlrlr

ADAD11

QQff

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

Long Run EquilibriumLong Run EquilibriumIn the extended In the extended AD-AS model, AD-AS model,

equilibrium equilibrium occurs at the occurs at the

intersection of intersection of AD and the ASAD and the ASlrlr

and the ASand the ASsrsr. .

QQf f is the amount is the amount

of Real GDP at of Real GDP at full employment.full employment.

DEMAND-PULL INFLATION DEMAND-PULL INFLATION and Self-Correctionand Self-Correction

DEMAND-PULL INFLATION DEMAND-PULL INFLATION and Self-Correctionand Self-Correction

Long Run Long Run Nominal Wages Nominal Wages

rise and ASrise and AS22srsr

moves left. moves left. RGDP returns RGDP returns

to previous to previous level on Aslevel on Aslrlr

But…PL rises But…PL rises even more to even more to

PLPL33!!o

PLPL11[2%][2%]

ASASsrsr

ASlr

ADAD11

a

QQf f

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

bPLPL22[5%][5%]

ADAD22

YY22

c

ASAS22srsr

PLPL33[7%][7%]

Short Run—Short Run—Increase in AD Increase in AD shows shows point bpoint b

COST-PUSH INFLATION COST-PUSH INFLATION with government action with government action

COST-PUSH INFLATION COST-PUSH INFLATION with government action with government action

If government If government stimulates AD to stimulates AD to dotted line, an dotted line, an inflationary spiral inflationary spiral will occur…PLwill occur…PL33 at at

QQf.f. We have Full We have Full

Employment but at Employment but at a higher price level.a higher price level.

o

PLPL11[[22%]%]

ASASsrsr

ASlr

ADAD11

a

QQff

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

b

ASAS22srsr

PLPL22[[33%]%]

YY22

ADAD22

cPLPL33[[55%]%]

COST-PUSH INFLATION COST-PUSH INFLATION with NO government action with NO government action COST-PUSH INFLATION COST-PUSH INFLATION with NO government action with NO government action

o

PLPL11[[22%]%]

ASASsrsr

ASlr

ADAD11

a

QQff

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

ASAS22srsr If government lets If government lets

the recession take the recession take its course, nominal its course, nominal wages will fall in wages will fall in the long run and the long run and return to point a…return to point a…PLPL11 at Q at Qf.f.

cPLPL33[[55%]%]

o

PLPL33[[22%]%]

ASAS22srsr

ASlr

ADAD22

a

QQff

Pri

ce L

evel

Pri

ce L

evel

Real domestic outputReal domestic output

bPLPL22[[33%]%]

ADAD11

YY22

c

ASAS11srsr

PLPL11[[55%]%]

Recession Recession Recession Recession This decline in This decline in the price level the price level will eventually will eventually shift the ASshift the AS11

srsr to to

ASAS22sr. sr. Price level Price level

declines to PLdeclines to PL33

at Qat Qf . f . Shown at Shown at

point c.point c.

This decline in This decline in the price level the price level will eventually will eventually shift the ASshift the AS11

srsr to to

ASAS22sr. sr. Price level Price level

declines to PLdeclines to PL33

at Qat Qf . f . Shown at Shown at

point c.point c.

An

nu

al r

ate

of in

flat

ion

An

nu

al r

ate

of in

flat

ion

Unemployment rate (percent)Unemployment rate (percent)

7

6

5

4

3

2

1

01 2 3 4 5 6 7

As inflation declines...As inflation declines...

The Phillips Curve ConceptThe Phillips Curve ConceptThe Phillips Curve ConceptThe Phillips Curve Concept

UnemploymentUnemploymentincreasesincreases

PCPC

√ √ In the long run, there is not a stable relationship In the long run, there is not a stable relationship

between unemployment and inflation.between unemployment and inflation.

√ √ The long-run Phillips curve is the vertical line at the The long-run Phillips curve is the vertical line at the

natural rate of unemployment.natural rate of unemployment.

The Phillips CurveThe Phillips CurveSummarySummary

The short run Phillips Curve is downward sloping.The short run Phillips Curve is downward sloping.

Aggregate Demand changes move along the same Aggregate Demand changes move along the same short run Phillips curve.short run Phillips curve.

Aggregate Supply changes create new short run Aggregate Supply changes create new short run Phillips curves.Phillips curves.

Expansionary Fiscal PolicyExpansionary Fiscal Policy

√ √ Increase Government SpendingIncrease Government Spending√ √ Decrease Tax RatesDecrease Tax Rates

……Or Combination of the TwoOr Combination of the Two

Goal: To Reduce Unemployment and Effects of Recession…

Contractionary Fiscal PolicyContractionary Fiscal Policy

√ √ Decrease Government SpendingDecrease Government Spending√ √ Increase Tax RatesIncrease Tax Rates

……Or Combination of the TwoOr Combination of the Two

Goal: To Reduce Demand—Pull Inflation…

Pri

ce le

vel

Real GDP (billions)

EXPANSIONARY FISCAL POLICYEXPANSIONARY FISCAL POLICY

$60 billion$60 billionincrease in increase in AggregateAggregateDemandDemand

ADAD11ADAD22

$20 billion decrease in tax rates; $15 billion in $20 billion decrease in tax rates; $15 billion in new consumption spendingnew consumption spending

the multiplier at work...the multiplier at work...

P1

$550 $550

AS

$490$490

P2

MPS = .25MPS = .25

Pri

ce le

vel

Real GDP (billions)

CONTRACTIONARY FISCAL POLICYCONTRACTIONARY FISCAL POLICY

$60 billion$60 billiondecrease in decrease in AggregateAggregateDemandDemand

ADAD44

ADAD33

$20 billion increase in tax rates; $15 billion lost $20 billion increase in tax rates; $15 billion lost in consumption spendingin consumption spending

the multiplier at work...the multiplier at work...

P1

$550$550

AS

$490$490

P2

MPS = .25MPS = .25

Built-in StabilityBuilt-in StabilityBuilt-in StabilityBuilt-in Stability

Some changesSome changes in relative levels of government in relative levels of government

expenditures and taxes occur expenditures and taxes occur automatically.automatically.

This is not like discretionary changes in spending This is not like discretionary changes in spending

and tax rates since these net tax revenues and tax rates since these net tax revenues vary vary

directly with RGDP.directly with RGDP.

……tends to increase the government deficit (or tends to increase the government deficit (or

reduce the surplus) during recession or to increase reduce the surplus) during recession or to increase

the surplus ( or reduce the deficit) during inflation the surplus ( or reduce the deficit) during inflation

without requiring specific action by policy makerswithout requiring specific action by policy makers..

Crowding —Out EffectCrowding —Out EffectCrowding —Out EffectCrowding —Out EffectR

eal I

nte

rest

Rat

e, (

per

cen

t)R

eal I

nte

rest

Rat

e, (

per

cen

t)

Quantity of Loanable FundsQuantity of Loanable Funds

i%i%

D

LF0

SIncreased Increased demand for demand for loanable funds loanable funds by government by government raises the raises the interest rate.interest rate.

D2

i%i%

LF1

Expansionary fiscal policyExpansionary fiscal policyProblem: RecessionProblem: Recession

More government spending More government spending and/or lower taxesand/or lower taxes

Higher domestic interest ratesHigher domestic interest rates(crowding-out effect)(crowding-out effect)

Increased foreign demand for Increased foreign demand for dollars (foreigners want to earn dollars (foreigners want to earn

higher interest)higher interest)Dollar appreciatesDollar appreciates

Net Exports decline Net Exports decline (AD decreases, partially (AD decreases, partially

offsetting expansionary policy)offsetting expansionary policy)

Fiscal policy weakened by NET EXPORT EFFECTFiscal policy weakened by NET EXPORT EFFECT

Contractionary fiscal policyContractionary fiscal policyProblem: InflationProblem: Inflation

Lower government spending and/or Lower government spending and/or higher taxeshigher taxes

Lower domestic interest ratesLower domestic interest rates(government role in loanable funds (government role in loanable funds

market is less)market is less)

Decreased foreign demand for dollars Decreased foreign demand for dollars (foreigners find (foreigners find

higher rates elsewhere)higher rates elsewhere)Dollar depreciatesDollar depreciates

Net Exports increase Net Exports increase (AD increases, partially offsetting (AD increases, partially offsetting

contractionary policy)contractionary policy)

Supply-Side Economics aims to manipulate aggregate supply by Supply-Side Economics aims to manipulate aggregate supply by enacting policies designed to stimulate enacting policies designed to stimulate incentives to work, to incentives to work, to save and investsave and invest (including measures to encourage (including measures to encourage entrepreneurship). entrepreneurship). These policies may include These policies may include tax cutstax cuts which will increase which will increase disposable incomes, thus disposable incomes, thus increasing household savingincreasing household saving and and increase the profitability of investments by businesses.increase the profitability of investments by businesses.•Tax cut stimulates more consumption, saving and investment Tax cut stimulates more consumption, saving and investment to increase AD.to increase AD.•The new investment moves the AS curve to the right. Work The new investment moves the AS curve to the right. Work incentives push more workers into employment and they spend incentives push more workers into employment and they spend and save increasing AD further.and save increasing AD further.•Low taxes act to push risk takers to move toward new Low taxes act to push risk takers to move toward new production methods and new products. production methods and new products.

Supply-Side Economics

……shows the relationship between tax rates shows the relationship between tax rates and tax revenuesand tax revenues

√ √ Up to a pointUp to a point, higher tax rates will result , higher tax rates will result in larger tax revenuesin larger tax revenues.. √ √ But still higher tax ratesBut still higher tax rates will adversely will adversely affect incentives to work and produce, affect incentives to work and produce, reducing the size of the tax base and reducing the size of the tax base and reducing tax revenues.reducing tax revenues. √ √ Lower tax ratesLower tax rates will lessen tax evasion will lessen tax evasion and avoidance, and reduce government and avoidance, and reduce government transfer payments.transfer payments.

Laffer Curve

MIMI• Checkable depositsCheckable deposits• Travelers checksTravelers checks• CurrencyCurrency

• Money market accountsMoney market accounts• Savings depositsSavings deposits• Small time depositsSmall time deposits

• Large time depositsLarge time deposits

M2M2

M3M3++

++

MM

OO

NN

EE

YY

MM

EE

AA

SS

UU

RR

EE

SS

i%

$$ demanded

Dm

i%1

Sm

The Money MarketThe Money MarketThe Money MarketThe Money MarketSupply of Supply of money is a money is a vertical line vertical line since monetary since monetary authorities authorities (FED) and (FED) and financial financial institutions institutions have provided have provided the economy the economy with a certain with a certain stock of money. stock of money.

Money supply is Money supply is increasedincreased when: when:

1. Banks 1. Banks issue loansissue loans to customers and receive a to customers and receive a demand deposit.demand deposit.

2. Banks 2. Banks buy securitiesbuy securities from the public and credit a from the public and credit a demand deposit for the cost.demand deposit for the cost.

Money supply is Money supply is decreaseddecreased when: when:

1. Customers 1. Customers repay loansrepay loans take money from their take money from their demand deposit.demand deposit.

2. Banks 2. Banks sell securitiessell securities to the public and a demand to the public and a demand deposit is reduced to pay for the bond.deposit is reduced to pay for the bond.

Creation of Money in the Banking SystemCreation of Money in the Banking System

MaximumMaximumDemand-Demand-DepositDepositcreationcreation

== ExcessExcessreservesreserves

xx MoneyMoneyMultiplierMultiplier

MoneyMoneyMultiplierMultiplier Required reserve ratioRequired reserve ratio

11==The Money MultiplierThe Money Multiplier

√ √ One bank can loan only its excess reserves and is One bank can loan only its excess reserves and is limited by those reserves in creating money.limited by those reserves in creating money.

√ √ The banking system creates a “multiplied” The banking system creates a “multiplied” amount.amount.

Currency drain and no creditable customers will Currency drain and no creditable customers will decrease the amount multiplied.decrease the amount multiplied.

MS i% IMS i% Inn C AD PL RGDP C AD PL RGDP

EASY MONEY EASY MONEY Goal: Cheap, available credit; Goal: Cheap, available credit; increase the money supplyincrease the money supply

Actions • FED willbuygovernmentbonds frombanks andthe public

• FED will lower thelegal reserve ratio

• FED will lowerthe discount ratecharged to memberbanks

Results √ Increasethe bankexcessreserves, andbanks canmake moreloans.

An increase in themoney supply willlower the interest rate,causing Investment toincrease andequilibrium GDP torise.

The amount of thechange will bedependent on thesize of the IncomeMultiplier (1/MPS)

Easy money is Easy money is reinforcedreinforced by the Net Export Effect by the Net Export Effect

Real domestic output, GDP

DDmm

InvestmentInvestmentDemandDemand

Rea

l rat

e of

inte

rest

, i

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

SSm1m1

ASAS

ADAD11(I=$15)(I=$15)

PLPL11

10

8

6

0

SSm2m2

ADAD33(I=$25)(I=$25)PLPL22

If the Money SupplyIf the Money SupplyIncreases to StimulateIncreases to Stimulatethe Economy…the Economy…

Interest Rate DecreasesInterest Rate DecreasesInvestment IncreasesInvestment IncreasesAD & GDP IncreasesAD & GDP Increases with slight inflationwith slight inflation

Pri

ce le

vel

ADAD22(I=$20)(I=$20)

PLPL33

SSm3m3

Increasing money supplyIncreasing money supply continues the growth –continues the growth – but, watch Price Level.but, watch Price Level.

Easy Monetary Policy And Equilibrium GDPEasy Monetary Policy And Equilibrium GDP

MS i% IMS i% Inn C AD PL RGDP C AD PL RGDP

Tight Money Tight Money Goal: Restrict credit; decrease the Goal: Restrict credit; decrease the money supplymoney supply

Actions • FED willsellgovernmentbonds tobanks andthe public

• FED will raise thelegal reserve ratio

• FED will raisethe discount ratecharged tomember banks

Results √ Decreasethe bankexcessreserves, andbanks willissue fewerloans

An decrease in themoney supply will raisethe interest rate,causing Investment toincrease andequilibrium GDP tofall.

The amount of thechange will bedependent on thesize of the IncomeMultiplier (1/MPS)

Tight money is Tight money is reinforcedreinforced by the Net Export Effect by the Net Export Effect

Real domestic output, GDP

Dm

InvestmentInvestmentDemandDemand

Rea

l rat

e of

inte

rest

, i

10

8

6

0Quantity of money demanded and supplied Amount of investment, i

SSm3m3

ASAS

ADAD33(I=$15)(I=$15)

PLPL33

10

8

6

0

SSm2m2

ADAD11(I=$25)(I=$25)PLPL22

If the Money SupplyIf the Money SupplyDecreases to “cool”Decreases to “cool”the Economy…the Economy…

Interest Rate IncreasesInterest Rate IncreasesInvestment DecreasesInvestment DecreasesAD & GDP DecreasesAD & GDP Decreases with lower PLwith lower PL

Pri

ce le

vel

ADAD22(I=$20)(I=$20)

PLPL11

SSm1m1

Decreasing money supplyDecreasing money supply continues the “cooling” –continues the “cooling” – as Price Level falls.as Price Level falls.

Tight Monetary Policy And Equilibrium GDPTight Monetary Policy And Equilibrium GDP

Nominal Rate = Nominal Rate = Real Interest rate + expected rate Real Interest rate + expected rate of inflationof inflation

Real Interest Rate =Real Interest Rate =Nominal rate—expected rate of Nominal rate—expected rate of inflation inflation

Nominal Rate = Nominal Rate = Real Interest rate + expected rate Real Interest rate + expected rate of inflationof inflation

Real Interest Rate =Real Interest Rate =Nominal rate—expected rate of Nominal rate—expected rate of inflation inflation

SSmmii%%

Q of $$ demanded

Dm

The supply of money is The supply of money is vertical no matter what vertical no matter what the interest rate is on the interest rate is on the vertical axis. The the vertical axis. The FED controls the FED controls the supply of money.supply of money.

The demand for The demand for money is money is composed of the composed of the transaction transaction demand and demand and asset demand.asset demand.

Money Market Money Market Graph—Graph—Nominal Nominal Interest RateInterest Rate

Money Market Money Market Graph—Graph—Nominal Nominal Interest RateInterest Rate

QQee

i%i%ee

rr

rree

Q of LF Q of LF QQee

SSLFLF

DDLFLF

Loanable Funds Market—Real Loanable Funds Market—Real Interest RateInterest Rate

Changes in the real interest rate caused by Changes in the real interest rate caused by movements of demand (from borrowers) and supply movements of demand (from borrowers) and supply (from savers).(from savers).

Demand is:Demand is:

• • Business for investmentBusiness for investment

• • Consumer for spendingConsumer for spending

• • Government for Deficit Government for Deficit spendingspending

Supply is mostly from Supply is mostly from private savingsprivate savings

GROWTH IN THE AD-AS MODELGROWTH IN THE AD-AS MODELGROWTH IN THE AD-AS MODELGROWTH IN THE AD-AS MODEL

AA

BB

CC

DD

Cap

ital

Goo

ds

Cap

ital

Goo

ds

Consumer GoodsConsumer Goods

Pri

ce L

evel

Pri

ce L

evel

Real GDPReal GDP

ASASLR1LR1 ASASLR2LR2

QQ11 QQ22

Classical View:Classical View:

√ √ AS is vertical and AS is vertical and

determines the output at determines the output at

QQff

√ √ AD is stable and AD is stable and

determines the price determines the price

level as long as money level as long as money

supply is stable. supply is stable.

√ √ If AD is unstable, If AD is unstable,

prices and wages adjust. prices and wages adjust.

P1

Qf

ASAS

ADAD11

Pri

ce L

evel

Real Domestic OutputA shift to ADA shift to AD22 shows shows that the price level that the price level declines. declines.

ADAD22

P2

Keynesian ViewKeynesian View::

√ √ Product prices and Product prices and wages are downward wages are downward inflexible inflexible √ √ AS is horizontal up to AS is horizontal up to Qf then becomesQf then becomes verticalvertical √ √ If AD is unstable, If AD is unstable, changes in AD have no changes in AD have no effect on PL but affect effect on PL but affect RGDP.RGDP. Movement from ADMovement from AD11 to AD to AD22

reduces the Real GDP but reduces the Real GDP but the PL remains constant.the PL remains constant.

P1

Qf

ASAS

ADAD11

Pri

ce L

evel

Real Domestic Output

ADAD22

Q2

NEW CLASSICAL VIEW OF SELF-CORRECTIONNEW CLASSICAL VIEW OF SELF-CORRECTIONNEW CLASSICAL VIEW OF SELF-CORRECTIONNEW CLASSICAL VIEW OF SELF-CORRECTION

P2

Q1

Pri

ce L

evel

Real Domestic Output

AD2

AD1

ASLR

P1

AS1

AS2

P3

Self-CorrectionSelf-Correction

a

bc

AD increases moves economy from a to b.Price level rises Price level rises (P(P22) and then ) and then

self-correction self-correction to c by shifting to c by shifting left to ASleft to AS2 2 as as

Nominal Wages Nominal Wages rise.rise.

Monetary ruleMonetary rule :: supported by Monetarists supported by Monetarists and other Neo-Classical Economists like and other Neo-Classical Economists like Rational Expectationists. Rational Expectationists. ……directs the directs the Fed to expand the money supply each Fed to expand the money supply each year at the same annual rate as the year at the same annual rate as the typical growth of the economy’s typical growth of the economy’s productive capacity. productive capacity.

Discretionary Fiscal and Monetary Discretionary Fiscal and Monetary Policy (especially monetary):Policy (especially monetary): supported supported by by Mainstream Economists. Mainstream Economists.

Summary of Alternative ViewsNew Classical Economics

Issue MainstreamMacroeconomicsKeynesian Based

Monetarism Rationalexpectations

View of theprivate

economy

Potentiallyunstable

Stable in long runat natural rate ofunemployment

Stable in long runat natural rate ofunemployment

Cause ofobserved

stability ofprivate

economy

Investment doesnot equal saving

causing changes inAD; AS shocks

Inappropriatemonetary policy

Unanticipated ADand AS shocks in

the short run

Appropriatemacro policy

Active fiscal andmonetary

Monetary rule Monetary rule

How changesin money

supply affectthe economy

By changinginterest rates,

changinginvestment and

real GDP

By directlychanging AD

which changesGDP

No effect on outputbecause price-level

changes areanticipated

View ofvelocity of

money

Unstable Stable No consensus

How fiscalpolicy affectsthe economy

Changes AD andGDP via themultiplier

No effect unlessmoney supply

changes

No effect on outputbecause price-level

changes areanticipated

View of Costpush inflation

Possible (wage-push, AS shock)

Impossible in longrun in absence ofexcessive moneysupply growth

Impossible in longrun in absence ofexcessive moneysupply growth

The The National or Public DebtNational or Public Debt is the is the accumulated deficits and surpluses of the accumulated deficits and surpluses of the government over time.government over time.

The The National or Public DebtNational or Public Debt is the is the accumulated deficits and surpluses of the accumulated deficits and surpluses of the government over time.government over time.

Deficits, Surpluses and DebtDeficits, Surpluses and DebtDeficits, Surpluses and DebtDeficits, Surpluses and DebtA A budget deficitbudget deficit is the amount by which the is the amount by which the government expenditure exceeds the government expenditure exceeds the government revenue in a particular year. government revenue in a particular year.

A A budget deficitbudget deficit is the amount by which the is the amount by which the government expenditure exceeds the government expenditure exceeds the government revenue in a particular year. government revenue in a particular year. A A budget surplusbudget surplus is the amount by which is the amount by which the government revenue exceeds the the government revenue exceeds the government expenditure in a particular government expenditure in a particular year. year.

A A budget surplusbudget surplus is the amount by which is the amount by which the government revenue exceeds the the government revenue exceeds the government expenditure in a particular government expenditure in a particular year. year.

Types of BudgetsTypes of Budgets

Annually Balanced—procyclicalAnnually Balanced—procyclical

Cyclically Balanced—to hard to Cyclically Balanced—to hard to

predict cyclespredict cycles

Functional Finance-work for goalsFunctional Finance-work for goals

√ √ Comparative AdvantageComparative Advantage …is the ability to …is the ability to produce an item at a lower opportunity cost. Resources produce an item at a lower opportunity cost. Resources are scarce, so that one can only produce more of one are scarce, so that one can only produce more of one product by taking the resources away from another. It product by taking the resources away from another. It means that total world output will be greatest when each means that total world output will be greatest when each good is produced by the nation which has the lowest good is produced by the nation which has the lowest domestic opportunity cost.domestic opportunity cost.

√ √ As a result of trade, countries that trade products based As a result of trade, countries that trade products based on their own specialization will have more of BOTH on their own specialization will have more of BOTH products (produced and traded for).products (produced and traded for).

√ √ Terms of Trade…the exchange ratio between goods Terms of Trade…the exchange ratio between goods traded. This ratio explains how the gains from traded. This ratio explains how the gains from international specialization and trade are divided international specialization and trade are divided among the trading nations; it depends on the world among the trading nations; it depends on the world supply and demand for the two products. supply and demand for the two products.

SS

DD

$ Price of$ Price ofForeign Foreign

Currency Currency

Quantity of Foreign CurrencyQuantity of Foreign Currency

The intersection The intersection will be the will be the

exchange rate.exchange rate.

Flexible exchange ratesFlexible exchange rates

QQfcfc

$$fcfc

A nation’s A nation’s Balance of PaymentsBalance of Payments records all the transactions that take records all the transactions that take place between its residents and the place between its residents and the

residents of a foreign nation.residents of a foreign nation.

Current AccountCurrent Account

Mdse. TradeMdse. Trade

Services TradeServices Trade

Net Investment Net Investment IncomeIncome

Net TransfersNet Transfers

Capital AccountCapital Account

Real InvestmentReal Investment

Financial InvestmentsFinancial Investments

Official Reserves AccountOfficial Reserves Account

+ to balance a deficit+ to balance a deficit

——to balance a surplusto balance a surplus

=

The Market For CurrencyThe Market For CurrencyThe Market For CurrencyThe Market For Currency

$P/$P/fcfc

QQ

DD

SS

Dol

lar

pri

ce o

f fo

reig

n cu

rren

cyD

olla

r p

rice

of

fore

ign

curr

ency

Quantity of foreign currencyQuantity of foreign currency

FCFCDepreciates;Depreciates; $ Appreciates$ Appreciates

FCFCAppreciates; Appreciates; $ Depreciates$ Depreciates

FCP/FCP/$$

QQ

DD

SS

FC

pri

ce o

f do

llar

sF

C p

rice

of

doll

ars

Quantity of $Quantity of $

DollarDollarDepreciates;Depreciates; FC AppreciatesFC Appreciates

DollarDollarAppreciates; Appreciates; FC DepreciatesFC Depreciates

Changes in tastesChanges in tastes

Changes in relative incomesChanges in relative incomes

Changes in relative pricesChanges in relative prices

Changes in relative interest ratesChanges in relative interest rates

Speculation in currenciesSpeculation in currencies

Determinants of exchange rates:Determinants of exchange rates:Determinants of exchange rates:Determinants of exchange rates: