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
$$fcfc
A nation’s A nation’s Balance of PaymentsBalance of Payments records all the transactions that take records all the transactions that take place between its residents and the place between its residents and the
residents of a foreign nation.residents of a foreign nation.
Current AccountCurrent Account
Mdse. TradeMdse. Trade
Services TradeServices Trade
Net Investment Net Investment IncomeIncome
Net TransfersNet Transfers
Capital AccountCapital Account
Real InvestmentReal Investment
Financial InvestmentsFinancial Investments
Official Reserves AccountOfficial Reserves Account
+ to balance a deficit+ to balance a deficit
——to balance a surplusto balance a surplus
=
The Market For CurrencyThe Market For CurrencyThe Market For CurrencyThe Market For Currency
$P/$P/fcfc
DD
SS
Dol
lar
pri
ce o
f fo
reig
n cu
rren
cyD
olla
r p
rice
of
fore
ign
curr
ency
Quantity of foreign currencyQuantity of foreign currency
FCFCDepreciates;Depreciates; $ Appreciates$ Appreciates
FCFCAppreciates; Appreciates; $ Depreciates$ Depreciates
FCP/FCP/$$
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: