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ECO 155 Class Notes

by: Jake Fuemmeler

ECO 155 Class Notes 32850 ECO 155 - 1

Jake Fuemmeler
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These notes cover the entire course of ECO 155. They cover the text Macroeconomics 1st edition by Karlan
Principles of Macroeconomics
Dr. Per Norander
Economics, Macroeconomics
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This 1 page Bundle was uploaded by Jake Fuemmeler on Friday March 18, 2016. The Bundle belongs to 32850 ECO 155 - 1 at Missouri State University taught by Dr. Per Norander in Spring 2015. Since its upload, it has received 24 views. For similar materials see Principles of Macroeconomics in Economcs at Missouri State University.

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Date Created: 03/18/16
T est 1 Chapter 1: Introduction to Economics I. Introduction & Terms Economics: the study of scarcity (limited resources) I.e. Money, time Unlimited wants Economics forces us to make choices and therefore trade-offs Macroeconomics: aggregate (total or sum) economy II. Assignment Types LearnSmart Pre-lecture Guaranteed 100% on each on completion Homework Assignments Post-lecture Harder (Maybe 2 hours of work) Applying the knowledge 2 attempts, highest score counts Exams 4 exams Non-comprehensive Last test: May 13th at 8:45-10:45 III. Models Representation, simplification of the real world Narrowing down to information that is needed. Assumption: Ceteis Paribus: "Everything else equal" Focusing on one thing at a time IV. Types of Economics Positive What we think will happen, based on experience and models Normative What we think should happen, based on judgements and values Chapter 2: Comparative Advantage I. Absolute Advantage Belongs to the person or nation that can produce the most goods/services with a given set of resources Who can make the most Came from Adam Smith: "Father of Economics” from 18th century When created, mercantilism was around, a winner and a loser of trade He made a model stating that each country that trades with one another is a winner Adam Smith created the “Wheat and Cloth" model 1 Person working 1 hour US - 10 W(heat), 2 C(loth) An abundance of land allows lots of production of wheat. Lack of industrialization leads to low cloth production. A worker can make 10 wheat OR 2 cloth but not both; A trade off Has an absolute advantage of wheat UK - 2 W, 8 C Bad environment and less land allows only low wheat production, the industrial revolution allows high cloth production Has an absolute advantage of cloth 2 hours of work: 1 on wheat, 1 on cloth In US: 10 W, 2 C In UK: 2 W, 8 C 2 hours of specialization according to A.A. US: 20 W UK: 16 C The wheat and cloth model is fixed by Trade 10 Wheat could be traded with 5 Cloth US would now only have 10W but 5C Gain of 3C UK would now only have 11C but 10W Gain of 8 W and 3C Specialization and trading allows gains for both parties II. Comparative Advantage Having the lowest opportunity cost Opportunity Cost: What must be sacrificed to have one more of product Who gives up the least Opportunity Cost “No such thing as a free lunch" The next best alternative use of a resource (time, money, etc) that must be sacrificed to attain one more of something else "Wheat and Cloth" For wheat US: 10W=15C; 1W=1.5C Lowest opportunity cost; UK: 2W=8C; 1W=4C For Cloth US 15C=10W; 1C=2/3W UK 8C=2W; 1C=1/4W UK has the best opportunity cost, C.A. Rule: To get the opp. cost for something (i.e. wheat) we always divide both sides with the number of that product. ‘Lost’ Example Goods: Fish or Bear Competitors: Jack, Sawyer Jack: 20F, 5B Absolute Advantage Comparitive Advantage: Fish Sawyer: 6F, 2B Advantage: Bears III. Production Possibilities Frontier (PPF) Shown in graphs, displays maximum production Anything out of a frontier are not possible Termed Unattainable Anything within or on the frontier is possible Termed Attainable When on the frontier, efficiency is maximum Linear slope of a PPF Always Negative: Representation of trade-offs Rise over Run In example 1: Change in classes/change in jokes Classes-Jokes 6-0, 5-2, 4-4, 3-6, 2-8, 1-10, 0-12 -6/12 or -.5 Opportunity Cost: 1 more joke = 1/2 less classes What is dividing is the opportunity cost Using the inverse gives the opportunity cost of the other good Example 2: 2 classes/hour or 1 joke/hour in a 6 hour day Classes-Joke 12-0, 10-1, 8-2, 6-3,4-4,2-5,0-6 Different slopes=different pop. cost Jokes: -12/6=2 classes Classes: -6/12= 1/2 jokes Compared to lower opportunity cost, example 1 has a comparative advantage IV. PPF for a nation A curved PPF Slope becomes steep, meaning higher opp. cost as production increases Iron ore vs Wheat production Scenario: Taking flatlands away from iron towards wheat 0% to 25% wheat, lowers iron to 97% V. Increasing Opportunity Cost Comes as we produce more of something Start with the cheapest resources “Taking low hanging fruit first" With a curved PPF, opportunity cost VARIES Add graph Can Dr. E & Dr. N produce 14 classes and 8 jokes? How? Dr. E 6 hours of classes=12 classes Dr. N 2 hours of classes= 2 classes; 4 hours of jokes= 8 jokes Economic growth is an expansion of a PPF graphically VI. Economic Resource Money is NOT an economic resources 1) Labor: Human skills, workers 2) Land: Natural Resources e.g. Soil; fresh water, oil, gold 3) Capital: Equipment, tools, factories, hotels Things used to produce other things 4) Entrepreneurship: Finding new ways of combining Labor, Land, Capital VII. Review of the PPF What it shows Opportunity Cost=Slope What can and cannot be produced Efficiency or inefficiency Trade-offs: More of one thing, less of the other What it doesn’t show What will or should be shown VIII. 3 Fundamental Questions that Every Economy Must Answer 1) What should be produced, how much? 2) How and by whom is it produced? 3) For whom is it produced? Prices decide these 3 questions Chapter 2 Homework Review (Questions Revisit-able on Exams) The opportunity cost of an activity is the value of: The next best alternative forgone If an economy is operating off its production possibilities curve for consumer goods and capital goods, this means that: The higher production of one good means less production of another good If a producer is operating at an inefficient point on a PPF using currently available resources, that producer: Can produce more of one good without producing less of the other good Chapter 3: Markets I. Introduction Market: A combination of all the potential buyers (demand) and all potential sellers (supply) of a given good or service Potential due to agreements of pricing II. Demand Demand is a representation of what quantity (how much) buyers want to buy at a given price Also called Quantity Demanded (Qd) At different prices, the quantity becomes different Inverse relationship between price and the quantity demanded When price goes up, quantity demanded goes down; vice versa Lower prices, higher Qd is a sale When the price changes, consumers react to the new price by demanding a higher or lower quantity Why? Income effect: A higher price for one good (i.e. pizza) means that more of our income must be spent on the good. Thus, there is less income left over to spend on other things Substitution effect: Consumers will find cheaper alternatives when the price of a certain good increases Look at Figure I in Notebook III. Supply Supply is a representation of what quantity (how much) sellers want to provide at a given price Also called Quantity Supplied (Qs) Direct relationship between price and quantity supplied As price goes up quantity supplied goes up; vice versa Why? The more we produce the higher the (opportunity) cost gets, starting with the cheapest resources (low hanging fruit) Look at Figure II in Notebook IV. Complete Market The use of both supply and demand Look at figures III, and IV in Notebook Market equilibrium Equal: Quantity demanded = quantity supplied (200=200) Stable: Not likely to change Look at Figure V in Notebook At a certain price, when quantities of supply are lower than demand is a shortage At a certain price, when quantities of demand are lower than supply is a surplus “The Market Function”: By allowing price to change, markets will establish the price where Qd=Qs with no surplus or shortage Why would a market be out of equilibrium? (Figure V Why different that $15?) What causes the price to change? Different factors in the business (oil drill goes dry, etc.) What causes demand curves to shift? Left=Less; Right=More What things other than price impact your behavior? (Changes to demand/Shifts of demand) Preferences, One’s Income, Convenience, quality Recap: Change in quantity demanded is a reaction to a change in a good’s own price Buyers reacting to a new price New price (vertical axis) shifts to a new quantity (horizontal axis) Movement along the curve Look at Figure VI Change in demand causes a change in consumer behavior; a shift of the entire curve Causes a change in a price V. Change in Consumer Behavior Preferences Buying winter clothes in winter, summer clothes in summer Income When income raises, more likely to change behavior Demand for normal goods goes right on a plot Demand for inferior goods goes left on a plot Ramen noodles, off brands, etc. When income decreases Normal goods shifts left Inferior goods shifts right Number of Buyers Expectations on the Future Guesses that prices might be better or worse soon Price of Related Goods Substitutes: If price of high demand product increases, next best thing will increase in demand Complements: Products that are used together Example: Peanut Butter & Jelly. Price of PB falls, demand for Jelly shifts right Look at Figure VII VI. How to Use Supply & Demand Curves Cause or Event A shift of at least one curve Reaction or Response Movement along a stationary curve Effect or Outcome A new price and quantity equilibrium 1) A shift of demand or supply A change in demand or supply 2) A reaction: A movement along the opposing curve 3) A new equilibrium of price and quantity VII. Changes/shifts of supply When supply shifts (left=less, right=more) it is called a change in supply Figure 8 A higher price of oil makes deep sea drilling profitable This is the Cause of the price change that consumers are responding to. When a movement on supply curve occurs, it is called a change in quantity supplied Figure 9 Fraching, a new technology allows for a greater oil reserve What causes changes? Costs of resources or inputs Productivity: more with less Availability of resources Expectations Competition VIII. Simultaneous Shifts With two shifts No reaction Only one effect is for certain (Price or Quantity, never both) Chapter 7 I. The Economic Engine (A simple economy) Households Supply resources to firms Demand finished goods/services from firms Firms Supply goods/services Demand resources II. Gross Domestic Product The aggregatemarketvalue of final goods/services produced within a nation in a given time period Breakdown Aggregate: Total or sum Market Value: For most goods, this is price Final goods: Is bought by the “end user”; used to avoid double counting Intermediate goods: Goods that is ‘used up’ in the production of a final good Within a Nation: Goods/services produced in the country Value added=final price Sum of all value added (intermediate + final)=market value of the good Where goods are made & why it matters Honda is a Japanese company and has a plant in Ohio: Raises US GDP Ford is an American company and has a plant in Mexico: Raises Mex GDP Example: Selling your home Built in 1950 for $250,000 you pay 6% in commission to the real estate agent ($15,000) What value is added to the GDP? Only $15,000 is produced because the house is not new but the agent’s service is produced III. What makes GDP? GDP IS CALCULATED WITH PRODUCTION AND CAN BE CHECKED WITH EXPENDITURE Value of final goods produced must be equal to the expenditure Expenditure Method: What is bought/consumed America’s GDP Households 2/3rds of all spending Government Investment Net Exports Households; Consumption=C Non-durable goods: things that must be replaced often (food, gasoline, clothing, etc) Durable goods: things that are new and last long (cars, furniture, computers) Services: Education, Healthcare, child care, etc Biggest consumption, service based economy Government Purchases (NOT government spending)= G Purchase: Gov’t gets something in return (good or service) Exclusions Transfer payment: Transferring money from one to another Welfare, foreign aid, social disability/security Debt payment: National debt Investment (NOT stocks/bonds) =I Buying more capital goods Business (fixed) investment: New factories, tools, etc. Residential investment: new houses All houses are potential rentals, owning home=renting to yourself Inventory: things produced but not sold immediately Ending inventories (Dec. 31st) - Beginning inventories (Jan 1st) See Example 1 in Notebook Net Exports Something has been subtracted Exports-Imports Export: produced domestically,bought abroad (not part of C, I, G)Adds to expenditure Part of GDP Import: produced abroad, purchased domestically (part of C,I,G) Not part of GDP, must be subtracted The cycle of the economy Production->Expenditure->Income-> Third of income is rent, profit, interest Two-thirds is income Only the present is important to the cycle’s functionality IV. GDP vs GDP per capita US GDP= 16,800 billion US population = +316 million Per capita 16,800,000/316 =$53,165 T est Review 1 Chapter 2: What can be produced Opportunity costs, production possibilities frontier, specialization Chapter 3: What (and how much) will be produced By whom, for whom Decided upon by price (S:D) Chapter 7: Measuring Economic Activity How is the economy doing? Gross Domestic Product (GDP) Standard of Living Income Imports & Exports I. Graph movements A change in quantity demanded/supplied Movement along the graph Reaction to a change in a good’s price Change in demand/supply Shift of entire curve Cause is a change in something other than good’s price Steps 1) A shift=cause 2) A movement=reaction to new price 3) Outcome or effect=New price and quantity 2 shifts=only 1 known outcome T est 2 Chapter 10 *Numbers unimportant I. Unemployment In January 2015: 9 million* unemployed; 316 million* citizens Unemployment rate was 5.7%* Who counts as workers? Who doesn’t? Not on the list: Children under 16 Institutionalized (prisoners) Military On the list: Civilian non-institutionalized population over 16 Subdivisions Labor force Unemployed Employed Not in Labor force Homemakers Choosing not to work based on other income (spouses income, investments, etc.) Stay at home parents Retired/disabled Full time students Discouraged workers Not looking for working 2 rates Unemployment rate = unemployed/labor force Participation rate = labor force/population over 16 Example 1 in Notebook 3 things that understate the official unemployment rate 1) Discouraged workers are not counted as unemployed 2) "Under employed" or part time for economic reasons 3) “Long term” unemployed; unemployed > 6 months II. Am I employed? As of last week? Yes: Employed No: Unemployed During the last month have you been actively looking? Yes: Unemployed No: Not in labor force III. Reasons for unemployment & Modified Rates Frictional Unemployment: Between Jobs Structural Unemployment: Lack of skills Cyclical Unemployment: Extra unemployment from bad economic times (recessions) Modified rates Actual rate = Frictional + Structural + Cyclical Natural rate = Structural + Frictional Finding cyclical unemp. = Actual - Natural Can be a negative value More employment The cost of unemployment Economic costs Not using all available resources Unemployment rising means less production Less income means less expenditure Less GDP Social costs Crime increases with unemployment Costly, people become “outside” the economy Psychological costs Self esteem issues IV. The Labor Market see Notebook Supply of labor potential workers = labor force SL shows: As wages increase the quantity supplied of labor increases A change in wages corresponds to a change in the quality supplied A movement along the graph A change in supply = shift of the supply of labor Caused by the labor force changing Example: Retirement, mortality rates, higher birth rate, migration Demand for Labor Firms/business=employers DL shows: A higher wage corresponds to a lower quantity demanded Low wages can mean hiring more labor; i.e. Henry Ford’s plant of 100,000 A change in the quantity of labor demanded means a movement along the demand curve A change in demand of labor means a shift in DL 2 Reasons: 1) Demand for products produced Example: If Dcars rises, D for car workers rises (right shift) If Dcars drops, D for car workers drops (left shift) A change in price acts as an alternative for demand of product 2) Productivity Productivity of workers rises, the demand for labor increases (shifts right) If you can make more of something with the labor costs dropping, demand increases Trends in the labor market See examples 1) During the entire 20th century productivity in the US grew 2) Since 1970, real wages have stayed constant, but employment have continued to grow 3) Increasing wage inequality Due to Globalization and Comparative Advantage Price floor= a minimum price that must be charged/paid Creates surplus labor, creates unemployment Minimum wage creates unemployment due to artificially made wage Creates higher price of goods The employed do get a higher wage (from nothing) See examples If Dl and/or Sl shifts right, what is known? More employment Higher GDP from more production Dl going right Productivity increases Sl going right More of population working Chapter 8 USA 1953 -> 2013 GDP in 1953 was $379.4 billion GDP in 2013 was $16,800 billion 44 times higher Why? Population increase 160.2 million to 316 million 2 times bigger GDP per capita (1953-2013) $2368.29 to $53,164 22 times bigger Inflation Is a reduction in the ‘purchasing power’ of one dollar (the “real value” of a dollar) I. Nominal GDP vs real GDP Nominal GDP= quantity produced in a given year x the prices in that year Real GDP: the quantity produced in a given year x the prices in a fixed “base year" Fixed because the prices do not change See example in Notebook Nominal GDP: Increases over time due to 1) Inflation - higher prices 2) More production - higher quantity Real GDP: is adjusted for changes in price Only changes if production changes Fixed prices cause adjustment Alternative: Using a price index II. Consumer Price Index (CPI) A way of presenting information in a way that is simple When CPI gets larger, prices (in general) become larger than before CPI measures changes in prices using the cost of a fixed basket of goods & services compared to the cost of the same basket in the base year Math CPI = cost of basket in a given year / cost of basket in the base year x100 See example 2 in Notebook What the numbers mean A CPI of 100 is the base year A CPI > 100 is an increase of prices compared to base A CPI < 100 is a decrease of prices compared to base 3 Uses of CPI 1) Compute the rate of inflation 2) Obtaining real values; deflating values 3) Use CPI values to adjust real values to inflation; Indexing CPI = Cost of basket now/ cost of basket of base year x 100 1)Rate of Inflation percent change Inflation rate = (New CPI - Old CPI)/Old CPI x 100% CPI/100 shows change (Nominal value [has inflation] / Real value [no inflation]) See example 3 See example 4 2) Deflating values Deflating: ‘push out’ inflation Adjusting nominal values for inflation to obtain real values If nominal values > real values (has inflation, adjusted [respectively]) Real value = Nominal/ (CPI/100) 3) Indexing Adjusting real values for inflation Protect real values from ‘erosion’ of inflation Nominal=Real x (CPI/100) Boslein Report (1990s) stated that CPI values usually overstate true inflation with about 2% Reasons: The fixed basket Substitution bias: Real people buy substitutes when one good becomes more expensive Technology or quality bias: better products cost more Real Income = Nominal Income Both are change in % Inflation rate (change in %) If 4% raise and 3% inflation = 1% better off See example 5 III. Purchasing Power Parity CPI is about US prices changing over time $1 in 1978 isn’t = $1 today Need to adjust to a common dollar; base year Prices across nations are also different Different currencies Fixed exchange rates Different dollar prices PPP is how income ‘stretches’ in different countries GDP per Capita of US: $53,143 GDP per Capita of Norway: $100,819 Income might not stretch as far due to different prices Big Mac Index Helps find differences in the dollar price of a certain good Example: Price of Big Mac Price in US - $4.80 Price in Norway - 48 croner Official exchange rate: 6.19cr = $1 $ price of Big Mac in Norway 48r/6.19 = $7.75 PPP adjustment factor (Implied exchange rate - official exchange rate)/official exchange rate In example: 6.19cr=$1 Finding implied exchange rate croner=$ price 48cr=$4.80; Give implied rate of 10cr/$ Factor=0.615 x 100 = 61.5% IV. Compare Across Nations With differences in the cost of living, these countries make these values hard to compare There needs to be adjustment for these dollar value differences in the cost of living Using PPP adjustment factor PPP adjustment factor = (implied exchange rate - official exchange rate)/official exchange rate Answers: Is life more or less expensive in other countries compared to the US? Previous examples: Life in Norway is 61.5% more expensive than in US Alternative: PPPadj. = ($ price in Norway - $ price in US)/$ price in US Example: 48r/6.19cr/$ = $7.75 (7.75-4.80)/4.80 = 0.615 x 100 = 61.5% PPP adjusted GDP/capita: Actual GDP/capita/ (1+PPP adjustment factor) 1 represents US cost of living Class Example GDP/capita: $6807 in China Big Mac cost US $4.8, China 16.9y Official Rate $1=6.2y Work Step 1: Find price in China 16.9/6.2 = $2.73 price in China Step 2: Find adjustment factor ($2.73 - $4.80)/ $4.80 = -.432 Step 3: Apply factor with GDP/capita $6807/(1+-.43) = $11,984 T est 3 Chapter 9 I. Real GDP & Employment Real GDP per capita is used to measure economic well-being or standard of living Formula: Real GDP per capita = % working X Productivity Share of working population multiplied by labor productivity II. How Productivity is Improved 1) Technology More output from our inputs 2) Capital Goods Things used to produce other things Machinery, tools, factories, equipment, roads Diminishing returns to capital The more capital we already have, the smaller the impact of even more capital 3) Human Capital Skills and education of labor 4) Land Natural Resources Not a guarantee nor a necessity for productivity 5) Entrepreneurship Leaders like Ford, Steve Jobs, etc. 6) Stable legal and political framework III. The Role of Governments in Productivity Direct: Government finances these improvements using tax funds Indirect: Creates incentives for private entities to do something Government in Technology Directly Fund research - Grants Ex. NASA, US Military Indirectly Subsidies; Tax Breaks Ex. Subsidies to build more hybrid/electric cars Government in Capital Directly Interstates, railways, airports, ports, internet Indirectly Tax credits for businesses Tax breaks on "savings" Retirement accounts IRAs, 401k's Government in Human Capital Directly K-12 public schooling A+ programs, 2 years of community college State schools Indirectly Student loans Government in Land Directly Use of public land Indirectly Tax breaks Government in Entrepreneurship It is a risk for government finance 1-4 Government must tax its businesses Benefits: Grants, loans, subsidies for new business Government in legal/political framework Cons: Paperwork for credit needed to borrow money IV. Financing Capital Investments How can business finance the capital investments and research needed to increase productivity and there by real GDP/capita? Savers: One who does not use all of income on current wants Consumers cannot use investments Stocks/bonds is saving, not investing Investments: Businesses buying more capital Chapter 13 I. Businesses and Capital Investments How can firms obtain the funds they need for capital investments? Retained earnings Companies use their own savings Business savings Bank loans Firms borrow funds deposited in the bank by mostly households FDIC = Federal Deposit Insurance Corporation Banks spread the risk of default (no payment) on many savers Diversifies the risk of each loan Banks specialize in assessing the risk And therefore charges different interest rates to different businesses (investors) Issue bonds "I owe you" Firms borrow directly from savers Savers “buy” bonds = lend funds Bond terms Face value: amount lended/borrowed (principle amount) Coupon rate: bonds paying a fixed interest rate Coupon payment: cash amount Term: length or life of the bond; 3 months to 30 years Maturity date: date when funds are returned Risk free rate: rate US pays to borrow money Risk premium: extra cost of borrowing for riskier firms (and countries) Depends upon: Riskiness of the company Term Issue (sell) stocks or shares II. Overview Savers Have: Anyone with extra funds Want: Funds to grow via interest Investors Have: Profitable uses/needs for capital goods Want: To borrow funds to make investment III. Ways investors obtain funds Retained earnings Extra funds (The business is the saver) Banks Bonds No middle man. Investors borrow directly from savers Stocks/Shares Firms issue stocks: selling partial ownership of the company Rewards of owning stocks 1. Capital gains: increase in the price of a stock Capital loss is the opposite 2. Dividend payments: shareholders share the profit Cash payment IV. Savings for Retirement Pension plans: Defined benefit plans Big liability, not common anymore 401k or 403b: Defined contribution plans For employers: Sponsored retirement plans Employer matching or fixed contributions Funds grow tax deferred and contributions are made pre-tax Withdraws after age 59.5 are taxed Withdraws before age 59.5 are taxed and penalized IRA: Individual Retirement Account Traditional style Contributions are pre-tax, funds grow tax deferred ROTH style Contributions are made with taxed dollars There will never be taxes on the account Funds grow without taxation Withdrawals are tax free Mutual funds Most common method for retirement investments Pool of many savers' funds that a fund manager places in many different stocks or bonds The power of compounding interest Example: starting with $10k; 10% annual return Start: $10,000 Year 1: $11,000 (From 10,000 x 1.1) Year 2: $12,100 Year 3: $13,310 Future value: Original value x (1+rate)^years In example, left for 40 years: $452,593 Invest as soon as soon as you can V. Price of Money Interest rates Cost of borrowing & reward for lend Savers: Like high interests rates Investors: Like low interest rates When interest rates change, we get new quantity values; movements along the plot Changes in savings creates a shift of S(avers) on the graph More or less savings, extra funds Occurs when: More income or wealth Expectations on the future Life changes; economic changes Culture Government surpluses or shortage Surplus=Saving Shortage=Borrowing Changes in investment creates a shift of I(nvestors) on the graph More or less investment; better borrowing Occurs when: Lower cost of capital New projects, technology Expectations on future profit VI. Types of Savings Savings rate = savings/income Public Savings= T-G T=Net taxes Transfer payments via tax money Interest on national debt G=Government Purchases Budget surplus Government savings When T>G Budget deficits Government borrowing When T<G Private Savings Household(C) + Income(Y)-Net Taxes(T) Household spending=-C Equation: Y-T-C=Private Savings National Savings Sn Public + Private Savings Y-C-G Income - Households - Government Spending Recall GDP=Y Y=C+I+G+Nx Households + Investment + Government Spending + Net Exports National Savings assumes ZERO NET EXPORT Y=C+I+G Sn=Y-C-G where Y=C+I+G Sn=Investment VII. Crowding Out When governments borrow funds from private savings it “pushes out” some private investment See figure 1 T est 4 Chapter 11: Short T erm Economic Fluctuations Several graphs in notebook I. Business Cycles Alternations of peaks (expansion) and troughs (recession) with real GDP per capita Recession Two or more consecutive quarters of negative economic growth Formal Definition: A recession is a time period when the economy is growing at a rate below its average Who gets to say it is a recession? NBER ( - National Bureau of Economic Research What does NBER monitor? Unemployment: Non-farm employment Production Spending in retail and wholesale Household income Most recent recessions are short Spending is less, production decreases Less production causes lay-offs Less income there is less spending GDP decreases II. Aggregate Demand (AD) Aggregate is the total or sum of something Aggregate Demand (AD): All demand in an economy AD = C + I + G + Nx Government purchases is independent of price level Graph in Notebook Key differences between one good’s demand and AD Income up: Demand of one good shifts right Income up with AD: Income=GDP Measured on axis. Movement on graph Looks like any demand curve but is different in 2 ways 1) Income(GDP) is measured in the graph Income can change independently of the amount of product bought (shifts the curve) Only changes if GDP does Substitution If price increases, quantity demanded decreases, and quantity demand of another product increases GDP could increase/decrease/stay the same Why is it downward sloping? When price level goes up, GDP demanded goes down Wealth Effect (Consumption) Households that ‘feel’ rich act rich (spend more) Higher prices make us feel poor -> spend less As price level increases, real wealth decreases Interest Rate Effect (Consumption and Investment) When the price level goes up, banks will raise nominal interest rates to maintain the same real interest rate As price level goes up, nominal interest rates go up When borrowing goes down, GDP demand goes down Exchange Rate Effect (Net Export) When US price level goes up, US exports become expensive and go down US imports become better priced Exports go down, imports go up. Net export goes down Price level goes up: Nx goes down: GDP demandedgoes down When price level change occurs, a new quantity of GDP demanded occurs; A movement along AD It is possible for AD to shift Caused by something other than price level or GDP change What can cause Aggregate Demand shifts Expectations on the future Positive expectations shifts right Negative expectations shifts left Rest of the world doing poorly Net export drops, AD shifts left Changes in real interest rates Interest rates down, consumption and investment go up, shifts right Fiscal policy: Govt. policy on spending and taxes When taxes drop shift right Govt. purchases (G) goes up; shifts right III. Aggregate Supply Upward sloping: A higher GDP comes with higher price levels A low GDP has lots of unused or idle resources making a low cost of production A high GDP uses most of resources and creates a high cost of production AS is sometimes known as short run aggregate supply (SRAS) Shifts of Aggregate Supply More resources=lower cost: shifts right Better use of resources=lower cost: shifts right Long Run Aggregate Supply Potential GDP 'Changing the goal line' Permanent Changes will create shifts Aggregate Supply shows with higher demand, more expensive resources become affordable Ex. Deep sea drilling Shifts Changes in cost of specific resource IV. Indicating what causes a shift in aggregate supply or demand Higher US prices make foreign goods more competitive here and abroad Movement along Aggregate Demand An economic boom means that there are more expensive resources being used Movement along Aggregate Supply GDP increase Discovery of new gas deposits lower cost of gas resources Shift of Aggregate Supply New resources with new cost makes the shift Increased optimism among households increase spending Shift of Aggregate Demand Look at notebook for graphs V. How to close output gaps Self-correction In a recession: Increase of Idle Resources Lower costs Shifts Aggregate Supply Right Lower wages Lower rent, etc. In an expansion: Shortage of Idle Resources Higher cost Shifts Aggregate Supply Left Government policy carried in Chapter 12 Chapter 12 I. Forms of Economics Classical Adam Smith Free markets=little or no government interventions Self-correction(supply side economics) Keynesian John H. Keynes Work in response to Great Depression Government does have a role in economics. “To spend against the wind." Complete opposite of the easy way Stated: Recessions are caused by insufficient spending Businesses will “meet demand” at pre-set prices rather than lower prices in a recession Stated: Prices are “sticky” in the short term Because wages are sticky (cost) Economies are very slow at self-correcting II. Types of Government Policy Fiscal Policy Government Spending Net Taxes Types of Policies Stabilizing Policy Smooth the business cycle; keep closer to Y* Expansionary Policy Stimulate the economy in a recession Tools for expansion: Increase government spending (Directly impacting AD) Decrease taxes (Indirectly impacting C & I) Contractionary Policy Cool down an economy in an expansion Tools for recession: Decrease government spending (Decrease AD directly) Increase taxes (Reduce AD through C & I) Monetary Policy Money supply which controls interest rates III. Multipliers Spending Multiplier 1/(1-MPC) Marginal Propensity Consumption Marginal is extra Propensity is likelihood (Percent chance) Consumption is household spending The likelihood of households spending their extra income Can be spent or saved Example Govt. Spending $1,000 Norander buys fish (MPC .5) $500 Fish store reinvest (MPC .5) $250 Fish store owner buys bike; Bike shop (MPC .5) $125 Total spent: $1,875 Tax Multiplier -MPC/(1-MPC) Tax up=Spend down and vice versa Example: How much will GDP increase if G increases by $600 billion. MPC=.6 How much must G be increased by if we want GDP to increase by $1,000 Spending Mult=2.5 / G x Mult = $1,500 Billion 1,000/Mult. = G = $400 Billion Example: How much will GDP change if taxes decrease by $300 billion MPC=.8 Mow much should taxes change if we want GDP to decrease by $800 billion Tax Mult. = -4; -$300 x -4 = GDP Change($1,200 Billion) -$800=T x -4 / T=200 IV. Problems with Fiscal Policy Slow, lags Information Lag: What’s going on with the economy? Formulation Lag: Passing laws Implementation Lag: Time for policy to have effect Debt (costly) Public Savings=T-G In recession Tax down, Spending Up Causes debt Crowding out Less private investment Government borrows money from the private sector Fiscal Policy being “pro-cyclical" Making things worse, creating a gaps in business cycle In fiscal policy: never is better than late. Late means a new gap. Fiscal policy is therefore more appropriate if the economy is slow to self correct and/or the recession is severe V. Automatic Stabilizers Faster than fiscal policy In a recession: Income drops, less tax => Spending goes up Income drops, unemployment benefits=> Government Spending In an expansion: Chapter 14 I. Money 3 things that makes something “money" Medium of exchange Store of value Unit of account Barter: Direct exchange of goods/services Currency (bills and coins) or “hard money” is form of money Money is more than currency M1(most forms): Currency + Checkable Deposits + Traveler’s Check M2: M1 + “near monies” such as CDs, money market account, savings account M1 without traveler’s checks is used in class Money supply: Money available in an economy Currency held by the publci and deposits Money is good for spending but nothing else; it does not earn interest Cost of holding money Lost interest, opportunity cost Borrowing the interest paid Who can “create or make” money US treasury is the only entity that is allowed to print currency Deposits are also made Our branching system is know as a “fractional-reserve” banking system Not a 100% reserve banking system II. Bank Reserves Currency held by banks to meet the withdraw needs deposits Not part of money supply In a fractional-reserve banking system (such as ours) banks can create new deposits Creating money The reserve-deposit ratio R-D ratio = reserves/deposits In a 100% reserve banking system r-d ratio is 100% Reserves and deposits are equal Fraction < 100% Deposits > Reserves FDIC: Federal Deposit Insurance Corporation Required reserves: A percent of deposits that banks must keep to meet with the withdrawal needs of deposits Required r-d ratio Smaller ratio=more loans=more risk “The Fed”: The federal reserve system; our central bank The Fed sets a minimum ratio of 10% for most banks Excess reserve: any reserves over the required amount Lendable reserves Deposit equation: Deposits= reserves/r-d ratio 1/rd ratio is a money multiplier Example 1 r-d ratio: 20% Reserve 500 million Money multiplier: 5 Deposits: 2,500 million Example 2 r-d ratio: 10% Reserve 500 million Money multiplier: 10 Deposits: 5,000 million III. Review - Formulas (1.) Money Supply=Currency held by public + 1/rd ratio x reserves (2.) Deposits=1/rd ratio x Reserves IV. Monetary Policy Control of the money supply by “The Fed" Why control the money supply? 1) Money is good for spending More money => more spending and opposite Measured in aggregate demand More money is a right AD shift Less money is a left AD shift 2) The more of an item, the less it is worth (price) Price of money (Interest Rate) More money=>lower interest rate=>more borrowing=>save less=>more spending Shift of AD to the right How money is controlled Equation 2 When the money supply increases, deposit increases When the money supply decreases, deposit decreases 1) Changing the r-d requirement (very unusual) r-d ratio is lowered; less required reserves =>more loans=>more deposits More deposits, more money supply 2) Discount lending The fed is known as the “lender of last resort" The Fed is the bank for banks Discount Lending: banks borrowing more reserves Lower discount rate=>more reserves being borrowed=>more bank loans for civilians=>MS goes up 3) Interest on excess reserves deposited with the Fed instead of lending to the public Profitable alternative to making risky loans When this rate increases, banks lend less, MS goes down 4) Open market operations Most common The buying or selling of government bonds from/to the public When the Fed buys bonds from the public =>give out more money Bond is good for savings; money is good for spending V. Review of Chapter 14 Policy tools: fiscal and monetary shifts of AD (spending) Compared to fiscal policy, monetary policy has two advantages Faster Not in the hands of politicians


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