Macroeconomics: Class notes, Vocab, Review for entire year
Macroeconomics: Class notes, Vocab, Review for entire year ECON 0110
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Heath Fienman 10814 ECON TuesThurs MacroEcon Problems MidTerm Review Sections 16 not 61 Major Economic Goals 1 Full employment 2 Price stability maximum purchasing power 3 Economic growth maximum production 4 Smooth out business cycle uctuations 0 We measure total output not price by using National Gross Domestic Product GDP 0 Economic growth 0 When prices increase that is in ation Growth Rate New Old Old X 100 1 New 2200 Old 2000 Growth Rate 220020002000 X 100 10 X 100 10 Price Index PnQOPOQO x 100 Item P0 Q0 P1 Q1 P2 Q2 Shirts 30 10 35 12 37 14 Shoes 24 15 25 16 28 19 Coats 17 21 20 25 23 26 Poo0 30x10 24x15 17 x 21 300 360 357 1017 year 0 PIQO 35x10 25x15 20 x 21 350 375 420 1145 year 1 o on0 37x10 28x15 23 x 21 370 420 483 1273 year 2 Year 0 POQO POQO x 100 10171017 x 100 10000 Year 1 P1Q0 POQO x 100 11451017 x 100 11259 Year 2 P2Q0 POQO x 100 12731017 x 100 12517 As a result prices increased each year so there was INFLATION REAL GDP Quantity changes Year 0 POQO 30X10 24x15 17 x 21 300 360 357 1017 Year 1 P0Q1 30X12 24x16 17 x 25 360 384 425 1169 Year 2 POQZ 3OX14 24X19 17 X 26 420 456 442 1318 Nominal GDP Year 0 POQO 30X10 24x15 17 x 21 300 360 357 1017 Year 1 P1Q1 35X12 25x16 20 x 25 420 400 500 1320 Year 2 PZQZ 37X14 28x19 23 x 26 518 532 598 1648 1 Nominal GDP increased each year This is because BOTH quantities increased AND prices increased each year 2 Real GDP increased each year This is because quantities increased We have held prices constant so none of the increase is caused by price increases Growth rate of NOMINAL GDP between Year 1 and Year 2 1648 13201320 x 100 2485 Growth rate of REAL GDP between Year 1 and Year 2 1318 11691169X100 1275 Real GDP Nominal GDPiPrice indexi X 100 RULE OF 72 If some quantity grows at an annual growth rate of g per year how long will it take for the quantity to double in size Years Required to Double 72 g EXAMPLE PRICES Assume in ation rate 6 per year Prices will double in 726 12 years 0 Average duration of a recession about 1 year 0 Average duration of an expansion About 6 years FACTORS OF PRODUCTION 1 LAND all the natural resources 2 LABOR 3 CAPITAL tools equipment factories etc 4 ENTREPRENEURSHIP risk taking by and leadership of the business owners MORAL OF THE STORY Opportunity Cost 0 Eventually to produce more of an item an increasing amount of resources not well suited to producing that item will have to be used Absolute Advantage Producer A is better at producing item Comparative Advantage Producer A can produce something at lower opportunity cost A 1600 of item X Cell Phones per day and 2000 of item Y Calculators per day B 2000 of item X per day and 8000 of item Y per day B has an absolute advantage in both 0 Goal move outside the PPF impossible without specialization and trade OC A of item X 2000 1600 125 of item Y OC A of item Y 1600 2000 08 of item X OC B of item X 8000 2000 4 of item Y OC B of item Y 2000 8000 025 of item X B has comparative advantage in Item Y because the OC is lower A has comparative advantage in Item X because the OC is lower Therefore A and B can BOTH benefit by specializing and trading Company Item X Item Y A 800 1000 B QM Total 1300 7 000 Total production is 1300 of item X and 7000 of item Y DISTRIBUTION OF OUTPUT AFTER SPECIALIZATION Company Item X Item Y A l 600 0 B 0 8000 Total 1600 8000 GAINS FROM SPECIALIZATION AND TRADE Output of item X increased by 300 and Output of item Y increased by 1000 Then they both trade with each other and there was a lower OC of the other item and each moved outside it s own PPF and is better off than they originally were SOL incr Heath Fienman 101414 ECON Tues Thurs Midterm Review Ch 61 11 0 To keep things simple let s assume that originally 1 yuan trades for 100 Let s assume that a doll costs 6 in the US and a similar doll costs 6 yuan in China 0 Now suppose China devalues or decreases the value of the yuan so that 1 yuan trades for 050 or 1 trades for 2 yuan Thus the yuan has depreciated and the dollar has appreciated A CHINESE CURRENCY DEVALUATION BOOSTS CHINESE EXPORTS 0 Before the Chinese devaluation the American consumer would need to trade 6 to get 6 yuan to purchase a Chinese doll 0 After the Chinese devaluation the American consumer would need to trade only 3 to get 6 yuan to purchase a Chinese doll 0 The Chinese devaluation makes Chinese products less expensive for foreigner consumers Other things being equal this causes Chinese exports to increase 0 American manufacturing companies complain that this gives Chinese companies an unfair advantage A CHINESE CURRENCY DEVALUATION DECREASES US EXPORTS 0 Before the Chinese devaluation the Chinese consumer would need to trade 6 yuan to get 6 to purchase an American doll 0 After the Chinese devaluation the Chinese consumer would need to trade 12 yuan to get 6 to purchase an American doll 0 The Chinese devaluation makes American products more expensive for Chinese consumers Other things being equal this causes American exports to decrease 0 Once again American manufacturing companies complain that this gives Chinese companies an unfair advantage and hurts sales of American goods 0 The US government has complained bitterly that the Chinese government has kept the value of the yuan artificially low in order to boost sales of Chinese exports Increased sales of Chinese made goods cause more Chinese workers to be employed and keep the Chinese unemployment rate low 0 US consumers benefit because they can purchase Chinese made goods at artificially low prices but US manufacturers complain that they are hurt by what they consider to be unfair trade practices TAXATION OF PROFITS SOLE PROPRIETOR AND PARTNERSHIP 0 Sales revenue business expenses Business profits 0 Business profits are taxed as wage income on your individual income tax return 0 2011 Top marginal tax rate 35 CORPORATION 0 Sales revenue business expenses Before tax profits 0 Corporations pay corporate taxes on its profits 0 Maximum corporate marginal tax rate is 35 Dividends Before Tax Profits Corporate Taxes After tax profits Retained earnings dividends DIVIDENDS Portion of aftertax profits that are distributed to stockholders RETAINED EARNINGS Portion of aftertax profits that are retained by the corporation for later use EXAMPLE Assume before tax profits 1 MILLION CORPORATE TAXES 350000 ASSUME RETAINED EARNINGS 0 DIVIDENDS 650000 At 35 stockholders tax on dividends 227500 After tax income for stockholder 422500 BIG DISADVANTAGE FOR CORPORATIONS Tax rate on dividends Maximum rate 15 BOND EXAMPLE Ford issues a bond with Par Value of 1 million for 30 years at 4 annual interest Principal 1 million Time to maturity 30 years Interest rate 4 per year Annual interest 40000 per year Interest of 40000 will be paid at the end of each year A payment of 1 million will be made at the end of 30 years Q V PP N THE REAL RATE OF INTEREST 0 Interest Rate after adjusting for in ation 0 Shows the lender s profit or loss after taking in ation into account Nominal interest rate in ation rate EXAMPLE 1995 POSITIVE REAL RATE 30 Year Treasury Bond 688 In ation rate 280 Real rate of interest 408 0 Lenders profit after adjusting for in ation I interest rate 10 for example PV Present Value of the debt OR the amount I should give you today PVx 110 11000 PV 10000 General case for money due in one year F Amount owed in one year I interest rate PV Present Value F 1 I What if money is owed in 2 years and I owe you 12100 PV 12100 1 01A2 PV 10000 How does interest rate in uence present value If the interest rate is LOW a current amount will grow slowly Thus more needs to be awarded today LOW interest rate HIGH present value If the interest rate is HIGH a current amount will grow rapidly Thus less needs to be awarded today 0 HIGH interest rate LOW PV Example In 2013 the PE is 3900 per person 0 So for a family of 4 3900 x 4 15600 0 As a result the taxpayer cam subtract 15 600 from his gross income before paying taxes Subtract for Standard or Itemized Deduction Example Standard Deduction 2013 Single 6100 Married 12200 Max Tax Rate 15 for capital gains and diVidends Example 0 Single Person Gross Income 60000 1 personal exemption 3900 Standard deduction based on table 6100 Taxable Income 60000 39006100 50000 Taxable Income Gross income Personal Exemption Standard Deduction Calculation of Income Tax due 0 Using the single person from before with a taxable income of 50000 0 10 of income from 0 to 8925 39 8925 x 10 89250 0 15 of income from 8925 to 36250 0 362508925 27325 0 27325 x 15 409875 Plus 0 25 of income from 36250 to 50000 0 5000036250 13750 0 13750 X 25 343750 Tax Due 39 89250 409875 343750 824875 Average Tax Rate Tax GROSS Income 0 Average Tax Rate 824875 60000 1405 0 1405 Marginal Tax Rate 0 Tax rate on last dollar of taxable income Example 0 Tax rate on taxable dollar number 50000 0 Marginal Tax rate 25 says table 0 The highest marginal tax rate has declined from 90 in early 1900 s to 70 in 1960 s to 35 in 2001 with uneven uctuations depending on president obviously Capital Gains Tax 0 To keep his purchasing power constant Johnny needs 62400 in 2013 Unfortunately after taxes he has only 51920 62400 10480 51920 His purchasing power has decreased by 20 0 This example shows that Johnny has not profited when his stock increased in value from 10000 in 1970 to 62400 in 2013 When the IRS takes 20 of the socalled capital gain it is virtually identical to a thief stealing 200 from the 1000 in Johnny s pillow case Social Security 0 Employers and employees pay 62 each so 124 total of wages and salary earnings to SS fund Heath Fienman Econ Tues Thurs Section 4 Production Possibility Frontier Production Possibility Frontier A graph that shows all combinations of 2 goods or services that can be produced if all of society s resources are used efficiently Illustrates the tradeoffs facing an economy that produces only 2 goods It shows the maximum quantity of one good that can be produced for any given quantity of another Assumptions about the PPF A B C D Amount of resources is FIXED State of technology is FIXED We have full employment of all resources No unemployment of labor and no excess capacity in factories We use all resources efficiently Factors of Production are 1 Land raw materials 2 Labor 3 Capital Plant and equipment 4 Entrepreneurship PPF shows maximum output possibilities that are available Points OUTSIDE the PPF are not possible given current resources and technology Points INSIDE the PPF are inefficient By better utilization of resources we could achieve points on the PPF Points on the frontier curve are EFFICIENT Why is a country inside its PPF Unemployment of labor Underemployment of labor Under use of plant and equipment Inefficient allocation of resources PPF Illustrates Full employment Efficiency Choice Economic Growth Opportunity Cost Suppose we are ON the PPF 0 To produce more of one item we must give up some of the other item 0 If we are INSIDE the PPF we can increase production of either both of the items by becoming more efficient Different points on the PPF re ect different choices made by society 0 An economy can produce any combination of outputs on its PPF 0 Different societies will choose different combinations 0 USA Emphasis on production of consumption goods 0 USSR Emphasis on production of military goods Different choices made by societies 0 Capital goods vs Consumption goods 0 Consumption goods food clothes cars TV s etc 0 Capital goods Factories tractors drills etc Goal Economic Growth Increase Output 0 Shift the PPF to the right 0 More output per person Higher standard of living Sources of Growth 0 More and better physical capital 0 Tools computers assembly lines tech and research development 0 Better Human Capital 0 Better and smarter workers 0 Education and training 0 1999 Congo 7 New Capital USA 17 Japan 30 Heath Fienman 91614 ECON TuesThurs Section 6 Comparative Advantage Theory of Comparative Advantage 0 Specialization and free trade benefit all trading parties 0 2 producers can BOTH gain by specializing in the production of the item in which they have a comparative advantage and then trading with each other Absolute Advantage 0 Producer A has an absolute advantage over producer B in the production of a given item if by using a given amount of resources Producer A can produce more of the given item than producer B 0 Alternatively absolute advantage is the ability to make something using fewer resources than other producers use 0 If A has Absolute Advantage over B then A is better at producing the item Comparative Advantage 0 The ability to produce something at a lower opportunity cost than other producers 0 Without specialization and trade neither party can move outside it s PPF 0 To determine comparative advantage we need to compare opportunity costs OCA Product B Product A Company A has a comparative advantage in the production of Product A because they have a lower opportunity cost than Company B in the production of Product A Therefore even if Company B has the Absolute Advantage in both Product A AND B if Company A has a comparative advantage with Product A and Company B has a comparative advantage in Product B then both 0 Can benefit by specializing in the production of the items in which they have a comparative advantage Gains from Trade 0 People or other countries can increase their total combined output if they concentrate on producing things in which they have a comparative advantage 0 Theory Company B has a comparative advantage in Product B so Company B should produce more of Product B and less of Product A and then trade with Company A which has a comparative advantage in Product A 0 In other words Company B theoretically could produce ALL Product B and NONE of Product A or a malady of that which still increases production 0 With total specialization by both companies total production OUTPUT increases for both products 0 As a result not only have both companies moved OUTSIDE its original PPF but each is definitely better of than originally 0 After specialization and trade total output has increased and the overall standard of living improves for both 0 Goal Increase the stock of both products for both companies Heath Fienman 91 814 ECON TuesThurs International Trade 61 Effects of Trade Restrictions 0 Restrictions to free trade Will result in a decrease in total output and an increase in selling price 0 Restrictions to free trade in a specific industry hurt consumers 0 In many cases the goal of the restrictions is to benefit protect producers and workers in a specific industry Embargo 0 Prohibits foreign firms or nations from exporting products to he US Tariff 0 Requires foreign firms or countries to pay taxes on their sales of foreign products in the US Quota 0 Puts a limit on how much of a foreign product a firm or country can sell in the US Effects on Trade Embargo 0 A government order that restricts a foreign country from exporting certain goods to the host nation or Which restricts a host nation from exporting things to a foreign nation 1 The price of sugar rises from PW to PE 2 The quantity demanded decreases from Q3 to QE 3 The amount sold by US producers increases from Q2 to QE 4 The amount provided by foreign sugar producers decreases from Q3 Q2 to 0 5 An embargo Will hurt the American consumer by raising prices and decreasing output 6 A tariff will help US sugar producers by increasing prices and increasing the amount purchased from them Thus a tariff on sugar imports has the following effects 1 The price of sugar rises from PW to PT 2 The quantity demanded decreases from Q3 to Q5 3 The amount sold by US producers increases from Q2 to Q4 4 The amount provided by foreign sugar producers decreases from Q3 Q2 to Q5 Q4 5 A tariff will hurt the American consumer by raising prices and decreasing output 6 A tariff will help US sugar producers by increasing prices and increasing the amount purchased from them Effects of a Quota 0 Numerical limit on the quantity of a good that can be imported into a country 1 The price of sugar rises from PW to PQ 2 The quantity demanded decreases from Q3 to Q5 3 The amount sold by US producers increases from Q2 to Q4 4 The amount provided by foreign sugar producers decreases from Q3 Q2 to Q5 Q4 Which is the amount of the quota 5 A quota Will hurt the American consumer by raising prices and decreasing output 6 A quota Will help US sugar producers by increasing prices and increasing the amount purchased from them 62 Foreign Exchange 0 The Euro has increased in value or has appreciated or become stronger 0 The dollar has become less valuable or depreciated or become weaker 0 A change in the exchange rate can have a big effect on imports and exports The increase in the value of the Euro caused the price of wine to increase for American consumers As a result American consumers will buy less wine and French exports of wine to the US will decrease The dollar depreciated This makes foreign goods more expensive This causes foreign exports or American imports to decrease This makes French wine exporters unhappy Also US consumers now need to pay more to purchase foreign goods CONCLUSION A decrease in the value of the dollar makes it less expensive for foreigners to purchase American dollars and then use those dollars to buy American goods Other things being equal a decrease in the value of the dollar Will cause US exports to increase A decrease in the value of the dollar makes it more expensive for Americans to purchase foreign currency such as Euros and then use those Euros to buy foreign goods Other things being equal a decrease in the value of the dollar Will cause US imports to decrease An increase in the value of the dollar makes it more expensive for foreigners to purchase American dollars and then use those dollars to buy American goods Other things being equal an increase in the value of the dollar Will cause US exports to decrease An increase in the value of the dollar makes it less expensive for Americans to purchase foreign currency such as Euros and then use those Euros to buy foreign goods Other things being equal an increase in the value of the dollar Will cause US imports to increase Heath Fienman 92314 ECON TuesThurs Section 7 3 Legal Forms of Business Enterprise 1 Sole Proprietor 2 Partnership 3 Corporation Liability 0 Who is responsible for paying outstanding debts Share of Stock 0 Represents partial ownership of a corporation Taxation 0 How does the government tax the profits Unlimited Liability Sole Proprietors and partners The business owners are personally liable for all business debts Each partner is liable for ALL debts Big disadvantage Limited Liability 0 Corporations stockholders 0 You sue a corporation as a separate legal entity 0 Personal assets of stockholders are safe Taxation of Profits 0 Sole Proprietorship and Partnership 0 Sales Revenue minus business expenses Business Profits 0 Business profits are taxed as wage income on your individual income tax return Corporation Sales Revenue minus business expenses Before Tax Profits Corporations pay corporate taxes on profits Maximum corporate marginal tax rate is 35 Before Tax profits corporate taxes After Tax Profits After Tax Profits Retained earnings dividends Dividends Portion of aftertax profits that are distributed to stockholders Retained Earnings Portion of aftertax profits that are retained by the corporation for later use Dividends 0 Reported on individual tax return of stockholder 0 Dividends are taxed just like wage income 0 Double Taxation of corporate profits as dividends too could be 35 Separation of Ownership and Control 0 Board of directors makes most corporate decisions 0 Does the board represent the interest of the owners shareholders Transfer of Ownership of Stock 0 Can be bought sold inherited Heath Fienman 92514 ECON TuesThurs Section 8 Stock and Bond Market 3 Ways to get Money for Business Expansion 1 Use your own income 2 Borrow 3 Sell part of the company to others by issuing stock 0 Each share of stock represents partial ownership of a corporation 0 Suppose you own 100 of the shares of stock thus you own the whole corporation 0 Suppose you need money to finance an expansion if you sell 20 of shares of stock to me now you own 80 of the corporation and I own 20 0 You gave up ownership of part of the company in return for some money which can be used to help the corporation grow Why own shares of Stock 0 Dividends 0 Capital Gains Dividends 0 When a corporation earns a profit it pays corporate income taxes on its before tax profits 0 The corporation can keep some or all of the after tax profits as RETAINED EARNINGS to finance future projects 0 OR the corporation can distribute some or all of the after tax profits to the stockholders as dividends 0 Tax Rate Maximum Rate 15 Capital Gain Increase in the price of an asset Capital Loss Decrease in the price of an asset 0 Individual income taxes are paid on capital gains when the asset is sold Short term capital gain 0 Own stock for less than one year 0 Gain is taxed at your regular marginal tax rate as high as 35 Long term capital gain 0 Own stock for more than one year 0 Maximum tax is 15 Stock Risk 0 Price can fall 0 Protected by limited liability 0 Maximum loss occurs if price falls to 0 0 Diversify your portfolio to reduce risk Stock mutual funds 0 Investors pool their funds With an investment company 0 Company purchases stocks for the investors NY Stock Exchange Wall Street 0 Location Where shares of several thousand major corporations are bought and sold 0 No new shares of stock are being trades DOW JONES Industrial Average 0 Adjusted average price of shares of stock in 30 major industrial corporations 0 Some are banking pharmaceuticals etc Standard and Poor s 500 Index 0 Adjusted average price of shares of stock in 500 major US corporations Prospectus 0 Official description of a corporation for purposes of selling new shares of stock Annual Report 0 Describes activities of a corporation during last year 0 Provides financial info sales revenue profits etc Section 81 Bond Market Bond 0 Legal contract specifying the terms of a loan between a borrower and a lender 0 Basically a bond is an IOU Borrowed money from various lenders and owes the lenders their money back in the future A bond contract specifies 1 Amount that a borrower will repay to the lender on the date of maturity Par Value or Principal 2 When the Principal will be repaid time to maturity or date of maturity 3 Interest rate or amount of interest that will be paid on the Par Value 4 Date when each interest payment will be made BOND EXAMPLE Ford issues a bond with Par Value of 1 million for 30 years at 4 annual interest Principal 1 million Time to maturity 30 years Interest rate 4 per year Annual interest 40000 per year Interest of 40000 will be paid at the end of each year A payment of 1 million will be made at the end of 30 years QMPPP 0 The price paid for a bond depends in part on the market interest rate 0 The price of a bond is the amount a lender will give the borrower today in return for the borrower s promise to make specified repayments in the future The price a lender will pay for a bond depends on 1 The market interest rate 2 The amount of interest offered on the bond Market interest rate 1 0 Suppose your bond offers 5 annual interest and other places are offering 8 interest Other things being equal if interest rates in the economy are HIGH then I can earn lots of interest elsewhere so your bond will not be so attractive to me and I will not offer as much for your bond Amount of interest offered on bond 2 0 Other things being equal if you offer to pay me 8 interest your bond will be more attractive to me than if you offer only 5 interest Thus I will pay you more for the bond BONDS ARE NEGOTIABLE 0 Suppose I own a bond issued by your company This means that I loaned you money and you owe me money I can resell the bond to another investor so that you will then owe the interest and principal to the new owner instead of me 0 When I try to resell the bond I might make a profit or I might make a loss Roughly speaking I make a profit if I resell the bond for more than I lent to you I make a loss if I resell the bond for less than I lent to you Factors that in uence resale price of bond 0 Market interest rates rise the price of a bond declines inverse relationship Price of bond depends of default risk Default risk 0 Risk that a borrower will not repay a loan 0 High risk leads to higher interest rate that must be offered to entice a lender to lend 0 Alternatively high risk means that a lender will offer a lower price to purchase the bond Risky Borrowers 0 Cities and states with falling populations declining tax bases rising expenditures 0 New corporations 0 Small corporations 0 Unprofitable or failing corporations 0 Corporations in declining industries or with intense competition Types of Bonds 0 US Gov Securities 0 Corporate 0 Municipal 0 Junk US Government Securities 0 Treasury Department writes checks to cover Federal Government SPENDING 0 Treasury gets its REVENUE from TAXES 0 If government SPENDING exceeds TAX REVENUE the government has a BUDGET DEFICIT 0 Then the Treasury Department must borrow to pay its bills 0 Thus new Treasury securities are issued 0 Maturity up to 1 year bills 0 Notes 1 year to less than 10 0 Bonds 10 years or more 0 Interest is taxable 0 Least risky No danger of default Corporate Bonds 0 Rated by Standard and Poor s or Moody s 0 AAA AA BAA etc 0 Interest is taxable 0 C Junk Bonds highest risk of default Municipal Bonds 0 Issued by cities and countries 0 Interest is NOT taxable 0 Big advantage for municipalities 0 It lowers the interest rate that municipalities must pay 0 Risk varies from city to city Other factors that in uence Bond Prices 0 In ation Rate 0 Lenders want to earn a profit after adjusting for in ation 0 Higher expected in ation causes lenders to demand a higher interest rate or they will offer a lower price Default Risk 0 Higher default risk causes lenders to demand a higher interest rate or they will offer a lower price Term to Maturity 0 Longer term to maturity causes lenders to demand a higher interest rate or they will offer a lower price Taxability of Interest 0 Taxable interest causes lenders to demand a higher interest rate or they will offer a lower price Lenders want to make a profit after adjusting for in ation Real Rate of Interest 0 Nominal interest rate in ation rate 0 Interest rate after adjusting for in ation 0 Shows the lender s profit or loss after taking in ation into account 0 Almost always positive otherwise lenders had incorrect expectations about the in ation rate Different interest rates Prime Rate 0 Interest rate charged by banks to their biggest and best corporate clients such as FORD GM EXXON etc Discount Rate 0 Interest rate charged by the Federal Reserve System for loans made to banks Federal Funds Rate 0 Interest rate charged by banks for overnight loans to other banks Heath Fienman 10214 ECON Tues Thurs Chapter 9 Notes Discounting to Present Value I interest rate 10 for example PV Present Value of the debt OR the amount I should give you today PV x 110 11000 PV 10000 General case for money due in one year F Amount owed in one year I interest rate PV Present Value F 1 I What if money is owed in 2 years and I owe you 12100 PV 12100 1 01A2 PV 10000 How does interest rate in uence present value 0 If the interest rate is LOW a current amount will grow slowly 0 Thus more needs to be awarded today 0 LOW interest rate HIGH present value 0 If the interest rate is HIGH a current amount will grow rapidly 0 Thus less needs to be awarded today 0 HIGH interest rate LOW PV Heath Fienman 10214 ECON Tues Thurs Section 10 Notes The Tax System Individual Income Tax System Calculate GROSS income 1 Wages and tips Salary Sole proprietor profits Partnership profits Taxable interest Dividends Royalties Rent profits Capital gains Social security income partial Unemployment compensation HHWWNQP PP P F O 0 Income taxes are paid on TAXABLE income not GROSS income 0 To determine taxable income various items are subtracted from gross income The most important subtractions are 1 Personal Exemptions 2 Standard deduction or itemized deductions 3 Contributions to IRA s Personal Exemptions 0 You are permitted to subtract a specified amount from your gross income for each member of your household Example In 2013 the PE is 3900 per person 0 So for a family of 4 3900 x 4 15600 0 As a result the taxpayer cam subtract 15600 from his gross income before paying taxes Subtract for Standard or Itemized Deduction Example Standard Deduction 2013 Single 6100 Married 12200 OR List Itemized Deductions and subtract for Medical expenses State and local taxes Real estate taxes Home mortgage interest Contributions to charity Work expenses union dues Theft losses and casualty losses Federal income taxes are based on taxable income not gross income Gross income Exemptions Deductions TAXABLE INCOME Capital gains and diVidends are taxed at slightly lower rates than other sources of income under current law Max tax rate 15 for capital gains and diVidends Example Single Person Gross Income 60000 1 personal exemption 3900 Standard deduction based on table 6100 Taxable Income 6000039006100 50000 Taxable Income Gross income Personal Exemption Standard Deduction Calculation of Income Tax due Using the single person from before With a taxable income of 50000 10 of income from 0 to 8925 8925 x 10 89250 15 of income from 8925 to 36250 362508925 27325 27325 x 15 409875 25 of income from 36250 to 50000 5000036250 13750 13750 x 25 343750 Tax Due 89250 409875 343750 824875 Average Tax Rate Tax GROSS Income Average Tax Rate 824875 60000 1405 1405 Marginal Tax Rate 0 Tax rate on last dollar of taxable income Example 0 Tax rate on taxable dollar number 50000 0 Marginal Tax rate 25 says table What is a fair tax system Horizontal Equity 0 People With equal incomes should pay approximately equal taxes 0 People in the same or at least very similar situations should be treated equally Problem With Horizontal Equity 0 People With equal incomes may have unequal deductions Vertical Equity 0 The normative opinion that people in different situations should be treated differently 0 For example people With higher incomes should pay more in taxes 0 Problem 0 What is actually fair 0 How much more taxes should the higher income person pay 0 How should we redistribute from the rich to the poor if at all for example in order to have a better society 0 With vertical equity almost no two people have exactly the same opinions Classification of taxes as progressive proportional or regressive Progressive Tax System 0 Marginal tax rate increases as the level of income increases 0 As your income increases the PERCENTAGE of your income that you pay in taxes increases 0 High income earners pay a higher proportion of income than low income earners 0 Example Federal Individual Income Tax Proportional Tax System 0 Marginal tax rate is constant regardless of level of income 0 Everyone pays the same proportion of income 0 Example PA Income tax is 307 of income Regressive Tax System 0 Marginal Tax rate decreases as level of income increases 0 Low income earners pay a higher proportion of income than high income earners 0 Example Sales Tax 0 Suppose everyone pays 6 on purchases 0 Problem Only the money that is spent on purchases Will be taxed 0 People with lower incomes spend a larger percentage of their incomes than do higher income people Some Regressive Taxes 0 The sales taxes on cigs and alcohol are considered to be regressive 0 If person a has salary of 10000 and person b has income of 100000 then in order to pay the same percentage in taxes Person b would need to purchase 10 times as much as person a Principles of Tax Policy 0 Who should pay a tax and how much should they pay The Benefits Principle 0 Those who benefit from public spending should bear the burden of the tax that pays for that spending 0 Example Gasoline taxes are spent on highway maintenance 0 Why aren t most taxes based on this principle 0 Adopting the benefits principle is too cumbersome 0 We d need too many different taxes to pay for all the government programs The Ability to Pay Principle 0 Those with greater ability to pay should pay more taxes 0 People with high incomes should pay more taxes than people with lower incomes 0 Question How much more Tax Base 0 The measure or value that determines how much tax a person pays Examples of different tax bases Income tax uses many forms of income Payroll tax uses wage earnings Sales tax excise tax uses value of purchase Profits tax uses corporate profits Property tax uses value of property Wealth tax estate tax uses value of estate QMPPP Why only a few states have progressive income taxes 1 Tax competition between states 2 People will move to places with lower taxes Why marginal tax rates matter 0 High marginal tax rates discourage productive activity 0 Since the 1960 s the trend is for lower marginal tax rates 0 The highest marginal tax rate has declined from 90 in early 1900 s to 70 in 1960 s to 35 in 2001 with uneven uctuations depending on president obviously Heath Fienman 10914 ECON Tues Thurs Section 101 Notes The Capital Gains Tax 0 The socalled thief is the federal government and the income tax system The way the government takes the money is via the capital gains tax MORAL OF THE STORY Suppose that over time the selling price of stock or any asset increases at exactly the same rate as the in ation rate The Federal government and the IRS treat this increase in price as a CAPITAL GAIN The IRS implicitly is assuming that an increase in the value of an asset that exactly matches the in ation rate somehow makes a person better off increases their purchasing power and yields a profit As a result the IRS is empowered to take a percentage of this socalled increase in purchasing power in the form of a capital gains tax When the IRS takes 20 of this increase in the selling price of the stock it is exactly the same as someone taking money from Johnny s pillow case PROPOSED SOLUTION Before applying any capital gains tax any socalled capital gain should be indexed for in ation Otherwise hundreds of millions of investors are paying taxes that are not justified by any rational theory of economics QUESTION Why does Congress refuse to index capital gains POSSIBLE ANSWER If Congress decided to index capital gains the Federal government would lose the 10480 that Johnny was required to pay on his socalled capital gain of 52400 Under this scenario the budget deficit and national debt would increase To keep total tax revenue constant Congress would need to raise taxes elsewhere or allow the national debt increase Obviously Congress does not want to raise other taxes and doesn t want the national debt to increase even more rapidly so Congress has decided to refuse to index capital gain although it is clear that the legislators know about the problem Heath Fienman 10919 Econ Tues Thurs Section 11 Notes Social Security 0 Employers and employees pay 62 each so 124 total of wages and salary earnings to SS fund Social Security Tax 0 Often called PAYROLL tax 0 Tax paid of wages salaries sole proprietor profits and partnership profits 0 Not paid of interest income dividends capital gains or royal ties 0 There are no deductions or personal exemptions 0 Pay on very first dollar of your wage earnings 0 Takes SAME PROPORTION of income from all workers 0 124 if self employed 0 Flat tax tax rate is the same for all workers up to the ceiling of 106800 Social Security Benefits 0 Retirees can begin receiving reduced benefits at age 62 0 Retirees can begin receiving unreduced benefits at age 66 3 workers for every 1 retiree During most years there are MORE contributions into the SS fund than benefits being paid out of the fund Social Security Surplus 0 All the past surplus social security contributions have been spent by the federal government to pay for other government expenses Baby Boomers 0 Begins with people born in 1946 0 After W11 0 The first Baby Boomers became 62 early retirement in 2008 0 After 2008 the number of retirees will expand rapidly and benefits being paid will also increase rapidly 0 Supposedly around 2018 benefits being paid out of the SS fund will begin to exceed contributions into the fund 0 Thus the annual SS surplus will disappear 0 The Federal Government will need to find new ways to finance the additional of SS benefits 0 Future projection 2 workers for every 1 retiree With no changes to the system eventually annual benefits paid to retirees will greatly exceed contributions into the fund SS Benefits are indexed Benefits paid to retires increase each year based on the rate of increase in average wages in the economy Possible solutions to the SS problem 1 Increase the age 62 at which workers can being receiving reduced benefits 0 This will reduce annual benefits and it will increase the labor force slightly 2 Increase the age 67 at which workers can begin receiving full benefits 3 O This will reduce annual benefits and it will increase the labor force slightly Increase the tax rate 0 The total tax rate now 124 has been increased many times in the past 0 This is an easy solution but could be political suicide Greatly increase the income cap currently 106800 0 Cap is indexed to in ation 0 Thus if it increases a little bit every year 0 A massive increase in the cap or removing it altogether is an easy solution 0 This is equivalent to a large tax increase on the higher income class 0 Could be political suicide as well Reduce your starting annual benefits Your starting benefit is based on your past 35 years of highest earnings 0 Your past earnings are increased to adjust for past increases in the average level of wages 0 Currently your starting benefit is calculated by adjusting your past wages according to the growth rate of wages in the us thus your earnings during say 1995 would be brought up to current value by increasing your 1995 earnings at the same rate as wages have increased since 1995 0 Proposed solution is to use lower growth rate in adjusting your past wages 0 Would reduce starting benefit 0 As a result it could be political suicide Instead of contributing all taxes into the SS fund let workers contribute a portion into their own personal accounts where funds would be invested in stocks and bonds 0 Similar to mandatory IRA 0 If the accounts grow rapidly future benefits might be increased 0 Problems with individual accounts 0 Who will supervise the individual accounts 0 Could be very expensive 0 What if the market declines 0 How will the government insure a basic minimum return 7 Increase the Labor force 0 Encourage or require workers to delay retirement 0 Change immigration policies to bring more workers into the country Heath Fienman 101614 ECON Tues Thurs Gross Domestic Product Gross Domestic Product 0 The market value of all final goods and services produced in the US in a given year Market Value 0 Output is valued at its selling price 0 If output remains constant but prices increase then nominal GDP will increase 0 Nominal GDP is in uenced by changes in prices 0 The fact that nominal GDP increased does NOT prove that output increased Final Goods and Services 0 Goods and Services produced for final use by final uses 0 Example New Car New tires for current car apple that I buy to eat Items not counted in GDP 0 Sales of used goods 0 Purely financial exchanges 0 Government and private transfer payments Government Transfer Payments 0 Cash payments made by governments to people who do not provide goods or services in exchange for these payments 0 SS benefits Welfare unemployment compensation veterans benefits subsidies to farmers Medicare and Medicaid payments to individuals Private Transfer Payments 0 Gifts inheritances charitable contributions are not included in GDP Intermediate Goods 0 Goods that are produced by one firm for use further processing by another firm 0 Example Apples purchased by a bakery to make a pie Some productive activities are omitted from GDP because there was no market transaction 0 Homemaker Activities 0 Doit yourself activities 0 Barter Transactions 0 Underground economy Nominal GDP 0 GDP measured in current dollars 0 Example Nominal GDP for 2008 measures the value of things produced during 2008 using 2008 prices Current Dollars 0 The current prices that people pay for goods and services during any specific year 0 Nominal GDP can increase because the quantity of output increased 0 Nominal GDP can increase because prices increased 0 Economic growth requires an increase in the quantity of output not an increase in the dollar value of output Interpretation of a price index 0 We arbitrarily always set the level of the price index during the base year to 100 so we set the index value to 100 in 1996 Now we want to determine how much things would have cost during other years if they cost 100 or 100 during 1996 0 Example Suppose that things that cost 100 or 100 during 1996 cost 6237 or 06237 during 1981 Then the value of the price index for 1981 would be 6237 Suppose that things that cost 100 or 100 during 1996 cost 11190 or 11190 during 2003 Then the value of the price index for 2003 would be 11190 REAL GDP 0 GDP for any year measured using the prices that existed during some selected base year BASE YEAR AND PRICE INDEX 0 Any year can be chosen as the base year and then prices in other years are compared to the level of prices during the base year in order to create a price index 0 Example Suppose we select 1996 as the base year The goal is to compare the level of prices during any year to the level of prices during 1996 Depreciation and Net Domestic Product NNP 0 During the production process firms typically use up or wear out lots of tools and equipment 0 This would give us a measure of our NET new production Depreciation 0 The amount by which the value of an asset falls in a given period 0 Also called the capital consumption allowance NET NATIONAL PRODUCT NNP Nominal GDP Depreciation INCOME APPROACH FOR CALCULATING GDP 0 Calculate the value of goods and services produced during a given year based on who received the eventual income from the sale of the output EXPENDITURE APPROACH FOR CALCULATING GDP 0 Calculate the value of goods and services produced during a given year based on who purchased the output and what types of goods and services were produced 0 Macroeconomics emphasizes the Expenditure approach 0 The output of goods and services is classified into 4 broad sectors CONSUMPTION C Purchases by consumers GROSS PRIVATE DOMESTIC INVESTMENT I Purchases by businesses G GOVERNMENT PURCHASES OF FINAL GOODS AND SERVICES Federal state and local NET EXPORTS EXPORTS IMPORTS NX X M GDPCIGXMCIGNX APPROXIMATE SHARES OF GDP C 67 I 17 G 17 X M 2 CONSUMPTION SPENDING Durables Cars appliances furniture Nondurables Food gasoline clothing Services Clerks secretaries teachers doctors attorneys dentists accountants entertainers beauticians pilots etc I GPDI US GROSS PRIVATE DOMESTIC INVESTMENT SPENDING BY PRIVATE BUSINESSES 0 Does not refer to financial transactions in the stock market 0 Excludes government investment purchases 3 Categories of Investment Spending 1 New plant and equipment expenditures 2 New home construction expenditures 3 Changes in business inventories Inventory 0 Items produced that have not yet been sold Change in Inventory Inventory at end of year inventory at start of year Total production during year Total sales during year An increase in Inventory 0 More was produced than was sold during a given year 0 Any unsold output is included in GDP under the inventory portion of investment spending A Decrease in Inventory 0 Suppose that a company sole more this year than was produced this year 0 This means that they must have produced some items during past years that were then sold this year The items that were produced during the past years were counted as part of GDP during those past years 0 Thus the items that were sold this year which were produced during past years should NOT be counted as part of this year s GDP 0 These sales must be subtracted to determine this year s output Net Investment 0 Some investment spending is undertaken to replace plant and equipment which has worn out or depreciated 0 Gross investment includes the value of all new tools and equipment etc even those tools and equipment that were produced to replace worn out tools and equipment 0 If all the tools and equipment were produced to exactly replace worn out tools and equipment then our productive capacity would remain constant 0 To increase our productive capacity we must increase our capital stock Thus we need to produce more than enough to replace the worn out tools and equipment Net investment gross investment depreciation Net investment will be negative if we fail to replace all depreciated worn out equipment 3 Net investment was minimal during the Great Depression Ni GOVERNMENT SPENDING G 0 Expenditures on final goods and services by federal state and local governments GOVERNMENT PURCHASES OF FINAL GOODS 0 Bridges highways schools hospitals libraries trucks tanks GOVERNMENT PURCHASES OF SERVICES 0 Wages and salaries of all govt employees Civilians and military 0 Transfer payments are not included in GDP 0 Transfer payments constitute a LARGE portion of total government spending Total federal government spending G Tr G Government spending on goods and services Tr Government transfer payments Federal G Tr gt 20 of GDP Federal G 6 of GDP State and local G 11 of GDP SURPLUS OR DEFICIT T Tax revenue SURPLUS T gt G Tr DEFICIT T lt G Tr EXPORTS X Purchases by foreigners of goods and services produced in the US IMPORTS M Purchases in the US of goods and services produced in other countries X 10 of GDP M 12 of GDP NET EXPORTS X M NX 0 Spending on imports has been included in C I and G 0 This spending needs to be subtracted TRADE SURPLUS X gt M TRADE DEFICIT X lt M Heath Fienman 102314 ECON Tues Thurs Section 13 Unemployment Employment Act of 1946 9 0 It is the responsibility of the federal government to seek maximum employment Civilian Noninstitutional Population CNP 0 Monthly Labor Review 0 All persons age 16 and over who are not inmates of penal or mental institutions sanitariums or homes for the aged infirm or needy 0 This is the potential labor force 0 It includes students old people and retirees Employed E 1 Worked for pay any time during the week which includes the 12th day of the month 2 Worked unpaid for 15 hours or more in a familyoperated business 3 Temporarily absent due to illness vacation etc 0 A person with 2 jobs is counted only once Unemployed U 1 Did not work during the survey week 2 Available for work 3 Had looked for jobs within the preceding 4 weeks or did not look for work because they were laid off 0 Persons who do not have a job would like one and are actively seeking a job Not in the Labor Force N 0 Everyone in the civilian noninstitutional population who is not classified as employed or unemployed Civilian Labor Force LF Employed Unemployed All employed or unemployed persons in the civilian noninstitutional population All individuals who have a job or are actively seeking work LF E U 0 However LF ignores people in the military Unemployment Rate Number unemployed as a percentage of the labor force U LF x 100 Employment Rate Number employed as a percentage of the labor force E LF x 100 Labor Force Participation Rate Labor force as a percentage of the CNP LF CNP x100 Example Population in 2000 2728 million 1 Under 16 military institutionalized 64 million 2 Employed 1352 million 3 Unemployed 57 million 4 Not in labor force 679 million Total 2728 million Civilian noninstitutional population employed unemployed not in labor force 1352 million 57 million 679 million 2088 million Labor force employed unemployed 135 2 million 57 million 1407 million Unemployment rate unemployed labor force X 100 57 million 1407 million X 100 041 X 100 41 Labor force participation rate labor forcecivilian noninstitutional population X 100 1407 million 2088 million X 100 674 X 100 674 SOME COSTS OF UNEMPLOYMENT 1 Individual hardship due to loss of income 2 Loss of output at the national level lower GDP 3 Lower standard of living 4 Lower aggregate income 5 Lower taX revenue for government 6 Increased government spending for welfare and unemployment compensation 7 Increased budget deficit 8 Increased national debt 9 Increased government borrowing 10 Increased interest payments on national debt 11 Increase in crime rates alcoholism suicide rates domestic violence and social unrest Problems Involved in measuring unemployment rate Discouraged Workers People who want to work but are unable to find a job and quit looking Underemployed workers People working in jobs far beneath their skill level and or working part time who want to work full time Underground Economy Portion of the economy where workers are paid in cash do not report income and do not pay taxes opal x CU Unemployment compensation affects the unemployment rate 0 People can get unemployed compensation for 26 weeks 0 Encourages people to remain unemployed 0 Other things being equal an increase in unemployment benefits will cause the unemployment rate to increase Reasons for Unemployment 1 Job losers 50 of the unemployed 2 Job leavers 15 3 Reentrants 25 4 New entrants 10 JOB LEAVERS Some job leavers quit because they have good prospects for a new job This is not an unemployment problem JOB LOSERS Job losers are the group that we worry about in macroeconomics The number of job losers will increase during a recession New entrants and reentrants are good for an economy Types of Unemployment 0 Frictional 0 Structural 0 Cyclical 0 Seasonal Frictional Unemployment 0 The portion of unemployment due to the normal workings of the labor market 0 Denotes short run problems in matching people with skills to available jobs 0 New and reentrants 0 People switching jobs 0 People laid off from seasonal employment 0 Jobs are available and workers have the necessary skills to perform the jobs 0 Problem Prospective employers and employees have not matched up 0 CURE provide better info about job availability Structural Unemployment 0 Unemployment caused by changes in the structure of the economy 0 Often leads to significant loss of jobs in certain industries 0 Example Steel Industry in PA 0 Usually leads to long term unemployment 0 Workers may lack transferable skills Some causes of Structural Unemployment 0 Changes in demand for goods 0 Shifts in technology 0 Worldwide competition Proposed CURES 0 Workers may need job retraining 0 Move to new locations 0 Accept lower wages Cyclical Unemployment 0 The increase in unemployment that occurs during a recession 0 Unemployment caused by a decline in aggregate demand for goods and services 0 Related to the business cycle Proposed CURE 0 Stimulate the economy via fiscal or monetary policy Policies to cure cyclical unemployment Fiscal policies 1 Cut taxes 2 Increase government spending Monetary Policies 3 Increase the money supply 4 Lower interest rates Seasonal Unemployment 0 Related to seasons of the year and weather 0 Construction highway repair house painting landscaping beaches etc 0 Holidays like Christmas or the start of school Natural Rate of Unemployment 0 Unemployment that occurs as a normal part of the functioning of the economy 0 Sum of frictional and structural unemployment 0 The unemployment rate that would prevail if there were no cyclical unemployment Full Employment The unemployment rate when there is no cyclical unemployment 0 There is always some firctional and structural unemployment in any economy 0 Unemployment can never reach 0 0 Assumed to occur when there is 45 unemployment Reasons for Unemployment 1 Job losers 483 2 Job leavers 148 3 Reentrants 274 4 New entrants 95 0 Approximately half of the unemployed are job losers 0 Many job leavers may quit because they have good prospects for a new job 0 Job losers are the group that we worry about in MACRO 0 The number of job losers will increase during a recession Why don t employers cut wages when there are unemployed workers competing for jobs 1 Wage cuts can lead to strikes and violence 2 Can lead to reduced worker motivation 3 It is likely that the best employees will leave to find work elsewhere and the worst workers will stay 4 Employers are more likely to hold wages constant and lay off the least productive workers In this way the best workers are retained Theory It appears that the classical theory is wrong Employers will not reduce wages across the board and hire cheaper labor Potential GDP The level of output when we are at full employment GDP Gap Potential GDP Actual GDP GDP gap measures loss in output due to cyclical unemployment Heath Fienman 10 28 14 ECON Tues Thurs Section 14 notes In ation In ation 0 A sustained increase in the average level of prices 0 Not an increase in price of a single item 2 Main Price Indexes 1 CONSUMER PRICE INDEX CPI 0 Based on prices of things consumers buy Includes used goods Includes imports Does not include raw materials steel aluminum oil wheat etc 0 Good indicator of changes in cost of living for consumers 2 GDP DEFLATOR 0 Includes prices of all new goods and services produced in the US 0 Includes prices of raw materials 0 Does not include prices of used goods or imports How to Create a Price Index 0 Create a typical Market Basket 0 Find cost of basket in a BASE YEAR 0 Find cost of some basket in CURRENT YEAR 0 The INDEX compares the current cost to the cost in the base year A Price Increase Does Not Cause an Overall Loss 0 Increased payment by buyer increased income for seller 0 Redistribution of income from the buyer to the seller In ation and Standard of Living 0 If wage increase In ation rate Then standard of living Constant If wage increase gt In ation rate Then standard of living improves If wage increase lt In ation rate Then standard of living decreases CPI EXAMPLE Base year 1983 CPI for 2001 1771 Interpretation What cost 100 in 1983 would cost 17710 in 2001 CALCULATION OF THE INDEX CPI Cost of market basket in current year cost same market basket in base year X 100 EXAMPLE Basket cost 400 in 1983 Basket cost 70840 in 2001 CPI in 1983 400400 X 100 100 CPI in 2001 70840400 X 100 1771 CALCULATION OF THE INFLATION RATE In ation rate Rate of growth of price index New value old value old value X 100 CPI in 1999 168 CPI in 2000 174 In ation rate for 2000 174 168168 X 100 6168 X 100 034 X 100 34 Harmful Effects of Variable In ation 0 Uncertainty inhibits long term planning and long term investment 0 More uncertainty implies greater risk ANTICIPATED VS UNANTICIPATED INFLATION When we make decisions we take into account our eXpectations about the future in ation rate CONTRACTS ARE BASED ON EXPECTED INFLATION 0 If actual in ation EXpected in ation Then borrower and lender are content If actual in ation gt EXpected in ation Then borrower gains and lender loses If actual in ation lt EXpected in ation Then borrower loses and lender gains UNANTICIPATED INFLATION HURTS LENDERS UNANTICIPATED INFLATION HELPS BORROWERS 0 When in ation is higher than eXpected the lender is repaid with dollars that can buy less than was eXpected 0 With hyperin ation the lender is repaid with dollars that are practically worthless De ation 0 A decrease in the average level of prices 0 Hurts Debtors Must repay debts with more valuable dollars 0 Tends to occur when the economy is in a steep economic decline 0 1933 CPI declined by 51 and GDP De ator declined by 21 De ation Hurts Debtors 0 Farmers 0 People with home mortgages 0 Business owners who have debts Disin ation 0 A decrease in the INFLATION RATE 0 Does NOT mean de ation 0 1990 IR 54 0 1991 IR 42 0 1992 IR 30 0 Prices increased but the rate of increase decreased Stag ation 0 Simultaneous existence of high in ation and high unemployment or recession 0 Economic stagnation and in ation occurring together 0 1975 IR 91 and Unemployment Rate 78 Hyperin ation 0 Very high in ation 0 Sometimes defined as In ation gt 50 per month 0 Caused by a very rapid increase in the money supply Germany 19211923 Total in ation 1 trillion percent Contributed to Hitler s rise 0 Brazil 1989 Total in ation 3398 0 Argentina 1989 Total in ation 4923 0 Yugoslavia 1993 Total in ation 20 per day Effects 0 Cash becomes almost worthless 0 Bonds have no value 0 People avoid holding cash 0 People avoid being paid in cash 0 Barter trading is prominent Indexing 0 Increasing contracted payments automatically to take into account in ation 0 Helps make in ation selfperpetuating Indexed Contracts 0 Union wage contracts 0 Social security benefits 0 Federal income tax brackets 0 Capital gains are NOT indexed COLA Causes 0 Cost of Living Adjustments 0 Pay increases which are indexed 0 Protect the worker s standard of living One Effect of Indexing Sustains In ation 0 In ation occurs Wages rise Production costs rise Producers raise prices Prices rise again Process repeats In ation Can In uence Foreign Trade 0 Assume US In ation gt Foreign in ation rate 0 US products become more expensive that foreigners products 0 People buy less from US and more from foreigners In ation and Foreign Trade 0 Rapid in ation in the US will cause exports to decline and imports to increase 0 US buys more from foreigners than they buy from US 0 US dollars accumulate in foreign countries Common Uses of Price Indexes 0 Calculate real GDP to determine if the economy is growing or contracting 0 Adjust wage contracts SS benefits and tax brackets 0 Helps determine the need for fiscal or monetary policy We tend to overestimate the in ation Rate 0 Suppose actual in ation is 3 but we measure it as 5 Indexed wages rise too fast Other workers seek similar increases Social security benefits rise too fast Tax brackets rise too much 0 Treasury will lose tax revenue In ation Measurement Bias 0 Why the BLS tends to overestimate the in ation rate We underestimate quality improvement medical care cars computers We do not take substitution into account The actual market base should change as prices change If hamburger prices increase relative to pizza prices we buy more pizzas and fewer hamburgers We are slow to include new goods in the market basket 0 Prices of new goods frequently decline when the goods become more widely produced but these items are not yet included in the market basket Thus the price drop is not re ected in the in ation rate 0 Outlet Malls and Discount Stores Producer Price Index Wholesale Price Index 0 Prices of raw materials Lending Indicator 0 Good predictor of future price increases Types or Causes of In ation 0 Demand Pull In ation 1960 s 0 Caused by an increase in aggregate demand 0 Tends to occur when economy is near full employment 0 Caused by increases in spending by consumers business firms Gov or foreigners COST PUSH INFLATION 1970 s Caused by increase in production costs Increases in fuel costs oil Increases in wage rates near full employment Increases in interest rates and the cost of borrowing Input shortages Stricter environmental regulations Stricter safety regulations Increased costs of fringe benefits Increased social security and Medicare taxes WNQ V PP N COST PUSH INFLATION 0 1974 Organization for Petroleum Exporting Countries OPEC raised the price of oil fourfold 0 1975 1977 Federal Reserve increased the money supply to offset a recession 0 Prices increased even more 0 1979 1980 More OPEC oil price increases THE PHILLIPS CURVE 0 Graph showing an inverse negative relationship between the unemployment rate and the in ation rate Theory 0 When the unemployment rate is low the economy is strong 0 Strong economy means lots of purchasing 0 Lots of purchasing causes in ation Demand Pull In ation 1960 s 0 Increase in buying and spending 0 Decrease in unemployment rate 0 Increase in the in ation rate Still in uences policy makers like Alan Greenspan 0 FED increased interest rates during mid90s to cool off the economy 0 Fear of demand pull in ation 0 FED lowered interest rates during in 2000 to boost borrowing and spending Heath Fienman 103014 ECON Tues Thurs Section 15 Notes The Consumption Function The Consumption Function 0 3 things to do With income Y 1 Spend it Consumption C 2 Save it Saving S 3 Pay Taxes Taxes T YCST Disposable Income Yd Income available after paying taxes YdY TCS There are only two things to do With disposable income 1 Spend it consumption C 2 Save it saving S Yd C S CONSUMPTION FUNCTION 0 Expresses consumption spending as a function of disposable income 0 Holding all other variables constant Other variables also in uence the level of consumption Wealth 0 Expected future income 0 Expected in ation rates 0 Level of interest rates Wealth Vs Income Wealth or Net Worth 0 Value of What you own minus What you owe Income 0 Amount you earn in a given time period 0 Wealth is What have saved over your lifetime 0 An old person could be extremely wealthy and have almost no income Consumption Function for a Household Consumption spending increase as income increases C fY or C fYd 0 The relationship between consumption and income is close to linear 0 Slope of function decrease as income increases Consumption Function got the US economy Consumption spending C increases as GDP increase C fGDP fY or C fYd 0 Where aggregate income Y GDP 0 Historically the relationship has been almost exactly linear 0 Frequently we express C as a function of Y rather than Yd Plotting the Consumption Function 0 Example C 6 7 Yd 0 Plot C on the Vertical axis 0 Plot Y of Yd on the Horizontal axis 0 Intercept 6 0 Value of C when Yd 0 0 Autonomous consumption 0 Slope 7 0 Change in C Change in Yd 0 Marginal Propensity to Consume 0 An easy way to plot the consumption function is to select some values of Y and find the corresponding values of C 0 Plot these points and draw a line through them Plotting the Consumption Function Example C 6 7 Yd Value of Y 0 10 20 30 40 Value of C 6 13 20 27 34 Plot the points C Y 6 0 13 10 20 20 etc 0 These points fall on a straight line INTERCEPT AUTONOMOUS CONSUMPTION 0 The intercept on the vertical axis is C 6 AUTONOMOUS CONSUMPTION It Will take place regardless of the level of income or economy output 0 Consumption spending that does not depend on the level of income or GDP 0 AUTONOMOUS SPENDING 0 Any spending that does not depend on the level of income or GDP 0 Consumption 0 Investment 0 Government 0 Foreign spending SLOPE MARGINAL PROPENSITY TO CONSUME 0 If Y increases by 10 0 C increases by 7 0 Slope Change in CChange in Y 710 7 0 Amount that C increases When Yd increases by 1 unit 0 The proportion of an increase in income that is spent by consumers 0 MPC Change in C Change in Yd A C A Yd INDUCED CONSUMPTION 0 the increase in consumption spending caused or induced by an increase in income 0 Suppose MPC 7 Example C 6 7 Yd If income increases by 10000 consumption Will increase by 7000 AYd 10000 AC 7000 MPC 7000 10000 7 PARALLEL SHIFTS IN THE CONSUMPTION FUNCTION 0 A change in the intercept causes the consumption function to shift parallel to itself With no change in the slope Some factors Which can cause the consumption function to shift upward 1 An increase in wealth such as a rise in the stock market 2 A decrease in interest rates which makes borrowing less expensive 3 An increase in expected future income such as a job promotion Example C 6 7 Yd C 10 7 Yd CHANGING THE SLOPE OF THE CONSUMPTION FUNCTION 0 An increase or decrease in the slope causes the consumption function to become steeper or atter with no change in the intercept Example C 6 7 Yd C 6 8 Yd The MPC takes a value between 0 and l O lt MPC lt 1 MARGINAL PROPENSITY TO CONSUME MPC VS THE AVERAGE PROPENSITY TO CONSUME APC 0 APC Total consumption spending Total income 0 APC C Yd 0 MPC AC AYd 0 The APC tells us the proportion of our entire disposable income that has been spent on consumption 0 The MPC tells us the proportion of any increase in our disposable income that will be spent on consumption IF THE CONSUMPTION FUNCTION IS A STRAIGHT LINE THE APC DECREASES AS Yd INCREASES Example C 6 7 Yd C Y APC 13 10 13 20 20 10 27 30 09 34 40 85 DRAW A 45 DEGREE LINE ON THE GRAPH WITH THE CONSUMPTION FUNCTION 0 The 45 degree line is the locus of all points such that the value on the vertical axis equals the value on the horizontal axis 0 The line representing the consumption function shows the amount of desired consumption spending associated with any level of disposable income Suppose a point on the consumption function lies ABOVE the 45 degree line 0 Then C gt Yd 0 This means that consumption exceeds income Suppose C exceeds disposable income 0 This tends to occur When income is low 0 These families dissave Suppose a point on the consumption function lies BELOW the 45 degree line 0 Then C lt Yd 0 Thus income exceeds consumption 0 This tends to occur When income is high Suppose a point on the consumption function lies ON the 45 degree line 0 Then C Yd 0 This means that income equals consumption 0 These families just BREAK EVEN IF THE CONSUMPTION FUNCTION IS A STRAIGHT LINE THE MPC IS CONSTANT C 6 7 Yd C Y APC 6 0 oo 13 10 13 ACAY 710 7 20 20 10 ACAY 710 7 27 30 09 ACAY 7 10 7 34 40 85 ACAY 7 10 7 Heath Fienman 1 14 14 ECON Tues Thurs Section 17 Notes Equilibrium Level of Output Equilibrium Level of Output 0 The level of output in which planned or desired purchases by consumers businesses governments and foreigners equals actual aggregate output 0 When the economy is in equilibrium producers have no incentive to increase or decrease output Equilibrium 0 Aggregate planned expenditures Total Actual Output 0 Total Production Production for immediate sale Production to increase inventories 0 Equilibrium is achieved When people want to buy everything that has been produced for immediate sale In this case the firm s level of inventories Will be at exactly the desired level 0 Equilibrium is achieved if the amount that people desire to spend matches the amount that producers produced for immediate sale THREE POSSIBLE SCENARIOS CASE 1 OUTPUT FOR SALE gt DESIRED PURCHASES 0 If actual output for immediate sale exceeds desired spending then producers produced too much and inventories Will increase above the desired level 0 Signal to producers REDUCE OUTPUT CONCLUSION 0 If actual output exceeds desired output actual output Will decline CASE 2 OUTPUT FOR SALE lt DESIRED PURCHASES 0 If actual output is less than desired spending people purchase more than expected and inventories Will decrease below the desired level 0 Signal to producers INCREASE OUTPUT CONCLUSION 0 If desired output exceeds actual output output Will increase CASE 3 OUTPUT FOR SALE DESIRED SPENDING 0 If actual output equals desired spending then people purchased exactly What the producers expected and inventories Will remain at the desired level 0 Signal to producers DO NOT CHANGE OUTPUT CONCLUSION 0 If actual output equals desired output equilibrium is achieved and output does not change Equilibrium Income in the Keynesian Model 0 Actual Output The actual level of C I G NX 0 The amount that households firms and governments and foreigners ACTUALLY purchase 0 Desired Spending the desired level of C I G NX 0 The amount that they WANT to purchase 0 Desired spending depends on the ACTUAL level of output because C depends on Y Equilibrium Output Ye 0 The level of output such that producers have no incentive to change the scale of production Equilibrium 0 Desired Spending Actual Spending Ye 0 Ye C I G NX Determination of the level of equilibrium output 0 THE FOLLOWING ANALYSIS ASSUMES THAT THERE ARE NO TAXES THE RESULTS WILL CHANGE WHEN WE INCLUDE TAXES IN THE MODEL 0 Substitute the equation of the consumption function into the EQUILIBRIUM CONDITION EQUATION and solve for Ye EXAMPLE Let C 100 75 Ye 0 Assume all investment spending government spending and foreign spending is autonomous Thus I IO G G0 NX NXO Let us denote A0 IO G0 NXO Assume A0 25 THE EQUILIBRIUM CONDITION IS Ye C I G NX SUBSTITUTE ALL VALUES INTO THIS EQUATION Ye 100 75 Ye 25 Ye 125 75 Ye Ye 75 Ye 125 1 75 Ye 125 25 Ye 125 Ye 125 25 500 CHECK YOUR RESULT Suppose Ye 500 DoesYeCIGNX C 100 75 Ye 100 75 500 475 I G NX 25 Therefore C I G NX 475 25 500 GENERAL SOLUTION FOR Ye Let C C0 mpc Ye C0 denotes autonomous consumption Let I 10 Let G G0 Let NX NXO YeC10G0NXO C0mche10G0NXO Ye mpc YeC010G0NXO 1 mpcYe C0 10 G0 NXO SOLUTION FOR EQUILIBRIUM Ye 11mpc X C0 10 G0 NXO In our example we have Ye 11 75 X 100 25 4 X 125 500 SECOND EXAMPLE Let C 100 75 Ye Let I 100 A11 investment is autonomous Let G 300 A11 government spending is autonomous Let NX 0 Net eXport spending is autonomous EQUILIBRIUM CONDITION Ye C I G NX SUBSTITUTE ALL INFORMATION INTO THE EQUILIBRIUM CONDITION Ye 100 75 Ye 100 300 0 SOLVE THE EQUATION FOR Ye Ye 500 75 Ye Ye 75 Ye 500 1 75 Ye 25 Ye 500 Ye 500 25 2000 CHECK YOUR RESULT Suppose Ye 2000 DoesYeCIGNX C 100 75 Ye 100 75 2000 1600 IGNX1003000 Therefore CIGNX 1600 10030002000Ye Heath Fienman 1 14 14 ECON Tues Thurs Section 18 Notes The Autonomous Spending Multiplier in a Model with No Taxes AUTONOMOUS SPENDING 0 Autonomous spending is any spending which is not induced by or in uenced by the level of income or the size of the economy INDUCED SPENDING 0 Induced spending is any increase in the level of spending that is related to an increase in the level of income or the size of the economy Suppose autonomous spending increases in the economy This could involve an increase in consumption spending investment spending government spending or foreign spending EXAMPLES AN INCREASE IN AUTONOMOUS CONSUMPTION SPENDING 0 Suppose the stock market rises so consumers decide to buy more cars AN INCREASE IN AUTONOMOUS INVESTMENT SPENDING 0 Suppose interest rates decline so a corporation decides to borrow money and builds a new factory AN INCREASE IN AUTONOMOUS GOVERNMENT SPENDING 0 Suppose the Federal government decides to build a new highway AN INCREASE IN AUTONOMOUS EXPORT SPENDING 0 Suppose the Chinese economy booms and foreigners decide to buy more American cars or make more visits to Disneyland Effect of an increase in Autonomous Spending 0 When autonomous spending increases some sector of the economy is purchasing more than it did before and this causes an increase in output 0 This increase in output causes an increase in the incomes of the workers producing the output 0 This increase in income causes an increase in the consumption spending of the producers This is called induced consumption spending 0 This induced consumption spending causes another increase in output and another increase in the incomes of the producers 0 This causes additional induced consumption spending 0 This process repeats itself over and over CONCLUSION Any increase in autonomous spending from any sector leads to a multiple increase in output THE AUTONOMOUS SPENDING MULTIPLIER 0 The multiplier is the change in equilibrium output divided by the change in autonomous spending that caused it MULTIPLIER AYe AAUTONOMOUS SPENDING Change in equilibrium outputChange in autonomous spending CALCULATION OF THE AUTONOMOUS SPENDING MULTIPLIER EXAMPLE Let C 100 75 Ye Let I 100 All investment is autonomous Business Let G 300 All government spending is autonomous Let NX 0 Net export spending is autonomous SOLVE FOR Ye0 Ye0 ll mpc X C0 10 G0 NXO Ye0 ll 75 X 100 100 300 0 Ye0 4 X 500 2000 Now suppose there is an autonomous increase in government spending Assume G increases by 100 Thus the new level of government spending is 400 rather than 300 Thus AG 400 300 100 NEW SOLUTION FOR EQUILIBRIUM Yel 11 mpc XC0 10 G1 NXO Yel ll 75 X 100 100 400 0 Ye 4 X 600 2400 Now let us calculate the value of the multiplier DEFINITION MULTIPLIER AYe AAUTONOMOUS SPENDING AYeAG AYe 2400 2000 400 AG 400 300 100 Multiplier 400 100 4 CONCLUSION The 100 in additional government spending led to a 400 increase in eventual output Thus each 1 of additional autonomous government spending caused a 4 increase in total output Thus the multiplier is 4 THE AUTONOMOUS SPENDING MULTIPLIER GENERAL SOLUTION Let C C0 mpc Ye C0 denotes autonomous consumption Let I IO Let G G0 Let NX NXO YeOCIOGONXO C0mcheIOGONXO Ye0 mpc Ye0 C0 IO G0 NXO 1 mpcYe0 C0 IO G0 NXO Therefore originally we obtain YeO ll mpc X C0 IO G0 NXO Now suppose G increases to G1 FIND THE NEW LEVEL OF EQUILIBRIUM Yel ll mpc X C0 IO G1 NXO MULTIPLIER AYE AAUTONOMOUS SPENDING AYe AG The change in Ye is AYe Yel YeO ll mpc X Gl G0 The change in autonomous spending is AG Gl G0 The autonomous spending multiplier is Multiplier ll mpc X Gl GO Gl G0 11 mpc EXAMPLE In the previous model we had mpc 75 We calculated the multiplier as Multiplier AYe AG 400100 4 From our formula we obtain the same result Multiplier 11 mpc 11 75 4 THE MULTIPLIER AN ALTERNATIVE EXPLANATION Round 1 Suppose G purchases increase by 100 Thus output increases by 100 and people s incomes increase by 100 GDP increases by 100 Round 2 Given that the mpc 75 the 100 increase in income induces an additional 75 increase in consumption spending Thus output increases by another 75 and people s incomes increase by 75 GDP increases by the additional 75 Round 3 Given that the mpc 75 the 75 increase in income induces an additional 5625 increase in consumption spending Thus output increases by 5625 and people s incomes increase by 5625 GDP increases by the additional 5625 Round 4 GDP increases by 4219 Round 5 GDP increases by 3116 Round 6 GDP increases by 2373 Round 7 GDP increases by 1780 Round 8 GDP increases by 1335 And so forth Total increase in GDP 100 75 5625 400 The 100 increase on autonomous spending induced a 400 increase in equilibrium output Similarly a 1 billion increase in autonomous spending would induce a 1 billion increase in equilibrium output In each case the multiplier is 4 FISCAL POLICY AND THE IMPORTANCE OF THE MULTIPLIER Suppose the economy is operating far below full employment Assume output is at level YU Assume output at full employment would be YF That is we have a GDP gap GDP gap YF YU SUPPOSE WE WISH TO INCREASE GDP BY A CERTAIN AMOUNT TO ELIMINATE THE GDP GAP AN INCREASE IN CO IO or G0 CAN BRING AB OUT THE DESIRED RESULT QUESTION 1 Suppose we increase G by the amount AG By how much will Ye increase SOLUTION Multiplier AYe AG ll mpc Thus AYe ll mpc X AG EXAMPLE Suppose we increase G by the amount AG 100 By how much will Ye increase Assume mpc 75 SOLUTION AYe ll mpc X AG 11 75 x 100 4 X100 400 FISCAL POLICY AND THE MULTIPLIER To eliminate a GDP gap we need to increase equilibrium output Suppose the desired increase in Ye is AYe By how much do we need to increase autonomous spending to achieve the desired increase in output SOLUTION The multiplier is given by Multiplier AYe AG ll mpc We obtain AG AYe X 1 mpc EXAMPLE Suppose the desired increase in Ye is AYe 800 By how much do we need to increase autonomous spending to achieve the desired increase in equilibrium output Assume mpc 75 SOLUTION AG AYe X 1 mpc 800 X 1 75 800 X 25 200 HOW THE MPC AFFECTS THE MULTIPLIER Multiplier mpc 1 mpc 11 mpc 2 8 1 80 125 4 6 1 60 167 5 5 1 50 200 6 4 1 40 250 7 3 1 30 333 75 25 1 25 400 8 2 1 20 500 CONCLUSION The magnitude of the multiplier depends on the magnitude of the mpc The larger the mpc the larger is the multiplier The examples used an increase in government spending as the change in autonomous spending The same results Will follow if the increase in spending occurs as a result of 1 An increase in autonomous consumption spending 2 An increase in autonomous investment spending 3 An increase in autonomous government spending 4 An increase in autonomous net eXport spending Heath Fienman 1 1 1 1 14 ECON Tues Thurs Section 21 Notes Goals of Tax Policy and The Budget Deficit SOME GOALS OF TAX POLICY 1 2 3 4 Generate revenue Redistribute income Reallocate resources In uence the economy via fiscal policy How tax policy can cause a redistribution of income High income households pay a much greater amount in taxes than low income households Low income households receive a much greater amount in unemployment compensation welfare benefits food stamps etc than high income people Thus the tax policy leads to a redistribution of income away from high income households to low income households How tax policy can cause a reallocation of resources A tax on a specific item or activity makes that item or activity more expensive Thus people purchase less of that item or activity A tax on cigarettes amp alcohol increases the prices of those items Thus people reduce their purchases Recently Allegheny County imposed a 7 tax on any alcohol purchased at restaurants Reportedly this has lead to a sizeable decrease in restaurant revenue Tolls on the Pennsylvania Turnpike increase the cost of travel Thus people reduce their travel on the Turnpike Tax exemptions make some activities less expensive Thus people spend more on those activities Interest on home mortgages is tax deductible This makes owning a home less expensive Money invested in an IRA and any interest earned from the investment is not taxed until it is Withdrawn after age 59 This encourages households to increase their current saving and causes a reallocation from current consumption to current saving Charitable contributions are tax deductible This encourages people to contribute more to charity BUDGET DEFICITS AND THE NATIONAL DEBT We incur a budget deficit When government spending on goods services and transfer payments exceeds tax revenue 0 Deficit years 1961 1968 1970 1997 2002 Present 0 We have a budget surplus when tax revenue exceeds government spending 0 Surplus years 1969 and 1998 2001 0 We have a balanced budget when government spending equals tax revenue THE NATIONAL DEBT Total amount owed by the Federal government Sum total of all past deficits and surpluses 0 The National Debt is the amount the Federal government currently owes to all the people who have lent money to the government Whenever the government has a deficit the national debt increases Financing a Deficit 0 The TREASURY DEPARTMENT collects taxes for the Federal government and is responsible for paying all the expenses incurred by the Federal government 0 Whenever the Treasury Department does not have enough money to pay its bills it borrows money from the public 0 The Treasury borrows from lenders by issuing government securities Treasury Bills Treasury Notes or Treasury Bonds depending on the length of the loan 0 The Treasury promises to pay the lenders interest and promises to repay the loans at the date of maturity 0 The interest earned by the lenders is taxable 0 US bonds are considered to be virtually riskfree 0 The Treasury Department has never defaulted on a loan or missed an interest payment Thus there is almost no risk of default Lenders can be almost certain that they will receive their interest and that their loan will be repaid Why do people complain about the National Debt 0 If the National Debt did not exist then the Treasury Department would not have to pay interest to the lenders As a result one item of government spending would be eliminated and it would be possible to lower taxes SOME OF THE INTEREST PAYMENTS ON THE NATIONAL DEBT ARE NOT LOST TO THE ECONOMY 0 Current taxpayers pay the interest on the Federal debt 0 Thus without a national debt current taxes would be lower 0 Are these taxes lost to the economy 0 The interest is paid to the lenders the bondholders 0 The bondholders are various consumers business firms governments foreigners and the Federal Reserve System 0 If we exclude the interest that is paid to foreigners the interest is paid to other US entities Except for the interest paid to foreigners there is no net loss to the US economy as a Whole Heath Fienman 1 11 1 14 ECON Tues Thurs Section 23 Notes Automatic Stabilizers Automatic Stabilizers Changes in tax revenue or government spending that occur automatically as the economy grows which reduce the size of the growth or which occur automatically when the economy contracts to reduce the size of the contraction Automatic stabilizers are effects which occur automatically and which reduce the magnitude of swings in the business cycle Beneficial Effect of Automatic Stabilizers During a Recession During a recession government spending on items such as welfare food stamps and unemployment compensation increases automatically This increased government spending tends to boost the consumption spending of households and reduces the size of the economy s contraction During a recession as incomes fall the amount that the government takes from us in taxes will decrease The reduction in taxes boosts our remaining disposable income a bit and helps reduce the magnitude of the economy s contraction Automatic stabilizers are beneficial during a recession Negative Effect of an Automatic Stabilizer During Expansion Fiscal Drag During an expansion household incomes increases and government tax revenue increases This dampens the potential increase in disposable income and thereby dampens the potential increase in consumption expenditures This causes the expansion to be moderated Also during an expansion government spending on welfare and unemployment compensation will decrease This reduction in government spending will again dampen the increase in consumption spending and will cause the expansion to be moderated Heath Fienman 1 1 1 1 14 ECON Tues Thurs Section 24 Notes Refinancing the National Debt REFINANCING THE NATIONAL DEBT When bonds mature the government must pay the principal that is due to the lenders the bondholders When the Treasury has a surplus which occurs very rarely the Treasury can use the excess tax revenue to pay off the principal to some of the bondholders The bond would now be cancelled and the National Debt would decrease When the Treasury has a deficit the Treasury must find some new way to obtain money so it can pay the principal to the bondholders whose bonds have matured The Treasury obtains the new money by refinancing the debt Refinancing the debt or rolling over the debt occurs when Treasury issues new bonds to generate enough revenue to pay off maturing bonds SHOULD WE PAY OFF THE NATIONAL DEBT Assume the Federal government has a surplus Treasury can retire some outstanding bonds National debt decreases Future interest payments decrease Less tax revenue is needed in the future Also as Treasury pays off debt more funds become available for other borrowers Interest rates tend to decrease This could stimulate consumer and business borrowing and spending MANY TAX PAYERS PREFER TAX CUTS TO PAYING OFF THE FEDERAL DEBT When the Treasury has a surplus it can use the surplus funds to pay off part of the National Debt When the Treasury has a surplus it is collecting more money from taxpayers than is needed to fund the govemment s current expenses In this case many taxpayers prefer cutting current taxes to eliminate the surplus President Bush followed this scenario in 2001 SOME OF THE NATIONAL DEBT IS OWNED BY THE FEDERAL RESERVE SYSTEM The FED can buy government bonds from bond holders The Federal Reserve System issues checks or prints new money when it purchases bonds from the public This causes the nation s money supply to increase The Fed now would own the government bonds and would be entitled to the interest payments and the principal at maturity The Fed is a nonprofit organization and returns much of the interest and principal back to the Treasury Department Thus the bonds owned by the Fed Bonds have basically been removed from the National Debt When the Fed purchases bonds from the public new money is inserted into the economy It is illegal for FED to purchase bonds directly from the Treasury This prevents the Treasury from colluding with the Fed to have an unlimited source of funds to pay for a vast expansion of government projects It helps prevents hyperin ation A FED purchase of bonds causes the money supply to increase This is called an OPEN MARKET OPERATION FED owns about 40 of the total national debt FED uses some of the interest to pay its bills FED returns unneeded interest to the Treasury Thus part of the national debt owned by the FED is interest free COST OF THE NATIONAL DEBT The true COST of the national debt is the interest that must be paid on the Treasury securities Current taxes would be lower if there were no Federal debt THE BENEFIT OF THE NATIONAL DEBT The BENEFIT of the national debt is the fact that current taxpayers have been spared the burden of paying for many of the goods services and transfer payments that have been provided by the government Current bondholders provided the money by lending to the government The national debt never needs to be paid off because the Treasury can always refinance the debt Heath Fienman 1 11314 ECON Tues Thurs Section 25 Notes Fiscal Policy and Timing Lags DISCRETIONARY FISCAL POLICY 0 Deliberate changes in government spending and taxing to in uence the economy COUNTERCYCLIC POLICY IS PREFERRED 0 When the economy is contracting we should try to stimulate the economy to reduce unemployment 0 Sometimes when the economy is expanding too rapidly we try to dampen the economy a bit to reduce the threat of in ation 0 This sometimes is called leaning against the wind 0 Recall that a balanced budget amendment is procyclic 0 Enforcing a BBA during a recession will make the recession worse TIMING PROBLEMS WITH FISCAL POLICY 0 It can be difficult to implement discretionary fiscal policy effectively 0 Fiscal policy usually requires a long time period to take effect 0 Thus by the time a policy is enacted and takes effect it is possible that it is no longer needed TIMING LAGS associated with fiscal policy RECOGNITION LAG or observation lag 0 The time it takes for policy makers to recognize that the economy is in a recession IMPLEMENTATION LAG or legislative lag or administrative lag 0 The time it takes to pass laws and put the desired policy into effect RESPONSE LAG execution lag operation lag 0 The time it takes for the enacted policy to actually have an effect on the economy Heath Fienman 1 11314 ECON Tues Thurs Section 26 Notes The Full Employment Surplus or Deficit The Full Employment Surplus or Deficit Economists argue that a more meaningful way to measure the impact of fiscal policy is to compare the actual level of government spending with the level of taxes that would be collected if the economy operated at full employment Let Tf Potential government tax revenue if the economy had been at full employment during a certain year Let GA Actual government expenses during that same year Tf GA The FULL EMPLOYMENT SURPLUS OR DEFICIT Many economists argue that instead of calculating the actual surplus or deficit in any year calculate what the surplus or deficit would have been if the economy operated at full employment EXAMPLE Suppose the economy is in a massive recession Tax revenue will be very low The government will probably have a large deficit If the economy was at full employment GDP would be higher and tax revenue would be higher Also government spending might be lower because unemployment compensation and welfare spending would be lower Thus at full employment the government might have a balanced budget or a surplus CONCLUSION When an economy is in a recession it is not necessarily fair to criticize a government for having a budget deficit EXAMPLE THE FULL EMPLOYMENT BUDGET FOR 1933 If the economy had achieved full employment during 1933 tax revenue would have been much higher Given the actual level of government spending in 1933 there would have been a gigantic surplus Thus the actual fiscal policy used during 1933 was not expansionary There would have been a surplus at full employment Thus the actual fiscal policy could be considered to be contractionary Minority view We should have an annually balanced budget Majority view We should try to balance the budget over the business cycle That is we should try to have surpluses during good years and deficits during bad years 0 Pursuing full employment without in ation is more important than achieving a balanced budget Heath Fienman 1 11314 ECON Tues Thurs Section 27 Notes Supply Side Economics SUPPLY SIDE ECONOMICS 0 Refers to government policies that focus on stimulating the economy by boosting the aggregate supply of goods and services rather than by boosting the aggregate demand for goods and services 0 It recommended tax cuts for businesses which would boost potential profits and encourage businesses to increase output 0 It also recommended tax cuts for households This would boost the rate of return on an hour of work and would encourage laborers to work more POSSIBLE COUNTER ARGUMENT 0 If individual tax rates are cut the disposable incomes of workers increase 0 With higher incomes some workers might choose to work less and enjoy leisure time EXAMPLE OF SUPPLY SIDE ECONOMIC POLICY TRICKLE DOWN ECONOMICS CUT CORPORATE TAX RATES 0 These causes after tax profits to increase 0 This stimulates investment and production 0 Employers hire more workers 0 As a result the effects of the corporate tax cut will trickle down and workers will benefit THE LAFFER CURVE 0 A graph showing total tax revenue as a function of the tax rate 0 Named after the economist Arthur Laffer who advised President Reagan 0 At what tax rate will tax revenue be a maximum If tax rate 0 tax revenue 0 If tax rate 100 tax revenue 0 because no one would work if the government took 100 of their income as taxes Thus there is some intermediate tax rate at which tax revenue is a maximum THE LAFFER CURVE 0 Used by supplyside economists and President Reagan to support arguments for a tax cut 0 They argued that tax rates are too high 0 They argued that a decrease in tax rates will cause output and ALSO will cause tax revenue to increase Heath Fienman 1 11314 ECON Tues Thurs Section 28 Notes Money WHAT IS MONEY The primary function of money is that it should serve as a MEDIUM OF EXCHANGE or MEANS OF PAYMENT Money is any item that is commonly used by buyers and commonly accepted by sellers as a medium of exchange Use of money eliminates the need for barter which is inefficient Besides serving as a MEDIUM OF EXCHANGE money has several other functions that make it useful Money serves as a UNIT OF ACCOUNT Any item that serves as money should serve as an agreed upon measure for stating the prices of goods and services To serve as a unit of account the item used as money should be able to designate the price of all items Thus money should be able to be broken into small fractions Le a piece of candy might cost 1 penny while a house might cost 500000 Suppose we used diamonds as money It would be difficult to state the prices of things in terms of diamonds A house might cost 100 diamonds or a piece of candy might cost one onethousandth of a diamond To be useful money should serve as a STORE OF VALUE Any item that is used as money should be able to be held for a period of time so that it could be used for payment later without losing value Thus any item used as money should retain its purchasing power over time During periods of high in ation currency loses value rapidly Thus it loses its usefulness as a store of value If the item serving as money is losing value rapidly people will try to get rid of the item and replace it with something that retains value over time Some items that retain value over time are land houses jewelry fine art etc These items could all serve as a store of value but they do not work well as a medium of exchange or unit of account SOME DESIRABLE PROPERTIES OF ANY ITEM USED AS MONEY Durable Coins but not tomatoes or cigarettes Portable Easy to carry and mail large sums Paper money but not gold bars Divisible Coins and paper money but not diamonds Uniform quality Low opportunity cost 0 Few valuable resources tied up in creating money 0 Paper money but not gold silver platinum diamonds Stable value 0 People are more willing to accept and hold money if it maintains its value over time Hard to counterfeit SOME FORMS OF MONEY 0 Commodity Money 0 Fiat Money Convertible paper money 0 Deposit money COMMODITY MONEY 0 Items that are used as money but which also have value in other uses EXAMPLES 0 Gold silver furs salt tobacco in prisons DISADVANTAGE OF COMMODITY MONEY 0 Difficult to control the SUPPLY of commodity money DISADVANTAGES OF GOLD AND SILVER 0 Finding additional gold or silver is random 0 Most gold and silver is mined in foreign countries The US money supply could be controlled by foreign countries Also gold and silver have other uses in industry and as jewelry ADVANTAGE OF COMMODITY MONEY 0 Because the supply is limited the potential for a rapid expansion of the money supply is reduced This limits the threat of high in ation or hyperin ation William Jennings Bryan gave the Cross of Gold speech 0 You cannot crucify man on a cross of gold 0 Farmers wanted the government to expand the money supply by including silver in the money supply along with gold 0 This would greatly increase the money supply 0 This would lead to in ation and higher selling price for farm output 0 Thus the farmers could more easily pay off their debts FIAT MONEY 0 Items designated by government decree to serve as money although the item itself is essentially worthless 0 EXAMPLE Coins and US paper currency 0 Federal Reserve Notes are fiat money They have no intrinsic value WHY CREATE FIAT MONEY 0 The supply of money should be able to be controlled by the government 0 A growing economy requires a growing money supply 0 With fiat money it is easy to increase the money supply when needed POTENTIAL PROBLEM WITH FIAT MONEY 0 At times governments have created far too much money perhaps in order to pay off government debts 0 This can cause in ation or hyperin ation WHY DO PEOPLE ACCEPT FIAT MONEYAS A MEANS OF PAYMENT 0 Because it is LEGAL Tender LEGAL TENDER 0 Fiat Money is accepted because the government has required it to be accepted in settlement of debts FEDERAL RESERVE NOTES ARE LEGAL TENDER 0 Every dollar bill contains the statement 0 This note is legal tender for all debts public and private 0 This means that you MUST accept Federal Reserve Notes as payment of a debt Otherwise the debt is considered paid under the law CONVERTIBLE PAPER MONEY 0 Prior to 1933 paper money could be exchanged for gold or some other precious metal 0 This represents a combination of both fiat money and commodity money 0 The US is no longer on the gold standard You cannot exchange dollar bills for gold 0 Federal Reserve Notes are not backed by anything but our faith and trust THE GOLD STANDARD 1879 to 1933 0 Dollars could be converted into gold at a guaranteed value on demand 1933 to 1971 0 It was illegal for US citizens to hold gold coins or ingots 0 The US Treasury continued to convert dollars into gold for foreign central banks and governments Pre 1968 0 Each Federal Reserve Note had to be backed by a 25 gold reserve This put a limit on the money supply 0 The value of gold far exceeded 35 per ounce 0 Foreign banks would exchange US dollars for gold and make a huge profit 0 In 1971 the US no longer converted dollars into gold for foreigners Since 1933 US citizens could not hold gold or ingots HYPERINFLATION IS CAUSED BY PRINTING TOO MUCH MONEY To pay for government spending the government gets money from one of three sources 1 Taxes 2 Borrowing 3 Print money Weak governments often choose option 3 This can lead to hyperin ation LIQUIDITY 0 The property of being easily converted into cash 0 An illiquid asset can be converted to cash only after a delay or at considerable cost 0 Currency and coins are perfectly liquid 0 Checking accounts are almost perfectly liquid 0 Savings accounts and certificates of deposit are less liquid than checking accounts 0 Stocks and bonds are not as liquid as checking accounts 0 Real estate houses jewelry antiques fine art etc are less liquid than checking accounts stocks or bonds DEPOSIT MONEY DEMAND DEPOSITS CHECKING ACCOUNTS 0 Any deposit account with a bank or other financial institution on which a check can be written Negotiable Order of Withdrawal accounts 0 NOW accounts 0 Demand deposits represent money because they are generally accepted as a means of payment DEPOSIT MONEY vs CURRENCY 0 In general checks are preferred to currency 0 Checks provide a written record of payment 0 Checks can be mailed without fear of theft Heath Fienman 1 120 14 ECON Tues Thurs Section 29 Notes Measuring the Money Supply Measuring the Money Supply 0 Currency is printed by the Bureau of Engraving at the request of the Federal Reserve System 0 Currency is issued by the Federal Reserve System 0 Our dollar bills are Federal Reserve NOTES 0 Federal Reserve Notes are accepted because they are Legal Tender M1 Money Used for daytoday transactions Coins and currency held outside banks Demand deposits Traveler s checks Other checkable deposits The types of money included in M1 are HIGHLY LIQUID They can easily and rapidly be transformed into cash PPM Liquid Assets 0 Assets that can be turned into cash rapidly with little loss of value 0 M1 contains those portions of the money supply that are closely connected to current economic activity 0 Money included in M1 is related to money being used as a medium of exchange rather than money being used as a store of value Other Measures of the Money Supply M2 M1 Money market fund shares Savings accounts less than 100000 Small time deposits 0 Small time deposits are certificates of deposits less than 100000 0 M2 is less liquid than M1 0 M2 is partially used as a store of value M3 M2 Large Savings Accounts Over 100000 Large certificates of deposit 0 M2 and M3 relate more to money as a store of value rather than as a medium of exchange 0 M2 is less liquid than M1 but more liquid than M3 Time Deposits Also called certificates of deposit or CD s Time deposits and savings deposits are less liquid than currency and demand deposits 1 If you withdraw your money before a maturity date you lose some interest 2 You need to go back to the bank or savings and loan to make your withdrawal Lack of liquidity 3 Small time deposits less than 100000 4 Large time deposits 100000 or more Money Market Mutual Fund A financial institution accepts money from the public and buys assets such as government bonds Depositors earn interest and can write checks on their accounts Theses are various restrictions on MMMF s which make them less liquid than regular checking accounts 1 2 3 0 Minimum deposit might be 2500 Smallest check allowed might be 500 Each check might cost 250 The interest earned is higher than what an individual investor would earn in a checking account because the funds are invested in large government bonds Heath Fienman 12214 ECON Tues Thurs Section 30 Notes The Commercial Banking System Heath Fienman 124 14 ECON Tues Thurs Section 31 Notes Structure of the Federal Reserve System Federal Reserve System 1 2 3 The central bank of the US Created in 1913 in response to banking crises Not mentioned in the Constitution Fear of a strong central bank having too much power Main Functions of the Federal Reserve System FED 1 Conducts the nation s monetary policy In uences the money supply and interest rates to promote economic goals Clearinghouse for check collection Banker for the Federal government Regulates banks and SampL s since 1980 Helps banks in distress by acting as a lender of last resort Issues paper currency QMPPP Nonprofit organization Earns interest from holding Treasury securities After paying its bills the FED returns the excess interest back to the Treasury Organization of The Fed 1 Board of Governors 7 2 The 12 Federal Reserve District Banks 3 The Federal Open Market Committee 12 Board of Governors 7 members Appointed by president subject to Senate approval Term 14 years One term expires every 2 years during January of even numbered years Cannot be fired Thus they have independence from political forces Unless there are resignations a President can appoint only 2 governors per term Chairman of the Board of Governors The President appoints one of the Governors as Chairman The Chairman serves for 4 years and can be reappointed over and over Alan Greenspan served four terms as chairman 0 President Reagan appointed Greenspan in 1987 reappointed by Bush in 1992 by Clinton in 1996 and by Clinton in 2000 and Bush in 2004 0 Current chairman is Ben Bernanke from Princeton University 0 He was appointed by President Bush and reappointed by President Obama 0 The FED Chairman is one of the most powerful people in the world 0 He dominates the Board of Governors The 12 Federal Reserve District Banks 0 Each district has 9 directors 0 6 elected by region banks 0 3 appointed by Board of governors 0 The 9 directors elect the regional bank president 0 Pittsburgh is in District 4 Ohio Western PA Eastern KY 0 HQ in Cleveland 0 Branch bank on Grant Street The Federal Open Market Committee FOMC 0 12 members 0 7 members of the BOARD OF GOVERNORS 0 President of the NY Federal Reserve Bank 0 4 Presidents from the other 11 district banks on a yearly rotating basis 0 FOMC meets 8 times a year nearly every 6 weeks 0 FOMC decides MONETARY POLICY process by which the monetary authority of a country controls the supply of money often targeting a rate of interest for the purpose of promoting economic growth and stability Heath Fienman 12414 ECON Tues Thurs Section 32 Notes Major Policy Tools of the FED Major Policy Tools 0 Required Reserve Ratio 0 Discount Rate 0 Conduct Open Market Operations TOOLS OF THE FED TOOL 1 REQUIRED RESERVE RATIO 0 The percentage of deposits that a bank must keep as reserves Deposits required reserve ratio 0 54 million 3 Over 54 million 10 0 The Fed can raise or lower the required reserve ratio 0 This affects the amount of money that banks are able to lend to the public EXPANSIONARY MONETARY POLICY LOWER THE REQUIRED RESERVE RATIO 0 This will free up excess reserves that can then be loaned out 0 This will increase the money supply CONTRACTIONARY MONETARY POLICY INCREASE THE REQUIRED RESERVE RATIO This will cause more required reserves to be held 0 Less money will be available to be loaned out This will decrease the money supply Changing the required reserve ratio is used very rarely TOOL 2 THE DISCOUNT RATE 0 The interest rate that banks pay to the Fed when banks need to borrow from the Fed 0 Assume a bank has loaned out too much money or depositors suddenly withdrew money Suddenly the bank has less than the required amount of reserves 0 To get the REQUIRED amount of reserves the bank can ask the Fed for an overnight loan The Fed charges INTEREST on these loans This is the PENALTY for violating the required reserve ratio The rate is called the DISCOUNT RATE The Fed can raise the discount rate or INCREASE THE PENALTY to discourage loans The Fed can lower the discount rate or DECREASE THE PENALTY to encourage loans EXPANSIONARY MONETARY POLICY LOWER THE DISCOUNT RATE A decrease in the discount rate makes it cheaper for banks to borrow from the Fed and encourages banks to borrow from the Fed In a sense the discount rate is the penalty that banks pay for violating the required reserve ratio If the penalty is high banks will be reluctant to make loans when they are near the required reserve limit A decrease in the discount rate sends a SIGNAL to the economy that the Fed wants to stimulate the economy and encourage economic growth CONTRACTIONARY MONETARY POLICY RAISE THE DISCOUNT RATE An increase in the discount rate discourages banks from borrowing from the Fed An increase in the discount rate sends a SIGNAL to the economy that the Fed wants to slow down the economy The discount rate sometimes is changed a few times a year depending on the state of the economy During 1933 the discount rate was 256 During 1939 the discount rate was 10 THE FEDERAL FUNDS RATE The interest a bank pays another bank for an overnight loan Assume a bank cannot meet the reserve requirement The bank needs to acquire extra reserves The bank can borrow from the Fed at the discount window but this is seldom done The bank can borrow from another bank that has excess reserves The Federal Open Market Committee sets targets for the Federal funds rate EXPANSIONARY MONETARY POLICY LOWER THE TARGETED FEDERAL FUNDS RATE POLICY IMPLEMENTED BY THE FOMC A decrease in the Federal funds rate lowers the cost for violating the required reserve ratio 0 A decrease in the Federal funds rate encourages banks to increase their loans to stimulate the economy CONTRACTIONARY MONETARY POLICY RAISE THE TARGETED FEDERAL FUNDS RATE 0 An increase in the Federal funds rate raises the penalty for Violating the required reserve ratio 0 An increase in the Federal funds rate discourages banks from making loans 0 The Federal funds rate has been changed frequently and is usually about a quarter to a half point lower than the discount rate 0 Changes in the targeted Federal funds rate make national headlines and frequently cause major movements in the stock market Heath Fienman 12514 ECON Tues Thurs Section 33 Notes Open Market Operations TOOLS OF THE FED TOOL 3 OPEN MARKET OPERATIONS 0 The purchase or sale of Treasury securities by the Fed in the open market 0 This tool is used to increase or decrease the amount of reserves in the system 0 This in uences the overall money supply and the level of interest rates Policy decisions concerning open market operations are made by the Federal Open Market Committee FOMC TOOLS OF THE FED OPEN MARKET OPERATIONS 0 The purchase or sale of Treasury securities by the Fed in the open market 0 A Fed PURCHASE of securities increases the money supply 0 A Fed SALE of securities decreases the money supply 0 Changing the amount of reserves in the system has a multiplier effect on the overall money supply and in uences the level of interest rates The FEDERAL OPEN MARKET COMMITTEE FOMC determines open market operations EXPANSIONARY MONETARY POLICY AN OPEN MARKET PURCHASE The Fed buys government securities from commercial banks and the general public in the open market The Fed gives a check to the bank The bank s reserves increase The money supply increases The Fed has CREATED money 0 The check is deposited in a bank bank reserves increase and the multiplier process begins The Fed now owns the government bonds and the public has more money The money supply has increased By law the Treasury cannot borrow directly from the Fed Thus the Fed is not permitted to buy bonds from the Treasury This law prohibits the Fed from printing money to finance government spending In many countries the Central Bank prints money to finance government spending This policy can lead to hyperin ation 0 When the Fed conducts an open market operation it usually makes a transaction with a large investment bank 0 Open market purchases and sales are carried out through the New York Federal Reserve Bank 0 Open market operations are by far the most frequently used tool of the Fed to conduct monetary policy CONTRACTIONARY MONETARY POLICY AN OPEN MARKET SALE BY THE FED When the Fed SELLS government securities to the public the Fed is paid by check This removes reserves DEPOSITS from the banking system This DECREASES bank reserves Decreased bank reserves lead to both fewer bank loans and higher interest rates Both effects are CONTRACTIONARY THE ROLE OF THE TREASURY DEPARTMENT The Treasury Department collects taxes and pays the bills of the Federal government If government spending exceeds tax revenue the government has a DEFICIT The Treasury needs to BORROW money to cover the deficit The Treasury issues BONDS and borrows money from the public By law the Treasury cannot borrow directly from the Fed WHEN THE PUBLIC LENDS MONEY TO AND BUYS BONDS FROM THE TREASURY THE MONEY SUPPLY DOES NOT CHANGE 0 The public lends money to the Treasury and receives bonds 0 The bonds represent a legal contract indicating that the Treasury promises to repay its debt plus interest 0 Now the public has less money and the Treasury has more money 0 When the Treasury pays its bills different members of the public receive the money 0 Thus the money changes hands but the amount of money does not change AN OPEN MARKET PURCHASE BY THE FED CAUSES THE MONEY SUPPLY TO INCREASE 0 Suppose the Fed wishes to increase the money supply The Fed writes a check and buys government securities from the public The sellers give up their securities and receive checks that are deposited in banks The Fed has created money out of nothing New bank reserves have been created The money supply has been INCREASED SOME OF THE NATIONAL DEBT IS HELD BY THE PUBLIC SOME OF THE NATIONAL DEBT IS HELD BY THE FED Year 2009 Total Federal debt 123 Trillion Held by Public 70 Trillion 57 Held by Fed 53 Trillion 43 The Treasury pays interest to the public and to the FED This is the cost of borrowing The Fed uses some of its interest income to pay its expenses and returns the remainder to the Treasury THE INTEREST ON THE NATIONAL DEBT IS NOT A LOSS TO THE ECONOMY The interest on the debt is paid out of our taxes Thus the National Debt represents a cost to all taxpayers Some of the interest on the debt is paid to US citizens and US business firms who hold Treasury securities Some interest is paid to foreigners Thus some of the interest on the debt is a TRANSFER PAYMENT from US taxpayers to US bondholders This interest on the debt does not represent a net loss to the US economy The interest on the debt that is paid to US citizens and businesses represents a redistribution of money from taxpayers to bond holders THE INTEREST ON THE NATIONAL DEBT THAT IS PAID TO FOREIGNERS IS NOT A LOSS TO THE ECONOMY The interest on the debt that is paid to foreigners represents a redistribution of money from US taxpayers to foreigners In return for this tax payment US citizens get the benefits of the government project that was financed by the borrowing The loans from foreigners enable US taxpayers to put off paying for the cost of government spending Thus US taxpayers have lower current taxes This represents a BENEFIT OF THE NATIONAL DEBT The COST associated with this is that INTEREST MUST BE PAID CONFLICTS IN ECONOMIC POLICY THE TRADE OFF BETWEEN UNEMPLOYMENT AND INFLATION EXPANSIONARY MONETARY POLICY Suppose the Fed conducts an open market purchase Bank reserves increase Bank loans increase and interest rates decrease These effects promote increases in economic growth total output and employment Similarly all of these effects promote demandpull in ation CONFLICTS IN ECONOMIC POLICY THE TRADE OFF BETWEEN UNEMPLOYMENT AND INFLATION CONTRACTIONARY MONETARY POLICY To slow down in ation the Fed would conduct an open market sale Bank reserves decrease 0 Bank loans decrease and interest rates increase 0 These effects tend to lower in ation rates 0 Similarly all of these effects would reduce growth of output and employment Heath Fienman Macroeconomics CH1 3 and 5 Running List of Vocabulary CH1 The Art and Science of Economic Analysis 1 Economics The study of how people use their scarce resources to satisfy their 9 10 11 12 13 14 15 16 17 18 19 20 21 unlimited wants Resources The inputs or factors of production used to produce the goods and services that people want resources consist of labor capital natural resources and entrepreneurial ability Labor The physical and mental effort used to produce goods and services Capital The buildings equipment and human skills used to produce goods and services Natural Resources All gifts of nature used to produce goods and services includes renewable used indefinitely if used conservatively and exhaustible does not renew itself and is therefore limited resources Entrepreneurial Ability The imagination required to develop a new product or process the skill needed to organize production and the willingness to take the risk of profit or loss Entrepreneur A profitseeking decision maker who starts with an idea organizes an enterprise to bring that idea to life and assumes the risk of the operation Wages Payment to resource workers for their labor Interest Payment to resource owners for the use of their capital Rent Natural Resources Profit Reward for entrepreneurial ability Sales Revenue Resource Cost Good A tangible product used to satisfy human wants Service An activity or intangible product used to satisfy human wants Scarcity Occurs when the amount people desires exceeds the amount available at a zero price Market A set of arrangements by which buyers and sellers carry out exchange at mutually agreeable terms Product Market A market in which a good or service is bought and sold Resource Market A market in which a resource is bought and sold Circular Flow Model A diagram that traces the ow of resources products income and revenue among economic decision makers Rational SelfInterest Each individual tries to maximize the expected benefit achieved with a given cost or to minimize the expected cost of achieving a given benefit Marginal Incremental additional or extra used to describe a change in an economic variable Microeconomics The study of the economic behavior in particular markets such as that for computers or unskilled labor 22 23 24 25 26 27 28 29 30 31 32 33 Macroeconomics The study of economic behavior of entire economies as measured for example by total production and employment Economic Fluctuations The rise and fall of economic activity relative to the long term growth trend of the economy also called business cycles Economic TheoryModel A simplification of reality used to make predictions about cause and effect in the real world Variable A measure such as price or quantity that can take on different values at different times Other Things Constant Assumption The assumption when focusing on the relation among key economic variables that other variables remain unchanged Ceteris paribus Behavioral Assumption An assumption that describes the expected behavior of economic decision makers what motivated them Hypothesis A theory about how key variables relate Positive Economic Statement A statement that can be proved or disproved by reference to facts Normative A statement that re ects an opinion which cannot be proved or disproved by reference to facts Association is Causation Fallacy The incorrect idea that if 2 variables are associated in time one must necessarily cause the other Fallacy of Composition The incorrect belief that what is true for the individual or part must necessarily be true for the group or the whole Secondary Effects Unintended consequences of economic actions that may develop slowly over time as people react to events p x 10 11 12 13 14 15 16 17 18 Chapter 3Economic Decision Makers Foreign Exchange Foreign money needed to carry out international transactions Tariff A tax on imports Quota Legal limit on the quantity of a particular product that can be imported or exported Utility The satisfaction received from consumption the sense of well being Transfer Payments Cash or inkind benefits given to individuals as outright grants from the government Industrial Revolution Development of large scale factory production that began in Great Britain around 1750 and spread to the rest of Europe North America and Australia Firms Economic units formed by profitseeking entrepreneurs who employ resources to produce goods and services for sale Sole Proprietorship Most common A firm with a single owner who has the right to all profits but who also bears unlimited liability for the firm s losses and debts Partnership Least Common A firm with multiple owners who share the profits and bear unlimited financial liability for the firm s losses and debts Corporation Most In uential A legal entity owned by stockholders whose liability is limited to the value of their stock ownership Cooperative An organization consisting of people who pool their resources to buy and sell more efficiently than they could individually Notforprofit Organizations Groups that don t pursue profit as a goal they engage in charitable educational humanitarian cultural professional or other activities often with a social purpose Information Revolution Technological change spawned by the microchip and the internet that enhanced the acquisition analysis and transmission of information Market Failure A condition that arises when the unregulated operation of market yields socially undesirable results Antitrust Laws Prohibitions against price fixing and other anticompetitive practices Monopoly A sole supplier of a product with no close substitutes Natural Monopoly One firm that can supply the entire market at a lower perunit cost than could 2 or more firms Private Good A good such as pizza that is both rival in consumption and exclusive 19 20 21 22 23 24 25 26 27 28 29 30 31 Public Good A good that once produced is available for all to consume regardless of who pays and who doesn t such a good is nonrival and nonexclusive such as a safer community Externality A cost or a benefit that affects neither the buy nor seller but instead affects people not involved in the market transaction Fiscal Policy The use of government purchases transfer payments taxes and borrowing to in uence economy wide variables such as in ation employment and economic growth Monetary Policy Regulation of the money supply to in uence economy wide variables such as in ation employment and economic growth Abilitytopay Tax Principle Those with greater ability to pay such as those earning higher incomes or those owning more property should pay more taxes Benefitsreceived Tax Principle Those who get more benefits from the government program should pay more taxes Tax Incidence The distribution of tax burden among taxpayers who ultimately pays the tax Proportional Taxation The tax as a percentage of income remains constant as income increases also called a at tax Progressive Taxation The tax as a percentage of income increases as income increases Marginal Tax Rate The percentage of each additional dollar of income that goes to the tax Regressive Taxation The tax as a percentage of income decreases as income increases Merchandise Trade Balance The value during a given period of a country s exported goods minus the value of its imported goods Balance of Payments A record of all economic transactions during a given period between residents of one country and residents of the rest of the world 10 ll 13 14 CH 5 Introduction to Macroeconomics Economy The structure of economic activity in a community a region a country or a group of countries or the world Gross Domestic Product GDP Market value of all final goods and services produced in the nation during a particular period usually a year Gross World Product Market value of all final goods and services produced in the world during a given period usually a year Flow Variable A measure of something over an interval of time such as your spending per week Stock Variable A measure of something at a particular point in time such as the amount of money you have with you right now Mercantilism Incorrect theory that a nation s economic objective should be to accumulate precious metals in the public treasury this theory prompted trade barriers to cut imports but other countries retaliated reducing trade and the gains from specialization Expansion A period during which the economy grows as re ected by rising output employment income and other aggregate measures Contraction A period during which the economy declines as re ected by falling output employment income and other aggregate measures Depression A severe and prolonged reduction in economic activity as occurred during the 1930 s Recession A period of decline in economic activity lasting more than a few months as re ected by falling output employment income and other aggregate measures In ation An increase in the economy s average price level 12 Leading Economic Indicators Variables that predict or lead to a recession or recovery examples include consumer confidence stock market prices and big ticket purchases such as cars or homes Aggregate output A composite measure of all final goods and services produced in an economy during a given period real GDP Aggregate Demand The relationship between the economy s price level and aggregate output demanded with other things constant 15 16 17 18 19 20 21 22 23 24 Price level A composite measure re ecting the prices of all goods and services in the economy relative to prices in a base year Real GDP Economy s aggregate output measured in dollars of constant purchasing power Aggregate Demand Curve A curve representing the relationship between the economy s price level and real GDP demanded per period with other things constant Aggregate Supply Curve A curve representing the relationship between the economy s price level and real GDP supplied per period with other things constant Federal Budget Deficit A ow variable measuring the amount by which the federal government outlays exceed federal government revenues in a particular period usually a year Demandside Economics Macroeconomic policy that focuses on shifting the aggregate demand curve as a way of promoting full employment and price stability Stag ation A contraction or stagnation of a nation s output by in ation in the price level Supplyside Economics Macroeconomic policy that focuses on a rightward shift of the supply curve through tax cuts or other changes to increase production incentives Federal Debt A stock variable that measures the net accumulation of annual federal deficits Real GDP per capita Real GDP divided by the population the best measure of an economy s standard of living
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