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URI / Economics / ECN 202 / what is Division of labor?

what is Division of labor?

what is Division of labor?


School: University of Rhode Island
Department: Economics
Course: Macroeconomics
Professor: Liam malloy
Term: Spring 2016
Tags: ECN202, ECN, Macro, Macroeconomics, final, and final study guide
Cost: 50
Name: ECN202 Final Exam Study Guide
Description: Covers everything that will be on the test. Study guide condenses each chapter into approximately 3 pages of material to study. Covers Chapter 1: Welcome to Economics, Chapter 2: Choice in a World of
Uploaded: 05/03/2016
40 Pages 4 Views 11 Unlocks

Marco Bruen (Rating: )

If you want to pass this class, use these notes. Period. I for sure will!

Macroeconomics Study Guide for the Final

what is Division of labor?

Chapter 1: Welcome to Economics 

1.1: What Economics is and Why It’s Important 

• Economics is the study of how humans make decisions in the face of scarcity.  The Problem of Scarcity:

• Scarcity means that human wants for goods, services and resources exceed what is available.  The Division of and Specialization of Labor:

• Division of labor means that the way a good or service is produced is divided into a number of  tasks that are performed by different workers, instead of all the tasks being done by the same  person.  

• Specialization in a particular small job allows workers to focus on the parts of the production  process where they have an advantage.  

o Workers who specialize in certain tasks often learn to produce more quickly and with  higher quality.  

• Economies of scale means that for many goods, as the level of production increases, the average  cost of producing each individual unit declines.  

what is Specialization?

We also discuss several other topics like What is a watershed?

Trade and Markets:

• Specialization requires trade.  

• Instead of trying to acquire all the knowledge and skills involved in producing all of the goods and  services that you wish to consume, the market allows you to learn a specialized set of skills and  then use the pay you receive to buy the goods and services you need or want.  

1.2: Microeconomics and Macroeconomics 

• Microeconomics focuses on the actions of individual agents within the economy, like households,  workers, and businesses  

• Macroeconomics looks at the economy as a whole. It focuses on broad issues such as growth of  production, the number of unemployed people, the inflationary increase in prices, government  deficits, and levels of exports and imports.  Don't forget about the age old question of who published an unfavorable review of research on psychotherapy outcome in 1953?
Don't forget about the age old question of What is pollination?


• The theory of consumer behavior and the theory of the firm.  


what is Economies of scale?

• An economy's macroeconomic health can be defined by a number of goals: growth in the standard  of living, low unemployment, and low inflation  

• Monetary policy, which involves policies that affect bank lending, interest rates, and financial  capital markets, is conducted by a nation’s central bank. For the United States, this is the Federal  Reserve.  

• Fiscal policy, which involves government spending and taxes, is determined by a nation’s  legislative body. For the United States, this is the Congress and the executive branch, which  originates the federal budget.  

1.3: How Economists Use Theories and Models to Understand Economic Issues • A theory is a simplified representation of how two or more variables interact with each other. The  purpose of a theory is to take a complex, real-world issue and simplify it down to its essentials. If  done well, this enables the analyst to understand the issue and any problems around it. A good  theory is simple enough to be understood, while complex enough to capture the key features of the  object or situation being studied.  

• A good model to start with in economics is the circular flow diagram. It pictures the economy as  consisting of two groups—households and firms—that interact in two markets: the goods and  services market in which firms sell and households buy and the labor market in which  households sell labor to business firms or other employees.  We also discuss several other topics like what is Semantic Memory?

• The circular flow diagram shows how households and firms interact in the goods and services  market, and in the labor market. The direction of the arrows shows that in the goods and services

market, households receive goods and services and pay firms for them. In the labor market,  households provide labor and receive payment from firms through wages, salaries, and benefits.  • In the diagram, firms produce goods and services, which they sell to households in return for  revenues. This is shown in the  We also discuss several other topics like what is Incomplete protein?

outer circle, and represents the two  

sides of the product market in  

which households demand and  

firms supply. Households sell their  

labor as workers to firms in return  

for wages, salaries and benefits.  

This is shown in the inner circle  

and represents the two sides of the  

labor market in which households  

supply and firms demand.  

1.4: How Economics Can Be Organized: 

An Overview of Economic Systems 

• Traditional economy: the oldest  

economic system. Traditional  

economies organize their economic  

affairs the way they have always done (i.e., tradition).  

o Because things are driven by tradition, there is little economic progress or development.  • Command economy: economic effort is devoted to goals passed down from a ruler or ruling  class.  

o In a command economy, the government decides what goods and services will be  produced and what prices will be charged for them. The government decides what  methods of production will be used and how much workers will be paid. Many  

necessities like healthcare and education are provided for free.  Don't forget about the age old question of What is apgar scale?

• A market is an institution that brings together buyers and sellers of goods or services, who may  be either individuals or businesses.  

o Market economy: decision- making is decentralized.  

o Market economies are based on private enterprise: the means of production (resources  and businesses) are owned and operated by private individuals or groups of private  individuals. Businesses supply goods and services based on demand.  

Regulations: The Rules of the Game:

• There is no such thing as an absolutely free market.  

• Heavily regulated economies often have underground economies, which are markets where the  buyers and sellers make transactions without the government’s approval.  

The Rise of Globalization:

• Globalization is the expanding cultural, political, and economic connections between people  around the world.  

• Exports are the goods and services that are produced domestically and sold abroad.  • Imports are the goods and services that are produced abroad and then sold domestically.  • The size of total production in an economy is measured by the gross domestic product (GDP).  

Thus, the ratio of exports divided by GDP measures what share of a country’s total economic  production is sold in other countries.  

• In recent decades, the export/GDP ratio has generally risen, both worldwide and for the U.S.  economy.  

Chapter 2: Choice in a World of Scarcity 

Introduction to Choice in a World of Scarcity:

• Because people live in a world of scarcity, they cannot have all the time, money, possessions, and  experiences they wish. Neither can society.

2.1: How Individuals Make Choices Based on Their Budget Constraint 

• A budget constraint is the outer boundary of a  

person’s opportunity set. The opportunity set  

identifies all the opportunities for spending  

within their budget. The budget constraint  

indicates all the combinations of goods the  

person can afford when they exhaust their  

budget, given the prices of the two goods.  

• Any point outside the constraint is not affordable

The Concept of Opportunity Cost:

• Opportunity cost indicates what must be given  

up to obtain something that is desired.  

o Opportunity cost is the value of the next best alternative.  

• Every choice has an opportunity cost.  

• Budget = P1 X Q1 + P2 X Q2

Identifying Opportunity Cost:

• In many cases, it is reasonable to refer to the opportunity cost as the price.  

Marginal Decision-Making and Diminishing Marginal Utility:

• Marginal analysis means comparing the benefits and costs of choosing a little more or a little less  of a good.  

• Satisfaction is utility  

• The law of diminishing marginal utility states that as a person receives more of a good, the  additional (or marginal) utility from each additional unit of the good declines.  

Sunk Costs:

• Sunk costs are costs that were incurred in the past and cannot be recovered,  

o Sunk costs should not affect the current decision.  

From a Model with Two Goods to One of Many Goods:

• Instead of drawing just one budget constraint, showing the tradeoff between two goods, you can  draw multiple budget constraints, showing the possible tradeoffs between many different pairs of  goods.  

2.2: The Production Possibilities Frontier and Social Choices 

• The constraints faced by society can be shown using a model called the production possibilities  frontier (PPF).  

• The production possibilities frontier plays the  

same role for society as the budget constraint  

plays for a person.

o Society can choose any combination  

of the two goods on or inside the  

PPF. But it does not have enough  

resources to produce outside the PPF.  

• Difference between a budget constraint and a  


o The first is the fact that the budget  

constraint is a straight line. This is  

because its slope is given by the  

relative prices of the two goods. In  

contrast, the PPF has a curved shape  

because of the law of the diminishing returns.  

o The second is the absence of specific numbers on the axes of the PPF. There are no  specific numbers because we do not know the exact amount of resources this imaginary  economy has.

The Shape of the PPF and the Law of Diminishing Returns:

• The law of diminishing returns holds that as additional increments of resources are added to a  certain purpose, the marginal benefit from those additional increments will decline.  o The law of diminishing returns produces the outward- bending shape of the production  possibilities frontier.  

Productive Efficiency and Allocative Efficiency:

• Productive efficiency means that, given the available inputs and technology, it is impossible to  produce more of one good without decreasing the quantity that is produced of another good.  • Allocative efficiency means that the particular mix of goods a society produces represents the  combination that society most desires.  

o Allocative efficiency means producers supply the quantity of each product that  consumers demand.  

• Only one of the productively efficient choices will be the allocatively efficient choice for society  as a whole.  

Why Society Must Choose:

• Every economy faces two situations in which it may be able to expand consumption of all goods.  o If a society improves efficiency and production on the production possibilities frontier, it  can have more of all goods

o In the second case, as resources grow over a period of years (e.g., more labor and more  capital), the economy grows. As it does, the production possibilities frontier for a society  will tend to shift outward and society will be able to afford more of all goods.  

The PPF and Comparative Advantage:

• Countries tend to have different opportunity costs of producing a specific good, either because of  different climates, geography, technology or skills.  

• When a country can produce a good at a lower opportunity cost than another country, we say that  this country has a comparative advantage in that good.  

• Countries’ differences in comparative advantage determine which goods they will choose to  produce and trade.  

• With trade, goods are produced where the opportunity cost is lowest, so total production increases,  benefiting both trading parties.  

2.3: Confronting Objections to the Economic Approach 

• When thinking about the economic actions of groups of people, firms, and society, it is reasonable,  as a first approximation, to analyze them with the tools of economic analysis

• Positive economic statements describe the world as it is.

• Normative economic statements describe how the world should be.  

• The invisible hand is an idea that self-interested behavior by individuals can lead to positive social  outcomes  

o The metaphor of the invisible hand suggests the remarkable possibility that broader social  good can emerge from selfish individual actions.  

Chapter 3: Demand and Supply 

Introduction to Demand and Supply:

• The discussion here begins by examining how demand and supply determine the price and the  quantity sold in markets for goods and services, and how changes in demand and supply lead to  changes in prices and quantities.  

3.1: Demand, Supply, and Equilibrium in Markets for Goods and Services 

Demand for Goods and Services:

• Demand to refer to the amount of some good or service consumers are willing and able to  purchase at each price.  

• What a buyer pays for a unit of the specific good or service is called price.  

• The total number of units purchased at that price is called the quantity demanded.  • A rise in price of a good or service almost always decreases the quantity demanded of that good or  service. Conversely, a fall in price will increase the quantity demanded.

• Economists call this inverse relationship between price and quantity demanded the law of  demand.  

• A table that shows the quantity demanded at each price is called a demand schedule.  • A demand curve shows the relationship between price and quantity demanded, with quantity on  the horizontal axis and the price on the vertical axis  

• Demand refers to the curve and quantity demanded refers to the (specific) point on the curve.  Supply of Goods and Services:

• Supply is the amount of some good or service a producer is willing to supply at each price.  • A rise in price almost always leads to an increase in the quantity supplied of that good or service,  while a fall in price will decrease the quantity supplied.  

• Economists call this positive relationship between price and quantity supplied—that a higher price  leads to a higher quantity supplied and a lower price leads to a lower quantity supplied—the law  of supply.  

• Supply refers to the curve and quantity supplied refers to the (specific) point on the curve.  • A supply schedule is a table that shows the quantity supplied at a range of different prices.  • A supply curve is a graphic illustration of the relationship between price, shown on the vertical  axis, and quantity, shown on the horizontal axis.  

Equilibrium- Where Demand and Supply Intersect:

• Together, demand and supply determine the price and the quantity that will be bought and sold in  a market.  

• The point where the supply curve (S) and the demand curve (D) cross, is called the equilibrium.  • The equilibrium price is the only price where the plans of consumers and the plans of producers  agree—that is, where the amount of the product consumers want to buy (quantity demanded) is  equal to the amount producers want to sell (quantity supplied).  

o This common quantity is called the equilibrium quantity.  

• The word “equilibrium” means “balance.”  

• At any above-equilibrium price, the quantity  

supplied exceeds the quantity demanded.  

We call this an excess supply or a surplus.  

• When the price is below equilibrium, there  

is excess demand, or a shortage—that is, at  

the given price the quantity demanded,  

which has been stimulated by the lower  

price, now exceeds the quantity supplied,  

which had been depressed by the lower  


3.2: Shifts in Demand and Supply for Goods and  


What Factors Affect Demand?:

• Willingness to purchase suggests a desire,  

based on what economists call tastes and  


• Ability to purchase suggests that income is important.  

The Ceteris Paribus Assumption:

• Ceteris paribus assumes that all else is held equal.  

How Does Income Affect Demand?:

• A shift in a demand curve captures a pattern for the market as a whole.  

• A product whose demand rises when income rises, and vice versa, is called a normal good.  • A product whose demand falls when income rises, and vice versa, is called an inferior good.  Other Factors That Shift the Demand Curves:

• Movements in taste, which change the quantity of a good demanded at every price: that is, they  shift the demand curve for that good

• Changes in the size and composition of the population can affect the demand for housing and  many other goods. Each of these changes in demand will be shown as a shift in the demand curve.  • A substitute is a good or service that can be used in place of another good or service.  

• Complements mean that the goods are often used together, because consumption of one good  tends to enhance consumption of the other.  

• A shift in demand happens when a change in some economic factor (other than price) causes a  different quantity to be demanded at every price.  

Summing Up Factors That Change Demand:

How Production Costs Affect Supply:

• A shift in supply means a change in the quantity supplied at every price.  

• Goods and services are produced using combinations of labor, materials, and machinery, or what  we call inputs or factors of production.  

Other Factors That Affect Supply:

• A drought means that at any given price, a lower quantity will be supplied; conversely, especially  good weather would shift the supply curve to the right.  

• When a firm discovers a new technology that allows the firm to produce at a lower cost, the  supply curve will shift to the right,  

• A technological improvement that reduces costs of production will shift supply to the right, so that  a greater quantity will be produced at any given price.  

• Government policies can affect the cost of production and the supply curve through taxes,  regulations, and subsidies.  

o A subsidy occurs when the government pays a firm directly or reduces the firm’s taxes if  the firm carries out certain actions.  

o Taxes or regulations are an additional cost of production that shifts supply to the left,  

leading the firm to produce a lower quantity at every given price

o Government subsidies reduce the cost of production and increase supply at every given  

price, shifting supply to the right.  

Summing Up Factors That Change Supply:

3.3: Changes in Equilibrium Price and Quantity: The Four-Step Process 

• Step 1. Draw a demand and supply model before the economic change took place. To establish the  model requires four standard pieces of information: The law of demand, which tells us the slope of  the demand curve; the law of supply, which gives us the slope of the supply curve; the shift  

variables for demand; and the shift variables for supply. From this model, find the initial  

equilibrium values for price and quantity.  

• Step 2. Decide whether the economic change being analyzed affects demand or supply. In other words, does the event refer to something in the list of demand factors or supply factors?  

• Step 3. Decide whether the effect on demand or supply causes the curve to shift to the right or to  the left, and sketch the new demand or supply curve on the diagram. In other words, does the  

event increase or decrease the amount consumer want to buy or producers want to sell?  

• Step 4. Identify the new equilibrium and then compare the original equilibrium price and quantity  to the new equilibrium price and quantity.  

3.4: Price Ceilings and Price Floors 

Price Ceilings:

• Laws that government enacts to regulate prices are called Price controls  

• A price ceiling keeps a price from rising above a certain level (the “ceiling”), while a price floor  keeps a price from falling below a certain level (the “floor”).  


• When the market price is not allowed to  

rise to the equilibrium level, quantity  

demanded exceeds quantity supplied,  

and thus a shortage occurs. Those who  

manage to purchase the product at the  

lower price given by the price ceiling  

will benefit, but sellers of the product  

will suffer, along with those who are  

not able to purchase the product at all.  

Quality is also likely to deteriorate.  

Price Floors:

• Price floors are sometimes called “price  


• The result is a quantity supplied in  

excess of the quantity demanded (Qd).  

When quantity supplied exceeds quantity demanded,  

a surplus exists.  

• Neither price ceilings nor price floors cause demand  

or supply to change. They simply set a price that

limits what can be legally charged in the market.  

o Remember, changes in price do not cause demand or supply to change. Price ceilings and  price floors can cause a different choice of quantity demanded along a demand curve, but  they do not move the demand curve. Price controls can cause a different choice of  `quantity supplied along a supply curve, but they do not shift the supply curve.  

3.5: Demand, Supply, and Efficiency 

Consumer Surplus, Producer Surplus, Social Surplus:

• The amount that individuals would have been willing to  

pay, minus the amount that they actually paid, is called  

consumer surplus. Consumer surplus is the area labeled  

F—that is, the area above the market price and below the  

demand curve.

• The amount that a seller is paid for a good minus the  

seller’s actual cost is called producer surplus.  

o Producer surplus is the area between the market  

price and the segment of the supply curve below  

the equilibrium.  

• The sum of consumer surplus and producer surplus is  

social surplus, also referred to as economic surplus or  

total surplus. In the figure, social surplus is the area F +  


o Social surplus is larger at equilibrium quantity  

and price than it would be at any other quantity.  

Inefficiency of Price Floors and Price Ceilings:

• The imposition of a price floor or a price ceiling will prevent a market from adjusting to its  equilibrium price and quantity, and thus will create an inefficient outcome.  

• Along with creating inefficiency, price floors and ceilings will also transfer some consumer  surplus to producers, or some producer surplus to consumers.  

• The loss in social surplus that occurs when the economy produces at an inefficient quantity is  called deadweight loss. In a very real sense, it is like money thrown away that benefits no one. In  the figure, the deadweight loss is the area U + W.  

• A second change from the price ceiling is that some of the producer surplus is transferred to  consumers.  

• The price ceiling transfers the area of surplus (V) from producers to consumers.  o A price ceiling will transfer some producer surplus to consumers—which helps to explain  why consumers often favor them.  

• A price floor will transfer some consumer surplus to producers, which explains why producers  often favor them.  

• Both price floors and price ceilings block some transactions that buyers and sellers would have  been willing to make, and creates deadweight loss. Removing such barriers, so that prices and  quantities can adjust to their equilibrium level, will increase the economy’s social surplus.

Demand and Supply as a Social Adjustment Mechanism:

• The demand and supply model emphasizes that prices are not set only by demand or only by  supply, but by the interaction between the two.  

Chapter 4: Labor and Financial Markets 

Introduction to Labor and Financial Markets:

• Labor markets are markets for employees or jobs. Financial services markets are markets for  saving or borrowing.  

• In labor markets job seekers (individuals) are the suppliers of labor, while firms and other  employers who hire labor are the demanders for labor.  

• In financial markets, any individual or firm who saves contributes to the supply of money, and any  who borrows (person, firm, or government) contributes to the demand for money.  

4.1: Demand and Supply at Work in Labor Markets 

• The law of demand applies in labor markets this way: A higher salary or wage—that is, a higher  price in the labor market—leads to a  

decrease in the quantity of labor  

demanded by employers, while a  

lower salary or wage leads to an  

increase in the quantity of labor  


• The law of supply functions in labor  

markets, too: A higher price for labor  

leads to a higher quantity of labor  

supplied; a lower price leads to a  

lower quantity supplied.  

Equilibrium in the Labor Market:

• At equilibrium, the quantity supplied  

and the quantity demanded are equal.  

Shifts in Labor Demand:

• The demand curve for labor shows the quantity of labor employers wish to hire at any given salary  or wage rate  

• A change in the wage or salary will result in a change in the quantity demanded of labor.  o If the wage rate increases, employers will want to hire fewer employees. The quantity of  labor demanded will decrease, and there will be a movement upward along the demand  


o If the wages and salaries decrease, employers are more likely to hire a greater number of

workers. The quantity of labor demanded will increase, resulting in a downward  

movement along the demand curve.  

• The demand for labor is based on the demand for the good or service that is being produced.  o Therefore the demand for labor is called a “derived demand.”  

• As the demand for the goods and services increases, the demand for labor will increase, or shift to  the right, to meet employers’ production requirements. As the demand for the goods and services  decreases, the demand for labor will decrease, or shift to the left.  

• When the demand for the good produced (output) increases, both the output price and profitability  increase. As a result, producers demand more labor to ramp up production.  

• Technology changes can act as either substitutes for or complements to labor. When technology  acts as a substitute, it replaces the need for the number of workers an employer needs to hire. An  increase in the availability of certain technologies may increase the demand for labor. Technology  that acts as a complement to labor will increase the demand for certain types of labor, resulting in  a rightward shift of the demand curve.  

o More and better technology will increase demand for skilled workers who know how to  use technology to enhance workplace productivity. Those workers who do not adapt to  changes in technology will experience a decrease in demand.  

• An increase in the number of companies producing a given product will increase the demand for  labor resulting in a shift to the right. A decrease in the number of companies producing a given  product will decrease the demand for labor resulting in a shift to the left.  

• Complying with government regulations can increase or decrease the demand for labor at any  given wage.  

• As the amount of inputs increases, the demand for labor will increase. As the quantity of other  inputs decreases, the demand for labor will decrease.  

• Similarly, if prices of other inputs fall, production will become more profitable and suppliers will  demand more labor to increase production. The opposite is also true. Higher input prices lower  demand for labor .

Shifts in Labor Supply:

• The supply of labor is upward sloping and adheres to the law of supply: The higher the price, the  greater the quantity supplied and the lower the price, the less quantity supplied.  

• An increased number of workers will cause the supply curve to shift to the right.  o An increased number of workers can be due to several factors, such as immigration,  increasing population, an aging population, and changing demographics.  

• The more required education, the lower the supply.  

• Government policies can also affect the supply of labor for jobs.  

o On the one hand, the government may support rules that set high qualifications for certain  jobs. When these qualifications are made tougher, the number of qualified workers will  decrease at any given wage.  

o On the other hand, the government may also subsidize training or even reduce the  required level of qualifications. Such provisions would shift the supply curve to the right.  o In addition, government policies that change the relative desirability of working versus  not working also affect the labor supply. These include unemployment benefits,  

maternity leave, child care benefits and welfare policy.  

• A change in salary will lead to a movement along labor demand or labor supply curves, but it will  not shift those curves.  

Technology and Wage Inequality: The Four-Step Process:

• Step 1. What did the markets for low-skill labor and high-skill labor look like before the arrival of  the new technologies?  

• Step 2. Does the new technology affect the supply of labor from households or the demand for  labor from firms?  

• Step 3. Will the new technology increase or decrease demand?  

• Step 4. The new equilibrium

Price Floors in the Labor Market: Living Wages and Minimum Wages:

• The U.S. government sets a minimum wage, a price floor that makes it illegal for an employer to  pay employees less than a certain hourly rate.  

• A living wage is a wage that ensures a reasonable standard of living

o Promoters of living wage laws maintain that the minimum wage is too low to ensure a  reasonable standard of living.  

• At the price floor, the quantity supplied exceeds the quantity demanded, and a surplus of labor  exists in this market. For workers who continue to have a job at a higher salary, life has improved.  For those who were willing to work at the old wage rate but lost their jobs with the wage increase,  life has not improved.  

The Minimum Wage as an Example of a Price Floor:

• Let’s suppose that the minimum wage lies just slightly below the equilibrium wage level. Wages  could fluctuate according to market forces above this price floor, but they would not be allowed to  move beneath the floor. In this situation, the price floor minimum wage is said to be nonbinding —that is, the price floor is not determining the market outcome.  

4.2: Demand and Supply in Financial Markets 

• Financial capital means savings

• Those who save money (or make financial investments, which is the same thing), whether  individuals or businesses, are on the supply side of the financial market. Those who borrow money  are on the demand side of the financial market.  

Who Demands and Who Supplied in Financial Markets?:

• The price is what suppliers receive and what demanders pay. In financial markets, those who  supply financial capital through saving expect to receive a rate of return, while those who demand  financial capital by receiving funds expect to pay a rate of return.  

• The interest paid to you as a percent of your deposits is the interest rate.  

• Law of demand: a higher  

rate of return (that is, a  

higher price) will decrease  

the quantity demanded.  

• Consequently, as the  

interest rate paid on credit  

card borrowing rises, more  

firms will be eager to  

issue credit cards and to  

encourage customers to  

use them.  

Equilibrium in Financial  


• If the interest rate  

(remember, this measures  

the “price” in the financial market) is above the equilibrium level, then an excess supply, or a  surplus, of financial capital will arise in this market  

• If the interest rate is below the equilibrium, then excess demand or a shortage of funds occurs in  this market.  

Shifts in Demand and Supply in Financial Markets:

• Participants in financial markets must decide when they prefer to consume goods: now or in the  future.  

• This is called intertemporal decision making because it  

involves decisions across time.  

• Social Security has shifted the supply of financial capital at  

any interest rate to the left because workers save more.  

• When consumers and businesses have greater confidence that  

they will be able to repay in the future, the quantity demanded

of financial capital at any given interest rate will shift to the right.  

The United States as a Global Borrower:

• The graph shows the demand for financial capital and supply of financial capital into the U.S.  financial markets by the foreign sector before and after the increase in uncertainty regarding U.S.  public debt. The original equilibrium (E0) occurs at an eqsuilibrium rate of return (R0) and the  equilibrium quantity is at Q0.  

• Thus, foreign investors’ diminished enthusiasm leads to a new equilibrium, E1, which occurs at  the higher interest rate, R1, and the lower quantity of financial investment, Q1.  

Price Ceilings in Financial Markets: Usury Laws:

• At the price ceiling (Rc), quantity demanded will exceed  

quantity supplied. Consequently, a number of people who  

want to have credit cards and are willing to pay the  

prevailing interest rate will find that companies are  

unwilling to issue cards to them. The result will be a  

credit shortage.  

• Usury laws impose an upper limit on the interest rate that  

lenders can charge.  

4.3: The Market System as an Efficient Mechanism for 


• An increase in the price of some product signals  

consumers that there is a shortage and the product should  

perhaps be economized on.  

• Those who seek price controls are trying to stifle an  

unwelcome message that prices are bringing about the equilibrium level of price and quantity. But  price controls do nothing to affect the underlying forces of demand and supply, and this can have serious repercussions.  

• Without this information, it becomes difficult for everyone—buyers and sellers alike—to react in  a flexible and appropriate manner as changes occur throughout the economy.  

Chapter 6: The Macroeconomic Perspective 

Introduction to the Macroeconomic Perspective:

• Three primary goals: economic growth, low unemployment, and low inflation.  • Economic growth ultimately determines the prevailing standard of living in a country. Economic  growth is measured by the percentage change in real (inflation-adjusted) gross domestic product.  • Unemployment, as measured by the unemployment rate, is the percentage of people in the labor  force who do not have a job but want to work.  

• Inflation is a sustained increase in the overall level of prices, and is measured by the consumer  price index.  

• Low inflation—an inflation rate of 1–2%—is a major goal.  

• We use the theories of aggregate demand (AD) and aggregate supply (AS). This book presents two  perspectives on macroeconomics: the Neoclassical perspective and the Keynesian perspective  • Monetary and fiscal policy influence the macroeconomy

6.1: Measuring the Size of the Economy: Gross Domestic Product 

• The size of a nation’s overall economy is typically measured by its gross domestic product  (GDP), which is the value of all final goods and services produced within a country in a given  year.  

o This task is straightforward: take the quantity of everything produced, multiply it by the  price at which each product sold, and add up the total.  

• Each of the market transactions that enter into GDP must involve both a buyer and a seller. The  GDP of an economy can be measured either by the total dollar value of what is purchased in the  economy, or by the total dollar value of what is produced.

GDP Measured by Components of Demand:

• This demand can be divided into four main parts: consumer spending (consumption), business  spending (investment), government spending on goods and services, and spending on net exports.  • Consumers’ spending decisions are the largest part of GDP.  

• Investment expenditure refers to purchases of physical plant and equipment, primarily by  businesses.  

• The only part of government spending counted in demand is government purchases of goods or  services produced in the economy.  

• Payments such as social security and Medicare are excluded from GDP because the government  does not receive a new good or service in return or exchange.  

• We must also subtract spending on imports—goods produced in other countries that are purchased  by residents of this country.  

• The net export component of GDP is equal to the dollar value of exports (X) minus the dollar  value of imports (M), (X – M).  

o The gap between exports and imports is called the trade balance. If a country’s exports  are larger than its imports, then a country is said to have a trade surplus.  

• GDP = Consumption + Investment + Government + Trade Balance (Exports-Imports) • GDP = C + I + G + (X – M)

GDP Measured by What is Produced:

• GDP must be the same whether measured by what is demanded or by what is produced.  • The largest part of GDP is services.  

• Inventories is a small category that refers to the goods that have been produced by one business  but have not yet been sold to consumers

The Problem of Double Counting:

• GDP is defined as the current value of all final goods and services produced in a nation in a year.  Final goods are goods at the furthest stage of production at the end of a year.  

• Double counting is when output is counted more than once as it travels through the stages of  production.  

• Only final goods and services are counted in GDP

o Intermediate goods, which are goods that go into the production of other goods, are  excluded from GDP calculations  

• The concept of GDP is fairly straightforward: it is just the dollar value of all final goods and  services produced in the economy in a year.  

What is Counted in GDP:

• Consumption, business, investment, government spending on goods and services, and net exports What is not included in GDP:

• Intermediate goods, transfer payments, non-market activities, used goods, and illegal goods  Other Ways to Measure the Economy:

• We mentioned above that GDP can be thought of as total production and as total purchases. It can  also be thought of as total income since anything produced and sold produces income.  • Gross national product (GNP) adds what is produced by domestic businesses and labor abroad,  and subtracts out any payments sent home to other countries by foreign labor and businesses  located in the United States. In other words, GNP is based more on the production of citizens and  firms of a country, wherever they are located.

• Net national product (NNP) is calculated by taking GNP and then subtracting the value of how  much physical capital is worn out, or reduced in value because of aging, over the course of a year.  o The process by which capital ages and loses value is called depreciation.  

• National income, which includes all income to businesses and individuals, and personal income,  which includes only income to people.  

6.2: Adjusting Nominal Values to Real Values 

• The distinction between nominal and real measurements refers to whether or not inflation has  distorted a given statistic.

o The nominal value of any economic statistic means the statistic is measured in terms of  actual prices that exist at the time.  

o The real value refers to the same statistic after it has been adjusted for inflation.  Generally, it is the real value that is more important.  

Converting Nominal to Real GDP:

• GDP deflator is a price index measuring the average prices of all goods and services included in  the economy.  

• Nominal GDP can rise for two reasons: an increase in output, and/or an increase in prices.  • Real GDP = !"#$%&' !"# 

!"#$! !"#$%�100

o A price index is a two-digit decimal number  

• ���� �����ℎ ���� = !"#$ !"# (!!)!!"#$ !"# (!!)

!"#$ !"# (!!)� 100 = % �ℎ����

• Real GDP = Price X Quantity

• % Change in Real GDP = % Change in Price + % Change in Quantity

6.3: Tracking Real GDP over Time 

• A significant decline in real GDP is called a recession.  

• An especially lengthy and deep recession is called a depression.  

• When real GDP rises, so does employment.  

• The highest point of the economy, before the recession begins, is called the peak; conversely, the  lowest point of a recession, before a recovery begins, is called the trough.  

o A recession lasts from peak to trough  

o An economic upswing runs from trough to peak.  

• The movement of the economy from peak to trough and trough to peak is called the business  cycle.  

6.4: Comparing GDP among Countries 

• Comparing GDP between two countries requires converting to a common currency.  • If we are trying to compare standards of living across countries, we need to divide GDP by  population.  

Converting Currencies with Exchange Rates:

• It is necessary to convert to a “common denominator” using an exchange rate, which is the value  of one currency in terms of another currency.  

• Market exchange rates vary on a day-to-day basis depending on supply and demand in foreign  exchange markets. PPP-equivalent exchange rates provide a longer run measure of the exchange  rate.  

o PPP-equivalent exchange rates are typically used for cross-country comparisons of GDP.  GDP Per Capita:

• GDP per capita is the GDP divided by the population.  

• GDP per capita = GDP/Population

6.5: How Well GDP Measures the Well-Being of Society 

• While GDP focuses on production that is bought and sold in markets, standard of living includes  all elements that affect people’s well-being, whether they are bought and sold in the market or not.  

Limitations of GDP as a Measure of the Standard of Living:

• GDP does not cover leisure time.  

• GDP does not include actual levels of environmental cleanliness, health, and learning.  • GDP does not address whether the air and water are actually cleaner or dirtier.  • GDP does not address whether life expectancy or infant mortality have risen or fallen  • GDP does not address directly how much of the population can read, write, or do basic  mathematics.  

• GDP does not cover production that is not exchanged in the market.  

• As women are now in the labor force, many of the services they used to produce in the non-market

economy like food preparation and child care have shifted to some extent into the market  economy, which makes the GDP appear larger even if more services are not actually being  consumed.  

• GDP has nothing to say about the level of inequality in society. GDP per capita is only an average.  • GDP also has nothing in particular to say about the amount of variety available.  • GDP has nothing much to say about what technology and products are available.  

Does a Rise in GDP Overstate or Understate the Rise in the Standard of Living?: • In some ways, the rise in GDP understates the actual rise in the standard of living.  o Because GDP does not capture leisure, health, a cleaner environment, the possibilities  created by new technology, or an increase in variety, the actual rise in the standard of  living for Americans in recent decades has exceeded the rise in GDP.  

GDP is Rough, but Useful:

• Even though GDP does not measure the broader standard of living with any precision, it does  measure production well and it does indicate when a country is materially better or worse off in  terms of jobs and incomes  

Chapter 7: Economic Growth 

Introduction to Economic Growth:

• Dramatic improvements in a nation’s standard of living are possible.  

• Period of modern economic growth refers to the last two centuries

• Rapid and sustained economic growth is a relatively recent experience for the human race.  • The Industrial Revolution refers to the widespread use of power-driven machinery and the  economic and social changes that resulted in the first half of the 1800s.  

• The new jobs of the Industrial Revolution typically offered higher pay and a chance for social  mobility. New inventions and investments generated profits, the profits provided funds for new  investment and inventions, and the investments and inventions provided opportunities for further  profits.  

• The Industrial Revolution began in Great Britain, and soon spread to the United States, Germany,  and other countries.  

• Most people today are better fed, clothed, and housed than their predecessors two centuries ago.  They are healthier, live longer, and are better educated.  

Rule of Law and Economic Growth:

• Economic growth depends on many factors.  

• Key among those factors is adherence to the rule of law and protection of property rights and  contractual rights by a country’s government so that markets can work effectively and  efficiently.  

o Laws must be clear, public, fair, enforced, and equally applicable to all members of  society.  

• Property rights are the rights of individuals and firms to own property and use it as they see fit.  • The definition of property includes physical property as well as the right to your training and  experience, especially since your training is what determines your livelihood.  

• Contractual rights are based on property rights and they allow individuals to enter into agreements  with others regarding the use of their property providing recourse through the legal system in the  event of noncompliance.  

• The World Bank considers a country’s legal system effective if it upholds property rights and  contractual rights.  

7.2: Labor Productivity and Economic Growth

• Sustained long-term economic growth comes from increases in worker productivity, which  essentially means how well we do things.  

• Labor productivity is the value that each employed person creates per unit of his or her input.  o Being more productive essentially means you can do more in the same amount of time.

This in turn frees up resources to be used elsewhere.  

o The first determinant of labor productivity is human capital. Human capital is the  accumulated knowledge (from education and experience), skills, and expertise that the  average worker in an economy possesses. Typically the higher the average level of  education in an economy, the higher the accumulated human capital and the higher the  labor productivity.  

o The second factor that determines labor productivity is technological change.  Technological change is a combination of invention—advances in knowledge—and  innovation, which is putting that advance to use in a new product or service.  

o The third factor that determines labor  

productivity is economies of scale. Recall that  

economies of scale are the cost advantages that  

industries obtain due to size.  

Sources of Economic Growth: The Aggregate Production  


• To analyze the sources of economic growth, it is useful to  

think about a production function, which is the process  

of turning economic inputs like labor, machinery, and raw  

materials into outputs like goods and services used by  


• In macroeconomics, the connection from inputs to outputs  

for the entire economy is called an aggregate production  


Components of the Aggregate Production Function:

• Economists construct different production functions  

depending on the focus of their studies.  

• The inputs in this example are workforce, human capital,  

physical capital, and technology.  

• An aggregate production function shows what goes into  

producing the output for an overall economy.  

Measuring Productivity:

• An economy’s rate of productivity growth is closely  

linked to the growth rate of its GDP per capita

• Over the long term, the only way that GDP per capita can  

grow continually is if the productivity of the average worker rises or if there are complementary  increases in capital.  

• A common measure of U.S. productivity per worker is dollar value per hour the worker  contributes to the employer’s output. This measure excludes government workers and farming  The “New Economy” Controversy:

• In recent years a controversy has been brewing among economists about the resurgence of U.S.  productivity in the second half of the 1990s.  

o One school of thought argues that the United States had developed a “new economy”  based on the extraordinary advances in communications and information technology of  the 1990s.  

o The most optimistic proponents argue that it would generate higher average productivity  growth for decades to come.  

o The pessimists, on the other hand, argue that even five or ten years of stronger  productivity growth does not prove that higher productivity will last for the long term.  • Productivity growth is also closely linked to the average level of wages. Over time, the amount  that firms are willing to pay workers will depend on the value of the output those workers  produce.  

o If a few employers tried to pay their workers less than what those workers produced, then  those workers would receive offers of higher wages from other profit-seeking employers.  o If a few employers mistakenly paid their workers more than what those workers

produced, those employers would soon end up with losses.  

o In the long run, productivity per hour is the most important determinant of the average  wage level in any economy.  

The Power of Sustained Economic Growth:

• Even small changes in the rate of growth, when sustained and compounded over long periods of  time, make an enormous difference in the standard of living.  

• Compound growth rate is the rate of growth when multiplied by a base that includes past GDP  growth  

• ��� �� �������� ���� � (1 + �����ℎ ���� �� ���)!"#$% = ��� �� ��� ���� 7.3: Components of Economic Growth 

• The category of physical capital includes the plant and equipment used by firms and also things  like roads (also called infrastructure).  

o Greater physical capital implies more output.  

o Physical capital can affect productivity in two ways: (1) an increase in the quantity of  physical capital and (2) an increase in the quality of physical capital  

• The category of technology  

o It includes new ways of organizing work, new methods for ensuring better quality of  output in factories, and innovative institutions that facilitate the process of converting  inputs into output.  

o Technology comprises all the advances that make the existing machines and other inputs  produce more, and at higher quality, as well as altogether new products.  

Capital Deepening:

• When society increases the level of capital per person, the result is called capital deepening.  • Capital deepening refers to the case when an economy has a higher level of physical and/or human  capital per worker

• The key dimension for deepening human capital in the U.S. economy focuses more on additional  education and training than on a higher average level of work experience.  

• The current U.S. economy has better-educated workers with more and improved physical capital  than it did several decades ago, but these workers have access to more advanced technologies.  • This recipe for economic growth—investing in labor productivity, with investments in human  capital and technology, as well as increasing physical capital—also applies to other economies.  Growth Accounting Studies:

• Economists have conducted growth accounting studies to determine the extent to which physical  and human capital deepening and technology have contributed to growth.  

• The usual approach uses an aggregate production function to estimate how much of per capita  economic growth can be attributed to growth in physical capital and human capital.  o The part of growth that is unexplained by measured inputs, called the residual, is then  attributed to growth in technology.  

• First, technology is typically the most important contributor to U.S. economic growth.  • Second, while investment in physical capital is essential to growth in labor productivity and GDP  per capita, building human capital is at least as important.  

• A third lesson is that these three factors of human capital, physical capital, and technology work  together.  

o Workers with a higher level of education and skills are often better at coming up with  new technological innovations. These technological innovations are often ideas that  cannot increase production until they become a part of new investment in physical  capital.  

o New machines that embody technological innovations often require additional training,  which builds worker skills further. If the recipe for economic growth is to succeed, an  economy needs all the ingredients of the aggregate production function.  

A Healthy Climate for Economic Growth:

• Both the type of market economy and a legal system that governs and sustains property rights and  contractual rights are important contributors to a healthy economic climate.

o A healthy economic climate usually involves some sort of market orientation at the  microeconomic, individual, or firm decision-making level.  

o Markets that allow personal and business rewards and incentives for increasing human  and physical capital encourage overall macroeconomic growth.  

o This market orientation typically reaches beyond national borders and includes openness  to international trade.  

• There are times when markets fail to allocate capital or technology in a manner that provides the  greatest benefit for society as a whole.  

o The role of the government is to correct these failures.  

• Important areas that governments around the world have chosen to invest in to facilitate capital  deepening and technology: Education, savings and investment, infrastructure, special economic  zones (SEZ: These are areas of the country, usually with access to a port where, among other  benefits, the government does not tax trade.), and scientific research

• A healthy climate for growth in GDP per capita and labor productivity includes human capital  deepening, physical capital deepening, and technological gains, operating in a market-oriented  economy with supportive government policies.  

7.4: Economic Convergence 

• Some low-income and middle-income economies around the world have shown a pattern of  convergence, in which their economies grow faster than those of high-income countries.  • The low-income countries have GDP growth that is faster than that of the middle-income  countries, which in turn have GDP growth that is faster than that of the high-income countries.  Arguments Favoring Convergence:

• Several arguments suggest that low-income countries might have an advantage in achieving  greater worker productivity and economic growth in the future.  

• A first argument is based on diminishing marginal returns. Even though deepening human and  physical capital will tend to increase GDP per capita, the law of diminishing returns suggests that  as an economy continues to increase its human and physical capital, the marginal gains to  economic growth will diminish.  

• An investment in capital deepening should have a larger marginal effect in these countries than in  high-income countries, where levels of human and physical capital are already relatively high.  Diminishing returns implies that low-income economies could converge to the levels achieved by  the high-income countries.  

• A second argument is that low-income countries may find it easier to improve their technologies  than high-income countries. High-income countries must continually invent new technologies,  whereas low-income countries can often find ways of applying technology that has already been  invented and is well understood.  

• Finally, optimists argue that many countries have observed the experience of those that have  grown more quickly and have learned from it. Moreover, once the people of a country begin to  enjoy the benefits of a higher standard of living, they may be more likely to build and support the  market-friendly institutions that will help provide this standard of living.  

Arguments That Convergence is neither Inevitable nor Likely:

• If the growth of an economy depended only on the deepening of human capital and physical  capital, then the growth rate of that economy would be expected to slow down over the long run  because of diminishing marginal returns. However, there is another crucial factor in the aggregate  production function: technology.  

• The development of new technology can provide a way for an economy to sidestep the  diminishing marginal returns of capital deepening.  

o Improved technology means that with a given set of inputs, more output is possible.  o With the combination of technology and capital deepening, the rise in GDP per capita in  high-income countries does not need to fade away because of diminishing returns. The  gains from technology can offset the diminishing returns involved with capital deepening.  o Improvements in technology have not run into diminishing marginal returns.  • One reason that technological ideas do not seem to run into diminishing returns is that the ideas of  new technology can often be widely applied at a marginal cost that is very low or even zero.

• The argument that it is easier for a low-income country to copy and adapt existing technology than  it is for a high-income country to invent new technology is not necessarily true, either.  • In theory, perhaps, low-income countries have many opportunities to copy and adapt technology,  but if they lack the appropriate supportive economic infrastructure and institutions, the theoretical  possibility that backwardness might have certain advantages is of little practical relevance.  The Slowness of Convergence:

• Although economic convergence between the high-income countries and the rest of the world  seems possible and even likely, it will proceed slowly.  

o Moreover, as the poor country catches up, its opportunities for catch-up growth are  reduced, and its growth rate may slow down somewhat.  

• The slowness of convergence illustrates again that small differences in annual rates of economic  growth become huge differences over time. The high-income countries have been building up their  advantage in standard of living over decades—more than a century in some cases. Even in an  optimistic scenario, it will take decades for the low-income countries of the world to catch up  significantly.  

Chapter 8: Unemployment 


• An unemployed worker is someone who

o Is over 16

o Is not currently working

o Has looked for work in the last four weeks

• Retirees, students, inmates, discouraged workers or stay at home spouses are not unemployed • Being unemployed does not mean you are eligible for unemployment benefits • Unemployment Rate = u = !!" = ! 

!!! � 100

o Even a small change such as a 1% change in the unemployment rate can have a huge  impact on 1.5 million people

Labor Force 

• The labor force is the unemployed + the employed (everyone who wants to work) o LF=E+U

• The labor force participation rate

= !" 

!"#!!"#$!$%$!&"'(!)*+ !"!#$%&'"( !"#$ !" � 100

• Labor force changes over time

o Went up when women entered the labor force

o Went down when the men participation rate fell

o Now both men and women participation rates are falling (due to the Baby Boomers  retiring)

o Civilian labor force participation rate for people ages 25 to 54 years old has been  decreasing slowly

Types of Unemployment 

• U3 is the standard unemployment rate

• U6 includes unemployed, discouraged, marginally attached, and part-time for economic reasons  workers

o A discouraged worker would like to work but have given up looking

o A marginally attached worker looked for work in the last 12 months but not in the last  four weeks

o An underemployed worker (Part-time for economic reasons) is someone who wants to  work full time but is forced to work part time

GDP Growth and Unemployment 

• A GDP growth of 1.5-2% keeps the unemployment rate constant

• To increase GDP

o New workers can join the labor force

o There can be increased productivity

o Workers move toward where the jobs are (labor mobility)

• Growth Rate: If x is growing at Y% for t years, then after t year

� = 1 + � !�! 

Constant Churning in the Labor Marker 

• There is a churning labor marker because people quit, switch jobs, are fired, are laid off, and are  hired

• Frictional unemployment is

o The unemployment that occurs due to the time it takes to find a new job

o Not necessarily a bad thing because we want people to find the best jobs

Types of Unemployment 

• Frictional Unemployment

o Discussed above

o Usually lasts less than 3 months

o Is an argument for unemployment benefits

• Structural Unemployment

o Occurs when the wage is greater than the equilibrium change or there is technological  change and the labor market doesn’t clear

o There is a surplus of labor

• Cyclical Unemployment

o Due to the business cycle

o Up in recessions and down in expansion

Structural Unemployment 

• Can be caused by minimum wage, unions, efficiency wages, or unemployment benefits o Efficiency wages are higher wages that are paid by firms to workers to reduce turnover  and increase productivity

o Unemployment benefits can cause workers to be fine not working

• Technological change can cause unemployment in local markets is a major employer goes out of  business

o Employees may need to get new skills

Natural Rate of Unemployment 

• Natural Rate = Frictional Unemployment + Structural Unemployment

• Varies over time and has to be estimated

• Changes in the Natural Rate of Unemployment

o Changes in the Labor Force

▪ Younger workers are more likely to be employed

▪ Changes in who works

o Changes in labor institutions

▪ Unions

▪ Temp Agencies

▪ Technological Change

o Government policy changes

▪ Minimum wage

▪ Job training

▪ Unemployment Insurance

▪ Tax incentives for hiring

Actual Unemployment 

• Varies with the business cycle so is also called cyclical unemployment

o Increases during a recession

o Decreases during an expansion

• Actual Unemployment = Natural Unemployment + Cyclical Unemployment • Caused by a lack of aggregate (total) demand

• Output falls as cyclical unemployment rises

• Nominal wages grow more slowly in recessions and at the beginning of expansions • Real wages may fall if inflation is greater than the nominal wage growth

Chapter 9: Inflation 

• Nominal measures use current dollars

o Not adjusted for inflation

• Real measures use base-year/chained/constant dollars

o Adjusted for inflation

• Inflation is measured by

o The Consumer Price Index (CPI): A spending based measure o The GDP Deflator: A production based measure

Measuring Inflation with the CPI 

• The CPI is a price index

• CPI = !"#$ !" ! !"#$%& !" !""#$ !"# !"#$%&"! 

!"#$ !" !!! !"#$%& !" !""#$ !"# !"#$%&"! !" !!! !"#$ !"#$� 100

• Inflation = Percent Change in CPI = !"#!!!"#! 

Nominal vs. Real Wages 

!"#!� 100

• Although nominal wages is often focused on, workers should care more about their real wages (what they can buy)

• Over time the nominal minimum wage has increased, but the real minimum wage has decreased GDP Deflator 

• GDP Deflator = !"#$%&' !"# 

!"#$ !"#� 100

• Inflation Rate = !"# !"#$%&'( ! – !"# !"#$%&'( ! 

!"# !"#$%&'( ! � 100

Differences between GDP Deflator and CPI 

• CPI uses a fixed basket of goods

• GDP Deflator uses what is actually produced

• The CPI may overstate inflation

Other Price Indices 

• Producer Price Index (PPI)

o Wholesale goods

o Costs of goods and services bought by firms

o Leading indicator for CPI (goes up before CPI goes up, goes down before CPI goes  down)

• Employment Cost Index

o Costs of hiring (wages, benefits, etc.)

• International Price Index

o Imports and Exports

• Purchasing Power Parity (PPP)

o Adjusts for different relative prices between countries

o Compares GDP per capita in different countries

Cost of Inflation 

• The level of aggregate prices is not important

• The costs of inflation come from the change in the price level

• The rate of change (inflation) can impose costs on the economy

• Shoe Leather Costs

o People spending time and effort making more financial transactions to prevent loss of  value due to inflation

o When inflation is high people spend more time moving their money around to protect its  value

• Menu Costs

o Firms have to spend time and resources changing their prices due to inflation • Unit of Account Costs

o Costs associated with the changing value of the dollar

Real vs. Nominal Interest Rates

• Nominal Interest Rate

o Almost all rates you see

▪ Mortgages, auto loans, savings accounts, etc.

o Not adjusted for inflation

• Real Interest Rate

o Adjusted for inflation

o What we actually care about

Calculating the Real Interest Rate 

• Ex-ante (Expected) Interest Rate = �! = �! − �!!

o �! is the inflation rate

o �!! is the expected inflation rate

• Ex-post (Actual/Real) Interest Rate = �! = �! − �! 

o �! is the inflation rate

o �! is the expected inflation rate

Unexpected Inflation 

• Unexpected inflation changes the real interest rate paid by borrowers to lenders o Higher inflation rate helps borrowers and hurts lenders

o Lower inflation rate (or deflation) hurts borrowers and helps lenders

The Costs of Disinflation 

• Disinflation is reducing the rate of inflation over time

o Can be difficult to achieve without higher unemployment

o The key is Central Bank Credibility

• One way to achieve disinflation is to reduce the growth in the money supply The Costs and Benefits of Price/Wage Indexing 

• Price/Wage Indexes adjust prices/wages/benefits automatically for changes in the price level  (changes in the cost of living)

o Examples: Social security, labor contracts, etc.

• Real purchasing power stays the same

• Can result in the wage-price spiral

o Pushes costs up automatically which results in higher prices

• We’ve had a more rapid increase in the quantity of money than in output and inflation remains  really low so we need people to buy more

Chapter 11: The Aggregate Demand/Aggregate Supply Model 

• Say’s Law

o People spend their incomes so supply creates its own demand

o Not everything that’s earned is spent in the short run

▪ Paradox of thrift

o Supply creating its own demand implies that we can’t have a recession

o This law is a better approximation for the long run, but the business cycle is a short run  phenomenon

• John Stuart Mill

o Says people might just increase their money holdings

o When supply is greater than demand, it leads to a recession

Aggregate Supply 

• Profit = Revenue – Costs = Price X Quantity – Costs

• Price per unit = Price per unit – production cost per unit

• The labor cost is different from other costs because

o The major cost for firms is labor

o Nominal wage is a very sticky price (changes very slowly)

o Wages change more slowly than other prices because they are sticky

• A change in the price per unit will change the profit

• In the short run, before wages adjust, output goes up as the price level goes up • As price level increases, profits increase because

o Labor costs adjust slowly

o Sticky wages

o Firms produce more

• The Short Run Aggregate Supply Curve (SRAS Curve) is upward sloping Shifts in the SRAS Curve 

• Changes in input prices

o As input prices increase, SRAS decreases

• Changes in nominal wages

o As nominal wages decrease, SRAS increases

• Changes in productivity

o As workers become more productive, SRAS increases

Long Run 

• We expect all prices, including wages, to adjust

• No relationship between output and price level

• Long Run Aggregate Supply Curve (LRAS Curve) is vertical

• Potential GDP

o Depends on physical capital, human capital, the level of technology and government  policy

o Related to natural rate of unemployment

▪ We are at the natural rate of unemployment (�!) when we are at the potential  GDP (�!)

• The economy never actually gets to the long run, it is always in some sort of short run • As nominal wages adjust, we move towards the LRAS Curve

Potential GDP and GDP 

• If GDP is less than the potential GDP

o The unemployment is greater than the natural rate of unemployment

o There is a surplus of workers

o There is downward pressure on wages so the SRAS curve shifts right

• If GDP is greater than the potential GDP

o The unemployment rate is less than the natural rate of unemployment

o There is a shortage of workers

o There is upward pressure on wages so the SRAS curve shifts left

Aggregate Demand 

• Y = C + I + G + X – IM

• Relaxes the assumption of fixed prices

• Can’t rely on the Law of Demand to determine change when aggregate price level changes  because all prices are changing, not a single market

Three Effects of Changes in Overall Price Level 

• Wealth Effect

o How changes in the price level affect people’s real wealth

o As the price level increases, real wealth decreases so consumption decreases and  aggregate demand decreases

o As the price level decreases, real wealth increases so consumption increases and  aggregate demand increases

o Negative relationship

• Interest Rate Effects

o Deals with the opportunity cost of holding money (interest rate) as the price level changes

o When the price level increases, the interest rate increases so investment decreases and the  aggregate demand decreases

o When the price level decreases, the interest rate decreases so investment increases and the  aggregate demand increases

o People save more as the interest rate increases

• Foreign Price Effect

o As the price level falls, the exchange rate increases, which weakens the dollar, making  American goods cheaper so exports increase, increasing the trade balance and increasing  aggregate demand

o Exporter view: The weak dollar is good

o Importer view: The strong dollar is good

o As the price level falls, aggregate demand increases

o As the price level rises, aggregate demand decreases

o Negative Relationship

• Aggregate Demand Curve (AD Curve) is downward sloping due to the three effects

Shifts of the AD Curve 

• Changes in expectation

o Optimistic: AD increases

• Changes in wealth

o As wealth increases, AD increases

• Size of existing stock of physical capital

o If stock of physical capital is small, AD will increase

• Fiscal Policy

o Increased government spending increases AD

• Monetary Policy

o If the central bank increases the quantity of money, the AD increases

Demand Shocks and Supply Shocks 

• Shifts in the SRAS and AD Curves

o Positive shock shifts curve right

o Negative shock shifts curve left

• The short run equilibrium may be above or below the long run equilibrium

• Output gap = �! − �! = !!!!! 

!!� 100 (percent terms)

• If the equilibrium GDP is less than the potential GDP then there is a recessionary gap • If the equilibrium GDP is more than the potential GDP then there is a inflationary gap • Usually we have positive real GDP growth and positive inflation

• Positive Demand Shock: GDP increases and the price level increases (there is faster than normal  GDP growth and higher than normal inflation)

• Negative Demand Shock: GDP decreases and the price level decreases (there is slower than  normal GDP growth and lower than normal inflation)



P (Price Level)

U (Unemployment Rate)

Positive Demand




Negative Demand




Positive Supply




Negative Supply




• A Negative Supply Shock is called Stagflation

• With a high unemployment rate wages fall (or stay the same), profits increase, the SRAS curve  shifts to the right and we more back towards potential GDP (The LRAS Curve)

Supply Shocks: Temporary vs. Permanent 

• Temporary

o We expect SRAS to shift back after the shock

o Example: Oil supply shock

• Permanent

o Shift LRAS curve

o Most are positive

Example: Technological growth

• Short run is usually 6 to 18 months

• During the short run, we experience positive and negative demand and supply shocks • The Long Run is when all prices (including wages) adjust, which is about a 5-10 year average but  we never really get there


• Average inflation was 0% in the 19th century

o Due to inflation and deflation because roughly equal

o Used the Gold Standard

• Post WWII

o Inflation almost always positive

o Fiat money: Money is valuable because the government says so and we agree on it o Central Banks manage the money supply

Keyne’s Law and Say’s Law in the AD/AS Model 

• The Keynesian zone of the SRAS curve

o The equilibrium level of real GDP is far below potential GDP, the economy is in  recession, and cyclical unemployment is high.  

o Portion of the SRAS curve on the far left, which is relatively flat.  

o If aggregate demand shifted to the right or left, it will determine the resulting level of  output (and thus unemployment).  

o Inflationary price pressure is not much of a worry in the Keynesian zone, since the price  level does not vary much in this zone.  

Chapter 12: The Keynesian Perspective 

• Short run business cycle

• How government can use fiscal and monetary policy to smooth out the business cycle • Focus on aggregate demand in recessions

• Aggregate demand might not be stable

o Unexpected changes

o “Animal Spirits”: People get really excited

o Role of expectations

• Because of sticky wages and a central bank that tries to stabilize the economy, the price level  doesn’t fall much when there’s a negative demand shock (the fall in real GDP is much larger) • Focus on Consumption and Investment for Aggregate Demand

• Consumer Spending is determined by

o Current income (As I increases, C increases)

o Expectations of the future (Optimism leads to increased C)

o Wealth (As wealth increases, C increases)

o Borrowing (If borrowing is easier, C increases)

• Investment is determined by

o Expected Future Profits (As expected future profits increase, I increases)

o Interest Rates (As interest rates increase, I decreases)

• The SRAS curve

o At potential GDP, an increased AD leads to inflation

o At below potential GDP, decreased AD leads to higher unemployment and lower GDP o SRAS Curve is horizontal up until potential GDP, then vertical at potential GDP

Aggregate Demand and Potential GDP 

• Sometimes AD is less than potential DGP

o Negative demand shock

o Consumer spending or investment falls unexpectedly

o Firms don’t need to produce as much so they don’t need as many workers and there are  layoffs

• Wages and price stickiness make it hard to adjust to new equilibrium

o Results in higher unemployment rate (negative demand shock)


• Says that new spending increases economic activity by more than the original amount o Especially when there are idle (available) resources

• Works with both an increase or decrease in spending

• Multiplier = ∆! 

∆!"#$%&$'> 1

• The multiplier is greater than one, especially in recessions

• If at potential GDP and money is added, inflation will increase

• If less than potential GDP and money is added, GDP increases

Macro Variables 

• Growth of GDP

• Unemployment (Wasted resources)

• Inflation (Real Costs)

• Okun’s Law

o As GDP growth increases, unemployment decreases, leads to expansions

o As GDP growth decreases, unemployment increases, leads to recessions

Short Run Phillip’s Curve 

• Short Run Phillip’s Curve (SRPC) caused by demand shocks

• Downward sloping, tradeoff between unemployment and inflation

• As unemployment decreases, inflation increases

• Supply shocks cause shifts in the SRPC

o Negative shocks shift SRPC up

o Positive shocks shift SRPC down

• Changes in expected inflation also shift SRPC

o Higher expected inflation shifts SRPC up

o Lower expected inflation shifts SRPC down

• Downward sloping

Long Run Phillip’s Curve 

• In the long run, the unemployment rate is the natural rate when GDP is equal to the potential GDP • The level of unemployment at which inflation equals the expected inflation is called the Non Accelerating Inflation Rate of Unemployment (NAIRU)

• Vertical

Chapter 13: The Neoclassical Perspective 

• Focus is on LRAS=Potential GDP

o Level of real GDP is consistent with stable inflation


• Aggregate demand shocks just lead to changes in inflation

o Output is determined by the LRAS

o Demand shocks are irrelevant

o Real GDP=Potential GDP

• Positive aggregate demand shocks lead to higher inflation

Real GDP and Unemployment are Determined by Potential GDP 

• Potential GDP=NAIRU

• Output and unemployment return to long run values very quickly

• Central bank should only focus on inflation and not on unemployment and RGDP growth o Less active monetary policy and basically no fiscal policy

o Follow monetary growth rule

• Economies may move back to the potential GDP faster after a positive demand shock than a  negative demand shock

Arguments for Neoclassical Economies 

• Policy should be stable and focused on keeping inflation low

o No short run involvement

• Policy should focus on long run growth

o Investment in capital and technology

o Labor marker reforms to reduce natural rate of unemployment

▪ “Right to work” laws and increasing wage flexibility

Causes of GDP Falling During Recession 

• Keynesian-negative demand shock

• Neoclassical-negative supply shock

Effects of World War Two 

• Government spending and draft reduced unemployment

• Rationing induced consumer spending due to high inflation

o Savings increased as government sold war bonds

• End of war

o Optimism was high

o There was pent up demand and high savings

o There was a huge economy boom after WWII

Great Depression vs. Great Recession 

Great Depression

Great Recession

Stock bubbles led to a financial crisis

• Thousands of banks closed

Housing bubble led to a financial crisis • Lehman Brother’s fails

Unemployment rate was over 25%

• No real government employment  insurance

Unemployment rate tops at 10%

• Unemployment benefits

• Food stamps

Double digit deflation

One year slight deflation

10 years after, unemployment rate is at 10%

Seven and one half years after, the  

unemployment rate is down to 5%

Chapter 14: Money and Banking 

Why We Use Money 

• We could trade or barter for things we want

o Have to have “double coincidence of wants”

o We each have to have something the other person wants

• As long as we are all willing to accept money in exchange for good and services, money solves  that problem

o We only need a single coincidence of wants

• Times people stopped accepting money

o When there is hyperinflation

o American revolution: Congress made money

• Money allows for more specialization

o Increases total output

Three Uses of Money 

1. Medium of exchange

• What we use to buy and sell things

2. Store of value

• Keeps value over time (although inflation reduces value)

• House, gold, diamonds, etc.

3. Unit of Account

• All prices are measured in terms of money

• Method of measuring prices

• Most useful if the same as medium of exchange

How Do We Measure Money 

• Liquidity

o How easy it is to buy something with the asset

o Money is more liquid than houses

o M1 is more liquid than M2

• M1

o Currency (bills, coins)

o Demand Deposits (Checking Accounts)

o About $3 Trillion

o Includes Traveler’s Checks

• M2

o Includes M1

o Most is savings deposits

o Includes time deposits and money market accounts (commercial paper markets, firms  borrowing money for a short time)

o About $12 Trillion

Goldsmiths to Banks 

• Goldsmiths store gold

o They have the best security

o Issue paper receipts

• Not all costumers want their gold at once

• Goldsmith sees an opportunity to lend and make money

• Banks are born

What Banks Do 

• Take in deposits

• Keep some in reserve

• Loan out the rest of the deposits

• Profit by charging a higher interest on loans than they pay on the deposits

T-Accounts or Balance Sheets 

• Income statement

o Measure flow variables (over a period of time)

o Revenue, costs and profit

• Balance Sheet (T-Account)

o Measure stock variables (at a point in time)

o Assets (things you own), Liabilities (things you owe), and Capital (assets-liabilities) • Typical Company

o Assets: Building, machines, etc.

o Liabilities: Loans from bank

• Bank

o Assets: Loans and reserves

o Liabilities: Deposits

• Go out of business when assets are less than liabilities

o Negative capital

Lending Long and Borrowing Short 

• Maturity Transformation

• Borrow short

o Bank deposits (at least checkable deposits) can be withdrawn at any time

• Lend long

o Loans typically get paid back over years (typically 3-30 years)

• Banks can’t return all deposits all at once

o Timing is a problem (even for healthy banks)

o This can lead to bank runs

Value of Banks to the Economy 

1. Keep money safe

2. Match borrowers with savers

• Banks evaluate credit risk and then invest or loan out money to the best options 3. Maturity Transformation

4. Create Money

Risks of Banks 

• Make profit based on interest spread between loans and deposits

o Incentive to make riskier loans

• Maturity transformations

o Makes banks susceptible to bank runs

• Interest Rates

o Are higher for longer term

o Are higher for risk

How Bank Runs Are Solved 

• Deposit Insurance


• Ended traditional bank runs

The Creation of Money 

• The Fractional Reserve Banking System

• Banks create money by lending out money from deposits

Reserve Requirement (rr) 

• Fraction of deposits that banks are required to keep on reserve

o Cash in vaults

o Reserve accounts with the central bank

o Around 10% in the United States

The Money Multiplier 

• How much money is created from new deposits

• When a bank accepts a deposit it must keep some of it in reserve

o But it is able to lend out the rest

• Depends on the reserve requirement and how much money people hold as cash o Maximum value when people hold no cash

o Maximum value = 1/rr

o MM = 1/rr (decimal)

Types of Money 

• Commodity Money

o Using something that has value outside its use as money such as gold, silver, etc. • Commodity Backed Money

o Paper money that can be exchanged for the commodity (like gold)

• Fiat Money

o What the US uses now

o Paper money that is accepted as money because the government says it’s money and  everybody agrees

Chapter 15: Monetary Policy and Bank Regulation 

Federal Reserve 

• The Federal Reserve controls the monetary base directly

o Monetary base is currency and circulation and bank reserves through monetary policy • Monetary supply

o Bank deposits and currency in circulation

Federal Reserve Bank of the U.S. 

• U.S. Central Bank

• Deposit insurance guarantees that depositors will receive their money


Need for Bank Regulation 

• Depositor know they will get their money back

o They don’t care how risky banks are

o Riskier loans can be more profitable for banks

• Federal Reserve steps in with regulation

• Powers of the Fed comes from the 1933 Glass-Seagall Act

o Set reserve requirements

o Set capital requirements

o Set lending restrictions

o Separation of commercial and investment banking

• Dismantled during the 1980s and 1990s

The Trusts of the Early 20th Century 

• National banks had a lot of lending restrictions

o Protects depositors

o Makes it hard to earn profit

• Trusts are born and start acting a lot like banks

o Less regulation

o More profit

o Riskier loans lend to failure and a financial crisis in 1907

The Federal Reserve is Born 

• Founded in 1913

• 12 Regional Federal Reserve Banks

• Board of governors in Washington, DC

o Set up to be semi-independent of the political process

o 14 year terms

• Federal reserve conducts monetary policy

1. Sets reserve requirements

2. Lends to banks through the discount window

o Discount rate is the federal funds rate plus a penalty

o Lender of last resort

o Usually banks lend to each other in the federal funds market

3. Target the federal funds rate through open market operations

o Federal funds rate is the interest rate

o Federal funds market is inter-bank lending overnight to share up reserves

• Does this by buying and selling bonds

o Federal open market committee (FOMC)

o Carried out by the New York Federal Reserve (with a limited number of large national  banks)

Monetary Policy 

• Trying to influence AD by changing interest rates

o As the interest rate decreases, investment increases and AD increases

o As the interest rate increases, investment decreases

• Fed targets the federal funds rate (the interest rate at which banks lend each other reserves), very  short term, and very safe

o Base interest rate for the economy

• Market for borrowing and lending reserves

o Price is the federal funds rate (FFR)

o Fed moves the FFR by changing the supply of Banks’ Reserves

o Open-market operations

o Buy or sell treasury bills in exchange for reserves

Bonds, Money, and Interest Rates

• If Fed wants to increase the FFR and decrease the monetary base

o Needs to decrease the supply of reserves

o Conducts an open market sale: the Fed sells T-bills in exchange for reserves, banks get  T-bills and pay with reserves

o FFR goes up

o Federal Reserve Assets: Treasury bills decrease, Liabilities: Monetary Base decreases o Banks: Assets: Treasury bills increase, Reserves decrease, Liabilities: No change • If Fed wants to decrease the FFR and increase the monetary base

o Needs to increase the supply of reserves

o Conducts an open market purchase: the Fed buys T-bills and pays with reserves, banks  sell T-bills and recieve reserves

o FFR goes down

o Federal Reserve Assets: Treasury bills increase, Liabilities: Monetary Base increases o Banks: Assets: Treasury bills decrease, Reserves increase, Liabilities: No change Monetary Base to Money Supply (M1) 

• Treasury bills are treasury bonds (loans to the government)

o T-bills last less than one year

o T-bonds last greater than one year

• Buying or selling bonds changes the monetary base

o Increases or reduces banks’ reserves

• Open-Market Purchase

o Reserves increase, loans increase, the monetary base increases, the interest rate decreases,  investment increases, and AD increases

• Open-Market Sale

o Reserves decrease, loans decrease, the monetary base decreases, the interest rate  increases, investment decreases, and AD decreases

Monetary Base and M1 and M2 

• Since 2007

o M1 from $1.4 trillion to $3.15 trillion

o M2 from $7.5 trillion to $12.4 trillion

o Monetary Base (Cash and Reserves) has increased from $0.9 trillion to $4 trillion • Monetary Base is the Fed’s liabilities

o Fed’s assets increased by the same amount

Fed Actions 

• 2008

o Fed lowered FFR to 0

o Lender of last resort (not at the discount rate)

o Troubled asset relief program

o Bought mortgage backed securities (non T-bill assets)

o Fed’s liabilities increased in equal amount to its assets

o Fed flooded the banking sector with reserves

o Based on lessons learned from great depression

The Money Supply and Great Depression 

• Currency in circulation had a 31% increase

• Checking accounts decreased by 35%

• M1 decreased by 25% (deflation)

• All occurred due to bank runs

How Monetary Policy Affects the Real Economy 

• Real economy is the production of goods and services

• Money is useful because it’s the medium of exchange (buy stuff with it) but it pays little or no  interest

• Choice between holding assets as money or something that pays a higher interest rate (such as  CDs or bonds)

• Holding money is the opportunity cost

Interest Rate

• “Price” of money

• Opportunity cost of holding money

• Depends on the amount of risk and the time of the loan

• Assumption: there is one interest rate

• Right now, interest rates, and the opportunity cost of holding money are very low o People would like to hold more money

Money Demand Curve 

• The Interest Rate depends on the Quantity of Money (M1 or M2)

• Downward sloping

Shifting the MD Curve 

• Changes in the aggregate price level (price level increases, MD decreases)

• Changes in real GDP (GDP increases, MD increases)

• Changes in technology (technology increases, MD decreases)

• Changes in institutions (such as the ability to pay interest on checking accounts) Money Supply 

• Vertical (Quantity of money vs. Interest rates)

• Use liquidity preference model of the interest rate (determined by supply and demand) • If the Fed controls money supply, it can price and point along the MD curve

Monetary Policy and the Fed 

• The Fed takes money demand as given

o Money demand comes from the economy

o Chooses a FFR target to try to move the economy to potential GDP and full employment o Choose the money supply

Changing the Money Supply 

• If the Fed wants to lower the FFR

o Fed buys T-bills to increase the money supply

o Conducts open market purchase (buys T-bills and pays banks reserves)

o Banks lend out their excess reserves (M1 increases and FFR decreases)

• If the Fed wants to increase the FFR

o Fed sells T-bills to decrease the money supply

o Conducts open market sale (sells T-bills and banks pay reserves)

o Reserves fall so banks lend less (M1 decreases and FFR increases)

Why The Interest Rate Matters 

• Interest rate represents opportunity cost of investment

o As interest rate increases, investment decreases and as interest rate decreases, investment  increases

• Changes in the interest rate lead to changes in investment which shifts the aggregate demand curve • Expansionary monetary policy

o Open-market purchase to reduce interest rate

• Contractionary monetary policy

o Open market sale to increase interest rates

o Decrease AD

o Decreases investment

The Fed’s Dual Mandates 

• Dual Mandate

o Stable Prices (inflation around 2%)

o Full employment (u=NAIRU=natural rate)

o Moderate long term interest rates

Fed Balances Price Stability and Fully Employment 


o As unemployment increases, the interest rate decreases

o As unemployment decreases, the interest rate increases

Unemployment vs. Inflation 

• Taylor Rule for Monetary Policy

o Approximation of FFR target based on current inflation and the output gap

o FFR = 1 + (1.5*inflation rate) + (0.5*output gap)

o Percentage terms

• Other central banks use inflation targeting

o Usually around 2%

o Try to hit a specific inflation goal

o Forward looking (what will inflation be) rather than backward looking  

o Banks told just to target the interest rate not the unemployment rate

o Argument: Markets know what bank is trying to do, transparent, public knows if the  target is hit or not

Long Run 


• LRPC=NAIRU=natural unemployment rate

• In the long run monetary policy does not affect real GDP

o Money is neutral

• Prices just change by change in the money supply

• Monetary neutrality (money doesn’t matter)

• Aggregate price level increases the same amount as the money supply increase (no change in  inflation or in GDP)

Monetary vs. Fiscal Policy 

• Most economists prefer monetary policy

o Fast, less political, more general

• In the last recession monetary policy hit zero lower bound

o Nominal interest can’t go below zero

Unusual Monetary Policy 

• Since 2008, the Fed has massively expanded its balance sheet and bought money assets besides T bills from banks

o Means banks have greater reserves than they are required to hold by the Fed

• Required Reserves

o Reserves banks have to have based on their deposits and the required reserve ratio (about  10%)

• Excess Reserves

• Reserves that are more than the required reserves

• Banks hold reserves because

1. Banks freaked out over financial crisis

2. Banks don’t see lots of great lending opportunities

3. Fed pays a low interest rate on excess reserves

• Capital=Assets-Liabilities

• The Fed has been able to pay interest on banks’ reserves since 201

o Rate started at 0.25%, increased to 0.5%

• One way to increase the FFR is to increase this interest rate

o After all, why would banks lend reserves to another bank if they can keep them and  receive a higher interest rate

o Could get expensive eventually

Chapter 17: Fiscal Policy 

1. Government Sending

o All levels (federal, state and local)

2. Taxes (all levels)

3. Transfers (federal, some state)

o Goal is to shift the aggregate demand curve to bring the economy back to potential GDP  and the natural rate of unemployment

Where the Money Comes From 

• Federal government

o Income tax (personal and corporate)

o Social insurance taxes

• State government

o Income tax (some)

o Sales tax

• Local government

o Property tax

o Sales tax (some)

Where Does the Money Go? 

• Federal government

o National defense

o Transfers (Social security, Medicare)

• State and local government

o Education

o Public safety

o Infrastructure

• State and local governments spend much more than the federal government

Federal Budget Balance 

• Government Savings = Taxes-Spending-Transfers

o Government savings less than 0 is a budget deficit

o Government savings more than 0 is a budget surplus

Federal Budget 

• Mandatory spending

o Congress doesn’t have to pass new spending laws

o Social Security, Medicare and Medicaid (#1 cost), Unemployment Benefits

o Transfers (about 1/3 of total spending), don’t count GDP

• Discretionary Spending

o Requires new spending laws every year

o Defense (Half)

o Non-defense (Half): Education, training, transportation, etc.

• When the federal government runs a deficit it has to borrow

o Sells government bills and bonds (issues new treasury bills)

• If there is a deficit

o Debt increases

• If there is a surplus

o Debt decreases

Fiscal Policy 

• Recessionary gap

o Expansionary fiscal policy

o Tax cuts

o Spending increases

• Inflationary gap

o Contractionary fiscal policy

o Increase taxes

o Cutting spending

Progressive Taxes and Fiscal Policy 

• Federal income tax is a progressive tax

o People pay a higher percentage of their income as their income goes up

o Negative: May provide a disincentive to work

o Positive: Tax bill goes down during a recession, consumption doesn’t fall by as much as  it would without it

• Income tax

o Based on tax brackets

Automatic Stabilizers vs. Discretionary Policy 

• Automatic Stabilizers

o Policies that change taxes and spending automatically based on the business cycle o Progressive taxes

o Unemployment benefits

o SNAP (Food stamps)

• Discretionary Fiscal Policy

o New fiscal policies

o Requires Congress to pass a bill and the President to sign

o Takes longer

Deficit vs. Debt 

• Deficit is over one year

• Debt is how much the government owes in total

o Some held by the US government

o Some held by the public

o Result of the previous years’ Deficits

Cyclically Adjusted Deficits 

• Automatic stabilizers

o Tax revenue decreases is a recession

o Spending (transfers) increase in a recession

o Deficit gets larger in a recession and smaller in an expansion

• Automatic stabilizers and discretionary fiscal policy should (and do) lead to larger deficits during  a recession

• Cyclically adjusted deficit is what the deficit would be if we were at potential GDP, the natural  rate of employment, and the NAIRU

• Ideally we would like to have a deficit during a recession and a surplus during an expansion o Politicians are unable to do this

Federal Deficit as a Percentage of GDP 

• Debt/GDP can go down if GDP grows faster than the debt

Problems with Debt 

• If debt gets too large, people won’t lend you money

o If the government borrows too much, it can “crowd out” private investment, reducing  growth

o If there is crowding out, interest rates should go up

• Ireland, Greece, Portugal, Spain had high levels of debt from financial crisis o Interest rates went up

o Makes borrowing more expensive and default more likely

Importance of Growth 

• Debt was extremely high, relative to GDP, after WWII

• Country did not run big surpluses to pay debt

• Focus on fraction of debt per GDP

Austerity and Growth in Europe 

• Austerity

o Reduced government spending and transfers and higher taxes

o Goal of balancing the budget

o Countries need to reduce deficits even when recovering from recessions

• More austerity is associated with lower GDP growth

Implicit Liabilities 

• Liability: Debt you owe to someone

• Implicits: Benefits promised by law

• Implicit liabilities: Future social security, medicare and Medicaid payments

Social Security 

• Retirement plan to keep seniors out of poverty

• Benefits depend on how much you pay into the system, but are capped at a fairly low level • Social Security is funded out of a payroll tax

Social Security Fixes

• Trust fund will run out by the 2030s or 2040s

• Can fix social security by raising taxes or reducing benefits

Medicare and Medicaid 

• Medicare

o Health insurance for seniors

o Federal program

• Medicaid

o Health insurance for the poor

o Join state and federal program

• Paid for by payroll tax, similar to social security

Health Care Costs 

• Have been rising faster than GDP over the last few decades

o Is eating up a larger share of output

• Taxes to support Medicare and Medicaid have not risen

o The federal deficit will grow out of control if taxes don’t increase and health care costs  rise

How We Control Health Care Costs 

• Countries with universal public health insurance tend to have much lower per patient costs o Government has power to reduce costs as only buyer

o People get primary care when they need it

• Doctors earn much more in U.S. than other developed countries

• Problem is with health care costs in general, not just with Medicare and Medicaid o Public health costs have risen slower than private health care costs

Chapter 21: Globalization and Trade 

• Globalization: Increase in trade of goods and services and increase flow of capital around the  world

o Has increased over the last 40 years

Benefits and Costs of Increased Trade 

• Trade wouldn’t happen if it didn’t benefit both sides

• For the U.S. increased trade results in lower prices and more products available for consumers • Trade, in total, almost certainly makes the world better off

• Increased international competition may hurt some workers in some industries (employment  lower, lower wages)

• Almost everyone is a consumer and a producer

Benefits Go to the Top 

• Much of the increase in trade comes from multi-national corporations that produce in low-wage  countries overseas

o Reduces production costs

o Lower prices for consumer

o Higher profits for firms

o Profits lead to higher pay for executives and capital gains for shareholders

• Strong correlation between trade and share of income going to the top 1%

Costs Paid For By Workers 

• Areas that are most vulnerable to competition from low cost overseas production for worse in the  medium run

o Wage growth lower

o Unemployment higher

• Workers in other countries benefit, especially in the long run

• The past 40 years show that the winners don’t compensate the losers

Ways to Limit Trade 

• Tariffs

o Tax on imports

o Used to make imports more expensive relative to domestic goods and services (reduced  since the end of WWII)

• Quotas

o Limit on how much can be imported

• Regulations

o Subtler restrictions that limit the type of goods and services that can be imported Protectionism and Overseas Labor 

• Working conditions in low wage countries are much worse

Short-Run Protectionism 

• Infant Industries

o Need to protect new industries from international competition while they develop • “Anti-dumping”

o Dumping: Some country will sell their product in your country for less than the cost • Protecting the environment

o Coal is cheap

o China and India have rising CO2 levels

o Trading with China and India pollutes environment

• Safety concerns

• National security

o If faced with war, want to be able to produce everything you need


• Have decreased in the last hundred years

The Problem with Agricultural Subsidies 

• Most developed countries have some sort of agricultural subsidies (price floors, crop insurance,  transfer payments)

• Leads to increased global supply and lower prices

• Hurts farmers in less developed countries

o Often can’t grow food profitably

o Don’t get the same subsidies from their government

Compensation from Free Trade 

• Transfers

o Higher taxes on higher income

o More generous unemployment benefits

o More generous education/training programs

• Problems

o Hard to individually identify winners and losers

o Not a lot of political support for a stronger safety net

Long Run Effects of Protectionism 

• Competition is engine of capitalism that leads to growth

o Lower prices

o Higher productivity

o Higher standard of living

• Reduces competition and standard of living in the world

• Significant short run costs from free trade, especially in higher wage countries

Works Cited

Greenlaw, Steven A., Eric R. Dodge, Cynthia Gamez, Andres Jauregui, Diane Keenan, Dan  MacDonald, Amyaz Moledina, Craig Richardson, David Shapiro, and Timothy Taylor.  "Chapters 1-4, 6 and 7." Principles of Macroeconomics. N.p.: n.p., n.d. N. pag. Print.

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