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Macroeconomics- Final Exam Study Guide

by: Rooshna Ali

Macroeconomics- Final Exam Study Guide Econ 10233

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Rooshna Ali

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This includes chapters 10, 11, 12, 15, 16, 17, & 20.
Intro Macroeconomics
Steven Ellis
Study Guide
Econ, Economics, Macro, macroecon, Macroeconomics
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This 34 page Study Guide was uploaded by Rooshna Ali on Saturday May 7, 2016. The Study Guide belongs to Econ 10233 at Texas Christian University taught by Steven Ellis in Winter 2016. Since its upload, it has received 45 views. For similar materials see Intro Macroeconomics in Economcs at Texas Christian University.


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Date Created: 05/07/16
FINAL EXAM- CHAPTERS 10, 11, 12, 15, 16, 17, 20 Chapter 10- Measuring a Nation’s Income Gross Domestic Product (GDP) • measures total income of everyone in the economy • measures total expenditure (spending) on the economy’s output of goods and services For the economy as a whole, income equals expenditure, because every dollar a buyer spends is a dollar of income for the seller. *GDP MEASURES PRODUCTION, NOT SALES* GDP is the market value of all final goods & services produced within a country in a given period of time Ø Goods are valued at their market prices, so: o All goods are measured in the same units (e.g. dollars in the U.S.) o Things that don’t have a market value are excluded (e.g. housework you do for yourself) Ø Final goods o GDP includes only final goods—these already include price of intermediate goods *Final goods: intended for the end user *Intermediate goods: used as components/ingredients in the production of other goods Ø Goods and services o GDP includes tangible goods (DVDs, mountain bikes, beer, etc.) and tangible services (dry cleaning, concerts, cell phone service) Ø Produced o GDP includes only currently produced goods, not goods produced in the past Ø Within a country o GDP measures the value of production that occurs within a country’s borders whether done by its own citizens or by foreigners located there Ø Given period of time o Usually a year or a quarter (3 months) Gross National Product (GNP) Measures production by citizens only! —Not by border. e.g. U.S. citizen doing something in Paris counts e.g. Illegal Mexican doing something in the U.S. doesn’t count.--- but counts for GDP The components of GDP (Y) v Consumption (C) o Total spending by households on goods and services Note: § For renters, consumption includes rent payments § For homeowners, consumption includes the imputed rental value of the house but not the purchase price or mortgage payments! v Investment (I) o Total spending on goods that will be used in the future to produce more goods o Includes spending on: § Capital equipment (e.g. machines, tools) § Structures (factories, office buildings, HOUSES) § Inventories (goods produced but not yet sold) Note: § “Investment” does not mean the purchase of stocks and bonds v Government Purchase (G) o All spending on goods and services by government at the federal, state and local levels Note: § Excludes transfer payments such as social security or unemployment insurance benefits à they are not purchases of goods and services v Net Exports (NX) NX = exports – imports o Exports represent foreign spending on the economy’s goods and services o Imports are portions of C, I, and G that are spent on goods and services produced abroad Y = C + I + G + NX 70% of GDP comes from consumption! à IT PLAYS THE BIGGEST ROLE Real vs. Nominal GDP Inflation can distort economic variables like GDP, so we have two version of GDP: Nominal GDP • Values output using current prices • NOT corrected for inflation Real GDP • Values output using the prices of a base year • IS corrected for inflation ???????????? = ???? ∗ ???? **First year calculations satisfies the definition of both nominal and real GDP à Not a coincidence o Real GDP per capita is the main indicator of the average person’s standard of living o GDP does not value: • The quality of the environment • Leisure time • Composition: what exactly is being produced • Distribution: GDP per capita is only an average, we don’t know if G/S or income are evenly distributed • Product Quality The GDP Deflator The GDP deflator is a measure of the overall level of prices ▯▯▯▯▯▯▯ ▯▯▯ = 100 ∗ ▯▯▯▯ ▯▯▯ *no units à dimensional number *GDP deflator in the base year is always a 100, not by a chance! Inflation rate is the percent increase in the GDP deflator from one year to the next Chapter 11- Measuring Cost of Living Consumer Price Index (CPI) • Measures the typical consumer’s cost of living • The basis of cost of living adjustments (COLAs) in many contracts and in social security How the CPI is calculated 1) Fix the “basket” The Bureau of Labor Statistics (BLS) surveys consumers to determine what’s in the typical consumer’s “shopping basket” 2) Find the prices The BLS collects data on the prices of all the goods in the basket 3) Compute the basket’s cost Use the prices to compute the total cost of the basket 4) Choose a base year and compute the index = 100 ∗ ▯▯▯▯ ▯▯ ▯▯▯▯▯▯ ▯▯ ▯▯▯▯▯▯▯ ▯▯▯▯ ▯▯▯▯ ▯▯ ▯▯▯▯▯▯ ▯▯ ▯▯▯▯ ▯▯▯▯ 5) Compute the inflation rate The percentage change in the CPI from the preceding year ▯▯▯ – ▯▯▯ = ▯▯▯▯ ▯▯▯▯ ▯▯▯▯ ▯▯▯∗ 100% ▯▯▯▯▯▯▯ ▯▯▯▯ Problems with CPI • Substitution bias o Over time, some prices rise faster than others o Consumers substitute toward goods that become relatively cheaper, migrating the effects of price increases o The CPI misses the substitution because it uses a fixed basket of goods o Thus, the CPI overstates increases in the cost of living • Introduction of new goods o The introduction of new goods increases variety, allows consumers to find products that more closely meet their needs o In effect dollars become more valuable o The CPI misses this effect because it uses a fixed basket of goods o Thus, the CPI overstates increases in the cost of living • Unmeasured quality change o Improvements in the quality of goods in the basket increase the value of each dollar o The BLS tries to account for quality changes but probably misses some, as quality is hard to measure o Thus, the CPI overstates increases in the cost of living Ø Each of these problems causes the CPI to overstate cost of living increase Ø The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5% year Ø This is important because social security payments and many contracts have COLAs tied to CPI Contrasting the CPI and GDP deflator Imported consumer goods ü Included in CPI ü Excluded from GDP deflator Capital goods ü Excluded from CPI ü Included in GDP deflator (if produced domestically) The Basket ü CPI uses a fixed basket ü GDP deflator uses a basked of currently produced goods and services à This matters if different prices are changing by different amounts Correcting variables for Inflation v Comparing Dollar Figures from Different Times ▯▯▯▯▯ ▯▯▯▯▯ ▯▯▯▯▯ ???????????????????????? ???????? ???????????????????? ???? ???????????????????????????? = ???????????????????????????? ???????? ???????????????? ???? ???????????????????????????? ∗ ▯▯▯▯▯ ▯▯▯▯▯ ▯▯ ▯▯▯▯ ▯ **to find dollar value back in time flip CPI ratio** v Indexation o A dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract o For example, the increase in the CPI automatically determines: § The COLA in many multi-year labor contracts § Adjustments in social security payments and federal income tax brackets v Real vs. Nominal Interest Rates o The nominal interest rate: § The interest rate is NOT corrected for inflation § The rate of growth in the dollar value of a deposit or debt o The real interest rate: § IS corrected for inflation § The rate of growth in the purchasing power of a deposit or debt ???????????????? ???????????????????????????????? ???????????????? = ???????????????????????????? ???????????????????????????????? ???????????????? − ???????????????????????????????????? ???????????????? Chapter 12- Production and Growth Incomes and Growth Around the World Since growth rates vary, the country rankings change over time: • Poor countries are not necessarily doomed to poverty forever, e.g. Singapore incomes where low in 1960 and are quite high now • Rich countries can’t take their status for granted: They may be overtaken by poorer but faster-growing countries Productivity A country’s standard of living depends on its ability to produce g&s This ability depends on productivity: the average quantity of g&s produced per unit of labor unit Y = real GDP = quantity of output produced L = quantity of labor ▯ So ???????????????????????????????????????????? = = (???????????????????????? ???????????? ????????????????????????) ▯ Why is productivity so important? v When a nation’s workers are very productive, real GDP is large & incomes are high v When productivity grows rapidly, so do living standards Physical Capital Per Worker K = [physical] capital = the stock of equipment and structures used to produce g&s ???? ???? = ???????????????????????????? ???????????? ???????????????????????? Productivity is higher when the average worker has more capital (machines, equipment, etc.) à an increase in K/L (capital per worker) causes an increase in Y/L (productivity) Human Capital Per Worker H = human capital = the knowledge & skills workers acquire through education, training & experience ???? = ????ℎ???? ???????????????????????????? ???????????????????????? ???? ℎ???????????????? ???????????????????????????? (????????????????????????????????????) ???? Productivity is higher when the average worker has more human capital (education, skills, etc.) à an increase in H/L (human capital per worker) causes an increase in Y/L (productivity) Natural Resources Per Worker N = natural resources = the inputs into production that nature provides, e.g. land mineral deposits ???? ???? = ???????????????????????????? ???????????????????????????????? ???????????? ???????????????????????? Productivity is higher when the average worker has more natural resources à an increase in N/l causes an increase in Y/L Some countries are rich because they have abundant natural resources (e.g. Saudi Arabia has lots of oil) But countries don’t need N to be rich (e.g. Japan imports the N it needs) Technological Knowledge Technological knowledge: society’s understanding of the best ways to produce g&s Technological progress does not only mean a faster computer, a higher-definition TV, or a smaller cellphone It means any advance in knowledge that boosts productivity (allows society to get more output from its resources) Tech. Knowledge vs. Human Capital Technological knowledge refers to society’s understanding of how to produce g&s Human capital results from the effort people expend to acquire this knowledge Production Function The production function is a graph of equation outputs & inputs: ???? = ????????(????,????,????,????) F( ) is a function that shows how inputs are combined to produce outbut “A” is the level of technology à “A” multiplies the function F( ) so improvements in technology (increases in “A”) allow more output “y” to be produced from any given combo of inputs The production function has the property constant returns to scale: Changing all inputs by the same percent causes output to change by that percent For example, doubling all inputs (multiplying each by 2) causes output to double: 2???? = ????????(2????,2????,2????,2????) *note: increasing by 10% means multiplying each by 1.1 This equation shows that productivity (output per worker) depends on: o Level of technology o Physical capital per worker (K) o Human capital per worker (H) o Natural resource per worker (N) How to Increase Productivity By increasing K, which requires investment Producing more capital requires producing fewer consumption Reducing consumption = increasing saving Hence a tradeoff between current and future consumption Chapter 15- Unemployment Employed: paid employees, self-employed, and unpaid workers in a family business Unemployed: people not working who have looked for work during previous 4 weeks Not in the labor force: everyone else Labor force- the total number of workers, including the employed and unemployed Unemployment rate (“u-rate”): percent of the labor force that is unemployed # ???????? ???????????????????????????????????????? = 100 ∗ ???????????????????? ???????????????????? The u-rate is not a perfect indicator of joblessness of the health of the labor market: It excludes discouraged workers It does not distinguish between full-time and part-time work, or people working part- time because full time is not available Some people misreport their work status in the BLS survey Labor force participation rate: percent of the adult population that is in the labor force ???????????????????? ???????????????????? = 100 ∗ ???????????????????? ???????????????????????????????????????? The Duration of Unemployment Most spells of unemployment are short: Typically, 1/3 of the unemployed have been unemployed under 5 weeks, 2/3 have been unemployed under 14 weeks Only 20% have been unemployed over 6 months Yet, • The small group of long-term unemployed persons has fairly little turnover, so it accounts for most of the unemployment observed over time. Knowing these facts helps policymakers design better policies to help unemployed Cyclical Unemployment vs. the Natural Rate There’s always some unemployment, though the u-rate fluctuates from year to year. Natural rate of unemployment: the normal rate of unemployment around which the actual unemployment rate fluctuates à not that big of a problem à cyclical unemployment is zero 5.5% = natural rate of unemployment ???????????????????????????? ???????????????? ???????? ???????????????????????????????????????????????? = ???????????????????????????????????????? ???????????????????????????????????????????????? + ???????????????????????????????????????? ???????????????????????????????????????????????? Even when the economy is doing well, there is always some unemployment, including: • Frictional unemployment: occurs when workers spend time searching for jobs that best suit their skills and tastes (talents) à short-term, for most workers • Structural unemployment: occurs when there are fewer jobs than workers à usually longer-term à more serious, but can usually be fixed o Supply (of workers) > demand (of workers) o 3 reasons for this 1. Minimum-Wage Laws § The minimum wage may exceed the equilibrium wage for the least skilled or experienced workers, causing structural unemployment **remember, minimum wage above equilibrium is BINDING** § But this group is a small part of the labor force, so the minimum wage can’t explain most of unemployment 2. Unions § Union: a worker association that bargains with employers over wages, benefits, and working conditions § Unions exert their market power to negotiate higher wages for workers § They typical union worker earns 20% higher wages and gets more benefits than a nonunion worker for the same type of work § When unions raise the wage above equilibrium, quantity of labor demanded falls and unemployment results à Supply > demanded § “Insiders”: workers who remain unemployed, are better off § “Outsiders”: workers who lose their jobs, are worse off o Some outsiders go to non-unionized labor markets, which increases labor supply and reduces wages in those markets 3. Efficiency Wages § The theory of efficiency wages: o Firms voluntarily pay above equilibrium wages to boost worker productivity § Four reasons why firms may pay efficiency wages: 1. Worker Health Higher wages = workers can eat better à more healthier à more productive 2. Worker Turnover Hiring & training is costly. Higher wages = workers stay à reduces turnover (no need to hire and train new employees) 3. Worker quality Higher wages à attracts better applicants à increase quality of firm’s workforce 4. Worker effort Cyclical unemployment: the deviation of unemployment from its natural rate à big problem: means you’ll be unemployed for a long long time Job Search • Workers have different tastes & skills, and jobs have different requirements • Job search: the process of matching workers with appropriate jobs • Sectoral shifts: changes in the composition of demand across industries or region of the country o Such shifts displace some workers, who much search for new jobs appropriate for their skills & tastes • The economy is always changing, so some frictional unemployment is inevitable Public Policy and Job Search • Government employment agencies: o Provide information about job vacancies to speed up the matching of workers to jobs • Public training programs o Aim to equip workers displaced from declining industries with the skills needed in growing industries Unemployment Insurance Unemployment insurance (UI): a government program that partially protects workers’ incomes when they become unemployed à UI increases frictional unemployment This is because of one of the Ten Principles of Economics: People respond to incentives. UI benefits end when a worker takes a job, so workers have less incentive to search or take jobs Benefits of UI: ü Reduces uncertainty over incomes ü Gives the unemployed more time to search, resulting in better job matches and thus higher productivity à benefits outweigh the negatives (increase in frictional unemployment) Chapter 16- The Monetary System • What Money Is and Why It’s Important? o Without money § Trade would require barter, the exchange of one good or service for another § Every transaction would require a double coincidence of wants, the unlikely occurrence that two people each have a good or service the other wants § People would have to spend time searching for others to trade with—a huge waste of resources o This search is unnecessary with money, the set of assets in an economy that people regularly use to buy goods and services from other people • The 3 Functions of Money 1) Medium of exchange- an item buyers give to sellers when they want to purchase goods & services 2) Unit of account- yardstick people use to post prices and record debts (measure & record of economic value) 3) Store of value- an item people can use to transfer purchasing power from the present to the future • The 2 Kinds of Money 1) Commodity money- takes the form of a commodity with intrinsic value e.g. gold coins, cigarettes in prisons 2) Fiat money- money w/out intrinsic value value; used as money because of govt. decree e.g. the U.S. Dollar *Intrinsic value- item would have value even If it were not used as money • The Money Supply o The money supply (or money stock): the quantity of money available in the economy = ???????????????????????????????? + ???????????????????????????????? = ???????????????????? ???????????????????????????????????????? ∗ ???????????????? ???????????????????????????????? o What assets should be considered part of the money supply? § Currency: the paper bills and coins in the hands of the (non-bank) public § Demand deposits: balances in bank accounts that depositors can access on demand by writing a check § Note: credit cards are not money; the credit card company spends money for you • Measures of the U.S. Money Supply o M1: Currency, demand deposits, traveler’s check, and other checkable deposits M1 = $2.6 trillion (Sept. 2013) o M2: everything in M1 plus savings deposits, small time deposits, money market mutual funds and a few minor categories • Central Banks & Monetary Policy o Central bank: an institution that oversees the banking system and regulates the money supply o Monetary policy: the setting of the money supply by policymakers in the central bank o Federal Reserve (Fed): the central bank of the U.S • The Structure of the Fed The Federal Reserve System consists of: o Board of Governors (7 members), located in DC o 12 regional Fed Banks, located around the U.S. o Federal Open Market Committee (FOMC), includes the Board of Governors and presidents of some of the regional Fed banks. § They decide monetary policy § Janet L. Yellen- current Chair of FOMC • Bank Reserves o In a fractional reserve banking system, banks keep a fraction of deposits as reserves and use the rest to make loans § They keep reserves in vaults or let Feds hold it § Lend out excess reserves (usually 10%) o The Fed establishes reserve requirements, regulations on the minimum amount of reserves that banks must hold against deposits o Banks may hold more than this minimum amount, if they choose o The reserve ratio, R = fraction of deposits that banks hold as reserves = total reserves as a percentage of total deposits ???????????????????? ???????????????????????????????? = ???????????????????? ???????????????????????????????? • Bank T-Account o T-account: a simplified accounting statement that shows a bank’s assets & liabilities § Liabilities (right) include deposits § Assets (left) include loans & reserves * Fiduciary- proper efforts to protect your money à banks have fiduciary responsibility to protect you r money • Banks and the Money Supply: An Example o No banking system § Public holds all the $$ as currency § Money supply = $$ o 100% reserve banking system § Deposits = $$, Reserves= $$, Loans = 0 § Money Supply = 0 + $$ § In a 100% reserve banking system, banks do not affect the size of money supply o Fractional reserve banking system § Deposits = $$, Reserves = .10($$), Loans = .90($$) § Money Supply = currency + deposits = .9($$) + $$ = 1.9$$ § A fractional reserve banking system creates money, but NOT wealth à your net worth did not go up, you owe debt!! • The Money Multiplier o The amount of money the banking system generates w/ each dollar of reserves 1 = ???? e.g. With a R = 10%, $100 of deposit will create $1000 of money • A More Realistic Balance Sheet o Assets: besides reserves and loans, banks also hold securities o Liabilities: besides deposits, banks also obtain funds from issuing debt and equity o Bank capital: the resources a bank obtains by issuing equity (stocks & ownership) to its owners = ???????????????????????? − ???????????????????????????????????????????? o Leverage: the use of borrowed funds to supplement existing funds for investment purposes o Leverage ratio: the ration of assets to bank capital ???????????????????????? = ???????????????????????????? e.g. leverage ratio= 20 Interpretation à for every $20 in assets, $1 is from the bank’s owners $19 is financed w/ borrowed money • Leverage Amplifies Profits and Losses • How the Fed Influences Reserves 1) Open-Market Operations (OMOs): the purchase & sale of U.S. government bonds by the Fed Ø Buy govt. bonds from a bank, it pays by depositing new reserves in that bank’s reserve account With more reserves, the bank can make more loans, increasing the money supply Ø Sell govt. bonds, decrease bank reserves and money supply 2) The Fed makes loans to banks, increasing their reserves v Traditional Method: adjusting the discount rate (the interest rateon loans the Fed makes to banks) to influence the amount of reserves banks borrow v New method: Term Auction Facility—the Fed chooses the quantity of reserves it will loan, then banks bid against each other for these loans Ø The more banks borrow, the more reserves they have for funding new loans and increasing the money supply Chapter 17- Money Growth and Inflation • The Value of Money P = the price level (e.g., the CPI or GDP deflator) P is the price of a basket of goods (measured in money) 1/P is the value of $1 (measured in goods) Ø Inflation drives up prices and drives down the value of money • The Quantity Theory of Money o Asserts that the quantity of money determines the value of money • Money Supply (MS) o In the real world, determined by the Fed, the banking system, and consumers o In this model we assume the Fed precisely controls MS and sets it at some fixed amount • Money Demand (MD) o Refers to how much wealth people want to hold in liquidity form o Depends on P § An increase in P reduces the value of money, so more money is required to buy g&s o Thus, quantity of money demanded is negatively related to the value of money and positively related to P, other things equal (“other things” include real income, interest rates, availability of ATMs) • The Money Supply-Demand Diagram o As the value of money rises, the price level falls o A fall in value of money (or increase in P) increases the quantity of money demanded • The Effects of a Monetary Injection o Suppose the Fed increases the money supply, then the value of money falls & P rises • A Brief Look at the Adjustment Process o Increasing MS causes P to rise. o How does this work? (LONG RUN) § At the initial P, an increase in MS causes an excess supply of money § People get rid of their excess money by spending it on g&s or by loaning it to others, who spend it. § Result: increased demand for goods § But supply of goods does not increase, so prices must rise • Real vs. Nominal Variables o Nominal variables are measured in monetary units (money) e.g. nominal GDP, nominal interest rate (rate of return measured in $), nominal wage ($ per hour) o Real variables are measured in physical units e.g. real GDP, real interest rate (measured in output), real wage (measured in output) o Prices are nominally measured in terms of money § Price of a CD: $15/CD § Price of a pepperoni pizza: $10/pizza o A relative price is the price of one good relative to (divided by) another § Relative price of CDs in terms of pizza- ???????????????????? ???????? ???????? = $15/???????? = 1.5 ???????????????????????? ???????????? ???????? ???????????????????? ???????? ???????????????????? $10/???????????????????? o Relative prices are measured in physical units, so they are real variables o An important relative price is the real wage: W = nominal wage = price of labor, $15/hour P = price level = price of g&s, $5/unit of output Real wage is the price of labor relative to the price of output ???? $15/ℎ???????????? = = 3 ???????????????????? ???????? ???????????????????????? ???????????? ℎ???????????? ???? $5/???????????????? ???????? ???????????????????????? • The Classical Dichotomy o Classical dichotomy: the theoretical separation of nominal & real variables o Hume and the classical economists suggested that monetary developments affect nominal variables but not real variables o If central bank doubles the money supply, § All nominal variables—including prices—will double § All real variables—including relative prices—will remain unchanged • The Neutrality of Money o Monetary neutrality: the proposition that changes in the money supply do not affect real variables e.g. doubling money supply causes all nominal prices to double, however the relative price remains unchanged o Similarly, the real wage W/P remains unchanged, so § Quantity of labor supplied does not change § Quantity of labor demanded does not change § Total employment of labor does not change o The same applies to employment of capital and other resources o Since employment of all resources is unchanged, total output is also unchanged by the money supply o The classical dichotomy and neutrality of money describe the economy in the long run • The Velocity of Money o Velocity of money: the rate at which money changes hands o Notation: P x Y = nominal GDP = (price level) x (real GDP) M = money supply V = velocity ???? ▯ ???? o Velocity formula: ???? = ???? o Interpretation: The average dollar was used in V transactions o Velocity is fairly stable over the long run • The Quantity Equation P x Velocity formula: = M o Multiply both sides of the formula by M: M x V = P x Y o This is called the quantity equation • The Quantity Theory in 5 Steps Start with the quantity equation: M x V = P x Y 1) V is stable 2) So, a change in M causes nominal GDP (P x Y) to change the same percent 3) A change in M doesn’t affect Y: Money is neutral. Y is determined by technology & resources 4) So, P changes by the same percent as P x Y and M 5) Rapid money supply growth causes rapid inflation o If real GDP is constant, then ???????????????????????????????????? ???????????????? = ???????????????????? ????????????????????ℎ ???????????????? o If real GDP is growing, then ???????????????????????????????????? ???????????????? < ???????????????????? ????????????????????ℎ ???????????????? o The bottom line: § Economic growth increases number of transactions § Some money growth is needed for these extra transactions § Excessive money growth causes inflation • Hyperinflation o Hyperinflation is generally defined as inflation exceeding 50% per month o Excessive growth in money supply always causes hyperinflation • The Inflation Tax o When tax revenue is inadequate and ability to borrow is limited, the govt may print money to pay for its spending o Almost all hyperinflations start this way o Inflation Tax: printing money causes inflation, which is like a tax on everyone who holds money o In the U.S., the inflation tax today accounts for less than 3% of total revenue • The Fisher Effect o Rearrange the definition of the real interest rate: ???????????????????????????? ???????????????????????????????? ???????????????? = ???????????????????????????????????? ???????????????? + ???????????????? ???????????????????????????????? ???????????????? o The real interest rate is determined by saving & investment in the loanable funds market o Money supply growth determines inflation rate o So, this equation shows how the nominal interest rate is determined o In the long run, money is neutral: A change in the money growth rate affects the inflation rate but not the real interest rate o So, nominal interest rate adjusts one-for-one w/ changes in the inflation rate o This relationship is called the Fisher effect after Irving Fisher, who studied it • The Fisher Effect & the Inflation Tax o The inflation tax applies to people’s holdings of money, not their holdings of wealth o The Fisher effect: an increase in inflation causes an equa l increase in the nominal interest rate, so the real interest rate (on wealth) is unchanged • The Costs of Inflation o The inflation fallacy: most people think inflation erodes real incomes § But inflation is a general increase in prices of the things people buy and the things they sell (e.g. their labor) § In the long run, real incomes are determined by real variables, not the inflation rate o Inflation causes the CPI and nominal wages to rise together over the long run o Shoeleather costs: the resources wasted when inflation encourages people to reduce their money holdings § Includes the time & transactions costs of more frequent bank withdrawals o Menu costs: the cost of changing prices § Printing new menus, mailing new catalogs, etc. o Misallocation of resources from relative-price variability: Firms don’t all raise prices at the same time, so relative prices can vary… which distorts the allocation of resources o Confusion & inconvenience: inflation changes the yardstick we use to measure transactions § Complicates long-range planning and the comparison of dollar amounts over time o Tax distortions: Inflation makes nominal income grow faster than real income § Taxes are based on nominal income, and some are not adjusted for inflation § So, inflation causes people to pay more taxes, even when their real incomes don’t increase § Inflation: Ø Raises nominal interest rates (fisher effect) but not real interest rates Ø Increases savers’ tax burdens Ø Lowers the after-tax real interest rate • A Special Cost of Unexpected Inflation o Arbitrary redistributions of wealth Higher-than-expected inflation transfers purchasing power from creditors to debtors Debtors get to repay their debt with dollars that aren’t worth as much Lower-than-expected inflation transfers purchasing power from debtors to creditors High-inflation is more variable and less predictable than low inflation So, these arbitrary redistributions are frequent when inflation is high • The Costs of Inflation o All these costs are quite high for economies experiencing hyperinflation o For economies with low inflation (<10% per year), these costs are probably much smaller, though their exact size is open to debate • Conclusion o Money is neutral in the long run, affecting only nominal variables Chapter 20- Aggregate Demand and Supply • Introduction o Over the long run, real GDP grows about 3% year on average o In the short run, GDP fluctuates around its trend. § Recessions: periods of falling real incomes and rising unemployment Also- negative real GDP for two consecutive quarters § Depressions: severe recessions (very rare) o Short-run economic fluctuations are often called business cycles • Three Facts About Economic Fluctuations 1. Economic fluctuations are irregular and unpredictable 2. Most macroeconomic quantiles fluctuate together 3. As output falls, unemployment rises • Classical economics— A Recap o Classical Dichotomy, the separation of variables into two groups: § Real – quantities, relative prices § Nominal – measured in terms of money o The neutrality of money: changes in the money supply affect nominal but NOT real variables o Most economists believe classical theory describes the world in the long run but not the short run o In the short run, changes in nominal (like the money supply or P) can affect real variables (like Y or the u-rate) • The Model of Aggregate Demand and Aggregate Supply o The model determines the equilibrium price level and equilibrium output (real GDP) • The Aggregate-Demand (AD) Curve o The AD curve shows the quantity of ALL goods & services demanded in the economy at ANY given price level • Why the AD Curve Slopes Downward Y = C + I + G + NX Assume G is fixed by govt. policy To understand the slope of AD, we must determine how a change in P affects C, I, and NX 1. The Wealth Effect (P and C) Suppose P rises Ø The dollars people hold buy fewer goods and services, so real wealth is lower (still have same amount of money though) Ø People feel poorer Result: C falls 2. The Interest-Rate Effect (P and I) Suppose P rises Ø Buying goods and services requires more dollars Ø To get these dollars, people sell bonds or other assets (price of bonds go up) Ø This drives up interest rates Result: I falls (recall I depends negatively on interest rates 3. The Exchange-Rate Effect (P and NX) Suppose P rises Ø U.S. interest rates rise (the interest-rate effect) Ø Foreign investors desire more U.S. bonds Ø Higher demand for money in foreign exchange market Ø U.S. exchange rate appreciates Ø U.S. exports more expensive to people abroad, imports cheaper to U.S. residents Result: NX falls • Why the AD Curve Might Shift o Any event that changes C, I, G, or NX –except a change in P— will shift the AD curve o Changes in C § Stock market boom/crash § Preferences re: consumption/saving tradeoff § Tax hikes/cuts o Changes in I § Firms buy new computers, equipment, factories § Expectations, optimism/pessimism § Interest rates, monetary policy § Investment tax credit or tax incentives o Changes in G § Federal spending e.g., defense § State & local spending e.g., roads, schools o Changes in NX § Booms/recessions in countries that buy our exports § Appreciation/depreciation resulting from international speculation in foreign exchange market • The Aggregate-Supply (AS) Curves o The AS curve shows the total quantity of g&s firms produce and sell at any given price level o AS is § Vertical in the long run § Upward sloping in the short run • The Long-Run Aggregate-Supply Curve (LRAS) o The natural rate of output (YN) is the amount of output the economy produces when unemployment is at its natural rate o (YN ) is also called potential output or full-employment output • Why LRAS is Vertical o (YN ) determined by the economy’s stocks of labor, capital, and natural resources, and on the level of technology o An increase in P does not affect any of these, so it does not affect ( ) N (classical dichotomy) • Why the LRAS Curve Might Shift o Changes in natural resources § Discovery of new mineral deposits § Reduction in supply of imported oil § Changed in weather patterns that affect agricultural production o Changes in technology § Productivity improvements from technological progress • Using AD & AS to Depict Long-Run Growth and Inflation o Over the long run, technological progress shifts LRAS to the right and growth in the money supply shifts AD to the right à Result: ongoing inflation & growth in output


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