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EC 111 Class Notes -- All Chapters

by: taflournoy

EC 111 Class Notes -- All Chapters Econ 111


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These notes were taken every day in class, the "red" font is points Zirlott said were important and would be on the test.
Kent 0. Zirlott
Study Guide
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This 49 page Study Guide was uploaded by taflournoy on Tuesday October 11, 2016. The Study Guide belongs to Econ 111 at University of Alabama - Tuscaloosa taught by Kent 0. Zirlott in Summer 2016. Since its upload, it has received 4 views. For similar materials see Macroeconomics in Macro Economics at University of Alabama - Tuscaloosa.


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Date Created: 10/11/16
EC 111 Class Notes Chapter 1: Ten Principles of Economics What economics is all about?  Scarcity—the limited nature of society’s resources  Economics—the study of how society manages its scarce resources How people decide what to buy, how much to work/save/spend How firms decide how much to produce How society decides to divide its resources  How people make decisions: Principle #1: People Face Tradeoffs Important tradeoff: efficiency v equality  Efficiency—when society gets the most from its scarce resources  Equality—when prosperity is distributed uniformly among society’s members Principle #2: The cost of something is what you give up to get it Making decisions requires comparing the costs and benefits of alternative choices The “opportunity cost” of any item is whatever must be given up to obtain it ***Measure opportunity cost by the highest valued alternative given up*** Principle #3: Rational people think at the Margin  Rational people- systematically and purposefully do the best they can to achieve their objectives  Make decisions by evaluating costs and benefits of “marginal changes”—incremental adjustments to an existing plan  Comparing “costs and benefits” Principle #4: People Respond to Incentives  Incentive—something that induces a person to act; i.e. the prospect of a reward or punishment  Rational people respond to incentives when cigarette taxes increase, smoking falls Principle #5: Trade can make everyone better off  Rather than being self-sufficient, people can specialize in producing one good or service and exchange it for other goods  Countries also benefit form trade and specialization  Buy other goods more cheaply from abroad than could be produced at home Principle #6: Markets are usually a good way to organize economic activity  Market—a group of buyers and sellers (need not be in a single location)  “Organize economic activity”—means determining: what goods to produce, how to produce them, how much of each to produce, and who gets them  Market Economy—allocates resources through the decisions of many households and firms as they interact in markets  Known as “The Invisible Hand”—which works through the price system -Interaction of buyers and sellers determines prices -Each price reflects the good’s value to buyers and the cost of producing the good - Prices guide self-interested households and firms to make decisions that, in many cases, maximize society’s economic wellbeing Principle #7: Governments can sometimes improve market outcomes  Important role for government: enforce property rights (with police, courts)  People are less inclined to work, produce, invest, or purchase if large risk of their property being stolen  Market failure—when the market fails to allocate society’s resources efficiently  Causes: Externalities—when the production or consumption of a good affects bystanders (ex. pollution) Market power—when a single buyer or seller has substantial influence on a market price (monopoly)  In such cases, public policy may promote efficiency because it promotes competition  Government may alter market outcome to promote equity  If the market’s distribution of economic wellbeing is not desirable, tax or welfare policies can change how the economic “pie” is divided. Principles 8, 9, & 10—Macroeconomics Principle #8: A country’s standard of living depends on its ability to produce goods and services—GDP  The most important determinant of living standards: “productivity”—the amount of goods and services produced per unit of labor  Productivity depends on the equipment, skills, and technology available to workers  Other factors (ex. labor unions, competition from abroad) have far less impact on living standards Principle #9: Prices rise when the government prints too much money  Inflation—increases in the general level of prices  In the long run, inflation is almost always caused by excessive growth in the quantity of money, which causes the value of money to fall.  The faster the government creates money, the greater the inflation rate Principle #10: Society faces a short-run tradeoff between inflation and unemployment  Known as “The Phillips Curve”  Tradeoff is always present Chapter 2 Assumptions and Models  Assumptions simplify the complex world, make it easier to understand  Ex. to study international trade assumes 2 countries and 2 goods. Unrealistic, but simple to learn and gives useful insights about the real world.  Model: a highly simplified representation of a more complicated reality; economists use models to study economic issues Our first model: The Circular-Flow Diagram  The Circular Flow Diagram: a visual model of the economy, shows how dollars flow through markets among households and firms  Two types of “actors”: households, firms  Two markets: the market for goods and services; “factors of production”—INPUTS Factors of Production  Factors of production: the resource the economy uses to produce goods & services including: labor, land, capital (equipment and machinery), entrepreneurship  Households: own the factors of production, sell/rent them to firms for income Buy and consume goods and services  Firms: buy or hire factors of production, use them to produce goods/services Sell goods and services **Households take factors of production to market for goods and services  4 types of payments: Wages goes to labor Rent goes to land Interest goes to capital (machinery, buildings, technology) Profit goes to the entrepreneur Our second model: The Production Possibilities Frontier  The production possibilities frontier: a graph that shows the combinations of two goods the economy can possibly produce given the available resources and available technology The PPF and Opportunity Cost  Recall: the opportunity cost of an item is what must be given up to obtain that item  Moving along the PPF involves shifting resources (e.g. labor) from the production of one good to the other  Society faces a tradeoff: getting more of one good requires sacrificing some of the other  The slope of the PPF tells you the opportunity cost of one good in terms of the other The Shape of the PPF  The PPF could be a straight line or bow-shaped  Depends on what happens to opportunity cost as economy shifts resources from one industry to the other If opp. cost remains constant, PPF is a straight line; essentially the same resources are equally useful for producing in either industry If opp. cost of a good rises as the economy produces more of the good, PPF is bow-shaped; essentially the resources are specialized and not easily adaptable for producing in either industry *** The slope of a line equals the “rise” over the “run”; the amount the line rises when you move to the right by one unit; downward slope=negative; upward=positive  Economic growth shifts the PPF outward Why the PPF might be Bow-Shaped  As the economy shifts resources from beer to mountain bikes, PPF becomes steeper and opp. cost of mountain bikes increases  Producing more bikes would require shifting some of the best brewers away from beer production, which would cause a big drop in beer output.  So, PPF is bow-shaped when different workers have different skills, different opp. costs of producing one good in terms of the other  The PPF would also be bow-shaped when there is some other resource, or mix of resources with varying opp. costs. Important Notes: PPF shows all combinations of two goods that an economy can possibly produce Microeconomics and Macroeconomics:  Microeconomics: the study of how households and firms make decisions and how they interact in markets  Macroeconomics: the study of economy-wide phenomena, including inflation, unemployment, and economic growth  These two branches of economics are closely intertwined, yet distinct—they address different questions The Economist as a Policy Advisor  As scientists, economists make “positive statements” which attempt to describe the world as it is  As policy advisors, economists make “normative statements” which attempt to prescribe how the world should be  Examples: Prices rise when the government increases the quantity of money— positive bc it describes a relationship that is actually true The govnt should print less money—normative: the use of the word “should” A tax cut is needed to stimulate the economy—normative ***PPF diagram on Exam 1 with questions attached*** Inside the frontier—inefficient Outside the frontier—unattainable On the line—efficient The PPF: What We Know So Far - Points on the PPF—possible, efficient (all resources are fully utilized) - Points under the PPF—possible, not efficient (some resources are under utilized) - Points above the PPF—currently unobtainable Chapter 4: Supply & Demand Markets and Competition:  A market is a group of buyers and sellers of a particular product  A competitive market is one with many buyers and sellers, each has a negligible effect on price  There are several different types of markets (such as perfect competition—producers producing the same good; monopoly— comes from one company; monopolistic competition—Starbucks, McDonald’s) each with their own unique characteristics Demand:  The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase at a specific point  The demand curve is a set of various quantities demanded at corresponding prices; it is the curve itself  Law of demand—negative or inverse relationship; the claim that the quantity demanded of a good falls when the price of the good rises; other things equal Why do we have law of demand?—ppl buy more when price goes down, people buy less when price goes up  Demand schedule: a table that shows the relationship between the price of a good and the quantity demanded Demand curves slope downward—and its does bc Law of Demand Price always goes on vertical axis; quantity always goes on horizontal Market Demand Verses Individual Demand:  The quantity demanded in the market is the sum of the quantities demanded by all buyers at each price  Sum up the Q^D which would equal the Market Q^D Demand Curve Shifters:  The demand curve shows how the price affects QD; other things being equal. A change in the price of the good changes QD and results in a movement along the D curve; the only thing that causes a change in QD is a change in the price itself  These “other things” are non-price determinant of demand (things that determine buyers demand for a good, other than the good’s price)  Changes in them shift the D curve…  Increase in demand, the entire curve shifts to the RIGHT  Decrease in demand, the entire curve shifts to the LEFT Demand Curve Shifters: # of Buyers  Increase in # of buyers  increases quantity demanded at each price; shifts D curve to the RIGHT Demand Curve Shifters: Income  Demand for a normal good is positively related to income  increase in income causes increase in quantity demanded at each price, shifts D curve to the RIGHT  Demand for an inferior good is negatively related to income  increase in income shifts D curves for inferior goods to the LEFT Demand Curve Shifters: Prices of Related Goods  Two goods are substitutes if an increase in the price of one causes an increase in demand for the other  Ex. Crest and Colgate  in increase in the price of crest toothpaste increases demand for Colgate toothpaste, shifting the Colgate demand curve to the right  Other ex. Coke and Pepsi; laptops and tablets  Two goods are complements if an increase in the price of one causes a fall in the demand for the other  Ex. computers and software  if price of computers rises, people buy fewer computers and therefore less software; software demand curve shifts left Demand Curve Shifters: Tastes  Anything that causes a shift in tastes toward a good will increase demand for that good and shift its D curve to the right  Ex. Atkins Diet caused an increase in demand for eggs which shifted the curve to the right  Anything that causes a shift in tastes away from a good will decrease demand for that good and shift its D curve to the left  Ex. teen/young retailers are experiencing a large decline in sales, and some are even going out of business due to changing tastes and preferences Demand Curve Shifters: Expectations  Expectations affect consumer’s buying decisions  Ex. If people expect their incomes to rise, their demand for meals at expensive restaurants may increase now  If the economy sours and people worry about their future job security, demand for new autos may fall now. Supply:  The quantity supplied of any good is the amount that sellers are willing and able to sell at a specific price; QS is a point on the supply curve  The supply curve is a set of various quantities supplied at corresponding prices  Law of Supply: the claim that the quantity supplied of a good rises when the price of the good rises; other things equal  If price goes up, QS goes up  If price goes down, QS goes down  Higher prices are an incentive to a producer to produce more The Supply Schedule:  Supply Schedule: a table that shows the relationship between the price of a good and the quantity supplied  Ex. Starbuck’s Lattes Market Supply versus Individual Supply:  The QS in the market is the sum of the quantities supplied by all sellers at each price  Suppose Starbucks and Crimson Cafe are the only two sellers in the market Supply Curve Shifters:  The supply curve shows how prices affects QS; other things being equal; a change in the price of the goods changes QS and results in a movement along the S curve  The things that shift demand are not the things that shift supply; income and population does not shift supply  Increase in supply shifts to the RIGHT; decrease in supply shifts to the LEFT Supply Curve Shifters: Input Prices  Ex. of input prices  wages; raw materials  A fall in input prices makes production more profitable at each output price; so firms supply a larger quantity at each a price, and the S curve shifts to the RIGHT Supply Curve Shifters: Technology  Technology determines how much inputs are required to produce a unit of output  A cost-saving technological improvement has the same effect as a fall in input prices, shifts S curve to the RIGHT  An increase in production technology ALWAYS shifts the Supply Curve to the RIGHT because it makes it more efficient and can produce more  Technology determines how much inputs are required to produce a unit of output Supply Curve Shifters: # of Sellers  An increase in the number of sellers increases the quantity supplied at each price, shifts S curve to the RIGHT Supply Curve Shifters: Expectations  Expectations is the only one that effects both supply and demand  In general, sellers may adjust supply (if the good is not perishable) when their expectations of future prices change Equilibrium: P has reached the level where the QS equal the QD  Equilibrium Price: the price that equates quantity supplied with quantity demanded  Surplus: (excess supply) when the QS is GREATER than the QD Facing a surplus sellers try to increase sales by cutting price and prices continue to fall until market reaches equilibrium  The market clears when the market is in equilibrium; no shortages and no surplus  Shortage: (excess demand) when QD is GREATER than QS Facing a shortage, sellers raise the price and prices continue to rise until market reaches equilibrium Three Steps to Analyzing Changes in EQ’M:  Decide whether event shifts S curve, D curve, or both  Decide in which direction curve shifts  Use supply-demand diagram to see how the shift changes equilibrium P and Q  EX: A shift in demand  increase in price of gas (Tastes/preferences is the most powerful determinant) D curve shifts to the RIGHT because high gas price makes hybrids more attractive The shift causes an increase in price and quantity of hybrid cars When P rises, producers supply a larger quantity of hybrids, even though the S curve has not shifted. A shift in Supply:  S shifts RIGHT because even reduces cost, makes production more profitable at any given price  The shift causes prices to fall and quantity to rise  When price falls, you move down along the demand curve A shift in Supply and Demand:  Price of gas rises AND new technology reduces production costs  Both curves shift  Both shift to the RIGHT  Q rises, but effect on P is AMBIGUOUS—we don't know how far the two curves shifted; when there are no numbers on the graph= abstract  Two pointers: When S&D are BOTH shifting in the SAME direction, PRICE will be Ambiguous, BUT Q will CHANGE When S &D are shifting in OPPOSITE directions, QUANTITY will be Ambiguous, but Price will change  Fall in price of frozen yogurt= within the market for ice cream Demand curve will shift LEFT P & Q will BOTH fall Because people will chose the cheaper substitute  Fall in milk prices=within the Market for ice cream S curve shifts (milk prices are part of seller’s costs) S shifts RIGHT P falls, Q rises  Fall in price of fro-yo and milk= quantity will be AMBIGUOUS Both curves shift *****Terms for Shift vs. Movement Along Curve:  Change in Supply—a shift in the S curve; occurs when a non- price determinant of supply changes (like technology or costs)  Change in the Quantity Supplied—a movement along a fixed S curve; occurs when P changes  Change in demand—a shift in the D curve; occurs when a non- price determinant of demand changes (like income or # of buyers)  Change in the Quantity Demanded—a movement along a fixed D curve occurs when P changes Conclusion: How Prices Allocate Resources  One of the 10 Principles from chapter 1—Markets are usually a good way to organize economic activity  In market economies, prices adjust to balance supply and demand. These equilibrium prices are the signals that guide the economic decisions and thereby allocate scarce resources. Chapter 5: Elasticity:  Basic idea: Elasticity measures how much of one variable responds to changes in another variable - One type of elasticity measures how much demand for your websites will fall if you raise your price  Definition: Elasticity is a numerical measure of the responsiveness of QD or QS to one of its determinants Price Elasticity of Demand:  Price Elasticity of Demand = percentage change in QD / percentage change in P  Price elasticity of demand measures how much QD responds to a change in P  Loosely speaking, it measures the price-sensitivity of buyer’s demand  Ex. P rises by 10%; Q falls by 15%  divide 15 by 10 = 1.5—is a “pure number” and it should be negative, however we quote elasticity of demand as a POSITIVE number  Along a D curve, P & Q move in opposite directions which would make price elasticity negative  Calculating Percentage Change:  (New – old / old) x 100%  Standard method of computing percentage change: (end value – start value) / start value x 100%  Can not use to calculate elasticity of demand ***** The standard method gives different answers depending on where you start; instead you use the “midpoint method” Calculating Percentage Changes for elasticity of Demand:  Midpoint Method  (end value –start value) / midpoint) x 100%  The midpoint is the number halfway between the start value and end values; the average of those values  It doesn't matter which value you use as the “start” or the “end”— you get the same answer either way  Using the midpoint method, the % change in P equals The Variety of Demand Curves:  The price of elasticity of demand is closely related to the slope of the demand curve but it is not equal to the slope of the demand curve The reason for this is because slope is a ratio of two changes and elasticity is a ratio of two % changes  Rule of Thumb: the flatter the curve, the bigger the elasticity; the steeper the curve the smaller the elasticity 5 Different Classifications of D curves:  Elastic demand—relatively flat D curve; price sensitivity is relatively high, elasticity is greater than 1; % change in Q is greater than 10%  Inelastic demand—relatively steep D curve; price sensitivity is relatively low; elasticity is less than 1; % change in Q is less than 10%  Unit elastic demand—the elasticity equals 1; the % change in Q is equal to the % change in P  Perfectly inelastic demand—(one extreme case) the D curve is a perfectly vertical line; no price sensitivity; elasticity equals 0; % change in Q equals 0 %  Perfectly elastic demand—(the other extreme) the D curve is horizontal; price sensitivity is extreme; elasticity is infinite; % change in Q equals any % What determines price elasticity?  Price elasticity is higher when close substitutes are available.  Price elasticity is higher for narrowly defined goods than broadly defined ones.  Price elasticity is higher for luxuries than for necessities  Price elasticity is higher in the long run than the short run Price Elasticity and Total Revenue:  Revenue = Price x Quantity  A price increase has two effects on revenue: price effect and output effect Higher P means more revenue of each unit you sell But you sell fewer units (lower Q), due to Law of Demand  Which of these two effects is bigger?  it depends on the price elasticity of demand  If demand is elastic (greater than 1), % change in Q will be greater than % change in P If you raise your price, your output falls a lot and you will lose revenue If you have an elastic product, you don't raise your Price, you lower it.  Increased revenue due to Higher P; lost revenue due to lower Q  When D is elastic, a price increase causes revenue to fall  If demand is inelastic (less than 1), % change in Q is less than % change in P  The fall in revenue from lower Q is smaller than the increase in revenue from higher P, so revenue rises. Ex. GAS  inelastic  When D is inelastic, a price increase causes revenue to rise.  Activity learning: Elasticity and expenditure/revenue A. P INCREASES 25%. QD falls by 25%, TR remains the same B. Since demand is perfectly inelastic, Q will not fall, so REVENUE RISES C. Luxuries are elastic  since demand is elastic, Q will increase more than 20%, so revenue rises. Price Elasticity of Supply:  Price elasticity of supply measures how much QS responds to a change in P  Loosely speaking, it measures seller’s price-sensitivity  % change in QS / % change in P  Midpoint method used to calculate The variety of Supply Curves:  The slope if the supply curve is closely related to price elasticity of supply  Rule of thumb: The flatter the curve, the bigger the elasticity. The steeper the curve, the smaller the elasticity  5 different classifications: SAME AS DEMAND  *** supply curve for concert, stadium seats  perfectly inelastic (vertical) The Determinants of Supply Elasticity  How easy is it for sellers to change the among they produce?  If its easy, you will have an elastic supply curve  the more easily sellers can change the quantity they produce, the greater the price elasticity of supply  *** Less elastic means “inelastic”  if it is difficult to change the amount you produce, it is inelastic  For many goods, price elasticity of supply is greater in the long run that in the short run, because firms can build new factories or new firms can enter the market Other Elasticities:  Income elasticity of demand: measures the response of QD to change in consumer income  Percentage change in QD / percentage change in income  An increase in income causes an increase in demand for a normal good  For normal goods, income elasticity = greater than 0  For inferior goods, income elasticity = less than 0  0.0001  still positive and therefore normal  If it’s equal to 0, you do not purchase…  Cross price elasticity of demand: measures the response of demand for one good to changes in the price of another good  % change in QD for good 1 / % change in price of good 2  for substitutes, cross- price elasticity > 0  if its greater than 0, they are SUBSTITUTES  if its less than 0, they are COMPLEMENTS if its equal to 0, they are not related TEST 2 NOTES: CHAPTER 6: Income and Expenditure:  Gross Domestic Product measures total income of everyone in the economy  GDP also measures total expenditure on the economy’s output of g&s  For the economy as a whole, income equals expenditure, because every dollar a buyer spends is a dollar of income for the seller The Circular Flow diagram:  A simple depiction of the macro economy  Illustrates GDP as spending, revenue, factor payments, and income  Preliminaries:  Factors of production: are inputs like labor, land, capital, and natural resources  Factors of payment:  Green arrows represent GDP What the diagram omits: The government (collects taxes, buys g&s), the financial system (matches savers’ supply of funds with the borrowers demand for loans), and the foreign sector (trades g&s, financial assets, and currencies with the country’s residents) Gross Domestic Product Is: ***MEASURED IN DOLLARS***  The market value of all final goods and services produced within a country in a given period of time  Goods are values at their market price: All goods measured in the same units (ex. dollars in the US) Things that don't have a market value are excluded (ex. housework you do for yourself)  Final goods: Intended for the user  Intermediate goods: used as components of ingredients in the production of other goods  don't use because that would be double counting  GDP only includes final goods—they already embody the value of the intermediate goods used in their production  GDP includes tangible goods like DVDs, mountain bikes, beer and intangible services like dry cleaning, concerts, and cell phone service  GDP only includes currently produced goods, not goods produced in the past  GDP measures the value of production that occurs within a country’s borders, whether done by its own citizens of by foreigners located there  GDP measured by year or a quarter (3 months) The Components of GDP:  Recall  GDP is total spending  Four Components: Consumption (C) Investment (I) Government purchases (G) Net exports (NX)  THESE COMPONENTS ADD UP TO GDP:  Y= C + I + G + NX  how to measure GDP Consumption: (C)  Is total spending by households on g&s; used for your own use  Note on housing costs: For renters, consumption includes rent payments (bc it's a current service) For homeowners, consumption includes the imputed rental value of the house, but not the purchase price of mortgage payments  they find one that is similar to mine that is on the market and being rented, and apply it to you, I am paying rent to myself to live in my own home—“imputed rental value” Investment: (I)  Is total spending on goods that will be used in the future to produce more goods; used for your business  Includes spending on  Capital equipment (machines, tools, technology) Structures (factories, office buildings) Inventories (goods produced but not yet sold; capital stock) ***They are only counted going in, we do not count them going out*** Houses (called residential fixed investment—brand new, never been lived in, recently constructed house) NOTE: “investment” does not mean the purchases of financial assets like stocks and bonds Government Purchases: (G)  Is all spending on the g&s purchased by government at the federal, state, and local levels  G excludes transfer payments, such a Social Security or unemployment insurance benefits  they are NOT purchases of g&s Net Exports: (NX)  NX= exports – imports  Exports represent foreign spending on the economy’s g&s  Imports are the portions of C, I, and G that are spent on g&s produced abroad  Adding up all the components of GDP gives: Y = C + I + G + NX Real versus Nominal GDP:  Inflation can distort economic variables like GDP, so we have two versions of GDP: one is corrected for inflation, the other is not  Nominal GDP values output using current prices; it is not corrected for inflation  REAL GDP values output using the prices of a base year; real GDP is corrected for inflation  Computing Nominal GDP Current year price times current year quantity; add them all together  Computing REAL GDP  use the base year; it will always be given to you; real GDP for base year will always be equal to nominal GDP; hold the price to the base year  REAL GDP IS CORRECTED FOR INFLATION The GDP Deflator:  The GDP deflator is a measure of the overall level of prices; way to measure inflation  Definition: GDP Deflator = 100 x (nominal GDP / real GDP)  One way to measure the economy’s inflation rate is to compute the percentage increase in GDP deflator from one year to the next  Carved in stone:  ***GDP Deflator for base year will always be 100***  To calculate deflator, you need nominal GDP and real GDP  Nominal GDP is current price x current quantity GDP and Economic Well Being:  Real GDP per capita is the main indicator of the average person’s standard of living  But GDP is not a perfect measure of well-being  Robert Kennedy issued a very eloquent yet harsh criticism of GDP: “GDP measures everything in short, except that which makes life worthwhile, and it can tell us everything about America except why we are proud that we are Americans” GDP Does Not Value:  The quality of the environment  Leisure time  Non-market activity, such as the child care a parent provides his or her child at home; time spent with family/friends  An equitable distribution of income Then why do we care about GDP?:  Having a large GDP enables a country to afford better schools, a cleaner environment, health care etc.  Many indicators of the quality of life are positively correlated with GDP  For example: Life expectancy Literacy Internet Usage and Technology Chapter 11: The Consumer Price Index:  Measures the typical consumer’s cost of living  The basis of cost of living adjustments (COLAs) in many contacts and in Social Security 5 Steps to Calculate the CPI: 1. Fix the Basket—the Bureau of Labor Statistics (BLS) surveys consumers to determine what's in the typical consumer’s “shopping basket”—anything consumers spend money on is in the 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 (base year will always be given)— The CPI in any years = 100 x (cost of basket in current year / cost of basket in base year) 5. Compute the inflation rate—the percentage change in the CPI from the preceding period  Inflation Rate = ((CPI this year – CPI last year) / CPI Last year) x 100 ***Carved in Stone  CPI for base year will ALWAYS be 100*** Problems with the CPI: Substitution Bias  Over time, some prices rise faster than others  QUANTITIES IN BASKET ARE FIXED AND THEREFORE CPI MISSES IT  Consumers substitute toward goods that come become relatively cheaper  The CPI misses this substitution because it uses a fixed basket  Thus, the CPI overstates increase in the cost of living Problems with CPI: Introduction of New Goods  The introduction of new goods increases variety, allows consumer to find products that more closely meet their needs—basket updates every 5 years  In effect, dollars become more valuable  The CPI misses this effect because it uses the fixed basket goods  Thus, the CPI overstates increases in the cost of living Problems with CPI: Unmeasured Quality Change  Improvements in the quality of goods in the basket increases the value of your dollar—new cars, trucks, phones every year  The BLS tries to account for quality changes but probably misses some, as quality is hard to measure  This, the CPI overstates increases in the cost of living—the price goes up because the product got better and you will have to pay more Problems with CPI:  Each of these problems causes the CPI to overstate cost of living increases  The BLS has made technical adjustments, but the CPI probably still overstates inflation by about 0.5 percent per year  This is important because Social Security payments and many contracts have COLAs tied to the CPI  Contrasting the CPI and GDP Deflator (also a measure of inflation):  The two are related because they both measure inflation  3 differences: Imported Consumer goods: included in CPI; excluded from GDP deflator Capital goods: excluded from CPI; included in GDP deflator (if produced domestically) The Basket: CPI uses fixed basket; GDP deflator uses basket of currently produced goods and services  When CPI goes up, GDP deflator goes up?? Correcting Variables for Inflation:  Comparing Dollar Figures form Different Times:   Inflation makes it harder to compare dollar amount from different times  Example: Minimum Wage 1.15 in DEC 1964 7.25 in Dec 2010  In which did min wage have more purchasing power?  To compare, use CPI to convert 1964 figure into “today’s dollars”…  Amount in Today’s Dollars = Amount in year T dollars x (Price level today / price level in year T)  Indexation:  a dollar amount is indexed for inflation if it is automatically corrected for inflation by law or in a contract  For example, the increase in the CPI automatically determines The COLA in many multi-year labor contracts The adjustments in Social Security payments and federal income tax brackets  Real vs. Nominal Interest Rates:   The nominal interest rate—the interest rate not corrected for inflation; the rate of growth in the dollar value of a deposit or debt  The real interest rate—correction for on inflation; the rate of growth in the purchasing power of a deposit or dept  Real Interest rate =  ***Inflation eats away your rate of return*** Chapter 15:  Labor Force Statistics:  Produced by Bureau of Labor Statistics (BLS), in the U.S. Dept of Labor  Based in regular survey of 60,000 households  Based on “adult population” (16 years old)  BLS divides population into 3 groups:  Employed—paid employess, self employed, and unpaid workers in a family business, full tme and part time worlers, and those not working because of a temporary absences form a job  unemployed—people not working who have looked for work during previous 4 weeks, also includes temporary lay offs who are waiting to be recalled to a job  not in the labor force—everyone else (minors (under 16), retirees, inmates, full time students, disabled, discouraged workers, illegal immigrants)  the labor force is the total # of workers, including the employed and unemployed.  Unemployment rate (“u-rate”)--% of the labor force that is unemployed  U-Rate = 100 x (#of unemployed/labor force)  labor force partcipaiton rate--% of the adult population that is in the labor force  labor force participation rate = 100 x (labor force/adult population)  What does the U-Rate really measure?:  The U-rate is not a perfect indicator of joblessness of the health of the labor market  It excludes discourged workers  It does not distinguish between full time and part time work, or people working part time because full time jobs are not available  Some people misreport their work status in the BLS survey (PhantomWorker)  It does not include workers being paid “under the table”  Despite these issues, the unemployment rate is still usefuluseful barometer of the labor market & economy  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 for over 6 months  yet most observed unemployment is long term  the small group of long term unemployed persons has fairly little turnover, so it accounts for the majority of observed time  knowing thiese facts helps policy makers design better policies to help unemployed  Cyclical Unemployment vs. The Natural Rate:  There’s always some unemployment, though the U-rate fluctuates form year to year  Natural rate of unemployment—the normal rate of unemployment around which the actual unemplouyment rate fluctuates  Cyclical unemployment—the deviation of unemplouyment from its natural rate; associated with business cycles, which we’ll study in later chapters  Explaining the Natural Rate: An Overview  Even when the economy is doing well, there is always some unemployment, including:  Frictional Unemployment  Structural Unemployment  Job Search—Frictional:  Workers have different tastes and skills, and jobs have different requirements  Job search—is the process of matching workers with appropriate jobs  Sectoral Shifts—changing economy  Such shifts displaces workers, who must search for new jobs appropriate for their skills and tastes  Public Policy and Jpb search:  Govnt employment agenies  Public trainiging programs  Both help speed up the job search process and reduce frictional job unemployment  Unemployment insurance:  Unemployment Insurance—  People respond to incentives  Explaining Structural Unemployment:  Structural unemployment occurs when not enough jobs to go around; occurs when wages is kept above equilibrium  3 reasons:  Minimum wage laws  Unions—2 ndcause of structural unemployment  Efficiency Wages  4 Reasons for Efficiency Wages  worker health, worker turnover (higher in retail/restaurants), worker quality, and worker effort TEST #3 NOTES: Chapter 16: What Money is and Why it’s Important:  Without money, trade would require barter—the exchange of one good or service for another  Most people would have to spend time searching for others to trade with—a huge waste of resources  This searching is unnecessary with money—the set of assets that people regularly use to buy g&s from other people The 3 Functions of Money:  Medium of exchange—an item buyers give to sellers when they want to purchase g&s  Unit of account—the yardstick people use to post prices and record debts  Store of value—an item people can use to transfer purchasing power from the present to the future The 2 Kinds of Money:  Commodity money—takes the form of a commodity with intrinsic value; ex. gold coins, diamonds, cigarettes in POW campus  Fiat money—money without intrinsic value, used as money because of government decree; ex. U.S. Dollar The Money Supply:  The money supply (or money stock)—the quantity of money available in the economy  What assets should be considered part of the money supply? Two candidates: 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 Measures of the U.S. Money Supply:  M1—currency, demand deposits, traveler’s checks, and other checkable deposits  M2—everything in M1 plus savings deposits, small time deposits, money market funds, and a few minor categories  M3—M1 and M2 plus large time deposits, repurchase agreements, and other categories (over 100,000)  bank can sell repurchase agreement and turn into money  The distinction between M1 and M1 will usually not matter when we talk about the “money supply” in this course; M3 not widely used anymore Where is all the currency?:  2013: $1.1 trillion currency outstanding Avg. Adult holds about $4,490 of currency Much of the currency is held abroad Much of the currency is held by drug dealers, tax evaders, and other criminals  Currency—not a particularly good way to hold wealth Can be lost of stolen Doesn't earn interest Central Banks & Monetary Policy:  Central bank—an institution that oversees the banking system and regulates the money supply  Monetary policy—the setting of the money supply by policymakers in the central bank  Federal Reserve (FED)—the central bank of the U.S.; institution that oversees the federal economy; extremely efficient; profitable The Fed’s Organization:  Created in 1913 form the Federal Reserve Act  After a series of bank failures in 1907  “Panic of 1907” also called “Knickerbocker Crisis’…the failure of the Knickerbocker Trust Company (a bank in NY)  Purpose: to ensure the health of the nation’s banking system  Board of Governors: 7 members, 14-year terms Appointed by the president and confirmed by the Senate  The Chairman Directs the Fed Staff Presides over board meetings Testifies regularly about Fed policy in front of congressional committees Appointed by the president (4 year term) Janet Yellen (Current Chairwoman)  The Federal Reserve System: Federal Reserve Board in Washington, D.C. 12 regional Federal Reserve Banks Major cities around the country The presidents—chosen by each bank’s board of directors  The Fed’s Jobs: Regulate banks and ensure the health of the banking system Regional Federal Reserve Banks Monitors each bank’s financial condition Facilitates bank transactions—clearing checks Acts as a bank’s bank The Fed—lender of last resort Control the money supply—quantity of money available in the economy Monetary policy—by Federal Open Market Committee (FOMC) Setting of the money supply Federal Open Market Committee:  7 members of the board of governors  5 of the 12 regional bank presidents All twelve regional bank presidents attend each FOMC meeting, but only 5 get to vote—NY regional president always votes—because of the Bond Market  Meets about every six weeks in Washington, D.C.  Discusses the condition of the economy  Consider changes in monetary policy Bank Reserves:  In a fractional reserve banking system—banks keep a fraction of deposits as reserves and uses the rest to make loans  The Fed establishes reserve requirements—regulations on the minimum amount of reserves that banks must hold against deposits. Banks can hold the reserves as vault cash or deposits at Fed—they can gain interest  Banks may hold more than this minimum amount if they choose —“excess reserve”  The reserve ratio (R)—fraction of deposits that banks hold as reserves; total reserves as a percentage of total deposits Bank T-Account:  T-account—a simplified accounting statement that shows a bank’s assets and liabilities  Banks liabilities include deposits, assets, include loans and reserves Banks and the Money Supply: An Example  Suppose $100 of currency is in circulation  To determine banks’ impact on money supply, we calculate the money supply in 3 different cases: 1) No banking system 2) 100% reserve banking system: banks hold 100% of deposits as reserves, make no loans 3) Fractional reserve banking system—what we have in America  CASE 1: No Banking System Public holds the $100 as currency Money supply = $100  Case 2: 100% Reserve Banking System Public deposits the $100 at First National Bank FNB holds 100% of deposit as resevers: Money supply = Currency + Deposits In a 100% reserve banking system, banks do not affect the size of money supply  Case 3: Fractional reserve banking system Suppose R = 10%; FNB loans all but 10% of the deposit: Money Supply = $190—depositors have $100 in deposits; borrowers have $90 in currency When banks make loans, they create money. A fractional reserve banking system creates money, but not wealth. Money Multiplier:  Money multiplier—the amount of money the banking system generates with each dollar of reserves  The money multiplier equals 1/R  In our example, R = 10% Money multiplier = 1/R = 10 $100 of reserves creates $1000 of money The Fed’s 3 Tools of Monetary Control:  1) Open-Market Operations—the purchase and sale of U.S. government bonds by the Fed.  OMOs are easy to conduct, and are the Fed’s monetary policy tool of choice. To increase money supply, Fed buys government bonds, paying with new dollars …Which are deposited in banks, increasing reserves …Which banks use to make loans, causing the money supply to expand To reduce money supply, Fed sells gov’t bonds, taking dollars out of circulation, and the process works in reverse ***The Fed does not issue government bonds or print money (Bureau of Engraving in D.C.)—The Treasury Department does***  2) Reserve Requirements (RR)—affect how much money banks can create by making loans To increase money supply, Fed reduces RR. Banks make more loans form each dollar of reserves, which decreases the reserve ratio and increases the money multiplier and the money supply To reduce money supply, Fed raises RR Fed rarely uses reserve requirements to control money supply: Frequent changes would disrupt banking  3) The Discount Rate—the interest rate on loans the Fed makes to banks When banks are running low on reserves, they can borrow reserve from the fed To increase money supply, fed can lower discount rate which encourages banks to borrow more reserves from Fed; banks can then make more loans which increases the money supply To reduce money supply, Fed can raise discount rate The Fed uses discount lending to provide extra liquidity when financial institutions are in trouble If no crisis, Fed rarely uses discount lending—Fed is a “lender of last resort” The Federal Funds Rate:  On any given day, banks with insufficient reserves can borrow form banks with excess reserves  The interest rate on these loans is the “federal funds rate”  The FOMC uses OMOs to target the fed funds rate  Many interest rates are highly correlated, so changes in the fed funds rate causes changes in other rates and have a big impact in the economy Problems Controlling the Money Supply:  If households hold more money as currency, banks have fewer reserves/make fewer loans/money supply falls  If banks hold more reserves than required (excess reserves), they make fewer loans/money multiplier decreases/money supply falls  Fed can compensate for household and bank behavior to retain fairly precise control over the money supply. Bank Runs and The Money Supply:  “Run on Banks”—when people suspect their banks are in trouble, they may “run” to the bank to withdraw their funds, holding more currency and less deposits  Under fractional reserve banking, banks don't have enough reserves to pay off ALL depositors, hence banks may have to close  Also, banks may make fewer loans and hold reserves to satisfy depositors  These events increase R, reverse the process of money creation, cause money supply to fall Financial Crisis of 2008-2009:  Bank Capital—resources a bank’s owners have put into the institution  Assets – (deposits + debt)  Used to generate profit  Leverage—use of borrowed money to supplement existing funds for purposes of investment  Leverage ratio—ratio of assets to bank capital (Reserves + loans + securities) / capital  Capital requirement—government regulation specifying a minimum amount of bank capital to protect depositors; depends on the type of assets a bank holds; the safer the assets, the lower the requirement  Banks in 2008 & 2009— Shortage of capital—after they had incurred losses on some of their assets Ex. mortgage loans, securities backed by mortgage loans, “subprime mortgage crisis” Reduce lending (credit crunch)—contributed to a severe downturn in economic activity  U.S. Treasury and the Fed—put many billions of dollars of public funds into the banking system To increase the amount of bank capital—TARP It temporarily made the U.S. taxpayer a part owner of many banks Goal: to recapitalize the banking system; bank lending could return to a more normal level (occurred buy late 2009) Chapter 17: Introduction:  This chapter introduces the quantity theory of money to explain on of the Ten Principles of Economics from Chapter 1:  Prices rise when the government prints too much money  Most economists believe the quantity theory is a good explanation of the long run behavior of inflation The Value of Money: 1/p  P= the price level  P is the price of a basket of goods, measured in money  1/P is the value of $1, measured in goods  Inflation drives up prices and drives down the value of money Money Supply: MS  In the real world, MS is determined by Fed, the banking system, and consumers  In this model, we assume the Fed precisely controls MS and sets it at some fixed amount—Supply curve will be perfectly vertical*** Money Demand: MD  How much wealth people want to hold in liquid form—cash is most liquid form  Depends on P: an increase in P reduces the value of money, so more money is required to buy g&s  Quantity of MD is negatively related to the values of money and positively related to P, other things equal  When prices go up, it takes more money to buy things, therefore you need to hold more money  A fall in value of money (or increase in P) increases the quantity of money demanded  P adjusts to equate quantity of money demanded with money supply  Then the value of money falls and P rises  monetary injection A brief look at the Adjustment Process:  Increasing MS causes P to rise  At initial P, increase in MS causes excess supply of money  Real vs. Nominal Variables:  Nominal variables are measured in monetary units  Real variables are measured in physical units  A relative price—is the price of one good relative to (divided by) another  Relative prices are measured in physical units, so they are real variables Real v Nominal wage:  Important relative price is the real wage  Minimum wage is a nominal wage  W= nominal wage = price of labor  Real wage is the price of labor relative to the price of output The Classical Dichotomy:  The theoretical separation of real and nominal variables  Hume and classical economists suggested that monetary developments affect nominal variables but not real variables The Neutrality of Money:  Money neutrality—  Applies to economy in the long run The velocity of money:  P x Y = nominal GDP  Formula: V = (P x Y) / M  Velocity is fairly stable over time The Quantity Equation:  Velocity formula: V = (P x Y) / M  Multiply both sides of formula by M:  M x V = P x Y  Quantity Equation  Velocity is stable*** 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 by the same percentage 3) a change in M does not affect Y: money is neutral and Y is determined by technology and resources 4) So, P changes by same percentage as P x Y and M  Rapid money supply growth causes rapid inflation Hyperinflation:  Generally defined as inflation exceeding 50% per month  Recall on of the 10 Principles: PRICES RISE WHEN THE GOVT PRINTS TOO MUCH MONEY  Excessive growth in money supply ALWAYS causes inflation The Inflation Tax:  When tax rev is inadequate and ability to borrow is limited, govt may print money to pay for its spending  Almost asll hyperinflations start this way  The revenue from printing money is the “inflation tax”—printing money causes inflation, which is like a tax in everyone who holds money  ***When govt prints money, prices go up, and the value of money declines***  in the US, the inflation tax today accounts for less then 3% of total revenue The Fisher Effect:  NOMINAL INTEREST RATE = INFLATION RATE + REAL INTEREST RATE  In long run, money is neutral change in money growth rate affects the inflation rate but not the real interest rate  ***FISHER EFFECT WILL BE ON EXAM 3**  Nominal interest rate adjusts one for one with changes in the inflation rate  after Irving Fisher  Fisher Efffect The Fisher Effect & The inflation Tax:  An increase in inflation causes an equal increase in the nominal interest rate, so the real interest rate is unchanged. In other words, a 1% increase in inflation causes a 1% increase in the nominal interest rate. The Cost of Inflation:  Inflation fallacy: inflation is not eroding your real income; but this is what people think  Inflation is a general increase in prices of the things people buy and the things they sell, so incomes rise with inflation  In the long run, real incomes are determined by real variables, not the price level, such as human capital, physical capital, technology, and natural resources, not the inflation rate.  Nominal income = real income + inflation  Inflation causes the CPI and nominal wages to run together  Shoeleather costs: by having to go to the bank more often, you are wearing down the leather in your shoes  ***holding less cash Includes the time and transactions costs of more frequent bank withdrawals  Menu costs: the cost of changing prices Printing new menus, mailing new catalogs, etc Higher inflation causes more frequent price changes, which leads to higher menu costs  Earning interest on your money, helps offset inflation***  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  Confusion & inconvenience  inflation changes the yardstick we use to measure transactions; complicates long-range planning and the comparison of dollar amounts over time  Tax distortions  Inflation makes nominal income grow faster than real income Taxes are based on nominal income, and some are not adjusted for inflation Inflation causes people to pay more taxes even when their real income doesn't increase A special cost of unexpected inflation:  Arbitrary redistributions of wealth:  ***Frequent when inflation is high***  higher than expected inflation transfers purchasing power from creditors and debtors: debtors get to repay their debt with dollars that aren’t worth as much  lower than expected inflations transfers purchasing power from debtors to creditors  high inflation is more variable and less predictable than low inflation All these costs are quite high for economies experiencing hyperinflation For economies with low inflation ( <10% per year), these costs are probably much smaller, though their exact size is open to debate. Chapter 18: Open Economy Introduction:  One of the 10 Principles: TRADE CAN MAKE EVERYONE BETER OFF  This chapter introduces concepts of international macroeconomics Closed vs. Open Economics:  Closed Economy—does not interact with other economies in the world  Open Economy—interacts freely with other economies around the world Variables that Influence Net Exports:  Consumers preferences for foreign and domestic goods  Prices of goods at home and abroad  Incomes of consumers at home and abroad  The exchange rates at which foreign currency trades for domestic currency  Transportation costs  Government policies Trade Surpluses and Deficits: MISSING SMTG  NX measures the imbalance in a country’s trade in goods and services  Trade Deficit:  An excess of imports over exports; NX < O and Y > C + I +G  Balanced trade:  When exports = imports; NX = O and Y = C + I + G  ***Table 1, page 380  KNOW THIS***   The Increasing openness of the U.S. economy:  Increasing importance of international trade finance   1950s imports  Increases in international trade  improvements in international trade, advances in telecommunications, technological progress, government’s trade policies—NAFTA & GATT The Flow of Capital:  Net Capital Outflow (NCO)— also called “”  (Domestic residents purchases of foreign assets) – (foreigners’ purchases of domestic assets)  DO NOT CONFUSE NCO with trade of foreign assets***  The flow of capital abroad takes two forms: “Foreign direct investment”: Ex. Mercedes up the road, Honda in Alabama “Foreign portfolio investment”: Ex. American buying stock in a foreign company  NCO measures the imbalance in a country’s trade in assets:  When NCO > O, “Capital outflow”  When NCO < O, “Capital inflow”  Capital Outflow = Disney recently opened a park in Shanghia  Capital Inflow = Foreign companies buying US companies—Miller, Busch Variables that Influence NCO: INTEREST RATES  Real interest rates paid on foreign assets  Real interest rates paid on domestic assets  Perceived risks of holding foreign assets  Government policies affecting foreign ownership of domestic assets The Equality of NX and NCO:  Accounting Identity  NCO = NX—arises because every transaction that affects NX also affects NCO by the dame amount (and vice versa)  When a foreigner purchases a good from the U.S., U.S. exports and NX increases The foreigner pays with currency of assets, so the U.S. acquires some foreign assets, causing NCO to rise  When a U.S. citizen buys foreign goods, U.S. imports rise and NX falls  The U.S. buyer pays with U.S. dollars or assests, so thte other country acquires U.S. assests **** Saving, Investment, and International Flows of Goods and Assets:  Y = C + I +G + NX  accounting identity  Y – C – G = I + NX  rearranging terms  S = I + NX  since S = Y – C – G  S= I + NCO  NX = NCO  Open economy  S = I + NCO  S – I = NCO and NX  When S > I, then NCO > O  trade surplus  When S < I, then NCO < O  trade deficit  ***When we have a trade deficit, we borrow more and more from foreign companies*** The Nominal Exchange Rate:  The rate at which one country’s currency trades for another  We express all exchange rates as foreign currency per unit of domestic currency  Some exchange as of July 16, 2008, all per $US Appreciation and Depreciation: ***KNOW FOR TEST***  Appreciation (STRENGTHENING it takes more foreign currency to buy one US dollar  A “strong dollar”—causes US goods to become more expensive  Depreciation (WEAKENING)  it takes less foreign currency to buy one US dollar  A “weak dollar”—causes US goods to become less expensive compared to foreign produced goods The Real Exchange Rate:  The rate at which the g&s of one country trade for the g&s of another  Real Exchange Rate = (e x P ) / P*; where: P = domestic price P* = foreign price (in foreign currency) e = nominal exchange rate; i.e foreign currency per unit of domestic currency ***HAVE TO DO THIS ON EXAM 3*** Interpreting the Real Exchange Rate:  Also called the “terms of trade” Purchasing-Power Parity (PPP):  *** We don't have to calculate for exam 3**  know what it is, what do we use it for, and what its problems are  A theory of exchange rates whereby a unit of any currency should be able to buy the same quantity of goods in all countries  Based on the “Law of One Price”—the notion that a good should sell for the some price in all markets  Implies that nominal exchange rates adjust to equalize the price of a basket of goods across countries PPP and Its Implications:  Implies that the nominal exchange rate “ e” between two countries should equal the ratio of price levels, “P*” is the foreign price level and “P” is the domestic price level  If the 2 countries have different inflation rates, then e will change over time  If inflation is higher in Mexico that in the U.S.   If inflation is higher in the U.S. than in Japan  Limitations of PPP Theory:  Two reasons why exchange rates do not always adjust to equalize prices across countries:  Many goods cannot be easily traded  Foreign, domestic goods not perfect substitutes CHAPTER 19: The Market for Loanable Funds:  An identity from the preceding chapter  S = I + NCO S =Saving I = Domestic Investment NCO = Net Capital Outflow  Supply of loanable funds = saving  A dollar of saving can be used to finance the purchase of domestic capital and the purchase of a foreign asset  So the demand for loanable funds = I +NCO  RECALL: S depends positively on the real in


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