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eco 181 ub

eco 181 ub

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What does the unemployment rate really measure?




Why is GDP important?




What this diagram leaves out?



Chapter 1: Ten principles of economics • Scarcity- shortness of supply of the world’s resources • Economics- The study of how society manages the scarcity of the resources   Principle 1: Tradeoffs  All decisions involve tradeoffs. Such as: • Skipping class to sleep in gives you a greater chance of falling behind and losing an  absence  • Buying a Toyota instead ofDon't forget about the age old question of heteroecy
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a Tesla because it is more affordable, but worse for the  environment  • This is an important tradeoff society faces today: efficiency vs. equality  • Efficiency- when society gets the most from its scarce resources  • Equality- when wealth is is distributed uniformly among members of society  • Tradeoff: To improve equality among society, income could be redistributed from  wealthy to poor. However, people would be less inclined to work and produce, and the  size of the economic pie would decrease Principle 2: Opportunity Cost Opportunity cost: The potential benefit that is given up when one alternative is  selected over the other. Examples: • You could start working after graduating high school making $12,000 a year, or attend  college paying $12,000 a year  • Buying shoes you really want at an expensive price, or buy a pair of shoes you don't  really care much for at half the price. It’s not just the cost of the shoe, but it is also how  much you value that shoe  Principle 3: People think rationally at the margin  • Rational people do the best they can to achieve their goals  • They make decisions by evaluating costs and benefits of marginal changes,  incremental adjustments to an existing plan. Examples: • When a personal is debating on whether or not to attend grad school, they compare  the tuition and fees, to increase in income they could earn with more education   Principle 4: Incentives • Incentive: something that inclines a person to act, usually to earn a reward or avoid  punishment  • Rational people respond to incentives. Examples: • The price of gas rising up would cause more people to buy more fuel efficient and  hybrid cars.  • When the fine for a speeding ticket increases, people will be more inclined to go the  speed limit, decreasing the number of citations issued   Principle 5: Trade can make everyone better off • Instead of being competent, people can excel in producing one good or service and  exchange it for other goods  • Countries also benefit from trade and specialization  • Get a better price abroad for goods they produce  • Buy other goods more cheaply from abroad than could be produced at home Principle 6: Markets are often a good way to organize Economic Activity Market- a group of buyers and sellers Organize economic activity means deciding on  • what goods to produce  • how to produce the goods  • quantity of goods to produce • who receives the goods  • A Market Economy distributes resources through the decentralized decisions of  many households and firms as they interact in market • The “invisible hand” works through the price system • The interaction of buyers and sellers determines prices  • Each price will reflect the value of the good to the buyer and the cost of the producing  the good  • Prices guide self-interested households and firms to make decisions that often  increases the economic well being of society   Principle 7: Governments can sometimes improve market incomes  • Market failure: when the market fails to locate society’s resources efficiently  • Causes of market failure  • Externalities- when production or consumption of good affects bystanders. Example:  pollution  • Market power- When a single buyer or seller has great influence on market price.  Example: Monopoly  • Public Policy may promote efficiency  • Government may alter market outcome to promote equity • If the market’s distribution of economic well-being is not desirable, tax or welfare  policies can change how the economic pie is divided   Principle 8: Standard of living is dependent on production of goods • The most essential principle of living standards: productivity- the amount of goods  and services produced per unit of labor. • Productivity is dependent on equipment, skills, and technology available to workers  • Other factors such as labor unions, and competition have far less influence on  standards   Principle 9: Inflation  • Inflation- increases in the general level of prices  • Long term, inflation is mostly caused by extreme growth in the quantity of money, in  result causes the value of money to decrease  • The faster the government produces money, the more the inflation rate increases   Principle 10: Tradeoff between inflation and unemployment  • For a short period of time (1-2 years), many economic policies push inflations and  unemployment in the opposite direction  • Other factors can make this tradeoff more or less favorable, but the tradeoff is always  there   Chapter 2: Thinking like an economist   Economist as a scientist  Economists have two roles  • As a scientist their role is try to explain the world• As a Policy Advisor their role is to try to improve the world  • Also as a scientist, economists use the scientific method by testing theories on how  the world works  Assumptions and Models  • Assumptions simplify the complex world, which makes it easier to understand  • Model- a highly simplified representation of a more complex reality. Economists use  models to study economic issues The Circular-Flow Diagram • The Circular-Flow Diagram- is a visual model of the economy, shows the flow of  money through markets among households and firms • Two types of actors • Households  • Firms  • Two markets  • the market for goods and services  • the market for ” factors of production” Factors of Production • Factors of production- the resources the economy uses to produce goods and  services. includes: • labor  • land  • capital (any asset used in production) Households • own the factors of production, sell/rent them to firms for income • Buyers and consumers of goods and services  Firms • Buy/hire the factors of production, use them for the production of goods and services  • Sellers of goods and services  The Production Possibilities Frontier  • The Production Possibilities Frontier (PPF)- is a graph that shows the  combinations of two goods the economy can possibly produce given the available  resources and the available technology  • Example • Two goods: apples and iphones  • One resource: labor (measured in hours) • Economy has 50,000 labor hour per month available for production  The PPF and Opportunity Cost  • The opportunity cost of an item is what is given up to get that item • Moving along a PPF involves moving resources from the production of one good to  the other  • Society encounters tradeoff: Getting more of one good means 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 shaped like a bow • The shape is dependent on what happens to opportunity cost as economy shifts  resources from one industry to the other  • If the opportunity cost remains the same PPF is a straight line  • If the opportunity cost of a good increases as more of the good is produced, PPF is  bow-shaped  Why the PPF might be shaped like a bow • PPF is bow-shaped when different workers have different skills, different opportunity  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 opportunity costs Summary of the PPF • The PPF shows all combinations of the of two goods that an economy can possibly  produce, given its resources and technology • The PPF shows the concepts of tradeoff and opportunity cost, efficiency and  inefficiency, unemployment and economic growth  • A bow-shaped PPF shows the concept of increasing opportunity cost Macroeconomics and Microeconomics • Microeconomics- The study of how households and firms make decisions and how  they interact in markets  • Macroeconomics- is the study of economy-wide phenomena, including inflation,  unemployment, and economic growth  • One focuses on economics as a whole, other one goes in depth and analyzes  economicsEconomist as Policy Advisor • As a scientist, economists make positive statements, which attempts to describe  how the world is  • As policy advisors, economists make, normative statements, which attempts to  prescribe how the world should be • positive statements can be proved or disputed normative statements cannot  Chapter 5: Measuring a Nations Income  Income and Expenditure  • Gross Domestic Product (GDP) - measures total income of everyone in the  economy  • GDP also measures total expenditure on the economy’s output of goods and services The Circular-Flow Diagram • A simple depiction of the macroeconomy  • Illustrates GDP as spending, revenue, factor payments, and income  • Preliminaries: Factors of production are inputs like labor, land, capital, and natural  resources. Factor payments are payments to the factors of productions  • Households- own the factors of production, sell/rent them to firms for income, buy  and consume goods and services  • Firms- buy/hire factors of production and use them to produce goods and services,  sell goods and services  What this diagram leaves out? • The government collect taxes, buys goods and services • The financial system matches savers’ supply of funds with borrowers’ demand for  loans  • The foreign sector trades goods and services, financial assets, and currencies with  the country’s residents GDP is…. The market value of all final goods and services produced within a country in a given  period of time  The Components of GDP • Recall: GDP is total spending  • 4 components  • Consumption (C) • Investment (I) • Government Purchases (G)  • Net Exports (NX)  • These 4 components add up to GDP  • Y = C + I + G + NX  Real GDP vs Nominal GDP • Inflation can distort economic variables like GDP, so we have two versions 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 GDP Deflator  • The GDP deflator is a measure of the overall level of prices • GDP deflator = 100x nominal GDP/real GDP • One way to measure the economy’s inflation rate is to compute the percentage  increase in the GDP deflator from one year to the next  The Inflation Rate • Inflation- Economy’s overall price level is rising  • Inflation rate- percentage change in some measure of the price level from one period  to the next  • One way to measure the economy’s inflation rate is to compute the percentage  increase in the GDP deflator from one year to the next  • Inflation in year 2 = GDP deflator in year 2 - GDP deflator in year 1/GDP deflator in  year 1 x100 GDP and Economic Well-Being  • Real GDP per capita is the main indicator of the average person’s standard of living  • However, GDP is not a perfect measure of well-being GDP Does Not Value  • Quality of environment  • Leisure time • non-market activity, such as parents taking care of their kids at home  • an even distribution of income  Why is GDP important? • Having a large GDP enables a country to afford better schools, healthcare, cleaner  environment, etc.• Many indicators of the quality of live are positively correlated with GDP  Chapter 10: Unemployment  Labor Force Statistics  • Produced by Bureau of Labor Statistics (BLS) in the US department of labor  • Based on survey of 60,000 households, which occur every month • Based on adult population (people who are 16 years or older  BLS divides population into 3 categories • Employed- paid employees, self-employed and unpaid workers in a family business • Unemployed- people not working who have been searching for work during the last  month • Not in the labor force- everyone else • Labor force- the total number of workers, including the employed and unemployed  Unemployment rate (“u-rate”)- the % of the labor force that is unemployed u-rate = 100x # of unemployed/labor force  Labor force participation rate- % of the adult population that is in the labor force  Labor force participation rate = 100x labor force/adult population  Labor force participation of men and women in the US economy  • Women’s role in American society has changed dramatically over the past century • New technologies reduce the amount of time required to complete routine household  tasks • Improved birth control reduced the # of children born to the usual family  • Changing social and political attitudes  • Young men stay in school longer • Old men retire earlier and live longer  • With more women employed, more fathers now stay at home to raise their children • Counted as being out of the labor force: Full time students, Retirees, Stay at home  dads Identifying unemployment • Some of those who are out of the labor force may want to work. Example:  discouraged workers • Discouraged workers- individuals who would like to work, but have given up looking  for employment  What does the unemployment rate really measure? • The unemployment rate is not a perfect indicator of joblessness or the status of the  labor market  • it excludes discouraged workers  • it does not differentiate between full-time and part-time employment, or people  working part-time because full-time employment is not available  • Some people misreport their job status in the BLS survey • Regardless of these issues, the unemployment rate is still a very good indicator of the  labor market and economy  The Duration of unemployment  • Most instances of unemployment are temporary, usually 33% of the unemployed have  been unemployed under 5 weeks 67% have been unemployed under 14 weeks, only  20% have been unemployed for more than 6 months • Yet, most observed unemployment is long term. The small group of long-term  unemployed people have fairly little turnover, so it accounts for most of the  unemployment observed over time  • Knowing this helps policymakers establish policies to help the unemployed  Cyclical Unemployment vs the Natural Rate  • There is always some type of unemployment, though the unemployment rate differs  from year to year  • Natural Rate of employment- the normal rate of unemployment around which the  actual unemployment rate changes  • Cyclical unemployment- the deviation of unemployment from its natural rate, also  associated with business cycles  The Natural rate: An overview • Frictional unemployment- occurs when workers spend time looking for jobs that best  fit their skills and tastes, short term for most workers. • Structural unemployment- occurs when there are fewer jobs than workers, usually  long term Job Search  • Workers have different tastes and 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 regions of  the country  • Such shifts displace some workers, who must look for new jobs that best fit their skills  and tastes • The economy always changes, so frictional unemployment is bound to happen  Public Policy and Job Search • Government employment agencies- provide information about job vacancies to speed  the matching of workers with jobs  • Public training programs- aim to equip workers displaced from declining industries  with the skills needed in growing industries  Unemployment Insurance (UI) • Unemployment insurance- a government program that partially protects workers  incomes when they become unemployed  • UI increases frictional unemployment  • UI benefits end when a worker takes a job, so workers have less incentive to search  or take jobs while eligible to receive benefits  • Benefits of UI: Reduces uncertainty over incomes, gives the unemployed more time to  search, resulting in better job matches and higher productivity  1. Minimum-Wage Laws • the minimum wage may exceed the the eq’m wage for the least skilled or experienced  workers casting structural unemployment  • However this group is a small part of the labor force so the minimum wage cannot  explain most 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 • The average 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 eq’m, quantity of labor demanded falls and  unemployment results  • “Insiders”- workers who remain employed are better off  • “Outsiders”- workers who lose their jobs are worse off • Some outsiders go to non-unionized labor markets, which increases labor supply and  reduces wages in those markets • Are unions good or bad? Economists disagree. • Critics: Unions are cartels They raise wages above eq’m which causes  unemployment and/or depresses wages in non-union labor market  • Advocates: Unions counter the market power of large firms, make firms more  responsive to workers concerns  3. Efficiency Wages • The theory of efficiency wages: Firms voluntarily pay above-equilibrium wages  • to boost worker productivity  • Different versions of efficiency wage theory suggest different reasons why firms pay  high wages  4 reasons why firms might pay efficiency wages  1. Worker health  In less developed countries, poor nutrition is a common problem. Paying higher wages  allows workers to eat better, makes them healthier, more productive 2. Worker Turnover Hiring and training new workers is costly. Paying high wages gives worker more  incentive to stay, reduces turnover. 3. Worker quality  Offering higher wages attracts better jobs applicants, increases quality of the firm’s  workforce  4. Worker effort Workers can work hard or shrink. Shrinkers are fired if caught. Is being fired a good  deterrent? Depends on the difficulty of finding another job, if market wage is above eq’m  wage, there aren't enough jobs to go around, so workers have more incentive to work  not shrink. 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  • In a perfectly competitive market: all goods are exactly the same, Buyers and  sellers are so numerous that no one can influence market price—each is a “price  taker” Demand  • The quantity demanded of any good is the amount of the good that buyers are  willing and able to purchase  Chapter 7: Production and Growth  An average family with all their possessions in the U.K, an advanced economy  • GDP per capita: $36,010 • Child mortality Rate: .5% • High school enrollment: 98% An Average family with all their possessions in Mexico, a middle income country • GDP per capita: $15,390 • Child Mortality Rate: 1.6% • High School Enrollment 71% An Average family with all their possessions in Mali, a poor country • GDP per capita: $1,040 • Child Mortality: 17.6% • High School Enrollment: 31%  Incomes and Growth Around the World  • Since growth rates vary, the country rankings can change over time • Poor countries are not exactly doomed to poverty forever. Ex: incomes in Singapore  were low in the 60’s and now it is one of the highest in the world. • Rich countries can’t neglect their status, they can be overtaken by poorer but faster growing countries  Productivity  • One of the 10 principles of economics is: A country’s standard of living depends on its  ability to produce goods and services • This ability depends on productivity- the average quantity of goods and services  produced per unit of labor input  • Y = real GDP = quantity of output produced  • L = quantity  • So productivity = Y/L (output per worker)  Why is productivity so important? • When a nation’s workers are very productive, real GDP is large and incomes are high  • When productivity grows rapidly, so do living standards   Physical Capital Per Worker • The stock of equipment and structures used to produce goods and services call  (physical) capital, also K • K/L = capital per worker  • Productivity is higher when the average worker has more capital. • An increase in K/L causes an increase in Y/L   Human Capital Per Worker • Human Capital (H) - the knowledge and skills workers acquire through education,  training, and experience  • H/L = the average worker’s human capital  • Productivity is higher when the average worker has more human capital  • An increase in H/L causes an increase in Y/L  Natural Resources Per Worker  • Natural Resources (N) - the inputs into production that nature provides • Other things equal, more N allows a country to produce more Y. In per-worker terms,  an increase in N/L causes in increase in Y/L • Some countries are rich because they have abundant natural resources. • However countries do not need to have much N to be rich   Technological Knowledge  • Technological knowledge - society’s understanding of the best ways to produce  goods and services  • Technological progress does not only mean a faster computer, a higher-definition TV,  or a smaller cell phone  • It means any advance in knowledge that boosts productivity   Technological Knowledge vs. Human Capital • Technological knowledge refers to society’s understanding of how to produce goods  and services  • Human capital results from the effort people expend to acquire this knowledge  • Both are important for productivity   The Production Function  • The production function is a graph or equation showing the relation between output  and inputs  • Y = A F(L, K, H, N) • F - is a function that shows how inputs are combined to produce output  • A is the level of technology  • A multiplies the function F, so improvements in technology allow more output to  produced from any given combination of inputs • The production function has the property constant returns to scale: changing all inputs  by the same % causes output to change by that %. Examples: • Doubling all inputs (x by 2), causes output to double  • Increasing all inputs 10% (x by 1.1) causes output increase by 10%   Are natural resources a limit to growth  • Over the last century population increased in 4 times, however, today people are  enjoying a much higher standard of than a century ago. • Can the scarcity of natural resources prevent this? • Technological progress can make natural resources less of a necessity  • Scarcity is reflected in market prices, which are either stable or falling in the long run  Saving and Investment • We can boost productivity by increasing K, which requires investment  • Since resources scarce, producing more capital requires producing fewer  consumption goods • Reducing consumption = increasing saving. This extra saving funds the production of  investment goods.  • Hence, a tradeoff between current and future consumption   Chapter 16 Aggregate Demand • Recall, the AD curve slopes downward for three reasons:  • The wealth effect  • The interest-rate effect  • The exchange-rate effect • Next:  A supply-demand model that helps explain the interest-rate effect and how  monetary policy affects aggregate demand.   Theory of Liquidity preference  • A simple theory of the interest rate (denoted r).  • r adjusts to balance supply and demand  for money.  • Money supply: assume fixed by central bank, does not depend on interest rate • Money demand reflects how much wealth people want to hold in liquid form.  • Liquidity refers to the ease with which that asses can be converted into the economy’s  medium of exchange.  • For simplicity, suppose household wealth includes only two assets:  • Money – liquid but pays no interest  • Bonds – pay interest but not as liquid  • A household’s “money demand” reflects its preference for liquidity  Effect of Interest Rate  • r is the opportunity cost of holding money  • An increase in r reduces money demand: households attempt to buy bonds to take  advantage of the higher interest rate.  • Hence, an increase in r causes a decrease in money demand, other things equal  (assuming that Y and P are unchanged).  Monetary policy and aggregate demand • To achieve macroeconomic goals, the Fed can use monetary policy to shift the AD curve.  • The Fed’s policy instrument is MS.  • The news often reports that the Fed targets the interest rate.  • More precisely, the federal funds rate, which banks charge each other on  short-term loans  • To change the interest rate and shift the AD curve,  the Fed conducts open market operations  to change MS.   Liquidity Traps • Monetary policy stimulates aggregate demand by reducing the interest rate.  • Liquidity trap: when the interest rate is zero  • In a liquidity trap, monetary policy may not work, since nominal interest rates cannot  be reduced further.  • However, central bank can make real interest rates negative by raising inflation  expectations.  • Also, central bank can conduct open-market ops using other assets—like mortgages  and corporate debt—thereby lowering rates on these kinds of loans. The Fed  pursued this option in 2008–2009  Fiscal Policy and Aggregate Demand  • Fiscal policy: the setting of the level of govt spending and taxation by govt  policymakers • Expansionary fiscal policy  • an increase in G and/or decrease in T,  shifts AD right  • Contractionary fiscal policy  • a decrease in G and/or increase in T,  shifts AD left  • Fiscal policy has two effects on AD…   The Multiplier Effect  • If the govt buys $20B of planes from Boeing, Boeing’s revenue increases by $20B.  • This is distributed to Boeing’s workers (as wages) and owners (as profits or stock  dividends).  • These people are also consumers and will spend a portion of the extra income.  • This extra consumption causes further increases in aggregate demand   MPC  • How big is the multiplier effect?  It depends on how much consumers respond to increases in income.  • Marginal propensity to consume (MPC):  the fraction of extra income that households consume rather than save  • E.g., if MPC = 0.8 and income rises $100,  C rises $80.   The multiplier effect:  Each $1 increase in G can generate  more than a $1 increase in agg demand. • Also true for the other components of GDP.  • Example: Suppose a recession overseas reduces demand for U.S. net  exports by $10B.  • Initially, agg demand falls by $10B.  • The fall in Y causes C to fall, which further reduces agg demand and  income  Crowding out Effect  • Fiscal policy has another effect on AD  that works in the opposite direction.  • A fiscal expansion raises r,  • which reduces investment,  • which reduces the net increase in agg demand.  • So, the size of the AD shift may be smaller than the initial fiscal expansion.  • This is called the crowding-out effect.   Changes in Taxes  • A tax cut increases households’ take-home pay.  • Households respond by spending a portion of this extra income, shifting AD to the  right.  • The size of the shift is affected by the multiplier and crowding-out effects.  • Another factor: whether households perceive the tax cut to be temporary or  permanent.  • A permanent tax cut causes a bigger increase in C—and a bigger shift in the  AD curve—than a temporary tax cut.  Fiscal Policy and Aggregate Supply  • A tax cut increases households’ take-home pay.  • Households respond by spending a portion of this extra income, shifting AD to the  right.  • The size of the shift is affected by the multiplier and crowding-out effects.  • Another factor: whether households perceive the tax cut to be temporary or  permanent.  • A permanent tax cut causes a bigger increase in C—and a bigger shift in the  AD curve—than a temporary tax cut.   Stabilization Policy: Case For  • • Keynes: “Animal spirits” cause waves of pessimism and optimism among  households and firms, leading to shifts in aggregate demand and fluctuations  in output and employment.  • Also, other factors cause fluctuations, e.g.,  • booms and recessions abroad  • stock market booms and crashes  • If policymakers do nothing, these fluctuations are destabilizing to businesses,  workers, consumers • Proponents of active stabilization policy  believe the govt should use policy  to reduce these fluctuations: • When GDP falls below its natural rate,  use expansionary monetary or fiscal policy  to prevent or reduce a recession.  • When GDP rises above its natural rate,  use contractionary policy to prevent or reduce an inflationary boom.   Case Against Stabilization Policy • Proponents of active stabilization policy  believe the govt should use policy  to reduce these fluctuations:  • When GDP falls below its natural rate,  use expansionary monetary or fiscal policy  to prevent or reduce a recession.  • When GDP rises above its natural rate,  use contractionary policy to prevent or reduce an inflationary boom.   Automatic Stabilizers • Automatic stabilizers - changes in fiscal policy that stimulate  agg demand when economy goes into recession, without policymakers having to  take any deliberate action  • The tax system  • In recession, taxes fall automatically, which stimulates agg demand.  • Govt spending  • In recession, more people apply for public assistance (welfare, unemployment  insurance). • Govt spending on these programs automatically rises, which stimulates agg  demand.   Chapter 11: Monetary System   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   2 kinds of Money  • Commodity money - takes the form of a commodity with intrinsic value.  • Examples: gold coins, cigarettes in POW camps • Fiat money - money without intrinsic value, used as money because of  govt decree  • Example: the U.S. dollar   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 • M1: currency, demand deposits,  traveler’s checks, and other checkable deposits.  • M1 = $2.6 trillion (September 2013)  • M2: everything in M1 plus savings deposits,  small time deposits, money market mutual funds, and a few minor categories.  • M2 = $10.8 trillion (September 2013)  Central Banks and 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.   Structure of the Federal Reserve  • The Federal Reserve System  consists of:  • Board of Governors (7 members),  located in Washington, DC  • 12 regional Fed banks,  located around the U.S.  • Federal Open Market  Committee (FOMC), includes the Board of Govs and presidents of some of the regional Fed banks.  The FOMC decides monetary policy.  Bank Reserves  • In a fractional reserve banking system,  banks keep a fraction of deposits as reserves and use the rest to make loans.  • The Fed establishes reserve requirements,  regulations on the minimum amount of reserves that banks must hold against  deposits.  • Banks may hold more than this minimum amount  if they choose.  • The reserve ratio, R • = fraction of deposits that banks hold as reserves  • = total reserves as a percentage of total deposits  Chapter 15: Aggregate Demand and supply Classical Economics: Recap • The previous chapters are based on the ideas of classical economics, especially:  • The Classical Dichotomy, the separation of variables into two groups:  • Real – quantities, relative prices  • Nominal – measured in terms of money  • The neutrality of money:  Changes in the money supply affect nominal but not real variables • The previous chapters are based on the ideas of classical economics, especially:  • The Classical Dichotomy, the separation of variables into two groups: • Real – quantities, relative prices  • Nominal – measured in terms of money  • The neutrality of money:  Changes in the money supply affect nominal but not real variables  Why AD Curve Might Shift  • Any event that changes C, I, G, or NX—except  a change in P—will shift the AD curve.  • Example:  A stock market boom makes households feel wealthier, C rises,  the AD curve shifts right.  • Changes in G • Federal spending, e.g., defense  • State & local spending, e.g., roads, schools  • Changes in NX  • Booms/recessions in countries that buy our exports  • Appreciation/depreciation resulting from international speculation in foreign  exchange market   Why LRAS might shift?  • Changes in L or natural rate of unemployment  • Immigration  • Baby-boomers retire  • Govt policies reduce natural u-rate  • Changes in K or H • Investment in factories, equipment  • More people get college degrees  • Factories destroyed by a hurricane  • Changes in natural resources  • Discovery of new mineral deposits  • Reduction in supply of imported oil  • Changing weather patterns that affect agricultural production  • Changes in technology  • Productivity improvements from technological progress   Sticky Wage Theory  • Imperfection:  Nominal wages are sticky in the short run, they adjust sluggishly.  • Due to labor contracts, social norms  • Firms and workers set the nominal wage in advance based on PE, the price level they  expect to prevail.  • If P > PE,  revenue is higher, but labor cost is not.  • Production is more profitable,  so firms increase output and employment.  • Hence, higher P causes higher Y,  so the SRAS curve slopes upward.  Sticky Price Theory • Imperfection:  Many prices are sticky in the short run.  • Due to menu costs, the costs of adjusting prices.  • Examples: cost of printing new menus,  the time required to change price tags  • Firms set sticky prices in advance based  on PE. • Suppose the Fed increases the money supply unexpectedly. In the long run, P will  rise.  • In the short run, firms without menu costs can raise their prices immediately.  • Firms with menu costs wait to raise prices. Meanwhile, their prices are relatively  low,  • which increases demand for their products, so they increase output and employment.  • Hence, higher P is associated with higher Y,  so the SRAS curve slopes upward  Chapter 8: Saving, Investment and the Financial system   Financial Institutions • The Financial system: the group institutions that helps match the saving of one  person with the investment of another  • Financial markets: institutions through which savers can directly provide funds to  borrowers. Examples: The bond market, The stock market   Financial Markets • The Bond market  • Bond: Certificate of indebtedness  • Date of Maturity - when the loan will be repaid  • Rate of Interest - Paid periodically until the date of maturity  • Principal - amount borrowed  • Borrowing from the public  • Used by large corporations, the federal, or state and local governments  • Term - length of time until maturity  • A few months, 30 years perpetually.  • Long term bonds are riskier than short term bonds. Long term bonds usually pay  higher interest rates. • Credit Risk - Probability of default   Characteristics of Bonds  • Debt Finance: the sale of bonds to raise money  • Principal- the amount borrowed  • Tax Treatment - the way the tax laws treat the interest earned on the bond  • Term • Credit Risk • Date of Maturity  Financial Institutions  • Financial Intermediaries - institutions through which savers can indirectly provide  funds to borrowers. Example: bank• Mutual Funds - institutions that sell shares to the public and use the proceeds to buy  portfolios of stocks and bonds   Saving and Investment  • Recall the national income accounting identity: Y = C + I + G + NX  • For the rest of this chapter focus on the closed economy case: Y = C + I + G • Solve for I: I = Y - C - G = (Y - T - C) + (T - G) • Saving = investment in a closed economy (S = I)  Different Kinds of Saving  • Private saving - The portion of households’ income that is not used for consumption  or paying taxes = Y - T - C • Public Saving - Tax revenue less government spending = T - G • National Saving - the portion of national income that is not used for consumption or  government purchases = (Y - T - C) + (T - G) = Y - C - G  Budget Deficits and Surplus  • Budget Surplus - an excess of tax revenue over government spending = T - G =  public saving • Budget Deficit - a shortfall of tax revenue from government spending = G - T = - (public saving)  The Meaning of Saving and Investment  • Investment - the purchase of new capital  • in economics, investment is not the purchase of stocks and bonds   The Market for Loanable funds Market for Loanable funds - the market in which those who want to save supply funds  and those who want to borrow to invest demand funds   Chapter 12: Money Growth and Inflation   Inflation  • Inflation - increase in the overall level of prices  • Deflation - Decrease in the overall level of prices • Hyperinflation - Extraordinary high rate of inflation   Price Level vs. The value of money • Price Level - price of the goods and services  • P measures the number of dollars needed to buy a basket of goods and services • Higher price level, P, means that the same $1 buy you less goods and services  • P = price level  • P is the price of a basket of goods, measured in money   Real vs. Nominal Variables  • Nominal variables are measured in monetary units  • Real variables are measured in physical units  • Classical dichotomy: the theoretical separation of nominal and real variables   The Neutrality of Money  • Money neutrality - the proposition that changes in the money supply do not affect  real variables   The Velocity of Money • Velocity of Money - the rate at which money changes hands  The Costs of Inflation • Shoeleather costs : the resources wasted when inflation encourages people to  reduce their money holdings. Includes the time and transactions costs of more  frequent bank withdrawals  • Menu Costs - the costs of changing prices  • Misallocation of resources from relative : Firms don’t all raise prices at the same  time, so relative prices can vary which distorts the allocation of resources  • Confusion and 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. So, inflation  causes people to pay more taxes even when their real incomes don’t increase  • 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.  Chapter 17: The Short-Run Tradeoff Between Inflation and  Unemployment • Phillips Curve : shows the rot-run trade-off between inflation and unemployment • Natural-rate hypothesis: the claim that unemployment eventually returns to its  normal or “natural” rate, regardless of the inflation rate  • Expected Inflation - a measure of how much people expect the price level to change • Supply Shock - an event that directly alters firms’ costs and prices, shifting the AS  and PC curves • Disinflation - a reduction in the inflation rate  • Sacrifice Ratio - percentage points of annual output lost per 1 percentage point  reduction in inflation  • Rational expectations - a theory according to which people optimally use the  information they have, including info about government policies, when forecasting the  future   Chapter 13: Open-Economy Macroeconomics • Closed economy - does not interact with other economies in the world  • Open economy - interacts freely with other economies around the world  • Exports - domestically-produced goods and services sold abroad  • Imports - foreign-produced goods and services sold domestically  • Net Exports (NX) = value of exports - value of imports  • Trade Deficit - an excess of imports over exports  • Trade Surplus - an excess of exports over imports  • Balanced trade - when exports = imports  • Net Capital Outflow (NCO) - domestic residents’ purchases of foreign assets minus  foreigners’ purchases of domestic assets. Is also known as net foreign investment  • Foreign direct investment - domestic residents actively manage the foreign  investment  • Foreign portfolio investment - domestic residents purchase foreign stocks or bonds  supplying “loanable funds” to a foreign firm  • NCO measures the imbalance in a country’s trade in assets  • NCO = NX• S = I + NX  • S = I + NCO  • when S > I, the excess loanable funds flow abroad in the form of positive net capital  outflow  • when S < I , foreigners are financing some of the country’s investment and NCO < 0 • Nominal exchange rate - the rate at which one country’s currency trades for another  • Appreciation - an increase in the value of a currency as measure by the amount of  foreign currency it can buy  • Depreciation - a decrease in the value of a currency as measured by the amount of  foreign currency it can buy  • Real exchange rate - the rate at which the goods and services of one country trade  for the goods and services of another  • Law of one price - the notion that a good should sell for the same price in all markets  • Purchasing-power-parity - a theory of exchange rates whereby a unit of any  currency should be able to buy the same quantity of goods in all countries

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