Class Note for ECON E202 with Professor Dilts at IPFW
Class Note for ECON E202 with Professor Dilts at IPFW
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INTRCHDUCTKDN39HDIWACWUDECCHMDNHCS E202 i z u u o u u u 39 n 0 n 39 Dr David A Dits Department of Economics Doermer School of Business and Management Sciences IndianaPurdue UniversityFort Wayne June 1 1993 Revisions May 1994 December 1995 July 1996 November 2000 May 2003 May 2006 PREFACE This Course Guide was developed in part because of the high cost of college textbooks and in part to help organize students studying by providing lecture notes together with the reading assignments This Guide is provided to the student online at the Department of Economics website Jayla Heller the Department s secretary has been kind enough to go through all of the frustration and hard work to put the guide in the appropriate format and put it online To her goes my gratitude The department neither school nor the professor make anything whatsoever from this Guide In fact the department s budget and the professor s own resources are used in the writing of the Guide and the numerous draft copies that are produced in the revisions of this document Like the sign in the Mom and Pop bait shop on Big Barbee Lake says This is a nonpro t organization wasn t planned to be it just worked out that way Well actually it was planned to be a nonpro t enterprise in this case The professor also wishes to acknowledge the fact that several students have proposed changes improvements caught errors and helped to make this document more useful as a learning tool Naturally any errors of omission or commission are those of the professor alone Introduction amp Use of Guide This Course Guide is provided to assist students in mastering the subject matter presented E202 Introduction to Macroeconomics The commercially available student guides and workbooks are notoriously inadequate and are simply of little value At several institutions prepared course materials are made available to students to assist their learning What research has been done concerning these course speci c materials suggests that students39 performances are enhanced by having access to these types of materials Because macroeconomics is such an important foundation for business engineering and the social sciences this Guide has been prepared The purpose of this Course Guide is fourfold First the course syllabus is included in the Guide Second the Guide provides the student a listing of the key concepts covered in the lectures Third the Guide provides students with problems and studyguides to aid each individual in the retaining the materials presented by the text and lecture Fourth sample exams are offered as selftest exercises and to give students an idea of the level of mastery expected in this course Organization The Guide is divided into twelve units following the organization ofthe Tentative Course Outline found in the syllabus At the end of each chapters in the reading assignments there is a section containing the key concepts developed in the chapter sample exam questions and a brief study guide Also in the Guide is the course syllabus included before the twelve sections covering the substantive portions ofthe course Following the reading assignments are the lecture notes for each chapter The nal section ofthe Guide contains sample examinations including answers Note to Students There is no substitute for doing the reading assignments attending class and working through the material A teacher cannot cause a student to learn all a teacher can do is to organize and present the material grades can provide a small extrinsic reward for accomplishment but it is the student39s ability effort and desire that determine how much and how well they will learn It is hoped this Guide will help in the learning effort SYLLABUS E202 Introduction to Macroeconomics Dr David A Dilts Department of Economics and Finance Room 340D Neff Hall School of Business and Management Sciences Phone 4816486 Indiana Purdue University Fort Wayne COURSE POLICIES 1 In all respects the policies ofthe School Department IPFW and the University shall be applied in this course 2 Of ce hours will be posted on the professor39s door appointments may also be arranged The Professor39s of ce is Neff 340D 3 The following grade scale will be applied in this course for determination of nal grades A 100 90 percent B 89 80 percent C 79 70 percent D 69 60 percent F below 60 percent All final grade calculations shall be rounded up In other words 6901 and 6999 percent are both considered 70 percent and will earn the student a grade of C 4 The majority of undergraduate economics courses this professor has taught have had average nal grades that fall within the range centered on 20 on a 40 scale 5 Course requirements A The MIDTERM examination is worth 40 ofthe nal grade The FINAL examination is worth 50 ofthe nal grade The QUIZZES are worth 10 of the nal grade and only the best two quiz scores will be used in this calculation lfa student improves their performance on the final examination by 10 full points above what they earned on the midterm I will change the weights to midterm 30 and nal exam 60 B Examinations will consist ofobjective items Examinations will be worth 100 points and will consist of twenty multiple choice questions worth four points each and twenty truefalse questions worth one point each for a total of 100 points 6 The nal examination will be given at the time and place scheduled by the university No exception is possible 7 No makeup exams will be permitted If you cannot attend class at exam time you must make prior arrangements to take an equivalent examination before your classmates Exceptions may be granted for cases where there was no possibility for an earlier examination ie injuries or illnesses etc things clearly beyond the student s control 8 Academic dishonesty in any form will result in a course grade of F and other sanctions as may be authorized by the university The over whelming preponderance of students do not engage in dishonesty and the professor owes it to these students to strictly police this policy 9 The provisions of these policies and the course objectives are subject to testing These policies are also subject to change at the discretion ofthe professor and do not constitute a binding contract COURSE OBJECTIVES This is an introductory principle of economics course that covers topics in macroeconomics The breath oftopical coverage limits the course objectives to subject matter mastery The course will present factual material concerning the operation of the aggregate economy as well as the development of rudimentary understanding of economic policy In general the ability to critically evaluate demonstrates the highest cognitive mastery of the material It is important that this level of understanding be achieved Therefore students will nd several examination and quiz questions are focused on complex applications or critical evaluation Even though there are no grades assigned for class participation students are encouraged to participate in classroom discussions The opportunity to have open discourse to debate to disagree is critical to a student39s learning experience particularly if students are to develop the ability to critically evaluate economic ideas REQUIRED TEXT David A Dilts Introduction to Macroeconomics E202 Fort Wayne 2003 memo SUPPLEMENTAL TEXT Campbell R McConnell and Stanley L Bruce Economics fteenth edition New York McGrawHill MampB in the outline TENTATIVE COURSE OUTLINE 1 Introduction to Macroeconomics Economic Policy and the Course DAD Chapter 1 M amp B Chapter 1 2 National Income Accounting DAD Chapter 2 M amp B Chapter 7 3 Unemployment and In ation DAD Chapter 3 M amp B Chapter 8 4 Aggregate Demand amp Supply DAD Chapter 4 M amp B Chapter 11 5 Classical and Keynesian Models DAD Chapter 5 M amp B Chapter 9 6 Equilibrium in the Keynesian Model DAD Chapter 6 M amp B Chapter 10 7 Fiscal Policy DAD Chapter 7 M amp B Chapter 12 MIDTERM EXAMINATION 8 Growth DAD Chapter 8 MampB Chapter 22 9 Money amp Banking DAD Chapter 8 M amp B Chapter 13 10 Multiple Expansion of Money DAD Chapter 9 M amp B Chapter 14 11Federal Reserve and Monetary Policy DAD Chapter 10 M amp B Chapter 15 12 Economic Stability and Policy DAD Chapter 11 M amp B Chapters 18 amp 19 FINAL EXAMINATION vi 1 Introduction to Economics Lecture Notes 1 Economics De ned Economics is the study of the allocation of SCARCE resources to meet unlimited human wants a Microeconomics is concerned with decisionmaking by individual economic agents such as rms and consumers b Macroeconomics is concerned with the aggregate performance of the entire economic system 0 Empirical economics relies upon facts to present a description of economic activity d Economic theory relies upon principles to analyze behavior of economic agents e Inductive logic creates principles from observation f Deductive logic hypothesis is formulated and tested 2 Usefulness of economics economics provides an objective mode of analysis with rigorous models that are predictive of human behavior 3 Assumptions in Economics economic models of human behavior are built upon assumptions or simpli cations that permit rigorous analysis of real world events without irrelevant complications a Model building models are abstractions from reality the best model is the one that best describes reality and is the simplest b simpli cations 1 Ceteris paribus means all other things equal 2 Problems with abstractions based on assumptions Too often the models built are inconsistent with observed reality therefore they are faulty and require modi cation When a model is so complex that it cannot be easily communicated or its implications understood it is less useful 4 Goals and their Relations Positive economics is concerned with what is normative economics is concerned with what should be Economic goals are value statements a Most societies have one or more ofthe following goals 1 2 Economic efficiency Economic growth Economic freedom Economic security Equitable distribution of income Full employment Price level stability and Reasonable balance oftrade 5 Goals are subject to a Interpretation precise meanings and measurements will often become the subject of different points of view often caused by politics b Complementary goals that are complementary are consistent and can often be accomplished together c Con icting where one goal precludes or is inconsistent with another d Priorities rank ordering from most important to least important again involving value judgments 6 The Formulation of Public and Private Policy Policy is the creation of guidelines regulations or law designed to affect the accomplishment of specific economic goals a Steps in formulating policy 1 Stating goals must be measurable with speci c stated objective to be accomplished 2 Options identify the various actions that will accomplish the stated goals amp select one and 3 Evaluation gather and analyze evidence to determine whether policy was effective in accomplishing goal if not reexamine options and select option most likely to be effective 7 Objective Thinking a Bias most people bring many misconceptions and biases to economics Because of political beliefs and other value system components rational objective thinking concerning various issues requires the shedding of these preconceptions and biases b Fallacy of composition is simply the mistaken belief that what is true for the individual must be true forthe group c Cause and effect post hoc ergo propter hoc after this because ofthis fallacy 1 Correlation statistical association oftwo or more variables 2 Causation where one variable actually causes another Granger causality states that the thing that causes another must occur rst that the explainer must add to the correlation and must be sensible d Costbene t or economic perspective marginal decisionmaking if bene ts of an action will reap more benefits than costs it is rational to do that thing 2 National Income Accounting Lecture Notes Gross Domestic Product GDP the total value ofall goods and services produced within the borders of the United States or country under analysis Gross National Product GNP the total value of all goods and services produced by Americans regardless ofwhether in the United States or overseas National Income Accounts are the aggregate data used to measure the well being of an economy a The mechanics ofthese various accounts are Gross Domestic Product Depreciation Net Domestic Product Net American Income Earned Abroad Indirect Business Taxes National Income Social Security Contributions Corporate Income Taxes Undistributed Corporate Pro ts Transfer Payments Personal Income Personal Taxes Disposable Income 4 Expenditures Approach vs Incomes Approach a Factor payments Nonincome charges GNPGDP adjustments GDP is the incomes approach b Y C lg G Xn is the expenditures approach where Y GDP 5 Social Welfare amp GDP GDP and GNP are nothing more than measures oftotal output or income More information is necessary before conclusions can be drawn concerning social welfare There are problems with both measures among these are a Nonmarket transactions such as householdprovided services or barter are not included in GDP b Leisure is an economic good but time away from work is not counted however movie tickets skis and other commodities used in leisure time are 0 Product quality no pretense is made in GDP to account for product or service quality d Composition amp Distribution of Output no attempt is made in GDP data to account for the composition or distribution of income or output We must look at sectors to determine composition and other information for distribution e Per capita income is GDP divided by population very rough guide to individual income but still mostly fails to account for distribution f Environmental problems damage done to the environment in production or consumption is not counted in GDP data unless market transactions occur to cleanup the damage g Underground economy estimates place the amount of underground economic activities may be as much a onethird of total US output Criminal activities tax evasion and other such activities are the underground economy 6 Price lndices are the way we attempt to measure inflation Price indices are far from perfect measures and are based on surveys of prices of a speci c market basket of goods a Market basket surveys The market basket of goods and services are selected periodically in an attempt to approximate what the average family of four purchases at that time b CPI U is for urban consumers amp CPI W is for urban wage earners GDP De ator is based on a broader market basket and may be more useful in measuring in ation 1 Standard of living is eroded if there is in ation and no equal increase in wages 2 COLA are escalator clauses that tie earnings or other payments to the rate of inflation but only proportionally 3 Other indices American Chamber of Commerce Research Association in Indianapolis does a cross sectional survey there are wholesale price indices and several others designed for speci c purposes 0 In ationDe ation throughout most of US economic history we have experienced de ation which is a general decline in all prices In ation is primarily a postWorld War II event and is de ned to be a general increase in all prices d Nominal versus Real measures economists use the term nominal to describe money value or prices not adjusted for in ation real is used to describe data which are adjusted for in ation 7 Measuring the price level a CPI current year market basket base year market basket X 100 the index number forthe base year will be 10000 or 1 X 100 b In ating is the adjustment of prices to a higher level for years when the index is less than 100 c Deflating is the adjustment of prices to a lower level for years when the index is more than 100 1 to change nominal into real the following equation is used Nominal value price index100 d Changing base years a price index base year can be changed to create a consistent series remembering market baskets also change hence the process has a fault The process is a simple one lfyou wish to convert a 1982 base year index to be consistent with a 1987 base year then you use the index number for 1982 in the 1987 series and divide all other observations forthe 1982 series using the 1982 value in 1987 index series 3 Unemployment and Inflation Lecture Notes 1 Business Cycle is the recurrent ups and downs in economic activity observed in market economies a Troughs are where employment and output bottomout during a recession downturn b Peaks are where employment and output topout during a recovery upturn 0 Seasonal trends are variations in data that are associated with a particular season in the year d Secular trends are longrun trend generally 25 or more years in macroeconomic data Secular trend Output Years 2 Unemployment there are various causes of unemployment including a Frictional consists of search and wait unemployment which is caused by people searching for employment or waiting to take a job in the near future b Structural is caused by a change in composition of output change in technology or a change in the structure of demand 0 Cyclical due to recessions business cycle 3 Full employment is not zero unemployment full employment unemployment rate is the same as the natural rate a Natural rate is thought to be about 4 and is structural frictional unemployment 1 Potential output is the output ofthe economy at full employment 4 Unemployment rate is the percentage of the workforce that is unemployed a Labor force those employed or unemployed who are willing able and searching for work the labor force is about 50 ofthe total population b Parttime employment those who do not have 40 hours ofwork or equivalent available to them at 6 million US workers were involuntarily parttime and about 10 million were voluntarily parttime employees in 1992 c Discouraged workers those persons who dropped out of labor force because they could not nd an acceptable job d False search those individuals who claim to be searching for employment but really were not some because ofunemployment compensation bene ts 5 Okun39s law a Okun39s Law states that for each 1 unemployment exceeds the natural rate there will be a gap of 25 between actual GDP and potential GDP 6 Burden of unemployment differs by several factors these are a Occupation mostly due to structural changes b Age young people tend to experience more frictional unemployment c Race and gender re ect discrimination in the labor market and sometimes in educational opportunities 7 In ation general increase in all prices a CPI is the measure used to monitor in ation b Rule of 70 the number of years for the price level to double 70annual rate of increase 8 Demand pull in ation Aggregate Supply Price Aggregate Demand Output Using a naive aggregate demand aggregate supply model similar to the supply and demand diagrams for a market except the supply is total output in all markets and demand is total demand in all markets as the aggregate demand shifts outwards prices increase but so does output 9 Cost push in ation again using a naive aggregate supply aggregate demand approach costpush in ation results from a decrease in aggregate supply 10 Aggregate Price Supply Aggregate Demand Output a Pure in ation results from an increase in aggregate demand that is equal to a decrease in aggregate supply Aggregate Supply Price Aggregate Demand Output 10 Effects ofinflation impact different people in different ways lfinflation is fully anticipated and people can adjust their nominal income to account for in ation then there will be no adverse effects however if people cannot adjust their nominal income or the inflation is unanticipated those individual will see their standard of living eroded a Debitors typically benefit from in ation because they can pay loansoff in the future with money that is worth less thereby creditors are harmed by in ation b In ation typically creates expectations among people of increasing prices which may contribute to future in ation 11 c Savers generally lose money because of in ation if the rate of return on their savings is not suf cient to cover the in ation rate 12 4 Aggregate Supply amp Aggregate Demand Lecture Notes 1 Aggregate demand is a downward sloping function that shows the inverse relation between the price level and domestic output The reasons that the aggregate demand curve slopes down and to the right differs from the reasoning offered for individual market demand curves substitution amp income effects these do not work with aggregates The reasons for the downward sloping aggregate demand curve are a Wealth or real balance effect higher price level reduces the real purchasing power of consumers39 accumulated nancial assets b Interestrate effect assuming a xed supply of money an increase in the price level increases interest rates which in turn reduces interest sensitive expenditures on goods and services eg consumer durables cars etc c Foreign purchases effect if prices of domestic goods rise relative to foreign goods domestic consumers will purchase more foreign goods as substitutes Prices Aggregate Demand Output 13 2 Determinants of aggregate demand factors that shift the aggregate demand curve a j Expectations concerning real income or in ation including profits from investments in business sector Consumer indebtedness Personal taxes Interest rates Changes in technology Amount of current excess capacity in industry Government spending Net exports National income abroad and Exchange rates 3 Aggregate Supply shows amount of domestic output available at each price level The aggregate supply curve has three ranges the Keynesian range horizontal the intermediate range curved and the classical range vertical a Aggregate Prices Supply Classic1 Range Intermediate Rana Keynesmn Range Output Keynesian range is the result of downward rigidity in prices and wages 14 b Classical range classical economists believed that the aggregate supply curve goes vertical at the full employment level of output c Intermediate range is the range in aggregate supply where rising output is accompanied by rising price levels 4 Determinants of Aggregate Supply cause the aggregate supply curve to shift a Changes in input prices b Changes in input productivity and c Changes in the legalinstitutional environment 5 Macroeconomic Equilibrium intersection of aggregate supply and aggregate demand Prices Output 6 Ratchet Effect is where there is a decrease in aggregate demand that producers are unwilling to accept lower prices rigid prices and wages therefore there is a ratcheting ofthe aggregate supply curve decrease in the intermediate and Keynesian ranges which will keep the price level the same but with reduced output In other words there can be increases in prices fonNard but no decreases but not backward 15 Prices AD2 Output An increase in aggregate demand from AD1 to AD2 moves the equilibrium from point a to point b with real output and the price level increasing However if prices are in exible downward then a decline in aggregate demand from AD2 to AD1 will not restore the economy to its original equilibrium at point a Instead the new equilibrium will be at point c with the price level remaining at the higher level and output falling to the lowest point The ratchet effect means that the aggregate supply curve has shifted upward a decrease in both the Keynesian and intermediate ranges 16 5 Classical and Keynesian Models Lecture Notes Classical theory of employment macroeconomics rests upon two founding principles these are a Underspending unlikely spending in amounts less than sufficient to purchase the full employment level of output is not likely b Even ifunderspending should occur then pricewage flexibility will prevent output declines because prices and wages would adjust to keep the economy at the full employment level of output Say39s Law quotSupply creates its own demandquot well not exactly a In other words every level ofoutput creates enough income to purchase exactly what was produced b Among others there is one glaring omission in Say39s Law what about savings Savings a Output produces incomes but savings is a leakage b Savings give rise to investment and the interest rates are what links savings and investment WagePrice flexibility a The classicists believed that a laissez faire economy would result in macroeconomic equilibria and that only the government could cause disequilibria Keynesian Model beginning in the 1930s the classical models failed to explain what was going on hence a new model was developed the Keynesian Model a Full employment is not guaranteed because interest motivates both consumers amp businesses differently just because households save does not guarantee businesses will invest b Pricewage rigidity ratherthan flexibility was assumed by Keynes 17 6 The Consumption schedule income amp consumption a Consumption schedule the 45degree line is every point where disposable income is totally consumed b Saving schedule shows the amount of savings associated with the consumption function Consumption Consumption Disposable Income Savings Dispmuble Income The consumption schedule intersects the 45degree line at 400 in disposable income this is also where the savings function intersects zero in the graph below the consumption function To the left ofthe intersection of the consumption function and the 45degree line the consumption function lies above the 45degree line The distance between the 45degree line and the consumption schedule is dissavings shown in the savings schedule graph by the savings function falling below zero To the right of the intersection of the consumption function with the 45 degree line the consumption schedule is below the 45degree line The distance that the consumption function is below the 45degree line is called savings shown in the bottom graph by the savings function rising above zero c Marginal Propensity to Consume MPC is the proportion of any increase in disposable income spent on consumption if all is spent MPC is 1 if none is spent MPC is zero The Marginal Propensity to Save MP8 is the proportion ofany increase in disposable income saved The relation between MPC and MP8 is 1 MPCMPS1 18 d 5 Consumption g 3 W 2 A8 2 A2 lt3 10 1o Disposable Disposable income mcome The slope rise divided by the run ofthe consumption function isthe MPG and the slope ofthe savings function is the MPS Add the slope of the consumption function 810 to the slope ofthe savings function 210 and they equal one 1010 The Average Propensity to Consume APC is total consumption divided by total income Average Propensity to Save APS is total savings divided by total income Again if income can be either saved or consumed and nothing else then the following relation holds 1 APCAPS1 7 The nonincome determinants of consumption and saving are these cause shifts in the consumption and saving schedules d e Wealth Prices Expectations concerning future prices incomes and availability of commodities Consumer debts and Taxes 8 Investment a Investment demand curve is downward sloping 19 Investment Demmd Expected Rate of Return Investment b Determinants of investment demand are C 1 2 3 4 5 Acquisition maintenance amp operating costs Business taxes Technology Stock of capital on hand and Expectations concerning pro ts in future Autonomous determined outside of system v induced investment function of GDP Induced Divestment E a Autonomous 3 Investment 5 Real GDP Instability in investment has marked US economic history 20 2 Causes ofthis instability are a Variations in the durability of capital b Irregularity of innovation 0 Variability of pro ts and d Expectations of investors 21 6 Equilibrium in the Keynesian Model Lecture Notes 1 Equilibrium GDP is that output that will create total spending just suf cient to buy that output where aggregate expenditure schedule intersects 45 degree line a Disequilibrium where spending is insufficient recessionary gap or too high for level ofoutput inflationary gap 2 Expenditures Output Approach a Y C I G X is the identity for income where Y GDP C Consumption I Investment G Government expenditures and X Net exports exports minus imports GDP The equilibrium level ofGDP is indicated above where C I is equal to the 45 degree line Investment in this model is autonomous and the amount of investment is the vertical distance between the C and the C I lines This model assumes no government and that net exports are zero 3 Leakages Injections Approach relies on the equality of investment and savings at equilibrium a I S is equilibrium in the leakages injections approach 22 4 b Planned v actual investment the reason that the leakages injection approach works is that planned investment must equal savings Inventories can increase beyond that planned hence output that is not purchased which is recessionary or intended inventories can be depleted which is in ationary 8amp1 13 ll 12 GDP The original equilibrium is where I1 is equal to S and that level of GDP is shown with the solid indicator line lfwe experience a decrease in investment we move down to l2 and ifan increase in investment is observed it will be observed at l3 lfthere is an increase in expenditures there will be a respending effect In other words if10 is injected into the system then it is income to someone That rst person will spend a portion of the income and save a portion lfMPC is 90 then the rst individual will save 1 and spend 900 The second person receives 900 in income and will spend 810 and save 090 This process continues until there is no money left to be spent Instead of summing all of the income expenditures andor savings there is a shorthand method of determining the total effect this is called the Multiplier which is a Multiplier M 11MPC or 1MPS b Signi cance any increase in expenditures will have a multiple effect on the GDP Paradox ofthrift the curious observation that if society tries to save more it may actually save the same amount unless investment moves up as a result ofthe savings all that happens is that GDP declines and if investment is autonomous then savings remain the same 23 6 Full Employment level ofGDP may not be where the aggregate expenditures line intersects the 45 degree line There are two possibilities 1 a recessionary gap or 2 an in ationary gap both are illustrated below a Recessionary gap Full Emp GD 45 degree I Spen39 CI GDP The distance between the C l line and the 45 degree line along the dashed indicator line is the recessionary gap The dotted line shows the current macroeconomic equilibrium b In ationary gap 45 degree Full Emp GDP C I Spending GDP The distance between the C l line and the 45 degree line along the dashed indicator line is the in ationary gap The dotted indicator line shows the current macroeconomic equilibrium 24 7 Reconciling ADAS with Keynesian Cross the various C l and 45 degree line intersections ifmultiplied by the appropriate price level will yield one point on the aggregate demand curve Shifts in aggregate demand can be shown with holding the price level constant and showing increases or decreases in C l in the Keynesian Cross model Both models can be used to analyze essentially the same macroeconomic events 25 7 Fiscal Policy Lecture Notes 1 Discretionary Fiscal Policy involves government expenditures andor taxes to stabilize the economy a Employment Act of 1946 formalized the government39s responsibility in promoting economic stability b Simplifying assumptions forthe analyses presented here 1 2 3 4 5 6 Exogenous amp X G does initially impact private decisions All taxes are personal taxes Some exogenous taxes collected No monetary effects xed initial price level and Fiscal policy impacts only demand side 2 Changes in Government Expenditures can be made for several reasons a Stabilization of the economy 1 2 To close a recessionary gap the government must spend an amount that time the multiplier will equal the total gap To close an in ationary gap the government must cut expenditures by an amount that times the multiplier will equal the in ationary gap b Political goals and 0 Provision of necessary goods amp services 26 4Sde gr CIGZ CIGl zoo quotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquot quot 1w 350 430 GDP MPC 75 An increased government expenditure of 20 billion results in an increase in GDP of 80 billion with an MP0 of 75 hence a multiplier of 4 3 Taxation effects both consumption and savings a lfthe government uses a lump sum tax increase to reduce an in ationary gap the reduction in GDP occurs thusly 3 The lump sum tax must be multiplied by the MP0 to obtain the reduction in consumption 4 The reduction in consumption is then multiplied by the multiplier b A decrease in taxes works the same way the total impact is the lump sum reduction times the MP0 to obtain the increase in consumption which is in turn multiplied by the multiplier to obtain the full impact on GDP 0 A shortcut method with taxes is to calculate the multiplier as you would with an increase in government expenditures and deduct one from it 4 The balanced budget multiplier is always one a Occurs when the amount of government expenditures goes up by the same amount that a lump sum tax is increased b That is because only the initial expenditure increases GDP and the remaining multiplier effect is offset by taxation 27 Tax structure refers to the burden of the tax a Progressive is where the effective tax rate increases with ability to pay b Regressive is where the effective tax rate increases as ability to pay decreases c Proportional is where a fixed proportion ofability to pay is taken in taxes Automatic stabilizers help to smooth business cycles without further legislative action a Progressive income taxes b Unemploymentcompensation 0 Government entitlement programs Fiscal Lag there are numerous lags involved with the implementation of fiscal policy It is not uncommon for scal policy to take 2 or 3 years to have a noticeable effect after Congress begins to enact scal measures a Recognition lag how long to start to react b Administrative lag how long to have legislation enacted amp implemented 0 Operational lag how long it takes to have effects in economy Politics and Fiscal Policy a Public choice economists claim that politicians maximize their own utility by legislative action b Logrolling and negotiations results in many bills that impose costs Government de cits and crowding out It is alleged that private spending is displaced when the government borrows to nance spending a Ricardian Equivalence deficit nancing same effect on GDP as increased tax 10 Open economy problems Because there is a foreign sector that impacts GDP there are potential problems for scal policy arising from foreign sources 28 a Increased interest net export effect 1 An increase in the interest rate domestically will attract foreign capital but this increases the demand for dollars which increases their value and thereby reduces exports hence GDP b Foreign shocks in addition to currency exchange rates 1 Oil crises increased costs of production in the US 29 8 Economic Growth Lecture Notes 1 Economic growth is defined in one oftwo ways as a total hence GDP or as a per capita hence GDP per capita Each of these de nitions has its uses The second de nition is of the greatest importance in de ning the standard of living in a country a The following production possibilities frontier shows economic growth in a simple twocommodity economy b The assumptions underpinning the production possibilities model is that there are only two commodities produced there is a fixed technology and number of resources and these resources are used in an economically ef cient manner 2 Developing economies are classified into two categories a Middleincome countries 760 to 9300 per capita GDP in 2000 b Lowincome countries those below 760 per capita GDP in 2000 30 1 The majority of Latin countries are middleincome countries and the majority of subSaharan African countries and SouthAsian countries are low income countries The industrial high income countries are the US Canada Australia New Zealand Japan and Western Europe c Growthpaths are the historical tracing of how an economy moved from being less developed to a developed economy The prerequisites to economic growth which include 1 Establishing and implementing domestic rules of law 2 Opening the economy to international trade 3 Controlling population growth 4 Encouraging foreign direct investment 5 Building human capital 6 Reasonable monetary institutions and markets 7 Minimizing the role ofthe military both domestically and internationally and 8 Encouraging the growth ofthe private sector relative to the public sector 31 d Aggregate demand aggregate supply over time shows accelerating economic growth 1 The following graph translates the ASAD model into the secular trend utput Thne 2 In Indonesia India and several middleeastern and African countries there are significant problems with corruption and capital ight It is nearly impossible to attract capital to a developing nation if the government is corrupt and there is little in the way of political stability or the rule oflaw In the late 1990s there were stories coming out of Indonesia where high government of cials were leaving the country with several suitcases of US dollars classic capital flight e Economic growth is a longterm secular trend 3 The accumulation of capital in the United States was both domestic capital and the attraction of foreign capital a Political instability in Europe b US natural resources c Rule of law and political stability d Innovation 4 The Asian Tiger economies China Taiwan Indonesia South Korea Malaysia the Philippines and Thailand all experienced very substantial growth 32 a Much of this growth depended on two things low wage labor for manufacturing particularly in the electronics industry and exports 5 The majority ofthe world s population lives in lowincome countries a lndebted 1 Help here is important b Population outgrowing the economy 0 Narcotic effect of foreign aid d Brain Drain e Political instability 1 Arms trade f Capital Flight g International Trade 33 9 Money and Banking Lecture Notes 1 Functions of Money there are three functions of money a Medium of exchange accepted as quotlegal tenderquot or something of general and speci ed value 1 Use avoids reliance on barter 2 Barter requires a coincidence ofwants and severely complicates a market economy Measure of value permits value to be stated in terms ofa standard and universally understood standard Store of value can be saved with little risk chance of spoilage and virtually no cost and later exchanged for commodities without these positive storage characteristics 2 Supply of money a There are numerous definitions of money M1 through M3 most commonly used 1 M1 is currency checkable deposits 2 M2 is M1 noncheckable savings account time deposits of less 100000 Money Market Deposit Accounts and Money Market Mutual Funds 3 M3 is M2 large time deposit largerthan 100000 3 Near Money are items that ful ll portions of the requirements ofthe functions of money a Credit cards fulfill exchange function but are not a measure of value and if there is a credit line can be used to store value 34 b Other forms of near money 2 Precious metals store ofvalue but not easily exchanged 3 Stocks and Bonds earnings instruments but can be used as store of value c Implications for near money stability spending habits amp policy 4 What gives money value a No more gold standard 1 Nixon eliminated gold standard b The Value of money depends upon 1 acceptability for payment 2 because the government claims it is legal tender and 3 its relative scarcity 5 Value of dollar D 1P 6 Demand for Money three components of money demand a Transactions demand b Asset demand c Total demand 35 The money supply curve is vertical because the supply of money is exogenoust determined by the Federal Reserve The money demand curve slopes downward and to the right The intersection of the money demand and money supply curves represents equilibrium in the money market and determines the interest rate price of money 7 Money market a V th bonds that pay a specified interest payment per quarter then 1 Interest rate and value of bond inversely related 8 US Financial System a FDIC Federal Deposit Insurance Corporation guarantees bank deposits b Federal Reserve System is comprised of member banks The Board of Governors and Chairman are nominated by the President of United States The structure ofthe system is 1 Board of Governors 2 Open Market Committee 3 Federal Advisory Council 4 12 regions c Functions 36 1 Set reserves requirements 2 Check clearing services 3 Fiscal agents for US government 4 Supervision of banks 5 Control money supply through FOMC 9 Moral hazard insuring reduces insured39s incentive to assure risk does not happen 37 10 Multiple Expansion of Money Lecture Notes 1 Balance sheet T accounts assets liabilities net worth a is nothing more than a convenient reporting tool 2 Fractional Reserve Requirements a Goldsmiths used to issue paper money receipts backed by stocks of gold The stocks of gold acted as a reserve to assure payment if the paper claims were presented for payment 1 Genghis Khan rst issued paper money in the thirteenth century it was backed by nothing except the Khan39s authority b The US did not have a central banking system from the 1820 through 1914 In the early part of this century several nancial panics pointed to the need for a central banking and nancial regulation 1 States and private companies used to issue paper money 2 In the early days of US history Spanish silver coins were widely circulated in the US 3 The rst US paper money was issued during the Civil War The Greenback Act which included fractional currency paper dimes amp nickelsl c Today the Federal Reserve requires banks to keep a portion of its deposits as reserves 1 Purposes to keep banks solvent amp prevent financial panics 3 RRR Required Reserve Ratio and multiple expansion of money supply through T accounts a How reserves are kept 1 Loans from Fed discount rate at which Fed loans reserves to members 38 2 Vault cash 3 Deposits with Fed 4 Fed funds rate the rate at which members loan each other reserves b RRR Required reservedemand deposit liabilities 0 actual required and excess reserves 4 Money created through depositloan redepositing a Money is created by a bank receiving a deposit and then loaning that nonreserve portion ofthe deposit which is deposited and loans made against those deposits 1 lfthe required reserve ratio is 10 then a bank must retain 10 of each deposit as a reserve and can loan 90 ofthe deposit the multiple expansion of money assuming a required reserve ratio of 10 is therefore Deposit Loan 1000 900 900 810 810 729 10000 9000 Total new money is the initial deposit of10 90 of multiple expansion for a total of10000 in new money 5 Money multiplier Mm 1RRR a Is the shorthand method of calculating the entries in banks39 T accounts and shows how much an initial injection of money into the system generates in total money supply b V th a required reserve ratio of 05 the money multiplier is 20 amp with a required reserve ratio of 20 the money multiplier is 5 39 c The Federal Reserve needs to inject only that fraction of money that time the multiplier will increase the money supply to the desired levels 40 11 Federal Reserve and Monetary Policy Lecture Notes 1 Monetary policy de ned and objectives a Monetary policy is carried out by the Federal Reserve System and is focused on controlling the money supply b The fundamental objective of monetary policy is to assist the economy in attaining a full employment noninflationary equilibrium 2 Tools of Monetary Policy a Open Market Operations is the selling and buying of US treasury obligations in the open market b Expansionary monetary policy involves the buying of bonds 1 The Fed buying bonds it puts money into the hands ofthose who had held bonds 0 Contractionary monetary policy involves the selling of bonds 1 The Fed sells bonds it removes money from the system and replaces it with bonds 3 Required Reserve Ratio the Fed can raise or lowerthe required reserve ratio a Increasing the required reserve ratio reduces the money multiplier hence reduces the amount by which multiple expansions ofthe money supply can occur 1 Decreasing the required reserve ratio increases the money multiplier and permits more multiple expansion ofthe money supply 4 The Discount Rate is the rate at which the Fed will loan reserves to member banks for short periods of time 41 Velocity of Money is how often the money supply turnsover a The quantity theory of money is MV PQ 1 This equation has velocity V which is nearly constant and output Q which grows slowly so what happens to the money supply M should be directly reflect in the price level P Target Dilemma in Monetary Policy a Interest rates and the business cycle may present a dilemma Expansionary monetary policy may result in higher interest rates which dampen expansionary policies b Fiscal and monetary policies may also be contradictory Easy Money lowering interest rates expanding money supply a mitigate recession and stimulate growth Tight Money increasing interest rates contracting money supply a mitigate in ation and slow growth Monetary rules Milton Friedman a Discretionary monetary policy often misses targets in US monetary history b Suspicion of Fed and FOMC perhaps overblown 42 12 Economic Stability and Policy Lecture Notes 1 In ation Unemployment and Economic Policy a The misery index is the in ation rate plus the unemployment rate 2 The Phillips Curve is a statistical relation between unemployment and in ation named for A W Phillips who examined the relation in the United Kingdom and published his results in 1958 Actually Irving Fisher had done earlier work on the subject in 1926 a Short run tradeoff In ation Phillips Curve shortrun tradeoff Unemployment Often used to support activitist role for government however the shortrun tradeoffview ofthe Phillips curve demonstrates that there is a cruel choice between increased in ation or increased unemployment but low in ation and unemployment together are not possible b Long run Phillips Curve is alleged to be vertical at the natural rate of unemployment 43 In ation Long run Vertical Phillips Curve Natural m Unanployment This longrun view of the Phillips Curve is also called the Natural Rate Hypothesis It is based on the idea that people constantly adapt to current economic conditions and that their expectations are subject to quotadaptivequot revisions almost constantly lfthis is the case then business and consumers cannot be fooled into thinking that there is a reason for unemployment to cure in ation or vice versa C Possible positive sloping has hypothesized by Milton Friedman Friedman was of the opinion that the may be a transitional Phillips curve while people adapt both their expectations and institutions to new economic realities The positively sloped Phillips curve is show in the following picture In u on Positively sloped Transitional Phillips Curve Unemployment The positively sloped transitional Phillips Curve is consistent with the observations ofthe early 1980s when both high rates of unemployment existed together with high rates of in ation a condition called stag ation 44 d Cruel choices only exist in the case of the shortrun tradeoff view of the Phillips Curve However there maybe a quotLady and Tiger Dilemmaquot for policy makers relying on the Phillips Curve to make policy decisions 3 Rational expectations is a theory that businesses and consumers will be able to accurately forecast prices and other relevant economic variables lfthe accuracy of consumers39 and business expectations permit them to behave as though they know what will happen then it is argued that only a vertical Phillips Curve is possible as long as political and economic institutions remain stable 4 Market policies are concerned with correcting speci c observed economic woes a Equity policies are designed to assure quota social safety netquot at the minimum and at the liberal extreme to redistribute income 1 The Lorenz Curve and Gini Coef cients are used to measure income distribution in economies 45 degree Ema Pm39cmtage of income in economy The Lorenz curve maps the distribution of income among across the population The 45 degree line shows what the distribution of income would be if income was uniformly distributed across the population However the Lorenz curve drops down below the 45 degree line showing that poorer people receive less than rich people The Gini coefficient is the percentage ofthe triangle mapped out by the 45 degree line the indicator line from the top of the 45 degree line to the percentage of income axis and the percentage of income axis that is accounted for by the area between the Lorenz curve and the 45 degree 45 line lfthe Gini coef cient is near zero income is close to uniformly distributed if is near 1 then income is maldistributed b Productivity is also the subject of speci c policies The Investment Tax Credit WIN program and various state and federal training programs are focused increasing productivity c Trade barriers have been reduced through NAFTA and GATT in hopes of fostering more US exports 5 WagePrice Policies a Attempts have been made to directly control in ation through price controls this seemed to work reasonably well during World War II Carter tried voluntary guidelines that failed and Nixon tried controls that simply were a disaster 6 Supply Side Economics ofthe Reagan Administration were based on the theory that stimulating the economy would prevent deficits as government spending for the military was increased This failed theory was based on something called the Laffer Curve a Laffer Curve named for Arthur Laffer is a relation between tax rates and tax receipts Laffer39s idea was rather simple he posited that there was optimal tax rate above which receipt went down and below which receipts went down The Laffer curve is shown below La cr Curve too hish Tax 46 The Laffer Curve shows that the same tax receipts will be collected at the rates labeled both quottoo highquot and quottoo lowquot What the supplysiders thought was that tax rates were too high and that a reduction in tax rates would permit them to slide down and to the right on the Laffer Curve and collect more revenue In other words they thought the tax rate was above the optimal We got a big tax rate reduction and found unfortunately that we were below the optimal and tax revenues fell while we dramatically increased the budget In other words recordbreaking de cits and debt b There were other tenets ofthe supplyside view ofthe world These economists thought there was too much government regulation After Jimmy Carter deregulated trucking and airlines there was much rhetoric and little action to deregulate other aspects ofAmerican economic life 7 Unfortunately the realities ofAmerican economic policy is that politics is often main motivation for policy a Tax cuts are popular tax increases are not b De cits are a natural propensity for politicians unwilling to cut pork from their own districts and unwilling to increase taxes 8 Politics economics provides a scienti c approach to understanding politics is the art of the possible what is good economically maybe horrible politically and vice versa a Public choice literature 1 Politicians act in selfinterest just like the rest of us 47 13 Epilogue Lecture Notes 1 Why study Macroeconomics a Knowledge is prerequisite for democracy 1 Founding fathers thought that knowledge was what prevented despotism Jefferson and the free Press b Business conditions 1 Environment in which business is conducted importance cannot be minimized in a practical sense 2 Becoming more important as economy becomes more global exchange rates reasons for shifting fortunes etc c Selfpreservation very powerful incentives 1 Individual economic planning 401 K investments etc 2 Understanding markets requires understanding the environment in which they work full circle to a and b above 2 Futurism macroeconomic variables are powerful determinants of the future well being of societies and people a Commodities Oil energy in general metals natural resources etc b Climate changes impacting markets and whole areas c Technological changes products and processes available today which didn t exist 10 years ago d Political and institutional changes terrorism foreign policy etc e Unanticipated issues and reactions the historical record shows that much of this shapes what the modern world is 3 Economics as a career a Economics majors areas in which they work one of fastest growing majors in US universities 48 b Graduate training almost required today economic foundations in business law teaching etc 0 Not dependent on institutional arrangements 49 Reading Assignments Introduction to Macroeconomics E202 50 Chapter 1 Introduction to Economics In general the purpose ofthis chapter is to provide the basic de nitions upon which the subsequent discussions of macroeconomics will be built The specific purpose of this chapter is to de ne economics and its major component elds of study describe the relation between economic theory and empirical economics and examine the role of objectivity in economic analysis before examining economic goals and their relations Forthose of you who have had E201 Introduction to Microeconomics much ofthe material contained in this chapter will be similar to the introductory material contained in that course Definitions Economics has been studied since sixteenth century and is the oldest of the social studies Most ofthe business disciplines arose in attempt to fill some of the institutional and analytical gaps in the areas with which economics was particularly well suited to examine The subject matter examined in economics is the behavior of consumers businesses and other economic agents including the government in the production and allocation processes Therefore any business discipline will have some direct relation with the methods or at least the subject matter with which economists deal Economics is one of those words that seems to be constantly in the newspapers and on television news shows Most people have some vague idea ofwhat the word economics means but precise definitions generally require some academic exposure to the subject Economics is the study of the allocation of SCARCE resources to meet UNLIMITED human wants In other words economics is the study of human behavior as it pertains to the material wellbeing of people as either individuals or societies Robert Heilbroner describes economics as a quotWorldly Philosophyquot It is the organized examination of how why and for what purposes people conduct their dayto day activities particularly as relates to the production of goods and services the accumulation of wealth earning incomes spending their resources and saving for future consumption This worldly philosophy has been used to explain most rational human behavior Irrational behavior being the domain of specialties in sociology psychology history and anthropology 51 Underlying all of economics is the base assumption that people act in their own best interest at least most ofthe time and in the aggregate Without the assumption ofrational behavior economics would be incapable of explaining the preponderance of observed economic activity Consistent responses to stimuli are necessary for a model of behavior to predict future behavior If we assume people will always act in their best economic interests then we can model their behavior so that the model will predict with some accuracy future economic behavior As limiting as this assumption may seem it appears to be an accurate description ofreality Experimental economics using rats in mazes suggests that rats will act in their own best interest therefore it appears to be a reasonable assumption that humans are no less rational Most academic disciplines have evolved over the years to become collections of closely associated scholarly endeavors of a specialized nature Economics is no exception An examination of one of the scholarly journals published by the American Economics Association The Journal of Economic Literature reveals a classi cation scheme for the professional literature in economics Several dozen specialties are identi ed in that classi cation scheme everything from national income accounting to labor economics to international economics In other words the realm of economics has expanded to such an extent over the centuries that it is nearly impossible for anyone to be an expert in all aspects ofthe discipline so each economist generally specializes in some narrow portion of the discipline The decline of the generalist is a function of the explosion of knowledge in most disciplines and is not limited to economists Economics can be classi ed into two general categories these are 1 microeconomics and 2 macroeconomics Microeconomics is concerned with decisionmaking by individual economic agents such as firms and consumers In other words microeconomics is concerned with the behavior of individuals or groups organized into rms industries unions and other identi able agents Microeconomics is the subject matter of E201 Introduction to Microeconomics which many of you have recently completed Macroeconomics is concerned with the aggregate performance of the entire economic system Unemployment inflation growth balance oftrade and business cycles are the topics that occupy most of the attention of students of macroeconomics These matters are the topics to be examined this course E202 Introduction to Macroeconomics Macroeconomics is a course that interfaces with several other academic disciplines A signi cant amount ofthe material covered in this course involves public policy and has a signi cant historical foundation The result is that much of what is currently in the news will be things that are being studied in this course as they happen In many respects that makes this course of current interest if not fun 52 Methods in Economics Economists seek to understand the behavior of people and economic systems using scientific methods These scienti c endeavors can be classified into two categories 1 economic theory and 2 empirical economics Economic theory relies upon principles to analyze behavior of economic agents These theories are typically rigorous mathematical models abstract representations of behavior A good theory is one that accurately predicts future behavior and is consistent with the available evidence Empirical economics relies upon facts to present a description of economic activity Empirical economics is used to test and re ne theoretical economics based on tests of economic theory The tests that are typically applied to economic theories are statistically based and is generally called econometric methods Theory concerning human behavior is generally constructed using one of two forms of logic Sociology psychology and anthropology typically rely on inductive logic to create theory Inductive logic creates principles from observation In other words the scientist will observe evidence and attempt to create a principle or a theory based on any consistencies that may be observed in the evidence Economics relies primarily on deductive logic to create theory Deductive logic involves formulating and testing hypotheses Often the theory that will be tested comes form inductive logic or sometime informed guesswork The development of rigorous models expressed as equations typically lend themselves to rigorous statistical methods to determine whether the models are consistent with evidence from the real world The tests of hypotheses can only serve to reject or fail to reject a hypothesis Therefore empirical methods are focused on rejecting hypotheses and those that fail to be rejected over large numbers oftests generally attain the status of principle However examples of both types of logic can be found in each of the social sciences In each ofthe social sciences it is common to nd that the basic theory is developed using inductive logic With increasing regularity standard statistical methods are being employed across all ofthe social sciences and business disciplines to test the validity oftheories The usefulness of economics depends on how accurate economic theory predicts behavior Even so economics provides an objective mode ofanalysis with rigorous models that permit the discounting of the substantial bias that is usually present with discussions of economic issues The internal consistency brought to economic theory by mathematical models often fosters objectivity However no model is any better than the assumptions that underpin that model lfthe assumptions are either unrealistic or formulated to introduce a speci c bias objective analysis ca still be thwarted under the guise of scienti c inquiry 53 The purpose of economic theory is to describe behavior but behavior is described using models Models are abstractions from reality the best model is the one that best describes reality and is the simplest the simplest requirement is called Occam39s Razor Economic models of human behavior are built upon assumptions or simpli cations that allow rigorous analysis of real world events without irrelevant complications Often as will be pointedout in this course the assumptions underlying a model are not accurate descriptions of reality When the model39s assumptions are inaccurate then the model will provide results that are consistently wrong known as bias One assumption frequently used in economics is ceteris paribus which means all other things equal notice that economists like lawyers and doctors will use Latin to express rather simple ideas This assumption is used to eliminate all sources of variation in the model except for those sources under examination not very realisticl Economic Goals Policy and Reality Most people and organizations do at least rudimentary planning the purpose of planning is the establishment ofan organized effort to accomplish some economic goals Planning to nish your education is an economic goal Goals are in a sense an idea ofwhat should be what we would like to accomplish However goals must be realistic and within our means to accomplish if they are to be effective guides to action This brings another classi cation scheme to bear on economic thought Economics can be again classified into positive and normative economics Positive economics is concerned with what is and normative economics is concerned with what should be Economic goals are examples of normative economics Evidence concerning economic performance or achievement of goals falls within the domain of positive economics Most nations have established broad social goals that involve economic issues The types of goals a society adopts depends very much on the stage of economic development system of government and societal norms Most societies will adopt one or more ofthe following goals 1 economic ef ciency 2 economic growth 3 economic freedom 4 economic security 5 an equitable distribution ofincome 6 full employment 7 price level stability and 8 a reasonable balance oftrade Each goal listed above has obvious merit However goals are little more than value statements in this broad context For example it is easy for the very wealthy to cite as their primary goal economic freedom but it is doubtful that anybody living in poverty is going to get very excited about economic freedom but equitable distributions ofincome full employment and economic security will probably find rather wide support 54 among the poor Notice ifyou will goals will also differ within a society based on sociopolitical views ofthe individuals that comprise that society Economics can hardly be separated from politics because the establishment of national goals occurs through the political arena Government policies regulations law and public opinion will all effect goals how goals are interpreted and whether they have been achieved A word of warning eCONomics can be and has often been used to further particular political agendas The assumptions underlying a model used to analyze a particular set of circumstances will often re ect a political agenda of the economist doing the analysis For example Ronald Reagan argued that government de cits were inexcusable and that the way to reduce the de cit was to lower peoples39 taxes thereby spurring economic growth therefore more income that could be taxed at a lower rate and yet produce more revenue Mr Reagan is often accused by his detractors of having a speci c political agenda that was well hidden in this analysis His alleged goal was to cut taxes for the very wealthy and the rest was just rhetoric to make his tax cuts for the rich acceptable to most of the voters Who really knows Most political commentators both left and right have mastered the use of assumptions and highsounding goals to advance a specific agenda This adds to the lack of objectivity that seems to increasingly dominate discourse on economic problems On the other hand goals can be publicly spirited and accomplish a substantial amount of good President Lincoln was convinced that the working classes should have access to higher education The Morrell Act was passed 1861 and created Land Grant institutions for educating the working masses Purdue Michigan State Iowa State and Kansas State the rst land grant school are all examples ofthese types of schools By educating the working class it was believed that several economic goals could be achieved including growth a more equitable distribution of income economic security and freedom In other words economic goals that are complementary are consistent and can often be accomplished together Therefore con ict need not be the centerpiece of establishing economic goals Because any society39s resources are limited there must be decisions about which goals should be most actively pursued The process by which such decisions are made is called prioritizing Prioritizing is the rank ordering of goals from the most important to the least important Prioritizing of goals also involves value judgments concerning which goals are the most important In the public policy arena prioritizing of economic goals is often the subject of politics Herein lies one of the greatest dif culties in macroeconomics An individual can easily prioritize goals It is also a relatively easy task for a small organization or rm to prioritize goals Forthe United States to establish national priorities is a far largertask Adam Smith in the Wealth of Nations 1 776 describes the basic characteristics of capitalism this book marks the birth of capitalism Smith suggests that there are three legitimate functions of government in a free enterprise economy These three functions are 1 provide forthe national defense 2 provide for a system ofjustice and 3 55 provides those goods and services that cannot be effectively provided by the private economy because of the lack ofa pro t motive There is little or no controversy concerning the rst two ofthese government functions Where debate occurs is over the third of these legitimate roles Often you hear that some nonprofit organization or government agency should be quotrun like a businessquot A business is operated to make a pro t lfthe capitalist model is correct then the only reason for an entrepreneur to establish and operate a business is to make profits othenNise the conduct of the business is irrational and cannot be explained as selfinterested conduct A church charity or school is established for purposes other than the making ofa pro t For example a church may be established for the purposes of maximizing spiritual wellbeing of the congregation the doing of goodworks giving testimony to one39s religion worship of God and the other higher pursuits The purpose ofa college or a secondaryelementary school system likewise is not to make pro ts the purposes of educational institutions is to provide access knowledge A University is to increase the body of knowledge through basic and applied research professional services and of primary importance to the students to provide for the education of students To argue that these public or charitable organizations should be run like a business is to suggest that these matters can be left to the private sector to operate for a profit Inherent in this argument is the assumption a fallacy that the pro t motive would suf ce to assure that society received a quality product spiritual or educational or both and in the quantities necessary to accomplish broad social objectives Can you imagine what religion would become if it was reduced to worldly pro tability some argue there39s too much of that sort of thing now can you imagine what you would have to pay for your education if instead of the State of Indiana subsidizing education the student was asked to pay for the total cost of a course plus some percentage of cost as a profit Perhaps worse still who would do the basic research that has provided the scienti c breaktroughs that result in thousands of new products each year Would we have ever had computers without the basic research done in universities what would be missing from our medical technology Priorities at a national level are rarely set without signi cant debate disagreements and even conflict It is through our free democratic processes that we establish national state and local priorities In other words the establishment of our economic priorities are accomplished through the political arena and therefore it is often impossible to separate the politics from the economics at the macro level 56 Policy Policy can be generally classified into two categories public and private policy The formulation of public and private policy is the creation of guidelines regulations or law designed to effect the accomplishment of specific economic or other goals Public policy is how national economic goals are pursued In the private sector policy formulation means the creation of rules regulations and procedures to guide the operation ofthe company Therefore to understand goals one needs to understand something ofthe process of formulating policy Business students will have an in depth treatment of policy making in Administrative Policy P401 and the School of Public and Environmental Affairs requires a similar course in some of its degree programs For students in other programs the brief treatment here will suf ce for present purposes The following diagram outlines the steps in formulating policy in suf ciently general terms to be applicable to both the public and private sectors Steps in formulating policy 1 Stating goals must be measurable with speci c stated objective to be accomplished 2 Options identify the various actions that will accomplish the stated goals amp select one and 3 Evaluation gather and analyze evidence to determine whether policy was effective in accomplishing goal if not reexamine options and select option most likely to be effective Both the public and private policy formulation process are dynamic processes Economic goals change with public opinion and with the achievement or failure of certain elements of policy Step 1 involves the setting of goals Often this is based on little more than stating value judgments but the statement of goals should be based on informed opinion which requires the gathering and analyzing of evidence concerning the effects ofthe goal on other economic activities and the expected results ofthe goal Step 2 involves selecting the appropriate model and the options associated with that model to accomplish the speci ed goal The nal step involves the implementation ofthe policies designed to accomplish the goal and the monitoring of progress toward 57 accomplishing that goal The monitoring of progress involves the gathering of evidence and the appropriate analysis to determine whether the policy is doing what was anticipated or whether the policy needs revision The process of formulating policy is therefore a loop and requires continuous monitoring and revising The major difference between public policy and private policy is that private policy is not subject to democratic processes The Board of Directors or management ofa company will decide what goals are to be accomplished and what policy options are best used to do so Often private policy is made behind closeddoors without public accountability Public policy is created in the open with free debate and has the force of law and not just company rules and regulations Objective Thinking Most people bring many misconceptions and biases to economics After all economics deals with people39s material wellbeing Because of political beliefs and other value system components rational objective thinking concerning various economic issues fail Rational and objective thought requires approaching a subject with an openmind and a willingness to accept whatever answer the evidence suggests is correct In turn such objectivity requires the shedding ofthe most basic preconceptions and biases not an easy assignment What conclusions an individual draws from an objective analysis using economic principles are not necessarily cast in stone The appropriate decision based on economic principles may be inconsistent with other values The respective evaluation ofthe economic and quotother valuesquot ie ethics may result in a con ict lfan inconsistency between economics and ethics is discovered in a particular application a rational person will normally select the option that is the least costly ie the majority view their integrity as priceless An individual with a low value for ethics or morals may nd that a criminal act such as theft as involving minimal costs In other words economics does not provide all of the answers it provides only those answers capable of being analyzed within the framework of the rational behavior that forms the basis of the discipline There are several common pitfalls to objective thinking in economics After all few things excite more emotion than our material wellbeing It should come as no surprise that bias and less than objective reasoning is common when it comes to economic issues particularly those involving public policy Among the most common logical pitfalls that affect economic thought are 1 the fallacy of composition and 2 post hoc ergo prompter hoc Each of these will be reviewed in turn The fallacy of composition is the mistaken belief that what is true for the individual must be true for the group An individual or small group of individuals may 58 exhibit behavior that is not common to an entire population In other words this fallacy is simply assuming a small unscienti cally selected sample will predict the behavior values or characteristics ofan entire population For example if one individual in this class is a U fan then everyone in this class must be an U fan is an obvious fallacy of composition Statistical inference can be drawn from a sample ofindividual observations but only within con dence intervals that provide information concerning the likelihood of making an incorrect conclusion E270 Introduction to Statistics provides a more in depth discussion of con dence intervals and inference Post hoc ergo prompter hoc means after this hence because of this and is a fallacy in reasoning Simply because one event follows another does not necessarily imply there is a causal relation One event can follow another and be completely unrelated All of us have at one time or another experienced a simple coincidence One event can follow another but there may be something other than a direct causal relation that accounts for the timing ofthe two events For example during the thirteenth century people noticed that the black plague occurred in a location when the population of cats increased Unfortunately some people concluded that the plague was caused by cats so they killed the cats In fact the plague was carried by eas on rats When the rat population increased cats were attracted to the area because of the food supply the rats The people killed the predatory cats and therefore rat populations increased and so did the population of eas that carried the disease This increase in the rat population also happened to attract cats but cats did not cause the plague if left alone they may have gotten rid of the real carriers the rats therefore the eas The idea that cats were observed increasing in population gave rise to the conclusion that the cats brought the plague is a post hoc ergo prompter hoc fallacy but this example has an indirect relation between cats in the real cause Often even this indirect relation is absent Many superstitions are classic examples of this type of fallacy Broken mirrors causing seven years bad luck or walking under a ladder brining bad luck are nothing but fallacies ofthe post hoc ergo prompter hoc variety There is no causal relation between breaking glass and bad luck or walking under ladder unless something falls off the ladder on the pedestrian Deeper examination of the causal relations are necessary for such events if the truth ofthe relations is to be discovered However more in depth analysis is often costly and the cost has the potential of causing decisionmakers to skip the informed part and cut straight to the opinion Economic history has several examples of how uniformed opinion resulted in very signi cant dif culties for innocent third parties in addition to those responsible for the decisions The following box presents a case where policy was implemented based on the failure to recognize that there is a signi cant amount of interdependence in the US economy 59 Unintended Consequences The Legend of39Pig39 Iron David A Dilts Indiana Policy Review Vol 1 No 5 pp 28 29 Many a clich seems to center on pork The head ofthe household is supposed to quot put bacon on the tablequot quotpork barrelsquot and politicians are frequently accused of being in too close a proximity It only seems tting that one more story concerning pork should be brought to your attention During World War II farmers in the corn belt argued that regulation of the price of pork had no effect on the war effort and that they should be permitted to sell their commodities without government interference The farmers brought political pressure to bear on the Congress and our representatives to deregulate the price of pork The end result was to shut down the steel mills in Gary Shut down our steel mills How could this be Since it is not intuitively obvious how this happened I39ll explain In 1942 there had been a change in management in the Philippines And as luck would have it we didn39t have good trade relations with the new management the Japanese Therefore we did not have access to Manila fibre necessary in making everything from rope to battleships We had not yet developed synthetic fibre and therefore has to rely on the fibre previously available That bre was hemp Now hemp grows in the same places under the same climatic conditions as does corn Corn is what hogs eat And because corn was not being grown in the Midwest the farmers sought alternative feed for the increased number of hogs they were raising Remember increased price results in a larger quantity supplied Oats wheat and barley were available from the Great Plains region The problem was shipping it to where the hogs were raised in the Corn Belt ofthe Lower Midwest In their search for transportation the farmers found that railroads were regulated and reserved for military and heavy industry trucks needed gasoline and rubber both in shortsupply and airplanes were being built almost exclusively for military purposes This left the farmers without a ready source of domestic transportation for the needed grain But they eventually found a source of shipping that was neither regulated nor controlled because it was international in nature the ironore barges on the Great Lakes They bid up the price and the barges started hauling oats to the pigs and stopped hauling ore to the Gary steel mills And there you have it Without the requisite iron ore the steel mills could not produce they were actually shut down for a period as a direct result of deregulating the price of pork US Economy This story shows fairly conclusively that private interests can damage society as a whole While our economic freedom is one ofthe prime ingredients in making our economy the grandest in the world such freedom requires that it be exercised in a responsible fashion lest the freedom we prize becomes a source of social harm Like 60 anything else economic freedom for one group may mean disaster for another through no fault of the victims Government and the exercise ofour democratic responsibilities is suppose to provide the checks on the negative results ofthe type portrayed in the above box Statistical Methods in Economics The use of statistical methods in empirical economics can result in errors in inference Most ofthe statistical methods used in econometrics statistical examination of economic data rely on correlation Correlation is the statistical association of two or more variables This statistical association means that the two variables move predictably with or against each other To infer that there is a causal relation between two variables that are correlated is an error For example a graduate student once found that Pete Rose39s batting average was highly correlated with movement in GNP during several baseball seasons This spurious correlation cannot reasonably be considered pathbreaking economic research On the other hand we can test for causation where one variable actually causes another Granger causality states that the thing that causes another must occur first that the explainer must add to the correlation and must be sensible As with most statistical methods Granger causality models permit testing for the purpose of rejecting that a causal relation exists it cannot be used to prove causality exists These types of statistical methods are rather sophisticated and are generally examined in upper division or graduate courses in statistics As is true with economics statistics are simply a tool for analyzing evidence Statistical models are also based on assumptions and too often statistical methods are used for purposes for which they were not intended Caution is required in accepting statistical evidence One must be satis ed that the data is properly gathered and appropriate methods were applied before accepting statistical evidence Statistics do not lie but sometimes statisticians do Objectivity and Rationality Objective thinking in economics also includes rational behavior The underlying assumptions with each ofthe concepts examined in this course assumes that people will act in their perceived best interest Acting in one39s best interests is how rationality is de ned The only way this can be done logically and rigorously is with the use of marginal analysis This economic perspective involves weighing the costs against the bene ts of each additional action In other words if bene ts of an additional action will be greater than the costs it is rational to do that thing othenNise it is not 61 KEY CONCEPTS Economics Microeconomics Macroeconomics Empirical economics v Theoretical economics Inductive logic v Deductive logic Model Building Assumptions Occam s Razor Normative economics v Positive economics Policy formulation Public v Private Objective Thinking Fallacy of Composition Cause and effect Bias Correlation v causation Costbene t analysis STUDY GUIDE Food for Thought Most people are biased in theirthinking particularly concerning economic issues Why do you suppose this is Sample Questions Multiple Choice 62 Which of the following is not an economic goal A Full Employment B Price Stability C Economic Security D All of the above are economic goals Which of the following methods can be applied to test for the existence of statistical association between two variables A Correlation B Granger causality C Theoretical modeling D None of the above True false Noneconomists are no less or no more biased about economics than physics or chemistry FALSE Assumptions are used to simplify the real world so that it may be rigorously analyzed TRUE 63 Chapter 2 National Income Accounting The aggregate performance ofa large and complex economic system requires some standards by which to measure that performance Unfortunately our systems of accounting are imperfect and provide only rough guidelines ratherthan crisp clear measurements of the economic performance of large systems As imperfect as the national income accounting methods are they are the best measures we have and they do provide substantial useful information The purpose ofthis chapter is to present the measures we do have of aggregate economic performance Gross Domestic and Gross National Product The most inclusive measures we have of aggregate economic activity are Gross Domestic Product and Gross National Product These measures are used to describe total output ofthe economy by source In the case of Gross Domestic Product we are concerned with what is produced within our domestic economy More precisely Gross Domestic Product GDP is the total value of all goods and services produced within the borders of the United States or country under analysis On the other hand Gross National Product is concerned with American production regardless of whether it was produced domestically More precisely Gross National Product GNP is the total value of all goods and services produced by Americans regardless of whether in the United States or overseas These measures GDP and GNP are the two most commonly discussed in the popular press The reason they garner such interest is that they measure all of the economy39s output and are perhaps the least complicated of the national income accounts Often these data are presented as being overall measures ofour population39s economic wellbeing There is some truth in the assertion that GDP and GNP are social welfare measures however there are signi cant limitations in such inferences To fully understand these limitations we must first understand how these measures are constructed The national income accounts are constructed in such a manner as to avoid the problem of double counting For example if we count a finished automobile in the national income accounts what about the paint steel rubber plastic and other components that go into making that car To systematically eliminate double counting only valueadded is counted for each rm in each industry The value ofthe paint used in producing a car is valueadded by the paint manufacturing company the application of that paint by an automobile worker is valueadded by the car company 64 but the value ofthe paint itself is not By focusing only on valueadded at each step of the production process in each industry national income accountants are thus able to avoid the problems of double counting GROSS DOMESTIC PRODUCT by COMPONENT 19402000 billions of current US dollars Personal Gross Domestic Government Net YEAR Consumption Investment Expenditures Exports GDP 1940 711 134 142 14 1001 1950 1921 551 326 07 2867 1960 3324 787 998 17 5134 1970 6465 1503 2120 12 10107 1980 17481 4676 5071 147 27080 1990 37426 8026 10429 744 55138 2000 62578 17729 15726 3991 92240 The above box presents the GDP accounts in the major expenditures components GDP is the summation of personal consumption expenditures gross domestic private investment lg government expenditures G and net exports Xn where net exports are total export minus total imports Put in equation form GDPYCgGXn GDP can also be calculated using the incomes approach GDP can be found by summing each ofthe income categories and deducting Net American lncome Earned Abroad The following illustration shows how GNP and GDP are calculated using the incomes approach as follows 65 Depreciation Indirect Business Taxes Employee Compensation Rents I nte re st Proprietors39 Income Corporate Income Taxes Dividends Undistributed Corporate Pro ts Gross National Product Net American Income Earned Abroad Gross Domestic Product In a practical sense it makes little difference which approach to calculating GDP is used the same result will be obtained either way What is of interest is the information that each approach provides The subaccounts under each approach provide useful information for purposes of understanding the aggregate performance of the economy and potentially formulating economic policy Under the expenditures approach we have information concerning the amount of foreign trade government expenditures personal consumption and investment The following accounts illustrates how GDP is broken down into another useful set of subaccounts Each ofthese additional subaccounts provides information that helps us gain a more complete understanding of the aggregate economic system The following illustration demonstrates how the subaccounts are calculated 66 Gross Domestic Product Depreciation Net Domestic Product Net American Income Earned Abroad Indirect Business Taxes National Income Social Security Contributions Corporate Income Taxes Undistributed Corporate Pro ts Transfer Payments Personal Income Personal Taxes Disposable Income The expenditures approach provides information concerning from what sector proportions ofGDP come Personal consumption government expenditures foreign sector and investment all are useful in determining what is responsible for our economic wellbeing Likewise the incomes approach provides greater detail to our understanding ofthe aggregate economic output Net National Product is the output that we still have after accounting for what is usedup in producing in other words the capital we usedup getting GDP is nettedout to provide a measure ofthe output we have left National Income takes out of Net National Product all ad valorem taxes that must be paid during production and net American income originating from overseas Appropriate adjustments are made to National Income to deduct those things that do not reach households ie undistributed corporate profits and adds in transfer payments to arrive at Personal Income The amount of Personal Income that households are free to spend after paying their taxes is called Disposable Income So far the national income accounts appear to provide a great deal of information However we do know that this information fails to accurately measure our aggregate economic wellbeing There are many aspects of economic activity that do not lend themselves well to standard accounting techniques and these problems must be examined to gain a full appreciation for what this information really means 67 National Income Accounts as a Measure of Social Welfare Accounting whether it is nancial cost corporate nonprofit public sector or even national income provides images of transactions The imagesthat the accounting process provides has value judgments implicit within the practices and procedures of the accountants National income accounting as do other accounting practices also has signi cant limitations in the availability of data and the cost of gathering data In turn the costs of data gathering may also substantially influence the images that the accounts portray GDP and GNP are nothing more than measures oftotal output or income However the total output measured is limited to legitimate market activities Further national income accountants make no pretense to measure only positive contributions to total output that occur through markets Both economic goods and economic bads are included in the accounts which signi cantly limits any inference that GDP or any of its subaccounts are accurate images of social welfare More information is necessary before conclusions can be drawn concerning social welfare Nonmarket transactions such as householdprovided services or barter are not included in GDP In other words the services ofa cook ifemployed are counted but the services ofa man or woman doing the cooking fortheir own household is not This makes comparisons across time within the United States suspect In the earliest decades of national income accounting many of the more routine needs of the household were served by the household members39 own labor As society became faster paced and two wage earners began to become the rule for American households more laundry housecleaning child rearing and maintenance work necessary to maintain the household were accomplished by persons hired in the marketplace In other words the same level of service may have been provided but more ofit is now a market activity hence included in GNP This is also the case in comparing US households with households in less developed countries Certainly less market activity is in evidence in less developed countries that could be characterized as household maintenance Few people are hired outside ofthe family unit to perform domestic labor in less developed countries and if they are they are typically paid pennies per hour Less developed countries39 populations rely predominately on subsistence farming or shing and therefore even food and clothing may be rarely obtained in the marketplace Leisure is an economic good but time away from work is not included in GNP The only way leisure time could be included in GNP is to impute estimate a value for the time and add it to GNP the same method would be required for household services of family members Because ofthe lack of consistency in the use of time for leisure activities these imputation would be a very arbitrary at best However commodities used in leisure activities are included in GNP Such things as movie tickets skis and 68 other commodities are purchased in the market and may serve as a rough guide to the bene ts received by people having time away from work Product quality is not reflected in GNP There is no pretense made by national income accountants that GDP can account for product or service quality There is also little information available upon which to base a sound conclusions concerning whether the qualitative aspects ofour total output has increased It is clear that domestic automobiles have increased in quality since 1980 and this same experience is likely true of most of US industry No attempt is made in GDP data to account forthe composition output We must look at the contributions of each sector ofthe economy to determine composition The US Department of Commerce publishes information concerning output and classifies that output by industry groups These industry groupings are called Standard Industrial Codes SC and permits relatively easy tracking oftotal output by industry group and by components of industry groups Over time there are new products introduced and older products disappear as technology advances Whale oil lamps and horseshoes gave way to electric lights and automobiles between the Nineteenth and Twentieth Centuries As we moved into the latter part ofthis century vinyl records gave way to cassettes which in turn have been replaced by compact disks In almost every aspect of life the commodities that we use have changed within our lifetimes Therefore comparisons ofGNP in 1996 with GNP in 1966 is really comparing apples and oranges because we did not have the same products available in those two years As we move further back in time the commodities change even more However it is interesting to note the relative stability ofthe composition of output before the industrial revolution For centuries afterthe fall of the Roman Empire the composition oftotal output was very similar Attila the Hun would have recognized most ofwhat was available to Mohammed and he would have recognized most ofwhat Da Vinci could have found in the market place Therefore the rapid change in available commodities is a function ofthe advancement of knowledge hence the advancement in technology Another shortcoming of national income accounting is that the accounts say nothing about how income is distributed In the early centuries ofthis millennium only a privileged few had lifestyles that most of us would recognize as middle income or above V th recent archaeological work at Imperial Roman sites many scholars have concluded that over 95 ofthe population lived in poverty the majority in life threatening poverty while a very few lived in extreme wealth With the tremendous increases in knowledge over the past twohundred years technology has increased our productivity so substantially that in the 28 industrialized nations ofthe world the majority of people in those countries do not know poverty However the majority of the world39s population lives in less developed countries and the ovenNhelming majority of the people in those countries do know poverty and a signi cant minority of these 69 people know life threatening poverty In short with the increase in output has come an increase in the wellbeing of most people Per capita income is GDP divided by the population and this is a very rough guide to individual income which still fails to account for distribution In the United States the largest economy in the world there are still over 40 million people about 1412 percent that live in poverty and only a very few these in life threatening poverty Something just under four percent ofthe population about 1 person in 26 are classified as wealthy The other 81 percent experience a middleincome lifestyle in the United States The distribution of poverty is not equal across the population ofthis country Poverty disproportionately falls to youngest and oldest segments of our population Minority group persons also experience a higher proportion of poverty than do the majority Environmental problems are not addressed in the national income accounts The damage done to the environment in the production or consumption of commodities is not counted in GDP data The image created by the accounts is that pollution deforestation chemical poisoning and poor quality air and water that give rise to cancer birth defects and other health problems are economic goods not economic bads The cost ofthe gasoline burned in a carthat creates pollution is included in GNP however the poisoning ofthe air especially in places like Los Angeles Denver and Louisville is not deducted as an economic bad The only time these economic bads are accounted for in GNP is when market transactions occurto cleanup the damage and these transactions are added to GNP The end result is that GNP is overstated by the amount ofenvironmental damage done as a result of pollution and environmental damage The largest understatement of GNP comes from something called the underground economy The underground economy is very substantial in most less developed countries and in the United States It includes all illegitimate mostly illegal economic activities whether market activities or not In less developed countries much of the underground economy is the quotblack marketquot but there is also a signi cant amount of crime in many ofthese countries Estimates abound concerning the actual size ofthe underground economy in the United States The middle range ofthese estimates suggest the amount of underground economic activities may be as much as onethird oftotal US output The FBl has for years tracked crime statistics in the United States and publishes an annual report concerning crime It is clear that drugs organized theft robberies and other crimes against property are very substantial in the United States But when these crimes result in income for the offenders there is also the substantial problem of income tax evasion from not reporting the income from the criminal activity After all Al Capone never went to jail for all of the overt criminal acts involved in his various criminal enterprises he went to jail for another crime that is because he did not pay income taxes on his illgotten gains 7O Drug traf cking in the United States is a very large business The maximum estimates place this industry someplace in the order of a 500 billion per year business in the US Few legitimate industries are its equal Worse yet the news media reports that nearly half of those incarcerated in this nation39s prisons are there on drug charges The image that the national income accounts portrays is that the 100 billion plus that is spent on law enforcement and corrections because of drug traf cking is somehow an economic good not a failure of our system Drugs however are not the only problem As almost any insurance company of cial can tell you car theft is also another major industry A couple ofyears ago CNN reported that a car theft ring operating in the Southeast and particularly Florida was responsible for a large proportion of vehicles sold in certain Latin American countries Further that ifthis car theft ring were a legitimate business it would be the fourteenth largest in the United States right above CocaCola in the Fortune 100 In an economy with total output of 6 trillion when nearly 10 of that is matched by only one illegitimate industry drugs there is a serious undercounting problem If estimates are anyplace close to correct and 500 billion per year are the gross sales of drug dealers and if the profits on this trade are only eighty percent likely a low estimate and ifthe corporate income tax rate of fortynine percent could be applied to this sum then instead of a 270 billion budget de cit the Federal government would be experiencing a surplus of something in the order of 1 30 billion without any reduction in expenditures for law enforcement and corrections which could be reallocated to education health care or other good purposes Maybe the best argument forthe legalization ofdrugs is its effect on the nation39s nances assuming of course drugs were only a national income accounting problem Price Indices Changes in the price level poses some significant problems for national income accountants lfwe experience 10 inflation and a reduction of total output of 5 it would appearthat we had an increase in GNP In fact we had an increase in GNP but only in the current dollar value of that number In real terms we had a reduction in GNP Comparisons between these two time periods means very little because the price levels were not the same lfwe are to meaningfully compare output we must have a method by which we can compare output with from one period to another by controlling for changes in the price levels Nominal GDP is the value oftotal output at the prices that exist at that time By adjusting aggregate economic data for variations in price levels then we have data that can be compared across time periods with different price levels Real GDP is the value oftotal output using constant prices variations in price levels being removed 71 Price indices are the way we attempt to measure in ation and adjust aggregate economic data to account for price level variations There are a wide array of price indices We measure the prices wholesalers must pay that consumers must pay either urban consumers CPU orthat wage earners must pay CPW we measure prices for all goods and services GNP Deflator and we also have indices that focus on particular regions of the country generally large urban areas called Standard Metropolitan Statistical Areas SMSA Price indices are far from perfect measures of variations in prices These indices are based on surveys of prices of a specific market basket of goods at a particular point in time The accuracy of any inference that may be drawn from these indices depends on how well the market basket of commodities used to construct the index match our own expenditures or the expenditures ofthe people upon whom the analysis focuses Further complicating matters is the fact that the market basket of goods changes periodically as researchers believe consumption patterns change Every ve to ten years generally seven years the Commerce Department Current Population Surveys changes the market basket of goods in an attempt to account for the current expenditure patterns ofthe group for which the index is constructed total GNP consumers wholesalers etc For the consumer price indices there is a standard set of assumptions used to guide the survey takers concerning what should be included in the market basket The market basket for consumers assumes a family of four with a male wage earner an adult female not employed outside ofthe home and two children one male one female There are also assumptions concerning home ownership gift giving diet and most aspects of the hypothetical family39s standard of living The cost ofliving and the standard ofliving are mirror images ofone another If someone has a xed income and there is a two percent inflation rate per year then their standard of living will decrease two percent per year assuming the index used is an accurate description of their consumption patterns In other words a standard of living is eroded ifthere is in ation and no equal increase in wages or other income ie pensions Underthe two percent annual in ation scenario a household would need a two percent increase in income each year simply to avoid a loss in purchasing power of their income standard of living During most if not all of your lifetime this economy has experienced inflation Prior to World War II however the majority of American economic history is marked by de ation That is a general decrease in all prices V th a deflationary economy all one must do to have a constant increase in their standard ofliving is to keep their income constant while prices fall However deflation is a problem Suppose you want to buy a house Most of us have mortgages we borrow to buy a house If you purchase a house worth 50000 and borrow eighty percent ofthe purchase price 40000 you may have a problem If we have five percent de ation per year it only takes ve years forthe market value ofthat house to reach 38689 In the sixth year you owe more on 72 your thirtyyear mortgage than the market value of the house Credit for consumer purchases becomes an interesting problem in a de ationary economy On the other hand ifyou owe a great deal of money you have the opportunity to pay back your loans with less valuable money the higher the rate of inflation Therefore debtors bene t from in ation if they have xed rate loans that do not adjust the rates for the effects of in ation The in ationary experience ofthe postWorld War II period has resulted in our expecting prices to increase each year Because we have come to anticipate in ation our behaviors change One of the most notable changes in our economic behavior has been the wide adoption of escalator provisions in collective bargaining agreements executory contracts and in entitlement laws social security veterans39 bene ts etc Escalator arrangements sometimes called Cost of Living Adjustments COLA typically equate earnings or other payments to the rate of in ation but only proportionally For example the escalator contained in the General Motors and United Auto Workers contract provides for employees receiving 1 per hour for each 2 the CPI increases This protects approximately 500 ofthe employees earnings from the erosive effects ofinflation 012100 assuming a base CPI of 100 There is no escalator that provides a greater bene t to income receivers than the GMUAW national agreement There are other price indices that focus on geographic differences Price data that measures changes over time are called time series and those that measure differences within a time period but across people or regions are called cross sections The American Chamber of Commerce Research Association ACCRA in Indianapolis does a cross sectional survey for midsized to large communities across the United States On this ACCRA index Fort Wayne generally ranges between about 960 and 1020 where 100 is the national average and the error of estimate is between 2 and 4 percent There are also producer and wholesale price indices and several component part ofthe consumer price indices that are designed for speci c purposes that focus on regions of the country or industries For example the components ofthe CPI are also broken down so that we have detailed price information for health care costs housing costs and energy costs among others Measuring the Price Level The discussion here will focus on the Consumer Price Index CPI but is generally applicable The CPl is based on a market basket of goods and is expressed as a percentage ofthe value of the market baskets39 value in a base year the year with which all prices in the index are compared Each year39s index is constructed by 73 dividing the current year market basket39s value by the base year market basket39s value and then multiplying the result by 100 Note that the index number for the base year will be 10000 or 1 X 100 By using this index we can convert nominal values into real values real value are expressed in base year dollars We can either inflate or de ate current values to obtain real values In ating is the adjustment of prices to a higher level for years when the index is less than 100 De ating is the adjustment of prices to a lower level for years when the index is more than 100 The process whereby we in ate and de ate is relatively simple and straightfonNard To change nominal into real values the following equation is used Nominal valueprice index100 For example in 1989 the current base year the CPI is 100 By 1996 the CPI increased to 1100 lfwe want to know how much 100 of 1996 money is worth in 1989 we must de ate the 1996 dollar We accomplish this by dividing 110 by 100 and obtaining 11 we then divided 1 by 11 and nd 909 which is the value ofa 1996 dollar in 1989 If we want to know how much a 1989 dollar would buy in 1996 we must in ate We accomplish this by dividing 100 by 110 and obtaining 909 we then divide 1 by 909 and nd 110 which is the value ofa1989 dollar in 1996 Because the government changes base years it may be necessary to convert one or more indices with different base years to obtain a consistent time series ifwe want to compare price levels between years decades apart Changing base years is a relatively simple operation If you wish to convert a 1982 base year index to be consistent with a 1987 base year then you use the index number for 1982 in the 1987 series and divide all other observations for the 1982 series using the 1982 value in 1987 index series This results in a new index with 1987 as a base year If in ation was experienced during the entire period then the index number for 1987 will be 100 for the years prior to 1987 the indices will be less than 100 and for the years after 1987 the numbers will be largerthan 100 The price index method has problems The assumptions concerning the market basket of goods to be surveyed causes speci c results that are not descriptive of a general population In the case ofthe consumer price index families without children or with more than two may find their cost of living differs from what the index suggests If both parents work the indices may understand the cost of living For families with ten year old fixed rate mortgages and high current mortgages rates the CPI may understate their current cost of living Therefore the CPI is only a rough measure and its applicability differs from household to household 74 Cost of Living Adjustments David A Dilts and Clarence R Deitsch Labor Relations New York Macmillan Publishing Company 1983 p 167 To the casual observer COLA clauses may appear to be an excellent method of protecting the real earnings of employees This is not totally accurate COLA is not designed to protect the real wage ofthe employee but is simply to keep the employee39s nominal wage within certain limits close to its original purchasing power With a 1 cent adjustment per 4 increase in the CPI if no ceiling is present the base wage which is being protected from the erosive effect of in ation is 250 per hour 1 cent per 3 increase in the CPI protects 333 per hour and 1 cent per 2 increase in the CPI protects 500 per hour This is quite easy to see since the CPI is an index number computed against some base year CPI 100 in 1967 and the adjustment factor normally required in escalator clauses is 1 cent per some increase X in the CPI the real wage which is protected by the escalator is the inverse ofthe CPI requirement or 1X KEY CONCEPTS National Income Accounting Social Welfare Underestimations Overestimations Gross Domestic Product v Gross National Product Value added Expenditures Approach Income Approach Criticisms Net Domestic Product v Net National Product Depreciation National Income Personal Income Disposable Income In ation v De ation 75 CostPush In ation v DemandPull In ation Pure Inflation Monetarist School Quantity Theory of Money Price Indices CPI Other Indices In ating v De ating STUDY GUIDE Food for Thought Critically evaluate the use of national income accounts as measures of social welfare Using the following data construct the price indices indicated Year Market basket 1989 350 1990 400 1991 440 1992 465 1993 500 Calculate a price index using 1989 as the base year Calculate a price index using 1991 as the base year Ifthe nominal price of new house in 1993 is 100000 how much is the house in 1989 dollars In 1991 dollars 76 Ifthe price ofa new house in 1989 is 90000 what is the price in 1991 dollars Critically evaluate the use of price indices for comparison purpose across time Using the following data calculate GDP NDP NI PI and DI Undistributed Corporate profits 40 Personal consumption expenditures 1345 Compensation of employees 841 lnterest 142 Gross exports 55 lndirect business taxes 90 Government expenditures 560 Rents 115 Personal taxes 500 Gross imports 75 Proprietors income 460 Depreciation 80 Corporate income taxes 100 Net Investment 120 Dividends 222 Net American income earned abroad 5 Social security contributions 70 77 Sample Questions Multiple Choice lf US corporations paid out all oftheir undistributed corporate pro ts as dividends to their stockholders then which ofthe following national income accountants would show an increase Gross Domestic Product Net Domestic Product Personal Income National Income 90003 The following are costs of market baskets of goods and services for the years indicated 1900 100 1910 102 1920 105 1930 90 1940 100 1950 110 1960 160 Using 1920 as a base year what is the price index for 1900 and for 1960 A 1900is1051960is160 B 1900 is 952 1960 is 1524 C 1900is11111960is1778 D Cannot tell from the information given lfthere is a very large underground economy in the United States then which of the following statements is true A The elimination ofthe underground economy may actually deprive some people oftheir ability to earn a living B lts existence means we are understating the GDP unless somehow we can measure it appropriately C We have de ned certain market activities as illegal and others as legal which has implications for GDP as a measure of economic wellbeing D All ofthe above are true 78 True False The GDP is overstated because of the relatively large amount of economic activity that occurs in the underground economy TRUE The difference between Personal Income and Disposable lncome is personal taxes TRUE 79 Chapter 3 Unemployment and Inflation The measurement of the efficacy of a macroeconomic system focuses on employment and price level stability The purpose of this chapter is to examine two of the most important and recurrent economic problems that have characterized modern economic history throughout the industrialized world including the United States These two problems are unemployment associated with recessions and inflation associated with the lose of purchasing power of our incomes Most economic policy focuses on mitigating these most serious of problems in the macroeconomy Mixed Economic System and Standard of Living American capitalism is a mixed economic system There are small elements of command and tradition and some socialism However our economic system is predominately capitalist The economic freedom and ability to pursue our individual selfinterest provides for the American people a standard of living in the main that is unprecedented in world history Perhaps more important our high standards of living are widely shared throughout American society with fewer than 175 of Americans living in poverty The accomplishments ofAmerican society ought not be taken lightly no other epoch and no other nation has seen a quotgoldenquot age as impressive as modern America However there are aspects ofour freedom ofenterprise that are not so positive Free market systems have a troubling propensity to experience recessions at the extreme depressions periodically As our freedom of inquiry develops new knowledge new products and new technologies our freedom ofenterprise also results in the abandonment ofold industries generally in favor of new industries At times we also seem to lose faith in accelerating rates of growth or economic progress At other times we have experienced little growth in incomes at the extreme declines in consumer incomes A ofthese problems have resulted in downturns in economic activity At othertimes consumer39s income have increased at accelerating rates people have become enthusiastic about our economic future and the growth of new industries have far outpaced the loss of old industries that have resulted in substantial expansions of economic activity Together these downturns and expansions are referred to as the business cycle 80 Business Cycles The business cycle is the recurrent ups and downs in economic activity observed in market economies Troughs in the business cycle are where employment and output bottomout during a recession downturn or depression serious recession Peaks in the business cycle are where employment and output topout during a recovery or expansionary period upturn These ups and downs peaks and troughs are generally shortrun variations in economic activity It is relatively rare for a recession to last more than several months two or three years maximum The Great Depression ofthe 19205 and 1930s was a rare exception In fact the 1981 85 recession was unusually long One ofthe most confusing aspects of the business cycle is the difference between a recession and depression Forthe most part recessionary trends are marked by a downturn in output This downturn in output is associated with increased levels of unemployment Therefore unemployment is what is typically keyed upon in following the course ofa recession In 1934 the US economy experienced 249 unemployment this is clearly a depression The recession of 195861 reached only 67 unemployment This level of reduced economic activity is clearly only a recession However in the 1981 through 1986 downturn the unemployment rate reached a high of 12 and in both 1982 and 1983 the annual average unemployment rate was 107 Probably the Reagan recession was close to if not actually a short depression arguably a deep recession This 198185 period was clearly the worst performing economy since World War II but it also was clearly nothing compared to the problems in the decade before World War II The old story about the difference between a recession and depression probably is as close to describing the difference between a recession and a depression as anything an economist can offer That is a recession is when your neighboris out of work a depression is when you are out of work In general the peaks and troughs associated with the business cycle are short run variations around a longterm secular trend Secular trends are general movements in a particular direction that are observed for decades at least 25 years in macroeconomic analyses Prior to World War II the secular trend started as relatively at and limited growth period and then it took a sharp downward direction until the beginnings of the War in Europe a period of about twenty years Since the end of World War II we have experienced a long period of rather impressive economic growth a period of over fifty years 81 The following diagram shows a longterm secular trend that is substantially positive the straight upward sloping line About that seculartrend is another curved line whose slope varies between positive and negative this is much the same as the business cycle variations about that longterm growth trend If we map out economic activity since World War II we would observe a positive longterm trend with marked ups and downs showing the effects ofthe business cycle Secular trend Output Years There are other variations observed in macroeconomic data These variations called seasonal variations last only weeks and are associated with the seasons of the year During the summer unemployment generally increases due to students and teachers not having school in the summer and both groups seeking employment during the summer months Throughout most ofthe Midwest agriculture and construction tend to be seasonal Crops are harvested in the fall then in the winter months farmers either focus on livestock production or wait for the next grain season In the upper Midwest north of Fort Wayne outside work is very limited due to extreme weather conditions making construction exhibit a seasonal trend In the retail industry from Thanksgiving through New Year39s Day is when disproportionately large amounts of business are observed with smaller amounts during the summer Unemployment Unemployment is defined to be an individual worker who is not gainfully employed is willing and able to work and is actively seeking employment A person who is not gainfully employed but is not seeking employment or who is unwilling or unable to work is not counted as unemployed or as a member ofthe work force During the Vietnam War unemployment dropped to 36 in 1968 and 35 in 1969 This period illustrates two ways in which unemployment can be reduced Because of 82 the economic expansion of the Vietnam era more jobs were available but during the same period many people dropped out ofthe work force who may othenNise have been unemployment or alternatively vacated jobs that became available to others to avoid military service One way to keep from being drafted was to become a full time student which induced many draftage persons to go to college rather than risk military service in Vietnam Additionally there was a substantial expansion in the manpower needs of the military with nearly 500000 troops in Vietnam in 1969 Therefore the unemployment rate was compressed between more job and fewer labor force participants Unemployment can decrease because more jobs become available It can also decrease because the work force participation of individuals declines in favor of additional schooling military service or leisure Unemployment is more than idle resources unemployment also means that some households are also experiencing reduced income In other words unemployment is associated with a current loss of output and reductions in income into the foreseeable future Economists classify unemployment into three category by cause These three categories ofunemployment are 1 frictional 2 structural and 3 cyclical Frictional unemployment consists of search and wait unemployment which is caused by people searching for employment or waiting to take a job in the near future Structural unemployment is caused by a change in composition ofoutput changes in technology or a change in the structure of demand new industries replacing the old Cyclical unemployment is due to recessions the downturns in the business cycle Structural unemployment is associated with the permanent loss ofjobs however cyclical unemployment is generally associated with only temporary losses of employment opportunities Full employment is not zero unemployment the full employment rate of unemployment is the same as the natural rate The natural rate of unemployment is thought to be about 4 and is a portion of structural unemployment and frictional unemployment However there is not complete professional agreement concerning the natural rate some economists argue that the natural rate today is about 5 The disagreement centers more on observation of the secular trend than any particular technical aspect ofthe economy and there are those in the profession who would disagree with this latter statement The reason that frictional and structural unemployment will always be observed is that our macroeconomy is dynamic There are always people entering and leaving the labor force each year there are new high school and college graduates and secondary wage earners who enter and leave the market There is also a certain proportion of structural unemployment that should be observed in a healthy economy Innovations result in new products and better production processes that will result in displacement of old products and production processes that results employees becoming unnecessary to staffthe displaced and less ef cient technology Therefore the structural component 83 ofthe natural rate is only a fraction ofthe total structural rate in periods where there is displacement of older industries that may result from other than normal economic progress Perhaps the best example of this is the displacement of portions ofthe domestic steel and automobile industries that resulted from predatory trade practices ie some of the dumping practices of Japan and others The level of output associated with full utilization of our productive resources in an efficient manner is called potential output Potential output is the output of the economy associated with full employment It is the level ofemployment and output associated with being someplace on the production possibilities curve from E201 This level of production will become important to us in judging the performance ofthe economy Full employment is not zero unemployment and potential GNP is not total capacity utilization full production such levels of production are destructive to the labor force and capital base because people ful ll other roles ie consumer parent etc and capital must be maintained The Nazi39s slave labor camps during World War II were examples of the evils of full production where people were actually worked to death Unemployment rates The unemployment rate is the percentage of the work force that is unemployed The work force is about half ofthe total population Retired persons children those who are either incapable ofworking or those who choose not to participate in the labor market are not counted in the labor force Another way to look at it is that the labor force consists of those persons who are employed or unemployed who are willing able and searching for work People who are employed may be either full time or part time employees In aggregate the average number of hours worked by employees in the US economy generally is something just under fortyhours per week generally between 38 and 39 hours per week This statistic re ects the fact that people have vacation time are absent from work and may have short periods of less than forty hours available to them due to strikes inventories or plant shutdowns Part time employees are included in the work force You are not counted as unemployed unless you do not work and are actively pursuing work Those who do not have 40 hours of work or the equivalent available to them are classi ed as part time employees At present there are about 65 million US workers were are involuntarily parttime workers and about 12 million were voluntarily parttime employees this is up about 3 million from total part time employment in 1982 84 The unemployment rate is calculated as UR Unemployed persons labor force There are problems with the interpretation ofthe unemployment rate Discouraged workers are those persons who dropped out of labor force because they could not nd an acceptable job generally after a prolonged search To the extent there are discouraged workers that have dropped out ofthe work force the unemployment rate is understated There are also those individuals who have recently lostjobs who are not interested in working but do not wish to lose their unemployment bene ts These individuals will typically go through the motions of seeking employment to remain eligible for unemployment bene ts but will not accept employment or make any effort beyond the appearance of searching This is called false search and serves to overstate the unemployment rate There has yet to be any conclusive research that demonstrates whether the discouraged worker or false search problem has the greatest impact on the unemployment rate However what evidence exists suggests that in recent years the discouraged worker problem is the larger ofthe two problem suggesting that the unemployment rate may be slightly understated Okun39s Law As mentioned earlier unemployment is not just a single dimensional problem Based on empirical observation an economist determined that there was a fairly stable relation between unemployment and lost output in the macroeconomy This relation has a theoretical basis As we move away from an economy in full employment non in ationary equilibrium we find that we lose jobs in a fairly constant ratio to the loss of output Okun39s Law states that for each one percent 1 the unemployment rate exceeds the natural rate there will be a gap of two and onehalf percent 25 between actual GDP and potential GDP This is why it is not technically incorrect to look to the unemployment rate to determine whether a recession has begun or stopped It is also true that unemployment tends to trail behind total output ofthe economy so it is not a perfect or current indicator This relationship permits some rough guesses about what is happening to total output in the economy however it is only a rough guide because unemployment is a trailing indicator In other words as the economy goes into recession that last variable to re ect the loss ofoutput is the unemployment rate 85 Burden of Unemployment The individual burden of unemployment is not uniformly spread across the various groups that comprise our society There are several factors that have been historically associated with who bears what proportion ofthe aggregate levels of unemployment Among the factors that determine the burden ofunemployment are occupation age race and gender The individual occupational choice will effect the likelihood of becoming unemployed Those with low skill and educational levels will generally experience unemployment more frequently than those with more skills or education There are also speci c occupations even highly skilled or highly educated that may experience unemployment due to structural changes in the economy For example with the decline in certain heavy manufacturing many skilledtrades persons experienced bouts of unemployment during the 1980s As educational resources declined in the 1970s and again recently many persons with a PhD level education and certified teachers experienced unemployment However unemployment for skilled or highly educated occupations tends to be infrequent and of relatively short duration Age also plays a role Younger people tend to experience more frictional unemployment than their older more experienced counterparts As people enter the work force forthe rst time their initial entry puts them into the unemployed category Younger persons also tend to experience a longer duration of unemployment However there is some evidence that age discrimination may present a problem for older workers the Age Discrimination Act covers those persons over 40 and it appears those over 50 experience the greatest burden ofthis discrimination Race and gender unfortunately are still important determinants of both incidence and duration of unemployment Most frequently the race and gender effects are the result of unlawful discrimination in the labor market There is also a body of evidence that suggests there may be significant discrimination in the educational opportunities available to minorities Edmund Phelps developed a theory called statistical theory of racism and sexism that sought to explain how discrimination could be eliminated as a determinate ofthe burden of unemployment His theory was that if there was not a ideological commitment to racism or sexism that ifemployers were forced to sample from minorities they would find that there was no difference in these employees39 productivity and the productivity ofthe majority This formed the basis of affirmative action programs The lack of effectiveness of most ofthese programs suggests that the racism and sexism that exists is ideological and requires stronger action than simple reliance on economic rationality and sampling 86 Inflation The news media reports in ation generally as increases in the CPI This is not technically accurate Inflation is defined as a general increase in all prices the price level The CPI does not purport to measure all prices wholesale prices and producer prices are not included in the consumer data The closest we have to a measure of in ation is the GNP de ator that measures prices for the broadest range of goods and services but even this broader index is not a perfect measure but its all we have and some information particularly when we know the shortcomings is better than perfect ignorance One ofthe more interesting bits oftrivia concerning inflation is something called the Rule of 70 The rule of 70 gives a shorthand method of determining how long it takes for the price level to double at current in ation rates It states that the number of years forthe price level to double is equal to seventy divided by the annual rate of increase ie 70annua rate of increaseexpressed as a whole number For example with ten percent in ation the price level will double every seven years 701 0 7 There are three theories of in ation that arise from the real conduct of the marcoeconomy These three theories are demandpull costpush and pure in ation There is a fourth theory that suggests that in ation has little or nothing to do with the real output of the economy this is called the quantity theory of money Each ofthese theories will be reviewed in the remaining sections of this chapter Demand Pull Inflation Using a naive aggregate supplyaggregate demand model we can illustrate the theory of demandpull in ation The following chapter will develop a more sophisticated aggregate supplyaggregate demand model but for present purposes the naive model will suf ce The naive model has a linear supply curve and a linear demand curve much the same as the competitive industry model developed in E201 However the price variable here is not the price ofa commodity it is the price level the CPI for want ofa better measure and the quantity here is the total output of the economy not some number ofwidgets 87 Aggregate Supply Price Aggregate Demand Output Using a naive aggregate demand aggregate supply model as the aggregate demand shifts to the right or increases all prices increase This increase in all prices is called in ation However this increase in aggregatedemand is also associated with an increase in total output Total output is associated with employment remember Okun39s Law In other words even though this increase in aggregate demand causes in ation it does not result in lost output hence unemployment Policy measures designed to control demandpull inflation will shift the aggregate demand curve to the left ie reduce aggregate demand and this reduction in aggregate demand is associated with loss ofoutput hence increased unemployment Cost Push Inflation Again using a naive aggregate supplyaggregate demand approach costpush in ation results from particular changes in the real activity in the macroeconomy In this case a decrease in the aggregate supply curve The following diagram shows a shift to the left or decrease in aggregate supply curve 88 Aggregate Supply Price Ag gre gate Demand Output The OPEC Oil embargo may present the best case for costpush inflation As oil prices doubled and then tripled the costs of production that were comprised at least in part from oil also dramatically increased Therefore the dramatic increase in the price ofoil shifted the aggregate supply curve to the left a decrease resulting in costpush in ation The general case is as the price ofany productive input increases the aggregate supply curve will shift to the left This decrease in aggregate supply also results in reduced output hence unemployment This is consistent with the economic experience ofthe early 1980s during the Reagan Administration when the economy experienced high rates of both in ation and unemployment Pure Inflation Pure in ation results from an increase in aggregate demand and a simultaneous decrease in aggregate supply For output to remain unaffected by these shift in aggregate demand and aggregate supply then the increase in aggregate demand must be exactly offset by an equal decrease in aggregate supply The following aggregate supplyaggregate demand diagram illustrates the theory of pure in ation 89 Aggregate Supply Price Aggregate Demand Output Notice in this diagram that aggregate supply shifted to the left or decreased by exactly the same amount that the aggregate demand curve shifted to the right or increased The result is that output remains exactly the same but the price level increased lntuitively this makes sense with the loss of aggregate supply we would expect an increase in prices and with an increase in aggregate demand we would also expect an increase in prices As aggregate supply and aggregate demand move in opposite directions it is not perfectly clear what happens to output In this case with equal changes in aggregate demand and supply output should remain exactly the same Quantity Theory of Money The Monetarist School of economic thought points to another possible explanation for in ation These economists do not reject the idea that in ationary pressures can occur because of an oil embargo or increases in consumer demand However these economists argue that in ation cannot occur simply as a result ofthese events They are quick to point out that a change in a single price in the price index market basket can give the appearances of in ation when all that happened was a change in the relative price of one commodity with respect to all others More ofthis theory will be discussed in the nal weeks of the semester however one point is necessary here In ation in the monetarist view can only occur if the money supply is increased which permits all prices to increase lfthe money supply is not increased there can be changes in relative prices for example oil prices can go up but there has to be offsetting decreases in the prices of other commodities An increase in all prices or in the price ofa particular good therefore is a failure ofthe Fed to appropriately manage the money supply 90 Effects of Inflation The effects of in ation impact different people in different ways Creditors and those living on a xed income will generally suffer However debtors and those whose incomes can be adjusted to re ect the higher prices will not and perhaps this group may even bene t from higher rates of in ation f in ation is fully anticipated and people can adjust their nominal income or their purchasing behavior to account for in ation then there will likely be no adverse effects however if people cannot adjust their nominal income or consumption patterns people will likely experience adverse effects This is the same as if people experience unanticipated inflation Normally ifyou cannot adjust income are a creditor with a xed rate of interest or are living on a xed income you will pay higher prices The result is that those individuals will see their standard of living eroded by in ation Debtors whose loans specify a xed rate of interest typically bene t from in ation because they can pay loansoff in the future with money that is worth less It is this paying of loans with money that purchases less that harms creditors It should come as no surprise that the double digit in ation of fteen years ago caused subsequent loan contracts to often specify variable interest rates to protect creditors from the erosive effects of unanticipated in ation Savers may also nd themselves in the same position as creditors f savings are placed in longterm savings certi cates that have a fixed rate of interest inflation can erode the earnings on those savings substantially Savers that anticipate inflation will seek assets that vary with the price level ratherthan risk the loss associated with in ation In ation will effect savings behavior in another way If a person fuy anticipates in ation rather than to save money now consumers may acquire signi cant debt at xed interest rates to take advantage of the potential in ationary leverage caused by xed rates Rather than to save now consumers spend now Therefore inflation typically creates expectations among people of increasing prices and if people increase their purchases aggregate demand will increase An increase in aggregate demand will cause demandpull in ation Therefore in ationary expectations can create a spiraling of increased aggregatedemand and inflationary expectations that can feed off one another At the other extreme recessionary expectations may cause people to save that results in reduced aggregate demand and another spiral effect can result but downwards To account for expectations in a less harsh way in economic behavior the theory of rational or adaptive expectations has been formulated It is more likely that people will not take extreme views of economic problems People will anticipate and react to relatively quotsure thingsquot and generally in the near term and wait to see what happens As 91 economic conditions change consumers and producers change their expectations to account for these changes in another words they adapt their expectations to current and near term information about future economic events The adaptive expectations model is supported by a substantial amount of economic evidence It appears that the ovenNhelming majority of the players in the macroeconomy are adaptive in their expectations Unemployment Differentials David A Dilts Mike Rubison Bob Paul Unemployment which person39s burden man or woman black or whitequot Ethnic and Racial Studies Vol 12 No 1 January 1989 pp 100114 The race and sex of the work force are signi cant determinants of the relative burdens of unemployment Blacks are experiencing a decreasing burden of unemployment over the period examined while white females exhibit a positive time trend increasing unemployment overthe period The dispersion of unemployment for blacks varies directly with the business cycle which suggests greater labor force participation sensitivity by this group The dispersions of white female unemployment vary counter cyclically with the business cycle which is consistent with the inherited wisdom concerning unemployment and macroeconomics These results together with the unemployment equation results indicate that the unemployment rate for white males is not sensitive to the fluctuations in the business cycle nor do these data exhibit any signi cant time trend These are rather startling results This evidence suggests that while males bear substantially the same relative unemployment rates over all ranges of the business cycle KEY CONCEPTS Business Cycle Peaks Troughs Seasonal trends Secular trends Unemployment frictional structural cyclical 92 Full employment Natural rate of unemployment Potential output Labor Force parttime employment discouraged workers false search Okun s Law Burden of Unemployment In ation v De ation CPI Rule of 70 Demandpull Costpush Pure in ation Monetarists Impact of Inflation STUDY GUIDE Using the basic supply amp demand model demonstrate costpush demandpull and pure in ation Critically evaluate the three categories of unemployment be sure to discuss the problems with conceptualizing and measuring each Critically evaluate the qualitative and quantitative costs of both in ation and unemployment Which is worse Why 93 Sample Questions Multiple Choice Which of the following is most likely to bene t from a period of unanticipated inflation assuming xed assets and liabilities A Those whose liabilities are less than their assets B Those whose liabilities exceed their assets and whose loans are variable rate C Those whose liabilities exceed their assets and whose loans are fixed rate loans D None of the above will benefit People who are unemployed due to a change in technology that results in a decline in their industry t which category of unemployment frictional structural cyclical natural 90003 True False Seasonal variations in data are impossible to observe in annual data TRUE Costpush in ation is often associated with increased unemployment TRUE 94 Chapter 4 Aggregate Supply amp Aggregate Demand The aggregate supply aggregate demand model ofthe macroeconomy will be developed in this chapter This model is one of two models the other is the Keynesian Cross ofthe US macroeconomic system that we will develop in this course The aggregate demand and aggregate supply model is the main mode ofanalysis that characterized the classical school of economic thought and provides some useful insights However because the Keynesian Cross permits more direct analysis ofthe multiplier effects and other economic phenomenon it will be the model that is relied upon for the majority ofthe course Aggregate Supply and Aggregate Demand The aggregate supplyaggregate demand model is comparative static slice of time model ofthe macroeconomy Rather than to be able to observe changes during each second ofa period oftime dynamic we will compare the economy in one time period with the model in a subsequent and distinct period Its elegance arises from the fact that the model has foundations in microeconomics In this view of the macroeconomy we simply aggregate everything on the supply side to obtain an aggregate supply curve and aggregate everything on the demand side to obtain an aggregate demand curve Where aggregate supply intersects aggregate demand we observe a macroeconomic equilibrium However because the two functions are aggregations the horizontal axis does not measure the quantity of a particular good it measures GNP The vertical axis is not a price in the sense ofa microeconomic market but is the price level in the entire economy Aggregate Demand The aggregate demand curve is a downward sloping function that shows the inverse relationship between the price level and gross domestic output GDP The reasons that the aggregate demand curve slopes down and to the right differ from the reasons that individual market demand curves slope downward and to the right ie the substitution amp income effects these do not work directly with macroeconomic aggregates for among other reasons we are dealing with all prices of all commodities not a single price ofa single commodity as in a microeconomic sense 95 The reasons for the downward sloping aggregate demand curve are 1 the wealth or real balance effect 2 the interest rate effect and 3 the foreign purchases effect As the price level increases with xed incomes the given amount of savings and assets consumers have will purchase less On the other hand as the price level decreases the savings and wealth consumers have will purchase more The negative relation between the price level and the purchasing power of savings wealth or real balances is called the real balances or wealth effect Assuming a fixed supply of money an increase in the price level will increase interest rates Increases in interest rates will reduce expenditures on goods and services for which the demand is interest sensitive eg consumer durables such as cars and investment This negative relation between the interest rate and purchases is called the interest rate effect lfthe prices of domestic goods rise relative to foreign goods an increase in the price level domestic consumers will purchase more foreign goods as substitutes assuming stable exchange rates for currencies Remember from Chapter 2 that if exports remain constant and imports increase GNP declines net exports Therefore as the price level increases imports will also increase ceteris paribus The foreign purchases effect is the propensity to increase purchases of imports when the domestic price level increases Each ofthese effects describes a negative relation between the price level and the aggregate demand for the total output of the economy Therefore the aggregate demand curve will slope downward and to the right as shown in the diagram below Prices Ammo Demand Output 96 The determinants of aggregate demand are the factors that shift the aggregate demand curve These determinants are 1 consumer and producer expectations concerning the price level and real incomes 2 consumer indebtedness 3 personal taxes 4 interest rates 5 changes in technology 6 excess capacity in industry 7 government spending 8 net exports 9 national income earned abroad and 10 exchange rates The expectations of producers and consumers concerning real income or in ation including profits from investments in business sector will effect aggregate demand In ationary expectations and anticipated increases in real income are consistent with increased current expenditures Should real income or in ation be expected to fall purchases may be postponed in favor of future consumption or investment As personal taxes interest rates and indebtedness increase aggregate demand should decrease due to a general reduction in effective demand Should any ofthese three decrease there should be an increase in aggregate demand due to the increased ability to purchase output Changes in technology operate on aggregate demand in two distinct ways the creation of new products or new production processes and the reduction of the costs of producing resulting in less expensive output The amount of excess capacity in industry will also impact the demand for capital goods lfthere is substantial excess capacity output can be increased without obtaining more capital on the other hand if there is very little excess capacity an expansion ofoutput will require purchasing more capital 97 Government expenditures account for a significant proportion of GNP lf government expenditures decrease so will aggregate demand ifthey increase so will aggregate demand The same is true of national income earned abroad as American economic activity moves abroad the demand for domestic output will generally decline Exchange rates refer to how much ofa foreign currency the US dollar will purchase lfthe Japanese Yen loses value with respect to the US dollar then Japanese goods will become cheaper As the dollar buys more imports aggregate demand will decrease simply because the US dollar gains value relative to that foreign currency As the dollar loses value relative to a foreign currency such as the Yen then the Japanese goods become more expensive and American consumers will substitute American goods for Japanese goods and aggregate demand increases These determinants of aggregate demand act together to shift the aggregate demand curve Several ofthese determinants may change at the same time and possibly in different directions The actual observed change in an aggregate demand curve will result from the net effects of these changes For example if the dollar gains one or two percent in value relative to the Yen this alone may cause a slight decrease in aggregate demand However if government purchases increase by two orthree percent this should offset any exchange rate tendency toward a reduction in aggregate demand and shift the aggregate demand curve to the right Aggregate Supply The aggregate supply curve shows the amount of domestic output available at each price level The aggregate supply curve has three ranges the Keynesian range horizontal portion the intermediate range curved portion and the classical range vertical portion These ranges of the aggregate supply curve are identified in the following diagram Await 39 Supply Classical Paces Range Intermediate Range Keynesian Range Output 98 The Keynesian range ofthe aggregate supply curve shows that any output is consistent with the particular price level the intersection ofthe aggregate supply curve with the price level axis up to where the intermediate range begins In other words wages and prices are assumed to be sticky xed in this range ofthe aggregate supply curve The classical range ofthe aggregate supply curve is vertical Classical economists believed that aggregate supply curve goes vertical at the full employment level of output In other words any price level above the end of the intermediate range is consistent with the full employment level potential of GNP The intermediate range is the transition between the horizontal and vertical ranges ofthe aggregate supply curve As the macroeconomy approaches full employment levels of output the price level begins to increase as output increases in this range The determinants of aggregate supply cause the aggregate supply curve to shift There are three general categories ofthe determinants of aggregate supply these are 1 changes in input prices 2 changes in input productivity and 3 changes in the legal or institutional environment As input prices increase aggregate supply decreases For example when the price of oil increased dramatically in 197980 aggregate supply decreased because the costs of production increased in general in the United States In other words forthe same level of production cost we got less GNP Should input prices decline we should expect to observe an increase in aggregate supply In other words for the same level of production cost we got more GNP Changes in input productivity will also shift the aggregate supply curve If labor or capital becomes more productive then producers will receive more output for the same cost of production This can occur because of better quality resources or because ofthe ability to use more efficient technology Changes in the legal or institutional environment will also increase aggregate supply One of the reasons that deregulation is so popular in certain business circles is that such changes in the legal environment will often result in lower costs of production To the extent that there are no diseconomies this increases aggregate supply More ef cient capital markets ie the recent proposed SEC changes concerned among 99 others the New York Stock Exchange better schools better health care and less crime all have the potential for increasing aggregate supply through the institutional environment of business Macroeconomic Equilibrium As mentioned earlier in this chapter macroeconomic equilibrium in this model is the intersection of aggregate supply and aggregate demand The idea of equilibrium in the macroeconomy is similar to that in microeconomic market Where aggregate supply and aggregate demand intersect ifthere is no force applied to disturb the intersection change in a determinant then there is no propensity for the output and price levels to change from those determined by the intersection The following diagram portrays a macroeconomy in equilibrium In this case the intersection of aggregate supply and aggregate demand is in the Keynesian range Should aggregate demand increase up to where the intermediate range starts only output will change Through the intermediate range both output and the price level will increase as aggregate demand increase In the classical range if aggregate demand increases output will remain the same but the price level will increase The following diagram shows a macroeconomy in equilibrium The solid aggregate demand curve is the initial equilibrium The two dotted lines show an increase in aggregate demand AD1 and a decrease in aggregate demand AD2 Prices The changes in aggregate supply are analytically only marginally more complicated than aggregate demand An increase in aggregate supply is simply a shift ofthe entire curve to the right downward As aggregate supply shifts downward along 100 the aggregate demand curve in the Keynesian and intermediate ranges the price level falls and output will increase However in the classical range a decrease in aggregate supply changes neither the price level or total output The following diagram portrays an increase in aggregate supply the line labeled A81 and a decrease in aggregate supply the line labeled A82 and the original aggregate supply curve is the solid line WM Paces A82 A5 A51 J oinpm There is a more complicated view of changes in equilibrium in the aggregate supply and aggregate demand model called the Ratchet Effect The Rachet Effect is where there is a decrease in aggregate demand but producers are unwilling to accept lower prices rigid prices and wages Rather than to accept the lower price levels resulting from a decrease in aggregate demand producers will decrease aggregate supply Therefore there is a ratcheting ofthe aggregate supply curve decrease in the intermediate and Keynesian ranges which will keep the price level the same but with reduced output In other words there can be increases in prices fonNard but no decreases in the price level but not backward because producer will not accept decreases price rigidity The same is argued to exist for wages in the labor market in other words unions will resist decreases in wages associated with a decrease in aggregate demand hence they too will place downward pressure on aggregate supply 101 The following diagram illustrates the rachet effect Pricw Output An increase in aggregate demand from AD1 to AD2 moves the equilibrium from point a to point b with real output and the price level increasing However if prices are in exible downward then a decline in aggregate demand from AD2 to AD1 will not restore the economy to its original equilibrium at point a Instead the new equilibrium will be at point c with the price level remaining at the higher level and output falling to the lowest point The ratchet effect means that the aggregate supply curve has shifted upward a decrease in both the Keynesian and intermediate ranges KEY CONCEPTS Aggregate Demand Real balance effect Interest rate effect Foreign purchases effect Determinants of Aggregate Demand Aggregate Supply Keynesian Range 102 Classical Range Intermediate Range Determinants of Aggregate Supply Equilibrium in Aggregate Supply and Aggregate Demand Rachet Effect STUDY GUIDE Food for Thought Explain and demonstrate the operation of the determinants of aggregate supply and aggregate demand Critically evaluate both the Keynesian and Classical ranges of the aggregate supply curve Is the ratchet effect plausible Explain Why does the aggregate demand curve slope downward Why do we nd ranges in the aggregate supply curve Explain 103 Sample Questions Multiple Choice The aggregate demand curve is most likely to shift to the right increase when there is a decrease in A the overall price level B the personal income tax rates C the average wage received by workers D consumer and business con dence in the economy A shortrun increase in interest rates on consumer loans may cause a decrease in aggregate demand What would we expect to observe if there is no ratchet effect A In the classical range only a reduction in prices B In the Keynesian range only a reduction in output C Both A and B are correct D Neither A or B are correct True False All economists are convinced that ratchet effect exists in today39s economy FALSE One ofthe major reasons that the aggregate demand curve slopes downward is the real balances effect TRUE 104 Chapter 5 Classical and Keynesian Models The purpose of this chapter is to extend the analysis presented in Chapter 4 Based on the foundations ofthe relatively simple aggregate supply and aggregate demand model both the Classical and Keynesian theories of macroeconomics will be developed and compared in this chapter Introduction The Classical theory of employment macroeconomics traces its origins to the nineteenth century and to such economists as John Stuart Mill and David Ricardo The Classical theory dominated modern economic thought until the middle of the Great Depression when its predictions simply were at odds with reality However the work of the classical school laid the foundations for current economic theory and a great intellectual debt is owed to these economists During the beginnings ofthe 19305 economists in both Europe and the United States recognized that current theory was inadequate to explain how a depression of such magnitude and duration could occur After all the miracle of free market capitalism was suppose to always result in a return to prosperity after short periods of correction recession For a long term disequilibrium to be observed was both disconcerting and fascinating It became very obvious by 1935 that the market mechanisms were not going to selfadjust and bring the economy out of a very deep depression John Maynard Keynes an English mathematician and economist is the father of modern macroeconomics His book The General Theory 1936 was to change how economists would examine macroeconomic activity for the next six decades until present Keynes39 work laid aside the notion that a free enterprise market system can selfcorrect He also provided the paradigm that explained how recessions can spiral downwards into depression without active government intervention to correct the observed deficiencies in aggregate demand Some of Keynes39 ideas were original however he borrowed heavily from the Swedish School in particular Gunar Myrdal in his explanations ofthe fact that there is no viable mechanism in our system of markets that provide for correction of recessionary spirals Many economists on both sides ofthe Atlantic were working on the problem of why the classical theory had failed so miserably in explaining the prolonged deep downturn and in offering policy prescriptions to cure the Great Depression In some ways it resembled an intellectual scavenger hunt As soon as John Maynard Keynes 105 had worked out the general theory he literally rushed to print before someone beat him to the punch so to speak The result is that The General Theoryis not particularly well written and has been subject to criticism for the rushed writing however its contributions to understanding the operation of the macroeconomy are unmistakable and considerable The Classical Theory The classical theory of employment macroeconomics rests upon two fundamental principles these are 1 underspending is unlikely to occur and 2 if underspending should occur the wageprice exibility of free markets will prevent recession by adjusting output upwards as wages and prices declined What is meant by underspending is that private expenditures will be insuf cient to support the current level of output The classicists believed that spending in amounts less than sufficient to purchase the full employment level ofoutput is not likely They also believed that even if underspending should occur then pricewage exibility will prevent output declines because prices and wages would adjust to keep the economy at the full employment level of output The classicists based their faith in the market system on a simple proposition called Say39s Law Say39s Law in its crudest form states that quotSupply creates its own demandquot In other words every level ofoutput creates enough income to purchase exactly what was produced However as sensible as this proposition may seem there is a serious problem There are leakages from the system The most glaring omission in Say39s Law is that it does not account for savings Savings give rise to gross private domestic investment and the interest rates are what links savings and investment However there is no assurance that savings and investment must always be in equilibrium In fact people save for far different reasons that investors39 purchase capital Further the classicists believed that both wages and prices were exible In other words as the economy entered a recession both wages and prices would decline to bring output back up to prerecession levels However there is empirical evidence that demonstrates that producers will cutback on production rather than to lower prices and that factor prices rarely decline in the face of recession The classicists believed that a laissez faire economy would result in macroeconomic equilibria through the unfettered operation of the market system and that only the government could cause disequilibria in the macroeconomy One need only look to the automobile industry of the last ten years to understand that wage price exibility does not exist Automobile producers have not lowered prices in decades When excess inventories accumulate the car dealers will offer rebates or inexpensive nancing but they have yet to offer price reductions There has 106 been some concession bargaining by the unions in this industry but even where wages were held down it is rare that a union accepts a nominal wage cut Modern neoclassical macroeconomics takes far less rigid views Even though the neoclassicists have come to realize that the market system has its imperfections they believe that government should be the economic stabilizer of last resort Further even though there is now recognition that the lauded wageprice exibility is unlikely by itself to be able to correct major downturns in economic activity the neoclassicists stubbornly hold to the view that government must stay out of the economic stabilization business The one exception they seem to allow is the possibility ofa major external shock to the system othenNise they claim there is suf cient exibility to prevent major depressions with only very limited government responses primarily through monetary rather than scal policy In other words the differences between the Keynesians and the neoclassicists are very subtle magnitude of government involvement and focus primarily on the starting point ofthe analysis Keynes with recession neoclassicist with equilibrium Keynesian Model Keynes recognized that full employment is not guaranteed because interest motivates both households and businesses differently just because households save does not guarantee businesses will invest In other words there is no guarantee that leakages will result in investment injections back into the system Further Keynes was unwilling to assume that selfinterest in a market system guaranteed that there would be wageprice flexibility In fact the empirical evidence suggested that wages and prices exhibited a substantial amount of downward rigidity Underthe Keynesian assumptions there is no magic in the market system The mechanisms that the classicist thought would guarantee adjustments back toward full employmentequilibrium simply did not exist Therefore Keynes believed that government had to be proactive in assuring that underspending did not spiral the economy into depression once a recession began Keynes39 views were revolutionary fortheirtime However it must be remembered that the Great Depression was an economic downturn unlike anything experienced during our lifetimes Parents and grandparents no doubt have related some of the traumatic experiences they may have endured during the Depression to their children and grandchildren perhaps you have heard some of these stories However such economic devastation is something that is nearly impossible to imagine unless one has lived through it Onequarter ofthe labor force was unemployed at points during the Depression The US economy had almost no social safety net no unemployment compensation little in the way of welfare programs no social security no collective bargaining and very small government Our generations have gotten 107 used to the idea that there is something between us and absolute poverty there are programs to provide income during times ofunemployment generally for a suf cient period to nd alternative employment Even though these programs may have a personal signi cance they were intended to prevent future demanddeficiency depressions The array ofentitlement programs particularly unemployment insurance various welfare programs and social security provides an automatic method to keep spending from spiraling into depression Once recessionary pressures begin to build in the economy the loss ofemployment does not eliminate a household39s consumption as soon as savings are depleted Unemployment compensation and then welfare will keep the lights on and l amp M employees working food on the table to the relief of those working at Kroger and Scotts and clothes on the back of the those in need keeping people working at Walmart through Hudsons Further the government has been proactive in stabilization of economic downturns since the beginning of World War II Thereby providing us with the expectation that something will be done to get things back in order as soon as possible once a recession starts The government39s ability to tax and to engage in de cit spending provides the exibility in the market system to deal with underspending that was only presumed to exist by deflating the economy Without the automatic stabilizers and the government exibility to deal with serious underspending the economy could theoretically produce the same results that it did in the 1930s Aggregate supply and aggregate demand can now be expanded to include the savings and investment in the analysis to make for a more complete model In so doing we can also create a more powerful analytical tool The Consumption Schedule ln beginning the development of the Keynesian Cross model we return to aggregate supply and aggregate demand Along the vertical axis we are going to measure expenditures consumption government or investment Along the horizontal axis we are going to measure income disposable income At the intersection ofthese two axes the origin we have a forty ve degree line that extends upward and to the right What this forty ve degree line illustrates is every point where expenditures and income are equal 108 45de Consumption Consumption Disposable Income Dispouble Income The consumption schedule intersects the 45 degree line at 400 in disposable income this is also where the savings function intersects zero in the graph below the consumption function At this point 400 all disposable income is consumed and nothing is saved To the left of the intersection of the consumption function with the 45 degree line the consumption function lies above the 45 degree line The distance between the 45 degree line and the consumption schedule is dissavings shown in the savings schedule graph by the savings function falling below zero Dissavings means people are spending out their savings or are borrowing negative savings To the right ofthe intersection ofthe consumption function with the 45 degree line the consumption schedule is below the 45 degree line The distance that the consumption function is below the 45 degree line is called savings shown in the bottom graph by the savings function rising above zero This analysis shows how savings is a leakage from the system Perhaps more importantly the analysis also shows that there is a predictable relation between consumption and savings What is not consumed is saved and vice versa However there is more to this than savings plus consumption must equal income The Marginal Propensity to Consume MP0 is the proportion of any increase in disposable income that is spent on consumption ifan entire increase in income is spent MP0 is 1 if none is spent then MP0 is zero The Marginal Propensity to Save MP8 is the proportion ofany increase in disposable income that is saved The relation between MPG and MP8 is that MPS MP0 1 in other words any change in income will be either consumed or saved This relation is demonstrated graphically in the following diagram 109 Consumption Savings s a 5 a a 8 53 412 U 1 0 1 0 DispOSable Disposable income income The slope rise divided by the run ofthe consumption function is the MPG and the slope of the savings function is the MP8 The slope ofthe consumption function is 8 or 810 and the slope of the savings function 2 or 210 Total change in income will be either spent or saved lften dollars of additional income is obtained then 2 10 times 2 will be saved and 8 10 times 8 will be spent on consumption The marginal propensities to save and to consume deal with changes in one39s income However average propensities to consume or save deal with what happens to total income The Average Propensity to Consume APC is total consumption divided by total income Average Propensity to Save APS is total savings divided by total income Again just like the marginal propensities ifincome can be either saved or consumed and nothing else then the following relation holds the average propensity to consume plus the average propensity to save must equal one APC APS 1 For example iftotal income is 1000 and the average propensity to consume is 95 and the average propensity to save is 05 then the economy will experience 950 is consumption 95 times 1000 and 50 in savings 1000 times 05 The nonincome determinants of consumption and saving cause the consumption and savings functions to shift The nonincome determinants of consumption and saving are 1 wealth 2 prices 3 expectations concerning future prices incomes and availability of commodities 4 consumer debts and 5 personal taxes In general it has been empirically observed that the greater the amount of wealth possessed by a household the more of their current income will be spent on consumption ceteris paribus All other things equal the more wealth possessed by a household the less their incentive to accumulate more Conversely the less wealth 110 possessed by a household the greaterthe incentive to save An Italian economist Franco Modigliani observed that this general rule varied somewhat by the stage in life a person was in The young twenties tend to save for homes and children in the late twenties through the forties savings were less evident as children were raised and with the empty nest came savings for retirement This is called the Life Cycle Hypothesis An increase in the price level has the effect of causing the consumption function to shift downward As prices increase the real balances effect from the previous chapter becomes a binding constraint As the value of wealth decreases so too does the command over goods and services so consumption must fall and savings increase lfthe price level decreases then we would expect consumption to increase and savings to fall The expectations of households concerning future prices incomes and availability of commodities will also impact consumption and savings As households expect price to increase real incomes to decline or commodities to be less available current consumption will increase and current savings decline If on the other hand households expect incomes to increase pricesto fall or commodities to become more generally available current consumption will decline and savings will increase Consumer indebtedness will also effect consumption and savings lf consumers are heavily indebted save a third oftheir income goes on debt maintenance then current consumption will decline to pay off debts dissavings However if indebtedness is relatively low consumers will consume more of their current income perhaps even engage in dissavings borrowing to consume more currently Taxation operates on both the savings and consumption schedules in the same way Because taxes are generally paid partly from savings and partly from current income an increase in taxes will cause both consumption and savings to decline On the other hand iftaxes are decreased then both the savings and consumption functions will increase shift upwards Investment Investment demand is a function ofthe interest rate The following diagram shows an investment demand curve The investment demand curve is downward sloping which suggests that as the interest rate increases investment decreases The reason for this is relatively simple lfthe expected net return on an investment is six percent it is not pro table to invest when the interest is equal to or more than six percent A rm must be able to borrow the money to purchase capital at an interest rate that is less than the expected net rate of return for the investment project to be undertaken Therefore there is an inverse relation between expected return and the 111 interest rate and the interaction ofthe interest rate with the expected rate of return determine the amount of investment Interest Investment Demand Investment The determinants of investment demand are those things that will cause the investment demand curve to shift The determinants of investment demand are 1 acquisition maintenance amp operating costs of capital 2 business taxes 3 technology 4 stock of capital on hand and 5 expectations concerning pro ts in future The investment demand depends on whether the expected net rate of return is higherthan the interest rate Therefore anything that increases the expected net return will shift the investment demand curve to the right anything that cause the expected return to fall will shift the investment demand curve to the left decrease As the acquisition maintenance and operating costs of capital increase the net expected return will decrease ceteris paribus thereby shifting the demand curve to the left lfthe acquisition maintenance and operating costs decline we would expected a higher rate of return on this investment and therefore the demand curve shifts to the right increase Business taxes are a cost ofoperation If business taxes increase the expected net after tax return will decline this shifts the investment demand curve to the left If business taxes decrease the expected net return on the investment will increase thereby increasing the investment demand curve Changes in technology will also shift the investment demand curve More ef cient technology will generally increase expected net returns and shift the investment demand to the right increase By decreasing production costs or improving product quality through technological improvements competitive advantages may be reaped and this is one of the most important determinants of investment since World War II 112 The stock of capital goods on hand will also impact investment demand To the extent that producers have a large stock of capital goods on hand investment demand will be dampened On the other hand if producers have little or no inventory of capital goods then investment demand may increase to restore depleted stocks of capital Business investment decisions are heavily in uenced by expectations Expectations concerning the productive life of capital its projected obsolescence expectations concerning sales and pro ts in the future will also impact investment decisions For example expectations that technological breakthroughs may make current computer equipment less competitive may dampen current investment demand Further if competitors are toolingup to enter your industry you may be hesitant to invest in more capital ifthe pro ts margins will be cut by the entrance of competitors Autonomous v Induced Investment Autonomous investment is that investment that occurs which is not related to the level Gross Domestic Product Investment that is based on population growth expected technological progress changes in the tax structure or legal environment or on fads is generally not a function of the level oftotal output of the economy and is called autonomous investment In examining the following diagram the autonomous investment function is a horizontal line that intercepts the investment axis at the level of autonomous investment lnduced investment is functionally related to the level of Gross Domestic Product The following diagram has an investment function that slopes upward increases as GDP increases lnduced investment is that investment that is quotinducedquot because of increased business activity In short induced investment means that investment that is caused by increased levels of GDP Induced 6 Investment g Autonomous 3 Investment 5 Real GDP 113 Throughout American economic history the level investment has been very volatile In fact much of the variation in the business cycle can be attributed to the instability of investment in the United States There are several reasons forthis instability including 1 variations in the durability of capital 2 irregularity of innovation 3 variability of pro ts and 4 the expectations of investors The durability of most capital goods means that they have an expected productive life of at least several years if not decades Because of the durability and expense of capital goods their purchase can be easily postponed For example a bank may redecorate and patchup an old building rather than build a new building depending on their business expectations and current nancial position Perhaps the most important contributors to the instability of investment in the post World War II period is the irregularity of innovations V th the increase in basic knowledge comes the ability to develop new products and production processes During World War II there was heavy public investment in basic research in medicine and the pure sciences What was intended from these public expenditures was for military use but many ofthese discoveries had important civilian implications for new products and better production methods Again in the late 1950s and early 1960s an explosion of basic research occur that led to commercial advantages The Russians launched Sputnik and gave the Western World a wakeup call that they were behind in some important technical areas the government again spent money on education and basic research For the private sector to invest there must be some expectation of pro ts owing from that investment Much of the decline in private investment during the Great Depression was because private investors did not expect to be able to make a profit in the economic environment ofthe time In the late 1940s automobile producers knew that pro ts would be nearly guaranteed because no new private passenger cars were built in the war years There was very signi cant investment in plant and equipment in the auto industry in those years mostly to convert from war to peacetime production The expectations of business concerning pro ts prices technology legal environment and most everything effecting their business are simply forecasts Because the best informed forecasts are still guesswork there is substantial variability in business conditions expectations Because these expectations vary substantially across businesses and over time there should be signi cant variability in investment decisions 114 KEY CONCEPTS Classical Theory Say s Law Keynesian Model pricewage rigidity No guarantee of full employment Income v Expenditures Consumption Function Marginal Propensity to Consume v Marginal Propensity to Save Determinants of consumption and savings Investment Demand Determinants of investment demand Investment instability in US Induced investment v autonomous investment STUDY GUIDE Food for Thought Compare and contrast the classical model of the economy with the Keynesian model Are these models really that different Explain Develop the consumption and savings schedules Fully explain the assumptions underlying the models its mechanics and its implications What is the relation between savings and investment Explain 115 Critically evaluate Say39s Law Sample Questions Multiple Choice If you receive 40 in additional income and you save 4 what is your marginal propensity to consume A B C D 04 09 10 None of the above Which of the following contribute to investment instability A B C D True lrregularity in innovation Variable investor expectations Purchases of capital durable goods are postponable All of the above False MPC MP8 1 TRUE The forty ve degree line in the consumption function model shows each point at which disposable income and consumption are equal TRUE 116 Chapter 6 Equilibrium in the Keynesian Model The purpose of this chapter is to extend the analysis of Chapter 5 The basic Keynesian Cross model will be developed and examine how equilibrium can be achieved in the macroeconomy In Chapter 7 that follows we will complete the analysis ofthe Keynesian view of the macroeconomy Equilibrium and Disequilibrium Equilibrium GDP is that output that will create total spending just suf cient to buy that output where aggregate expenditure schedule intersects 45 degree line Further once achieved an equilibrium in a macroeconomy has no propensity to change unless there is a shock to the system or some variable changes to cause a disequilibrium Disequilibrium where spending is insuf cient recessionary gap or too high for level of output in ationary gap The neoclassicists view the primary macroeconomic as one of maintaining equilibriums Their analysis of the system begins with equilibrium because unless there is some external intervening problem they believe this is the state of nature for the macroeconomy Keynesians on the other hand begin their analysis with disequilibrium because this is the natural state for a macroeconomy The constant changes associated with policies technological change and autonomous influences will impact the economy periodically and cause it to move out of equilibrium In fact this is the major analytical difference between the neoclassical and Keynesian economists Keynes39 Expenditures Output Approach From Chapter 2 rememberthat one ofthe waysthat GDP can be calculated is using the identity Y C I G X where Y GDP C Consumption I Investment G Government expenditures and X Net exports exports minus imports This provides for us the formula by which we can complete the model we began in the previous chapter Consider the following diagram 117 GDP Remember that the 45 degree line is each point where spending is exactly equal to GDP The above gure shows a simple economy with no public or foreign sectors We begin the analysis by adding investment to consumption and obtaining Y C I The equilibrium level of GDP is indicated above where C I is equal to the 45 degree line Investment in this model is autonomous and the amount of investment is the vertical distance between the C and the C I lines Keynes39 Leakages Injections Approach The same result obtained in the expenditures output approach above can be obtained using another method Remember that APC APS 1 and MPC MP8 1 this suggests that leakages from the system are also predictable The leakages injections approach relies on the equality of investment and savings at equilibrium in a macroeconomic system I S The reason that the leakages injection approach works is that planned investment must be equal savings The amount of savings is what is available for gross private domestic investment When investors use the available savings the leakages savings from the system are injected back into the system through investment However this must be planned investment Unplanned investment is the cause ofdisequilibrium Inventories can increase beyond that planned and inventories are investment stock of unsold output When inventories accumulate there is output that is not purchased hence reductions in spending which is recessionary or on the other hand if intended inventories are depleted which this in ationary because ofthe excess spending in the system Consider the following diagram where savings is equal to I1 investment Ifthere is unplanned investment the savings line is below the investment line at the lowest level 118 ofGDP the vertical line label UPI Unplanned Investment ifinventories are depleted beyond the planned level then the savings line is above l1 as illustrated with the highest level of GDP and that vertical line is labeled Dep lnv for Depleted Inventory 5amp1 13 II 12 GDP The original equilibrium is where I1 is equal to S The ifthe unplanned inventory or unplanned depletion of inventory become planned investment the analysis changes If we experience a decrease in planned investment we move down to l2 with a reduction in GDP Recession just like an increase in unplanned investment and if an increase in investment is observed it will be observed at l3 which is expansionary and this is similarto unplanned depletion of inventories which could also be in ationary Respending The interdependence of most developed economies results in an observed re spending effect ifthere is an injection of spending in the economy This respending effect is called the multiplier and we will provide a more detailed analysis ofthe multiplier effects in the following chapter however the respending effect represented by the multiplier will be introduced here to provide a full understanding of the model lfthere is an increase in expenditures there will be a respending effect In other words if10 is injected into the system then it is income to someone That rst person will spend a portion of the income and save a portion lf MPC is 90 then the rst individual will save 1 and spend 900 The second person receives 900 in income and will spend 810 and save 090 This process continues until there is no money left to be spent Instead of summing all ofthe income expenditures andor savings there is a shorthand method of determining the total effect this is called the Multiplier which is 11MPC or 1MPS The significance any increase in expenditures is that it will increase GDP by a multiple ofthe original increase in spending 119 The respending effect and the leakage injection approach to GDP provides for curious paradox This paradox is called the paradox of thrift To accumulate capital it is often the policy of less developed countries to encourage savings to reduce the country39s dependence on international capital markets What often happens is that as a society tries to save more it may actually save the same amount this is called the paradox of thrift The reason that savings may remain the same is that unless investment moves up as a result ofthe increased savings all that happens is that GDP declines The higher rate of savings with a smaller GDP results in the same amount of savings if GDP declines proportionally with the increase in savings rates If investment is autonomous then there is no reason to believe that investment will increase simply because the savings rate increased In fact because of the respending effects ofthe leakages generally savings will remain the same as before the rate went up Full Employment Simply because C l G intersects the 45 degree line does not assure utopia The level of GDP associated with the intersection ofthe C l G line with the 45 degree line may be a disequilibrium level of GDP and not the full employment level of GDP The full employment level ofGDP may be to the right orto the left of the aggregate expenditures line Where this occurs you have respectively 1 a recessionary gap or 2 an inflationary gap In either case there is macroeconomic disequilibrium that will generally require appropriate corrective action as will be described in detail in the following chapter on scal policy Both forms of disequilibrium can be illustrated using the expenditures output approach Consider the following two diagrams Recessionary Gap Full Emp GD 45 degree I Spendin CI GDP 120 In the above diagram the dashed line labeled Full Employment GDP Is the level of GDP that is associated with potential GDP or full employment The distance between the C l line and the 45 degree line along the dashed indicator line is the recessionary gap The dotted line shows the current macroeconomic equilibrium Okun39s Law Chapter 3 provides some insight into what this means remember that every 25 of lost potential GDP is associated with 1 unemployment above the full employment level Therefore this recession represents lost output and unemployment is fixed proportions of 1 to 25 Inflationary Gap Full Emp GDP Spending GDP Again the full employment nonin ationary level of GDP is indicated by the dashed line labeled full employment GDP The distance between the C l line and the 45 degree line along the dashed indicator line is the in ationary gap The dotted indicator line shows the current macroeconomic equilibrium In this case there is too much spending in the economy or some other similar problem that has resulted in an in ated price level A reduction in GDP is necessary to restore price level stability and to eliminate excess output These same problems can be shown somewhat less elegantly using the aggregate supply aggregate demand model but with the loss of as precise representation ofthe multiplier The various C land 45 degree line intersections if multiplied by the appropriate price level will yield one point on the aggregate demand curve Shifts in aggregate demand can be shown with holding the price level constant and showing increases or decreases in C l in the Keynesian Cross model Both models can be used to analyze essentially the same macroeconomic events However from this point on will concentrate on our efforts on mastering the Keynesian Cross 121 KEY CONCEPTS Macroeconomic Equilibrium v Macroeconomic Disequilibrium Expenditures Output Approach Leakages Injections Approach Planned v Unplanned Investment Respending Multiplier Effect Paradox of Thrift Economic Development constraints Full Employment Potential GDP Natural Rate of Unemployment Recessionary Gap In ationary Gap STUDY GUIDE Food for Thought Critically evaluate the paradox of thrift What speci cally is meant by a recessionary gap Explain and how does this differ from an inflationary gap Explain What insight does the multiplier forthe Bush tax cuts of 2003 Explain 122 Sample Questions Multiple Choice V th a marginal propensity to consume of 8 the simple multiplier is A 025 B 200 C 400 D None of the above An in ationary gap is A The amount by which CG exceeds the 45 degree line at or above the full A employment level of output B The amount by which CG is below the 45 degree line at the full employment level of output C The amount by which the full employment level ofoutput exceed the current level ofoutput D None of the above True False A recessionary gap is how much the aggregate expenditure line must increase to attain full employment without in ation TRUE The equilibrium level ofoutput is that output whose production will create total spending just suf cient to purchase that output TRUE 123 Chapter 7 Fiscal Policy The Great Depression demonstrated that the economy is not selfcorrecting as alleged by many ofthe classical economists of the time The revolutionary Keynesian view that government must take a proactive role in stabilization ofthe business cycle focused in large measure on the powers ofthe federal government to tax and to make expenditures Together the government39s activities involving taxing and spending are called fiscal policy The purpose ofthis chapter is to examine the scal policy tools and their effectiveness Discretionary Fiscal Policy The Employment Act of 1946 formalized the federal government39s responsibility for promoting economic stability The economic history of the first half ofthe twentieth century was a relatively stormy series of nancial panics prior to World War a relatively stagnant decade after World War and the Depression ofthe 1930s After World War II a new problem arose called in ation It should therefore come as no surprise that the Congress wished to assure that there was a proactive role for the government to smoothout these swings in the business cycle The government has several roles to ful ll in society Its scal powers are necessary to providing essential public goods V thout the federal government national defense the judiciary and several other critical functions could not be provided for society There is also the ebb and flow of politics The Great Society of Lyndon B Johnson represents the public opinion of the 1960s today39s political agenda seems to be substantially different The result is that as political opinion changes so will the government39s pattern oftaxation and expenditures The government39s taxing and spending authority to stabilize the economy is called discretionary fiscal policy Taxation and spending by the federal government has been used with some frequency to smooth out the business cycle In times of underspending the shortfall is made up by government spending or reductions in taxes In times ofin ation cuts in spending or increases in taxes have been used to cooloff the economy However in recent year the discretionary scal policies of the federal government have become extremely controversial The first step in understanding this controversy is to understand the role of scal policy in economic stabilization Milton Friedman and others have argued that there is no role for discretionary scal policy Friedman39s position is that much of the business cycle is the result of 124 governmental interference and that the long lags in scal policy becoming operationalized makes it only a potential force for mischief and not hope for stability In other words Friedman believes that the classical economists while over simplifying the argument were basically correct about keeping government out of the economy Simplifying Assumptions As was discussed in E201 Introduction to Microeconomics assumptions are abstractions from reality The utility of these abstractions is to eliminate many ofthe complications that have the potential to confuse the analyses and to simplify the presentation of the concepts in which we are interested It must be remembered that the assumptions underlying any model determine how good an approximation of reality that model is In other words a good model is one that is a close approximation of the real world To analyze the macroeconomy using the Keynesian Cross some simplifying assumptions are necessary We will assume that all investment and net exports are determined by factors outside of GDP exogenously determined it is also assumed that government expenditures do initially impact private decisions and all taxes are lumpsum personal taxes with some exogenous taxes collected ie customs duties It is also assumed that there are no monetary effects associated with scal policy that the initial price level is fixed and that any scal policy actions impact only demand side The Goals of Government Expenditures The primary and general goal of discretionary scal policy is to stabilize the economy Often other goals involving public goods and services as well as political are included in the discretionary aspects of scal policy However for present purposes we are concerned only with government expenditures used to stabilize the economy taxes will be examined elsewhere in this chapter To remedy a recession the government must spend an amount that will exactly makeup the shortfall in spending associated with that recession The government can also mitigate inflation by reducing government expenditures However the amount of increased expenditures necessary to bring the economy back to full employment is subject to a multiplier effect the same is true of decreases in government expenditures Therefore the government must have substantial information about the economy to make scal policy work effectively To determine the proper value of the multiplier the fiscal policy makers must know either the Marginal Propensity to Save or to Consume Further the policy makers will need to know the current level of output and what potential GDP is potential GDP is that output associated with full 125 employment In a practical sense in the nearterm the government may have reasonably accurate information upon which to base forecasts to conduct scal policy For present purposes we will assume the government has all the necessary information at hand to conduct fiscal policy The Simple Multiplier When the government increases expenditures the effect on the economy is more than the initial increase in government expenditures In fact this is also true of investment and consumption expenditures not just government expenditures When there is an increase in expenditures through an increase in government expenditures those expenditures become income for someone They will save a portion ofthe expenditures and spend the rest which then become income to someone else The result of this chairreaction respending is that there is a direct relation between the total amount of respending and the marginal propensity to save This is the respending effect discussed in Chapter 6 The multiplier is the reciprocal ofthe marginal propensity to save The multiplier 1MPS Because MPS MP0 1there is an equivalent expression 1MPS 11MPC The multiplier is the shortcut method of determining the total impact of an increase or decrease in total spending in the economy For example if the government spends 10 more and the marginal propensity to consume is 5 then the multiplier is 2 and the total increase in spending resulting from the increase of10 in government expenditures is 20 This is called the simple multiplier because the only leakage in the respending system is savings In reality there are more leakages People will use a portion oftheir income to buy foreign goods imports and will have to pay income taxes These are also leakages and would be added to the denominator in the multiplier equation The Council of Economic Advisors tracks the multiplier that contains each of these other leakages called the complex multiplier The complex multiplier has remained relatively stable over the past couple of decades is estimated to be about 20 The following diagram presents a case of recession that will be eliminated by increasing government expenditures by just enough to eliminate the recession but not to create in ation Assuming that our current level of GDP is 350 billion and we know that full employment GDP is 430 we which to eliminate this recession using increases in government expenditures We also know that MP0 is 75 and therefore MP8 is 25 126 4Sde gr CIGZ CIGl zoo quotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquotquot quot 1w 350 430 GDP MPC 75 V th an MPC of 75 we know the multiplier is 4 125 We also know that we must obtain another 80 billion in GDP to bring the economy to full employment The distance between the forty ve degree line and the CG1 line at 430 is 20 billion which is our recessionary gap in expenditures Therefore to close this gap we must spend 20 billion and the multiplier effect turns this 20 billion increase in government expenditures into 80 billion more in GDP Another way to calculate this is that we are 80 billion short of full employment GDP we know the multiplier is 4 so we divide 80 by the multiplier 4 and find the government must spend an additional 20 billion The leakages approach yields the same results Spending s 40 I 62 20 1 Gl 350 430 GDP An increase in 20 of government expenditures moves the investment plus government expenditures line for G1 to G2 by a total of 20 billion dollars on the expenditures axis but because of the respending effects this increase results in 80 billion more in GDP from 350 billion to 430 billion 127 Taxation in Fiscal Policy The government can close a recessionary gap by cutting taxes just as effectively as it can by increasing government expenditures Assuming that it is a lumpsum tax the government will use lumpsum meaning it is the same amount oftax regardless of the level of GDP The lump sum tax must be multiplied by the MPC to obtain the reduction in consumption however such taxes are also paid proportionately from savings 80 the effect is not the same as is observed with government expenditures The tax is multiplied by the MPC and then by the simple multiplier to obtain the total impact on GDP In other words the taxation multiplier is always the simple multiplier minus one or taxation multiplier 1MPS 1 Spending 45 degree CIG2 CIGl so 500 600 GDP f full employment GDP is 600 billion and we are presently at 500 billion with an MPC of 8 then ifwe are going to increase GDP by 100 billion we must cut taxes by 25 billion The simple multiplier with an MPC of 8 is 12 5 but the taxation multiplier is the simple multiplier minus one hence 4 The decrease in taxation necessary to increase GDP by 100 billion is the 100 billion divided by 4 or 25 billion The major difference between increasing expenditures or decreasing taxes is that the multiplier effect for taxation is less In other words to get the same effect on GDP you must decrease taxes by more than you would have had to increase expenditures 128 Balanced Budget Multiplier An alternative policy is to increase taxes by exactly the amount you increase expenditures This balanced budget approach can be used to expand the economy Rememberthat the simple multiplier results in 1MPS times the increase in expenditures but the taxation multiplier is one less than the simple multiplier In other words ifyou increases taxes by the same amount as expenditures GNP will increase by the amount ofthe initial increase in government expenditures That is because only the initial expenditure increases GDP and the remaining multiplier effect is offset by taxation Therefore the balanced budget multiplier is always one For example if full employment GDP is 700 billion and we are presently at 650 billion with an MPC of 75 then the simple multiplier is 4 125 and the taxation multiplier is 3 1251 therefore the government must spend 50 billion and increase taxes by 50 to increase GDP by 50 Tax Structure Taxation is always a controversial issue Perhaps the most controversial of all tax issues concerns the structure of taxation Tax structure refers to the burden ofthe tax Progressive taxation is where the effective tax rate increases with ability to pay Regressive taxation is where the effective tax rate increases as ability to pay decreases A proportional tax structure is where a fixed proportion of ability to pay is taken in taxes In general consumption is more greatly effected by taxation when the tax is progressive and savings are impacted more when the tax is regressive Therefore if the distribution of the tax across income groups will have a variable impact on the consumption and savings At present the federal income tax structure is nearly proportional most ad valorem taxes tobacco etc are regressive State income tax structures also vary substantially States like Kansas California and New Jersey have mildly progressive income taxes States like Indiana and South Carolina use gross income tax schemes that tend to be very regressive Therefore the current tax structures are not neutral with respect to their redistributional effects across income groups In total the taxes collected across the federal state and local level are at best proportional and are probably slightly regressive Probably the most regressive of these taxes is the gasoline tax 129 Automatic Stabilizers During the New Deal period several social welfare programs were enacted The purpose of these programs was to provide the economy with a system ofautomatic stabilizers to help smooth business cycles without further legislative action Among these programs were 1 progressive income taxes 2 unemployment compensation and 3 government entitlement programs Since the end ofthe Carter administration these automatic stabilizers have become controversial President Clinton moved in his rst term in of ce to eliminate some of these programs but it was really the Republican congress and Governors like Tommy Thompson in Wisconsin who eliminated much of then welfare programs Since 2002 much ofthis welfare reform has also come under re for not having produced the results that were advertised In 2002 the movie Bowling for Columbine by Michael Moore brought many ofthese issues to an international audience The idea behind a progressive income tax was basic fairness Those with the greatest wealth and income have the greatest ability to pay and generally receive more from government As recessions occur it is that segment of the population with the greatest wealth that will have resources upon which to draw to pay taxes the poor will generally be impacted the most by high level of unemployment and recessions generally leave them with very little ability to pay Unemployment compensation is paid for in every state ofthe union by a payroll tax The payroll tax is generally less than one percent ofthe rst 10800 of payrolls Most states also impose an experience rating premium that is those companies that have laid people offin the last year will pay a higher rate based on their experience The preponderance ofthis tax is paid during periods of expansion and is placed in a trust fund Unemployment bene ts are then paid from this trust fund as the economy enters a recession The effect is that money is taken out ofthe system during expansion and injected during recession which dampens the top ofthe cycle peaks and eases the bottom of the cycle trough Most social welfare programs have essentially the same effect except that the expansions tend not to be dampened as much because the funding comes from general budget authority rather than a payroll tax The signi cant increases in the proportion of poor people during recessions however do not add as much to the downward spiral of underspending that would have othenNise been observed in the absence of these entitlement programs 130 Problems with Fiscal Policy There are several serious problems with fiscal policy as a method of stabilizing the macroeconomy Among these problems are 1 scal lags 2 politics 3 the crowdingout effect and 4 the foreign sector Each of these will be addressed in turn in the following paragraphs Fiscal Lag There are numerous lags involved with the implementation of scal policy It is not uncommon for scal policy to take 2 or 3 years to have a noticeable effect after Congress begins to enact corrective scal measures These fiscal lags fall into three basic categories There is a recognition lag The recognition lag is the amount oftime for policy makers to realize there is an economic problem and begin to react Administrative lags are how long it takes to have legislation enacted and implemented Operational lags are how long it takes for the scal actions to effect economic activities Because ofthe typical two to three years for scal policy to have its intended effects they may cause as many problems as they cure For example it is not uncommon for the Congress to cut taxes because of a perceived recession that subsequently ends within months ofthe enactment of the legislation When the effects ofthe scal policies actually effect the economy it may be in a rapid expansion and the tax cut or increase in government expenditures add to in ationary problems Politics Crowdingout the Foreign Sector and Fiscal Policy Often politics ovenNhelms sound economic reasoning in formulating scal policies Public choice economists claim that politicians maximize their own utility by legislative action and are little concerned with the utility oftheir constituents Perhaps worse is the fact that most bills involve logrolling and negotiations Special interest often receive benefits simply to because they pay many ofthe election costs and the interests ofthese lobbyists may be inconsistent with the best interests ofthe nation as a whole The end result is that politics confounds the formulation of policy designed to deal with technical ills in the economy The neoclassicist have long argued that government de cits often associated with scal policy results in increased interest rates that crowdsout private investment 131 there is little empirical evidence that demonstrates the exact magnitude ofthis crowdingout effect but there is almost certainly some small element of this The neoclassicist also argue that there is another problem with government borrowing to fund de cit nancing of scal policies This problem is called Ricardian Equivalence David Ricardo hypothesized that the deficit nancing of government debt had the same effect on GDP as increased taxes To the extent that capital markets are not open foreign investors the argument is plausible however in open economies there is little empirical evidence to support this view There are also problems that result from having an open economy The most technical of these problems isthe net export effect An increase in the interest rate domestically associated with a recession or with an attempt to control inflation will attract foreign capital but this increases the demand for dollars which increases their value with respect to foreign currencies As the value of the dollar increases it makes US goods more expensive overseas and foreign goods less expensive domestically This results in a reduction of net exports hence a reduction in GDP There have also been shocks to the US economy that have their origins outside ofthe United States and are dif cult if not impossible to address with fiscal policy The Arab Oil Embargo is a case in point The United States and Holland supported the Israeli in their war with the Arabs in the early 1970s The problem was we also had treaty obligations to some ofthe Arab states Because ofour support the Arabs embargo oil shipments to the United States and Holland which had the result of increasing domestic oil prices and decreased aggregate supply hence driving up the price level This all occurred because ofAmerican Foreign Policy but little could be done with scal policy to offset the problems for aggregate supply caused by the embargo KEY CONCEPTS Social Welfare Programs 1946 Employment Act Politics and change Expenditures Expansionary v Contractionary Fiscal Policy Political Goals Public Goods and Services Taxation Expansionary v Contractionary Fiscal Policy Multipliers Simple 132 Taxation Balanced Budget Tax Structure Proportional Regressive Progressive Automatic Stabilizers Progressive Income Taxes Unemployment Compensation Entitlement Programs Fiscal Lags Recognition Administrative Operational Politics and Fiscal Policy Logrolling Public Choice Economics Government Deficits Crowdingout Ricardian Equivalence Open Economy STUDY GUIDE Food for Thought Develop the expenditures output model and show an increase decrease in taxes to close an inflationary recessionary gap Now do the same thing using increases and decreases in government expenditures Do the exercise one more time using the balanced budget approach do this exercise using various MPCs Critically evaluate scal policy as an economic stabilization policy 133 Critically evaluate the Ricardian Equivalence Theorem and be careful to explain its implications for the national debt Which is most reliable as a scal policy tool taxes or expenditures Defend your answer Sample Questions Multiple Choice V th an in ationary gap of 1 00 million and a large budget deficit which has become a serious political issue and an economy with an MP0 of 95 what would you do to close the gap lncrease taxes 5 million Decrease expenditures 5 million lncrease taxes 100 and decrease expenditures 100 None of the above 90003 2 With a recessionary gap of 70 million and an MP8 of 1 which ofthe following policy would close the gap 134 A Increase taxes and expenditures by 70 million B Increase expenditures by 7 million C Decrease taxes by 78 million D All of the above will work True False The crowding out effect is the theory that a government de cit raises interest rates and absorbs resources that could have been used for private investment TRUE Automatic stabilizers such as unemployment compensation provide counter cyclical relief from economic instability without additional government action TRUE 135 Chapter 8 Economic Growth This chapter focuses on economic growth Some definitions of growth will offered before proceeding to discussion ofthe causes of economic growth in the United States and other nations The decade of the 1990s witnessed unprecedented growth in the United States and in many Asian countries much of which has not been sustained for several reasons in the rst years ofthe twentyfirst century Definitions Economic growth is defined in one oftwo ways as a total hence GDP or as a per capita hence GDP per capita Each ofthese de nitions has its uses The second de nition is ofthe greatest importance in de ning the standard of living in a country The following production possibilities frontier shows economic growth in a simple two commodity economy Remember the assumptions underpinning the production possibilities model is that there are only two commodities produced there is a xed technology and number ofresources and these resources are used in an economically ef cient manner 136 As the frontier expands to the right more pizza can be obtained with the previous production levels of beer and vice versa The way that this growth can be obtained is that the assumptions are relaxed In other words more resources or a better technology is necessary to obtain growth While this model shows growth it shows it only as a total concept and nothing is represented with respect to how these additional commodities are distributed Countries with developing economies are of particular concern in this increasing global economy Developing economies are classified into two categories middle income countries 760 to 9300 per capita GDP in 2000 and lowincome countries those below 760 per capita GDP in 2000 The majority of Latin countries are middle income countries and the majority of subSaharan African countries and SouthAsian countries are low income countries The industrial high income countries are the US Canada Australia New Zealand Japan and Western Europe Economists generally discuss economic growth in terms of growthpaths Growthpaths are the historical tracing of how an economy moved from being less developed to a developed economy In general the currently industrialized countries have several characteristics in common These commonalities have given rise to the theory that there are prerequisites to economic growth which include 1 Establishing and implementing domestic rules of law 2 Opening the economy to international trade 3 Controlling population growth 4 Encouraging foreign direct investment 5 Building human capital 6 Reasonable monetary institutions and markets 7 Minimizing the role ofthe military both domestically and internationally and 8 Encouraging the growth ofthe private sector relative to the public sector It is hypothesized that if these prerequisites can be ful lled then the developing country has created an environment that permits the building ofa substantial infrastructure suf cient to support a modern growing economy Once the infrastructure is in place the a substantial private economy can be expected to grow ifthese prerequisites and the infrastructure continue in place 137 In Indonesia India and several middleeastern and African countries there are signi cant problems with corruption and capital ight It is nearly impossible to attract capital to a developing nation ifthe government is corrupt and there is little in the way of political stability or the rule of law In the late 1990s there were stories coming out of Indonesia where high government officials were leaving the country with several suitcases of US dollars classic capital ight Economic growth is a longterm secular trend There are periods in which increased economic activity may be observed but without the secular trend the accumulation of capital necessary for an industrialized economy is unlikely The above diagram shows several aggregate demand and aggregate supply curves Ifthe AD1 and A81 are for 1900 and each subsequent equilibrium is for a period 25 years later one can see the secular trend in economic growth and that the economic growth observed is accelerating greater distance between the aggregate supply curves The mapping out ofthe equilibriums lling in all the intermediate periods is basically a mapping ofa long term secular trend of economic activity This secular trend shows that output increases at a rather leisurely rate in the beginnings ofthe period and that the growth rate grows exponentially in the later periods pretty much the same as the actual data for the 20th century in the United States 138 utput Thne US Growth The accumulation of capital in the United States was both domestic capital and the attraction of foreign capital Much ofthe industrial revolution in Europe was eventually exported to the United States because of the Napoleonic Wars in the beginning of the 19th century and continued political instability in Western and Central Europe At the beginning of the 19th century the US had substantial European ties and was insulated from the political instability in Europe by the great barrier ofthe Atlantic Ocean In addition to this geographic advantage the United States also had substantial amounts of natural resources and agriculturally productive land in great abundance V th this the British traditions in common law and a strong constitutional form of government gave this country both the rule of law and substantial political stability which permitted both foreign and domestic sources of capital accumulation to thrive As the United States progressed through the 19th century education and technological innovation both steppedup to assist in driving economic growth Cyrus McCormick George Washington Carver Alexander Graham Bell and Thomas Edison all were responsible for signi cant innovations that created whole industries and contributed substantially to the economic growth of the United States As this country entered the 20th century the rate of technological innovation accelerated and that acceleration continues to this very day The decade ofthe 1990s saw growth rates in the United States that were unprecedented US growth in excess of 4 of is not common yet the 1990s witnessed growth rates in excess ofthis in several years Much of this growth ended in 139 2000 In a large measure this new economy growth was due to a bubble in the NASDAQ attributable to an internet craze that produced substantial income for investors in these dotcom companies However this craze was as Alan Greenspan identi ed it irrational exuberance The Asian Tiger economies China Taiwan Indonesia South Korea Malaysia the Philippines and Thailand all experienced very substantial growth Much ofthis growth depended on two things low wage labor for manufacturing particularly in the electronics industry and exports The semiconductor industry has suffered substantial decline since 2000 and the growth rates of these Asian Tiger economies have gone down drastically Further much of the manufacturing upon which these economies relied was low value added and the end result is that the incomes in these economies did not grow as once forecasted hence failing to create the kinds of consumer economies observed in North America and Western Europe Global Economic Development The majority of the world s population lives in lowincome countries and many of these lowincome countries have very substantial foreign debts The role of industrialized or high income countries is not so clear in helping to develop the world s middle and lowincome countries It is clear that population growth the lack of health care education and infrastructure added to the heavy debt burdens ofthese developing countries are substantial impediments to economic growth There are several suggestions that scholars and international organizations have offered concerning assistance to developing nations Many of the low income countries particularly in Africa are heavily in debt to governments and private banks in the industrialized portions of the world This debt is a crushing burden that in many cases makes economic development nearly impossible In many cases this debt was acquired to buy military hardware or was stolen by corrupt former government leaders Saddam Hussein is alleged to have left Iraq with tens of billions of dollars in 2003 Debt rescheduling has become a way of life with these creditor banks and governments simply so that the debtor countries can pay back at least the principle of these debts Debt relief is something that is just beyond the horizon if economic disaster is to be avoided in many of these indebted countries The issue of foreign aid is also controversial The United States and Japan both provide very significant amounts of foreign aid to the developing portions ofthe world The United States as of 2001 was providing just under 2 percent of its GDP in various foreign aid programs to developing countries Japan s percentage of GDP was slightly higher but was lower in absolute dollars because of its smaller GDP More than a dozen other high income also provide substantial amounts in foreign aid 140 Foreign aid is criticized from two perspectives Corrupt foreign governments can easily divert aid from productive endeavors to things never intended by the donor country Perhaps worse still is the fact that there is a narcotic effect of foreign aid Foreign aid can provide substantial improvements in infrastructure incomes and even political stability However over a period oftime the receiving country may become dependent on foreign grants and loans and not be successful in finding alternative means of generating revenues to pay for these items The end result the developing country becomes addicted with no way out or so the criticism goes Whether this really is a problem is an empirical question and there is insufficient evidence to make any nal judgments in this matter An open economy is also one way in which a growth path can be established Both the British and the Japanese developed their respective economies by engaging in international trade International trade free and open trade is one way in which a developing economy might very well increase their per capita incomes and hence develop a consumer economy to assist in their own economic development The issue of trade is a controversial issue Developing economies fear becoming economic colonies of industrialized nations and are suspicious of such free trade On the other hand vested interests in the developed economies also fear the loss of domestic jobs and income due to trade with low wage economies There are historical reasons for these fears but free and open trade based on comparative advantage and living wages is likely beneficial to all ofthe trading partners Finally one of the severest problems facing the developing world is the brain drain The highly skilled and educated persons in developing countries seem to have a propensity to immigrate to North America and Western Europe If economic growth is to bring the developing world into the 21St century the developing world is going to need its human capital At the same time the less skilled and educated are remaining in the developing world when such workers are in short supply in certain parts of the industrialized world hence immigration policies towards those workers might serve both groups of countries better ifthey were liberalized As one might imagine such policy proposals generally meet with harsh criticism in the industrialized world If political stability is to be achieved and maintained in the developing world then the industrialized countries need to create some sensible policies towards the exportation ofarms to developing countries At present the proliferation of conventional arms in both Africa and Latin America suggests the potential for substantial armed con ict in both regions either internationally or domestically 141 KEY CONCEPTS Economic Growth Total Per capita Developed or high income countries Developing countries Middle income countries Low Income countries Growth Paths Prerequisites to Growth Secular Trend Asian Tigers lmpediments to Growth Debt Brain Drain Role of Developed Economies in Developing Economies Foreign Aid International Trade Human Capital Brain Drain STUDY GUIDE Food for Thought Why is growth deemed to be a long term seculartrend Explain What costs and bene ts are there for foreign aid from developed economies for both developing and developed economies Critically evaluate total GDP growth and per capita growth as measures of economic growth 142 Sample Questions Multiple Choice Which of the following are NOT prerequisites to economic growth Brain Drain Controlling population growth Opening the economy to international trade Encouraging foreign direct investment Dow How is growth illustrated in a production possibilities curve A A point inside the curve B A point outside the curve C A shift of the curve to the left D A shift of the curve to the right True False Foreign aid to a developing economy is unambiguously good for the country receiving that aid FALSE Most low income countries are in Africa and South Asia TRUE 143 Chapter 9 Money and Banking In primitive tribal societies the development and use of money occurs only after that society reaches a size and complexity where barter is no longer a viable method of transacting business Barter the trading of one good or service for another requires a coincidence ofwants When one individual has something another wants and vice verse trade can be arranged be there is a coincidence of wants Larger more complex social orders generally require the division of labor and specialization which in turn increases the number of per capita market transactions When individuals live in a higher interdependent society most necessities oflife are obtained through market transactions In a modern industrialized country it is not uncommon for an individual to make more than a dozen transactions per day This volume of business makes barter nearly impossible The result is that societies will develop money to facilitate the division of labor and specialization that provide for higher standards of living The purpose of this chapter is to introduce the readerto money and to the banking system This chapter will provide the basic de nitions essential to understanding our complex monetary and banking systems The following chapters will extend the analyses to demonstrate how money is created and how the monetary system is used to stabilize the uctuations in the business cycle Functions of Money There are three functions of money these are 1 a medium of exchange 2 a measure of value and 3 a store ofvalue Each ofthese functions will be examined in turn in the following paragraphs Money serves as a medium of exchange It is generally accepted as quotlegal tenderquot or something of general and speci ed value such that people have faith that they can accept it for payment because they can use it in exchange without loss of value Because barter requires a coincidence of wants trade occurs only when two people have different commodities that the other is willing to accept in trade for their 144 own wares A barter economy makes exchange dif cult it may take several trades in the market before you could obtain the bread you want for the apples you have Money solves the barter problem lfyou have apples and want bread you simply sell the apples for money and exchange the money for bread lf barter persists it may take a dozen or more transactions to turn apples into bread In other words money is the grease that lubricates modern sophisticated economic systems Money is also a measure ofvalue Without money as a standard by which to gauge worth value would be set by actual trades The value of a horse in eighteenth century Afghanistan could be stated in monetary units in the more modern areas of the country However the nomads that wandered the northern plains ofthat country could tell you in terms of goats carpets skins and weapons what the range of values were for horses However there were as many prices of horses as there were combinations of goods and services that could be accepted in exchange forthe animal Money permits the value of each commodity to be stated in simple terms of a single and universally understood unit of value Money is also a store ofvalue Money can be saved with little risk with virtually no chance of spoilage and little or no cost Money is far easierto store than are perishable foodstuffs or bulky commodities such as coal wool or our To store money save and later exchange it for commodities is far more convenient than having to store commodities for future use or to have to continually go through barter exchanges Together these functions vest in money a critical role in any complex modern economy Our prices are stated in terms of money our transactions are facilitated by money and we can store the things we which to consume in the future by simply saving money In fact money may not make the world go 39round but it certainly permits the economic world to go 39round much more smoothly The Supply of Money The supply of money has a very interesting history in both US economic history and world economic history Several historians note that one ofthe contributing factors to the fall of the Roman Empire was that there was signi cant deflation in the third and fourth centuries The reason for this was that money in those days was primarily coinage minted of gold silver and copper As gold and silver was traded for commodities from the orient there was a flow of coinage out ofthe west In addition quotbarbariansquot were constantly raiding Roman territory and it was the gold and silver that they carried back with them for trade Further as the population grew at a faster rate than the availability of precious metals the money supply fell relative to the need for it to make the economy function ef ciently This rapid de ation added to a extremely mal distributed income and loss of productive resources resulting in a rapidly declining 145 economy after the second century AD The Roman economy collapsed with the collapse of the economy the military and government were also doomed Given the times once the Roman government and military were ruined it was shortwork to eliminate the empire and social structure In 1792 the US Congress enacted the rst coinage act The Congress authorized the striking of gold and silver coins The Congress set the ratio ofthe value of gold to silver in the coinage at 15 units of silver equaled one unit of gold The problem with this was that gold was worth more than silver as bullion than as coinage This arbitrary setting ofthe coinage value of these metals resulted in the gold coins disappearing from circulation being melted down as bullion and only silver coins circulating At the same time most coinage that circulated in the eighteenth century western hemisphere including the United States was of Spanish origin In fact the standard unit adopted for US coinage was the dollar however the Spanish minted coins that were also called dollars from a Dutch word tolar The Spanish one dollar coins contained more silver than did the US dollar and the Spanish coins were being melted down and sold at a pro t at the US mint Herein is the problem with using gold or silver as minted coins or as backing for currency Money has value in exchange that is unrelated to the value of precious metals Their relative values uctuate and result in money disappearing ifthe value of the metal is more than the unit of currency in which the metal is contained One ofthe classical economists noted this volatility in the monetary history of most countries As the value ofthe gold or silver made the currency worth more as bullion that currency disappeared and was quickly replaced by monetary devices of lesser value Gresham39s Law is that money of lesser value will chase money of greater value out of the market A modern example ofthis is available from US coinage In 1964 the value of silver became nearly 4 times and later that decade nearly 22 times its worth in coinage Therefore the last general circulation coins that were minted in the United States that contained any silver was 1964 Today the mint issues one dollar coins that contain one ounce of silver rather than 67 ounces but that silver is worth 530 per ounce as bullion Therefore you do not see actual silver dollars in circulation and will not until the value of silver drops below 100 per ounce This observation is Gresham39s law in operation Since the American Civil War there have been various forms of money used in this country other than coinage The government issued paper money particularly after the Greenback Act of 1861 there were numerous examples of US paper money before that year including bank notes state notes and colonial notes The Greenback Act provided for the denominations of bills with which you are familiar but it also provided for 5 10 25 and 50 bills fractional currency 146 Today there are numerous de nitions of money The most commonly used monetary items are included in the M1 through M3 de nitions of money these de nitions are 1 M1 is currency checkable deposits 2 M2 is M1 noncheckable savings account time deposits of less 100000 Money Market Deposit Accounts and Money Market Mutual Funds and 3 M3 is M2 large time deposit largerthan 100000 The largest component ofthe M1 money supply is checkable deposits checking accounts credit union share drafts etc currency is only the second largest component of M1 Near Money Near money are the items that ful ll portions ofthe requirements of the functions of money Near money can be simply a store of value such a stocks and bonds that can be easily converted to cash Credit cards are often accepted in transactions and the line of credit they represent can serve as a medium of exchange Gold silver and precious stones have historically served as close substitutes for money because these commodities have inherent value and can generally be converted to cash in almost any area ofthe world Much ofthe wealth smuggled out of Europe at the end of World War II by escaping Nazis was smuggled out in the form of gem stones gold and silver bullion The widespread use of near money is relatively rare in the world39s economic history However in modern times there is a potential for problems lndiana39s history presents an interesting example The State of Indiana issued currency in the 1850s in part to help nance the canals that were being built across the State In 1855 and 1856 the railroads put the canals out of business even before they were completed virtually bankrupting the State hence the 1857 Constitution rather the year lndiana entered the Union State currency or even private bank currency is not controlled by a central bank and is worth only what faith people have in it orthe intrinsic value ofthe monetary unit lfthe full faith and credit ofa bankrupt State or bank is all that backs the currency it is worthless What Gives Money Value The value of the US dollar or any other currency can be expressed as the simple reciprocal ofthe price level D 1P Where D is the value of the dollar and P is the price level In other words the value of the dollar is no more or less than what it will buy in the various markets This is true of 147 any currency money in general However there are reasons why money has value The value of money is determined by three factors these factors are 1 its general acceptability for payment 2 because the government claims it is legal tender hence must be accepted for payment and 3 its relative scarcity as a commodity Money can be used to buy goods and services because people have faith in its general acceptability It is not that the coin or paper has intrinsic value that makes money ofvalue in exchange it is simply because people know that they can accept it in payment and immediately exchange it for like value in other commodities because virtually everyone trusts its value in exchange Money also has value in international currency markets not just domestic ones The international currency markets provide a very good example of why trust provides money with value The world39s currencies are generally divided into two categories hard currency and soft currency A hard currency is one that can be exchanged for commodities in any nation in the world A soft currency is one whose value is generally limited to nation that issued it and often to some limited extent in the world currency markets often with signi cant limitations or even discounts The US dollar French franc German deutsche mark Canadian dollar Japanese Yen British pound and Italian lire are recognized as hard currencies generally the Swiss franc is also included in the hard currencies These seven nations are the G7 nations and are the world39s creditor nations The reason that these countries are the creditor nations is that they are the largest free market economies have democratic and stable governments and long histories of rather stable nancial markets These nations39 currencies are termed quothardquot currencies because they are relatively stable in value and can be readily exchanged for the goods and services of these largest most advanced economies In other words the economic systems and governments that generate these currencies are the markets from which everyone else imports a wide array of necessary commodities On the other hand the Mexican peso Kenyan dollar and Greek drachma among 165 others are currencies of less developed nations that have very little of value relative to any ofthe G7 nations in the world39s markets do not have histories of stable nancial markets governments and they are typically in debt to the G7 nations Because oftheir limited value in exchange and rather volatile value these currencies are called quotsoftquot currencies The difference between a hard and a soft currency is trust in its present and future value in exchange for commodities Hard currencies are generally trusted hence accepted soft currencies are not There is also an element of legality in the value of money For example the United States is a large economically powerful country lts government is also a large powerful government that has always paid its bills People have faith and trust in the US government making good on its financial obligations therefore people have taken notice when the United States government says that Federal Reserve Notes are legal tender 148 Also contributing to the value of money is its scarcity Because money is a scarce and useful commodity it also has value the same as any other commodity It is interesting to note that the US 100 bill is the most widely circulated currency outside ofthe United States and more ofthese bills circulate outside ofthe US than within the US This suggests something ofthe commodity value of US dollars as well as the general international trust in the US dollar By spring 1971 the exchange rate problems had become acute This was true for Japan and especially for West Germany who had large trade surpluses with the United States and held more dollars than they wanted Underthese conditions the US dollar was rapidly losing value against the German deutsche mark From January to April of 1971 in keeping with the Bretton Woods agreements the German Bundesbank had to acquire more than 5 billion of international reserves in order to defend the value ofthe dollar To protect the value of the dollar and its exchange rate with the German mark however the German central bank was losing control over its domestic monetary policy By May 5 1971 the Bundesbank abandoned its efforts to protect the dollar and permitted the deutsche mark to seek its own value in the world39s currency markets The scenario was the same for all countries that had trade surpluses with the United States The excess supply of dollars was causing those countries to lose control over their money supplies Given that the United States was rapidly losing its gold reserves on August 155 1971 by Richard Nixon39s order it was announced that the United States of cially abandoned the Bretton Woods system and refused to exchange gold for US dollars held by foreigners For the rst time in modern monetary history the US dollar was permitted to seek its value in open markets The move to a flexible exchange rate system where the exchange rates are determined by the basic market forces was the official demise of the Bretton Woods system Mashaalah RahnamaMoghadam Hedayeh Samavati and David A Dilts Doing Business in Less Developed Countries Financial Opportunities and Risks Westport Conn Quorum Books 1995 p 74 The Demand for Money The demand for money consists of two components of total money demand these are 1 transactions demand and 2 asset demand Transactions demand for money is the demand that consumers and business have for cash or checks to conduct business Transaction demand is related to a preference to have wealth or resource in a form that can be used for purchases liquidity There is also an asset demand for money In times of volatility in the stock and bond markets investors may 149 prefer to have their assets in cash so as not risk losses in other assets Together the asset and transaction demand for money comprise the total demand for money Money is much the same as any other commodity it has a demand curve and a price The price of money is interest primarily because money is also a claim on capital in the nancial markets The demand curve for money is a downward sloping function that is a schedule of interest rates to the quantity of money The Money Market The money market is a particularly interest market In reality there are several markets in which money is exchanged as a commodity In examining only M1 the currencies ofvarious countries are exchanged for one another for the purpose of doing business across national boundaries The price ofone nation39s currency is generally expressed in terms of another countries currency For example 105 Yen is the value of a dollar in the case ofa Deutsche Mark 126 DM is worth one dollar There is also the credit market The credit market is where consumers and businesses go to borrow money A consumer purchasing a house will typically need a mortgage and will borrow to buy a house Businesses will need to borrow to purchase capital equipment investing to produce commodities to sell in product markets Both types of borrowing in uence the credit markets because money is a relatively scarce commodity One ofthe largest borrowers in the US economy isthe US Treasury Typically the government borrows by selling Treasury Bonds The following diagram is for a general money market credit market Money 150 The money supply curve is vertical because the supply of money is exogenoust determined by the Federal Reserve The Federal Reserve System regulates the money supply through monetary policy and can increase or decrease the money supply by the various actions it has available to it in regulating the banking system and in selling or buying Treasury Bonds The money demand curve slopes downward and to the right The intersection ofthe money demand and money supply curves represents equilibrium in the money market and determines the interest rate price of money Bonds are financial obligations Both private companies and governments issue bonds and receive cash The bonds typically state that the owner ofthe bond will receive a specific payment in dollars periodically for holding the bond and at the end of the bonds life it will be redeemed for its face value This is the primary market where bonds are sold directly by the government or company In the case of the Treasury the bonds are generally sold at auction This method of paying interest creates a quotsecondaryquot market for bonds Bonds may be resold for either a discount or a premium As the market value of the bond increases it drives down the rate of return on the bond conversely ifthe market value ofthe bond decreases the rate of return increases For example consider a 1000 bond that the government agrees to pay 60 per year in interest over its life lfthe bond remains at the 1000 face value the interest rate is 6 However if bonds are viewed as a safer investment than other possible investments or there is excess demand for bonds the market price may increase lfthe market price of this 1000 bond increases to 1200 then the rate of return falls to only 5 601200 05 On the other hand if the bond is viewed as more risky or there is an excess supply of bonds the market price may fall say to 800 then the rate ofreturn increases to 75 60800 075 Notice how bonds become a good investment Bonds are good investments when the interest rate is falling As the interest rate falls the market value ofthe bond increases rememberthat the payment made by the original borrower is a xed payment each period In other words falling interest rates mean larger market values for the bonds and greater pro ts for investors in bonds An Overview of the US Financial System The US nancial system is a complex collection of banks thrifts savings amp loans credit unions bond and stock markets and numerous markets for other nancial instruments such as mutual funds options and commodities The complete analysis of these markets is not a single course its an entire curriculum called Finance What is important for understanding the basics ofthe effects of money on the macroeconomy is the banking system and the closely associated regulatory agencies such as the Federal Reserve System and Federal Deposit Insurance Corporation FDC 151 Federal Reserve System FED is comprised of member banks These member banks are generally large nationally chartered banks that do signi cant amounts of commercial banking The FED is owned by these member banks However under the Federal Reserve Act the Board of Governors and Chairman are nominated by the President of United States and confirmed by the Senate The structure ofthe system is 1 Board of Governors that governs the FED and is responsible for the operations of the Fed 2 Open Market Committee buys and sells bonds called open market operations 3 Federal Advisory Council provides advise concerning appropriate banks regulations and monetary policies and 4 The FED has 12 regional banks that serve as check clearing houses conduct research and supervises banks within the region Fort Wayne is in the Chicago region however Evansville is in the St Louis region The functions of FED are basically associated with bank regulation and the conduct on monetary policy The functions of the FED include 1 Set reserves requirements 2 Check clearing services 3 Fiscal agents for US government 4 Supervision of banks and 5 Control money supply through Open Market Operations buying and selling of bonds The supervision of banks and check clearing services are routine FED functions that are focused on making the banking system safer and more ef cient Because the FED is the agency through which Treasury obligations are bought and sold the FED is the scal agent for the federal government The setting of reserve requirements for the banking system and open market operations are the tools of monetary policy and are the subjects ofthe following chapter The Federal Deposit Insurance Corporation is a quasigovernmental corporation whose purpose is to insure the deposits of member banks Credit unions thrifts and savings amp loans had separate independent agencies designed to provide the same insurance However after the savings amp loans crisis these other agencies were consolidated underthe control of FDC The reason for these programs was the experience ofthe banking industry during the Great Depression when many depositors lost their life savings when the banks failed Many banks failed simply because of quotrunsquot Runs are where depositors demand their funds simply because they have lost faith in the nancial ability ofthe banks to meet their obligations sometimes the loss of faith was warranted often it was nothing more than panic Therefore to foster 152 depositor faith in the banking system FDC was created that provided a guarantee that depositors would not loss their savings even ifthe bank did fail There is a problem with such insurance arrangements This problem is called moral hazard Moral hazard is the effect that having insurance reduces the insured39s incentive to avoid the hazard against which they are insured The savings and loan crisis was at least in part the result of moral hazard The managers ofthe failed saving and loans often would extend loans or make investments that were high risk but were less concerned because if it resulted in failure the government would payback the depositors This is a classic example of moral hazards but there were also other problems involving fraud bad loans in Mexico and shaky business practices against which it was not intended that FDC would risk substantial exposure KEY CONCEPTS Functions of Money Medium of Exchange Avoidance of Barter Measure of Value Store of Value Supply of Money M1 M2 and M3 Near Money Value of Money Demand for Money Transactions Demand Asset Demand Total Demand Money Market Interest rates Federal Reserve System Board of Governors FMOC Federal Advisory Council 12 regions Functions of the Fed Sets Reserve Requirements 153 Check clearing Fiscal agent for the US government Supervision of Banks Control of Money Supply Moral Hazard STUDY GUIDE Develop and explain each Functions of money Demand for money Money supply and Value of money Critically evaluate the Federal Reserve System as a regulatory agency What is near money Explain and critically evaluate the use of near money 154 Sample Questions Multiple Choice The US money supply is backed by Gold Gold and Silver Gold silver amp government bonds People39s willingness to accept it 90003 2 lfa US government 30year bond sold originally for 1000 with a speci ed interest rate of ve percent each yearthe bond holder receives 50 from the government lfthe sales price of the bond falls to 900 what is the interest rate A 556 B 500 C 450 D None of the above True False lfthe Fed wishes to decrease the money supply they can buy bonds FALSE The FDIC provides insurance for deposits in member banks TRUE 155 Chapter 10 Multiple Expansion of Money The purpose of this chapter is to analyze how banks create money and how the Federal Reserve System plays an essential role in regulating the banking system After a brief history of banking reserves is examined we will proceed to analyze the multiple expansion of money Paper money is produced at the United States Bureau of Printing and Engraving in Washington DC Each day the Bureau of Printing and Engraving produces about 22 million in new currency Once the Bureau of Printing and Engraving produces the money it is then shipped to the twelve regional Federal Reserve banks for distribution to the member banks The stock of currency is created and maintained by a simple printing and distribution process However the stock of paper money is only a small part of the M1 money supply The majority ofthe M1 money supply is checkable deposits Counterfeiting is of US currency is a signi cant problem The US Bureau of Printing and Engraving has developed a new fty dollar bill that will make counterfeiting more difficult Periodically for the next several years the new design will be extended to all denominations of US currency A few years ago a strip was added to US currency that when held to the light shows the denomination ofthe bill so that counterfeiters cannot use paper from one dollar bills to create higher denomination bills The government agency responsible for enforcing the counterfeiting laws in the United States is the US Secret Service the same agency that provides security for the President Assets and Liabilities of the Banking System Assets are items ofworth held by the banking system liabilities are claims of nonowners ofthe bank against the banks39 assets Net worth is the claims ofthe owners of the bank against the banks39 assets Over the centuries a system of double entry accounting has evolved that presents images of businesses The double entry system accounts for assets liabilities and net worth Accounts have developed a balance sheet approach to present the double entry results ofthe accounting process On the left hand side are entered all ofthe bank39s assets On the right hand side ofthe ledger are entered all ofthe claims against those assets claims by owners are net worth and claims by nonowners are liabilities The assets side ofthe ledger must equal the net worth and liabilities side This rather simple method is an elegant way to assure that claims and assets balance 156 The balance sheet method will permit us a method to track how banks create money through the multiple expansion process Rational for Fractional Reserve Requirements The fractional reserve approach to monetary stability dates from the middleages in Europe Goldsmiths received gold to make jewelry religious objects and to hold for future use In return the goldsmiths would issue receipts forthe gold they received In essence these goldsmith receipts were the rst European paper money issued and they were backed by stocks of gold The stocks of gold acted as a reserve to assure payment if the paper claims were presented for payment In other words there was a 100 reserve of gold that assured the bearer ofthe receipt that the paper receipt would be honored The reserves of gold held by the goldsmiths created faith in the receipts as mediums of exchange even though there was no governmental involvement in the issuing ofthis money However the goldsmiths in Europe were not the rst to issue paper money Genghis Khan rst issued paper money in the thirteenth century Genghis did not hold reserves to back his money it was backed by nothing except the Khan39s authority which was absolute Therefore in the case ofthe Great Khan it was the ability to punish the untrusting individuals that gave money its value In Europe twohundred years later it was trust in reserves that gave money its value The US did not have a central banking system as we know it from the 1840s through 1914 There were two early quotnationalquot banks whose purpose was to serve as the scal agent of the US government and to provide limited regulation for the US monetary system Both failed and were eliminated In the early part of this century several nancial panics pointed to the need for a central banking system and for strong nancial regulations During the rst half ofthis country39s history both states and private companies issued paper money Mostly this paper money was similar to the gold receipts issued by the European goldsmiths except the money was not backed by gold typically the money was a claim against the assets of the state or company in other words the money issued represented debt It is little wonder that most ofthis currency became worthless except as collectors39 items Prior to 1792 Spanish silver coins were widely circulated in the US because they were all that was available for use as money for more details see the previous chapter The rst widespread issuance of US paper money was during the Civil War The Greenback Act which included fractional currency paper dimes amp nickelsl Earlier attempts to issue US notes were less than successful simply because people 157 trusted coinage because of the silver and gold therein contained and paper money was a novelty but not a very valuable one Today the Federal Reserve requires banks to keep a portion of its deposits as reserves to help assure the solvency of the bank in case of a nancial panic like those experienced in the rst decade ofthis century and again in the 1930s The fact that these reserves are kept also helps to assure the public ofthe continuing viability of their banking system hence the safety oftheir deposits In turn this public faith should prevent future runs on the banking system that have historically caused so much economic grief due to bank failures The Required Reserve Ratio The Required Reserve Ratio RRR is set by the FED39s Board of Governors within limits set by statute The minimum legally allowable RRR is three percent where the current RRR has been set by the Board of Governors The RRR determines by how much the banking system can expand the money supply The RRR is the amount of reserves that a bank must keep as a percentage of theirtotal liabilities deposits Banks are permitted some freedom to determine how their reserves are kept A bank can keep reserves as vault cash or deposits with the regional Federal Reserve bank Should a bank be short ofthe amount required to meet the reserves necessary then a bank can borrow their reserves for short periods from either the FED or other member banks The FED regulates the borrowing ofreserves and sets an interest rate forthese short term loans ifthey are borrowed from the FED The rate charged on borrowed reserves from the FED is called the discount rate The rate ofinterest charged on reserves borrowed from other member banks is called the Federal Funds Rate currently about 55 The banking system has three forms of reserves these are actual required and excess reserves Actual reserves are the amounts the banks have received in deposits that are currently held by the bank The required reserves are the amounts the Board of Governors requires the banks to keep as vault cash deposits with the FED or borrowed The excess reserve is amount of actual reserves that exceeds the required reserves It is the excess reserves ofthe banking system that may be used by the member banks to expand the checkable deposits component of the US money supply 158 Multiple Expansion of Checkable Deposits The largest component ofthe M1 money supply is checkable deposits Rather than printing Federal Reserve Notes the majority ofthe money supply is created through a system of deposits loans and redeposits Money is created by a bank receiving a deposit and then loaning that nonrequired reserve portion of the deposit excess reserve which in turn is deposited in another checking account and loans are subsequently made against those deposits after the required reserve is deducted and placed in the bank s vault or deposited with the FED For example if the RRR is 10 then a bank must retain 10 of each deposit as its required reserve and it can loan the 90 excess reserves of the deposit The multiple expansion of money assuming a required reserve ratio of 10 can therefore be illustrated with the use of a simple balance sheet Taccount Deposit Loans 1000 900 900 810 810 729 I 10000 9000 1000 required reserves 10000 The total new money is the initial deposit of10 and an additional 90 of multiple expansion for a total of 10000 in new money The Taccount used to illustrate this multiple expansion of money is really a crude balance sheet for the banking system with the liabilities on the left side and the assets on the right side ofthe ledger Notice however that the Taccount balances and that there is 10000 on each side of the ledger There is a far easier way to determine how much the money supply can be expanded through the multiple deposit loan redeposit loan mechanism This short cut method is called the money multiplier Mm The money multiplier is the reciprocal ofthe required reserve ratio Mm 1RRR 159 The money multiplier is the shorthand method of calculating the total entries in the banking systems39 Taccounts and shows how much an initial injection of money into the system can generate in total money supply through checkable deposits One of the tools of the FED to expand or contract the money supply is to make or withdraw deposits from its member banks This element of monetary policy will be discussed in greater detail in the following chapter The following chapter examines monetary policy and how the FED operates to maintain control overthe money supply The potential creation of money is therefore inversely related to the required reserve ratio For example with a required reserve ratio of 05 the money multiplier is 20 This means that a 100 increase in deposits can potentially create 20 in new checkable deposits as it is loan and redeposited through the system On the other hand with a required reserve ratio of 20 the money multiplier is 5 and only 5 of new money can be created from an initial deposit of 1 00 V th the current required reserve ratio of 03 the money multiplier is 3333 Currently an initial deposit of100 can potentially create 3333 in new money through increased checking deposits The reason that the word potential is used to describe this process is that there is no guarantee that the banking system will be able to loan all of its available excess reserves The amount that will be loaned still depends on the demand for money and investment in plant and equipment The monetary history of several nations illustrates how well the multiple expansion of money has been understood The United States has had recurrent bouts ofin ation during the postWorld War II period As the FED struggled with understanding how the system worked in this country the Swiss understood since the turn of the century Switzerland is a relatively small economy and the money supply in this small nation was very competently managed The result is that the Swiss have experienced unusually stable price levels ever since 1945 The recurrent bouts of inflation in the postWorld War II economic history ofthe United States is not consistent with the economic history ofthis country prior to World War II Most of American history experienced significant deflation De ation is rarely discussed today but is in many ways a far more destructive problem than in ation The reason this problem persisted for so many decades in this country was that there was no stable central banking system to manage the money supply and that the value ofthe US dollar was tied to an increasingly rare commodity gold Need for Regulation and Inflation One ofthe serious implications ofthe money multiplier is that the banking system has the potential for signi cant harm to economic stability In Chapter 3 we examined the various theories of in ation One ofthose theories is called the quantity theory of 160 money where MV PQ Because V and Q grow very slowly they are generally regarded as nearly constant The implication is that what happens to the money supply should be nearly directly re ected in the price level During expansions in the business cycle investment demand is generally high and banks can often loan all oftheir excess reserves If we reduced the required reserve ratio to 01 then banks could expand the money supply 100 for each 100 in additional deposits made in the system lfthe required reserve ratio was only 001 then 1000 of new money can be created for every dollar of new deposits V thout any required reserve ratio the money supply could be theoretically be expanded in nitely for each dollar of new deposits These high multiple potential expansions could create serious in ationary problems for the economy and therefore the required reserve ratio ofthe central bank is an essential portion of any nation39s economic stabilization policies During this period of a political swing to the right of public opinion the idea of de regulation has gained some new support However there is no serious and informed move toward deregulating the money supply V thout monetary controls imposed by a central bank there will most certainly be serious economic problems associated with the loss of some modicum of sensible control ofthe money supply To return to the pre World War period with its nearly endless financial panics and collapses and destructive reliance on gold and silver to operate the economy makes no rational sense No professional economist today advocates such a policy Unfortunately there are those on the political fringe who occasionally gain a public forum and advocate the return to the gold standard and other illinformed policies but thankfully they are not taken seriously This need for regulation has been long recognized by economists Since at least the 1890s classical economists described the role of money in the economy and the need to control the money supply if price stability was to achieved Most prominent among the classical economists writing at the beginning of the twentieth century concerning monetary economics was Irving Fisher who developed the modern quantity theory of money presented in Chapter 3 The quantity theory of money has not been wellunderstood by policy makers in Western economies and the history ofthe 19th and 20th Centuries are marked with events which simply make you wonder how we understood so little The German experience immediately following World War l was one such event The printing of paper currency to pay offthe reparations required by the Treaty of Versailles resulted in in ation of Biblical proportions which brought down the Weimar Republic and ushered in the Nazis 161 Consider the following short excerpt from Irving Fisher s classical work on the Quantity Theory of Money We come back to the conclusion that the velocity of circulation either of money or deposits is independent ofthe quantity of money or of deposits No reason has been or so far as is apparent can be assigned to show why the velocity of circulation of money or deposits should be different when the quantity of money or deposits is great from what it is when the quantity is small There still remains one seeming way of escape from the conclusion that the sole effect of an increase in the quantity of money in circulation will be to increase prices In may be claimed in fact it has been claimed that such an increase results in an increased volume of trade We now proceed to show that except during transition periods the volume of trade like the velocity of the circulation of money is independent of the quantity of money An in ation of the currency cannot increase the product of farms and factories nor the speed of freight trains or ships The stream of business depends on natural resources and technical conditions not on the quantity of money The whole machinery of production transportation and sale is a matter of physical capacities and technique none ofwhich depend on the quantity of money We conclude therefore that a change in the quantity of money will not appreciably affect the quantities of goods sold for money Since then a doubling in the quantity of money 1 will normally double deposits subject to check in the same ratio and 2 will not appreciably affect either the velocity of circulation of money or of deposits or the volume of trade it follows necessarily and mathematically that the level of prices must double Irving Fisher The Purchasing Power ofMoney New York Macmillan 1911 pp 154 57 KEY CONCEPTS Fractional Reserve Requirements Balance Sheet Required Reserve Ratio Money Multiplier Monetary History Genghis Kahn Gold Receipts US had no central bank priorto 1914 Greenback Act 162 Reserves Required Excess Actual Money Creation STUDY GUIDE Food for Thought Trace the deposit of 100 through a banking system with a 25 RRR Does an injection of100 really result in an increase in the money supply of 400 Explain Explain the sources of reserves for member banks How does the Fed control the money supply when reserves can be borrowed Explain and critically evaluate this practice Sample Questions Multiple Choice V th a required reserve ratio of 05 by how much will the money supply be increased in the Federal Reserve deposits a check of 1000 with National City Bank 163 A 1000 B 5000 C 20000 D None of the above Which of the following is the interest rate that member banks charge one another for borrowing excess reserves Federal funds rate Money Market rate Discount rate Prime rate PPS True False Excess reserves are the funds in the Federal Reserve Banks that the Fed does not need to assure the solvency ofthe banking system FALSE Money multiplier with a RRR of 25 is 4 TRUE 164 Chapter 11 Federal Reserve and Monetary Policy The neoclassicists continue to reject the idea that the government has a pro active role to play in economic stabilization However where the neoclassicists see any role for government in stabilizing the macroeconomy it is in monetary policy arena There is some merit to this point of view Fiscal policy has significant lags that often results in counterproductive governmental actions by the time the scal policy actually impacts the economy Monetary policy on the other hand has very short lags between the recognition ofa problem and the impact on the macroeconomy At a minimum monetary policy is quicker to change the economy39s direction is involved in far less political gameplaying and is more efficient than is scal policy The purpose of this chapter is the examine the role of the FED in the formulation and implementation of monetary policy forthe purpose economic stabilization Each of the major tools of monetary policy will be examined and their potential effects present Monetary Policy The monetary policies of a government focus on the control of the money supply These policies directly control inflation or de ation but also can influence real economic activity The focal point of control over real economic activity through the management of monetary aggregates is the interest rate The demand for investment is dependent upon the relation between expected rates of return from that investment and the interest rate that must be paid to borrow the money to buy capital Monetary policy in the United States is conducted by the Federal Reserve either through the Board of Governors orthe Open Market Committee The monetary policies ofthe United States has focused primarily on the control of various monetary aggregates ie the money supply which in turn in uences interest rates and aggregate economic activity The fundamental objective of monetary policy is to assist the economy in attaining a full employment nonin ationary macroeconomic equilibrium Tools of Monetary Policy The Federal Reserve has an arsenal of weapons to use to control the money supply The FED can buy and sell US Treasury bonds called open market operations it can control the required reserve ratio within statutory limits and it can manipulate the discount rate the interest rate charged by the FED for member banks to borrow 165 reserves This array oftools provides the FED with several options in taking corrective actions to help stabilize the economy Each ofthese tools will be examined in the following paragraphs Open Market Operations Open Market Operations OMO involves the selling and buying of US Treasury obligations in the open market OMO directly influences the money supply through exchanging money for bonds held by the public generally commercial banks and mutual funds Expansionary monetary policy involves the buying of bonds When the FED buys bonds it replaces bonds held by the public with money When someone sells a bond they receive money in exchange which increases the money supply Contractionary monetary policy involves the FED selling bonds to the general public When the FED sells bonds it removes money from the hands of the public and replaces that money with US Treasury bonds The FED sells and buys both longterm thirty year Treasury bonds and short term primarily two ve and ten year Treasury bonds In theory the FED can focus its in uence on either longterm interest rates or short terminterest rates However what most security analysts argue is that the FED39s bond buying and selling behavior is not a leadership position In recent years the FED buys and sell bonds afterthe money market establishes a direction for interest rates In times of high inflation or steep recession however the evidence suggests that the FED39s OMO leads the market rather than follows In reality this is what we should expect to observe in the responsible exercise of monetary policies The Required Reserve Ratio As discussed in the previous chapter it is the required reserve ratio that determines the size ofthe money multiplier The money multiplier determines how much money can be created by the member banks through the deposit loan process Therefore the FED can directly control how much the banking system can expand the money supply through the manipulation ofthe required reserve ratio The FED can raise or lower the required reserve ratio within statutory limits Increasing the required reserve ratio reduces the money multiplier hence reduces the amount by which multiple expansions of the money supply can occur By decreasing the required reserve ratio the FED increases the money multiplier and permits more multiple expansion ofthe money supply through the deposit loan process described in the previous chapter 166 Most ofthe new deposits that result in the multiple expansion of money occur because the FED bought bonds from the public When the FED buys bonds this is injecting new money into the system that is in turn deposited which set the money multiplier multiple expansion into motion The Discount Rate The Discount Rate is the rate at which the FED will loan reserves to member banks for short periods oftime To tighten monetary policy the FED will raise the discount rate The raising of the discount rate will discourage the borrowing of required reserves by member banks hence encourages using their reserves as required reserves rather than excess reserves which they loan and start the multiple expansion of money By lowering the discount rate the FED encouragesthe borrowing of required reserves which may result in more excess reserves hence potentially more loans and a greater expansion of the money supply through the loan deposit process described in the previous chapter Chapter 10 FED Targets The FED must have benchmarks to determine the need for and effectiveness of monetary policies The quantity theory of money suggests that the money supply itself is the appropriate policy target forthe FED As noted by Irving Fisher the velocity of money is how often the money supply turnsover and is unrelated to economic activity Further Fisher argued that money does not directly in uence the real output ofthe economy Therefore in any policies aimed at controlling in ation or de ation the FED39s monetary targets should simply be the money supply However the economy is not as simple as the quantity theory of money would suggest Many consumer purchases and most investment is interest rate sensitive Therefore to the extend that the FED39s policies do impact interest rates the FED can also correct downturns in the business cycle If investment is too low to maintain full employment level of GDP the FED can reduce the required reserve ratio or buy bonds thereby increasing the supply of money and lowering the interest rate The lower interest rate may encourage consumption expenditures and investment thereby mitigating recession There are dilemmas for the FED in selecting targets for their monetary policies Interest rates and the current business cycle may present a dilemma Expansionary monetary policy may result in higher interest rates by increasing the rate of in ation which will be re ected in the interest rates As the interest rate increases and people39s in ationary expectations develop these may serve to dampen the expansionary effects 167 ofthe FED39s monetary policies At the same time there is no necessary coordination of scal and monetary policies At the time an expansion monetary may be necessary to reverse a recession contractionary scal policies may begin to affect the economy Therefore the FED must keep an eye on the Congress and account for any scal policies that may be contradictory to the appropriate monetary polices The presents a delicate balancing act forthe FED Not only must the FED correct problems in the economy it may well have to correct Congressional scal mistakes or at least account for this errors when implementing monetary policies Tight and Easy Money Discretionary monetary policy therefore ts into one oftwo categories 1 easy money and 2 tight money policies Easy money policies involves the lowering of interest rates and expanding the money supply The purpose of easy money policies are typically to mitigate recession and stimulate economic growth Tight money policies involve the increasing interest rates and contracting the money supply The purpose oftight money policies is generally to mitigate in ation and slow the rates of economic growth typically associated with in ation Consider the following diagram showing both tight and easy money policies Tight Easy Quantin of money Assuming that the money supply remains constant we can analyze the changes in the money supply imposed by the FED As the FED engages in tight money policies the supply curve is shifted to the left dashed line labeled tight this increasesthe 168 interest rate and lowers the amount of money available in the economy On the other hand easy money policy is a shift to the right ofthe money supply curve dashed line labeled easy With easy money policies the quantity of money increases and the interest rate falls The effectiveness of such policies in influencing GDP result from changes in autonomous investment In the case of an easy money policy as the interest falls investment will increase which results in an increase in the CG line as illustrated below Spending GDP The decrease in the interest rate is associated with an increase in investment the vertical distance between CG1 and CG2 which results in an increased GDP and levels of spending The acceptance of discretionary monetary policies are often associated with Keynesian views of a proactive role for government in economic stabilization Even though most neoclassicists argue that monetary policy is necessary to the proper functioning ofa market economy However there is another view The most extreme ofthe neoclassicists argue there is simply no role for either discretionary scal or monetary policies except in dealing with extreme variations in economic activity Friedman39s Monetary Rules Argument The leading economist of the neoclassical school Chicago School of Thought or Monetarist is the Nobel Prize winning economist Milton Friedman Friedman won his Nobel Prize for among other contributions his work on the monetary history ofthe United States Friedman argues with some persuasion that lrving Fisher39s work establishes the appropriate standard for monetary policy Based on the presumption 169 that discretionary scal policy can be abolished Friedman would have all monetary policies based on a simple rule that follows directly from the quantity theory of money Assuming that discretionary scal policy has been eliminated and that the economy is operating at a fullemployment noninflationary equilibrium monetary policy should be nothing more or less than estimating the growth rate of economy change in Q and matching the growth rate ofthe money supply to the growth rate of the economy Such monetary policy leaves nothing to the discretion of policy makers The FED39s sole role is to make sure that the money supply simply facilitates economic growth by expanding at the same pace as the real economic activity lfthe FED underestimates growth there could be small deflations that could be eliminated but subsequent adjustments to the money supply and overestimations ofthe growth rate causing in ation could be dealt with in the same type of subsequent adjustments If nothing else Friedman39s suggestion would eliminate any government induced variations in economic activity Real Business Cycle Theory is another paradigm that has arisen out of the ashes of the classical school and these economists would not nd much to argue with Friedman about as far as the analysis goes These economists primarily Thomas Sargeant from the University of Minnesota argue that recessions and in ations result from either major structural changes in the economy or external shocks such as the Arab Oil Embargo When these types of events occur the Real Business Cycle Theorists would have the government play a proactive role but focused speci cally on the shock or structural problem In this sense there is a role for discretionary scal and monetary policies but very narrowly focused on very speci c events KEY CONCEPTS Monetary Policy Expansionary Contractionary Tools of Monetary Policy Bonds Required Reserves Ratio Discount Rate Velocity of Money Quantity Theory of Money Target Dilemma in Monetary Policy 170 STUDY GUIDE Food for Thought Critically evaluate the tools and the independence of the Fed to use them in monetary policy lfthe MV PQ equation is correct then in ation can be dealt with as a monetary problem If we are experiencing 10 percent in ation with 4 billion real economy in other words nominal GDP is 44 billion and the velocity of money 28 how do we control inflation Would we want to Explain What must the Fed do with each ofits tools to create 1 a tight money policy and 2 an easy money policy Critically evaluate each Sample Questions Multiple Choice lfthe Fed wanted to create a tight money policy which ofthe following is inconsistent with this goal A Increasing the Required Reserve Ratio Increasing the Discount Rate B C Buying bonds D All ofthe above are consistent with a tight money policy 171 Ifthe Fed wishes to stimulate the economy during a recession what might we expect to observe Lowering the Required Reserve Ratio Lowering the Discount Rate Fed Buying Bonds None of the above 90003 TrueFalse The main goal of the Federal Reserve System is to assist the economy in achieving and maintaining a fullemployment nonin ationary stability TRUE A tight money policy assists in bringing the economy out of recession but at the risk of possibly causing in ation FALSE 172 Chapter 12 Economic Stability and Policy Perhaps the most important macroeconomic problems ofthe last forty years are unemployment and price level instability During the postWorld War II period price level instability has primarily been in ation There are several other matters that have also been the focus of economic policy including poverty income distribution and the federal debt and budget de cit The purpose of this chapter is to examine these policy Issues The Misery Index During the Reagan administration both unemployment and in ation topped ten percent This record gave rise to an economic statistic called the misery index The misery index is the summation ofthe civilian unemployment rate and the consumer price index For example with 10 percent unemployment and twelve percent in ation the misery index would be 22 The consumer price index is based on a market basket of goods that household typically purchase Therefore the CPI measures the impact of increasing prices on the standard of living of consumers The unemployment rate also focuses on the welfare of families when the household wage earning is out of work it has serious implications for that household39s income The misery index can be interpreted as a measure ofthe loss ofwellbeing of households Since 1973 American households have not fared well The US Department of Commerce Current Population Survey tracks economic and demographic data concerning households Between 1973 and 1993 the median real income ofAmerican households has not changed The slight increases enjoyed in the 1970s were all given back during the 1980s However between 1973 and 1993 there has been a dramatic increase in the number oftwo wage earner households and households where a full time worker also has a parttime job Increasingly economists are warning that the distribution of misery in the US economy is becoming more extreme and that the social ills associated with this misery are increasing Crime drug abuse social and economic alienation and stress related illnesses have become epidemic The fraudulent arguments that what was needed was a return to traditional family values is used as a substitute for what is really transpiring something must be done to reduce economic disparity particularly as it negatively effects the family As Lester Thurow has noted 173 lfthe real GNP is up and real wages are down for two thirds ofthe work force as an algebraic necessity wages must be up substantially for the remaining one third That one third is composed of Americans who still have an edge in skills on workers in the rest ofthe world basically those with college educations In the 1980s educational attainment and increases or decreases in earnings were highly correlated American society is now divided into a skilled group with rising real wages and an unskilled group with falling real wages The less education the biggerthe income reduction the more education the bigger the income gains These wage trends have produced a sharp rise in inequality In the decade of the 1980s the real income ofthe most affluent ve percent rose from 120253 to 148438 while the income ofthe bottom 20 percent dropped from 9990 to 9431 While the top 20 percent was gaining each of the bottom four quintiles lost income share the lower quintile the biggerthe decline At the end of the decade the top 20 percent of the American population had the largest share of total income and the bottom 60 percent the lowest share oftotal income ever recorded Lester Thurow Head to Head The Coming Economic Battle Among Japan Europe and America New York V lliam Morrow and Company 1992 p 164 It is beyond dispute that since 1981 there has been a fundamental change in American society As Lester Thurow notes America is becoming two separate and unequal societies one group with an increasing misery index and another one with increasing af uence The Bush Administration s 2003 Tax Cut has also been heavily criticized as having provided significant tax relief for the wealthy in the form of reduced rates on dividends At the same time the de cits necessary to fund those dividend tax cuts will increase interest rates over the next few quarters which impact mortgage rates and consumer loan interest rates This is an empirical question and will be answered by cold objective evidence within the year The Phillips Curve Since the Kennedy administration much of American economic policy has been based on the idea that there is a tradeoff between unemployment and in ation It was not until the recession of 198185 that we experienced very large amounts of unemployment together with high rates of in ation It was thought that there was always a cruel choice in any macroeconomic policy decision you can have 174 unemployment and low in ation or you can have low rates of unemployment but at the cost of high rates of in ation This policy dilemma results from acceptance ofa statistical relation observed between unemployment and inflation named for A W Phillips who examined the relation in the United Kingdom and published his results in 1958 Actually lrving Fisher had done earlier work on the subject in 1926 focused on the United States The ShortRun Tradeoff Phillips Curve The following diagram presents the shortrun tradeoffview ofthe Phillips curve Actually A W Phillips39 original research envisioned a linear downward sloping curve that related nominal wages to unemployment Overtwo years after A W Phillips39 paper was published in Economica Richard Lipsey replicated Phillips39 study specifying a nonlinear form ofthe equation and using the price level rather than nominal wages in his model It is Lipsey39s form that is commonly accepted in the literature as the short run tradeoffview ofthe Phillips curve In ation Phillips Curve shortrun trade Unanploymult The shortrun tradeoff view ofthe Phillips curve is often used to support an activist role for government However the shortrun tradeoff view of the Phillips Curve shows that as unemployment declines in ation increases and vice versa It is this negative relation between unemployment and in ation portrayed in the above diagram that gives rise to the idea of cruel policy choices between unemployment and in ation However there are alternative views ofthe Phillips Curve relation 175 Natural Rate Hypothesis Classicists argue that there can only be a shortrun tradeoff type Phillips Curve if in ation is not anticipated in the economy Further these economists argue that the only stable relation between unemployment and in ation that can exist is in the long run In the long run the Phillips Curve is alleged to be vertical at the natural rate of unemployment as shown in the following diagram Natural F Unanployment In this view ofthe Phillips Curve any rate of in ation is consistent with the natural rate of unemployment hence the Natural Rate Hypothesis It is based on the idea that people constantly adapt to current economic conditions and that their expectations are subject to quotadaptivequot revisions almost constantly lfthis is the case then businesses and consumers cannot be fooled into thinking that there is a reason for unemployment to cure in ation or vice versa as is necessary for the shortrun tradeoff of the Phillips Curve to exist lftaken to the extreme the adaptive expectations view can actually result in a positively sloped Phillips Curve relation The possibility ofa positive sloping Phillips Curve was rst hypothesized by Milton Friedman Friedman was ofthe opinion that there may be a transitional Phillips Curve caused by people adapting both their expectations and institutions to new economic realities In fact the experience of 198185 may well be a transitional period just like that envisioned by Friedman The beginning ofthe period was marked by OPEC driving up the price of exported oil and several profound changes in both the American economy and social institutions The Reagan appointments to the NLRB Justice Department particularly the AntiTrust Division the Supreme Court and Circuit Courts oprpeals and District Courts and signi cant changes in the tax code changed much of the legal environment signi cantly Further the very signi cant erosion of the traditional base 176 industries in the United States automobiles transportation steel and other heavy manufacturing together with massive increases in government spending on defense arguably created a transitory economy consistent with the increases in both in ation and unemployment The positively sloped Phillips Curve is show in the following picture In ation Positively sloped Transitional Phillips Curve Unemployment The positively sloped transitional Phillips Curve is consistent with the observations ofthe early 1980s when both high rates of unemployment existed together with high rates of in ation the positive slope a condition called stag ation economic stagnation accompanied by in ation Cruel choices may only exist in the case ofthe shortrun tradeoffview ofthe Phillips Curve However there maybe a quotLady and Tiger Dilemmaquot for policy makers relying on the Phillips Curve to make policy decisions lf scal policy is relied upon only the timing of the impact ofthose scal policies will result in any positive in uence on the economy Therefore to act through taxes or expenditures may result in having a counterproductive effect by the time the policy impacts the economy the tiger On the other hand if accurate two and three year into the future forecasts can be acted upon in time recession or in ation could be mitigated by current action a real longshot the lady However ifthe rational expectations theories are correct then the longshot is exactly what would be predicted Rational expectations is a theory that businesses and consumers will be able to accurately forecast prices and other relevant economic variables lfthe accuracy of consumers39 and businesses39 expectations permit them to behave as though they know what will happen then it is argued that only a vertical Phillips Curve is possible as long as political and economic institutions remain stable 177 Market Policies Market policies are focused on measures that will correct specific observed economic woes These market policies have been focused on mitigating poverty mitigating unemployment and coolingoffin ation Forthe most part these market policies have met with only limited success when implemented One class of market policies have been focused on reducing poverty in the United States These equity policies are designed to assure quota social safety netquot at the minimum and at the liberal extreme to redistribute income In part the distribution of income is measured by the Lorenz Curve and more completely by the Gini coef cient The following diagram presents the Lorenz Curve 45 degree manila of Population Lorenz 39Curve 100 Percentage of income in economy The Lorenz curve maps the distribution of income across the population The 45 degree line shows what the distribution of income would be if income was uniformly distributed across the population However the Lorenz curve drops down below the 45 degree line showing that poorer people receive less than rich people The furtherthe Lorenz Curve is bowed toward the percentage of income axis the lower the income in the poorer percentiles of the population The Gini coefficient is the percentage of the triangle mapped out by the 45 degree line the indicator line from the top of the 45 degree line to the percentage of income axis and the percentage of income axis that is accounted for by the area between the Lorenz curve and the 45 degree line fthe Gini coefficient is near zero income is close to uniformly distributed and the 45 degree line ifis near 1 then income is distributed in favor ofthe richest percentiles ofthe population and the Lorenz curve is close to the horizontal axis fthat distribution is consistent with the productivity or meritorious performance ofthe population there may be an ef ciency argument that can be used to justify the distribution However if the high income skewness ofthe 178 distribution is not related to productivity then the skewed distribution is inef cient and unfair hence maldistributed In the United States the Gini coefficient exceeds 5 and while incomes in the lower threequarters ofthe upper quintile are highly correlated with education and presumably productivity the overwhelming amount of the highest part of the distribution does not have any prima facie evidence to prove the justice or ef ciency of such high incomes Recently December 8 1995 CNN reported that Chief Executive Of cer salaries in the entertainment industries appeared to be out of line with similar officials in more productive industries and that stock holders in several ofthese companies were beginning to revolt overthese high levels of compensation In particular Viacom and Disney were experiencing stock holder queries concerning executive salaries In general most economists familiar with the income distribution in the United States would probably agree that income in this country is maldistributed because it does not reflect the market contributions ofthose at either the highest end or in the lower end of the distributions Productivity has also the subject of speci c policies The Investment Tax Credit WIN program and various state and federal training programs have been focused on increasing productivity For the most part there has been very little evidence concerning most of these programs that give reason for optimism The one exception was the work of Mike Seeborg and others that found substantial evidence that Job Corps provided skills that helped low income minority teenagers nd and keep reasonably wellpaying jobs Many of the recent treaties concerning international trade have aspects that can be classi ed as market policies To the extent that trade barriers to American exports have been reduced through NAFTA and GATT it was hoped that there may have been positive effects from these treaties In fact little ifany positive effects have been observed from these initiatives There have been recurrent attempts have to directly control in ation through price controls These controls worked well during World War II mainly because of appeals to patriotism during a war in which the United States was attacked by a foreign power Further during World War II the idea of sacrifice was reinforced by many families having relatives serving in the military which made the idea of sacrifice more acceptable to most people However absent the popular support forthese policies created by World War II for rationing and wage and price controls these policies have been uniformly failures President Carter tried voluntary guidelines that failed and Richard Nixon had earlier tried shortlived wage and price controls that simply were a policy disaster 179 Debt and Deficit The supply side economics ofthe Reagan Administration were based on the theory that stimulating the economy would prevent de cits as government spending for the military was substantially increased This failed theory was based on something called the Laffer Curve The Laffer Curve named for Arthur Laffer is a relation between tax rates and tax receipts Laffer39s idea was rather simple and straightfonNard he posited that there was optimal tax rate above which and below which tax receipts fell lfthe government was below the optimal tax rate an increase in the rate would increase receipts and in the rate was above the optimal rate receipts could be increased by lowering tax rates The Laffer Curve is shown below La er Curve The Laffer Curve shows that the same tax receipts will be collected at the rates labeled both quottoo highquot and quottoo lowquot What the supplysiders thought was that tax rates were too high and that a reduction in tax rates would permit them to slide down and to the right on the Laffer Curve and collect more tax revenue In other words they thought the tax rate was above the optimal Therefore Reagan proposed and obtained from Congress a big tax rate reduction and found unfortunately that we were below the optimal and tax revenues fell While tax revenue fell signi cantly the Reagan Administration increased the defense budget by tens of billions of dollars per year The reduction in revenues combined with substantial increases in government spending made for recordbreaking federal budget de cits and substantial additions to our national debt There were other tenets ofthe supplyside view of the world These economists thought there was too much government regulation They would have deregulated most aspects of economic life in the United States However after Jimmy Carter de 180 regulated the trucking and airlines industries there was considerable rhetoric and little action concerning the deregulation other aspects of American economic life Politics and Economic Policy Unfortunately the realities ofAmerican economic policy is that politics is often main motivation for policy Whatever anyone may think of Reagan39s Presidency there is simply no doubt that he was probably the most astute observer of the political arena of any of his competitors Reagan argued that taxes were too high and needed to be cut This is probably the single most popular political theme any candidate can adopt Remember McGovern He said if he were elected President he would raise taxes he did not have to worry about how because he won only two states The surest way to lose a bid for public office is to promise to raise taxes As it turnedout McGovern was right there should have been a tax increase at the time Reagan cut them Being right does not have anything to do with being popular What we now face is a direct result of the unprecedented de cits run during the Reagan years In fact during those eight years this country acquired nearly 17 trillion of its national debt No other President in US history has generated this amount of debt in nominal dollars However before Reagan isjudged too harshly it must remembered that we were in the midst ofa major recession during his rst term in of ce and the cold war was still at its zenith Again in Mr Reagan39s defense the first three years of his administration also witnessed exceedingly high rates of in ation that are re ected in the nominal value ofthe de cits that his administration ran up which contributed to these high national debts Debt itself is not necessarily an economic evil There has been substantial debate among economists as to the overall impact ofthe debt lfthe debt is used to fund education KennedyJohnson administration orto build highways as in the Eisenhower administration the future stream of economic bene ts may generate growth which pays off the debt Typically when the debt is acquired in military build ups it does not generate a stream of economic growth because there is no infrastructure or human capital to generate the growth So in large measure whether the debt is an economic constraint or not depends critically on what that the government expenditures that resulted in the debt provided for the future growth ofthe US economic system 181 The following table shows the US National Debt forthe period 1980 through 1988 Table I National Debt 1980 1988 NATIONAL DEBT YEAR billions of US dollars 1980 9083 1981 9943 1982 11368 1983 13712 1984 15641 1985 18170 1986 21201 1987 23456 1988 26006 1989 28680 1990 32066 1991 35985 1992 40021 1993 43514 1994 46437 1995 49210 1996 51819 1997 53697 1998 54787 1999 56061 2000 56290 2001 58031 Nearly 16923 of additional debt was accumulated during the years that President Reagan was in of ce The rst nine months of this period was under Carter39s budget but the rst nine months of 1989 was under Reagan39s and this data makes Reagan39s record look better than it really was At a six percent interest rate the current yield on the 30 year Treasury Bond as of December 8 1995 the debt accumulated during these eight years adds 1015 billion to the federal budget in interest payments There is a lesson here that has nothing to do with political propensities tax cuts that do not generate continuing economic growth will add to the national debt and the 182 interest payments on that debt will add to even further budget de cits It cannot be denied that Reagan was one of the most popular Presidents ofthis century the very things that made him popular tax cuts and military build ups are responsible for much ofour current controversy concerning the balanced budget Is the Debt Really a Problem In addition to the issues discussed above there is a substantial historical experience with the Federal debt The most valid criticism of the debt is its potential for disrupting credit markets by arti cially raising interest rates and crowding out private investment Naturally a debt as large as ours will have an upward influence on interest rates but the evidence does not suggest that it is substantial Today we nd ourselves in roughly the same position this country was in 1805 President Jefferson borrowed about the same amount as our GDP from England and Holland to buy Louisiana from the French we owe an amount almost the same as GDP History has taught us that even when we added the debt acquired in the War of 1812 it did not bankrupt the government or its citizens By the end of World War II we again had a national debt of 271 billion and a GDP of 21 1 6 billion The predictions that my generation would be paying 60 and 70 percent effective tax rates to pay off the debt never materialized Frankly I wish my debt was only equal to my annual income and I suspect most people in their thirties and forties have the same wish Surely the size of debt and current de cits are not a source ofany grief If it is then little is learned from history and little is known about economics The serious question is why did we acquire the debt and what must we give up if we are to pay it off When Reagan took of ce we were in the midst of a cold war The increases in government expenditures for the military caused our chief rivals to spend larger proportions oftheir GNP on the military and eventually caused the economic and political collapse ofthe Soviet bloc Was the end ofthe Cold War worth the debt we acquired Are the bene ts of education worth a few million dollars in current debt ls providing for the poor the elderly and children worth a few billion in debt Are veterans39 pensions for those who stood between us and our enemies worth a few billion in debt What about the Interstate Highway System subsidies for the company where you work research for medical reasons the pure sciences the social sciences and the tens ofthousands ofthings on which the government spends our tax dollars These are the priorities that any society must set Probably the only realistic answer to whether the debt is a problem is what we do about it and what priorities we set History will judge this society whether we are judged as compassionate or barbarians or economically astute or fools is for future generations of historians Let us all hope that we choose correctly 183 Hedayeh Samavati David A Dilts and Clarence R Deitsch quotThe Phillips Curve Evidence of a 39Lady or Tiger Dilemmaquot39 The Quarterly Review ofEconomics and Finance Vol 34 No 4 V nter 1994 pp 333345 During the period examined January 1974 to April 1990 the evidence reported here suggests that there is a unidirectional causal relation from the inflation rate to the rate of unemployment If the Phillips Curve were vertical over this sixteen year period one should have observed no causality between the unemployment rate and the rate of inflation the natural rate hypothesis ie any rate of in ation can be associated with the natural rate of unemployment The empirical ndings reported here however suggest a nonvertical Phillips Curve Finally the results reported here suggest the proper specification ofthe empirical models used to test the Phillips Curve relation Friedman argued that the proper speci cation of the regression equations used to estimate the Phillips Curve relation is of signi cance both theoretically and empirically quotThe truth of 1926 and the error of 1958quot as Friedman argued is supported by the evidence presented in this paper The statistical evidence presented here supports Friedman39s claim that inflation is properly specified as the independent variable in quotPhillips Curvequot analyses That is rather that the speci cation proposed by A W Phillips 1958 the proper speci cation is that proposed by Irving Fisher 1926 as asserted by Friedman This nding is of signi cance to those researchers using ordinary least squares to examine relations between in ation and unemployment Irving Fisher39s speci cation is consistent with Friedman39s well known theoretical arguments concerning posited relations between inflation and unemployment hence his taste for in ation as the independent variable Maybe this box does not represent the final word in the Phillips curve controversy but this research suggests that there is a shortrun view of the Phillips curve and that the idea of rational expectations may not be as good as it looks at rst blush This study employed the Granger causality methods to in ation and unemployment data in the United States forthe period identified to see if there was causality the evidence suggests that in ation causes unemployment 184 KEY CONCEPTS Misery Index In ation Unemployment Phillips Curve Shortrun Tradeoff Longterm natural rate hypothesis Positively sloped Rational Expectations Market Policies Lorenz Curve Gini Coef cient Investment Tax Credits NAFTA amp GATT WagePrice Policies Laffer Curve Supply Side Economics Budget Deficit National Debt STUDY GUIDE Food for Thought Compare and contrast the various views of the Phillips Curve Map out each and demonstrate how there may be a cruel choice in economic policy Develop the Laffer Curve What does it tell us How then can we have witnessed the large increases in the de cit during the years this model held center stage Critically evaluate 185 What are market policies Explain the major market policies observed in the US economy today Compare and contrast these Sample Questions Multiple Choice In the shortrun view ofthe Phillips curve policymakers are left with a cruel choice What is this cruel choice ln ation will exist regardless ofthe level of unemployment Unemployment will exist regardless of the level of in ation Policies that improve unemployment will create inflation and vice versa ln ation appears not to have a causal relation with unemployment hence a downward sloping Phillips curve is not plausible 90003 Stag ation is A general decreases in the price level B excess employment which causes in ation C both high rates of unemployment and inflation D both very low rates of unemployment and in ation True False The Laffer curve suggests that the higher the tax rate the lower will be tax revenues FALSE Supply side economics was the view ofthe Reagan administration which believed Say39s Law FALSE 186 CHAPTER 13 EpHogue Why should we study economics at all Well there are three pretty sound reasons for becoming as knowledgeable as possible about macroeconomic issues These reasons are 1 to be a good citizen 2 to understand business conditions and 3 simple selfpreservation each ofthese will be examined in turn in the following paragraphs Democracy is a very tough form of government Our Constitution whether you realize it or not is based on some pretty heroic assumptions The founding fathers did not provide us with a foolproofway of life or system of government The Constitution is based on the idea that we will participate in elections and inform ourselves of what the candidate s stand for and that will we closely monitor what our government does and does not do In other words knowledge is prerequisite for democracy Jefferson argued that a free and unfettered press was necessary to keep the people informed ofwhat was transpiring in our society and with our government If certain factions in our society became antisocial it was up to the government to rein those factions in and ifthe government because unruly it was up to the electorate to rein it in It was a delicate balance a balance struck on the basis of everyone understanding what was occurring and why In today s economy things are complicated The government has dozens of roles to play in protecting the general welfare and interest of society However unless one understands how the economy works and what the implications ofthe actions ofthe major players are one cannot hope to maintain a free and balanced society In other words you need to know enough to make informed decisions concerning candidates for of ce and the various causes you are asked to support nearly every day In a practical sense the environment in which business is conducted will in large measure determine the success or failure of that enterprise The demand for many products is interest rate sensitive In an environment where the Federal Reserve is raising the interest rates it would be unadvisable to start a construction business or invest heavily in banking stocks A great number of businesses spend a significant amount of money on attempting to forecast economic aggregates so as to create for themselves an economic advantage in the market place The importance ofthis understanding cannot be minimized It has also become increasingly important to understand the economy not so much as a system of domestic interrelationship but more as a global system One of the major reasons that the prices of copper gold silver and oil are rising at nearly 187 unprecedented rates is the dollar is losing value with respect to most other currencies The result ofthe dollar losing value is that it will buy less foreign manufactured goods and fewer resources from abroad Oil from the Middle East gold from South Africa Copper from Chile silver from Peru and Beer from Holland have all gone up in price in some signi cant measure because the dollar is losing its value The reason the dollar is losing value has to do with macroeconomic phenomenon To understand these shifting fortunes you must understand the macroeconomy and keep abreast ofthe relevant economic data Perhaps the best reason to remain a lifelong student of macroeconomics is simple selfpreservation I presume for most people selfpreservation is as powerful an incentive as l have always found it to be We have all developed several bad habits we think we need to eat everyday be cool in the summer warm in the winter dry when it rains and entertained These habits require resources and resources are best obtained when we can bring a comparative advantage to bear Retirement investments and passive income all require some understanding ofwhat s happening in the economy now and in the near future lfyou need no other reason to keep up with what s happening in economics keep in mind you need a retirement income and would like to accumulate at least enough wealth to be comfortable The Future The future is tough to predict Overthe next fty years there are going to be significant changes in the way we do business and what businesses will thrive V th nonrenewable resources comes the need for technological changes As we use up our initial endowment of oil coal iron copper and a whole array of other resources we will need to procure substitutes for these items either close substitutes or entirely different approaches to meeting many ofour basic human needs The result is that we will experience mixes of opportunities and crises How we as individuals and as societies respond to these opportunities and crises will in large measure determine what our economic future will be In general overthe past couple of centuries the historical record shows that as a group people have done pretty well Our standard of living and our ability to cope has seemingly increased faster than at any time in history In other words we have responded well to the challenges in aggregate and the opportunities have directed our progress more than the crises have hampered it Thomas Malthus wrote nearly 300 years ago that people were going to face a crises The ability to grow food grew arithmetically while the population grew geometrically The end result according to Malthus is we re all going to starve Well as it turns out he was wrong His dismal prediction hence economics is called the Dismal Science failed to account for the favorable changes in agricultural technologies that have resulted in obesity being a greater killer in this country than starvation 188 However in defense of Malthus there was no way to predict the increases in farmer productivity over the last few hundred years Global warming terrorism our deteriorating relations with other countries changes in technology increasing life expectancies and an increasingly global economy will have signi cant effects on our futures Being informed and keeping current with the economic data will help each of us succeed in this future Economics Majors Whether one becomes an economics major or not it is clear that there should be a commitment to continued study ofthe subject even informally However it is interesting to note that economics is one of the fastest growing majors on most university campuses Rather than report this second hand here is an article which can be found on the Economics Department website and which is very informative from the Wall Street Journal The Hot Major For Undergrads ls Economics By Jessica E Vascellaro Staff Reporter of THE WALL STREET JOURNAL July 5 2005 Page A11 What39s your major Around the world college undergraduates39 timehonored question is increasingly drawing the same answer economics US colleges and universities awarded 16141 degrees to economics majors in the 20032004 academic year up nearly 40 from ve years earlier according to John J Siegfried an economics professor at Vanderbilt University in Nashville Tennessee who tracks 272 colleges and universities around the country for the Journal of Economic Education Since the mid1990s the number of students majoring in economics has been rising while the number majoring in political science and government has declined and the number majoring in history and sociology has barely grown according to the government39s National Center for Education Statistics quotThere has been a clear explosion of economics as a majorquot says Mark Gertler chairman of New York University39s economics department The number of students majoring in economics has been rising even faster at top colleges At New York University for example the number of econ majors has more than doubled in the past 10 years At nearly 800 it is now the most popular major 189 Economics also is the most popular major at Harvard University in Cambridge Mass where 964 students majored in the subject in 2005 The number of econ majors at Columbia University in New York has risen 67 since 1995 The University of Chicago said that last year 24 of its entire graduating class 240 students departed with economics degrees The trend marks a big switch for the socalled dismal science which saw big declines in undergraduate enrollments in the early 1990s as interest in other areas like sociology was growing Behind the turnaround is a cleareyed reading of supply and demand In a global economy lled with uncertainty many students see economics as the best vehicle for a job promising good pay and security And as its focus broadens there are even some signs that economics is becoming cool In addition to probing the mechanics of in ation and exchange rates academics now use statistics and an economist39s view of how people respond to incentives to study issues such as AIDS obesity and even terrorism The surprise best seller of the spring was quotFreakonomicsquot a book coauthored by a University of Chicago economist Steven Levitt which examines issues ranging from corruption among real estate agents to sumo wrestling Pooja Jotwani a recent graduate of Georgetown University in Washington BC says she is certain her economics degree helped her land a job in Lehman Brothers Holdings lnc39s sales and trading division where she will earn 55000 not including bonus She says the major strengthened her business skills and provided her with something very simple quot nancial securityquot quotPeople are fascinated with applying the economic mode of reasoning to a wide variety of issues and these forces are causing them to study economics more and morequot says Lawrence H Summers president of Harvard and former secretary ofthe Treasury According to the National Association of Colleges and Employers economics majors in their first job earn an average of nearly 43000 a year not as much as for computerscience majors and engineering majors who can earn in excess of 50000 a year But those computer and engineering jobs look increasingly threatened by competition from inexpensive highly skilled workers in places like India and China quotHistorically the trends in college degrees are largely connected to perceived job prospectsquot says Marvin Lazerson historian of education and a professor at the University of Pennsylvania39s Graduate School of Education in Philadelphia He cites the recent example of computer science majors whose ranks swelled in the 1990s and quickly subsided in the early 2000s soon after the dotcom bubble 190 burst and many companies started outsourcing computerprogramming jobs abroad In contrast economics and business majors ranked among the ve most desirable majors in a 2004 survey of employers by the National Association of Colleges and Employers along with accounting electrical engineering and mechanical engineering It wasn39t just banks and insurance companies that expressed interest in economics majors companies in industries such as utilities and retailing did so too Like many people whose eyes glaze over at a supplyanddemand curve Nicholas Rendler a 19yearold student at Brown University in Providence Rl says he nds economics boring But he has gravitated to the topic anyway He chose a major combining economics sociology and anthropology because he thinks economics is crucial to understanding the world quotEconomics can be very frustrating but it is the world we are currently operating in and we need the basic frameworkquot he says Roberto Angulo chief executive of AfterCollege Inc a San Francisco online recruiting service with 267000 registered users says an economics major has practical job value quotStudents are more employable if they study economicsquot he says He graduated from Stanford University with an economics degree ve years ago It isn39t just the job calculus that is drawing students to the major It also is the rapid spread of economic globalization Many students around the world are wondering what effect global economic trends will have on them Foreign students studying in the US are ocking to the major Sabrina De Abreu a student from Argentina about to start her senior year at Harvard says her country39s experiences made her choice easy quotWhen I grew up in Argentina my country plunged into a recessionquot she says quotUnderstanding economics has become a fundamental part of my lifequot Indeed the rising popularity of the economics major appears to be a global phenomenon A recent McKinsey Global Institute study found that the share of degrees in economics and business awarded in Poland from 1996 to 2002 more than doubled to 36 from 16 in Russia the share jumped to 31 from 18 John Sutton chairman of the economics department at London School of Economics says the school39s popularity is at an alltime high in part due to interest from Eastern Europe Dr Sutton says that as these countries undergo capitalist changes quotbright young students are beginning to see economic issues highlightedquot 191 APPENDIX 1 SAMPLE MIDTERM AND FINAL EXAMINATIONS Introduction to Macroeconomics E202 192 Sample Midterm Examination ANSWERS ARE FOUND AT THE END OF THE SECTION Multiple Choice 4 points each 1 The way air pollution affects the measurement ofGDP is 90003 pollution is entirely ignored any cleaning up of pollution is subtracted from GDP any bad affects of pollution are subtracted from GDP any cleaning up of pollution is added into GDP as production 2 A college student graduates from school and is looking for a job What is the college student experiencing 90003 Frictional unemployment Structural unemployment Natural rate unemployment False search 3 An increase in the price of crude oil will in the shortrun result in A B C D A decrease in supply of all goods and therefore costpush in ation An increase in supply ofa goods and therefore costpush in ation A decrease in demand for all goods and therefore demandpull in ation An increase in demand for all goods and therefore demandpull in ation 4 fthe consumers expect that there will be a recession that will possibly cause them to lose theirjobs or suffer a reduction in real earnings assuming downward in exible wages and prices what should we expect to observe A B Prices will decline but output will remain the same in the classical range ofAS Output will remain the same but prices will decline in the Keynesian range ofAS fthe ratchet effect is observed then prices will remain the same in the classical range but output will decline None of the above will be observed 193 Which of the following methods can be applied to test for the existence of statistical association between two variables A Theoretical modeling B Granger causality C Correlation D None of the above If you consume 150 out of 200 in addition income then your marginal propensity to save is A 133 B 75 C 67 D 25 In 1990 the market basket survey found the cost of goods and services was 500 In 1991 this same market basket cost 550 in 1992 it was 600 What is the cost ofthe 1990 market basket in 1992 dollars A 833 B 600 C 120 D 500 Which of the following concepts is associated with the natural rate of unemployment A Natural disasters B Full employment C Recession D None of the above A longterm trend 25 to 100 years in an economic variable is an example of A A trough in a recession within a business cycle B A peak in a business cycle C A seasonal variation D A seculartrend 194 10The aggregate demand is most likely to shift to the left decrease when there is a decrease in the A money income B overall price level C total unemployment rate D level of personal income taxes 11Evaluate this statement quotAs long as per capita money incomes are rising in the United States so is the living standards of its residentsquot A This statement is essentially correct B This statement is true when incomes are rising at the same rate as prices C This statement fails to distinguish between real income and nominal income D This statement is true during business cycle peaks but is incorrect during recessionary troughs 12The difference between Personal Income and Disposable Income is Undistributed Corporate Pro ts Social Security Contributions Personal Taxes None of the above 90003 13Which of the following is an automatic stabilizer A Unemployment Security Programs B Progressive Income Tax Structure C Welfare Programs such as Food Stamps D All ofthe above are 14Which of the following is most likely to bene t from a period of unanticipated in ation assuming xed assets and liabilities A Those whose liabilities are less than their assets B Those whose liabilities are more than their assets C Those with assets but no signi cant liabilities D None of the above 195 15 lfthe unemployment rate is 8 and the current GDP is 100 billion how much is the recessionary gap A B There is no recessionary gap 417 billion C 10 billion D 1111 billion 16The unemployment rate is 10 the potential GDP is 10000 billion the marginal propensity to save is 05 which of the following fiscal policies may be used to close this recessionary gap A B C D lncrease government expenditures by 75 billion Decrease taxes by 75 billion lncrease taxes and expenditures by 2500 billion None of the above will work 17V th a recessionary gap of 100 billion and a need to balance the budget what policy will work best assuming an MP8 of 2 90003 lncrease both taxes and expenditures by 80 billion lncrease both taxes and expenditures by 100 billion Decrease both taxes and expenditures by 80 billion Decrease both taxes and expenditures by 100 billion 18A tax structure that requires that as one s ability to pay increases so too should their tax rates is 90003 Proportional Progressive Regressive Lump sum 19What is the tax multiplier A B C D Always one 1MPC minus one 1MPS minus one 11MPC 20Which of the following is an contractionary scal policy 90003 Decrease taxes and expenditures lncrease expenditures lncrease taxes None of the above are contractionary 196 TrueFalse 1 point each 1 Macroeconomics is the study of economic systems in aggregate 2 Okun39s law states that for every 2 that the unemployment rate exceeds the natural rate there will be a 5 recessionary gap in GDP 3 Demandpull in ation is the result ofan increase in the costs of production 4 The Keynesian range ofthe aggregate supply curve is vertical but the classical range is horizontal 5 The difference between GDP and GNP is that GNP excludes incomes earned by foreigners in the United States and includes incomes earned by Americans abroad 6 Economic policy is concerned with describing people39s behavior but economic theory is concerned with in uencing people39s behavior 7 A discouraged worker is one that will quit her or hisjob and become unemployed in the near future 8 A regressive tax structure means that those with the highest ability to pay more will pay more taxes 9 In the shortrun there can be an increase in aggregate demand in the classical range of aggregate supply that results only in higher prices and no change in output 10 It is difficult to compare overall social welfare over great periods of time decades because of the quality and mix of goods and services will differ 11The real interest rate is the nominal interest rate minus the rate ofinflation 12 Political considerations in passing budgets and tax bills help to enhance the effectiveness of scal policy for economic stabilization 13The fallacy of composition is the mistaken beliefthat what is true forthe individual must be true for the group 14 The existence of a substantial underground economy in the United States probably means that GDP is overstated 197 15 Positive economics is concerned with what is and normative economics is concerned with what should be 16MPC MP8 1 17The multiplier is equal to 1MPC 18The balanced budget multiplier is one 19The lags associated with scal policy include administrative operational and recognition lags 20 Keynesians believe that wages and prices are flexible but the classical economists believed that wages and prices were inflexible downward 198 Sample Midterm Examination ANSWERS Multiple Choice TrueFalse 1 D 1 T 2 A 2 T 3 A 3 F 4 A 4 F 5 C 5 T 6 B 6 F 7 D 7 F 8 B 8 F 9 D 9 T 10 A 10 T 11 C 11 T 12 C 12 F 13 D 13 T 14 B 14 F 15 D 15 T 16 A 16 T 17 B 17 F 18 B 18 F 19 C 19 T 20 C 20 F 199 Sample Final Examination ANSWERS ARE FOUND AT THE END OF THE SECTION Multiple Choice 4 points each 1 The US money supply is backed by Gold Gold and Silver Gold silver amp government bonds People39s willingness to accept it 90003 2 A bond sold for 2000 with an original interest rate of 10 yields 200 per year lfthe market price of the bond changes causing its yield to go to 8 what is its market price A 1600 B 2500 C 2800 D None of the above 3 If 100 is deposited in a local bank and goes through the entire banking system by how much could the money supply be expanded with 1 RRR A 10 B 100 C 1000 D None of the above 4 Which of the following is the interest rate that member banks charge one another for borrowing excess reserves Federal funds rate Money Market rate Discount rate Prime rate 90003 200 In the shortrun view ofthe Phillips curve policymakers are left with a cruel choice What is this cruel choice A In ation appears to have a causal relation with unemployment hence a downward sloping Phillips curve is plausible B Policies that improve unemployment will create inflation and vice versa C In ation will exist regardless ofthe level of unemployment D Unemployment will exist regardless of the level of in ation What does the Laffer curve predict A Above some tax rate revenues fall B Below some tax rate revenues can be increased by raising the rate C That there is some optimal tax rate that generates the most revenue D All ofthe above Ifthe Fed wishes to reduce the rate of unemployment what policies might we expect to observe A An increase in the discount rate B Buying of bonds on the open market C Selling of bonds on the open market D An increase in the required reserve ratio Which of the following is a function of money A Asset demand B Store ofvalue C Total money demand D Transactions demand The selling of bonds in the open market by the Federal Reserve does which of the following A Takes money out of circulation B Is appropriate if the Fed is engaged in a tight money policy C Ifthe Fed wishes to control in ation or increase interest rates D All ofthe above are true 10Who controls the Required Reserve Ratio for Fed A Member banks vote on it B The Board of Governors C Open Market Committee D US President 201 11Which of the following is true about the Fed39s policy targets A B C D Stabilization of interest rates is no problem but the money supply has been hard to control Stabilization of the money supply is no problem but interest rates have been hard to control The Fed has had dif culty stabilizing both the money supply and interest rates at the same time The Fed has had no dif culty in stabilizing all of the monetary aggregates at the same time 12Which of the following is consistent with the traditional view ofa shortrun trade offview ofthe Phillips curve A B C D Cost push in ation Demand pull inflation The natural rate hypothesis The adaptive expectation hypothesis 13 Stag ation is 90003 general decreases in the price level excess employment which causes in ation both high rates of unemployment and in ation both very low rates of unemployment and in ation 14Which of the following have NOT been suggested as a method of reducing the Federal deficit 90003 Lineitem veto Devaluing the US dollar Privatization of government services Balanced budget amendment to US Constitution 15Which of the following is the interest rate that the Fed charges member banks for borrowing reserves 90003 Discount rate Federal funds rate Money Market rate Prime rate 202 16Which of the following is a cause of the delayed effects associated with using scal policy for economic stabilization A The Ricardian Equivalence Theorem B Operational lags C Okun39s Law D None of the above 17Which of the following is true of developing countries A The population growth is generally too high B The is typically capital flight from the country C They suffer from a brain drain D All ofthe above are true 18What roles can developed nations play in developing countries economic growth A Foreign Aid B Open Foreign Trade C Assist with debt reduction for these countries 19A tax structure that requires that as one s ability to pay increases so too should their tax rates is Proportional Progressive Regressive Lump sum 90003 20What is the tax multiplier A Always one B 1MPC minus one C 1MPS minus one D 11MPC TrueFalse 1 point each 1 The majority ofthe US money supply is currency 2 There are twelve regional banks in the Federal Reserve System 3 The Discount Rate is the interest rate the Fed charges member banks to loan them reserves 203 4 If MV PQ is correct and V and Q are stable and grow at very slow rates then the money supply has nothing to do with the general price level 5 Nixon was the last US President to use wageprice controls to attempt to control in ation 6 The Ricardian Equivalence Theorem states that there is little difference between de cit nancing and tax increases on the aggregate economy 7 The national debt has no effect on incentives within the US economy 8 Cyclically balanced budgets require that the budget be balanced on some fixed cycle of several years 9 When the price of bond increases the interest rate increases 10V th a required reserve ratio of 2 the money multiplier is 5 11The dilemma in monetary policy is that monetary policy effects each of the money aggregates in different ways and at different times may effect the economy differently 12The velocity of money is how fast its value changes with respect to other currencies 13 Supply side economists were concerned that there was too little regulation in the US economy and that lack of regulation hurt productivity 14 In ation in a general increase in all prices not just in some prices 150ne problem with scal and monetary policy is there is no mechanism to assure the coordination ofthe two policies 16The paradox ofthrift has several dimensions however in general it refers to the observation that households may save more when the economy needs greater consumption to reach a long stable equilibrium 17 Developing countries have little ifany debt because they are not creditworthy 18A regressive tax structure means that those with the highest ability to pay more will pay more taxes 19 Say s Law states that for every 1 the unemployment rate exceeds the natural rate we have lost 25 of potential GDP 204 20The Employment Act of 1946 formalized the Federal Government s role in stabilizing the US economy 205 Sample Final Examination ANSWERS Multiple Choice TrueFalse 1 D 1 F 2 B 2 T 3 C 3 T 4 A 4 F 5 A 5 T 6 D 6 T 7 B 7 F 8 B 8 F 9 D 9 F 10B 10 T 110 11 T 12A 12 F 130 13 F 14B 14 T 15A 15 T 16B 16 T 17D 17 F 18D 18 F 19B 19 F 200 20 T 206
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