PRIN OF MACROECON
PRIN OF MACROECON ECON 2105
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Date Created: 09/12/15
NOTE Page numbers refer to the old Chapter Eight Notes edition of the textbook but it should be easy to nd identify their counterparts in the new edition Just ask me ifany cross reference is unclear Unemployment 7 There are four categories of unemployment Frictional unemployment people who are voluntarily between jobs Structural unemployment people whose jobs became obsolete due to technological progress Cyclical unemployment people who lost their jobs due to a downturn in the business cycle Discourageal workers people who have given up looking for a job The labor force consists of people who are gainfully employed or actively seeking employment It includes the frictionally structurally and cyclically unemployed but not discouraged workers nor people who voluntarily do not work eg retirees and stayathome parents The of cial or actual unemployment rate is the percentage of the labor force that is not employed ie frictionally structurally cyclically unemployed labor force The natural rate of unemployment is the percentage of the labor force that is not employed for reasons other than businesscycle uctuations ie frictionally structurally unemployed labor force Full employment is attained when the actual unemployment rate is the natural unemployment rate ie when there is no cyclical unemployment This is the full employment that we associate with the vertical segment of the AS curve In ation 7 There are both losers and winners from in ation 7 Losers include people on xed incomes eg pensions wage contracts leases and savers since the real value of savings declines when the interest rate is less than the in ation rate 7 Winners include all borrowers since the real cost of the loan or debt declines when the interest rate is less than the in ation rate In ationary and recessionary gaps refer to Exhibit 3 7 In the lower graph the intersection of AD1 and AS at point g is the idea equilibrium since there is full employment but no in ation as there is at point t In the upper graph the intersection of the AE1 curve with the 45degree line corresponds to this same equilibrium 7 If aggregate demand decreases from AD1 to AD2 the price level falls reverse demandpull in ation and aggregate expenditure decreases from AE1 to AEZ At the new equilibrium at P100 and GDP800 the economy is in a recession The recessionary gap is the amount by which aggregate expenditure falls short of the fullemployment amp nonin ationary level ie the amount by which it must increase to shi the AE curve from AE2 back to AE1 thereby restoring the idea equilibrium Graphically this is the vertical distance between the two AE curves between points g and h 7 If aggregate demand increases from AD1 to AD3 the price level rises demandpull in ation and aggregate expenditure increases from AE1 to AE3 At the new equilibrium at Pl33 and GDP1200 there is in ation The in ationary gap is the amount by which aggregate expenditure exceeds the fullemployment amp nonin ationary level ie the amount by which it must decrease to shift the AE curve from AE3 back to AE1 thereby restoring the ideal equilibrium Graphically this is the vertical distance between the two AE curves between points e and f Fiscal policy closing the gaps with government spending 7 You already know from Chapter 4 that a change in government spending will shi the AD curve and from Chapter 7 also the AE curve Therefore the government can increase or decrease its spending to close a recessionary or in ationary gap and restore the economy to the ideal equilibrium It can nance its spending with tax revenue by borrowing or both 7 If the government decides to nance its spending G entirely with tax revenue T then it has a balanced budget GT 7 The tax multiplier is the multiple by which national income decreases as a direct result of an increase in taxes For example if the MPC is 8 and the government increases taxes by 10 then consumers will spend 8 less 8 times 10 on consumption This decrease in consumption triggers successive decreases in others consumption spending this is llly explained in the previous chapter s discussion of the income multiplier ultimately causing a 40 decrease in national income The multiplier is therefore 740 10 74 It can be directly calculated from the MPC tax multiplier 7 MPC 17MPC 7 When the government spends the tax revenue national income increases according to the income multiplier Ch7 Continuing the above example if the MPC 8 then the income multiplier is 5 so the govemment s new expenditure of 10 causes a 50 increase 5 times 10 in national income 7 The balanced budget multiplier combines the two above effects the decrease in NI caused by the tax and the increase in NI caused by the government spending Adding together the tax multiplier and the income multiplier the balanced budget multiplier always equals 1 This means that a change in both government spending and taxes will cause an identical change in national income Continuing the above example the tax decreased NI by 40 and the government spending increased NI by 50 so the net increase was 10 which was the amount of the tax increase itself Using the balanced budget multiplier to reach this same conclusion this 10 increase in taxes caused a 10 increase 1 times 10 in national income Chapter Nine Notes Skip pp 200 205 Theories of the Business Cycle 7 There are two general types of theories about why business cycles exist External theories posit that cycles are caused by noneconomic events such as wars or technological innovations Internal theories assert that cycles are consequences of economic activity 7 The sunspot theory was a 19thcentury idea that weather sunlight affects agricultural harvests and thereby can indirectly cause an upturn or downturn in the economy Clearly this theory can t be taken completely seriously nevertheless it represents the linkage between environmental randomness and the business cycle 7 War induced cycles are just that changes in the business cycle that are caused by wars Since warfare requires extensive government military spending the outbreak of war can and historically always has jumpstart economic growth When G increases AE which by de nition equals CIG increases causing a higher level equilibrium NI ie economic growth review Chapters 7 and 8 or an upturn in the business cycle 7 The housing cycle is a 15 to 20year cycle of housing construction that was observed by an economist He theorized that it was these periodic bursts that in uenced business cycles Recall that housing construction is considered part of investment when I increases AE CIG increases causing NI to increase and the business cycle to take an upturn 7 The innovation cycle theory postulates that major technological innovations eg electricity the automobile computers cause a wave of further innovations and consequently increased investment p138 The reasoning is the same as with the housing cycle the increase in I ultimately raises NI and causes an upturn 7 An example of an internal cycle involves the same sequence of causes and effects as the housing and innovation cycle theories 7 I increases so AE increases so NI increases 7 but goes further the increase in NI raises rms expectations of future growth so rms increase I even more p140 which causes an even higher level of NI which again increases I and so on 7 this is the upturn in the business cycle Obviously this cycle cannot be neverending eventually rms will have overinvested so they lower I I decreases so AE decreases so NI decreases which lowers rms expectations causing them to invest even less and so on 7 this is the downturn in the business cycle 7 Real Business Cycle theory is the theory that there are no business cycles According to this argument the yeartoyear variations in the rate of economic growth 7 which other economists interpret as the phases of the business cycle 7 are simply caused by many minor unconnected technological changes In other words RBC theorists believe that the economic growth does not follow a cyclical pattern but is more or less random Countercyclical scal policy 7 The government can attempt to offset or prevent dramatic swings in the business cycle with countercyclical fiscal policy 7 by changing its level of spending ie increasing G during a recession and decreasing G during an in ationary period Theoretically this should work perfectly However government economists don t have reliable crystal balls so they can t always accurately predict the direction of the economy Exhibit 7 on p213 illustrates two very different possible paths b and c that the business cycle might take each of which would cause countercyclical fiscal policy here increasing G to fight the downturn preceding point a to have a very different effect 7 poorlyplanned policy or bad luck could even exacerbate the extremes of the business cycle Another drawback to countercyclical fiscal policy is that there is an administrative lag between the time that the policy is decided upon and the time that it actually takes effect so it might no longer be appropriate by the time it actually begins to work Chapter Ten Notes Characteristics functions and types of money 7 Desirable characteristics of money are durability portability divisibility homogeneity and a stable supply If these characteristics are satis ed then money can effectively perform its three primary functions being a medium of exchange a measure of value and a store of value or wealth Gold satis es these characteristics and for millennia was the common form of money A bank like the Us s central bank the Treasury can issue backed paper money which are certi cates that the bank promises to exchange for gold Most currency today however is unbacked or fiat money which is universally accepted as legitimate legal tender The money supply 7 Liquidity is the degree to which an asset can be exchanged for money 7 There are three categories of money in modern economies M1 M2 and M3 M1 consists of the most liquid assets currency demand deposits checking accounts and travelers checks All can be immediately converted into money M2 consists of M1 plus other lessliquid assets mostly time deposits CDs and savings moneymarket and mutualfund accounts which can be easily but not instantly converted into money Unlike Ml these assets tend to earn interest since the holder e g a bank can invest them M3 consists of M2 plus notveryliquid assets such as largedenomination 100K time deposits Note that credit cards are not money they are simply shortterm loans Theories of money classical and Keynesian 7 The velocity of money is the average number of times per year that the money supply circulates Therefore the money supply M times its velocity V is the total volume of money that circulates in the economy per year The price level P times real GDP Q for quantity is the total value of the economy s output in a year Equating the two MVPQ is the equation of exchange which can be algebraically rewritten as P MV Q Classical economists believe that the only motive for using money is transactional 7 using money to buy and sell goods They also assume that the velocity of money is constant despite the historical evidence shown in Exhibit 3 on p237 and that real GDP is constant since they assume that the economy is always operating at fullemployment level along the vertical segment of the AS curve Since V and Q are constants then the only variables in the equation of exchange PMVQ are P and M Clearly they have a direct relationship when the money supply increases decreases the price level 7 and only the price level 7 increases decreases Keynesian economists however believe that consumers motives for using money are not only transactionary but also precautionary for safekeeping and speculative for earning interest They further disagree with classical economists since they do not believe that velocity V is constant Nor do they believe that real GDP Q is constant they accept the possibility that the economy might be at a lessthanfullemployment level like GDP1 or GDP2 in Exhibit 5 on p240 during a recession Therefore all four terms not just P and M in the equation of exchange are variable In particular an increase in the money supply can cause not only an increase in price level as classical economists predict but also or either an increase in real GDP 7 Exhibit 5 on p240 graphically illustrates this conclusion In panel a the money demand curve D illustrates consumers speculative demand for liquid money 7 the higher lower the interest rate is the more less appealing interesteaming time deposits are so the less more liquid money is demanded If the central bank increases the money supply from M1 to M2 not to be confused with M1 and M2 which is shown by the rightward shift of the moneysupply curve from 1 to 2 the interest rate falls from i1 to i2 not to be confused with I for investment Panel b shows the effect of this decrease in the interest rate on investment 7 the lower interest rate causes firms to increase investment p1389 from 11 to 12 Panel c shows that this increase in investment shifts the AD curve to right p88 which can increase real GDP andor the price level In short these graphs show how Keynesians reason that an increase in M can cause an increase in P andor Q 7 not just Q as the classical economists conclude Chapter Eleven Notes Reserves 7 A bank s reserves are the portion of its assets demand deposits that it holds and has not loaned out 7 In a fractional reserve system of banking banks hold only a fraction of their assets demand deposits as reserves and loan out the remainder yet account holders are entitled to immediate access to their demand deposits The legal reserve requirement LRR is the minimum fraction of total demand deposits that a bank must hold as reserves e g if LRR10 then a bank with 100000 in demand deposits must hold at least 10000 in reserves 7 Banks can and usually do hold excess reserves which are the reserves in excess of the legallyrequired amount e g if LRR10 and a bank with 100000 in demand deposits has 25000 in reserves then its excess reserves are 15000 Bank loans create money 7 Pages 246251 provide an example of how banks create money by making loans In this example the legal reserve requirement is 20 so 200 of the 1000 initial deposit in PFN Ba must be held as reserves and the remaining 800 can be loaned out On the balance sheet on p247 this 800 loan is listed in the Assets column since the borrower s IOU is an asset to the bank and it also increases demand deposits in the Liabilities column by 800 think of the loan as an 800 checking account that is spent by the borrower The important point is that this 800 loan increased the money supply by 800 7 The example continues by assuming that the 800 loan was spent and the recipient deposited this 800 into his own bank PSN PSN keeps the legallyrequired 20 or 160 of this deposit as reserves and loans out the remaining 640 As above the loan appears in the bank s Assets column and the bank s demand deposits increase by the same amount Therefore this loan increased the money supply by an additional 640 7 The example continues by following the same pattern each loan is spent and deposited into a bank which keeps 20 of it as reserves and loans out the other 80 The table on pp2501 lists the rst ten such transactions and the amount by which each one increases the money supply If this continued infinitely the total amount of M1 money would be 5000 the 1000 initial deposit plus 4000 created by the loans 7 To easily calculate the increase in the money supply that an increase in demand deposits can create without adding up each individual increase as in the example use the potential money multiplier m 1 LRR Potential refers to the assumption that the banks loan out the maximum amount they can ie they hold no excess reserves In the example m 1 2 5 multiply this 5 by the amount of the initial deposit 1000 to compute the potential change in the money supply 5000 7 This money creation process works in reverse too and the potential money multiplier is applied in the same way For example if the LRR10 then the potential money multiplier mll10 so if you withdraw 2000 from your demand deposit account then the money supply will decrease by up to 10200020000 Bank failure and safeguards 7 If there is a bank run ie if too many depositors try to withdraw their demand deposits at the same time then a bank can fail Banks can also fail if too many loans or a few large loans default ie if the borrowers cannot pay back the loans Pages 256260 describe several episodes in recent history that have caused major bank failures 7 The Federal Deposit Insurance Corporation FDIC is a govemmentrun insurance agency that guarantees that each account of up to 100000 at an insured bank is protected This protection is not free 7 as with any insurance policy the bank must pay the FDIC a premium Banks willingness to loan does not coincide with economic needs 7 During a recession the economy needs more loans to stimulate consumption and investment spending and thereby boost national income However interest rates are low during a recession so loans are not very pro table for banks 7 Similarly during an in ationary period the economy needs fewer loans to decrease spending and thereby lower in ation However interest rates are high during an in ationary phase so loans are profitable for banks Chapter Twelve Notes Skip to How the Fed controls the money supply 7 The Fed can adjust the money supply to offset swings in the business cycle this is called countercyclical monetary policy Don t confuse with countercyclical scal policy Exhibit 7 on p278 which you rst saw in Chapter 10 as Exhibit 5 on p240 illustrates how increasing the money supply can increase real GDP which ghts a recession this is expansionary monetary policy The reverse works too decreasing the money supply can decrease in ation lower the price level this is contractionary monetary policy 7 One way the Fed can attempt to change the money supply is by changing the legal reserve requirement LRR If the Fed increases the LRR banks must keep a higher fraction of their deposits as reserves leaving less to lend contractionary monetary policy If the Fed decreases the LRR banks have more loanable money expansionary monetary policy Note that changing the LRR might not be effective if banks have excess reserves 7 Another way the Fed can attempt to change the money supply is by changing the discount rate If the Fed increases the discount rate then it becomes more expensive for member banks to borrow from the Fed to make loans contractionary monetary policy If the Fed decreases the discount rate then it becomes cheaper for member banks to borrow from the Fed to make loans expansionary monetary policy Note that changing the discount rate might not be effective since member banks can altogether avoid borrowing from the Fed by borrowing from each other instead on the fealeralfunals market 7 A third and the most effective way the Fed can change the money supply is by engaging in open market operations buying or selling govemment securities Essentially these purchases exchange unliquid money the securities for liquid money Ml If the Federal Open Market Committee buys securities it increases the money supply expansionary if it sells securities it decreases the money supply contractionary Margin requirement Note that the definition in the sidebar on p 289 of the textbook is incorrectl The description in the text anal of course the summary below are correct 7 A stock market margin requirement is the minimum percentage of the cost of a stock that an investor must pay in cash to purchase it Therefore 100 minus the margin requirement is the maximum percentage that the investor can borrow from a bank when using the purchased stock itself as collateral on the loan For example if the margin requirement is 60 then a stockmarket player who wants to buy 10000 in stocks must pay for at least 6000 cash and can borrow at most 4000 to finance the purchase The higher the margin requirement the less an investor can borrow from the bank to pay for the stocks resulting in fewer loans contractionary monetary policy By lowering the margin requirement the Fed can encourage speculative bank loans stimulating investment in firms expansionary monetary policy
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