Principles of Economics II
Principles of Economics II EC 132
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LECTURE NOTES ON MACROECONOMIC PRINCIPLES Peter N Ireland Department of Economics Boston College irelandpbcedu httpwwabceduirelandpec132html Copyright c 2009 by Peter N Ireland Redistribution is permitted for educational and research purposes so long as no changes are made All copies much be provided free of charge and must include this copyright notice Ch 30 Money Growth and In ation Introduction Remember our previous example from Chapter 23 llMeasuring the Cost of Living I In 1931 the Yankees paid Babe Ruth an annual salary of 80000 But then again in 1931 an ice cream cone cost a nickel and a movie ticket cost a quarter The overall increase in the level of prices as measured by the CPI or the GDP deflator is called inflation Although at least some inflation seems inevitable today in the 19 h century many economies experienced long periods of falling prices or deflation And even in the more recent past there have been wide variations in the inflation rate from rates exceeding 7 percent per year in the 1970s to the current rate of about 2 percent per year Also in some countries during some periods extremely high rates of inflation have been experienced In Germany after World War I for instance the price of a newspaper rose from 03 marks in January 1921 to 70000000 marks less than two years later These episodes of extremely high inflation are called hyperinflations But exactly what economic forces produce inflation and lead to variations in the rate of inflation An economic theory called the quantity theory of money indicates that excess money creation is the underlying cause of inflation Interestingly the 18 h century Scottish philosopher David Hume was one of the first to formulate a version of the quantity theory of money A more recent proponent was Milton Friedman After developing the quantity theory of money to explain inflation this chapter goes on to identify the costs that inflation particularly very high rates of inflation impose on the economy Outline 1 The Classical Theory of Inflation A The Level of Prices and the Value of Money Money Supply Money Demand and Monetary Equilibrium The Effects ofa Monetary Injection A Brief Look at the Adjustment Process The Classical Dichotomy and Monetary Neutrality Velocity and the Quantity Equation QT IT UOW The Inflation Tax H The Fisher Effect 2 The Costs of Inflation A Fall in Purchasing Power Shoeleather Costs Menu Costs Relative Price Variability InflationInduced Tax Distortions Confusion and Inconvenience Arbitrary Redistributions of Wealth DTWPOWP The Classical Theory of In ation The quantity theory is often called the classical theory of inflation because it can be traced back to Hume and other early writers on economics The Level of Prices and the Value of Money We ve already observed that for example an ice cream cone costs a lot more today than it did in the 1930s Is this because ice cream cones are so much better today that people are willing to pay more for them Probably not More likely the rise in the price of an ice cream cone indicates that dollars have become less valuable not that ice cream cones have become more valuable In essence that s what the quantity theory is all about the value of money as opposed to the value of goods To make this idea concrete let P denote the price level as measured by the CPI or the GDP deflator P number of dollars needed to purchase a basket of goods and services dollars baskets of goods Now flip the reasoning around 1 baskets of goods P dollars 1P number of baskets of goods required to quotpurchasequot a dollar This last equation highlights that inflation an increase in P represents a decline in the value of money Another way to think about this idea P is the lldollar price of goods 1P is the llgoods price of a dollar Money Supply Money Demand and Monetary Equilibrium Let s build on this idea that 1P measures the goods price of a dollar Figure 1 applies standard microeconomic supplyanddemand theory to money The quantity of the good in this case money appears on the horizontal axis The price of the good in this case 1P appears on the vertical axis The money demand curve slopes downward There are two ways to think about this 0 When the price of money rises the demand for money falls 0 When the goods price of money 1P rises the dollar price of goods P falls Since fewer dollars are needed to buy the same number of goods the demand for money falls The money supply curve is vertical as the money stock is determined by Federal Reserve policy and by the response of banks to that policy The goods price of money 1P is determined by the intersection between demand and supply When the goods price of money is below its equilibrium value there is excess demand for money putting upward pressure on the goods price of money until equilibrium is restored When the goods price of money is above its equilibrium value there is excess supply of money putting downward pressure on the goods price of money until equilibrium is restored Translate the goods price of money 1P back into the money price of goods P and the same theory determines the price level The Effects of 3 Monetary Injection Figure 2 illustrates what happens when the Fed acts to increase the money supply either by Using open market operations to increase the supply of reserves to the banking system which then increases the money supply working through the money multiplier or Lowering its target for the federal funds rate which requires it to use open market operations to increase the supply of reserves to the banking system When the supply curve shifts a new equilibrium occurs at a lower goods price of money 1P and hence a higher price level P The upshot is that inflation a rising price level is associated with a policy of money creation This theory is called the quantity theory of money as it asserts that the quantity of money available determines the price level and the growth rate of money available determines the inflation rate A Brief Look at the Adjustment Process Figure 2 can also be used to think about the process through which money creation leads to a higher level of prices Suppose again that the money supply curve shifts reflecting an increase in the money supply lf 1P does not change there is an excess supply of money In other words people find themselves with more money than they need Some people will use the extra money to buy more goods and services This causes the money price of goods P to increase and the goods price of money 1P to fall Other people will deposit the extra money in the bank But then the bank will lend the money to a borrower who wants to buy more goods and services Again P will rise and 1P will fall This process will continue until monetary equilibrium is restored at a higher price level The Classical Dichotomy and Monetary Neutrality The quantity theory of money describes how changes in the money supply affect the price level But how do those changes affect other economic variables like GDP unemployment and interest rates David Hume and his contemporaries suggested that economic variables be divided into two groups 1 Nominal variables that are measured in units of money monetary units 2 Real variables that are measured in units of goods physical units According to this classification for example Nominal GDP is a nominal variable because it measures the dollar value of an economy s output of goods and services Real GDP is a real variable because it measures the value of an economy s output of goods and services correcting for inflation that is eliminating the effects of changes in the value of money The CPI is a nominal variable because it measures the number of dollars that are required to purchase a basket of goods and services The unemployment rate is a real variable because it measures the percentage of the labor force that is unemployed This theoretical separation of nominal and real variables is called the classical dichotomy The quantity theory of money implies that changes in the money supply affect nominal variables The theory of monetary neutrality goes a step further and says that changes in the money supply do not affect real variables Hume s thought experiment Suppose that the money supply doubles from 100 million to 200 million Everybody has twice as much money but the ability to produce goods and services has not changed lntrospection suggests that the overall price level P should double leaving output and all other real variables unchanged An analogy suppose that the definition of a foot was changed from 12 inches to 6 inches Would this make everyone twice as tall No Everyone would physically be the same height as before but their height when measured in feet would be twice as big Similarly when the government doubles the money supply the physical quantity of goods produced would be the same as before but prices measured in dollars would all be twice as big Hume conceded that it might take time for the price level to fully adjust to a change in the money supply Today most economists agree that the adjustment process takes time But Hume and most economists today also agree that in the long run monetary neutrality holds true Velocity and the Quantity Equation A complementary perspective on the quantity theory of money builds on the idea of the velocity of money defined as the rate at which money changes hands as measured by the number of times each dollar in the economy gets spent during a year Mathematically the velocity of money Vis defined as V P X YM Where Y is real GDP P is the GDP deflator P x Yis nominal GDP recall that nominal GDP measures the dollar value of expenditures in the economy as a whole and M is the quantity of money Example Suppose that an economy produces only a single good pizza The economy produces 100 pizzas per year so that Y 100 Each pizza costs 10 so that P 10 The quantity of money is 50 so that M 50 ln math v P x YM 10 x 10050 100050 20 ln words total spending is 10 x 100 1000 But the money is 50 So each dollar has to be spent 100050 20 times Rearranging the equation defining the velocity of money leads to the socalled quantity equation M X V P X Y Figure 3 plots the money supply M nominal GDP P x Y and velocity Vin the US since 1960 Velocity V has remained relatively stable Hence longrun increase in M has been paralleled by a longrun increase in nominal GDP In terms of the quantity equation the quantity theory of money and the closely related idea of monetary neutrality can be stated as 1 The velocity of money Vis relatively stable over time 2 Because velocity is stable an increase in the money supply M leads to an increase in nominal GDP Px Y 3 The increase in Mdoes not affect real GDP Yin the long run because the economy s output of goods and services Y is primarily determined by the availability of factors of production labor physical capital human capital and natural resources and by the stock of technological knowledge recall our analysis from Chapter 24 4 Hence in the long run the increase in nominal GDP brought about by an increase in the quantity of money is reflected in the price level P rather than real output Y 5 And so when the central bank increases the money supply the result is inflation Figure 4 shows the behavior of money supplies and inflation rates during four periods of hyperinflation In all four cases price levels rose dramatically in tandem with money supplies And in all four cases when the extreme growth in the money supply ended so did the hyperinflation Analysis of these extreme historical cases bolstered economists confidence in the quantity theory of money The In ation Tax Why do some economies experience hyperinflation Almost always it is because the government needs to raise revenue to finance spending but for political reasons cannot obtain that revenue through standard income taxation Hence it must pay for the goods and services it purchases not with existing money collected through taxes but instead using newly created money Since money creation leads to inflation the inflation tax refers to the revenue that the government raises through money creation Historically many cases of hyperinflation occur during or after a war when the government is in need of large amounts of revenue to finance high levels of spending and may not have the ability to raise this revenue through standard income taxation All of the hyperinflations shown in Figure 4 for example occurred in the aftermath of World War The Fisher Effect Another application of the classical dichotomy is to interest rates The nominal interest rate is the interest rate measured without correcting for inflation The real interest rate is the interest rate measured after correction for inflation Recall from Chapter 24 that mathematically Real Interest Rate Nominal Interest rate lnflation Rate Example A bank pays interest at the rate of 7 percent per year You deposit 100 today and have 107 at the end of one year But the inflation rate is 3 percent so your money next year buys 3 percent less Your real or inflationadjusted return is 7 percent 3 percent 4 percent We can rearrange this equation to read Nominal Interest Rate Real Interest Rate Inflation Rate Under monetary neutrality an increase in the rate of money growth will increase the rate of inflation but leave the real interest rate unchanged Hence under monetary neutrality an increase in the rate of money growth will lead to a higher nominal interest rate as well as a higher rate of inflation This application of monetary neutrality to interest rates is associated with the economist Irving Fisher and the predicted association of the nominal interest rate and the inflation rate is called the Fisher effect Figure 5 plots the inflation rate and the nominal interest rate in the US economy since 1960 Note that these two variables move together providing evidence for the Fisher effect The Costs of In ation Generally economists and noneconomists alike believe that inflation is costly for the economy But why A Fall in Purchasing Power Many people dislike inflation because they believe it erodes the purchasing power of their income What this argument fails to recognize is that while inflation leads to an increase in the dollar prices of goods and services it also leads to an increase in nominal dollardenominated wages and incomes Real inflationadjusted wages and incomes should according to the principle of monetary neutrality remain unaffected This argument would appear to be a fallacy so long as monetary neutrality holds Shoeleather Costs But inflation does erode the value of money that each person holds in his or her wallet Thus when inflation rises people make greater efforts to reduce the amounts of money that they hold for example by going to the bank or the ATM more often but withdrawing smaller amounts each time The costs that are associated with these efforts are called shoeleather costs based on the imagery of someone wearing out his or her shoes walking to the bank more often Generally under moderate rates of inflation like those currently prevailing in the US shoeleather costs appear small maybe even trivial But these costs can be substantial during episodes of hyperinflation During the Bolivian hyperinflation of 1985 prices rose at an annual rate of 38000 percent This translates into a daily rate of inflation of about 165 percent Over the course of a week money loses 12 percent of its value As soon as people received their paychecks they rushed to either spend the money or convert pesos into US dollars Menu Costs Menu costs refer to the costs that firms incur when changing their prices based on the imagery of a restaurant having to print up new menus Again these costs appear quite small under modest rates of inflation but get much bigger as inflation rises Relative Price Variability and the Misallocation of Resources Building on the menu cost story suppose that a restaurant prints new menus with new prices once per year while the economy experiences continual inflation throughout the year At the beginning of the year just after the new menus have been printed the restaurant s prices are high relative to the overall price level But as the price level rises because of inflation the restaurant s relative prices decline But these changes in prices have nothing to do with changes in the costs of preparing and serving food In this example inflation interferes with the market s ability to use prices to efficiently allocate scarce resources In ation Induced Tax Distortions While all of the costs mentioned so far appear to be minor in a lowinflation economy like the US costs relating to the operation of the tax system may be more important Table 1 illustrates an example of how inflation interacts with the tax system Consider two economies one in which the inflation rate is zero and the other in which the inflation rate is 8 percent In both economies the real interest rate is 4 percent The differences in interest rates lead through the Fisher effect to differences in nominal interest rates With zero inflation the nominal interest rate is 4 percent but with 8 percent inflation the nominal interest rate is 12 percent Suppose that interest income is taxed at the rate of 25 percent 0 This means that with a 4 percent before tax interest rate the saver pays 1 percent in taxes 0 But with a 12 percent before tax interest rate the saver pays 3 percent in taxes With zero inflation the after tax real return to saving is 3 percent But with 8 percent inflation the after tax return is just 1 percent Hence saving may be much lower in the economy with 8 percent inflation Confusion and nconvenience Recall the analogy used earlier in our discussion of monetary neutrality in a sense a doubling of the money supply and a corresponding doubling of the price level is like changing the definition of a foot from 12 inches to 6 inches If the definition of a foot or a pound or a mile were continually changed it would be confusing and inconvenient to make comparisons over time Extending the analogy the same might be said about the effects of inflation Arbitrary Redistributions of Wealth Suppose that you take out a 30year mortgage at 7 percent interest expecting the inflation rate to be 3 percent The real interest rate that you are paying is 4 percent But now suppose that unexpectedly inflation turns out to be 1 percent Now the real interest rate that you are paying is 6 percent considerably higher The bank wins but you lose On the other hand if inflation turns out to be 5 percent the real interest rate you pay is only 2 percent You win but the bank loses Unexpected changes in inflation lead to redistributions of wealth across borrowers and lenders On net the effects cancel out but before knowing who wins and who loses everyone might object to the arbitrariness of these potential redistributions Conclusions Both theory and evidence points to excessive money growth as the principal cause of inflation Many sources of the costs of inflation appear trivial when inflation is low but become much more significant when inflation is much higher However even at modest rates of inflation interactions between inflation and the tax code can have negative effects of saving And even small changes in inflation if unexpected can lead to large and arbitrary redistributions of wealth across borrowers and lenders LECTURE NOTES ON MACROECONOMIC PRINCIPLES Peter N Ireland Department of Economics Boston College irelandpbcedu httpwwabceduirelandpec132html Copyright c 2009 by Peter N Ireland Redistribution is permitted for educational and research purposes so long as no changes are made All copies much be provided free of charge and must include this copyright notice Ch 33 Aggregate Demand and Aggregate Supply Introduction Typically increases in the labor force increases in the capital stock and advances in technological knowledge allow the economy to produce more and more over time But in some years this normal growth does not occur These periods of declining incomes and rising unemployment are called recessions when they are relatively minor and depressions when they are more severe What causes these shortrun fluctuations in economic activity This chapter starts by presenting some facts about shortrun economic fluctuations and then develops the model of aggregate demand and aggregate supply to help explain and understand those facts Outline 1 Three Key Facts About Economic Fluctuations 2 Explaining ShortRun Fluctuations 3 The Aggregate Demand Curve A Why the Aggregate Demand Curve Slopes Downward B Why the Aggregate Demand Curve Might Shift 4 The Aggregate Supply Curve A Why the Aggregate Supply Curve is Vertical in the Long Run B Why the LongRun Aggregate Supply Curve Might Shift C Using Aggregate Demand and LongRun Aggregate Supply to Depict LongRun Growth and Inflation D Why the Aggregate Supply Slopes Upward in the Short Run E Why the ShortRun Aggregate Supply Curve Might Shift 5 Two Causes of Economic Fluctuations A The Effects of a Shift in Aggregate Demand B The Effects of a Shift in Aggregate Supply Three Key Facts About Economic Fluctuations Fact 1 Economic Fluctuations are Irregular and Unpredictable Fluctuations in economic activity are often called the business cycle But this term is somewhat misleading since these fluctuations do not follow a regular and predictable pattern Panel a of Figure 1 shows that recessions are sometimes close together as in 1980 and 1982 but sometimes farther apart as with 1991 and 2001 Fact 2 Most Macroeconomic Quantities Fluctuate Together Although real GDP is the variable that is most commonly used to monitor the economy other variables also fluctuate along with GDP corporate profits investment consumption retail sales home sales etc But some variables fluctuate more than others Panel b of Figure 1 shows that investment spending in particular tends to fluctuate widely Even though investment averages only about oneseventh of GDP its fluctuations account for about twothirds of the decline in GDP that takes place during recessions Fact 3 As Output Falls Unemployment Rises Panel c of Figure 1 shows that the unemployment rate rises considerably during recessions When the recession ends and real GDP begins to grow again the unemployment declines But notice that the unemployment rate never falls to zero instead it fluctuates around its natural rate of 5 or 6 percent Explaining ShortRun Economic Fluctuations The Assumptions of Classical Economics Recall that the classical dichotomy is the separation of economic variables into real variables which are measured in units of physical quantities and nominal variables which are measured in units of money According to classical macroeconomic theory changes in the money supply affect nominal variables but not real variables The classical idea of monetary neutrality allows us to study the determination of real variables like output and unemployment separately from the determination of nominal variables like inflation The Reality of ShortRun Fluctuations Most economists believe that monetary neutrality holds in the long run but not in the short run and hence that changes in the money supply do have shortrun effects Even the classical economists like David Hume observed that changes in the money supply appear to affect output and employment in the short run The Model of Aggregate Demand and Supply The model of aggregate demand and aggregate supply is used by economists to explain shortrun fluctuations in economic activity around its longrun trend The model focuses on the behavior of two variables The economy s quantity of output which can be measured by real GDP The economy s price level which can be measured by the CPI or the GDP deflator Since the first of these two variables is a real variable and the second a nominal variable the model departs from the classical assumptions that allow these variables to be considered separately Figure 2 illustrates the model The downwardsloping aggregate demand curve shows the quantity of goods and services that households firms the government and customers abroad want to buy at each price level The upwardsloping aggregate supply curve shows the quantity of goods and services that firms choose to produce at each price level But where do these curves come from and why do they have the slopes shown in Figure 2 The Aggregate Demand Curve In figure 2 and again in figure 3 the aggregate demand curve slopes down indicating that as the price level falls the quantity of goods and services demand rises Why the Aggregate Demand Curve Slopes Downward Recall that an economy s GDP Y can be decomposed into four components consumption C investment I government purchases G and net exports NX Y C I G NX For now let s take G as being fixed by government policy independent of the price level Why might the demand for consumption investment and net exports fall as the price level rises The Price Level and Consumption The Wealth Effect Some of the wealth that individuals possess is held in nominal form as money in their wallets or in the bank When the price level falls the real value of this wealth that is its value in terms of the goods it can purchase rises This increase in wealth increases consumer spending and hence also increases the quantity of goods and services demanded Conversely when the price level rises the real value of monetary wealth falls leading to a decrease in consumer spending and the quantity of goods and services demanded The Price Level and Investment The Interest Rate Effect When the price level falls the real value of each consumer s money holdings rises In response some consumers will attempt to reduce their money holdings by purchasing more bonds As they do so the interest rate on these bonds will fall And when interest rates fall firms will become more willing to borrow to finance new investment projects Conversely when the price level rises the real value of each consumer s money holdings falls In response some households will try to acquire more money by selling bonds As they do the interest rate of these bonds will rise And as the interest rate rises firms will become less willing to borrow to finance new investment projects Hence as the price level falls the demand for investment goods rises and as the price level rises the demand for investment goods falls Note too that this interest effect can also impact on household s purchases of consumer durables which may be bought on credit The Price Level and Net Exports The Exchange Rate Effect When the price level falls in the US the US interest rate falls as well This makes US bonds less attractive to investors both in the US and overseas As these investors turn to other countries bonds as alternative higheryielding investments they will sell dollars and buy foreign currencies As a result the US dollar depreciates that is its value in terms of foreign currencies falls Since each dollar buys fewer units of foreign currencies foreign goods become more expensive than US goods This change in relative prices affects spending both in the US and abroad US consumers buy fewer goods from abroad and foreign consumers buy more US goods Both of these changes cause net exports to rise Conversely when the US price level rises the US interest rate rises as well Since US bonds become more attractive to international investors they buy dollars and sell foreign currencies Hence the US dollar appreciates that is its value in terms of foreign currencies rises Since each dollar buys more units of foreign currencies foreign goods become less expensive than US goods This change in relative prices makes US consumers buy more goods from abroad and foreign consumers buy fewer US goods Both of these changes cause net exports to fall Hence as the price level falls net exports rise and as the price level rises net exports fall Why the Aggregate Demand Curve Might Shift Shi s Arising from Changes in Consumption lf consumers become more concerned about saving for retirement they will reduce their demand for goods and services at any given price level The aggregate demand curve shifts left If consumers feel wealthier because the stock market rises they will increase their demand for goods and services at any given price level The aggregate demand curve shifts right When the government cuts taxes consumers have more aftertax income to spend They will increase their demand for goods and services at any given price level The aggregate demand curve shifts right Shifts Arising from Changes in Investment lf firms become more optimistic about future business conditions they will want to invest more at any given price level The aggregate demand curve shifts right An investment tax credit that is a tax rebate that is tied to firms investment decisions will also make firms want to invest more at any given price level Again the aggregate demand curve will shift right As we will see in the next chapter an increase in the money supply tends to lower the interest rate again making firms want to invest more at any given price level and shifting the aggregate demand curve to the right Conversely a decrease in the money supply raises the interest rate making firms want to invest less at any given price level and shifting the aggregate demand curve to the left Shifts Arising from Changes in Government Purchases The most direct way for government policy to shift the aggregate demand curve is simply by changing government purchases an increase in government purchases shifts the aggregate demand curve to the right and a decrease in government purchases shifts the aggregate demand curve to the left Shifts Arising from Changes in Net Exports When Europe experiences an economic boom its demand for US exports rises at any given price level Net exports rise shifting the aggregate demand curve to the right Conversely when Europe or any other foreign economy experiences a recession the demand for US exports falls shifting the aggregate demand curve left Net exports can also change because of exchange rate movements Suppose for instance that speculators lose confidence in foreign currencies and purchase US dollars instead This leads to an appreciation of the dollar which in turn makes US goods more expensive relative to foreign goods This depresses net exports and causes a leftward shift in the aggregate demand curve The Aggregate Supply Curve Unlike the aggregate demand curve which always slopes downward the aggregate supply curve describes a relationship between output and the price level that depends crucially on the time horizon being considered In the long run the aggregate supply curve is vertical whereas in the short run it slopes upward Why the Aggregate Supply Curve is Vertical in the Long Run In the long run an economy s production of goods and services depends on its supplies of capital labor and natural resources as well as its stock of technological knowledge The longrun neutrality of money implies that if two countries are identical except that one has a money supply that is twice as large then the price level in that economy will be twice as large too but the output of goods and services will be the same The way of depicting the classical dichotomy and the neutrality of money in the aggregate demand aggregate supply model is to draw the aggregate supply curve as vertical in the long run as shown in figure 4 Why the LongRun Aggregate Supply Curve Might Shift The position of the vertical longrun aggregate supply curve is often called potential output full employment output or the natural rate of output The last term captures the idea that this is the level of output that results when the unemployment rate is at its natural rate or normal level And just as the unemployment rate tends to gravitate towards its natural rate over time so too will the level of output tend to gravitate towards its natural rate Then what causes the aggregate supply curve to shift Anything that would cause the natural rate of output to change including 1 Changes in the supply of labor due to immigration 2 Changes in natural rate of unemployment due to changes in minimum wages changes in unionization etc 3 Changes in the stock of capital physical or human 4 Discoveries or depletion of stocks of natural resources 5 Changes in technological knowledge Using Aggregate Demand and Aggregate Supply to Depict LongRun Growth and In ation Figure 5 uses the aggregate demand and aggregate supply model to describe the behavior of output and prices over long periods of time The initial aggregate demand curve is downward sloping The aggregate supply curve is vertical as the graph focuses on the long run In the long run growth in the labor force and more importantly growth in the stocks of capital and technological knowledge shift the aggregate supply curve to the right as the natural rate of output rises If the Federal Reserve keeps the money supply constant this longrun economic growth will tend to reduce the price level that is cause deflation But historically the Federal Reserve has acted to increase the money supply over long periods of time This increase in the money supply has shifted the aggregate demand curve to the right too Indeed the money supply has grown at a rate that has caused the aggregate demand curve to shift rightward at a pace that is associated with inflation Why the Aggregate Supply Curve Slopes Upward in the Short Run Most economists believe in the longrun neutrality of money but also believe that changes in money or other nominal variables are associated with changes in output employment and other real variables in the short run That is most economists believe that while the longrun aggregate supply curve is vertical the shortrun aggregate supply curve is upward sloping as shown in figure 6 The upwardsloping shortrun aggregate supply curve implies that the quantity of output supplied deviates from its natural rate when the actual price level in the economy deviates from the price level that most people expect to prevail When prices rise above the level that people expect output rises above its natural rate When prices fall below the level that people expect output falls below its natural rate Economists have devised several explanations for the upwardsloping shortrun aggregate supply curve Sticky Wage Theory As its name suggests sticky wage theory posits that wages are slow to adjust to changing economic conditions either because workers and firms sign longterm contracts or because wagesetting conventions make it difficult for firms to rapidly adjust the wages they pay An example best illustrates how the theory works Suppose that one year ago a firm expected the price level P to equal 100 and based on this expectation agreed to pay its workers 20 per hour Now suppose that instead the price level turns out to be P 105 In the long run the firm will have to pay its workers higher wages to compensate them for the higher cost of living but in the short run the wages it pays are in real terms that is in units of output lltoo low Since the firm can hire workers at relatively low wages it hires more and produces more output The unexpectedly high price level leads to an increase in output above its natural rate And the same story works in reverse if the price level turns out to be unexpectedly low real wages rise in the short run leading firms to hire fewer workers and produce less Sticky Price Theory Sticky price theory emphasizes instead that the prices of certain goods and services are slow to adjust to changing economic conditions This theory uses the metaphor of menu costs a restaurant may print up new menus with new prices only once or twice per year In the short run its prices are fixed even if economic conditions change Menus and mail order catalogs provide literal examples of menu costs to changing prices But other prices may be slow to change because of managerial costs For example executives at Dunkin Donuts may decide at the beginning of the year that 149 is the quotright price to charge for a cup of coffee They may meet again later in the year to reconsider the pricing decision but until then the price stays fixed So suppose that Dunkin Donuts sets its price at 149 but the price level reflecting mainly the prices of other goods and services turns out to be unexpectedly high A cup of coffee now looks quotcheapquot to consumers More will visit Dunkin Donuts and buy coffee Dunkin Donuts will hire more workers and produce more output Hence the unexpectedly high price level leads to an increase in output above its natural rate And the same story works in reverse if the price level turns out to be unexpectedly low a cup of coffee with a quotstickyquot price of 149 will look expensive People will buy less Dunkin Donuts will hire fewer workers and produce less The unexpectedly low price level leads to a decrease in output below its natural rate But like sticky wage theory sticky price theory also suggests that in the long run prices will adjust and output will return to its natural rate Misperceptions Theory A third story to explain the upwardsloping shortrun aggregate supply curve is the misperceptions theory Another example illustrates how this theory works Suppose at the beginning of the year everyone expects the price level P to equal 100 But instead the price level rises to P 110 This means that on average the prices of all goods and services have risen by 10 percent In the shortrun however individual firms may mistakenly believe that it is reallyjust the price of their particular good that is rising Believing that it is an especially good time to produce those firms will hire more workers As a result the unexpectedly high price level will lead to an increase in output above its natural rate Conversely if the price level unexpected falls each individual firm might mistakenly believe that it is really just the price of its own output that is falling The firm will hire fewer workers The unexpectedly low price will lead to a decrease in output below its natural rate Summary Although some economists debate over which of these three theories sticky wages sticky prices or misperceptions comes closest to describing actual economies there is probably an element of truth in each of them And they are not mutually inconsistent that is they could all work together to describe why the aggregate supply curve slopes upward And all three imply a shortrun relationship of the form Quantity of Output Supplied Natural Rate of Output aActual Price Level Expected Price Level Where a is a number that governs the extent to which actual output responds to unexpected changes in the price level Note that this same equation and each of the three theories also captures the idea that in the long run after expectations have shifted to recognize actual changes in the price level the longrun aggregate supply curve is vertical Why the ShortRun Aggregate Supply Curve Might Shift The equation from above also allows us to identify factors that will shift the shortrun aggregate supply curve 1 Anything that shifts the natural rate of output and hence the longrun aggregate supply curve 2 Changes in the expected price level The equation indicates that an increase in the expected price level causes the quantity of output supplied at any given actual price level to decrease How Consider the answer given by sticky wage theory If the expected price level increases firms will set higher wages to compensate workers for the higher cost of living But if the actual price level is held constant this means higher real wages Firms will hire fewer workers and produce less output at the given price level The shortrun aggregate supply curve shifts to the left Conversely if the expected price level falls firms will be able to set lower wages hire more workers and produce more output all at any given price level The shortrun aggregate supply curve shifts to the right Can you give the answers as they would be provided by the sticky price and misperceptions theories Two Causes of Economic Fluctuations Figure 7 depicts in the economy in its longrun equilibrium Aggregate demand intersects with longrun aggregate supply determining output and the price level But here the shortrun aggregate supply passes through the equilibrium point as well indicating that the expected price level has adjusted to this longrun equilibrium as well From this starting point we can consider the effects of forces that shift either aggregate demand or aggregate supply according to these four steps 1 Decide whether the event shifts the aggregate demand curve the aggregate supply curve or both 2 Decide in which direction the curve shifts 3 4 Use the aggregate demand and aggregate supply diagram to see how output and the price level change in the short run Use the same diagram to see how output and the price level change in the long run The Effects of a Shift in Aggregate Demand Let s consider a specific example a wave of pessimism hits the economy because of a political scandal or a stock market crash What happens to the economy as a result JI l 4gt Since the wave of pessimism affects spending plans it shifts the aggregate demand curve Because households and firms want to buy a smaller quantity of goods at a given price level the aggregate demand curve shifts left Figure 8 shows that in the short run this leftward shift of aggregate demand causes output to fall below its natural rate The price level falls as well Can you tell the specific stories implied by sticky wage sticky price and misperceptions theories We have now moved from point A to point B in figure 8 As time passes however the expected price level will also fall This shifts the aggregate supply curve to the right again can you tell the specific stories implied by sticky wage sticky price and misperceptions theories Now we move to point C in figure 8 the price level falls still further but output returns to its natural rate In this example we implicitly assumed that the government does not respond to any of these events Another possibility is that the Federal Reserve could respond to the initial fall in aggregate demand by increasing the money supply As discussed earlier and in more detail in the next chapter an increase in the money supply will shift the aggregate demand curve to the right offsetting the initial leftward shift In this case the economy can move back to its initial longrun equilibrium point A without a shift in the expected price level and without a shift in aggregate supply Figure 9 shows changes in real GDP in the US since 1900 Two large swings stand out the decline in GDP during the Great Depression and the growth in GDP during World War II Most economists now blame the Great Depression on a large decline in the money supply From 1929 to 1933 the money supply fell by 28 percent To a large extent this decline in the money supply was the result of bank failures which lead to a contraction of the money multiplier A decline in the money supply causes the aggregate demand curve to shift to the left In the short run output falls as does the price level Eventually expectations adjust to the lower price level The aggregate supply curve shifts to the right The price level falls further but output returns to its natural rate During World War II government military spending rose dramatically An increase in government purchases causes the aggregate demand curve to shift to the right In the short run output rises as does the price level In the long run the expected price level also rises The aggregate supply curve shifts to the left The price level rises further but output returns to its natural rate The US economy also experienced a recession during 2001 most likely due to shifts in aggregate demand Between August 2000 and August 2001 stock prices fell by about 25 percent A fall in stock prices shifts aggregate demand to the left Then in September 2001 terrorist attacks hit New York and Washington lncreased pessimism and uncertainty brought about by the attacks also shift the aggregate demand curve to the left But the Federal Reserve responded by cutting interest rates which as we discussed previously involves an increase in the money supply Also Congress responded by cutting taxes All of these policy decisions work to shift aggregate demand back to the right Let s consider one final example What happens when the Federal Reserve just decides to increase the money supply Again an increase in the money supply will shift the aggregate demand curve to right Output increases in the short run as does the price level But in the long run the expected price level will rise as well shifting the aggregate supply curve to the left Output returns to its natural rate but the price level is permanently higher This example illustrates how the aggregate demand and aggregate supply model reconciles the short and longrun effects of monetary policy The Effects of a Shift in Aggregate Supply Let s suppose again that the economy starts out in its long run equilibrium in which aggregate demand longrun aggregate supply and shortrun aggregate supply all intersect Now suppose that there is a disruption to worldwide oil supplies What happens to the economy as a result 1 Because the availability of natural resources affects firms ability to produce goods the aggregate supply curve shifts 2 Because the reduction in oil supplies makes it more difficult and costly for firms to produce goods the aggregate supply curve shifts to the left 3 Figure 10 shows that in the short run output falls and the price level rises The economy experiences stagflation stagnation of economic growth and inflation 4 Assuming that oil supplies are eventually restored in full however the longrun aggregate supply curve remains fixed lnstead as oil supplies come back the shortrun aggregate supply curve will shift back to its original position This example assumes that government policymakers do not respond to the oil supply shock Figure 11 shows what happens when instead the Federal Reserve expands the money supply or Congress increases government spending in an attempt to counteract the shortrun decline in output Now in the short run the aggregate demand curves to the right If the monetary andor fiscal stimulus to demand is sufficiently strong the government can bring output back to its natural rate even in the short run But as the figure shows this comes at the cost of making the inflation even worse In cases like this one the government is said to accommodate the shift in aggregate supply accepting a permanently higher price level in order to insulate output and employment from the effects of the shift in aggregate supply LECTURE NOTES ON MACROECONOMIC PRINCIPLES Peter N Ireland Department of Economics Boston College irelandpbcedu httpwwabceduirelandpec132html Copyright c 2009 by Peter N Ireland Redistribution is permitted for educational and research purposes so long as no changes are made All copies much be provided free of charge and must include this copyright notice Ch 24 Measuring the Cost of Living Introduction In 1931 the New York Yankees paid Babe Ruth an annual salary of 80000 In 2005 the New York Yankees paid Alex Rodriguez an annual salary of 26 million and that amount went up to 28 million in 2008 But then again in 1931 an ice cream cone cost a nickel and a movie ticket cost a quarter More generally the cost of living has risen greatly since then This chapter focuses on the consumer price index or the CPI as a measure of the cost of living The inflation rate is the percentage rate of change in the CPI Once we understand how the CPI is constructed and how it has behaved in the US we can return to the question who was really paid more after adjusting for inflation Ruth or Rodriguez Outline 1 The Consumer Price Index A How the CPI is Measured B Problems in Measuring the Cost of Living C The GDP Deflator and the CPI 2 Correcting Economic Variables for the Effects of Inflation A Dollar Figures at Different Points in Time B lndexation C Real and Nominal Interest Rates The Consumer Price Index The CPI is computed by the Bureau of Labor Statistics BLS a division of the Department of Labor to measure the overall cost of goods and services bought by a typical consumer How the CPI is Measured Table 1 highlights the 5 steps involved in measuring the CPI Survey consumers to determine the relevant llbasket of goods Record the price of each good in each year Compute the cost of the basket in each year bUJNH Choose a base year and compute the CPI for the current year Cast of the Basket in the Current Year CPI X 100 Cost of the Basket in the Base Year 5 Compute the inflation rate as the percentage change in the CPI from one year to the next CPI in Current Year CPI in Previous Year Inflation Rate X 100 CPI ln Prevmus Year The example in Table 1 assumes for simplicity that the basket includes only two goods Figure 1 illustrates in more detail what is really in the CPI basket In addition to the CPI the BLS also computes the producer price index or the PPl to measure the cost of goods and services bought by the typical firm Problems in Measuring the Cost of Living Three problems prevent the CPI from being a perfect measure of the cost of living 1 Substitution bias 2 The introduction of new goods 3 Unmeasured quality change Substitution bias arises because in any give year the prices of some goods rise faster than others The basket holds the quantity of each good purchased fixed But in fact consumers tend to substitute less expensive goods for more expensive goods Does substitution bias cause the CPI to overstate or understand the true change in the cost of living To answer this question return to the example from Table 1 There the price of hot dogs rises at a faster rate than the price of hamburgers The CPI holds the number of hot dogs and the number of hamburgers fixed But in reality consumers are likely to buy more hamburgers and fewer hot dogs Hence the true changing basket of goods is less expensive than the fixed basket used in computing the CPI The CPI therefore overstates the true change in the cost of living When new goods are introduced the true cost of achieving a given level of consumer satisfaction falls For example which would you rather have A 100 gift certificate for a small store with a limited range of choices Or a 90 gift certificate for a large store with a wide variety of goods The CPI does not account for these effects so it again overtstates the true change in the cost of living Unmeasured quality change many types of goods improve in quality over time A new cellphone purchased today is a lot better than a cellphone purchased two or three years ago even if it sells at a higher price The BLS tries to correct for this quality change But to the extent that it underestimates the extent of quality change it again overstates the true change in the cost of living Many economists believe that the because of the combined effects of these three problems the inflation rate based on the CPI overstates the true increase in the cost of living by about 05 percentage points per year These effects are important since for example Social Security benefits get adjusted upwards automatically in a way that is tied to the CPI inflation rate The GDP De ator and the CPI Usually the GDP deflator and the CPI move together as shown in Figure 2 One difference however arises because The GDP deflator reflects the prices of all goods produced domestically Whereas the CPI reflects the prices of all goods consumed domestically So let s ask what happens when the price of an imported good rises The CPI increases But the GDP deflator does not This effect is particularly important when the price of imported oil rises What happens when the price of a domesticallyproduced capital investment good rises The GDP deflator increases But the CPI does not A second and more subtle difference arises because The GDP deflator is based on the prices of goods as currently produced Whereas the CPI is based on the prices of a fixed basket of goods So differences arise when the prices of different goods are rising or falling at different rates Correcting Economic Variables for the Effects of In ation Dollar Figures at Different Points in Time Let s go back to the question from the beginning after correcting for inflation who was paid more Ruth 80000 in 1931 or Rodriguez 26 million in 2005 To answer this question ask first how many quotbasketsquot of goods could Ruth buy in 1931 80000 in 1931 N b BktB htbRth391931 um eraf as es my y u m CostofEachBasketin1931 Now ask how much would this same number of baskets have cost in 2005 2005 Cost of the Baskets Bought by Ruth in 1931 Cost of Each Basket in 2005 gtlt Number of Baskets Bought by Ruth in 1931 80000 in 1931 Cost of Each Basket in 2005 gtlt Cost of Each Basket m 1931 This last formula can be rewritten as 2005 Cost of the Baskets Bought by Ruth in 1931 Cost of Each Basket in 2005 Cost of Each Basket in a Base Year Cost of Each Basket in a Base Year Cost of Each Basket in 1931 gtlt 80000 in 1931 But now it simplifies to CPI in 2005 2005 Cost of the Baskets Bought by Ruth in 1931 gtlt 80000 in 1931 CPI m 1931 This equation is true more generally CPI This Year CPI in the Past Year Value in This Year s Dollars Value in a Past Year39s Dollars X It turns out that CPI Price Levelin 1931 152 CPI Price Levelin 2005 195 And so doing the math 195 Value of Ruth s Salary in 2005 Dollars 80000 in 1931 dollars X E 102631579 Even after adjusting for inflation Rodriguez s salary is much much higher But interestingly President Herbert Hoover s 1931 salary was 75000 Let s convert that into 2005 dollars in the same way 195 Value of Hoover s Salary in 2005 Dollars 75000 in 1931 dollars X m 96217105 After adjusting for inflation Hoover s salary is more than twice as large as the 400000 earned in 2005 by President George W Bush Table 2 does these calculations for box office receipts for movies released in different years lndexation lndexation refers to the automatic correction by law or contract of a dollar amount for the effects of inflation As noted above Social Security benefits are indexed that is adjusted every year based on the percentage increase in the CPI Union contracts often specify indexed wages that increase each year based on the inflation rate Such a provision is often referred to as a costof livlng allowance COLA Real and Nominal Interest Rates Since bank accounts bonds automobile loans and mortgages all make or require dollar payments at different points in time the interest rates on these investments or loans must also be corrected for the effects of inflation to gauge their true economic significance Suppose for example that you deposit 1000 in a bank account that pays interest at a 10 annual rate One year from now you will have 1100 your original 1000 plus 100 interest But let s say that the inflation rate over the next year is 3 You have 10 more dollars but those dollars buy 3 less Your quotrealquot return is actually 10 3 7 In this example the nominal interest rate that is the interest rate as it is usually reported without correcting for inflation is 10 But the real interest rate corrected for the effects of inflation is 7 In general Real Interest Rate Nominal Interest Rate Inflation Rate Note that the real interest rate can even be negative if the nominal interest rate on your bank account is 10 but the inflation rate turns about to be 12 the real interest rate is 10122 Most frequently prices rise over time so that the inflation rate is positive But sometimes as in the US economy during the Great Depression of the 1930s and in Japan during the last decade prices actually fall over time so that the inflation rate is negative These are periods of deflation as opposed to inflation Which is bigger the nominal interest rate or the real interest rate Under inflation the nominal interest rate is bigger than the real interest rate since the value of dollars is falling over time Under deflation the real interest rate is bigger than the nominal interest rate since the value of dollars is rising over time Figure 3 shows the relationship between nominal and real interest rates in the US During the 1970s nominal interest rates were high but real interest rates were low Why Because inflation was high During the 1980s and 1990s nominal interest rates were low but real interest rates were high Why Because inflation was low This is an important lesson for personal finance and investing when evaluating the payoff on an investment or the interest rate on a loan you need to make a judgment on what the inflation rate will be over the lifetime of the investment or loan to convert the nominal interest rate into a real interest rate
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