Principles of Macroeconomics
Principles of Macroeconomics ECO 231
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Chapter 11 Money and Banking IN CLASS Stocks bonds and mutual fund notes beginning of lecture are in chapter 10 notes A Overview 1 Functions of money a Medium of exchange contrast W barter b Unit of account a standard c Store of value wealth 2 Types of money a Commodity money gold silver copper cattle rocks shells Requirements divisibility uniformity size durability 2 Examples Silver and gold Cigarettes in POW camps 3 Paper money has exchange merits a Historically debt notes i Initially payment for storingsafekeeping valuables ii Later loans and the quotfractional reservequot system b Inter quotsilver certificatesquot exchangeable b Fiat money a fiduciary system faith 3 Measuring money money is CURRENCY and DEPOSITS owned by individuals a 2000 M1 1105B the narrow definition of money Checkable deposits 579B coins and paper 518B traveler39s checks 8B b 2000 M2 4683B the broad de nition of money plus savings deposits time deposits money market mutual funds and other deposits c quotNear moneyquot reasonably liquid assets Credit cards Plastic money No B Money actually Deposit Creation 1 Taccounts a Assets If paper is converted to cash bank cash will increase b Liabilities plus net worth Reverse the above 2 Immigrant example Japanese immigrant deposits 10 million yen 100000 a Required reserves with rrr 2 02100000 b Excess reserves 12100000 80000 also 100000 20000 c The bank loans its excess reserves 1 The loan amount is deposited into a checking account 2 Check is written for full 80000 and deposited by someone else into another bank As the check goes through the Federal Reserve check clearing process this bank will then have 64000 in excess reserves which it can loan out 3 Money creation is original 100000 plus 80000 plus 64000 plus 3 Widower example 100000 in mattress deposited into bank 1 The initial shock is not money creation cash held by the public has decreased while the demand deposit balance has increased 2 Money creation is only the maximum loan 80000 divided by rrr 4 Summary the 80000 loan from Bank A is deposited in Bank B which can then loan 64000 which is deposited in Bank C 5 Money creation has a quottheoretical maximumquot initial shockrrr a Banks must loan out their entire excess reserves b Each loan recipient must redeposit full amount no leakage Chapter 13 Money and the Economy 1 II II gt 1 IV Money and Prices A The Equation of Exchange MV PQ GDP 1 Velocity de ned 2 Velocity calculated 3 Verbally Expenditures MV Sales PQ B The Quantity Theory of Money 1 Stated Assuming that V and Q are relatively constant xed then changes in the Money Supply lead to changes in Prices 2 If MV TE and TE C I G NX then changes in the Money Supply or in Velocity lead to a shift in AD 3 If Q real GDP is relatively xed in the short run then AS is vertical and changes in the Money Supply lead to changes in prices and nothing else 4 Dropping the constancy assumptions P MV Q Prices depend on M V Q Monetarism A Revised assumptions 1 Velocity changes in a predictable way 2 AD depends on V and the Money Supply not C I G NX 3 SRAS is upward sloping not vertical 4 The selfregulating economy exible wages and prices B When Velocity or the Money Supply change 1 AD will shift in one direction and SRAS will shift in the other to get back to LRAS 2 The short run and long run impacts are different a In the short run both the price level and RGDP can change b In the long run only the price level changes In ation A OneShot In ation 1 Demand induced AD Shift followed by selfregulating SRAS shift 2 SupplySide induced SRAS shift followed by reverse selfregulating SRAS shift B Continued In ation It takes continued increases in AD to cause continued in ation whether the initial shock is an AD increase or a SRAS decrease Money and Interest Rates A Increased MS reduces interest rates through increased supply of loans B Increased MS also affects interest rates decrease and increase through Real GDP 1 An increase in RGDP increases the demand for bonds driving up the price of bonds and reducing bond returns and interest rates 2 An increase in RGDP increase business expectations to expand they issue more bonds lowering the price of bonds and increasing bond returns and interest rates C Increased MS increases interest rates through prices in ation increased borrowing D Increased MS increases interest rates through in ationary expectations E Which effect dominates It s an empirical issue F Real interest rates are nominal interest rates with in ation subtracted Chapter 14 Monetary Policy Chapter 5 In ation and Unemployment I Introduction The Macroeconomy A GNPGDP National Income Disposable Income Per Capita Income B Growth Recession Depression Expansion T r I 1 U 39 L p J rate Interest rates Prime Mortgage TBill Federal Funds Rates of Return ROR Trade Balance Imports Exports Exchange Rates II In ation A C I J D In ation CPI PPI E F The In ation Rate 1 Price index an aggregate weighted average of a set of prices The aggregation is across all items to be considered The weighting is according to importance a 90 Consumer Price Index CPI Aggregation across all items hat a typical household would normally consume weighted by share of expenditures in a typical budget Producer Price Index PPI Similar to above except for rms and their costs of production that is we use resourceinputs prices The GDP De ator uses total value of economic activity Dow Jones Index uses stock values for 30 large companies Your semester GPA is an index If you had 2 A s 2 B s and 1 C in ve 3hour courses 40 of your grade is A 40 of your grade is B and 20 is C so your GPA is calculated as 440 430 220 16 12 04 32 2 Calculation of the CPI a b c Determine a base year a standard for comparison and calculate the total dollar expenditure for a basket of goods and services for that year For the current year do the same buy the same market basket Divide current year by base year and multiply by 100 1 Note that the value for the CPI in the base year is 100 2 US CPI currently uses 19821984 average as the base year p 117 3 Calculating percent changes in the CPI give us the in ation rate a b c Pick a common date for each year typically December 31 or midyear In ation in 2000 CPI2000CPI999 CPIl999 100 In ation in 1990s CPIl999CP11989 CPIl989 100 B Inaccuracy of the In ation Rate 1 Changes in the market basket a b c Tastes change The substitution bias substitute away from highprice goods For c use a chainweighted price index disregard for our class 2 Changes in quality 3 Changes in outlets how goods and services are sold delivered C Using the in ation rate 1 In ation and real incomes Is your income keeping up with in ation 2 Prices or incomes then and now Why I remember when D E The Effects of In ation 1 Redistribution 2 Uncertainty Inef ciency and Risk Aversion 3 Menu Costs 4 International Effects Types of In ation 1 Costpush 2 Demand pull III Unemployment A 711 The Unemployment Rate 1 Calculated as Unemployed in Civilian Labor Force 100 2 Who is unemployed and who is employed a You are not in the CLF if you are under 16 in the miliary in an institution or you have voluntarily elected not to be a part of the work force student retiree homemaker etc b You are in the work force if you work lll or parttime or are selfemployed c You are unemployed if you don t have a job and you are actively seeking work d Civilian labor Force Employed Unemployed 3 There is also an employment rate and a labor force participation rate Classifying the Unemployed 1 Unemployed Job loser Job leaver Reentrant New entrant 2 Discouraged workers are NOT unemployed The Data 1 The National Unemployment Rate 2 Unemployment Rates for Selected Groups of People Types of Unemployment 1 Frictional Unemployment 2 Structural Unemployment 3 Cyclical Unemployment Natural Rate of Unemployment is Frictional plus Structural Full Employment 1 When Unemployment rate Natural Rate of Unemployment 2 When Cyclical unemployment zero IV Job Search Theory A B C D Wage Offer Curve You don t take the first job you are offered Reservation Wage Curve Your reservation wage decreases over time Optimal Search Time Optimal Search Time and the Unemployment Rate Chapter 8 The SelfRegulating Economy Classical Economics A OlderAdam Smith David Ricardo Thomas Malthus John Stuart Mill Alfred Marshall B Modern NeoClassical Monetarists C Resource Markets 1 a b c d 2 a b c d 3 4 Labor markets Downward sloping demand employers upward sloping supply workers Equilibrium wage rates Difficult times recession led to layoffs and unemployment and unemployed workers went elsewhere sometimes displacing higher wage workers Boom times expansion led to increased employment and tight labor markets and workers could easily move to higher wage positions Interest rates credit markets loanable funds Downward sloping demand investors upward sloping supply savings Equilibrium rates of interest Increase in savings led to decrease in interest rates it also led to an equal decrease in consumption but Total Expenditures remained unchanged as businesses increased their investment levels correspondingly Decrease in savings led to increase in interest rates and reverse of above Bottom line FLEXIBILITY in returns to owners of resources in resource markets Same outcome for product markets prices move according to demandsupply Real GDP and Natural RGDP Full employment RGDP A Three possibilities 1 2 3 RGDP Natural RGDP Equilibrium RGDP RGDP lt Natural RGDP Recessionary gap think Aggregate Demand is deficient RGDP gt Natural RGDP In ationary gap think Aggregate Demand is excessive B The SelfRegulating Economy I II III Poli A B 1 Wh a b 2 Wh a b at if RGDP lt Natural RGDP a Recessionary gap With unemployment higher than the natural rate of unemployment as new contracts are negotiated employers will be able to negotiate lower wage rates shifting SRAS to the right to LRAS Prices will drop and the recessionary gap will be eliminated at if RGDP gt Natural RGDP a Recessionary gap With unemployment lower than the natural rate of unemployment as new contracts are negotiated employers will be forced to pay higher wage rates shifting SRAS to the left to LRAS Prices will rise and the in ationary gap will be eliminated cy Implications Inissez Faire Let the market alone If the ec onomy is on LRAS a change in AD will result in an opposite shift in SRAS to the LRAS mction and will result in price changes only 1 2 Increase in AD will lead to decrease in AS and higher prices Decrease in AD will lead to increase in AS and lower prices Chapter 7 I II Agg A B C Graphing the Macroeconomy regate Demand Components of AD Consumers Businesses Government the Foreign Sector Aggregate Demand Has a Negative Slope 1 The Real Balance Effect AssetsWealth Effect 2 The Interest Rate Effect 3 The International Trade Effect Movements Along vs Shifts in Aggregate Demand 1 Recall change in the quantity demanded vs change in demand 2 Change in the quantity demanded of real GDP vs change in Aggregate Demand 3 Only a change in the aggregate price level can move us from one point on a given Aggregate Demand mction to another point on the same mction The items in B above all re ect impacts that result from changes in the price level 4 Shifts in Aggregate Demand Consumers Businesses Government Net Exports a Consumption Wealth expectations interest rates income taxes b Investment Interest rates expectations business taxes c Net exports Foreign real national income exchange rates III Short Run Aggregate Supply A Aggregate Supply Has a Positive Slope 1 Sticky wages a Nominal wages vs real wages rms hire based on real wages b Long term labor contracts lead to increased short term profits 2 Sticky prices If aggregate prices rise and you do not raise your prices you will sell out your stock quickly and have to orderproduce more 3 Producer and worker misperceptions Movements Along vs Shifts in Short Run Aggregate Supply 1 Recall change in the quantity supplied vs change in supply 2 Change in the quantity supplied of real GDP vs change in SRAS 3 Only a change in the aggregate price level can move us from one point on a given Aggregate Supply mction to another point on the same mction The items in A above all re ect impacts that result quotom changes in the price level 4 Shifts in Aggregate Supply a Technology and productivity b Supply shocks resource quantities weather trading partners c Resource Prices wage rate prices of nonlabor inputs IV Short Run Macroeconomic Equilibrium B C D Lon A B Equilibrium the intersection of AD and SRAS 1 Quantity demand of RGDP equals quantity supplied of RGDP 2 Determines the equilibrium price level Disequilibrium Any price level that is not the equilibrium price level will lead to surpluses or shortages that move prices up or down to the equilibrium level RGDP and the unemployment rate are inversely related ceteris pa bus Changes in AD or SRAS lead to changes in prices RGDP and the unemployment rate g Run Aggregate Supply LRAS Defined as the output the economy produces in the long run A vertical line Questions for iture consideration Pages 182184 Chapter 12 The Federal Reserve System and Money Supply Management I Money Credit and the Government A The Treasury is the government s FISCAL budget entity 1 2 3 4 1 2 3 1 2 3 Treasury is a Cabinet level department Department of the Treasury Treasury is concerned with collecting revenues IRS and paying the bills In the past expenditures have exceeded revenues and DEFICITS have resulted De cits are nanced by borrowing a Treasury borrows by selling securities Treasury bills bonds and notes to investors banks insurance companies mutual fund managers etc at a sealed bid auction held every Monday aftemoon Securities are promises by the government to pay X in the iture typically 3 or 6 months for Tbills longer for bonds and notes in exchange for cash today Securities purchasers are asking What am I willing to pay today to receive 10000 in three months Treasury gets that amount b Treasury rst quotranksquot the sealed bids then begins borrowing with those willing to give it the most money and stops when it has enough of what it wants The more bills bonds and notes the Treasury sells the lower is the amount of cash it receives and the higher the return to the securities purchasers These returns are thus quotmarketdrivenquot short and longterm rates of interest The Federal Reserve System is the government s MONETARY entity The FRS is an independent entity independent of Congress and the President Organization of the FRS a Twelve Fed district banks the most important is the New York district bank b Board of Governors 1 Seven members with staggered 14year terms 2 Chair currently Alan Greenspan is appointed by the President c Fed Open Market Committee 1 Seven Board members 2 Five bank presidents including New York other four alternate Functions of the FRS see text pp 296297 Money Supply Management money creation is by banks Open Market Operations a To increase money supply Fed buys securities on the open market making dollar deposits in accounts of banks in payment for the securities It exchanges an increase in an asset for an increase in a liability These deposits are purely excess reserves which banks can now loan out thus increasing the money supply through the money multiplier As the Fed buys more securities it drives up the price of the securities thereby driving down the return on the security lowering interest rates Thus increases in the money supply lowers interest rates directly and through the increase in bond prices b To decrease money supply Fed sells securities on open market Changes in the required reserve ratio rrr raising rrr lowers money supply Changes in the discount rate raising the discount rate lowers money supply II Credit Markets A Money Demand 1 Is negatively related to interest rates opportunity costs 2 Shifts right with rising real GDP 3 Shifts right with higher price levels 4 Shifts left with nancial innovation credit cards interest checking Money Supply is upward sloping wrt interest rates At higher interest rates banks will be somewhat prone to loan more Money Supply and Money Demand 1 MS and MD intersect to generate equilibrium interest rate 2 Equilibrium explained in terms of disequilibrium as in supplydemand Increases in the Money Supply actually in the rate of growth of the money supply 1 Leads to lower interest rates ceteris paribus 2 Leads to increases in Total Expenditure a Increased Consumption via decreased savings b Increased Investment as a negative mction of the interest rate c Increased Net Exports 1 Lower dollar value as investors look for higher returns elsewhere 2 Exports increase Imports decrease with cheaper dollar 3 Increase in Total Expenditures is a rightward shift of Aggregate Demand a Price level rises b RGDP rises 4 Thus an increase in the Money Supply has impacts on all major macroeconomic variables Interest rates Unemployment as RGDP increases Prices Exchange rates Trade balance 5 The Fed controls the economy by controlling the Money Supply and interest rates Thus the interest rate is both an outcome variable and a policy tool 30900 Exchange Rate Determination and Impacts I EXCHANGE RATE DETERMINATION FLEXIBLE RATES A Terms and De nitions 0 U 1 Foreign exchange as a dollarvalued asset FC Higher FC is rise in asset value their currency appreciates it takes more dollars to buy their currency depreciates 2 Dollar as a foreign asset FC Higher FC is rise in dollar value dollar appreciation it takes more FC to buy one dollar FC depreciation 3 When exchange rates are xed devaluation revaluation Foreign currency as a quotgoodquot with price expressed in FC on the vertical axis 1 Demand for a foreign currency is a mction of a home demand for foreign goods commodities products b home demand for foreign services tourism insurance c home demand for foreign investment nancial physical 1 Demand for goods and services a function of tastes and preferences substitutes and relative prices Demand for physical investment expected pro ts purchase price interest rates taxes etc Demand for nancial investment interest rates 2 3 Their demand for our currency re ects our exports 2 Supply of a foreign currency is a mction of their demand for our goods services and investment They supply their currency as they demand US dollars Our supply of our currency re ects our imports 3 Supply demand intersection determines dollar price of foreign currency ie the buying and selling of currencies determines exchange rates Shifts in demand and supply mctions 2 and 3 above lead to changes in the dollar price of foreign currency 1 As FC increases dollar depreciates more dollars to purchase same amount of FC 2 As FC decreases dollar appreciates less dollars to purchase same amount of FC Multilateral Exchange Rates and Arbitrage 1 Suppose 1 2 DM and 1 DM 3 FF gt 1 6 FF a If 1 trading for 5 FF take 100 and sell it to buy 200 DM then buy 600 FF and convert that to 120 making money b Alternatively take 100 and buy 500 FF then buy 16666 DM and convert that to 8333 losing money 2 hi the FF market in 1 above arbitreurs are selling their FF to get undervalued thereby bidding up the value of the and driving down the value of the FF hi the FF market in 2 the opposite is happening E A change in the money supply affects exchange rates indirectly 1 As M increases P increases in ation decreases demand for US goods services and investment depreciating the dollar 2 As M increases US interest rate falls decreasing foreign demand for US nancial instruments 3 Hence increasing US money supply leads to depreciation II A BRIEF MONETARY HISTORY A Precious Metals weighing out gold and silver 1 Goods saddles blankets and services blacksmith doctor are paid for in gold and silver bullion Price specie ow as an automatic adjustment mechanism a All prices quoted in goldsilver b Exporting country has gold in ow prices in ate becomes too expensive c Importing country has gold out ow de ation more competitive internationally B The Gold Standard 18801914 1 One UK pound sterling contained 113 grains of pure gold One US gold dollar contained 2322 grains of pure gold Therefore 487 US dollars equaled one UK pound sterling boom 391 WC Standardized coinage gt This is known as mint parity Note 487 113 divided by 2322 Under gold standard specie ow mechanism gold is the money supply a With exports gold ows in prices in ate exports dry up b With imports gold ows out prices de ate imports dry up c Major problems 1 Sterilization not allowing prices to in ate 2 No nation had control of its money supply 3 World commerce was at the mercy of gold discoveries 4 Constant price uctuations up and down The Gold Exchange Standard 19471971 1 Bretton Woods New Hampshire 1946 a The International Monetary Fund IMF b Standard Drawing Rights SDRs c Because of WWII and problems with gold became central exchange currency 1 All currencies tied to dollar dollars exchange for gold 35 1 ounce gold a Other currencies exchange for dollars 1 British pound 240 b Thus 146 British pounds 35 24 would buy 1 ounce gold 2 Other nations buy and sell dollars to hold rates stable 3 Change in rates only with quotfundamental disequilibriumquot 4 Unfortunately only devaluations occurred because only deficits were painful 5 Speculation was quotwith the windquot sell weak currencies Flexible or Floating Exchange Rates 1971 present Fixed Pegged Exchange Rates 1 Fixed pegged exchange rates are rates that are fixed with respect to a larger currency and do not change except by government order devaluation revaluation Used by smaller countries smaller currencies many LDCs Why pegged exchange rates a Risk reduction stability b Transactions costs The ultimate xed exchange rate One currency III EXCHANGE RATE IMPACTS ON TRADE A depreciation means lower US imports Our import price is FC FC depreciation is rise in FC higher import price B depreciation means higher US exports their import price yen is price FC depreciation is lower FC lower yen price C Exchange rate changes have no impacts on domestic demand and supply mctions Prices change due to demand or supply shifts IV RECENT INTERNATIONAL EVENTS A Introduction of the Euro January 1 1999 NOTE EC France Germany Italy BeNeLux 1958 United Kingdom Denmark Ireland 1973 Greece 1981 Spain Portugal 1986 Austria Finland Sweden 1995 Under consideration Poland Czechia Hungary Conspicuously absent Switzerland Norway 1 A European common currency a Eleven countries of 15 have agreed to fix their currency exchange rates to a common currency the EURO b United Kingdom Denmark Sweden opted out Greece did not meet the convergence criteria 1 In ation lt 15 percent above average of 3 EC lowest 2 Interest rates lt 2 points above same three in 1 above 3 Budget de cits lt 3 percent of GDP 4 Debt lt 60 percent of GDP c Introduced 1199 at 1311669 EUR or 08566 EUR39 d Today 22800 10259 EUR or 09744 EUR 2 Good Internet sites httpwwwoandacom httpwwwecbinthomeeurofxrefhtm B The Asian Currency Crisis 1 Longstanding problems Russia Japan 2 July 2 1997 Devaluation of the Thai bhat Then followed Indonesia South Korea Philippines Malaysia Taiwan Hong Kong Singapore 3 Largely unnoticed in US until August 31 1998 512 point drop in DowJ ones index gt20 down from July 17 peak The problem Currency overvaluation excess investment a Too much foreign money looking for bigger returns b Corruption and a lack of oversight resulted in a reverse dollar ow back into US assets stocks mutual mds 4 VI 3 391 ram Balance of Payments The Bookkeeping 1 Exports are Credited dollar demand Exchange rate strengthening 2 Imports are Debited dollar supply Exchange rate weakening The Balances 1 Balance on merchandise trade 2 Balance on goods and services 3 Balance on current account Capital Account 1 With doubleentry bookkeeping CURRENT account CAPITAL account 0 2 Autonomous vs accomodating entries a Autonomous entries are investment demands b Accommodating entries are payments for goods services Government 1 The Of cial Settlements Balance 2 The only accurate account Generally associated with xed or quotpeggedquot exchange rates De cits in the Balance of Payments Intervention for temporary de cits Price de ation Reduce aggregate demand with restrictive monetary amp scal policies Raise interest rates to attract foreign capital Devaluation for persistent de cits P PP P Chapter 9 Economic Instability Keynes Critique of the SelfRegulating Economy I Keynes Problems with Classical Theory A Say s Law Supply creates its own demand implied that there could never be demand de ciencies because individuals produce goods only to ful ll their consumption desires Furthermore if consumption fell off and savings increased then interest rates would fall and increased investment would make up for the decreased consumption gtKeynes maintained that there was nothing sacred about a particular level of total expenditures If consumption fell and savings increased by X investment might increase by less or by more than X Savings and investment were dependent on more than just the one variable the interest rate He thought savings was more a mction of income than of the interest rate and that investment was a mction of animal spirits and that investment was particularly driven by business expectations of pro t and general economic activity B Wage rates are exible downward if cyclical unemployment is present gtKeynes maintained that wages were in exible downward that employees and their labor unions naturally resisted wage rate cuts Keynes followers NeoKeynesians have also added longterm labor contracts and ef ciency wage models as further reasons for why wages are in exible downward This latter point simply means that wages and productivity are positively related pay a worker more and the worker will work better A wage cut is a recipe for disaster see the Henry Ford example p 211 C Prices are exible downward if surpluses are present gtKeynes maintained that there were noncompetitive elements in the economy such as monopolistic or oligopolistic rms that prevented prices om falling D Is it simply a question of time that the economy will adjust sometime gtKeynes maintained that the world was mired in a Great Depression and that there was no foreseeable end in sight His major work The General Theon of Employment Income and Money was published in 1936 II The Keynesian Framework assumes constant prices no international or monetary sector A Total I 1 J t 1 I Government purchases 1 Consumption as a mction of Disposable Income C C0 MPC kYU1 a C0 is autonomous consumption in contrast to induced consumption b Ya1 is disposable income income net of taxes c MPC is the marginal propensity to consume AC Ayu1 2 Consumption will increase with increases in C0 MPC or Yd 3 Savings is equal to Disposable Income less Consumption S Ya1 C a MPC MPS 1 b Savings is also a mction of Disposable Income If S Ya1 C and C C0 MPCYd then S YdC gtS YdC0MPCYd gtS C0l1MPCYU1 B Total Expenditures as a mction of Disposable Income 1 TE C 1 G 2 C is a positivelysloped function of Yd and I and G are invariant wrt changes in Yd Then TE is a positivelysloped function of Yd with a vertical intercept of C0 IG Total Expenditures TE and Total Production TP RGDP 1 Three possible states of the economy a TE TP equilibrium TE gt TP disequilibrium inventory reduction TE lt TP disequilibrium inventory buildup Firms make optimal inventory decisions and automatically move to TE TP Diagrammatic Exhibit 6 p 218 1 TE as a positively sloped mction 2 TP measured as the 45 line horizontal values re ected to vertical values 9900 2 The Recessionary Gap revisited a It is possible to be at TE TP equilibrium at less than full employment RGDP with no tendency to change Why Wages and prices are rigid downward b With no selfcorrecting system in place there is a role for government policy The Multiplier 1 Autonomous independent of changes in RGDP vs induced spending 2 An increase in an autonomous spending item CO I G leads to an increase in RGDP that is greater than the original autonomous spending increase a The original increase is multiplied throughout the economy 1 Begin with increase in autonomous spending 2 This autonomous increase INDUCES an increase in consumption 3 The increased consumption induces a second round consumption increase 4 And a third round etc until the increase becomes negligible b Value of the multiplier m 1 1 MPC c The change in RGDP is equal to the autonomous increase times the multiplier 3 In reality multipliers are not so large 4 In ASAD framework Keynesian AS is horizontal 1 2 3 a There must be underutilized resources b Consumers must spend the full MPC increase c The process will take time The multiplier works in reverse also Autonomous decreases gt decreased RGDP Prices are constant Idle resources must be available No price movements with increased AD Canwill the private sector bring about a closure of the Recessionary Gap Chapter 17 International Trade A The Importance of Trade B The Basis for Trade general equilibrium two goods 1 Absolute Advantage Production superiority a Two linear PPFs one steep and one at 1 Calculate Opportunity Costs for each a Flat PPF is lower 0C for Horizontal good b Steep PPF is lower 0C for Vertical good Show production trade ratio a Pass steep ratio to at PPF and show gain b Pass at ratio to steep PPF and show gain b Mutual gains from trade for intermediate trade ratio 2 Comparative Advantage Lower opportunity cost 3 Specialization and Exchange C International Trade in a SupplyDemand Framework partial equilibrium one good 1 Digression on Consumer Surplus and Producer Surplus a Consumer Surplus 1 Marginal Bene t Value Willingness to Pay Demand 2 Consumer surplus is value in excess of price a Consumer surplus for a given unit b Aggregation a Triangle bounded by Demand Price and Vertical axis b Producer Surplus 1 Marginal Cost minimum acceptable price Supply 2 Producer Surplus is selling price in excess of cost a Consumer surplus for a given unit b Aggregation a Triangle bounded by Supply Price and Vertical axis c Market Ef ciency 1 Where the sum of producer surplus and consumer surplus is maximized a At the equilibrium price b An invisible hand at work 2 Deadweight loss a From underproduction shorting production and charging more b From overproduction a subsidy to increase production 2 Total Demand Supply the Inrge Country assumption a Total Demand is equal to Domestic Demand plus Foreign Demand b Total Supply is equal to Domestic Supply plus Foreign Supply c Intersection of Total Demand and Total Supply is the equilibrium world trade price 3 The Small Country assumption a World market in the left panel domestic market in right panel b World market price passes into domestic market c At high prices an excess supply is made available as exports to other nations Quantities supplied consumed domestically exported d At low prices an excess demand is requested as imports from other nations Quantities demanded produced domestically imported 2 v D The Gains From Trade in a Partial Equilibrium SupplyDemand Context 1 Exporting nation a Producer surplus 1 Show calculate producer surplus at notrade price 2 Showcalculate producer surplus at freetrade price 3 There is a gain in producer surplus at the freetrade price Consumer surplus 1 Show calculate consumer surplus at notrade price 2 Showcalculate consumer surplus at freetrade price 3 There is a loss in consumer surplus at the eetrade price There is a net gain to the exporting nation 1 The gain in producer surplus exceeds the loss in consumer surplus 2 Gainers producers could compensate losers consumers and still be better off 2 Importing nation a Producer surplus 1 Show calculate producer surplus at notrade price 2 Showcalculate producer surplus at freetrade price 3 There is a loss in producer surplus at the freetrade price Consumer surplus 1 Show calculate consumer surplus at notrade price 2 Showcalculate consumer surplus at freetrade price 3 There is a gain in consumer surplus at the freetrade price There is a net gain to the importing nation 1 The gain in consumer surplus exceeds the loss in producer surplus 2 Gainers consumers could compensate losers producers and still be better off E Restrictions to Free Trade 1 Types of restrictions a b c c Quotas Tariffs Domestic policies Voluntary export restrictions 2 Impacts of restrictions a On consumers b On domestic producers C On other industries E Alg 1 2 3 4 5 ebra Low price nation exports lower opportunity costs high price nation imports World price will fall between US price Pu and foreign nation price Pf World price determined by setting the horizontal sum of the domestic demand functions equal to the horizontal sum of the domestic supply mctions Quantity traded Numerical Example Demand Supply Pe Excess Supply in exporter Imports US Qd 802P Q5 2021gt 802P 202P 41gt 100 P6 25 Sum of the demands 802P704P 10P PW 80 216 48 20 216 12 48 12 36 Excess Demand in importer Foreign Qd 704P Q5 102P 704P 102P 6P 60 P6 10 Sum of the supplies 202P102P 160 16 Q01 70 416 6 QS 10 216 42 Exports 42 6 36 Chapter 10 Taxes De cits Surpluses and the Public Debt I Your Paycheck A Gross vs Net pay B Taxes and other deductions 1 2 Withholding taxes Federal State Local Payroll taxes a Deducted from you Social Security 62 Medicare 145 b Employer matches 765 Total is 153 Self Employment tax Bene ts a Medicalhealth insurance including dental eye care etc pretax b Retirement Max out the employer matching Other a Savings b Charitable contributions c Judicial withholdings IRS alimonychild support C Types oftaxes 1 Progressive larger percentage taken out with higher earned income Our income tax system is designed as progressive 15 28 36 396 Proportional constant percentage taken out with higher earned income Also known as at tax Malcolm Forbes Regressive smaller percentage taken out with higher earned income Sales taxes Social Security lotteries and in reality federal income tax II Compound Interest and the Rule of 72 A Simple vs Compound Interest 1 2 3 Borrow 100 at 10 interest Simple interest is simply principal plus 10 each year 110 120 130 140 Compound interest is interest on interest 110 121 13310 14641 B The Rule of 72 stated The Rule of 72 will give you the number of years in which an original amount will double through compound interest growth Calculations 72 rate of interest number of years for doubling a Interest rate of 8 72 8 9 years of doubling time mortgage interest b Interest rate of 3 72 3 24 years of doubling time savings accounts c Interest rate of 18 72 18 4 years of doubling time credit card debt The Rule of 72 works for or against you If you39re loaning money to someone else it works for you shows how quickly you can double your money If you39re borrowing money it shows you how quickly your debt can double The Rule of 72 works for any item that has a consistent growth rate a Consider population growth rates of 1 or 2 or ZPG How quickly will populations double How many doublings in a century Infectious diseases the Center for Disease Control in Atlanta Cancer It s why doctors can say You ve got three months to live Retirement Bottom line the faster the growth rate the shorter the doubling time 9900 III Spending See text IV Be cits Surpluses and Debt A De nitions B De cit Issues 1 Cyclical vs Structural de cits 2 In ation 3 Capital budgeting 4 Fiscal Policy C The Public Debt 1 Public Debt vs Net Public Debt 2 Who owns the debt 3 The burden of the debt 4 Net debt debt compared to government assets V Social Security A Social Insurance Program A Established in 1935 amended since 1 More than just retirement Survivors bene ts plus disabled and their dependents 2 Medicare for Social Security recipients B Social Security Taxes and Bene ts 1 Social Security Taxes are REGRESSIVE a Workers pay only on the rst 80400 of their 2001 income b Only wage earnings are taxable 2 Social Security Bene ts are PROGRESSIVE a Higher replacement rate for lower income workers b Medicare bene ts are identical for all covered Social Security recipients C Problems and Issues 1 The longrun problem is an aging population especially babyboomers The number of retirees is growing faster and retiring earlier and earlier 2 Potential Solutions a Increased social security taxes Reduced bene ts Find another source of mding Increasing the normal retirement age Building up Trust Fund balances for baby boomer bene ts f Taxing Social Security retirement bene ts D Should Social Security be made voluntary NO it s a bad idea 1 Some people would opt out and we would still have to care for them welfare 2 Adverse selection 3 The poor can not afford private insurance E Social Security s treatment of women 1 The widow s income gap 2 Unfair treatment of working wives F Does Social Security Decrease Savings Only if the wealth effect more consumption during our working years exceeds the early retirement effect 9900 IV How Will You Retire Investing for Retirement A 1 Different types of investments primarily stocks vs bonds a Stocks re ect ownership to hold stocks is to own a share of a company 1 The stock marke NYSE buying and selling of stocks a Stocks increase and decrease in value Stocks can be either highrisk mediumrisk or lowrisk Highrisk stocks can have huge returns or you can lose it all examples include new companies especially overseas that can yield high returns or can quickly crash taking your money with it Low risk stocks include utilities wellestablished older companies like GE ATampT etc that will always be around b Additional items Options IPOs stock splits 2 Stock market indexes DowJones SampP 500 NASDAQ b Bonds re ect indebtedness If you own US Savings Bonds you are loaning the government money Likewise Corporate bonds Municipal bonds 1 Bonds always have 1 face value 2 maturity date 3 dividend payout 2 Premium is typically paid every six months You are paying today for the right to receive iture income Thus bonds are incomeyielding assets that are bought and sold in a secondary market like mortgages 3 Bonds are particularly attractive as retirement income c Mutual funds 1 Mutual Funds are investment vehicles that 1 are diversi ed 2 are professionally managed by an expert who buys and sells the assets in the fund and 3 have a large number of investors buying into the md 2 There are fundamentally two types of Mutual Funds Growth and Income Growth funds are heavily loaded with stocks income funds with bonds B Watching your money grow Future Value FV of a growth asset a Value of a growth asset in one year is FV PV1 r where FV iture value PV present value r interest rate b Value of a growth asset in N years is FV PV1 r n number of years c Value of 20000 at 4 interest in 5 years 20000 1045 2433306 That is if I loan 20000 at 4 interest in 5 years they d pay me 2433306 Present Value PV of a stream of iture income a The question If I am guaranteed a iture stream of income I win the lottery how much is that worth today b How much would you take today if I promised to pay you 100 in one year 100 gt100 lt100 c The calculation If FV PV1 r then PV FV 1 r In general If FV PV1 r then PV FV 1 rn d If someone says they will pay you 20000 in10 years they could put 12278 in the bank at 5 interest to get it The balance would be interest That is PV FV 1 rn 20000 10510 1227827 e To calculate a stream of income add up the discounted values for all N years PV FV 1 r0 FV 1 r1FV 1 r2 FV 1 rn Social Security bene ts calculation Go to W ssa gov Click on electronic publications top left compute your own bene t estimate bottom quick 62 xx000 currentin ated Chapter 10 Fiscal Policy I 1 gt 1 gt 1 Fiscal Policy A Budget Expenditures and Revenues B De ned Demand Side Fiscal Policy A Changes in Government Purchases and Taxes Effects on Aggregate Demand B Crowding Out 1 Impacts a On Consumption Direct b On Investment Indirect through the increase in the rate of interest c On Net Exports Indirect through the increase interest rates and exchange rates 2 Degree of completeness to what extent does crowding out occur p 236 Ex 2 a Zero none there is no crowding out b Incomplete partial there is some crowding out c Complete Government spending completely crowds out the sum of C I NX 3 New Classical view there is no change in the interest rate because consumers increase their savings in anticipation of later taxation increases to pay for G C Lags and the Effectiveness of Fiscal Policy 1 Data lag Getting the latest numbers 2 Wait and see lag Is it a transitory problem or is there a fix needed 3 Legislative lag Getting it through Congress 4 Transmission lag Implementing the legislation bids and contracts 5 Effectiveness lag Waiting for results D Theoretical impacts 1 For an increase in government spendingARGDP AG m the multiplier 2 For a decrease in taxation ARGDP AT MPCm MPC times the multiplier Supply Side Fiscal Policy A Marginal Tax Rates Does a tax decrease lead to less work more disposable income or more work higher cost of leisure greater opportunity costs Tax Rates and Revenues the I ffer Curve 1 Tax revenues will be zero with zero taxes or 100 taxes no one works 2 Presumably tax revenues will increase and then decrease with positive tax rates 3 Two questions a What is the shape of the curve heavy to the left or the right b Where are we on the curve 4 Supply side theory as scal policy suggests that we re on the down side of the curve that if we reduce taxes we will increase tax revenues